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INFLATION AND UNEMPLOYMENT
INFLATION
1. Historical experience of inflation
2. Causes of inflation
3. Costs of inflation: why is inflation a problem?
4. How can inflation be controlled?
UNEMPLOYMENT
1. Historical experience
2. Causes of unemployment
3. Policies to reduce unemployment
CAUSES OF INFLATION: THEORY
1. The quantity theory of money: inflation in the long-run
2. The excess demand model of inflation
3. Supply-side explanations of inflation: cost-push
4. A dynamic model of inflation: the wage price spiral
The quantity theory of money
Expenditure = Sales
quantity x velocity = price level x outputof money of circulation (P) (y) (M) (V)
MV = Py
Suppose V and y are constant
then P = (V/y)M
or rate of change in P = rate of change in M
Excess demand model of inflation
If AD > AS……….prices riseif AD < AS……….prices fall
AS
AD1
AD2
P2
P1
y1 y2
AD3
y3
Price
Output
But can output continue to rise?
AD can increase for several reasons:
• consumption suddenly increases
• investment increases (expectations improve)
• money supply increases (fall in r)
• exports increase (world trade expands)
Supply-side explanations of inflation
AD
AS1
AS4AS3
AS2
Price
Output
P4
P3
P2
P1
y1 y2 y3 y4
Supply-side:• increase in wages• increase in import prices• price-fixing by suppliers
Interaction between demand and supply
P1
P2
P3
y*
AD1
AD2
AD3
AS1
AS2
AS3
Govt policy is to keep y at y*:- increase in costs offset by govt expansionary policy
But what about continued increase in prices?
Inflation is self-perpetuating:
• the wage-price spiral- wages ‘cause’ prices- prices ‘cause’ wages
• expectations of inflation- wage negotiators look at future price levels
A dynamic model of inflation: the wage price spiral
The wage-price spiral: a dynamic model of inflation
Demand shockDemand for
goods increases
Demand for labour increases
Wages increase
Prices increase
Supply shock:wage push
Supply shock:e.g. OPEC
Real wagebargaining
Cost-pluspricing
A dynamic model of inflation: the augmented Phillips curve
Price inflation
Wage inflation
Inflationary expectations: low
Inflationary expectations: high
p1
0u1
Inflation
Unemployment0
The Phillips Curve ‘Trade-off’
I
II
III
Inflation = Expected inflation - U
COSTS OF INFLATION
• menu costs
• shoe-leather costs: searching for best buy
• adverse effects on fixed income groups
• adverse effects on savings
•adverse effects on growth of GDP / capita - lower investment due to uncertainty - shortens investors time horizon (quick returns)
• costly to reduce inflation: dis-inflation => unemployment
• hyper-inflation is economically and politically disastrous - complete collapse of market economy - political instability
An example of hyper-inflation: Germany 1923
Price index1921 July 1
1922 July 7
1923 Jan 195
July 5,230August 66,017Sept 1,674,755Oct 496,209,790Nov 15 54,448,000,000
COSTS OF DEFLATION
• borrowers find their real debts increasing - discourages borrowing - fall in asset prices reduces consumption
• lenders lose if debtors go bankrupt
• prices decline but wages are sticky - decline in demand for labour - fall in profits and investment
• real interest rates increase - discourages investment
• leads to persistent recession: consumers delay spending
CONTROL OF INFLATION
• requires a powerful commitment to stable prices - implies strict control over G (G = T)
• control over inflation in hands of CB - inflation is lower in countries with independent CB
• govt needs to set clear inflation targets - avoids govt pressure to relax monetary policy
• govt not permitted to finance deficits through creation of high-powered money - must borrow from private sector
•supply-side policies needed - labour market flexibility - anti-monopoly policy to increase competition
• high level of scrutiny of CB needed - openness of how decisions are reached - subject to scrutiny / questioning by elected body • increasing emphasis placed on controlling interest rates - less emphasis on controlling money supply - use open market operations to control interest rates
•accurate forecasts of macro-economy needed - lagged effect of monetary policy on economy - need forecasts of turning points - need to forecast ‘leading indicators’ (change in stock, long-term bond yields, commodity prices, overtime working)
• stopping hyper-inflation - nominal exchange rate ‘anchor’(e.g. dollarisation) (to restrain cost-push inflation, including imported inflation)
- restrictive fiscal policies (balanced budget) - tight monetary policies (e.g. via independent CB) - structural reforms (liberalise financial markets, flexible labour markets, free trade, privatisation of public enterprise, anti-monopoly policies)
Argentina 1989-94
Fiscal balance Inflation Growth (% GDP)
1988 -5.6 340 -1.91989 -0.6 3000 -6.21990 +1.4 2300 0.11991 +1.7 170 8.01992 +2.2 24 8.71993 +2.2 10 6.01994 +1.1 3 4.5
Short-term pain = long-term gain?
Has inflation been beaten?• strong public support for price stability - ageing population prefers low inflation
• financial markets strongly averse to inflation - govt keeps close eye on financial markets - pre-emptive action taken v. inflation
• greater price competition - supply-side changes (labour markets, privatisation, internet trading, creation of new markets) - erosion of trade union power
• less vulnerable to oil price hikes - more alternative sources of energy - diversification in use of energy
UNEMPLOYMENT
• varies between countries
• varies within countries over time
• varies within countries at any point in time
CAUSES OF UNEMPLOYMENT
• collapse in aggregate demand
Policy action: - need for fiscal / monetary policy action
• mismatch between labour demand and labour supply - geographical immobility of labour - skill / occupational mismatch
Policy action: - need for spatial policies - re-training programmes
• welfare benefits ‘too high’ Policy action: - creation of work incentives (New Deal) • hiring / firing costs too high - employment legislation ‘too tough on employers’
Policy action: - reduce fixed costs of employing labour
• wages too high (trade union power) - wages are sticky downwards - efficiency wage v. nominal wage
Policy action: - more flexible wages needed (especially with fixed exchange rate e.g. euro)
NATURAL RATE OF UNEMPLOYMENT
Definition: unemployment existing when the economy is in equilibrium (AD =AS)
Determinants:
• job search
• structural factors (mismatch)
• voluntary unemployment
• unemployment benefit
• hysteresis and long-term unemployment
CHARACTERISTICS OF HIGH UNEMPLOYMENT COUNTRIES
1. Unemployment benefit• available for long periods• no pressure on unemployed to get a job 2. Unions• high degree of unionisation• unions very active in wage negotiations• no co-ordination in collective bargaining
3. Taxation• high payroll taxes• high minimum wages• high income taxes