Inflation, government expenditure and real income in the long-run

This paper examines the relationship between inflation and real income in Australia, Canada, Finland, New Zealand, Spain, Sweden and the UK which have adopted a "formal" policy of low or zero inflation target. Using cointegration analysis and a vector error correction model (VECM), it is found that the long-run relationship between inflation and real income is positive in most cases. It is also found that contrary to the belief of new-classical economics, government expenditure too is positively related to real income in the long-run. These findings raise a serious doubt about the "inflation first" policy. While the cost of disinflation in terms of lost output and human misery is well known, the benefit of low inflation is at best illusory. Furthermore, if the positive relationship between inflation and real GDP does indicate anything, the battle against inflation may have permanently damaged the productive capacity by removing the necessary lubricants from the economic wheels.