Inflation only matters when the prices of goods and services increase more than incomes. If inflation went up by 10 per cent and the income of every household went up by 10 per cent, then there would be little concern on the domestic front (though if prices went up in only one country then that would have cross-border and exchange rate effects). Hence, inflation is fundamentally a distributional phenomenon, something that is well-recognised by Keynesian economists.
Unfortunately, the contemporary analytical framework used to tackle the problem — inflation targeting — does not recognise this. It views inflation principally as a supply-side phenomenon. To do this, it has to define the “potential output” of an economy. In a developed country this is the full employment (of all resources) level of output; in emerging economies, the definition tends to be more normative and astrological. The “output gap” is defined as the differen
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