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Unit 11: Control of Inflation and Philips Curve

Notes
Most of the time, prices go up because there’s too much money chasing too few things.
That sort of inflation is relatively easy to bring to heel, by getting central banks to raise
interest rates and suck out the excess cash from the system. That, alas, doesn’t seem to be
working anymore.

Source: www.articles.economictimes.indiatimes.com

Stagflation Needs ‘Shock’ Treatment

There is a nagging fear these days that India is facing the risk of stagflation, an economic
affliction first noticed in the 1970s in the Western countries. Even now, the causes and nature of
stagflation are matters of controversy. The nature of stagflation is explained best in terms of the
supply demand equilibrium normally depicted as shown in Figure 11.5.
Figure 11.5

The point E at which the supply line SS intersects the demand line DD is the equilibrium point
at which the goods supplied by producers exactly equal the goods demanded by consumers.
Suppose, for some reason or the other, the market suffers a shock that suddenly raises the cost of
production. (According to the theory of Rational Expectations, only a shock, the more unexpected
the better, will lead to permanent change.)
In sympathy with the increase in production costs, the supply curve will shift upward to S S
1 1
and, hence, the equilibrium point will move from E to E .
1
With this shift, the price levels rise and at the same time, the quantities bought and sold become
less. The price increase indicates inflation: the decrease in quantity implies recession. So we get
both inflation and recession simultaneously. That is exactly what stagflation is.

In other words, stagflation will result whenever a sudden shock increases costs of supply. The
stagflation of the 1970s was caused by the sudden increase in oil prices enforced by the OPEC.

Task Find out more about the stagflation of the 1970s what factors lead to it, what was the
role of OPEC, what did the government do, etc.

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