A Strategic Theory of Inflation

A strategic mechanism of price adjustment is introduced to explain inflations in the U.S. during 1909-1974. The mechanism follows from our theory that when the profit rate is above a normal-target rate, competitive forces operate to lower prices while if the profit rate is below the target a correlated strategy among firms operates to generate a rise in prices as a strategy to improve profitability. The notion of "correlated strategy" is adopted from game theory. The mechanism may operate in harmony or against demand and the net effect is what we call the "basic inflation." Contrary to a-priori notions of positive association between inflation rates and profit rates, our theory proposes a critical test of a negative association between these variables. Such a relationship is in fact empirically established. The analysis shows that large and persistent inflationary pressures are generated by low profitability and during 1971-1977 those accounted for some 20%-50% of total inflation. These pressures would be present even if no increase in cost occurs. This suggests that an important cause of the 1970's inflation is the low profit rate in the private sector and any public policy against inflation will fail if it does not aim at the same time to raise the profit rate on private capital.