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Understanding Inflation and Phillips Curve

  • Vrinda Mathur
  • Jan 31, 2024
  • Updated on: Oct 01, 2023
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You aren't dreaming if it seems like your money doesn't go as far as it once did. Inflation, which is defined as the progressive erosion of the purchasing power of your money over time, is the cause. Here are some tips on how to comprehend inflation and how to safeguard the worth of your money.

 

What do We Understand by Inflation?

 

Price increases, or inflation, can be thought of as the gradual loss of purchasing power. The average price increase of a selection of products and services over time can serve as a proxy for the rate at which buying power declines. A unit of currency effectively buys less as a result of the increase in pricing, which is sometimes stated as a percentage. Deflation, which happens when prices drop and buying power rises, can be compared to inflation.

 

Deflation is the term for a decrease in prices across all economic sectors or the overall economy. The ability to purchase more for less money tomorrow may seem appealing, but experts caution that deflation can be even more harmful to an economy than unrestrained inflation. When deflation sets in, buyers put off current purchases in anticipation of larger price drops in the future. Deflation can reduce or even stop economic growth if it is allowed to continue, which would destroy wages and paralyze an economy.

 

A measure of the economy's rate of rising prices for goods and services is called inflation. In the end, it demonstrates the rupee's declining purchasing power. It is quantified in percentage terms.

 

This quantitative economic analysis determines how quickly prices of particular commodities and services change over time. Inflation shows how much the average price for the chosen basket of goods and services has changed. A percentage is used to represent it. A rise in inflation signals a decline in the economy's purchasing power.

 

This percentage shows the change from the prior time period, either up or down. As inflation increases, the value of money continues to decline, which is a cause for concern. Inflation may be a devastating factor in an economy if allowed to spiral out of control and skyrocket. Unchecked inflation may bring a country's economy crashing down, as happened in 2018 when Venezuela's inflation rate reached over 1,000,000% each month, leading the economy to collapse and prompting tens of thousands of inhabitants to abandon the country

 

Inflation may be a devastating factor in an economy if allowed to spiral out of control and skyrocket. Unchecked inflation may bring a country's economy crashing down, as happened in 2018 when Venezuela's inflation rate reached over 1,000,000% each month, leading the economy to collapse and prompting tens of thousands of inhabitants to abandon the country.

 

Also Read | How is Inflation affecting Consumer Behaviour?
 

What Causes Inflation?

 

What are the fundamental factors that gradually reduce the purchasing power of the dollar or any other currency since prices don't just rise on their own?

 

The supply and demand theory of a free market is the most popular theory to explain inflation. If there is more demand than supply for a thing in a free and open market, the price of that product will often increase. Prices decrease as supply outpaces demand. To put it another way, each unit loses value when there is an excessive amount of the product on the market.

 

When prices increase throughout the economy, your money has less buying power and inflation results. For instance, the average price of a cinema ticket in 1980 was $2.89. The average cost of a movie ticket increased to $9.16 by 2019. A $10 dollar from 1980 would buy two fewer movie tickets in 2019 than it did nearly four decades earlier if you had saved it.

 

However, don't conceive of inflation as simply increasing costs for a single good or service. Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy.

 

A product has a higher weight when it comes to evaluating inflation if consumers spend more of their income on it. For example, household costs for food and petrol are larger than for postcards or shaving creams, so these costs are given bigger weights when calculating inflation. As a result, changes in the price of food or gasoline have a greater impact on inflation than changes in the price of shaving cream.

 

Too-low inflation can also impede growth by keeping an excessive amount of money in savings accounts as people hold off on spending while they wait for the value of their dollars to increase, just as high inflation can suffocate the economy by diminishing purchasing power. The ideal inflation rate encourages people to spend money now rather than store it for the future, which leads to the correct kind of economic growth.

 

The Consumer Price Index (CPI), Producer Price Index (PPI), and Personal Consumption Expenditures Price Index (PCE), which all use different measures to track the change in prices consumers pay and producers receive in industries across the entire American economy, are the three main measures of U.S. inflation.

 

Although it can be discouraging to realize that your money is depreciating, most economists view a tiny amount of inflation as a positive indicator of a robust economy. A moderate inflation rate encourages you to invest or use your money now rather than stowing it away and watching it lose value.

 

Inflation, while a source of concern for the economy, does not have a negative impact on everyone. It is a blessing for a certain group of people. While inflation reduces consumers' purchasing power, it benefits investors. Investors who hold assets affected by inflation for an extended period of time will undoubtedly benefit from it. A rise in house prices, for example, could have an impact on consumers. Those who have already purchased a home, on the other hand, will gain from capital appreciation.

 

What is The Phillips Curve?

 

The Phillips curve is an economic hypothesis that states that unemployment and inflation have a constant and inverse connection. It was developed by William Phillips and asserts that economic expansion leads to inflation, which leads to more jobs and decreased unemployment. The basic premise of the Phillips curve has been somewhat disproven due to the incidence of stagflation in the 1970s, when both inflation and unemployment were high.

 

The Phillips Curve is a graphical illustration of an economy's short-term relationship between unemployment and inflation. According to the Phillips Curve, there is a negative, or inverse, relationship between an economy's unemployment rate and its inflation rate.

 

The Phillips curve notion asserts that changes in unemployment within an economy have a predictable influence on price inflation. The inverse link between unemployment and inflation is displayed as a concave, downward sloping curve, with inflation on the Y-axis and unemployment on the X-axis. Inflationary pressures reduce unemployment, and vice versa.

 

Alternatively, focusing on lowering unemployment raises inflation, and vice versa. In the 1960s, it was assumed that any fiscal stimulus would enhance aggregate demand and trigger the following effects. As labor demand rises, the pool of unemployed workers shrinks, and employers raise wages to compete and recruit a smaller talent pool. Wage expenses rise for corporations, and those costs are passed on to customers in the form of price hikes.

 

Following the release of John Maynard Keynes' "The General Theory," most economists and policymakers felt that in order for the economy to grow, aggregate demand in the market needed to be boosted. However, if policymakers used monetary and fiscal policy to encourage aggregate demand, the increase in employment and output was accompanied by a fast rising price level. In order to minimize inflation, officials would have to restrict output and employment in the short run.

 

When an economy faces slow economic growth, high unemployment, and high price inflation, this is referred to as stagflation. Of course, this scenario completely contradicts the principle underlying the Phillips curve. Stagflation did not occur in the United States until the 1970s, when rising unemployment did not correspond with lowering inflation.Between 1973 and 1975, the US economy saw six consecutive quarters of falling GDP while tripling its inflation rate.

 

When the central bank raises inflation to reduce unemployment, it may create an initial movement along the short-run Phillips curve, but as worker and consumer inflation expectations adjust to the new environment, the Phillips curve itself can shift outward in the long term. This is assumed to be especially true around the natural rate of unemployment, also known as the NAIRU (Non Accelerating Inflation Rate of Unemployment), which effectively represents the typical amount of frictional and institutional unemployment in the economy.

 

So, if expectations can adjust to changes in inflation rates in the long run, the long-run Phillips curve resembles a vertical line at the NAIRU; monetary policy merely boosts or lowers the inflation rate after market expectations have been worked out.

 

Also Read | How is Deflation different from Disinflation?

 

How to Prevent Inflation in India?

 

Retail inflation in India rose to 6.52% in January 2023, owing primarily to an increase in food inflation caused by rising wheat and product prices.In December 2022, retail inflation based on the Combined Price Index (Combined) was 5.72%.

 

In addition, the Combined Food Price Inflation (CFPI) climbed to 5.94% in January 2023, up from 4.19% in December 2022 and 5.43% the previous year.

 

Inflation is a tricky issue in any economy. While modest inflation is appropriate, beyond a particular level might lead to a devastating economic situation. Here's what causes inflation, how to stop it, and what steps the government may do to keep it under control.

 

The basic technique for preventing inflation is to change monetary policy by adjusting interest rates. Increased interest rates reduce economic demand. This leads to slower economic growth and, as a result, reduced inflation.

 

Due to the higher dollar value, India must purchase (import) raw materials and other items at a higher price. Importing at a high cost raises the cost of production, resulting in increased prices for finished goods or services, generating inflation in the Consumer Price Index. In order to manage inflation, the government employs both monetary and fiscal policies.

 

  1. Economic Policies  

 

Controlling the money supply in the economy is an important monetary approach to combat inflation. If the money supply shrinks, demand for things falls, forcing prices to fall. Another approach for the government to limit the money supply is to withdraw certain paper notes or coins from circulation. Lowering commercial bank lending rates gives for greater control over money circulation. The Central Bank can also prevent commercial banks from borrowing money by issuing government securities.  

 

  1. Budgetary Policies

 

Government revenue and expenditure are the two most important components of fiscal policy.  The government can adjust tax rates to boost revenue or to better manage spending. When demand exceeds supply, an inflationary gap is generated. The government has two options for dealing with this.   

 

One way is to reduce overall government spending and transfer payments. Two, raising tax rates reduces individual demand and reduces the economy's money supply.  


 

  1. RBI Monitoring 

 

In May and June, the RBI raises repo rates for the second time in a row. In the last two months, the interest rate has risen by 0.90%. The RBI is expected to raise it more in order to keep inflation under control.   

 

The government has announced a reduction in the excise duty on petrol and diesel. The excise duty drop on petrol and diesel will result in a shortfall of INR 1 lakh crore for the government. Fuel costs in India have been reduced further as the price of crude oil per barrel has fallen. 

 

  1. Wage/price restrictions 

 

In theory, attempting to limit wages and prices could assist to alleviate inflationary pressures. They are, however, rarely utilized since they are rarely successful. 

The government has capped sugar exports and prohibited wheat exports entirely. Its primary purpose is to ensure appropriate supply and food security inside the country while also lowering prices.  

 

Conclusion

 

To wrap up, Inflation is likely to continue erratic given the significant volatility in global crude oil prices since late February. The rate is subject to changes in oil and commodity prices in the future. Considering the RBI's previous actions, we can confidently expect that India's central bank would take additional rate raise measures to keep inflation below acceptable ranges. 


Also Read | Benefits of Inflation in the Economy

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