The triangular model of inflation, derived from the Phillips curve, identifies three types of inflation: embedded, cost-push, and demand-driven. Each type is interconnected and affects the economy differently.
The triangular model of inflation is a way of looking at inflation, derived from what is known as the Phillips curve. In the triangle model, inflation is considered to be driven by three distinct types of inflation: embedded inflation, cost-cutting inflation, and demand-level inflation.
Embedded inflation, one of the three sides of the triangular model, is inflation that was caused at some point in the past – either by cost-based or demand-based inflation – and continues to be a factor to this day. Due to certain principles of macroeconomics, such as what is known as the wage-price spiral, this inflation never went away. Conversely, embedded inflation becomes an expected part of the economy. In the triangle model, integrated inflation forms the basis of the triangle.
Cost-push inflation, the second part of the triangular model, is often called supply-shock inflation. Cost-based inflation occurs when the cost of something in the economy increases and nothing can be easily replaced. Cost-based inflation often occurs when external suppliers of a key product or service increase their costs and the importing economy is forced to pay higher prices.
The classic example of inflation between cost and supply shock is the oil crisis that occurred in the 1970s. When the Organization of the Petroleum Exporting Countries (OPEC) raised oil prices, the United States was forced to pay higher prices. Since oil is used in essentially all industries, this has sent shockwaves to the US and prices have risen, while wages paid have remained unchanged. It should be noted that not all economists agree that cost-cutting inflation exists – notable economists such as Milton Friedman argue that the ultimate cause of inflation in these cases is government increases in the money supply.
Demand-driven inflation, the third part of the triangular model, is perhaps the most important aspect of the triangular model of inflation. It is mainly from the Philips curve which describes the attraction of demand, that the triangle model has been derived. In essence, the theory of demand-driven inflation states that there is a point at which the demand for a product in a society will exceed the society’s ability to produce that product. When unemployment levels fall and overall spending rises, eventually a shortage of desired products is created. This shortage causes an increase in the cost of these products, resulting in inflation.
Fortunately, demand-driven inflation tends to be quite short-lived in most modern economies. Since no modern society has reached full employment – which essentially has a 0% unemployment rate – and as technology continues to develop, the output of a product can generally be increased. As production increases, the shortage is reduced and prices fall again. Often, however, prices do not fully return to previous levels, resulting in built-in inflation.
While each of these three types of inflation may seem disconnected at first glance, if one takes a closer look at them, one begins to find connections. It is this understanding of the interconnectedness of these three integral types of inflation that has led to the formulation of the triangular model of inflation. The Philips curve has been found to be insufficient by itself to explain inflation and the triangle model goes one step further towards better management of inflation in modern societies.
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