Inflation and Phillip Curve

Inflation

  • Inflation is a term used to define a situation int the economy when the purchasing power of currency decreases. In other words, Inflation occurs when the price of goods and services in an economy begins to rise.

Causes of Inflation

  • Demand-Pull Inflation: This type of inflation occurs when the demand for a product is more than its supply. If the demand increases keeping the supplies constant, the price of commodities will increase which will lead to inflation. E.g. Fruits become costly in the off-season due to reduced supplies.
  • Cost-Push Inflation: This type of inflation occurs when the price of commodities rises due to an increase in the manufacturing costs of the commodity. E.g. The increase in Labour Rate will lead to an increase in the final price of the commodity.

Phillip Curve: Relation Between Inflation and Unemployment

  • A.W. Phillip stated that there is an inverse relationship between unemployment and inflation. According to him, the higher the inflation, the lower is the unemployment and vice-versa.
  • Higher Inflation implied higher cost of commodities which implied more revenue from the companies, if the company can sell their product at high prices, they will employ more people and increase output, this will lead to lesser unemployment in the economy. Lower inflation will lead to less revenue for the company and it will employ fewer people, this will lead to an increase in unemployment.
  • When we plot the above relation on a graph of Inflation vs Unemployment, the curve obtained is known as Phillip Curve. The following graph shows the Phillip Curve.
  • Many economies made their monetary policies considering the relation between inflation and unemployment and soon they experienced high inflation with high unemployment. The reason for the failure of Phillips Theory is as below:
  • When inflation strikes an economy, initially the price of commodities tends to rise, and the companies generate revenue but after some time, the public starts asking for extra wages:
    • If the wage of the Public is Increased, the cost of the commodity will rise further, this will diminish the increase in wage as the purchasing power of the money remained the same. This will lead to unemployment because there is no real increase in wages.
    • If the wage of the Public is not increased, the unemployment will increase, many workers quit the job due to low wages, this increase the unemployment in the economy along with increased inflation.
  • The scenario when the economy experiences high inflation along with high unemployment is known as Stagflation.
  • NAIRU (Non-Accelerating Inflation Rate of Unemployment) is the rate of unemployment, which is consistent with a rate of inflation, it is the lowest rate of unemployment an economy can sustain without any upward pressure on the inflation rate. If unemployment is at the NAIRU level, inflation is constant.

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