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CAUSES OF INFLATION – NEO-KEYNESIAN THEORY

Developed largely by the economists John Hicks, Franco Modigliani and Paul Samuelson between the 1950’s and 1970’s, Neo-Keynesian Theory was developed in an attempt synthesize neo-classical economic models originally developed by John Maynard Keynes.

According to the Neo-Keynesian school, inflation can be one of the 3 main types, which form a part of what is commonly referred to as the ‘Triangle Model’. These 3 types are:

Demand Pull Inflation

These are price rises due to high aggregate demand across the overall economy, characterized by GDP growth and low unemployment. This is also known as Phillips Curve Inflation.

Cost – Push Inflation

More commonly referred to as ‘Supply-Shock Inflation’, these price rises occur because of a one-off economic shock such as a sharp spike in oil prices.

Built-In Inflation

Considered by many economists as a form of inherent tendency for prices to rise whatever the level of economic activity, this type of inflation is due to the ‘price/wage’ spiral, where workers demanding higher wages leads to employers passing on these higher costs to consumers in the form of higher prices for goods and services, thereby creating a vicious cycle. Built-In Inflation is also known as ‘Inertial Inflation’, ‘Inflationary Momentum’ and ‘Structural Inflation’

These 3 types of inflation can therefore be used to explain any rise in the general level of prices within the overall economy. Over time however, both demand-pull and cost-push inflation will affect the level of built-in inflation, since consistently high (or low) inflation will generate expectations that inflation will continue to be high (or low) in the future. So, there are two main elements within the Triangle Model framework:

MOVEMENTS ALONG THE PHILLIPS CURVE

As discussed previously, the Phillips Curve depicts the negative relationship between inflation and unemployment, suggesting that higher levels of employment can only be secured at the cost of higher prices.

While this model described the situation in the US during the 1960’s relatively well, it failed to explain the combination of high inflation and economic contraction (an economic situation described as stagflation). This leads to the modern version of the Phillips Curve describing the relationship in employment growth and the general level of inflation instead.

SHIFTS OF THE PHILLIPS CURVE

In addition to movements along the Phillips Curve, the curve can actually shift itself due to sudden external shocks to the economy occurring, thus changing the trade-off between unemployment and inflation. These shifts are much better when used to describe the spike in oil prices during the 1970’s, which caused much higher levels of unemployment to occur at the same rate of inflation.

This brings us to another Keynesian concept known as the Non-Acceleration Inflation Rate of Unemployment (NAIRU), a ‘natural’ level of GDP where the economy is operating at optimal capacity under the constraint of resources available to it. NAIRU is determined by the normal functioning of the economy through three specific mechanisms:

  • If GDP exceeds NAIRU, higher aggregate demand will cause prices to rise, thereby fuelling inflationary pressure. This will cause the Phillips Curve to shift upwards generating both higher inflation and unemployment.
  • If GDP falls below NAIRU, lower aggregate demand will cause prices to fall, thereby leading to disinflation and even possibly deflation. This will cause the Phillips Curve to shift downwards, generating both lower inflation and unemployment.
  • However, if GDP is equal to NAIRU, the level of inflation will remain stable – provided no external shocks occur to the economy. Therefore, most Neo-Keynesian depict the Long-Term Phillips Curve as being vertical, where a certain level of unemployment will always be experienced regardless of the level of prices prevalent within the economy.
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