Inflation: Theory vs Reality

The shift of focus from employment generation to inflation targeting seem to have taken place during the period India was being liberalised. Inflation, however, is a concern to the populace of any nation where wages are not indexed to inflation. In India, inflation poses problems as a rise in prices reduces the real wages and hence their purchasing power. Life, itself, can become difficult.

This post briefly tries to clarify how inflation is conceptualised in economics (neoclassical). Initially, it needs to be pointed out that neoclassical economics analyses equilibrium positions and differences between them – commonly termed as comparative statics. Another significant issue is that, in neoclassical demand and supply, the analysis is entirely carried out in logical time. Now, let us take a look at how prices are formed in equilibrium. In equilibrium, it is required that total demand of a commodity equals its total supply. And, if demand is more than the supply, prices are caused to rise, in order to restore equilibrium. Surprisingly, it is this insight that forms the basis of the current theory of inflation, which is mentioned in the media and talked about by economists.

Thinking through this ‘insight’, a few points come to my mind. First, an economy is never in a state of equilibrium. And neoclassical theory does not have the necessary tools to understand disequilibrium. Though, neoclassical theory can point out the characteristics of disequilibrium positions vis-a-vis equilibrium position. I doubt whether this is adequate. Secondly, prices in an economy does not rise, just because demand increases. Such a behaviour is commonly seen in markets for vegetables, fruits, meat, etc. It seems absurd to posit that prices of manufactured commodities will move according to changes in demand.

This much said, let us examine the impact of money supply on prices in an economy. Is there a relation between money supply and prices’ The first question which needs to be answered is how are prices formed. According to neoclassical economics, when demand rises, it implies that money supply in the economy has risen compared to the equilibrium state of affairs. The quantity theory of money seems to corroborate the hypothesis that money supply and prices are directly related. But what if they are not’ Wouldn’t the policies fail’

It is dangerous to build flimsy theories; for, policies draw arguments from these theories. For instance, the central bank tries to reduce money supply during inflationary conditions by raising the interest rates (indirectly) or through open market operations. How far are they effective’ Or, is inflation just a temporary phenomenon’ It needs to be mentioned that cases of hyperinflation is significantly different as they are strongly correlated with the breakdown of institutions.

This post ends by asking whether an increased rate of interest leads to decreased money supply’ Or whether an increased rate of interest causes prices to rise because the cost of borrowing increases’ Also, high interest rates attract capital from abroad. Very often, causes of inflation are not properly identified, which makes policy construction very difficult.

On Inflation Targeting

The rate of Inflation is of great concern to the Central Bank of a country as well as to its Government.

This concern of the authorities is what makes ‘inflation targeting’ important. But should it be the only concern’

What is ‘Inflation targeting”

Inflation targeting is a framework for operating monetary policy. The first authority to formulate it was the Reserve Bank of New Zealand in the early 1990s. It is undertaken by the monetary authorities and it tries to keep the price stable without adversely affecting output and employment. [Khatkhate 2006]

On Phillips curve

The Phillips curve represents the relationship between the rate of inflation and the unemployment rate. Although several people had made similar observations before him, A. W. H. Phillips published a study in 1958 that represented a milestone in the development of macroeconomics. Phillips discovered that there was a consistent inverse, or negative, relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957. When unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. [Hoover]

Inflation targeting has gained a lot of importance, mainly owing to the downward slope of the Phillips curve.


NAIRU or Non-accelerating inflation rate of unemployment was introduced by Milton Friedman and Edmund Phelps during the 1970s.

NAIRU is a steady state unemployment rate above which inflation would fall and below which inflation would rise.

The natural rate of unemployment is a key concept in modern macroeconomics. Its use originated with Milton Friedman’s 1968 Presidential Address to the American Economic Association in which he argued that there is no long-run trade-off between inflation and unemployment: As the economy adjusts to any average rate of inflation, unemployment returns to its “natural” rate. Higher inflation brings no benefit in terms of lower average unemployment, nor does lower inflation involve any cost in terms of higher average unemployment. A second important unemployment rate is the “Non-Accelerating Inflation Rate of Unemployment,” or NAIRU. This is the unemployment rate consistent with maintaining stable inflation. According to the standard macroeconomic theory enshrined in most undergraduate textbooks, inflation will tend to rise if the unemployment rate falls below the natural rate. Conversely, when the unemployment rate rises above the natural rate, inflation tends to fall. Thus, the natural rate and the NAIRU are often viewed as two names for the same thing, providing an important benchmark for gauging the state of the business cycle, the outlook for future inflation, and the appropriate stance of monetary policy. [FRBSF Economic Letter 1998]

A digression

I am digressing from ‘inflation targeting’ and am going to talk about a welcome proposal by the Indian Government.

In a bid to obtain a `true picture’ of the effect of price changes on the economy, the Union Finance Ministry has proposed the inclusion of services in the Wholesale Price Index (WPI) which is used to measure point-to-point inflation. In India, the services sector accounted for 54 per cent of the GDP during the previous fiscal year. [The Hindu 2007]

In an earlier post of mine, I had argued for a restructuring of the WPI.


Giving too much significance to the ‘Inflation rate’ without adequate and corresponding developments in food supply, public distribution systems, etc will not help combat the problems of unemployment. Thus the fiscal and monetary authorities must ensure that such areas are targeted during a ‘rise in inflation’.

Increasing interest rates and importing food grains so as to bring down inflation rates will not succeed as the ‘inflation’ is basically caused by distributional inefficiencies.


1) Deena Khatkhate, Inflation Targeting, Dec 9 2006, EPW.

2) Kevin D. Hoover, The Concise Encyclopedia of Economics.

””’ 3) Federal Reserve Bank of San Francisco, The Natural Rate, NAIRU, and Monetary Policy, 1998.

Further Reading

1) The Phillips curve by Bradford DeLong.

2) The NAIRU by Bradford DeLong.

3) History and Theory of the NAIRU: A Critical Review by Espinosa and Russell.

””’ 4) Why inflation still matters, Frontline, Jayati Ghosh, 2006.