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Tag Archives | Phillips Curve

Why Moderate Inflation is a good thing

By Prakhar Misra

Inflation is not always bad for the economy. Some amount of inflation can aid the growth of an economy.

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In economics and in public discourse, inflation is a highly debated term spurring very extreme emotional responses. The media reports tend to suggest, albeit subtly, that inflation is a bad thing and that rising inflation is a cause of concern that needs to be dealt with immediately.

However, that is not true. Inflation, like all other Economic concepts is one that is beneficial if maintained in balance. Too high or too low inflation can be problematic. The costs of a deflationary economy are all too clearly seen in Europe now and in Japan since the 1990s.

Inflation is basically a resultant of supply and demand of money in relation to the amount of goods and services produced in an economy. If there is more money, the value of each unit of the currency is reduced. So, it makes the currency less valuable in effect causing a rise in price. But, there is a general consensus that some amount of moderate inflation in healthy for the Economy.

The first caveat of this wisdom lies in John Maynard Keynes’ description of “Paradox of thrift”. Keynes talked about this paradox with respect to savings rate and one way to go around it was to have some positive inflation. If there is no inflation and prices keep reducing, then individuals will keep delaying their spending which will lead to a fall in aggregate demand resulting in less production, layoffs and hence a decline in Economic growth. Hence, having a positive inflation rate helps in preventing such a situation.

In theory, inflation also helps in increasing production. More money means more spending which further translates to an increase in aggregate demand. This increase feeds into increasing production of goods in the country.  Infact, the Phillips Curves showed that by increasing inflation, we can successfully bring down unemployment levels. Although the 1970s era of ‘stagflation’ successfully rebutted this claim- but it was in the minds of many until then.

Higher inflation would lead to a price rise which would push companies to raise wages too. This might not be by full effect of inflation, but some sort of a rise can be expected. Thus, the rise in prices is more than the rise in wages as revision of wages takes time due to rewriting of contracts. This leads to an increase in the income of the firm which in turn helps in reducing the debt on loans and mortgages, effectively benefitting companies.

Inflation also helps governments reduce its debt burdens in 2 ways.Firstly, a healthy dose of inflation in the economy helps governments to collect more taxes. Even if the economy is stagnant, as long as there is inflation- the revenues of the government would continue to increase. Thus, even though inflation may devalue the currency – it may be offset by the excess money coming into the system that can be used to invest, build, hire more staff and spend in other areas of boosting economic activity. Secondly, the debt owed by governments to its lenders is not indexed to inflation. Thus, a higher rate of inflation reduces the value of the government’s debt, assisting the government in effectively paying back a lesser value than what it would otherwise.

But, all of these benefits are to inflation only if it is administered in moderation. Unless interest rates are higher than inflation rate, too much inflation leads to an inflationary spiral. Because of high prices- the profits of a company rise and so they hire more workers and increase wages. So, now goods are priced higher and people have more money to spend- and this leads to a successive increase in price rise. So, prices keep rising, but we don’t receive any benefit for our excess money. A deflationary spiral is equally dangerous, if not more. Prices reduce and people spend less because they delay their spending in expectation of prices to reduce further. This leads to companies laying off workers and cutting costs which further leads to a price-cut and so on.

For the first time in 2015, a Monetary Policy Framework was signed between the RBI and the Government of India which categorically states the following with respect to inflation: “The target for financial year 2016-17 and all subsequent years shall be 4% +/- a band of 2%.”

The target for January 2016, from the MPF, was to bring Inflation below 6% and the RBI has succeeded in doing that. Although, some Economists argue that even 5% is too high for India given that many countries in the world are hovering between 1-3% inflation rate.

A 3% inflation rate is generally accepted to be ideal, i.e, pushing a country to economic growth and preventing it from sliding into recession. While the inflation target of USA is set at 2%, countries like Zimbabwe had an inflation rate of 231 million % until very recently. So, Inflation can go either way depending on how well it is managed.

As the Austrian philosopher and economist Ludwig Von Mises said, “The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague, inflation is a policy.”

Prakhar Misra is a Chanakya Scholar at the Meghnad Desai Academy of Economics. He is an Alumnus from the GCPP. He tweets @prakharmisra .

 

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The Macroeconomic Case for Central Bank Independence – I

The Long Run Phillips Curve shows that any policy that tries to increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and lower GDP growth rate in the long run.

In a pioneering paper titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, engineer turned economist E.W Phillips noticed a statistical correlation between two macroeconomic variables that would define economic policies in the decades to come. He noticed an inverse relationship between unemployment and inflation, i.e. when unemployment was low, inflation was high and vice-versa. Graphically, this is a downward sloping curve as shown below.

Figure 1: The original Phillips curve for the period 1948 to 1957, showing the inverse relationship between inflation and unemployment.

Figure 1: The original Phillips curve for the period 1948 to 1957, which shows the inverse relationship between inflation and unemployment.

This particular statistical relationship had huge implications for fiscal and monetary policy. The correlation between the two macro variables was now seen as a trade-off – an economy can lower unemployment if it tolerates a bit of inflation. Noted economists Solow and Samuelson used this relationship to advocate large governmental (deficit) spending and lower interest rates. The rationale behind this was that as long as you can lower unemployment rate, through increased GDP growth, a slightly higher level of inflation can be tolerated. It was believed that the welfare gain through higher growth and lower unemployment would offset the welfare loss due to a higher rate of inflation.

This line of reasoning was employed in the US in the 1960s – the decade of previously unprecedented economic growth – to reduce unemployment to record lows while inflation went up only slightly. Democratic President Lyndon B Johnson initiated “The Great Society”, which involved huge government expenditure to boost growth and lower unemployment. In the 1969 Economic Report of the President to the Congress, the Phillips Curve was again used to justify the large deficit spending in infrastructure, war expenditure (Vietnam), education, Medicare and Medicaid and finally, welfare benefits. Notice that the unemployment rate was reduced from 7% in 1961 to less than 4% in 1968, with inflation increasing from about 1% to 4% in the same period.

 

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Then came the great stagflation. The first part of 1970s saw the US and UK economy go through something unusual that could not be explained by the Phillips Curve. Inflation and unemployment both increased simultaneously. This peculiar phenomenon was called as stagflation (a term coined by British Chancellor of the Exchequer, Iain McLeod to denote stagnation plus inflation). The US stagflation is wrongly attributed, even today in most economic textbooks, to the infamous oil price shocks in the early 1970s. However, that is simplistic and flawed reasoning. The real cause of the episode of stagflation in the US is the buildup of inflation momentum. By the time of the OPEC oil shock, inflation in the US had doubled from 3% to 6% due to the expansionary fiscal and monetary policy followed in the 1960s. The high US inflation caused the dollar to depreciate in the world markets and since oil was invoiced in dollars, the OPEC was forced to increase their prices.

The Long Run Phillips Curve

The US stagflationary episode is better explained by the Expectations Augmented Phillips Curve (EAPC). The Chicago School monetarists led by Milton Friedman deconstructed the inflation-unemployment tradeoff suggested by the Phillips Curve.  The EAPC demonstrated that the Phillips curve tradeoff holds true only in the short run and it turns vertical in the long run. The policy implication of the long run Phillips Curve is that though lower levels of unemployment can be achieved in the short run by compromising on inflation, in the long run, both inflation and unemployment will end up being higher. This is shown in the graph below. Taking 1981 as the end period (before Paul Volcker’s war on inflation in the 1980s), it can be seen that unemployment has increased by half a percentage point, while inflation has increased by about 8 percentage points from 1961.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Theoretically, in a long enough period, there can be several short run Phillips curves where high GDP growth rates can be achieved with small increases in inflation. In the long run, however, the Phillips curve will be vertical, denoting that there is no tradeoff between the two variables.

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

Relevance Today:

Due to the inherent nature of democratic cycles, most policy makers in developing countries still try to trade off high GDP growth rate with inflation. Since the political term is for five years, there is a tendency to ride on the short run Phillips Curve. Furthermore, the level of economic activity (GDP) reacts much quicker than inflation – it takes time for the population to adjust their inflation expectations and renegotiate their contracts. Thus, it is always tempting for policy makers to push through policies that increases GDP growth rate immediately (especially, if the elections are around the corner) and worry about inflation in the next term or leave it as a parting gift for the next government.

India saw incredible growth rate between 2004 and 2009 mainly because of policies (both monetary and fiscal) that pushed the GDP growth rate above its potential GDP (See post on Potential GDP). Expansionary fiscal policy through increased welfare spending (MGNREGA, MSP, etc) along with interest rate cuts by the RBI (through sustained pressure by the Finance Ministry) saw GDP growth rates touch 9% for three years. The long run Phillips curve took effect after 2010 where India underwent a stagflationary period of increased inflation and lower growth.

Much of India’s fiscal policy still aims to take advantage of the short run Phillips curve, despite the knowledge of the consequences it entails. This is precisely the reason why leaving monetary policy in the hands of the government will have disastrous effects. The inherent growth bias in politicians will naturally opt for lower interest rates to push up growth. An independent central bank is not prone to time bound election pressures and will thereby maintain price stability in the long run, which, by itself is conducive to sustainable growth.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

Read Part II Here

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