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Why inflation is not relative price-neutral for primary products
World Development, 1977, Vol. 5, No. 8, pp. 707 713. Pergamon Press. Printed in Great Britain.
Why Inflation is Not Relative Price-Neutral for Primary Products JOHN
SPRAOS*
Uttil'ersity College, L o n d o n Summary. Studies of inflation tend to neglect relative prices although it has long been known (and recently confirmed) that relative price changes are more pronounced in periods of severe inflation. This paper advances the hypothesis that for the developing countries' primary products the distinction between demand and cost inflation is important: the former will improve the relative price of primary products; the latter will cause them to deteriorate if the cost inflation originates in developed countries. In the long run these effects may be cancelled out but not before they have lasted long enough to merit our attention.
This p a p e r argues t h e case against the view that i n f l a t i o n raises all prices p r o p o r t i o n a t e l y and t h a t it is t h e r e f o r e u n n e c e s s a r y , and even intellectually disreputable, t o e n q u i r e h o w the relative prices o f primary c o m m o d i t i e s will be a f f e c t e d by it. This is n o t t o say t h a t it is easy to p r e d i c t a priori the direction o f relative price m o v e m e n t s . T h e r e are m o r e t h a n one kind o f i n f l a t i o n and c i r c u m s t a n c e s differ b e t w e e n one p r i m a r y c o m m o d i t y and a n o t h e r ; t h e b e s t t h a t one can t h e r e f o r e h o p e t o do at a t h e o r e t i c a l level is to outline s o m e o f the factors w h i c h may be e x p e c t e d to p u s h one way or the o t h e r and try to discern any s y s t e m a t i c influence at work. The f o c u s will be on prihaary c o m m o d i t i e s o f m a j o r i n t e r e s t to d e v e l o p i n g c o u n t r i e s relatively to m a n u f a c t u r e s o f d e v e l o p e d countries. Relative price changes o c c u r all the time. We are i n t e r e s t e d here in changes over and above these, changes a t t r i b u t a b l e wholly t o inflation.
i n c o m e s do keep rising in t h e same p r o p o r t i o n ( w h i c h requires inter alia p e r f e c t a n t i c i p a t i o n of the realized i n f l a t i o n rate by all i n d e p e n d e n t e c o n o m i c u n i t s and b o t h the desire and ability to adjust t o it w i t h insignificant lags), the equilibrium values o f q u a n t i t i e s and relative
I. C O N D I T I O N S F O R U N C H A N G E D R E L A T I V E PRICES If q u a n t i t y d e m a n d e d o f each g o o d r e m a i n s u n c h a n g e d w h e n all g o o d s prices and m o n e y i n c o m e s rise in the same p r o p o r t i o n (in m a t h e matical jargon: if d e m a n d f u n c t i o n s are h o m o g e n e o u s o f degree zero in prices and i n c o m e s ) and if q u a n t i t y s u p p l i e d o f each g o o d remains u n c h a n g e d w h e n all g o o d s prices and f a c t o r prices rise in t h e same p r o p o r t i o n (supply f u n c t i o n s h o m o g e n e o u s o f degree zero) and if all g o o d s prices, f a c t o r prices and o t h e r m o n e y
* A revised version of a paper written in 1974 at the invitation of the World Bank following a World Banksponsored conference at Merton College, Oxford in October 1973 where it was argued by some participants that inflation, being a monetary phenomenon, was related to the absolute price level and would be expected not to affect any relative prices, be they prices of primary products or any other. Viewed as a hypothesis about the short-run, this has recently been refuted by D. R. Vining and T. C. Elbertowski ('The relationship between relative prices and the general price level', American Economic Review Vol. 66 (September 1976) pp. 699-708) who find that high inflation rates in the United States are associated with a significantly larger variance of relative prices than low inflation rates. The present paper complements this finding by advancing (in the context of primary products) some theoretical considerations for not accepting the hypothesis that inflation is relative price-neutral in the short or medium run. There is an alternative view, founded on the writings of Prebisch, that inflation in developed countries can cause a virtually bottomless deterioration in the terms of trade of primary products over the long run. This gained support among developing countries in 1974-5, when high inflation rates in developed countries coincided with a drastic fall in the relative prices of primary products in which developing countries are most interested. This is not a tenable view either. Thanks are due to the World Bank for releasing the copyright of this paper though, needless to say, it must not be assumed to share any of the views expressed herein.
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prices for all goods will remain unchanged when there is a general inflation.
II. I M P L A U S I B I L I T Y OF THE C O N D I T I O N S A mere e n u m e r a t i o n of the conditions for unchanged relative prices leads one to rehlize that they are liable not to be satisfied at various points. (a) Not all incomes rise in the same proportion in an inflation: (i) the relation between wages and profits alters; (ii) the relation b e t w e e n wages and ' f i x e d ' incomes alters; (iiD the shares of different groups of workers (including the unemployed) alter; (iv) the shares in world i n c o m e of various groups of countries alter. (b) Not all goods prices rise in the same proportion: (i) they have different degrees of stickiness; (iit they are subject to varying nonmarket influences (oligopolistic price making, cartelization, marketing boards, g o v e r n m e n t regulations, international commodity agreements); (iii) the prices of factors engaged in their p r o d u c t i o n do not rise uniformly ; (iv) p r o d u c t i o n takes place in a variety of countries whose costs are subject to a variety of national influences which are not exactly offset by exchange rate m o v e m e n t s . (c) The d e m a n d functions are not h o m o geneous of degree zero in prices and incomes: (i) decisions to buy are influenced also by assets and liabilities some of which are d e n o m i n a t e d in fixed m o n e y terms and such assets and liabilities w o u l d not be e x p e c t e d to cancel out when s u m m e d over the buyers of any one c o m m o d i t y ; (ii) variable price assets m o v e inversely with the rate of inflation if they bear a fixed interest, and this may be true also of equities in a costpush inflation if g o v e r n m e n t price controls or liquidity squeezes or other restrictive measures of demand management become more severe as the rate of inflation increases;
(iii)
many primary c o m m o d i t i e s lend themselves to hedging and speculation but in different degrees they differ inter alia in durability and ease of grading and storage. (d) The supply functions are not honlogeneous of degree zero in own market price, prices of other goods and prices of factors: (i) marketing boards interpose a variable wedge between market price and price received by producers; (ii) firms have debts fixed in m o n e y terms~ (iii) there are different capital intensities between one industry and a n o t h e r so that short-run m o n e y marginal costs are unequally affected by a p r o p o r t i o n a l rise in all m o n e y wages. A few concrete illustrations of the above from the episode of accelerating inflation and rapidly rising primary product prices in the period 1973 4 should suffice. In Ghana, the d o m i n a n t cocoa p r o d u c e r in the world, the cocoa marketing board has not allowed the price received by producers to keep pace with the rise of cocoa prices in world markets. In Malaysia, the d o m i n a n t natural rubber p r o d u c e r in the world, m o n e y wages of plantation workers did not keep pace with increases in the price of the basket of goods they purchase let alone the price of rubber. In industrialized countries, prices not only of bonds but of equities also were falling as inflation rates were reaching u n p r e c e d e n t e d post-World War 11 peaks in 1973 4. The share of profits and of high-income individuals was being squeezed between restrictive d e m a n d m a n a g e m e n t and trade union pressure or by the operation of incomes policies. A major redistribution of world i n c o m e t o o k place with the jacking up of oil prices in 1973. It is obviously possible to extend at length this e n u m e r a t i o n of violations of the conditions for unchanged relative prices. But it might be argued that the violations are r a n d o m and that they cancel each o t h e r out. It is therefore useful to make an a t t e m p t at identifying some of the influences that may be e x p e c t e d to be m o r e d o m i n a n t in the c o n t e x t of primary p r o d u c t prices relatively to manufactures.
111. D E M A N D I N F L A T I O N For this purpose it is essential to distinguish between demand-initiated and cost-initiated
INFLATION AND PRIMARY PRODUCTS inflation. The f o r m e r will be taken first. Think of it as a Keynesian excess d e m a n d abetted by a c c o m m o d a t i n g m o n e t a r y management. At the start it consists of all-round and world-wide excess d e m a n d ; if excess d e m a n d were sectorally biased right f r o m the beginning, we would not be picking up pure inflation effects on relative prices. The initial rate of increase of prices will differ b e t w e e n goods according to their degree of flexibility. For a variety of well-known reasons, primary p r o d u c t prices are more responsive to excess d e m a n d t h a n the prices of m a n u f a c t u r e d goods. The prices of primary p r o d u c t s will therefore rise faster than those of manufactures. R o u n d 1 thus benefits the primary producers. In R o u n d 2 the change in relative prices channels the excess demand p r e d o m i n a n t l y to the m a n u f a c t u r i n g sector and, as the built-in inflexibilities in the pricing of manufactures are gradually eroded, a catching-up process starts. If the rate of inflation is low, the erosion of inflexibilities is slow and therefore the initial i m p r o v e m e n t in primary product prices more persistent. A high rate of inflation would be associated with a m o r e dramatic but shorterlived relative price i m p r o v e m e n t . The speed of response of m o n e y wages in manufacturing will be material here. Resistance to a fall in real wages would be e x p e c t e d to be generated more quickly than resistance to real wages which fail to keep up with labour productivity but nevertheless grow absolutely. Thus if the relative price rise in primary product prices occurs against a background of slow or zero m a n u f a c t u r i n g productivity growth (implying a fall in m a n u f a c t u r i n g real wages) the catching up by manufacturing prices will be speeded up. R o u n d 3, let us suppose, sees the end of inflation, with a level of e c o n o m i c activity comparable to that of R o u n d 0 (the preinflation period). Aggregate excess demand is now back to zero. It could be argued that all relative prices will n o w end up where they would have been had the inflationary episode not intervened. This would be so if all real changes in the system were i n d e p e n d e n t of the time path taken. Historians must find this a shocking proposition, but it follows from the timelessness of d e m a n d and supply functions (and the underlying utility and p r o d u c t i o n functions) which economists typically assume. But only a very blinkered e c o n o m i s t will insist a outrance that each historical phase carries no influence over its successor. It does not take m u c h ingenuity to think of
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possible p a t h - d e p e n d e n t and not easily reversible changes which would cause R o u n d 3 to differ from R o u n d 0. One such change could be the diversion of capital to primary p r o d u c t i o n in R o u n d 1 w h e n inflation had raised the relative price of primary products. (Note, however, that, with excess demand in the system, the ultimate allocation of resources is not easily predictable because, in the general scramble, the random c o m p o n e n t in the resolution of c o m p e t i n g and incompatible claims will be substantial). A n o t h e r such change could be price-induced raw material-saving innovations or shifts of dietary habits. Both would have the effect of making the relative price of primary products lower in R o u n d 3 than in Round 0 as c o m p a r e d to what they w o u l d have been but for the inflation of Rounds 1 and 2. But we m u s t not exaggerate. Industryspecific capital c a n n o t m o v e from one industry to another overnight -- but, as it wears out, it need not be replaced. If price-induced changes in diet or in raw material c o n s u m p t i o n can occur in one direction when relative prices are as in R o u n d 1, they can occur in the opposite direction when relative prices are as in Round 3, though more slowly in the latter case if, as may be presumed, inflation-attributable relative price differences are less b e t w e e n Rounds 3 and 0 than they are b e t w e e n Rounds 1 and 0. So, one may conceive of a Round 4 in which the relative price effects traceable (in principle) to the inflationary interlude w o u l d have grown so small that they would be swamped (in practice) by the new historical setting created by unforeseen events in R o u n d 3. The economist who insists on neglecting the relative price effects of inflation c o m e s into his own in R o u n d 4, but he may be neglecting a large chunk of time. So far all primary c o m m o d i t i e s have been grouped together. But their prices are not going to change proportionately. The response of supply to the excess demand of R o u n d 1 will be different between one c o m m o d i t y and another according to how their short-run supply elasticities differ. On the demand side price elasticities will also differ b e t w e e n c o m m o d i t i e s and speculative d e m a n d will focus on the more durable and easily storable c o m m o d i t i e s as people switch out of inflationvulnerable assets. This latter element is in principle transient: the equilibrium stock of storable primary p r o d u c t s rises when the inflation rate reaches the p o i n t at which people take steps to hedge against it, but once the higher stock is attained the pressure on prices from this source will dry up. The same is true if
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the real rate of i n t e r e s t falls as a result of t h e m o n e y rate failing t o k e e p pace w i t h t h e price level. However, t h o u g h t r a n s i e n t in principle, the a d j u s t m e n t t o a h i g h e r s t o c k is n o t , t h a n k s to a variety of lags, a q u i c k o n c e - o v e r affair b u t m a y e x t e n d over a s u b s t a n t i a l period. Moreover, if t h e i n f l a t i o n accelerates or is m e r e l y e x p e c t e d to do so, the e q u i l i b r i u m s t o c k goes on increasing a n d this keeps tlae pressure of d e m a n d from this s o u r c e going. if i n f l a t i o n e r o d e s the real wages of w o r k e r s in s o m e p r i m a r y i n d u s t r i e s m o r e t h a n in o t h e r s (Malaysian r u b b e r , as cited earlier, is a case in point), then the products of these industries will e x p e r i e n c e a lesser increase in t h e i r price t h a n w o u l d have o t h e r w i s e b e e n t h e case since this is t a n t a m o u n t t o a r i g h t w a r d shift in t h e i r s u p p l y curve. If, o n t h e o t h e r h a n d , a c o m m o d i t y is s u b j e c t t o t h e c o m p u l s o r y i n t e r m e d i a t i o n of a m a r k e t i n g b o a r d w h i c h does n o t allow t h e m a r k e t price t o be fully r e f l e c t e d in t h e price paid to p r o d u c e r s (as w i t h c o c o a in G h a n a ) , the R o u n d 1 increase of c o c o a prices will be a c c e n t u a t e d because t h e p r a c t i c e restricts the m o v e m e n t up t h e s u p p l y curve t h a t corresp o n d s to any given rise in m a r k e t price. ( S h o u l d , h o w e v e r , the s u p p l y curve be ' b a c k ward b e n d i n g ' , t h e e f f e c t o f the m a r k e t i n g b o a r d p r a c t i c e w o u l d be t h e reverse: to lessen the u p w a r d pressure e x e r t e d by excess d e m a n d o n price.) The c o n c l u s i o n at this p o i n t is t h a t n o t o n l y s h o u l d o n e n o t e x p e c t d e m a n d - i n i t i a t e d inflation t o be relative p r i c e - n e u t r a l for p r i m a r y c o m m o d i t i e s as a w h o l e b u t also as b e t w e e n one p r i m a r y c o m m o d i t y a n d a n o t h e r , at least over a p e r i o d t h a t e x t e n d s up t o a p e r h a p s r e m o t e long-run. A m o r e specific c o n c l u s i o n m u s t o b v i o u s l y be s u b j e c t to s u b s t a n t i a l reservations, b u t b r o a d l y t h e p r e d i c t i o n is t h a t d e m a n d - i n i t i a t e d i n f l a t i o n will begin b y raising the price of p r i m a r y p r o d u c t s relatively to m a n u f a c t u r e s and t h a t some e l e m e n t o f this will r e m a i n u n t i l i n f l a t i o n slows d o w n . But if t h e r e b y m o r e resources b e c o m e c o m m i t t e d to p r i m a r y p r o d u c t i o n t h a n w o u l d have o t h e r w i s e b e e n the case, this s i t u a t i o n c o n t a i n s the seeds of its o w n reversal later on.
IV. C O S T I N F L A T I O N In a c o s t - i n i t i a t e d i n f l a t i o n t h e r e is n o excess d e m a n d in R o u n d 1. The i n f l a t i o n a r y p r o c e s s is s t a r t e d a n d t h e n k e p t going by a p u s h of wages a n d m a r k - u p s in excess o f p r o d u c t i v i t y g r o w t h in t h e d e v e l o p e d i n d u s t r i a l c o u n t r i e s . As before,
an a c c o m m o d a t i n g m o n e t a r y policy m a y be a s s u m e d in t h e b a c k g r o u n d . In this t y p e of i n f l a t i o n , by d e f i n i t i o n , the prices o f m a n u f a c t u r e d g o o d s will be the first to rise and a n initial l o w e r i n g of t h e relative prices o f p r i m a r y p r o d u c t s will occur. Once again, t h e r e f o r e , i n f l a t i o n will n o t be relative price-neutral: its effect o n p r i m a r y p r o d u c t s is n o w adverse, the o p p o s i t e of t h a t u n d e r d e m a n d - i n i t i a t e d inflation. T h e s i t u a t i o n is tha! w h i c h the Prebisch h y p o t h e s i s w o u l d lead o n e to expect. But the c o n s e q u e n c e of l o w e r relative prices will be to g e n e r a t e excess d e m a n d for p r i m a r y p r o d u c t s a n d in R o u n d 2, let us say, this will begin to e x e r t an u p w a r d pull o n t h o s e a m o n g p r i m a r y p r o d u c t prices w h i c h are c o m p e t i t i v e l y d e t e r m i n e d . ( T h e case of c a r t e l - d e t e r m i n e d p r i m a r y p r o d u c t prices will be t a k e n up in Section V). T h e r e will t h e r e f o r e be 11o c u m u l a tive d e t e r i o r a t i o n o f t h e i r relative price vis-d-vis m a u f a c t u r e s , but the R o u n d 1 d e t e r i o r a t i o n will be s u s t a i n e d so l o n g as cost i n f l a t i o n in d e v e l o p e d c o u n t r i e s c o n t i n u e s , for in t h a t case p r i m a r y p r o d u c t prices, t h o u g h rising, will lag o n e step b e h i n d all t h e t i m e (albeit a small step p e r h a p s , since p r i m a r y p r o d u c t prices are r e a s o n a b l y flexible). However, hedging a n d speculative activity c o m p l i c a t e s m a t t e r s . In a c o s t - i n i t i a t e d inflation, as in a d e m a n d - i n i t i a t e d one, there will be an a t t e m p t to s w i t c h o u t of i n f l a t i o n - v u l n e r a b l e assets and this will g e n e r a t e a d e m a n d for t h e easily s t o r a b l e p r i m a r y p r o d u c t s and m o r e p a r t i c u l a r l y for minerals, since these, being available in a finite s t o c k o n l y , are m o r e likely to e x p e r i e n c e a relative price rise over t i m e a n y w a y . F o r t h o s e p r i m a r y p r o d u c t s w h i c h are subject to this i n f l u e n c e , t h e Prebisch effect m a y t h e n be m o r e t h a n c o u n t e r a c t e d in w h i c h e v e n t t h e i r relative price vis-gl-vis m a n u f a c t u r e s will i m p r o v e . This will be r e i n f o r c e d if e q u i t i e s fail in t h e i r t r a d i t i o n a l i n f l a t i o n - h e d g i n g role, as t h e y are liable to do w h e n p r o f i t s are s q u e e z e d b e t w e e n wages p u s h i n g up a n d prices b e i n g held d o w n by g o v e r n m e n t c o n t r o l s . If an i n c o m e s policy is used by g o v e r n m e n t s and it succeeds in e l i m i n a t i n g i n f l a t i o n c o m pletely, we m o v e i n t o R o u n d 3 - a b o u t w h i c h m o r e later. If it o n l y slows d o w n i n f l a t i o n , t h e s t o r y of R o u n d 2 needs no a m e n d m e n t so far as relative prices are c o n c e r n e d , e x c e p t t h a t i n c o m e s policies t e n d t o a f f e c t i n c o m e distribut i o n and d e m a n d for p r i m a r y p r o d u c t s m a y be income distribution-sensitive. If g o v e r n m e n t s r e s p o n d t o cost i n f l a t i o n by r e s t r i c t i n g d e m a n d , we c o u l d have c o n t i n u i n g cost i n f l a t i o n ( t h o u g h p r e s u m a b l y at a s o m e -
INFLATION AND PRIMARY PRODUCTS what lower rate) combined with a depression in developed countries. The scenario of Round 2 would have to be amended accordingly. Demand restriction in the face of cost inflation is a third or fourth-best policy if not worse, but might be resorted to because of an incorrect diagnosis of the course of inflation (or doctrinal disbelief in cost inflation, which comes to the same thing) or, in developed countries with faster than average inflation, in order to correct balance-of-payments imbalances when the exchange rate cannot perform this role because of the feedback on costs. In any ,event, the effect of depression and unemployment in developed countries will be to lower the relative price of primary products. And if the depression is at all deep and prolonged, this is bound to outweigh the contrary effect from the buying of certain primary commodities for hedging purposes. The Prebisch effect would thus be reinforced - but also overshadowed because the industrial depression would be expected to be the stronger downward influence. We end up with a certain presumption that in Round 2, as in Round 1, of a cost-initiated inflation the price of primary products relative to manufactures will be lower than in Round 0 as compared to what it would have been in the absence of inflation. Let us now identify, once again, Round 3 with the cessation of inflation: average money income rises in proportion to average productivity and the level of economic activity is comparable to that of Round 0. As in the case of demand-initiated inflation, the semiirreversible changes which are inherited from the inflation of Rounds 1 and 2 may be expected to relate to changes in the stock of capital committed to primary production, changes in dietary habits and technological changes affecting the natural resource-intensity of industry. Only now all these things, having been influenced by the lowering of relative prices of primary products in Rounds 1 and 2, will decrease the supply of and increase the demand for primary products in Round 3 with the result - opposite to that of demandinitiated inflation - that the relative price of primary commodities will be subject to an inflation-attributable increase in Round 3 as compared with Round 0. This increase may not be very pronounced, but it is noteworthy that in any case a Prebisch-type deterioration of relative product prices will not survive beyond Rounds 1 and 2. It is equally noteworthy that the hypothesis that inflation is relative price-neutral is as open
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to challenge in the case of cost-initiated inflation as it is in the case of demand-initiated inflation. Only in some remote Round 4 (which needs no elaboration here because remarks analogous to those of the preceding section apply) could such a doctrine find some sustenance.
V. CARTEL1ZATION OF PRIMARY PRODUCTS AND COST INFLATION
Until recently the possibility of a sustained cost inflation emanating from the primaryproducing sector of the world economy would not have been deemed worth considering. The source of sustained cost inflation that we knew was the struggle between classes or groups in industrialized countries attempting to increase and defend respectively their share of aggregate income. In the bulk of primary production, and particularly in the part emanating from developing countries (with which this paper is concerned), labour is not suitably organized to engage effectively in such a struggle. However, the successful cartelization of oil since 1973 has changed this perception of the world. It is now possible to entertain seriously the possibility of a sustained cost inflation arising from a struggle for reapportionment of world income between primary-producing countries acting in concert (or a group of them such as the oil producers) and the manufacturing countries. Very schematically, this can be envisaged along the following lines. The primary producers cartelize and introduce a dramatic increase in price. Demand for primary products being price inelastic, this generates a big surplus in their current account but the whole surplus is used to acquire existing assets in the developed countries. In consequence the developed countries as a group do not have any immediate balance-of-payments or exchange rate problems. The fact that every developed country would not be expected to be in this comforting position unless very effective country-bycountry recycling of the primary producers' current account surplus takes place, is neglected for the present purpose. A Keynesian would say, however, that the developed countries do have a demand deficiency problem, the higher revenue of the primary producers having accrued to them at the expense of expenditure elsewhere. But, equally, a Keynesian would say that this could be offset by expenditureincreasing policy measures, since the balance of payments presents no constraint under the postulated circumstances. Let us then assume
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that Keynesian d e m a n d m a n a g e m e n t o f this kind is in operation. A monetarist, on the o t h e r hand, would say that there will be no d e m a n d deficiency provided the m o n e y supply rises by just enough to a c c o m m o d a t e the rise in the price level due to the increase in the price of primary products. Let such a m o n e t a r y policy be pursued so as to exclude an e c o n o m i c depression from the monetarist viewpoint also. The only substantial and i m m e d i a t e macroe c o n o m i c p r o b l e m that is left for developed countries from the rise in primary p r o d u c t prices is that real i n c o m e per head has been reduced, a fact which generates a reaction familiar to cost inflation models. Money wages are pushed up to c o m p e n s a t e for the loss of purchasing power. Prices of industrial goods then rise to c o m p e n s a t e for higher m o n e y costs and to defend the share of profits, which in turn leads to m o r e pushing up of m o n e y wages. If i n c o m e earners in developed countries insist on and succeed in raising m o n e y incomes by 1% for each 1% rise in the price level, the process is going to end only when prices of goods p r o d u c e d in developed countries rise by the same p r o p o r t i o n (give or take a few percentage points for things which have not been allowed for) as the increase in primary p r o d u c t prices which initiated the process. The primary producers will thus be back to square one. The current and capital accounts of the balance o f p a y m e n t s and everything else will bear no trace of any effects specifically attributable to the initial rise in primary p r o d u c t prices. But, of course, the primary producers' cartel, if it continues to hold, will n o t be satisfied at having its initial gain eroded by the rise in the price level of industrial goods. Before the erosion is c o m p l e t e it will raise the prices of primary p r o d u c t s and may well keep doing this to stay one step ahead of the prices of m a n u f a c t u r e d goods in a continuing world-wide cost inflation. In terms of the schematic ' r o u n d s ' of preceding sections, R o u n d 1 will see a large increase in the relative price of primary products. In R o u n d 2 prices of m a n u f a c t u r e d goods will do some catching up but this will be i n c o m p l e t e if the cartel retains its cohesion and keeps its nerve. If we allow for some primary p r o d u c t s being cartelized (oil) and others not, the story is only slightly different. As the relative price of non cartelized primary vis-gt-vis m a n u f a c t u r e s falls in the early part of R o u n d 2 (at the time when the price of manufactures begins to chase the price of oil), excess demand for non cartelized primary products will be generated and thereafter they will follow one step behind
the price of m a n u f a c t u r e s along the lines ol R o u n d 2 of the preceding section. An interesting question, but one not amenable to an a priori answer, is whether the c o n c e n t r a t i o n of increments of wealth in the hands of the oil-producing countries will affect tile demand for primary products as hedging assets. Does it make sense for oil-producing countries to diversify their natural wealth by selling some of their oil and investing the proceeds in o t h e r durable primary products? One reason which may point towards an affirmative answer is that, in contrast to alternative assets that the oil producers may acquire, they can transport stocks of primary p r o d u c t s to their o w n territories and thus put them out of easy reach of possible e c o n o m i c reprisals by developed countries a far-fetched but not utterly implausible scenario. In the course of R o u n d 2 we may expect g o v e r n m e n t s in developed countries to react against inflation. If this takes the form of an incomes policy which succeeds in keeping d o w n the growth of m o n e y incomes to less than 1% for each 1% rise in the price level, eventually cost inflation will c o m e to an end (in terms of the previous schema, R o u n d 3 will be reached) and the rise in the relative price o f cartelized primary p r o d u c t s will be consolidated. The price of beating inflation some price is unavoidable in the face of a successful priceraising cartel action is the acceptance of a substantial deterioration in the developed countries' terms of trade. If the policy reaction to inflation is to create d e m a n d deficiency by turning off, in part or in whole, the injections of aggregate d e m a n d needed to offset the d e m a n d which has been s y p h o n e d off (as Keynesians would have it) by the higher primary p r o d u c t prices, then we would have, at least for a time, cost inflation and industrial depression side-by-side. Such a situation was also envisaged in the preceding section, only now the industrial depression will not affect adversely the price of the cartelized primary p r o d u c t s if the cartel takes the reduced demand in its stride. (The cartel's profit maximizing price may not be u n a f f e c t e d by an industrial depression but there is no general p r e s u m p t i o n as to which way it will go.) A m o n g primary products, it will be the non cartelized ones that will experience a relative price decline. For the countries producing these, this is the worst situation of them all. Their terms of trade will suffer from a relative rise in the price of cartelized c o m m o d i t i e s bigger than the industrial countries and suffer also additionally from a relative rise in the price of manufactures. A n o t h e r way of looking at
INFLATION AND PRIMARY PRODUCTS this is that the price paid by developed countries for slowing down inflation, in so far as it relates to a terms of trade deterioration, is partially transferred to the developing countries which do not produce cartelized commodities. However, under this scenario, the price paid by developed countries also includes the loss of employment and output due to policyengineered depression. Moving to Round 3, in which, in keeping with the practice of preceding sections, inflation is no more and the level of economic activity is comparable to that of Round 0, the dominant feature will be the relative rise in the price of cartelized commodities, provided the cartel holds while priceqnduced substitution processes gradually mature and while sources of production beyond the reach of the cartel (in the developed countries' own territories) come 'on stream'. In the case of oil it is not likely that such developments will be substantial enough to threaten the cohesion and undermine the raison d'etre of the cartel in the foreseeable future. Should, however, the cartel perceive a serious threat from such developments, it could resort to price warfare occasional sharp price reductions to undermine the economics of rival operations. Some substitution is, however, inevitable and this may well help the relative price of non-cartelized commodities - for example, demand for cotton will benefit from the greater cost of petrochemicals used in the manufacture of artificial fibres. But note that all the relative price effects stressed in Round 3, which will also persist in the remoter Round 4, are the result of the cartel and not of the cost inflation of which the cartel was the initiator back in Round 1. Indeed, for all four Rounds, the pure inflation effects on the relative price of non-cartelized primary commodities will not be different from those of the cost inflation initiated in developed countries which was discussed in Section IV.
CONCLUSION The relative price effects of inflation are an
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unexplored territory and the only thing which can be asserted with confidence is that these will be substantial for as long as inflation lasts and for some time thereafter. The direction of relative price effects is more conjectural. The principal message of this paper is that in the context of primary products a systematic analysis of these effects must make a sharp distinction between demand-initiated and costinitiated inflation. In the former, primary product prices will be expected to benefit, on the hypothesis that they respond to excess demand more quickly than the prices of manufactures. In the cost inflation case, if it originates in developed countries, the prices of manufactures will be the first to rise and for a time may stay ahead of primary product prices. This will be reinforced if a policy response takes the form of demand restriction, for such a response to a cost inflation will inevitably lead to a depression, which will affect adversely the relative prices of primary products. If, alternatively, the cost inflation has its origin in the cartelization of a primary commodity, the price of the cartelized commodity will obviously not suffer for as long as the cartel holds but the experience of non-cartelized commodities is likely to be similar to that under the other cost inflation, the one which originates in developed countries. Hedging and speculation will also affect relative prices and some conjectures in this area were offered. Of these, the most general relates to relative prices between one co m m o d i t y and another. Commodities which thanks to durability and storability lend themselves well to the role of anti-inflation hedges will find their prices enhanced by inflation relatively to those that do not. Looking beyond the end of inflation, some effects purely attributable to inflation will persist for a time to the extent that the relative price movements experienced while inflation was still in progress cause shifts in resource allocation and consumption patterns which are difficult or take time to reverse. Therefore, only those who are content to peer exclusively at the long-distant future can profess indifference about the relative price effects of inflation.
Why Inflation is Not Relative Price-Neutral for Primary Products JOHN
SPRAOS*
Uttil'ersity College, L o n d o n Summary. Studies of inflation tend to neglect relative prices although it has long been known (and recently confirmed) that relative price changes are more pronounced in periods of severe inflation. This paper advances the hypothesis that for the developing countries' primary products the distinction between demand and cost inflation is important: the former will improve the relative price of primary products; the latter will cause them to deteriorate if the cost inflation originates in developed countries. In the long run these effects may be cancelled out but not before they have lasted long enough to merit our attention.
This p a p e r argues t h e case against the view that i n f l a t i o n raises all prices p r o p o r t i o n a t e l y and t h a t it is t h e r e f o r e u n n e c e s s a r y , and even intellectually disreputable, t o e n q u i r e h o w the relative prices o f primary c o m m o d i t i e s will be a f f e c t e d by it. This is n o t t o say t h a t it is easy to p r e d i c t a priori the direction o f relative price m o v e m e n t s . T h e r e are m o r e t h a n one kind o f i n f l a t i o n and c i r c u m s t a n c e s differ b e t w e e n one p r i m a r y c o m m o d i t y and a n o t h e r ; t h e b e s t t h a t one can t h e r e f o r e h o p e t o do at a t h e o r e t i c a l level is to outline s o m e o f the factors w h i c h may be e x p e c t e d to p u s h one way or the o t h e r and try to discern any s y s t e m a t i c influence at work. The f o c u s will be on prihaary c o m m o d i t i e s o f m a j o r i n t e r e s t to d e v e l o p i n g c o u n t r i e s relatively to m a n u f a c t u r e s o f d e v e l o p e d countries. Relative price changes o c c u r all the time. We are i n t e r e s t e d here in changes over and above these, changes a t t r i b u t a b l e wholly t o inflation.
i n c o m e s do keep rising in t h e same p r o p o r t i o n ( w h i c h requires inter alia p e r f e c t a n t i c i p a t i o n of the realized i n f l a t i o n rate by all i n d e p e n d e n t e c o n o m i c u n i t s and b o t h the desire and ability to adjust t o it w i t h insignificant lags), the equilibrium values o f q u a n t i t i e s and relative
I. C O N D I T I O N S F O R U N C H A N G E D R E L A T I V E PRICES If q u a n t i t y d e m a n d e d o f each g o o d r e m a i n s u n c h a n g e d w h e n all g o o d s prices and m o n e y i n c o m e s rise in the same p r o p o r t i o n (in m a t h e matical jargon: if d e m a n d f u n c t i o n s are h o m o g e n e o u s o f degree zero in prices and i n c o m e s ) and if q u a n t i t y s u p p l i e d o f each g o o d remains u n c h a n g e d w h e n all g o o d s prices and f a c t o r prices rise in t h e same p r o p o r t i o n (supply f u n c t i o n s h o m o g e n e o u s o f degree zero) and if all g o o d s prices, f a c t o r prices and o t h e r m o n e y
* A revised version of a paper written in 1974 at the invitation of the World Bank following a World Banksponsored conference at Merton College, Oxford in October 1973 where it was argued by some participants that inflation, being a monetary phenomenon, was related to the absolute price level and would be expected not to affect any relative prices, be they prices of primary products or any other. Viewed as a hypothesis about the short-run, this has recently been refuted by D. R. Vining and T. C. Elbertowski ('The relationship between relative prices and the general price level', American Economic Review Vol. 66 (September 1976) pp. 699-708) who find that high inflation rates in the United States are associated with a significantly larger variance of relative prices than low inflation rates. The present paper complements this finding by advancing (in the context of primary products) some theoretical considerations for not accepting the hypothesis that inflation is relative price-neutral in the short or medium run. There is an alternative view, founded on the writings of Prebisch, that inflation in developed countries can cause a virtually bottomless deterioration in the terms of trade of primary products over the long run. This gained support among developing countries in 1974-5, when high inflation rates in developed countries coincided with a drastic fall in the relative prices of primary products in which developing countries are most interested. This is not a tenable view either. Thanks are due to the World Bank for releasing the copyright of this paper though, needless to say, it must not be assumed to share any of the views expressed herein.
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prices for all goods will remain unchanged when there is a general inflation.
II. I M P L A U S I B I L I T Y OF THE C O N D I T I O N S A mere e n u m e r a t i o n of the conditions for unchanged relative prices leads one to rehlize that they are liable not to be satisfied at various points. (a) Not all incomes rise in the same proportion in an inflation: (i) the relation between wages and profits alters; (ii) the relation b e t w e e n wages and ' f i x e d ' incomes alters; (iiD the shares of different groups of workers (including the unemployed) alter; (iv) the shares in world i n c o m e of various groups of countries alter. (b) Not all goods prices rise in the same proportion: (i) they have different degrees of stickiness; (iit they are subject to varying nonmarket influences (oligopolistic price making, cartelization, marketing boards, g o v e r n m e n t regulations, international commodity agreements); (iii) the prices of factors engaged in their p r o d u c t i o n do not rise uniformly ; (iv) p r o d u c t i o n takes place in a variety of countries whose costs are subject to a variety of national influences which are not exactly offset by exchange rate m o v e m e n t s . (c) The d e m a n d functions are not h o m o geneous of degree zero in prices and incomes: (i) decisions to buy are influenced also by assets and liabilities some of which are d e n o m i n a t e d in fixed m o n e y terms and such assets and liabilities w o u l d not be e x p e c t e d to cancel out when s u m m e d over the buyers of any one c o m m o d i t y ; (ii) variable price assets m o v e inversely with the rate of inflation if they bear a fixed interest, and this may be true also of equities in a costpush inflation if g o v e r n m e n t price controls or liquidity squeezes or other restrictive measures of demand management become more severe as the rate of inflation increases;
(iii)
many primary c o m m o d i t i e s lend themselves to hedging and speculation but in different degrees they differ inter alia in durability and ease of grading and storage. (d) The supply functions are not honlogeneous of degree zero in own market price, prices of other goods and prices of factors: (i) marketing boards interpose a variable wedge between market price and price received by producers; (ii) firms have debts fixed in m o n e y terms~ (iii) there are different capital intensities between one industry and a n o t h e r so that short-run m o n e y marginal costs are unequally affected by a p r o p o r t i o n a l rise in all m o n e y wages. A few concrete illustrations of the above from the episode of accelerating inflation and rapidly rising primary product prices in the period 1973 4 should suffice. In Ghana, the d o m i n a n t cocoa p r o d u c e r in the world, the cocoa marketing board has not allowed the price received by producers to keep pace with the rise of cocoa prices in world markets. In Malaysia, the d o m i n a n t natural rubber p r o d u c e r in the world, m o n e y wages of plantation workers did not keep pace with increases in the price of the basket of goods they purchase let alone the price of rubber. In industrialized countries, prices not only of bonds but of equities also were falling as inflation rates were reaching u n p r e c e d e n t e d post-World War 11 peaks in 1973 4. The share of profits and of high-income individuals was being squeezed between restrictive d e m a n d m a n a g e m e n t and trade union pressure or by the operation of incomes policies. A major redistribution of world i n c o m e t o o k place with the jacking up of oil prices in 1973. It is obviously possible to extend at length this e n u m e r a t i o n of violations of the conditions for unchanged relative prices. But it might be argued that the violations are r a n d o m and that they cancel each o t h e r out. It is therefore useful to make an a t t e m p t at identifying some of the influences that may be e x p e c t e d to be m o r e d o m i n a n t in the c o n t e x t of primary p r o d u c t prices relatively to manufactures.
111. D E M A N D I N F L A T I O N For this purpose it is essential to distinguish between demand-initiated and cost-initiated
INFLATION AND PRIMARY PRODUCTS inflation. The f o r m e r will be taken first. Think of it as a Keynesian excess d e m a n d abetted by a c c o m m o d a t i n g m o n e t a r y management. At the start it consists of all-round and world-wide excess d e m a n d ; if excess d e m a n d were sectorally biased right f r o m the beginning, we would not be picking up pure inflation effects on relative prices. The initial rate of increase of prices will differ b e t w e e n goods according to their degree of flexibility. For a variety of well-known reasons, primary p r o d u c t prices are more responsive to excess d e m a n d t h a n the prices of m a n u f a c t u r e d goods. The prices of primary p r o d u c t s will therefore rise faster than those of manufactures. R o u n d 1 thus benefits the primary producers. In R o u n d 2 the change in relative prices channels the excess demand p r e d o m i n a n t l y to the m a n u f a c t u r i n g sector and, as the built-in inflexibilities in the pricing of manufactures are gradually eroded, a catching-up process starts. If the rate of inflation is low, the erosion of inflexibilities is slow and therefore the initial i m p r o v e m e n t in primary product prices more persistent. A high rate of inflation would be associated with a m o r e dramatic but shorterlived relative price i m p r o v e m e n t . The speed of response of m o n e y wages in manufacturing will be material here. Resistance to a fall in real wages would be e x p e c t e d to be generated more quickly than resistance to real wages which fail to keep up with labour productivity but nevertheless grow absolutely. Thus if the relative price rise in primary product prices occurs against a background of slow or zero m a n u f a c t u r i n g productivity growth (implying a fall in m a n u f a c t u r i n g real wages) the catching up by manufacturing prices will be speeded up. R o u n d 3, let us suppose, sees the end of inflation, with a level of e c o n o m i c activity comparable to that of R o u n d 0 (the preinflation period). Aggregate excess demand is now back to zero. It could be argued that all relative prices will n o w end up where they would have been had the inflationary episode not intervened. This would be so if all real changes in the system were i n d e p e n d e n t of the time path taken. Historians must find this a shocking proposition, but it follows from the timelessness of d e m a n d and supply functions (and the underlying utility and p r o d u c t i o n functions) which economists typically assume. But only a very blinkered e c o n o m i s t will insist a outrance that each historical phase carries no influence over its successor. It does not take m u c h ingenuity to think of
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possible p a t h - d e p e n d e n t and not easily reversible changes which would cause R o u n d 3 to differ from R o u n d 0. One such change could be the diversion of capital to primary p r o d u c t i o n in R o u n d 1 w h e n inflation had raised the relative price of primary products. (Note, however, that, with excess demand in the system, the ultimate allocation of resources is not easily predictable because, in the general scramble, the random c o m p o n e n t in the resolution of c o m p e t i n g and incompatible claims will be substantial). A n o t h e r such change could be price-induced raw material-saving innovations or shifts of dietary habits. Both would have the effect of making the relative price of primary products lower in R o u n d 3 than in Round 0 as c o m p a r e d to what they w o u l d have been but for the inflation of Rounds 1 and 2. But we m u s t not exaggerate. Industryspecific capital c a n n o t m o v e from one industry to another overnight -- but, as it wears out, it need not be replaced. If price-induced changes in diet or in raw material c o n s u m p t i o n can occur in one direction when relative prices are as in R o u n d 1, they can occur in the opposite direction when relative prices are as in Round 3, though more slowly in the latter case if, as may be presumed, inflation-attributable relative price differences are less b e t w e e n Rounds 3 and 0 than they are b e t w e e n Rounds 1 and 0. So, one may conceive of a Round 4 in which the relative price effects traceable (in principle) to the inflationary interlude w o u l d have grown so small that they would be swamped (in practice) by the new historical setting created by unforeseen events in R o u n d 3. The economist who insists on neglecting the relative price effects of inflation c o m e s into his own in R o u n d 4, but he may be neglecting a large chunk of time. So far all primary c o m m o d i t i e s have been grouped together. But their prices are not going to change proportionately. The response of supply to the excess demand of R o u n d 1 will be different between one c o m m o d i t y and another according to how their short-run supply elasticities differ. On the demand side price elasticities will also differ b e t w e e n c o m m o d i t i e s and speculative d e m a n d will focus on the more durable and easily storable c o m m o d i t i e s as people switch out of inflationvulnerable assets. This latter element is in principle transient: the equilibrium stock of storable primary p r o d u c t s rises when the inflation rate reaches the p o i n t at which people take steps to hedge against it, but once the higher stock is attained the pressure on prices from this source will dry up. The same is true if
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the real rate of i n t e r e s t falls as a result of t h e m o n e y rate failing t o k e e p pace w i t h t h e price level. However, t h o u g h t r a n s i e n t in principle, the a d j u s t m e n t t o a h i g h e r s t o c k is n o t , t h a n k s to a variety of lags, a q u i c k o n c e - o v e r affair b u t m a y e x t e n d over a s u b s t a n t i a l period. Moreover, if t h e i n f l a t i o n accelerates or is m e r e l y e x p e c t e d to do so, the e q u i l i b r i u m s t o c k goes on increasing a n d this keeps tlae pressure of d e m a n d from this s o u r c e going. if i n f l a t i o n e r o d e s the real wages of w o r k e r s in s o m e p r i m a r y i n d u s t r i e s m o r e t h a n in o t h e r s (Malaysian r u b b e r , as cited earlier, is a case in point), then the products of these industries will e x p e r i e n c e a lesser increase in t h e i r price t h a n w o u l d have o t h e r w i s e b e e n t h e case since this is t a n t a m o u n t t o a r i g h t w a r d shift in t h e i r s u p p l y curve. If, o n t h e o t h e r h a n d , a c o m m o d i t y is s u b j e c t t o t h e c o m p u l s o r y i n t e r m e d i a t i o n of a m a r k e t i n g b o a r d w h i c h does n o t allow t h e m a r k e t price t o be fully r e f l e c t e d in t h e price paid to p r o d u c e r s (as w i t h c o c o a in G h a n a ) , the R o u n d 1 increase of c o c o a prices will be a c c e n t u a t e d because t h e p r a c t i c e restricts the m o v e m e n t up t h e s u p p l y curve t h a t corresp o n d s to any given rise in m a r k e t price. ( S h o u l d , h o w e v e r , the s u p p l y curve be ' b a c k ward b e n d i n g ' , t h e e f f e c t o f the m a r k e t i n g b o a r d p r a c t i c e w o u l d be t h e reverse: to lessen the u p w a r d pressure e x e r t e d by excess d e m a n d o n price.) The c o n c l u s i o n at this p o i n t is t h a t n o t o n l y s h o u l d o n e n o t e x p e c t d e m a n d - i n i t i a t e d inflation t o be relative p r i c e - n e u t r a l for p r i m a r y c o m m o d i t i e s as a w h o l e b u t also as b e t w e e n one p r i m a r y c o m m o d i t y a n d a n o t h e r , at least over a p e r i o d t h a t e x t e n d s up t o a p e r h a p s r e m o t e long-run. A m o r e specific c o n c l u s i o n m u s t o b v i o u s l y be s u b j e c t to s u b s t a n t i a l reservations, b u t b r o a d l y t h e p r e d i c t i o n is t h a t d e m a n d - i n i t i a t e d i n f l a t i o n will begin b y raising the price of p r i m a r y p r o d u c t s relatively to m a n u f a c t u r e s and t h a t some e l e m e n t o f this will r e m a i n u n t i l i n f l a t i o n slows d o w n . But if t h e r e b y m o r e resources b e c o m e c o m m i t t e d to p r i m a r y p r o d u c t i o n t h a n w o u l d have o t h e r w i s e b e e n the case, this s i t u a t i o n c o n t a i n s the seeds of its o w n reversal later on.
IV. C O S T I N F L A T I O N In a c o s t - i n i t i a t e d i n f l a t i o n t h e r e is n o excess d e m a n d in R o u n d 1. The i n f l a t i o n a r y p r o c e s s is s t a r t e d a n d t h e n k e p t going by a p u s h of wages a n d m a r k - u p s in excess o f p r o d u c t i v i t y g r o w t h in t h e d e v e l o p e d i n d u s t r i a l c o u n t r i e s . As before,
an a c c o m m o d a t i n g m o n e t a r y policy m a y be a s s u m e d in t h e b a c k g r o u n d . In this t y p e of i n f l a t i o n , by d e f i n i t i o n , the prices o f m a n u f a c t u r e d g o o d s will be the first to rise and a n initial l o w e r i n g of t h e relative prices o f p r i m a r y p r o d u c t s will occur. Once again, t h e r e f o r e , i n f l a t i o n will n o t be relative price-neutral: its effect o n p r i m a r y p r o d u c t s is n o w adverse, the o p p o s i t e of t h a t u n d e r d e m a n d - i n i t i a t e d inflation. T h e s i t u a t i o n is tha! w h i c h the Prebisch h y p o t h e s i s w o u l d lead o n e to expect. But the c o n s e q u e n c e of l o w e r relative prices will be to g e n e r a t e excess d e m a n d for p r i m a r y p r o d u c t s a n d in R o u n d 2, let us say, this will begin to e x e r t an u p w a r d pull o n t h o s e a m o n g p r i m a r y p r o d u c t prices w h i c h are c o m p e t i t i v e l y d e t e r m i n e d . ( T h e case of c a r t e l - d e t e r m i n e d p r i m a r y p r o d u c t prices will be t a k e n up in Section V). T h e r e will t h e r e f o r e be 11o c u m u l a tive d e t e r i o r a t i o n o f t h e i r relative price vis-d-vis m a u f a c t u r e s , but the R o u n d 1 d e t e r i o r a t i o n will be s u s t a i n e d so l o n g as cost i n f l a t i o n in d e v e l o p e d c o u n t r i e s c o n t i n u e s , for in t h a t case p r i m a r y p r o d u c t prices, t h o u g h rising, will lag o n e step b e h i n d all t h e t i m e (albeit a small step p e r h a p s , since p r i m a r y p r o d u c t prices are r e a s o n a b l y flexible). However, hedging a n d speculative activity c o m p l i c a t e s m a t t e r s . In a c o s t - i n i t i a t e d inflation, as in a d e m a n d - i n i t i a t e d one, there will be an a t t e m p t to s w i t c h o u t of i n f l a t i o n - v u l n e r a b l e assets and this will g e n e r a t e a d e m a n d for t h e easily s t o r a b l e p r i m a r y p r o d u c t s and m o r e p a r t i c u l a r l y for minerals, since these, being available in a finite s t o c k o n l y , are m o r e likely to e x p e r i e n c e a relative price rise over t i m e a n y w a y . F o r t h o s e p r i m a r y p r o d u c t s w h i c h are subject to this i n f l u e n c e , t h e Prebisch effect m a y t h e n be m o r e t h a n c o u n t e r a c t e d in w h i c h e v e n t t h e i r relative price vis-gl-vis m a n u f a c t u r e s will i m p r o v e . This will be r e i n f o r c e d if e q u i t i e s fail in t h e i r t r a d i t i o n a l i n f l a t i o n - h e d g i n g role, as t h e y are liable to do w h e n p r o f i t s are s q u e e z e d b e t w e e n wages p u s h i n g up a n d prices b e i n g held d o w n by g o v e r n m e n t c o n t r o l s . If an i n c o m e s policy is used by g o v e r n m e n t s and it succeeds in e l i m i n a t i n g i n f l a t i o n c o m pletely, we m o v e i n t o R o u n d 3 - a b o u t w h i c h m o r e later. If it o n l y slows d o w n i n f l a t i o n , t h e s t o r y of R o u n d 2 needs no a m e n d m e n t so far as relative prices are c o n c e r n e d , e x c e p t t h a t i n c o m e s policies t e n d t o a f f e c t i n c o m e distribut i o n and d e m a n d for p r i m a r y p r o d u c t s m a y be income distribution-sensitive. If g o v e r n m e n t s r e s p o n d t o cost i n f l a t i o n by r e s t r i c t i n g d e m a n d , we c o u l d have c o n t i n u i n g cost i n f l a t i o n ( t h o u g h p r e s u m a b l y at a s o m e -
INFLATION AND PRIMARY PRODUCTS what lower rate) combined with a depression in developed countries. The scenario of Round 2 would have to be amended accordingly. Demand restriction in the face of cost inflation is a third or fourth-best policy if not worse, but might be resorted to because of an incorrect diagnosis of the course of inflation (or doctrinal disbelief in cost inflation, which comes to the same thing) or, in developed countries with faster than average inflation, in order to correct balance-of-payments imbalances when the exchange rate cannot perform this role because of the feedback on costs. In any ,event, the effect of depression and unemployment in developed countries will be to lower the relative price of primary products. And if the depression is at all deep and prolonged, this is bound to outweigh the contrary effect from the buying of certain primary commodities for hedging purposes. The Prebisch effect would thus be reinforced - but also overshadowed because the industrial depression would be expected to be the stronger downward influence. We end up with a certain presumption that in Round 2, as in Round 1, of a cost-initiated inflation the price of primary products relative to manufactures will be lower than in Round 0 as compared to what it would have been in the absence of inflation. Let us now identify, once again, Round 3 with the cessation of inflation: average money income rises in proportion to average productivity and the level of economic activity is comparable to that of Round 0. As in the case of demand-initiated inflation, the semiirreversible changes which are inherited from the inflation of Rounds 1 and 2 may be expected to relate to changes in the stock of capital committed to primary production, changes in dietary habits and technological changes affecting the natural resource-intensity of industry. Only now all these things, having been influenced by the lowering of relative prices of primary products in Rounds 1 and 2, will decrease the supply of and increase the demand for primary products in Round 3 with the result - opposite to that of demandinitiated inflation - that the relative price of primary commodities will be subject to an inflation-attributable increase in Round 3 as compared with Round 0. This increase may not be very pronounced, but it is noteworthy that in any case a Prebisch-type deterioration of relative product prices will not survive beyond Rounds 1 and 2. It is equally noteworthy that the hypothesis that inflation is relative price-neutral is as open
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to challenge in the case of cost-initiated inflation as it is in the case of demand-initiated inflation. Only in some remote Round 4 (which needs no elaboration here because remarks analogous to those of the preceding section apply) could such a doctrine find some sustenance.
V. CARTEL1ZATION OF PRIMARY PRODUCTS AND COST INFLATION
Until recently the possibility of a sustained cost inflation emanating from the primaryproducing sector of the world economy would not have been deemed worth considering. The source of sustained cost inflation that we knew was the struggle between classes or groups in industrialized countries attempting to increase and defend respectively their share of aggregate income. In the bulk of primary production, and particularly in the part emanating from developing countries (with which this paper is concerned), labour is not suitably organized to engage effectively in such a struggle. However, the successful cartelization of oil since 1973 has changed this perception of the world. It is now possible to entertain seriously the possibility of a sustained cost inflation arising from a struggle for reapportionment of world income between primary-producing countries acting in concert (or a group of them such as the oil producers) and the manufacturing countries. Very schematically, this can be envisaged along the following lines. The primary producers cartelize and introduce a dramatic increase in price. Demand for primary products being price inelastic, this generates a big surplus in their current account but the whole surplus is used to acquire existing assets in the developed countries. In consequence the developed countries as a group do not have any immediate balance-of-payments or exchange rate problems. The fact that every developed country would not be expected to be in this comforting position unless very effective country-bycountry recycling of the primary producers' current account surplus takes place, is neglected for the present purpose. A Keynesian would say, however, that the developed countries do have a demand deficiency problem, the higher revenue of the primary producers having accrued to them at the expense of expenditure elsewhere. But, equally, a Keynesian would say that this could be offset by expenditureincreasing policy measures, since the balance of payments presents no constraint under the postulated circumstances. Let us then assume
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that Keynesian d e m a n d m a n a g e m e n t o f this kind is in operation. A monetarist, on the o t h e r hand, would say that there will be no d e m a n d deficiency provided the m o n e y supply rises by just enough to a c c o m m o d a t e the rise in the price level due to the increase in the price of primary products. Let such a m o n e t a r y policy be pursued so as to exclude an e c o n o m i c depression from the monetarist viewpoint also. The only substantial and i m m e d i a t e macroe c o n o m i c p r o b l e m that is left for developed countries from the rise in primary p r o d u c t prices is that real i n c o m e per head has been reduced, a fact which generates a reaction familiar to cost inflation models. Money wages are pushed up to c o m p e n s a t e for the loss of purchasing power. Prices of industrial goods then rise to c o m p e n s a t e for higher m o n e y costs and to defend the share of profits, which in turn leads to m o r e pushing up of m o n e y wages. If i n c o m e earners in developed countries insist on and succeed in raising m o n e y incomes by 1% for each 1% rise in the price level, the process is going to end only when prices of goods p r o d u c e d in developed countries rise by the same p r o p o r t i o n (give or take a few percentage points for things which have not been allowed for) as the increase in primary p r o d u c t prices which initiated the process. The primary producers will thus be back to square one. The current and capital accounts of the balance o f p a y m e n t s and everything else will bear no trace of any effects specifically attributable to the initial rise in primary p r o d u c t prices. But, of course, the primary producers' cartel, if it continues to hold, will n o t be satisfied at having its initial gain eroded by the rise in the price level of industrial goods. Before the erosion is c o m p l e t e it will raise the prices of primary p r o d u c t s and may well keep doing this to stay one step ahead of the prices of m a n u f a c t u r e d goods in a continuing world-wide cost inflation. In terms of the schematic ' r o u n d s ' of preceding sections, R o u n d 1 will see a large increase in the relative price of primary products. In R o u n d 2 prices of m a n u f a c t u r e d goods will do some catching up but this will be i n c o m p l e t e if the cartel retains its cohesion and keeps its nerve. If we allow for some primary p r o d u c t s being cartelized (oil) and others not, the story is only slightly different. As the relative price of non cartelized primary vis-gt-vis m a n u f a c t u r e s falls in the early part of R o u n d 2 (at the time when the price of manufactures begins to chase the price of oil), excess demand for non cartelized primary products will be generated and thereafter they will follow one step behind
the price of m a n u f a c t u r e s along the lines ol R o u n d 2 of the preceding section. An interesting question, but one not amenable to an a priori answer, is whether the c o n c e n t r a t i o n of increments of wealth in the hands of the oil-producing countries will affect tile demand for primary products as hedging assets. Does it make sense for oil-producing countries to diversify their natural wealth by selling some of their oil and investing the proceeds in o t h e r durable primary products? One reason which may point towards an affirmative answer is that, in contrast to alternative assets that the oil producers may acquire, they can transport stocks of primary p r o d u c t s to their o w n territories and thus put them out of easy reach of possible e c o n o m i c reprisals by developed countries a far-fetched but not utterly implausible scenario. In the course of R o u n d 2 we may expect g o v e r n m e n t s in developed countries to react against inflation. If this takes the form of an incomes policy which succeeds in keeping d o w n the growth of m o n e y incomes to less than 1% for each 1% rise in the price level, eventually cost inflation will c o m e to an end (in terms of the previous schema, R o u n d 3 will be reached) and the rise in the relative price o f cartelized primary p r o d u c t s will be consolidated. The price of beating inflation some price is unavoidable in the face of a successful priceraising cartel action is the acceptance of a substantial deterioration in the developed countries' terms of trade. If the policy reaction to inflation is to create d e m a n d deficiency by turning off, in part or in whole, the injections of aggregate d e m a n d needed to offset the d e m a n d which has been s y p h o n e d off (as Keynesians would have it) by the higher primary p r o d u c t prices, then we would have, at least for a time, cost inflation and industrial depression side-by-side. Such a situation was also envisaged in the preceding section, only now the industrial depression will not affect adversely the price of the cartelized primary p r o d u c t s if the cartel takes the reduced demand in its stride. (The cartel's profit maximizing price may not be u n a f f e c t e d by an industrial depression but there is no general p r e s u m p t i o n as to which way it will go.) A m o n g primary products, it will be the non cartelized ones that will experience a relative price decline. For the countries producing these, this is the worst situation of them all. Their terms of trade will suffer from a relative rise in the price of cartelized c o m m o d i t i e s bigger than the industrial countries and suffer also additionally from a relative rise in the price of manufactures. A n o t h e r way of looking at
INFLATION AND PRIMARY PRODUCTS this is that the price paid by developed countries for slowing down inflation, in so far as it relates to a terms of trade deterioration, is partially transferred to the developing countries which do not produce cartelized commodities. However, under this scenario, the price paid by developed countries also includes the loss of employment and output due to policyengineered depression. Moving to Round 3, in which, in keeping with the practice of preceding sections, inflation is no more and the level of economic activity is comparable to that of Round 0, the dominant feature will be the relative rise in the price of cartelized commodities, provided the cartel holds while priceqnduced substitution processes gradually mature and while sources of production beyond the reach of the cartel (in the developed countries' own territories) come 'on stream'. In the case of oil it is not likely that such developments will be substantial enough to threaten the cohesion and undermine the raison d'etre of the cartel in the foreseeable future. Should, however, the cartel perceive a serious threat from such developments, it could resort to price warfare occasional sharp price reductions to undermine the economics of rival operations. Some substitution is, however, inevitable and this may well help the relative price of non-cartelized commodities - for example, demand for cotton will benefit from the greater cost of petrochemicals used in the manufacture of artificial fibres. But note that all the relative price effects stressed in Round 3, which will also persist in the remoter Round 4, are the result of the cartel and not of the cost inflation of which the cartel was the initiator back in Round 1. Indeed, for all four Rounds, the pure inflation effects on the relative price of non-cartelized primary commodities will not be different from those of the cost inflation initiated in developed countries which was discussed in Section IV.
CONCLUSION The relative price effects of inflation are an
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unexplored territory and the only thing which can be asserted with confidence is that these will be substantial for as long as inflation lasts and for some time thereafter. The direction of relative price effects is more conjectural. The principal message of this paper is that in the context of primary products a systematic analysis of these effects must make a sharp distinction between demand-initiated and costinitiated inflation. In the former, primary product prices will be expected to benefit, on the hypothesis that they respond to excess demand more quickly than the prices of manufactures. In the cost inflation case, if it originates in developed countries, the prices of manufactures will be the first to rise and for a time may stay ahead of primary product prices. This will be reinforced if a policy response takes the form of demand restriction, for such a response to a cost inflation will inevitably lead to a depression, which will affect adversely the relative prices of primary products. If, alternatively, the cost inflation has its origin in the cartelization of a primary commodity, the price of the cartelized commodity will obviously not suffer for as long as the cartel holds but the experience of non-cartelized commodities is likely to be similar to that under the other cost inflation, the one which originates in developed countries. Hedging and speculation will also affect relative prices and some conjectures in this area were offered. Of these, the most general relates to relative prices between one co m m o d i t y and another. Commodities which thanks to durability and storability lend themselves well to the role of anti-inflation hedges will find their prices enhanced by inflation relatively to those that do not. Looking beyond the end of inflation, some effects purely attributable to inflation will persist for a time to the extent that the relative price movements experienced while inflation was still in progress cause shifts in resource allocation and consumption patterns which are difficult or take time to reverse. Therefore, only those who are content to peer exclusively at the long-distant future can profess indifference about the relative price effects of inflation.