Inflation and unemployment and Phillips Curve
Inflation are the two most talked-about words in the contemporary society. These two are the big problems that plague all the economies. Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confusion because it is difficult to define it unambiguously.
1. Meaning of Inflation: Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation.
Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or average of prices.
In other words, inflation is a state of rising prices, but not high prices. It is not high prices but rising price level that constitute inflation. It constitutes, thus, an overall increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon.
While measuring inflation, we take into account a large number of goods and services used by the people of a country and then calculate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market.
It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense.
Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year was 223.8- 193.6/ 193.6 x 100 = 15.6 As inflation is a state of rising prices, deflation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation.
2. Types of Inflation:
As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish between different types of inflation. Such analysis is useful to study the distributional and other effects of inflation as well as to recommend anti-inflationary policies. Inflation may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.
Thus, one may observe different types of inflation in the contemporary society:
A. On the Basis of Causes:
(i) Currency inflation: This type of inflation is caused by the printing of currency notes.
(ii) Credit inflation: Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.
(iii) Deficit-induced inflation: The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.
(iv) Demand-pull inflation: An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply. If the supply of money in an economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”
Keynesians hold a different argument. They argue that there can be an autonomous increase in aggregate demand or spending, such as a rise in consumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money supply. This would prompt upward adjustment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument).
DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and price level on the vertical axis. In Range 1, total spending is too short of full employment output, YF. There is little or no rise in the price level. As demand now rises, output will rise. The economy enters Range 2, where output approaches towards full employment situation. Note that in this region price level begins to rise. Ultimately, the economy reaches full employment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull inflation. The essence of this type of inflation is that “too much spending chasing too few goods.
Inflation: Meaning, Types, Causes, Effects and Remedies What is Inflation? – Meaning
Inflation refers to a situation when there is an overall increase in the prices of goods leading to a general decline in the value of money. Inflation is phenomena marked by an excess of money supply over the demand for it, that is to say, an excess of the supply of currency and credit over the actual requirements of trade, commerce and industry. We have inflation when there is an increase in the value of total money supply multiplied by its velocity of circulation without a corresponding increase in goods and services. Inflation is characterized by a fall in the purchasing power of money and an extraordinary rise in the cost of living. As a result of increased money supply in the hands of people and the consequent competition for purchasing goods which are in scarcity, there is a general increase in the price indices.
Types We will discuss the two major types of inflation:
1. Demand Pull Inflation: Inflation arises when there is an increase in the supply of money but there is no corresponding increase in the supply of goods useful to the community. Accumulation of more money than before raises the purchasing power of people and stimulates the demand for goods but the supply of the latter being limited, the necessary consequence will be the inflation of the price level. Demand Pull Inflation thus means, in plain words, too much money chasing too few goods.
2. Cost Push Inflation: When the prices of goods increases because of an increase in the cost of production, it is known as cost push inflation.
What causes Inflation?
Additional money put in the hands of people naturally creates in them a desire to spend more on goods. The sellers these commodities get more money and they too feel an urge to add something to what they already possess, and the new purchases made with additional money will correspondingly benefit other producers and sellers too in an ever-widening circle. In this way, the demand for various commodities and services will go on rising in a spiral order in times of inflation. The activities of speculators, hoarders, and profiteers also contribute much to the upward trend of prices. The selling prices of good also increases if there is an overall increase in manufacturing cost. If the production of industrial and agricultural goods did not multiply in proportion to the increase in demand, the prices of commodities increases by leaps and bounds resulting into steep inflation. The underdeveloped countries, in particular, in trying to industrialize themselves and advance materially, resort to deficit financing when other monetary resources have been completely tapped. There will be a tremendous increase in money supply and its velocity of circulation due to greater public borrowing and printing of more currency notes, and as it is not accompanied by a corresponding increase in agricultural and industrial production and services there is every possibility of an inflationary trend setting in the economy.
What are the effects of Inflation?
It is not always true that additional purchasing power in the hands of people will develop inflationary tendencies. If the resources of a country are in an undeveloped condition, an addition to the purchasing power may stimulate investment leading to an increased supply of commodities. Money will be available at lower rates of interest and it will be a powerful factor in increasing the production of goods through larger investments of capital. Unemployed labor will get wider opportunities for gainful occupations and the standard of living for all classes of people will necessarily go higher. However, the evil effects of inflation are particularly noticeable in those highly industrialized countries where there is hardly any surplus or unemployed labor. Any increase in the supply of money cannot further widen the scope for employment or raise the productive capacity of the nation. The limits of productive capacity having been reached already, any increase in the supply of money can only result in pushing up the level of prices. The value of money fell rapidly and its depreciation affected particularly the interests of people with fixed incomes and investing classes. Inflation does incalculable harm to planning also. Once the prices are allowed to raise their ugly heads, all the calculations of the Government fail. If there is an increase in the general price level and it has its being on the projects, undertaken. Consequently, the Government needs more money to fulfill the targets. The Government must either resort to further deficit financing or must cut down the objectives as originally planned. The bright side of the picture it that an increase in the supply of money often creates opportunities for employment largely and considerably relieves the burden of unemployment. The resources of the country are more fully exploited and production is stepped up in all spheres of industrial activities. Thus, it is seen that inflation does some positive good to a backward country whose resources are undeveloped and where a large section of people remain idle for want of employment.
Remedial Measures:
However, the harmful tendencies of inflation should be minimized. In countries where inflation prevails, the Government must take effective steps to keep it under check.
Inflation can be combated by reducing the purchasing power of the people through imposition of additional taxes. The Governments sought to minimize the evil of inflation by resorting to taxation, controls, bans on speculation and encouragement to savings. Income tax, tobacco tax, entertainment tax and excess profit tax are all meant to withdraw currency from the money-market. A high rate of taxation may, however, prove annoying and take away the initiative for enterprise.
The Government sometimes raises public loans, which also effectively restricts the purchasing power of people.
It may also be necessary to impose a system of control on production and distribution of many goods. Rationing systems are introduced and prices of consumer goods are controlled.
Governments encourage people to invest in bank deposits, and government securities, thus withdrawing the currency in excess.
However, these measures, we must remember, can gain only a limited measure of success. They can check further rise in prices but cannot effectively bring them down.
Conclusion
While controls and the monetary measures enumerated above, have gone a long way to check inflation they alone are not sufficient. Inflationary tendency have to be fought on the production front. Although deficit financing increases the risks of inflation in economy for the time being, it would tend to check inflation in the long run when the investment would begin to yield results. While on one side money in circulation would be withdrawn by higher taxation and in the form of savings, greater production in agriculture and industrial spheres would place more commodities in the market to be purchased for the same amount of money.