Adam Smith's Theory Of Inflation And Economic Growth Theory

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THEORETICAL FRAMEWORK 2.1. Inflation and Economic growth Theoretical discussion From many years ago, the relationship between inflation and growth was a debatable topic among economists. More economic theories were developed by various theorists and schools to explain relationship between inflation and growth. These theories are founded on various study of the phenomenon but no theory gives full explanation. The former inflation-growth theories were built on cyclical observations. The persistent inflation is observed as a post world war II phenomenon (Gokal & Hanif (2004)). During the period of after II world war, the theories suggested a positive relationship between inflation and growth. The Keynesian school of thought raised the same argument.…show more content…
Classical Growth Theory Adam Smith has founded the classical theory of economic growth based on the production inputs (Land, Labor and Capital). He has expressed his production function as follows: Y=f (L, K, T) Where Y stands for output, L in labor, K is capital and T is land. He considered savings as engine to growth hence it creates investment and also he released that the income distribution is major driven to the nation grow either fast or low. According to the classical theory, the variation in price level relates to its tax impact is not straight linked to the profit and output. The higher wage cost reduces the firm’s profit level and the relationship between inflation and output become implicitly negative (Gokal and Harfi (2004)). 2.1.2. Neo-Classical Growth…show more content…
Fischer’ transaction Approach can be also described as follows: MV=PT Where, M stands for Money Supply, V are the Velocity of money circulation, P is the Price Level and T is a Transaction. From the equation above and based on theory assumptions, there is unidirectional causality from price to money supply, it therefore that the price is directly influenced by an increase in money supply. For T increases, P will remain relatively constant; however, if there is no corresponding increases in the quantity and services produced, P will increase. Consequently this increase in price level causes inflations (cited in: Sattarov, 2011). 2.1.6. Neo-Keynesian The Neo-Keynesian theory is developed by the followers of Keynesian thoughts to overcome the theory crisis faced by Keynesian in 1970. Throughout this Neo-Keynesian period, the concept of potential output and its related unemployment rate was brought out. The potential GDP is the output level which is reached when economy is at high level of production by utilizing all available resources. The theory argues that Potential GDP is corresponded to the full employment or unemployment rate, at this level inflation is maintained at constant state (no increase or fall), this inflation state in economy is called the Non-Accelerating Inflation Rate of Unemployment (NAIRU) or the natural rate of

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