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