Role of Inflation in the Economic Development of a Country

Read this article to learn about the crucial role of inflation in economic development of a country.

An unnecessary controversy has come to revolve round the idea whether inflation helps or hinders economic development. It is not possible to attempt a categorical reply.

However, one thing is certain that in the fundamental equation Y = C + I, if the level of income (Y) is to be raised, the level of investment (I) has to be raised [because, it is not possible to increase consumption (C) unless Y is raised]. Hence a case for inflationary finance is generally made.

The policy of ‘mild inflation’ either through public or private agencies, becomes absolutely essential for the mobilization of resources and for breaking what we call ‘vicious circle of poverty. Maurice Dobb remarks, “inducements are necessary for large-scale movements of labour and for increased supplies of foodstuffs and raw materials to be made available by the village for the town.”

Prof. Kaldor has also pointed out that “a slow and steady rate of inflation provides a most powerful aid to the attainment of a steady rate of economic progress.” Prof. Robertson has also favoured a policy of raising price level. Such a policy of slow and steady inflation is particularly significant in underdeveloped economies, where a great part of the labour force is self-employed and price incentives (through mild inflation) assume greater importance, than wage incentives (at least in the initial stages of breakthrough).

Prof. W.W. Rostow has maintained that several ‘take off processes were assisted by inflation. In the view of Hamilton, inflation has been a powerful stimulant in a large number of historical instances and could perform a similar function in underdeveloped countries. Keynes also spoke in favour of profit inflation’ in his Treatise on Money. The advocates of development through inflation hold that such a policy is fruitful for capital formation through the redistributive effects of inflation in favour of the rich class, having a higher propensity to save and invest than the poor, and to divert the disguised unemployed labour to industry.

These and many other economists believe that a mild or creeping inflation is not necessarily an undesirable thing because the alternative to this is unemployment and impaired economic growth. They argue that since prices are flexible only in the upward direction in our present institutional set up, resource allocation through the price system must operate through price increases in the areas of the economy that are growing rather than through price decrease in areas that are stagnating.

They argue that the monopoly power of unions and enterprises is such that price increases are inevitable and, therefore, it is better for the authorities not to follow deflationary policies which might cause unemployment rather than a fall in price level. Thus, a mild or creeping inflation helps economic development by creating favourable profit expectations amongst businessmen. Prof. Lewis feels that inflation for purpose of creating useful capital is often ultimately self-termination, since sooner or later it is likely to result in an increased supply of goods to the market.

There are other economists who put forward overriding objection. They fear that inflation instead of being ‘self-destructive’ may also become ‘self-cumulative’. ‘Demand pull’ inflation, according to them, may degenerate into ‘cost-push’ inflation and may hinder rather than help economic development. They argue that the resources could be mobilized by direct measures as well, without resorting to inflation. Milton Friedman, for example, totally disagrees with the policy of ‘development through inflation’ more so in developing economies. He does not agree with the argument that inflation will tend to stimulate development through its redistributive effects. According to him, it is a mistake to consider deficit financing, or printing money, as a source of revenue distinct from taxation and borrowings.

It is useful to realize that there exists a two-way relationship between price change (inflation) and economic development. The latter affects the behaviour of prices and price changes affect the rate of economic development. Research and empirical studies have not been able to establish any direct or consistent correlation between the two. One study points out that “even if some consistent statistical relationship could be established between price changes and rates of economic growth, this relationship would not justify any definite conclusion about causation.”

It is not possible to say with certainty which is the independent and which the dependent variable is. The studies have revealed no systematic relationship between price changes (inflation) and rate of growth. The relationship, if any, has been different from country to country; where the two were inversely related in Germany and Japan, they moved together in Sweeden and Canada.

Despite this doubt about the exact relationship between inflation and economic growth, all evidence tends to suggest that in an underdeveloped country, which has followed a consistent policy of inflationary finance, the process of capital formation and economic growth have been adversely affected. Our conclusion, therefore, is that while there seems to be some case, at least in the short- run, in favour of inflationary finance for capital formation and economic growth; a policy of continuous inflation may do more harm than good especially in the face of ineffective and infant nature of fiscal and monetary policies that are adopted in less developed countries.

It is quite obvious that no text-book approach to money and inflation in developing economies will take us nearer solution. It is really surprising that the term ‘inflation’ has been misused even by those who should understand it better! As such it has been the cause of great muddle! If words are to be used with some accuracy it would imply ‘an increase in the quantity of money beyond the point necessary for full employment of resources. It does not mean merely rise in prices which has led to the fear complex and the urge to fight inflation as and when it appears without realizing its extent— and how an increase in the quantity of money is essential for full employment of resources.

To prefer stable prices to rising real income and living standards is to fall flat into the ancient ‘money illusion’— i.e., to treat the measuring rod as more important than what it measures and indeed to crucify the mankind on a cross of paper ! In modern industrial societies, full use of labour and capital equipment has not been possible without at least a slow rise in prices.

The historical and empirical evidence go to support this. During the last 25 years, except in West Germany in early 1950 and in USA in early 1960, no country has been able to achieve economic growth and price stability together. Apart from the debate that goes on between Friedmanites and anti-Friedmanites on the artificial question whether monetary or fiscal policy has greater effect on prices ; the least we can do is to avoid using frightful phrases like ‘fighting inflation’ and aiming at price stability because fighting inflation without appropriate incomes policy is a wild goose chase!