Concept of Inflation-PG (p)

7/27/2019 Concept of Inflation-PG (p)

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Concept of Inflation & Phillips Curve

Like other branches of Economics, Macro economics too has been witnessed

revisions and additions. They are:

Phenomenon of Phillips Curve

Stagflation

Natural Rate of Un-employment

Rational Expectations

Definition of inflation:

There are many definitions of inflation. By inflation most people understand a

sustained and substantial rise in prices. For example:

Crowther defines inflation as a state in which the value of money is

falling.

Harry G Johnson, “We define inflation as substantial increase in

prices”.

Milton Friedman writes ”By inflation I shall mean a steady and

sustained rise in prices”

According to Rowan, “inflation is the process of price increase”

Prof Samuelson puts it as “Inflation occurs when the general level of

prices and costs is rising”.

Thorp and Quandt, opine that it is of great help to define inflation in

terms of observable, to some economists, Inflation is a pure monetary

phenomenon, while to others, it is a post-full employment phenomenon.

Phenomenon and for his reason the process of rising prices should be

considered as inflation.



Types of Inflation:

Open Inflation:

When Government interference is nil and, prices rise freely, it is situation

of open inflation.

Suppressed Inflation:

when increase in price prevented by government through certain measures

like price control or rationing is suppression inflation.

Depend on Degree of Price rise, inflation can be categorized as:

Creeping Inflation is the mildest form and price rise imperceptibly over

period of time.

Walking Inflation gets helps from some other factors and price rise

becomes more marked, is known as walking inflation.

Running inflation is that the price rise becomes more rapid and the price

rise by fits and starts.

Hyper Inflation where the prices rise every moment in fact limitlessly.

Modern views on Inflation:

Demand Pull Inflation:

It is due to excess demand which is pulled above what economy is capable

of producing in the short period.



For instance, Demand for goods > Supply of Goods leads to increase inprices and increase in costs, increase in incomes than increase in demand

so that price rise.

Cost-Push Inflation:

It is due to increase in cost of production. We call it as wage spiral

inflation also which means rise in prices is due to increase in wages since it

is one of the important cost component.



Post Keynesian view on Inflation:

Inflationary pressures in terms of conflicts among different classes. Classes

are: Workers, Capitalists, Government. Each one these classes attempts to

squeeze as much of the surplus as in the economy is possible by way of

wages, profit and Taxes etc these leads to inflation.

Phillips Curve Analysis:

One of the objectives of this study was to identify whether the demand pullor cost push had been strong in the British economy

Another objective is to determine the extent by which restrictive monetary

policy and fiscal policy would be appropriate for the control of inflation.



A W Phillips in 1958 drew a diagram plotting the rate of inflation against

the rate of unemployment in the United Kingdom for each year from 1861-

1957.

He found clear evidence of a negative relation between inflation and

unemployment. When unemployment is low, inflation was high, and when

unemployment was high, inflation was low, often even negative.

Phillips found that wage rates rose rapidly when un-employment was low

and remain unchanged where about 5.5% of the labor force was out of job.

Phillips determined that a rate of 5.5% un-employment in the UK is

needed, if wages are to be held steady.



And a rate of 2.5% un-employment is needed if prices are to be steady.

Phillips stated that there will be an inverse relationship between rate of UE

and rate of Wages over a period of time. It means that PC slopes downwards

from left to right.

Two years later, Paul Samuelson and Robert Solow replicated Phillips‟

exercise for the United States, using data from 1900-1960.

Using CPI inflation as a measure of the inflation rate. Apart from the period

of very high unemployment during the 1930 to 1939, there also appeared to be

a negative relation between inflation and unemployment in the United States.

This relation, which Samuelson and Solow labeled the Phillips curve, rapidly

become central to macroeconomic thinking and policy.

It appeared to imply that countries could choose between different

combinations of unemployment and inflation.



A country could achieve low unemployment if it was willing to tolerate higher

inflation or it could achieve price level stability if it was willing to tolerate

higher unemployment.

In the 1970s, however, the relation broke down. There was both high inflation

and high unemployment, clearly contradicting the original Phillips curve. This

situation is nothing but stagflation.

Criticism:

J A Penchman has pointed out that the inverse relationship in Britain

economy is rather exaggerated.

Studies similar to Phillips were conducted by Lipsey & Routh covering the

period 1862-1957 and raised objections to the validity of Phillips data andmethod of aggregation.

R J Bhatia, covered the period 1900-1958 found that there was much less

evidence of Philips type relationship.

Natural Rate of Un-Employment (NRU):

In the late 1960s, two economists, Milton Friedman and Edmund Phelps,

questioned the existence of a trade-off between unemployment and inflation.

They questioned it on logical grounds, arguing that such a trade-off could

exist only if wage setters systematically under predicted inflation, and that

they were unlikely to make the same mistake forever.

Friedman and Phelps also argued that if the government attempted to sustain

lower unemployment by accepting higher inflation, the trade-off would

ultimately disappear, the unemployment rate could not be sustained below

certain level, a level they called the „Natural Rate of Un-Employment‟.

Events proved them right, and the trade-off between the unemployment rate

the inflation rate indeed disappeared.

Today, most economists accept the notion of a natural rate of unemployment.



NRU as the rate of Un-employment which has the property that is consistent

with equilibrium in the structure of real wage rate, corresponding to an

equilibrium level of output in any economy, there is an accompanying of Un-

employment determined by real forces, this rate can be consider as Natural

Rate. This rate also called as „Non-accelerating inflation rate of Un-

employment‟.

NRU Hypothesis is also known as „Accelerationist Hypotheses or Adoptive

Expectations Hypotheses‟.

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Concept of Inflation-PG (p)