programs not only depress aggregate demand but also tend to constrain production activity, thus reducing total domestic supply. One reason for this is that inefficient state-owned companies cannot continue their production under high interest rates. Chart 1-I-6 illustrates how too tight a demand control policy can hamper the supply-side benefits of price liberalization.

The initial price is assumed to be P0, assuming a centrally-planned economy. After price liberalization, pent-up demand pushes the price level up to P1. With tight demand policy, the government tries to reduce the price level to P2. However, price liberalization increases producers' input prices, which then causes the supply curve to shift to the left. After this, the price level will be at P3-higher than price level P2.

Policy makers assume that price liberalization will automatically create competition on the supply side, shifting the AS curve in Chart 1-I-6 to the right. In fact, however, it takes longer than policy makers expect for this effect be realized.

(2) Scenario Two: Phased Price Liberalization

In this scenario tentative price controls are retained over commodities essential for people's daily life, and over fundamental input materials. Initial inflation should not be as high as in Scenario One. Still, the initial shock must be strong enough to deal a blow to vested interests within the socialist system. And demand control may still be necessary to combat excess demand which will have built up with the increase in real purchasing power under zero-inflation in a centrally-planned economy.

Such a phased strategy has merits and dangers. Its greatest merit is to allow supply capability to recover under mild inflation. Also it should allow basic resources to be allocated to strategic sectors, which will contribute further to supply growth. The main danger is the increased risk of future inflation. After the prices of the main regulated commodities have been liberalized, renewed inflation may ensue, induced from the upward shift of the aggregate supply curve. Therefore, the phased strategy needs to be carefully managed in order to prevent a second round of hyper-inflation.

In Chart 1-I-7, the initial price level is P0. Following an initial, limited price liberalization, the price level rises to P1. After demand control policy is implemented, the price level falls back to P2 (with no leftward shift of the supply curve AS). Then if gradual price liberalization succeeds in increasing aggregate supply, the supply curve will shift to the right, which will lower the price level to P3. However, this will not be a sustainable equilibrium. Stabilization will require a second price liberalization, accompanied by another tight demand policy. Overall, such phased demand control should ultimately result in a lower price level than the crude shock approach of Scenario One.

## 3 -4-2 The Need for Phased Inflation Control, from Both the Demand Side and the Supply Side

Phase I (demand-side): In a supply shortage economy, price liberalization induces hyperinflation due to excessive demand. The necessary response is tight demand policy, the shock approach.

Phase II (supply-side): Delay in supply recovery causes inflation from the other side of the demand-supply equation. In order to combat this kind of inflation, supply should be