Inflation is a major challenge; the world is facing today and has become an impediment to robust growth. However, this problem is not new. In 1981, The Gallup Organisation in the US conducted opinion polls asking people, what is the most important problem, their country was facing, and a majority named inflation.
Although governments in different countries have been using policies to contain it, it’s not so simple. Lowering inflation may lead to a rise in unemployment which could act as an obstacle to economic growth.
This debate, whether there’s actually a trade-off between inflation and unemployment, has been puzzling the macro-economists for decades now, but we’ve still not been able to arrive at a concrete conclusion. Different schools of thought have their own viewpoints and their own theories to support those viewpoints.
In this paper, I shall discuss briefly, the different schools of thought and their viewpoints and try to unravel this mystery by amalgamating the different viewpoints.
I. ‘Old’ Classical school
The classical school including Adam Smith, David Ricardo, John Stuart Mill etc. that existed prior to the ‘Great Depression’, believed that the economy ultimately (in the long-run) reaches full employment. The disturbances, if any, would be temporary and very short-lived. There was no need for any countercyclical policy (whether fiscal or monetary) to boost the economy. According to them, there is perfect wage-price flexibility and thus, no possibility of involuntary unemployment. Their explanation was also backed by the well known ‘SAY’S LAW’, according to which, supply creates its own demand. Thus, whatever is produced will be demanded, and therefore economy is always at full employment. A ‘glut’ can occur, but only temporarily. Therefore, we get a vertical (almost) AS curve (and correspondingly, a vertical Philips curve). Hence, there is no trade-off whatsoever, between inflation and unemployment, and therefore any type of countercyclical policy (fiscal or monetary) is impotent.
According to the classicists, economy is always at full employment level, as shown by the vertical AS curve. Thus, there is no trade-off between inflation and unemployment even in the short run.
II. ‘Orthodox’ Keynesian school
Keynes gained popularity during the Great Depression, through his ideas of using fiscal policies to avoid the slump, and he became a pioneering face in the macroeconomics field during the 1950s and early 60s. He was against the view that the economy always stays at full employment. He believed in wage price rigidity and therefore, a rigid real wage leading to an involuntary unemployment (ie. u>un). Now, this unemployment could only be controlled if some fiscal or monetary policy is used. Keynes called for a fiscal expansion during the Great depression that would stimulate the aggregate demand. Thus, AD curve shifts rightwards. At the initial price level P, we have an excess demand, thus price level rises to P1 and now output, Y=Yf. Thus, there is a trade off between inflation and unemployment.
Keynes gave the following insights to explain this trade-off:
(a) The persistence of unemployment
According to Keynes, persistence of unemployment was due to the failure of money wages to adjust with sufficient speeds to clear labour markets, and therefore a fiscal expansion is required to contain this unemployment, which would create inflation. For him, absolute rigidity in money wage rates is not required; all that is needed is that wages fail to fall to market clearing levels.
(b) The fluctuations in unemployment
According to Keynes, investment is highly unstable and is driven largely by animal spirits. This leads to fluctuations in unemployment. However prices and interest rates, according to...