In the previous section the direct price effect of commodity prices presume that commodity prices are unaffected by economic adjustments; this represents a significant limitation of this theory. However Kaldor (1976) had a different assumption. In his view, an increase in commodity prices has a significant inflationary effect on industrial prices, since the higher prices of basic materials are passed through different channels into unit labour costs and understandably into final product prices.
According to Kaldor’s (1976) assumption, in order to demonstrate the indirect effect of commodity prices, it is necessary to distinguish between the "primary sector" of the world economy, the “secondary" and " tertiary" sectors. While inflationary pressures are not expected to arise from the tertiary sector, both the industrial sector and the primary sector can become sources of inflation, however of a different character, differing both in the nature of the causal mechanism, and in the general economic consequences. In the primary production,
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the market price is given to the individual producer or consumer, and prices move in direct response to market pressures in the classical manner and act as signals for the adjustment of production and consumption in the future. In industry, the adjustment of production to changes of demand takes place independently of price changes, through a stock-adjustment mechanism, industrial prices (in contrast to the prices of primary products) are not acting as a market cleaner. The asymmetry can be according to Kaldor’s assumption explained by the fact that while commodity prices are demand-determined, industrial prices are cost- determined, and because of that the rise in commodity prices has a very powerful inflationary effect operating on the cost side thus the rise in the price of basic materials and fuels is passed through the various stages of production into the final price with an exaggerated effect.
As a consequence, inflation has a deflationary effect on the effective demand for industrial goods in real terms, since the rise in the profits of producers in the primary sector is higher than their expenditure which can be observed from the accumulation of financial assets by the oil producers. The accumulation of financial assets is also resulting from the fiscal and monetary policies in the industrial countries which are likely to react to the domestic inflation and lead to reduction of consumer demand and industrial investment. As a result, the increase in commodity prices may also lead to a wage – price spiral inflation and restrict industrial activity. The main point that Kaldor (1976) made is that volatility of commodity prices is mainly due to inflationary expectations. In the absence of a stable monetary policy which could act as a hedge against inflation, the recovered demand will have a speculation effect in commodity prices which in consequence will lead to an increase in unemployment and lower effectiveness in using resources.
Kaldor’s (1976) assumption is based on the reaction of monetary and fiscal policy in developed countries, since the deflationary effect of commodity price inflation on demand for industrial goods is caused by a restrictive policy in order to avoid the acceleration of domestic inflation. However, a certain degree of caution should be taken when applying Kaldor’s theory of indirect effect, since his hypothesis does not reflect the crucial development in monetary policy in developed countries. While in 1970s and 1980s most of the developed countries moved from a fixed to a floating exchange rate, and the period until 1990s can be taken as “looking for the right way to go,” nowadays developed countries approach inflation targeting. Kaldor (1976) assumed that the rise of commodity prices above a certain level would lead to a restrictive policy (monetary or fiscal) in developed countries in order to avoid the inflationary pressure on domestic inflation.
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However, it can be assumed that this action of policy makers is not so straightforward in inflation targeting countries such the UK, since the central bank targets consumer price inflation and strictly does not react to external developments in prices if the commodity price fluctuations are only temporally (Frankel, 2012). However, according to Bosworth and Lawrence (1982) when policy makers are interested in the “balance” between consumer price inflation and unemployment, a shock to commodity prices is accommodated into the decisions of policy makers through an expansion of the money supply. Their argument has a rationale in the assumption that if policy is more inflation orientated, in the event of a positive exogenous shock to commodity prices, a significant rise in unemployment is required in order to avoid accelerating consumer price inflation. Indeed the study by Labys and Maizels (1990) that tested Kaldor’s indirect commodity price effect shows a strong correlation between primary commodity prices and domestic consumer prices as well as unemployment, and shows that increases in unemployment in developed countries are underlined by commodity prices. The most important conclusion derived from their findings is that developed countries in the 1970s and 1980s did make monetary policy adjustments to a certain level as a response to commodity price swings by cutting interest rates and increasing the money supply.
However, what Bosworth and Lawrence (1982) did not consider is that not only movements in commodity prices can have an effect on fiscal or monetary policy in developed countries but the relationship can also be the other way round, thus there is a possibility for the shocks being endogenous.