Chapter 5: Inflation and Monetary Policy: Theories, Models and Approaches
5. Inflation and monetary policy: theories, models and approaches Inflation and unemployment are the twin ‘evils’ in a capitalist economy. Their importance in the ‘matrix of national welfare indicators’ is expressed in the form of a ‘misery index’, which in a simplified form is defined as the sum of the inflation and unemployment rates. An interpretation of this index is that the society benefits from a reduction in inflation but loses from a rise in unemployment and therefore a reduction in inflation by say one percentage point may exactly offset the social cost of a rise in unemployment by one percentage point. An implication is that the society is indifferent in the trade-off between inflation and unemployment because this keeps the level of societal misery unchanged. When both inflation and unemployment rise (fall) simultaneously, the society’s welfare deteriorates (improves) (Blanchard and Fischer, 1989; Blanchard and Sheen, 2007; Gordon, 1993). There is, however, a lack of consensus on the above interpretation of the misery index. Not all economists agree with the view that both inflation and unemployment are equally bad. The Keynesian economists put greater emphasis on the costs of unemployment, while the monetarists put greater emphasis on the costs of inflation (Driffill et al., 1990; Evans, 1991). The late Noble Laureate James Tobin, for example, maintained the view that ‘inflation is greatly exaggerated as a social evil’ (Gordon, 1993: 284). This is apparently because the costs of lowering inflation in terms of lost output could be significantly greater than the...
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