In economics the term ‘inflation’ generally describes the prevailing annual rate at which the prices of goods and services are increasing. However, it is a common lace that all prices tend to rise at broadly the same rate; thus, when prices of domestic goods and services are rising fast this will generally be true also of wages, of the prices of the imported goods, of the money supply and of the prices of assets. This is because inflation is one sector of the economy permeates rapidly into other sectors. The phrase “a high rate of inflation” therefore usually describes a situation in which the money values of all goods in an economy are rising at a fast rate. The view commonly taken is that inflation should be kept close to zero; prices should rise at no more than about 2 to 3 percent a year on average. This is because high inflation affects the economy adversely in a number of ways. For example, it distorts the income distribution; because of the difficulty and risk associated with the complete index-linking of pensions tend to suffer. Also, it biases investment decisions: the cost of borrowing money rises making debt finance expensive in the early years of a project and reducing the incentive to invest. In theory inflation accounting could correct for this, but in practice this has proved difficult to implement.
Further, because different prices are set at different times of year, high price inflation is
associated with a volatility of relative prices. This can lead to an inefficient allocation
of resources2 it is difficult for decision makers to interpret price signals correctly when
relative prices are volatile. Thus, when inflation is high decisions may not be taken in a
way that is consistent with the efficient allocation of scarce resources.
The control of inflation is therefore an issue of primary concern
in designing macroeconomic policy. In order to use policy instruments to prevent
inflation from rising, or to reduce it where there has been an increase, it is necessary to
understand as fully as possible the process that create it, the way in which it perpetuates
itself, and the circumstances in which it declines.
However, it is not an easy matter to discover the cause of a
rise in inflation. It is a familiar fact that prices influence each other: wages follow
prices of goods and services, prices follow wages; the currency tends to depreciate
when domestic inflation is higher than that abroad, and to rise when it is lower,
influencing the domestic currency price of imports. Import prices, in their turn, affect
domestic prices. The 'inflation spiral' has a dynamic structure that results from the
interaction of these markets. But it is not usually at all obvious which of the possible
causes has been the initiating factor of any particular rise or fall in inflation. Indeed it is
usually unclear in which market an inflationary pressure originates; for as soon as an
inflationary shock impinges on any one market; its influence is spread across a wide
range of other markets by the feed-backs in the inflation spiral and its origin becomes
difficult to detect.
Developments in the Modeling of Inflation:
The two main strands of empirical work on modeling
inflation relate to the Phillips curve ( the relation between inflation and unemployment)
and the money supply ( the role of the monetary authorities in determining nominal
values). In 1958 Phillips reported an apparent empirical trade-off between inflation and
the rate of unemployment, subsequently known as the "Phillips curve", with its
implication that the level of employment could, in principle, be used as if it