Chapter 6 The theoretical foundations of the stabilisation policy part 2

Outline:

01st The three most important alternative conceptions

02nd The basic statement of the quantity theory

03rd Political conclusions

04th The criticism of the quantity theory

05th The basic statement of the demand-oriented inflation theory

06th Political conclusions

07th The criticism of the demand-oriented inflation theory

08th Basic statements of the supply-oriented inflation theory

09th Political conclusions

10th The criticism of the supply-oriented inflation theory

06th Political conclusions

Which political conclusions were drawn from this demand-oriented inflation theory? Since the market process is not able to reduce excess demand on its own, it is necessary to reduce this by political means. The demand growth shall be limited to the potential supply growth. The following relationship is valid:

The price-increase rate (dP/P) corresponds to the difference between the increase in demand (dN/N) and the increase in supply (dA/A). This means that there is no risk of inflation precisely when supply and demand match. It is valid:

dP/P = O if d/N = dA/A

The stability success does not depend on the type of demand limitation (C, I, G-T, EX-IM), however. The state can achieve this effect by reducing previously granted transfer incomes or investment subsidies, by reducing its spending or raising tax rates, or finally by valorisation of its own currency, in order to ensure that its export surplus is reduced.

07th The criticism of the demand-oriented inflation theory

It is generally accepted that demand surpluses cause price increases. The claim for reducing demand surpluses is therefore undisputed. However, there are doubts as to whether price increases will only arise due to demand surpluses.

Stagflation phenomena confirm these doubts: There are price increases both in the upswing and in the downturn. Thus, in times of stagflation, price increases take place even if supply surpluses are present. This phenomenon can be explained by the fact that the fixed cost share determines the total unit costs.

In contrast to the variable unit costs, which increase at least from a critical limit on at increasing production, the fixed costs are characterised by the fact that at increasing production the average fixed costs decrease always. So, if there is a preponderance of the fixed costs, then in case of a production decline, the total unit costs will increase, and the entrepreneurs will endeavour to pass on these cost increases to the selling price.

The behaviour of the trade unions could also prevent a stability success. Suppose that the government wants to reduce the surplus demand by increasing the wage tax rates. In this case, the privately available wage income is reduced. The trade unions could now take this reduction in privately available wage income as an opportunity to enforce a compensation for this loss of income by demanding a corresponding increase in gross wage rates.

If they succeed in this endeavour, the consumption expenditures of the workers budgets will not fall, as it was hoped for by the government. The privately available wage income, which determines the level of consumer demand, has not declined. Since to the same extent to which the wage tax has been increased, the nominal wage income has been increased, too.

08th Basic statements of the supply-oriented inflation theory

Let us now turn to the supply-oriented inflation theory. According to this, cost increases are the most important cause of inflation processes. The starting point is a microeconomic analysis, whereby a price calculation for a single enterprise is assumed.

It is assumed that the individual enterprise bases its price calculation on the amount of the total unit costs and adds a customary profit mark-up. This profit mark-up is considered as constant in the short term and predefined.

p = K+g * K = K * ( 1 + g)

· p: price of an individual good

· K: unit costs

· g: percentage mark-up pricing.

By this, the traditional assumption of the neoclassical theory that the entrepreneur tries to maximise his profits is abandoned at least apparently. However, this assumption does not necessarily have to contradict the profit maximisation thesis. Namely, if we assume an entrepreneur who is in strong competition with other enterprises and therefore takes the price of the market as a price taker, the result is largely the same, whether it is assumed that the entrepreneur takes the entire price or only the profit premium of the market, provided that the unit costs of individual entrepreneurs are not significantly different.

However, if the unit costs differ to a great extent, the entrepreneur with the higher costs will certainly not be able to simply adopt the customary profit mark-up, otherwise most of his clients would switch to competitors.

Moreover, according to a suggestion by Erich Schneider, accepting the customary profit mark-up can also be understood simply as a first attempt to maximise the profit. If, in hindsight, it turns out that the market accepts a higher profit, then the entrepreneur will certainly correct his price calculation and charge a higher profit mark-up.

In a second step, a transfer of this microeconomic model to the entire national economy will take place now. This formula is not meant to explain the price of a single product, but rather to explain the price level as the average of all produced goods, and this price level depends firstly on the average unit cost of the real domestic product and secondly on the average profit mark-up of the entrepreneurs. Here, the amount of the real domestic product itself is a fictitious quantity, which is calculated by assuming the nominal domestic product and dividing it by the price level.

p = K + g * K = K * (1 + g)

· p: price level

· K : unit costs referred to the domestic product

· g : average percentage profit mark-up.

If we take this macroeconomic equation as a basis, then the price level cannot merely increase if individual costs or profit mark-ups increase. Structural relocations from the industries with low unit costs to those industries of high unit costs or from industries of low profit mark-ups to high profit mark-ups may also be responsible for a rise in the price level. For example, if unit costs would remain constant in all industries, but the share of the industry with the higher unit costs would increase, then the price level would increase.

09th Political conclusions

Political conclusions from the supply-oriented inflation theory were drawn especially for the wage policy of the collective bargaining partners. A productivity-oriented wage policy is demanded, and thereby the claim is understood that the standard wages negotiated by the tariff partners should be oriented to the increase of the labour productivity. Thus, if labour productivity increased by 2% in a certain year, then collectively agreed wages on average should not increase more than 2% during this period.

Here, this aim can be achieved in two ways. Either collectively agreed wages in all sectors are rising just by the amount of this increase in the overall labour productivity, or the collectively agreed wages are oriented in each industry on the growth in the industry-related labour productivity. In this case, too, the average (collectively agreed) wage increase of the entire economy corresponds just to the overall productivity increase.

However, even if the bargaining partners kept strictly to this demand for a productivity-oriented inflation theory, it cannot be expected that the wages will effectively be limited by the increase in labour productivity. We must assume namely that the enterprises, in addition to the collectively agreed wages, also grant extra payments which are above the pay scale, that is, sometimes pay a higher wage to the employees than it was agreed in the collective agreements.

Several factors are responsible for these deviations. Already from the fact that the official statistics sometimes cannot consider all wage supplements, the wage level indicated in the official wage statistics is too low. But since these wage components are considered in the statistics on the effective earnings, the extra payments which are above the pay scale are shown as too high at the same time.

Actual differences between the collective wage level and the effective wage level arise, however, above all from the fact that the individual enterprises often provide more wage classes than agreed in the collective agreement. Suppose that a collective agreement distinguishes between three wage classes with different pay rates, but that an enterprise regards as desirable to differentiate between 6 wage classes because of different performance profiles. Whereat, for example, each wage class is subdivided into two subgroups.

Since the collective wage represents a minimum wage, thus is to be paid also to every union-organised employee of a class, the enterprise can only provide for two subclasses, if it grants beyond the standard wage for one of the two subgroups an extra payment which is above the pay scale.

The enterprises often see themselves forced to pay a little more than the standard wage because they were only able to recruit certain employees by paying a wage above the pay scale.

The fact that the actual wage level exceeds the standard wage level in normal periods, however, makes it possible for the enterprises to achieve also that the effective earnings will rise less than the standard wages at certain times. Such a reduction in this gap results just from the fact that enterprises can also withdraw them again, since the wage subsidies are voluntary.

The fact that the average effective earnings level can sometimes also be below the average standard wage level is furthermore because, legally speaking, only employees in trade unions are entitled to the collective wage, but a mayor part of the employees does not belong to any trade union.

Although far more than half of the employees do not belong to a trade union, however, in practice the differences between the standard wage and the level of the effective earnings are not as great as one might expect, since a major part of entrepreneurs grants the collectively agreed wages also to the employees who are not organised.

Employers do this for one side because they can only obtain internal peace if within an enterprise the same wage is paid for equal performance. On the other side, entrepreneurs know that if wages were differentiated, employees would have much more incentive to join the union.

The demand that wage rates should be raised only to the extent of productivity increase, results directly from the demand for monetary stability. The price level remains actually - assuming a supply-oriented inflation theory - only constant if the unit costs also remain constant at constant profit mark-ups. However, the unit costs only remain constant if the ratio between wage rate (l) and labour productivity remains unchanged. The formula applies:

Now, if the changes in the wage rates are limited as a percentage (dl/l) to the percentage price increases (dp/p), then the unit costs (K/X) also remain constant and with them the price level P:

If dl/l = dp/p, then K/X and P constant

Incidentally, similar conclusions can also be drawn with a demand-oriented inflation theory:

If the increase in demand (dN) is limited to the increase in the production of goods (dX), then the price level P remains constant also here:

if dN = dX, then P constant

If we additionally assume now that the consumption rate (c) and the number of working hours per employee (a) remain constant, the following applies:

· X = supply of goods

· N = demand for goods

· a = amount of working hours

· l = wage rate

· c = consumption rate

This means, however, that whenever the percentage increase in wage rate equals the percentage increase in labour productivity, no inflationary tendencies emanate from the wage side.

The most important difference between supply-oriented and demand-oriented inflation theory consists now in the following: investment wages only have an inflationary effect at a supply-oriented view.

In the case of a supply-oriented view, the following applies: the growth in the investment wage increases the unit costs, but if the unit costs rise, the price level rises, too.

In the case of demand-oriented analysis applies conversely: an increase in the investment wage does not affect the demand. But since within this theory the price level rises only if the demand overhang increases, too, in this case no inflationary effect takes place.

10th The criticism of the supply-oriented inflation theory

The main criticism of a supply-oriented inflation theory consists therein that no satisfactory theory about the importance of supply and demand factors is formulated here. The importance of these two factors depends primarily on the economic situation. Thus, demand increases are raising prices in the economic boom. The fixed costs also play a certain part in this. At stagflation, a decline in demand due to high fixed costs leads to price increases, too.

The difference between the two inflation theories can also be seen in the fact that the supply theory is reasoning statically but the demand theory is reasoning dynamically:

In a static view, it is only asked which data changes lead to price variations ultimately. But how this process of a price variation takes place remains unanswered.

A data change shifts e.g. the supply (costs) curve to the left-up and causes a price increase in the equilibrium.

In the dynamic model, the increase of the cost curve at initially equal prices triggers an excess demand. This excess demand itself leads in turn to price increases. These price increases eventually cause the reduction of the excess demand.