Analysis of factors affecting inflation rate in Rwanda (1990-2009)

2.2 THEORETICAL FRAMEWORK

A great deal of economic literature concerns the determinants and causes of inflation, in which inflation's role in the economy has been at the center of economic studies and has been debated for a long time.

There are three main schools of thought which attempt to explain the main determinants of inflation. First, The classical which revolved around the quantity theory of money,

Blinder (2002), a representative of the second school of thought, the Keynesian economists, states that the main determinants of inflation are aggregate demand in the economy rather than the money supply.

Thirdly, the monetary approach led by Milton Friedman, Friedman and Schwartz (1970), who wrote an influential book on the monetary history of the United States, argue that "inflation is always and everywhere a monetary phenomenon". Whereas Neo-Keynesians and other critics of monetarism argue that the demand for money is directly linked to supply and that the demand for money cannot be predicted. Stiglitz and Greenwald (2003) have proposed that the relationship between inflation and money supply growth cannot be separated for ordinary inflation, in contrast to hyperinflation, which is mostly considered an effect of monetary policy.

A. Classical theory of inflation

The classical economists' view of inflation revolved around the quantity theory of money, and this theory was in turn derived form the Fisher Equation of Exchange.

According to Fisher's Formula, we how MV = PQ. Here M represents that the average number of currency in circulation during a certain period; V represents the velocity of money circulation; P represents the price index of goods and services and Q represents transaction volume of goods and services. Fisher recognized that V and Q are invariable because V is decided by social system and custom and Q is stable under the condition of sufficient employment. Therefore, to some extent, the formula means the Quantity Theory of Money (IBR, 2009:42).

Therefore the come to the conclusion that:

M P

In other words, increases in the money supply would lead to inflation. The message was simple: Control the money supply to control inflation.

B. Keynesian view of inflation

Keynes didn't agree with the classical economists. In fact the easiest way to look at Keynesian theory is to see the argument he gave for Classical theory being wrong. The key to the classical view of inflation was the Quantity Theory of Money. This theory revolved around the Fisher Equation of Exchange as we have seen above.

Keynes once again rejected this theory. He argued that increases in money supply would not inevitably lead to increases in inflation. Increasing M may instead lead to a decrease in V. in other words the average speed of circulation of money would fall because there was more of it about.

Alternatively, the increase in M may lead to an increased in T (Number of transactions), because Keynes disputes the assumption that the economy will find its own equilibrium. It may be in a position where there is insufficient demand for full employment and in that case increasing the money supply will fund extra demand and move the economy closer to full employment. Keynesians tend to argue that inflation is more likely to be cost-push inflation or from excess levels of demand. This is usually termed demand-pull inflation (Robert J. Gordon 1988: )

According to the Keynesians, the natural level of gross domestic product is a level of GDP where the economy is at its optimal level of production. If GDP increases beyond its natural level, inflation will accelerate as suppliers increase their prices. If GDP decreases below its natural level, inflation will decelerate as suppliers attempt to fill excess capacity by lowering prices.

Keynes argued that money has no significant relationship with inflation, but inflation is an outcome of the goods market. He proposed the "inflationary gap" model to explain the change in price level, (Keynes 1936). But Pigou (1949) rejected the inflationary gap theory. He placed attributed inflation to the increase in money income. According to Pigou, inflation exists when money income increases more than the income earning capacity.

The most popular neo-classical economic critique of Keynesian economic theory is by Lucas (1976), who argues that rational expectations will defeat any monetary or fiscal policy. The new Keynesian argument is that this critique only applies if the economy has a unique equilibrium at full employment, and that rational expectations models do not produce any simple result. They claim that because of price stickiness, there are a variety of possible equilibriums in the short run.

C. Monetarists' theory of inflation

Much of the Monetarists' theory is a development of earlier Classical theoretical work. Their main contribution is in updating many of these ideas to fit them into a more modern context.

Classical economists suggested that V would be relatively stable and T would (as we have seen above) always tend to full employment. Friedman developed this and tested it further, coming to the conclusion that V and T were both independently determined in the long-run. The conclusion from this was that:

M P

If the money supply grew faster than the underlying growth rate of output there would be inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment.

Apart from the above schools of thought which was undertaken to explain the main determinants of inflation, other theories have been illustrated

Balance of payments and forcing a depreciation of the exchange rate, The interactions between fiscal policy and inflation are particularly highlighted in Razin and Sadka (1978:239) and Bruno and Fisher (1990: 353). This category indicates the change in money supply and real exchange rate as sources of the inflation

Henry Hazlitt (1978:111) believes that one of the reasons why inflation is persistently advocated by Keynesians and others is that it is thought to increase the profitability of business. This is, in fact, an essential part of the argument of those who believe that inflation tends to bring full employment. By improving the outlook for profits, it leads enterprises to start new businesses or to expand old businesses, and therefore to take on more workers.