In chapters 5 and 6, I argued that inflation can potentially damage developing countries because it erodes the purchasing power of wages and shifts the burden of financing development to workers. This is unethical and conflicts with the idea of inclusive growth. In this chapter, I address the following three questions: (i) Can full employment be achieved without inflation? (ii) How high does inflation have to be to represent a serious problem? (iii) What causes inflation? This discussion serves as prologue to the discussion of monetary and fiscal policies in the next chapter. As the discussion in chapter 6 made clear, price increases that lead to real wage reductions (especially for the workers at the bottom of the wage distribution, for whom low inflation is a public good of special importance) are inconsistent with the notion of inclusive growth, and measures should be taken to combat it.

Unemployment and Inflation

Many economists have long accepted that a trade-off exists between unemployment and inflation (rate of change of money wages). This trade-off is summarized statistically in the Phillips curve. The degree of trade-off and the interpretation varies depending on the theory. Perhaps with the exception of the New Classicals (who think that the trade-off is an illusion), most economists believe in some sort of Phillips curve, namely, that unemployment will fall if demand expands faster than the economy's long-run productive capacity, and that if demand keeps on expanding faster than the economy's long-run productive capacity then, in the long run, inflation will rise.