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One of the most commonly discussed metrics when speaking about the state of an economy is the inflation rate. Ever since the end of the Second World War, governments and central banks around the world have framed their monetary policy around inflation. Too high or too low and it is a problem. Monetary and fiscal policy is adjusted very carefully in order to achieve that perfect balance that sustains the inflation rate at just the right amount. Why is it so important?

Understanding Inflation

First, we must understand what inflation is. Simply put, it is the rate at which prices grow in an economy. If inflation last year was 3%, that means that the average prices of all goods and services were 3% more expensive than the previous year. How does this happen? Let’s say there were 500,000 new jobs created. This means that 500,000 people now earn an income, which then means that they have money to spend. This is new money that entered the economy because these people didn’t have jobs before. The jobs emerged because new businesses opened, and the businesses were only able to open because they managed to secure funding which they got from a bank or from an investor. The bank was able to give these businesses a loan because it got money from the Central Bank, which either printed the money or purchased bonds from the government.

With new money in the economy, people buy more goods. The company’s that sell these goods see their profits go up and presumably they pass these profits on to their employees, making them richer. With everyone now having more money than they did before, the value of each individual rupee goes down. The more you have of something, the less it is worth. So the goods sold in the economy cannot be priced at the same amount because the money that is being used to buy it is now worth less, meaning that the price of the goods has to go up. In this way, the general level of prices in an economy rises.

This is how inflation happens. The root of inflation is in the supply of money in an economy. In other words, inflation is the decline of the purchasing power of a currency over time.

Some amount of inflation is good for an economy, but too much or too little, as mentioned earlier, is an issue. If inflation can match up with the growth rate of the economy then it isn’t a problem. If it is too much, then goods become overpriced for everyone and if it is too little, i.e there is deflation, then this usually signifies a period of recession. Deflation is when the general level of prices decreases, and this tends to happen when demand in an economy falls.

Achieving the balance between too much and too little inflation is the responsibility of the Central Bank. There was a point in time when the government used to make these decisions itself, but it led to to politicians tweaking the interest rate/money supply to suit their own political goals. This led to periods where inflation was too high, too often. A Central Bank ensures an independent and unbiased handling of the situation and ever since countries decided to keep the government out of such practices, inflation has generally been lower.

The Phillips Curve

One of the most famous empirical findings in economics was published by New Zealand economist William Phillips. He studied the relationship between unemployment and inflation in the UK between 1861 and 1957 and found that the two were inversely related, i.e when one goes up the other goes down. This finding was presented in the form of a graph, known as the ‘Phillips Curve’.

This led to economists and policymakers to come to the conclusion that there was a tradeoff between the two. If a country wanted unemployment to be low, then it would have to accept higher inflation and vice-versa. The reason as to why they were inversely related was simple. As more people get jobs, there is more income to be spent. For decades thereafter, mainstream economics has always viewed inflation and unemployment to be two phenomena that work in tandem.

In the US, the impact of the Phillips Curve on its economic policies cannot be understated. Policymakers actively sought to increase unemployment when they saw that inflation was getting to be too high. They did this indirectly by withholding stimulus to the economy. This has gone on for decades thanks to the belief that employment and inflation were inversely related, yet research over the years has shown that that may not be the case. The most prominent example would be that of the 1970s when there was an energy crisis thanks to OPECs withholding of oil supplies. This led to a recession in the West with productivity falling drastically and unemployment rising as well. The rise in unemployment, however, was not met with a fall in inflation. Both unemployment and inflation remained high for much of the decade, leading many to start questioning the implications of the Phillips Curve.

One important thing to remember is that William Phillips’ findings were purely empirical and not theoretical. He found data but lacked the theory to explain it. A very straightforward explanation by looking at the data would tell you that they were inversely related, but as usual, there is more than meets the eye.

Since the 1970s, research has gone on to show that expectations play a central role in determining what inflation is likely to be. If a government announces stimulus measures, then people will start to expect inflation to rise. Once they have this expectation, they begin preparing for higher inflation by negotiating higher wages with their employers. The employers will also raise the prices of their goods and services in anticipation of higher inflation in order to protect their profit margins. In this way, inflation goes up before the government has even done anything.

Since expectations can have such a powerful impact on inflation, how much influence does the Central Bank or government really have? What tends to happen in practice is that monetary policy only really influences the inflation rate, having little to no effect on employment. Employment is something that is determined by a host of other factors which also include inflation, but only to a very limited extent. This calls into question decades of policymaking decisions that sought to control employment in a country by means of inflation. Inflation also is not as affected by the unemployment rate as it is by the actual amount of wages paid to the workers. So it is not the number of people employed, but how much these people are getting paid that affects the inflation rate.

What this means is that the level of employment can not be used as a metric to judge inflation in a country. In August of 2020 the Federal Reserve in the US announced that it would no longer raise interest rates if unemployment were to fall below a certain level, which had been standard practice until then. This is how most Central Banks function but it is now being accepted that the theoretical understanding of the Phillips Curve is still incomplete.

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