——An analytical framework on China's inflation

Fan Jianjun

Recently, whether China has entered into the era of "high inflation" has become the focal point among various sides. Most are of the opinion that China has stepped into the era of "high inflation", whereas this paper does not agree with that opinion. It is held that, the viewpoint of "China entering into an era of structural inflation" seems more accurate to suggest the price movement in China over a long period of time in the future.

I. Two Types of Inflation

Inflation is a very complicated economic phenomenon. People usually judge the occurrence of the inflation by observing changes in a certain price index. This price index can be CPI (Consumer Price Index) or PPI (Producer Price Index). Certainly, the most ideal is GDP Deflator. Any of the types of index represents the average price level of a specific commodity basket. If the rise of the price index is attributable to the rise of the prices of all commodities in the basket, then we can say an overall inflation has taken place in the economy; if the rise of the price index is triggered by the rise of the prices of a type or several types of commodities in the basket, then we can say that a structural inflation has taken place.

Although the mechanism of inflation is very complicated, the result indicates that there are simply two types of inflation in the world: generalized inflation and structural inflation. The generalized inflation often takes place in developed economies; whereas both generalized and structural inflations occur in emerging economies or developing countries, even with more features of the structural inflation¹

II. How to Control the Generalized Inflation

The generalized inflation can be roughly divided into overall price rise possibly incurred by the excessive expansion of the aggregate demand or by excess issue of money and the overall price rise possibly triggered by the sharply deteriorating potential total supply capacity.

1. How to control nominal aggregate demand

If generalized inflation is incurred by the excessive expansion of the nominal aggregate demand, or triggered by excess issue of money, then, measures should be adopted to control the money. The monetary policy of the central bank is made for this purpose.

In China, broad money M2 is often used to represent nominal aggregate demand. There are two sources for M2 growth, one of which is bank loan and the other is funds outstanding for foreign exchange. The bank loan makes up roughly for 60%~70% and the funds outstanding for foreign exchange constitute about 30%~40%. Due to the bigger ratio of bank loan, the people's bank usually reduces loans to curb the excessive expansion of money, while little attention has been paid to the funds outstanding for foreign exchange proportioning 30%~40%. The result of such control over the aggregate demand is that although the nominal aggregate demand can be contained to a certain extent, the control will also severely impair the actual aggregate supply -- which is the major issue existing in China's control over the nominal aggregate demand. As loan reduction will inevitably reduce the investment for expanding reproduction, and the reduction of investment signifies the deterioration of the future potential capacity of total commodity supply, the offsetting of the two may dwindle the effects of the control over inflation. Therefore, for a country like China whose funds outstanding for foreign exchange are handsome, if the price rise is triggered by the excessive expansion of the nominal aggregate demand, then the policy aimed at containing nominal aggregate demand should be focused on controlling the excessively rapid growth of funds outstanding for foreign exchange rather than reducing loans blindly.

As Milton Friedman's famous saying "inflation is whenever and wherever a monetary phenomenon" is widely known in China, most think inflation can be brought under control as long as the money is in proper command. Therefore, the Chinese government has always paid much attention to the control over nominal aggregate demand (namely, the money supply), and such control is successful in general. Over more than ten years' time since the outbreak of Asian financial crisis in 1997, except for the rapid growth of the broad money M2 in 2009 for the reason of addressing the global financial crisis, the M2 growth in other years has all been controlled under 20% (15%~16% in most of the years). For China, a country undergoing its economic transformation and with its average economic growth rate reaching more than 10%, such a percentage of M2 growth is not high.

2. How to control actual aggregate supply

Although the central bank's control over the nominal aggregate demand (money supply) has been generally successful in recent ten years, China has experienced the severe inflation thrice in its economic development. It reveals that bringing money under good control to properly handle commodity prices is far from enough. The reason is that not only does inflation relate to money (nominal aggregate demand), but it also relates to commodities (actual aggregate supply), and that when excess money chases after limited number of commodities, the inflation will unavoidably turn up. The saying of "inflation is whenever and wherever a monetary phenomenon" is correct in itself, but it lays excess stress on monetary factors that trigger inflation. Just for this reason, the Chinese government, when implementing control over inflation, has paid too much attention to the control over nominal aggregate demand or money supply, with little attention paid to the control over actual aggregate supply——China's macroeconomic policy has even been little oriented toward the control over aggregate supply, whereas problems existing in control over aggregate supply are more serious than those in aggregate demand control.When the potential level of aggregate supply slumps, even if the nominal aggregate demand remains stable, the generalized inflation is likely to occur in real economy. The inflation occurring thrice in China over recent ten years has been much related to improper control over aggregate supply (rather than improper monetary control) to a large extent.

As China carries out the open-door policy, its commodity supply comes from two sources: domestic production and net imports from overseas (which might be negative). Therefore, control over aggregate supply should include the aforesaid two aspects.

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1. Economic theories or general equilibrium do not distinguish "structural inflation" from "generalized inflation". Inflation is by all means triggered by "excess money chasing after limited number of commodities, leading to an all-out price rise", and what excess money chases after are all commodities rather than only a certain or several types of commodities. However, in reality or in terms of policy, "structural inflation" seems quite prevalent due to two reasons: First, there is a world of difference in price demand elasticity between commodities. The price demand elasticity of "luxuries" is big, while that of "necessities" is small. When money supply is in excess, the rise of prices of various types of commodities may not be completely consistent. The rise of prices of "necessities" is usually big, while the rise of prices of "luxuries" is usually small; Secondly, the productivities of various commodity manufacturers may be different, namely, the allocation of economic resources is unbalanced or is being made balanced among various manufacturers, resulting in a difference in rise of commodity prices among various manufacturers: the rise of prices of low-productivity manufacturers tends to be dramatic, while rise of commodity prices of high-productivity manufacturers will turn out small. Given unbalanced productivities of various manufacturers (namely, productivities of various manufacturers are yet not consistent), even if the money supply remains normal, structural price rise will also happen.