Keynes’s analysis is subjected to two main drawbacks.

First, it lays
emphasis on demand as the cause of inflation, and neglects the cost side of
inflation. Second, it ignores the possibility that a price rise may lead to
further increase in aggregate demand which may, in trun, lead to further
rise in prices.

However, the types of inflation during the Second World War, in the
immediate post-war period, till the middle of the 1950s were on the
Keynesian model based on his theory of excess demand. “In the latter
1950s, in the United States, unemployment was higher than it had been in
the immediate post-war period, and yet prices still seemed to be rising, at
the same time, the war time fears of postwar recession had belatedly been
replaced by serious concern about the problem of inflation. The result was
a prolonged debate...On the one side of the debate was the ‘cost-push’
school of thought, which maintained that there was no excess
demand...On the other side was the “demand-pull” school...Later, in the
United States, there developed a third school of thought, associated with
the name of Charles Schultz, which advanced the sectoral ‘demand-shift
theory’ of inflation...While the debate over cost-push versus demand-pull
was raging in the United States, a new and very interesting approach to
the problem of inflation and anit-inflationary policy was developed by
A.W. Phillips.”2

In the present chapter, we shall study all theories mentiond here, besides
Keynes’s thoery of the inflationary gap. But before we analyse them, it is
instructive to know about the meaning of inflation.

MEANING OF INFLATION

To the neo-classicals and their followers at the University of Chicago,

inflation is fundamentally a monetary phenomenon. In the words of
Friedman, “Inflation is always and everywhere a monetary
phenomenon...and can be produced only by a more rapid increase in the
quantity of money than output.”3 But economists do not agree that money
supply alone is the cause of inflation. As pointed out by Hicks, “Our
present troubles are not of a monetary character.” Economists, therefore,
define inflation in terms of a continuous rise in prices. Johnson defines

Download more at Learnclax.com

“inflation as a sustained rise”4 in prices. Brooman defines it as “a
continuing increase in the general price level.”5 Shapiro also defines
inflation in a similar vein “as a persistent and appreciable rise in the
general level of prices.”6 Dernberg and McDougall are more explicit
when they write that “the term usually refers to a continuing rise in prices
as measured by an index such as the consumer price index (CPI) or by the
implicit price deflator for gross national product.”7

However, it is essential to understand that a sustained rise in prices may

be of various magnitudes. Accordingly, different names have been given
to inflation depending upon the rate of rise in prices.

2. Harry G. Johnson, Essays in Monetary Economics.

3. The Counter Revolution in Monetary Theory, 1970.

4. Harry W. Johnson op. cit, p. 104.

5. F. S. Brooman, op. cit., p. 285.

6. Edward Shapiro, op. cit., p. 142.

7. Macroeconomics,, pp. 288.

1. Creeping Inflation. When the rise in prices is very slow like that of a
snail or creeper, it is called creeping inflation. In terms of speed, a
sustained rise in prices of annual increase of less than 3 per cent per
annum is characterised as creeping inflation. Such an increase in prices is
regarded safe and essential for economic growth.

2.Walking or Trotting Inflation. When prices rise moderately and the

annual inflation rate is a single digit. In other words, the rate of rise in
prices is in the intermediate range of 3 to 7 per cent annum or less than 10
per cent. Inflation at this rate is a warning signal for the government to
control it before it turns into running inflation.

3. Running Inflation. When prices rise rapidly like the running of a horse
at a rate of speed of 10 to 20 per cent per annum, it is called running
inflation. Such an Inflation affects the poor and middle classes adversely.
Its control requires strong monetary and fiscal measures, otherwise it leads

Download more at Learnclax.com

 to hyperinflation.

4. Hyperinflation. When prices rise very fast at double or triple digit rates
from more than 20 to 100 per cent per annum or more, it is usually called
runaway or galloping inflation. It is also characterised as hyperinflation
by certain economists. In reality, hyperinflation is a situation when the
rate of inflation becomes immeasurable and absolutely uncontrollable.
Prices rise many times every day. Such a situation brings a total collapse
of monetary system because of the continuous fall in the purchasing
power of money.

The speed
with which
prices tend
to rise is
illustrated in
Figure 1.
The curve C
shows
creeping
inflation
when within
a period of
ten years the
price level
has been
shown to
have risen by about 30 per cent. The curve W depicts walking inflation
when the price rose by more than 50 per cent during ten years. The curve
R illustrates running inflation showing a rise of about 100 per cent in ten
years. The steep curve H shows the path of hpyerinflation when prices
rose by more than 120 per cent in less than one year.

THE INFLATIONARY GAP

In his pamphlet How to Pay for the War published in 1940, Keynes
explained the concept of the inflationary gap. It differs from his views on

Download more at Learnclax.com

 Demand-Pull Inflation and Cost-Push Inflation
Demand-Pull Inflation
When consumer demand outpaces the available supply of many types of
consumer goods, demand-pull inflation sets in, forcing an overall
increase in the cost of living.
Demand-pull inflation is a tenet of Keynesian economics that describes
the effects of an imbalance in aggregate supply and demand. When the
aggregate demand in an economy strongly outweighs the aggregate
supply, prices go up. This is the most common cause of inflation.

In Keynesian economic theory, an increase in employment leads to an

increase in aggregate demand for consumer goods. In response to the
demand, companies hire more people so that they can increase their
output. The more people firms hire, the more employment increases.
Eventually, the demand for consumer goods outpaces the ability of
manufacturers to supply them.

There are five causes for demand-pull inflation

1. A growing economy: When consumers feel confident, they spend

more and take on more debt. This leads to a steady increase in
demand, which means higher prices.
2. Asset inflation: A sudden rise in exports forces an undervaluation
of the currencies involved.
3. Government spending: When the government spends more freely,
prices go up.
4. Inflation expectations: Companies may increase their prices in
expectation of inflation in the near future.
5. More money in the system: An expansion of the money
supply with too few goods to buy makes prices increase.
Cost-Push Inflation

Cost-push inflation occurs when overall prices increase (inflation) due to

increases in the cost of wages and raw materials. Higher costs of
production can decrease the aggregate supply (the amount of total
production) in the economy. Since the demand for goods hasn't changed,
the price increases from production are passed onto consumers creating
cost-push inflation.

Causes for Cost push inflation

 Cost-push inflation occurs when overall prices increase (inflation)

due to increases in the cost of wages and raw materials.
 Since the demand for goods hasn't changed, the price increases
from production are passed onto consumers creating cost-push
inflation.
 Unexpected causes of cost-push inflation are often natural
disasters, which can include floods, earthquakes, fires, or
tornadoes. If a large disaster causes unexpected damage to a
production facility and results in a shutdown or partial disruption
of the production chain, higher production costs are likely to
follow.
 Other events might qualify if they lead to higher production costs,
such as a sudden change in government that affects the country’s
ability to maintain its previous output. However, government-
induced increases in production costs are more often seen in
developing nations.
 Government regulations and changes in current laws, although
usually anticipated, may cause costs to rise for businesses because
they have no way to compensate for the increased costs associated
with them. For example, the government might mandate that
healthcare be provided, driving up the cost of employees or labor.
Let us look at some of the points of difference between demand pull
inflation and cost push inflation.
Demand Pull Inflation Cost Push Inflation

Definition

Inflation that occurs due to increase in aggregate Inflation that results from decline in aggregate supply
demand is referred to as demand pull inflation due to external factors is referred to as cost push
inflation.

Impact of aggregate demand

Increased aggregate demand results in demand In cost push inflation the aggregate demand remains the
pull inflation same.

Caused by

Rise in aggregate demand Rise in price of inputs like raw materials, labour, etc

What it represents

The beginning of price inflation The idea that inflation is difficult to stop, once it has
started

Causative Factors

Monetary factors and real factors Caused by business groups of society who respond to
rise in costs of the product (input prices)

Prevalence

Demand pull inflation occurs in most economies Cost push inflation is not that relevant in current times
of the world
474 PA R T E I G H T S H O R T - R U N E C O N O M I C F L U C T U AT I O N S

the money supply, which a nation’s central bank controls. In the long run, there-
fore, inflation and unemployment are largely unrelated problems.
In the short run, just the opposite is true. One of the Ten Principles of Economics
discussed in Chapter 1 is that society faces a short-run tradeoff between inflation
and unemployment. If monetary and fiscal policymakers expand aggregate de-
mand and move the economy up along the short-run aggregate-supply curve, they
can lower unemployment for awhile, but only at the cost of higher inflation. If pol-
icymakers contract aggregate demand and move the economy down the short-run
aggregate-supply curve, they can lower inflation, but only at the cost of temporar-
ily higher unemployment.
In this chapter we examine this tradeoff more closely. The relationship be-
tween inflation and unemployment is a topic that has attracted the attention of
some of the most important economists of the last half century. The best way to un-
derstand this relationship is to see how thinking about it has evolved over time. As
we will see, the history of thought regarding inflation and unemployment since
the 1950s is inextricably connected to the history of the U.S. economy. These two
histories will show why the tradeoff between inflation and unemployment holds
in the short run, why it does not hold in the long run, and what issues it raises for
economic policymakers.

THE PHILLIPS CURVE

The short-run relationship between inflation and unemployment is often called the
Phillips curve. We begin our story with the discovery of the Phillips curve and its
migration to America.

ORIGINS OF THE PHILLIPS CURVE

In 1958, economist A. W. Phillips published an article in the British journal Eco-

nomica that would make him famous. The article was titled “The Relationship be-
tween Unemployment and the Rate of Change of Money Wages in the United
Kingdom, 1861–1957.” In it, Phillips showed a negative correlation between the
rate of unemployment and the rate of inflation. That is, Phillips showed that years
with low unemployment tend to have high inflation, and years with high unem-
ployment tend to have low inflation. (Phillips examined inflation in nominal
wages rather than inflation in prices, but for our purposes that distinction is not
important. These two measures of inflation usually move together.) Phillips con-
cluded that two important macroeconomic variables—inflation and unemploy-
ment—were linked in a way that economists had not previously appreciated.
Although Phillips’s discovery was based on data for the United Kingdom, re-
searchers quickly extended his finding to other countries. Two years after Phillips
published his article, economists Paul Samuelson and Robert Solow published an
article in the American Economic Review called “Analytics of Anti-Inflation Policy”
in which they showed a similar negative correlation between inflation and un-
employment in data for the United States. They reasoned that this correlation
 CHAPTER 21 T H E S H O R T - R U N T R A D E O F F B E T W E E N I N F L AT I O N A N D U N E M P L O Y M E N T 475

arose because low unemployment was associated with high aggregate demand,
which in turn puts upward pressure on wages and prices throughout the economy.
Samuelson and Solow dubbed the negative association between inflation and un-
employment the Phillips curve. Figure 21-1 shows an example of a Phillips curve Phillips curve
like the one found by Samuelson and Solow. a curve that shows the short-run
As the title of their paper suggests, Samuelson and Solow were interested in tradeoff between inflation and
the Phillips curve because they believed that it held important lessons for policy- unemployment
makers. In particular, they suggested that the Phillips curve offers policymakers a
menu of possible economic outcomes. By altering monetary and fiscal policy to in-
fluence aggregate demand, policymakers could choose any point on this curve.
Point A offers high unemployment and low inflation. Point B offers low unem-
ployment and high inflation. Policymakers might prefer both low inflation and
low unemployment, but the historical data as summarized by the Phillips curve
indicate that this combination is impossible. According to Samuelson and Solow,
policymakers face a tradeoff between inflation and unemployment, and the
Phillips curve illustrates that tradeoff.

A G G R E G AT E D E M A N D , A G G R E G AT E S U P P LY,
AND THE PHILLIPS CURVE

The model of aggregate demand and aggregate supply provides an easy explana-
tion for the menu of possible outcomes described by the Phillips curve. The Phillips
curve simply shows the combinations of inflation and unemployment that arise in the
short run as shifts in the aggregate-demand curve move the economy along the short-run
aggregate-supply curve. As we saw in Chapter 19, an increase in the aggregate de-
mand for goods and services leads, in the short run, to a larger output of goods
and services and a higher price level. Larger output means greater employment

Figure 21-1

T HE P HILLIPS C URVE . The

Inflation
Rate
Phillips curve illustrates
(percent a negative association between
per year) the inflation rate and the
unemployment rate. At
6 B
point A, inflation is low and
unemployment is high. At
point B, inflation is high
and unemployment is low.

A
2

Phillips curve

0 4 7 Unemployment
Rate (percent)