INFLATION AND UNEMPLOYMENT

1
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
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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
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The quantity theory of money
Expenditure Sales quantity x velocity
price level x output of 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
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Excess demand model of inflation If AD gt
AS.prices rise if AD lt AS.prices
fall
Price
AS
P2
P1
AD3
AD2
AD1
Output
y1
y2
y3
But can output continue to rise?
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• AD can increase for several reasons
• consumption suddenly increases
• investment increases (expectations improve)
• money supply increases (fall in r)
• exports increase (world trade expands)

6
Supply-side explanations of inflation
AS4
Price
AS3
AS2
P4
AS1
P3
P2
P1
AD
Output
y1
y2
y3
y4

• Supply-side
• increase in wages
• increase in import prices
• price-fixing by suppliers

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Interaction between demand and supply
AS3
AS2
AS1
P3
P2
P1
AD3
AD2
AD1
y
Govt policy is to keep y at y - increase in
costs offset by govt expansionary policy But
what about continued increase in prices?
8
A dynamic model of inflation the wage price
spiral

• Inflation is self-perpetuating
• the wage-price spiral
• - wages cause prices
• - prices cause wages
• expectations of inflation
• - wage negotiators look at future price levels

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The wage-price spiral a dynamic model of
inflation
Demand shock
Demand for goods increases
Demand for labour increases
Wages increase
Supply shock wage push
Real wage bargaining
Cost-plus pricing
Prices increase
Supply shock e.g. OPEC
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A dynamic model of inflation the augmented
Phillips curve
Price inflation
p1
Inflationary expectations high
0
Wage inflation
u1
Inflationary expectations low
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The Phillips Curve Trade-off
Inflation
III
Unemployment
0
II
I
Inflation Expected inflation - ?U
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• 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)

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• costly to reduce inflation dis-inflation gt
  unemployment
• hyper-inflation is economically and politically
  disastrous
• - complete collapse of market economy
• - political instability

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An example of hyper-inflation Germany
1923 Price index 1921 July 1 1922 July
7 1923 Jan 195 July
5,230 August 66,017 Sept
1,674,755 Oct 496,209,790 Nov 15
54,448,000,000
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• 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

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• 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

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• 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

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• 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)

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• 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)

20
Argentina 1989-94 Fiscal balance Inflation
Growth ( GDP) 1988 -5.6
340 -1.9 1989 -0.6
3000 -6.2 1990 1.4 2300
0.1 1991 1.7 170
8.0 1992 2.2 24 8.7 1993
2.2 10 6.0 1994 1.1 3
4.5 Short-term pain long-term gain?
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• 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

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• UNEMPLOYMENT
• varies between countries
• varies within countries over time
• varies within countries at any point in time

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• 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

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• 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

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• 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)

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• 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

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• 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