Inflation in a Developing Economy

Basically, inflation is supposed to occur after reaching the stage of full employment, for till that stage is reached an increase in effective demand and price level will,be followed by an increase in output, income and employment. It is after the stage of full employment when all men are employed that a rise in the price level will not be accompanied by an increase in production and employment. Theoretically, therefore, it is not possible to imagine an inflationary situation existing side by side with full employment. It is in this context that the question of inflation in a developing country, which has both widespread unemployment and underemployment is raised.

Bottlenecks of  Inflation

It is interesting to observe that Keynes himself visualized the possibility of an inflationary situation even before full employment was reached. Such a situation can arise even in advanced countries, if there are difficulties in perfect elasticity of supply of goods and services. It is possible that full employment is not reached but even then, there is no scope for increased production. The factors responsible for imperfect elasticity of supply are law of diminishing returns, absence of homogeneous factors and unemployed resources, which cannot be used to increase production. All these factors are lumped together and are known as bottlenecks. As monetary demand increases with the increase in money supply, supply of goods does not increase in proportion, due to imperfect elasticity. The difficulties or handicaps, which prevent supply from increasing in the face of rising demand, are also known as bottlenecks. The result is that the cost of production is pushed up and price level is raised. Apart from these, other bottlenecks of inflation are as follows:

  1. Market imperfections in developing countries, such as imperfect knowledge on the part of producers and consumers, mobility of factors, divisibility of factors and lack of specialization  All these are responsible for inefficient use of resources. There is, thus, imperfect elasticity of supply in a developing country.
  2. Developing countries face shortage of technical labor, capital, equipment and transport and power facilities. Therefore, these countries are unable to grow because  of these bottlenecks.
  3. Unemployment and underemployment are extensively present in a developing country. The existence of unemployment in the advanced country helps increase output, whenever there is increased demand. However, this is not so in a country with a large magnitude of disguised unemployment and open unemployment.
  4. Developing countries generally have high marginal propensity to consume. This factor prevents an increase in the supply of goods and services.
  5. A special feature of developing countries is that a large volume of primary production is exported. Therefore, the supply available for home consumption is reduced. The problem of inflationary rise in prices worsened whenever the income earned from exports is spent on domestic goods and not on imports.

Since World War II, many of the developing countries have started resorting to extensive borrowing from the banks and deficit financing with the idea of speeding up economic development. For one thing, much of this expenditure is on social and economic overheads, such as education, transport and power and on capital goods industries such as development of cement, iron and steel industry. This implies that there is an increase in the production of consumption goods. Therefore, the volume of purchasing power with the general public is increased, resulting in increased demand for consumption goods.

All these factors explain the existence of inflationary pressure in a developing country, even though the stage of full employment has not been reached. The existence of bottlenecks such as shortage of technical know-how and scarcity of capital equipment has worsened the various problems related to developing countries. It is, therefore, correct to use the concept of inflation even in developing countries, provided we remember the existence of special bottlenecks.

Credit: Managerial Economics-CU

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