INFLATION AND UNEMPLOYMENT INFLATION 1 Historical experience of

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 output of money of circulation (P) (y) (M) (V) MV = Py Suppose V and y are constant then or P = (V/y)M rate of change in P = rate of change in M

Excess demand model of inflation If AD > AS………. prices rise if AD < AS………. prices fall Price AS P 2 P 1 AD 3 AD 2 AD 1 Output y 1 y 2 y 3 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 AS 4 AS 3 AS 2 AS 1 Price P 4 P 3 P 2 P 1 AD y 1 y 2 y 3 y 4 Supply-side: • increase in wages • increase in import prices • price-fixing by suppliers Output

Interaction between demand supply AS 3 AS 2 AS 1 P 3 P 2 P 1 AD 3 AD 1 AD 2 y* Govt policy is to keep y at y*: - increase in costs offset by govt expansionary policy But what about continued increase in prices?

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

The wage-price spiral: a dynamic model of inflation Demand shock Demand for goods increases Demand for labour increases Supply shock: wage push Wages increase Cost-plus pricing Supply shock: e. g. OPEC Prices increase Real wage bargaining

A dynamic model of inflation: the augmented Phillips curve Price inflation p 1 Inflationary expectations: high 0 u 1 Wage inflation Inflationary expectations: low

The Phillips Curve ‘Trade-off’ Inflation III Unemployment II 0 I 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 index 1 1921 July 1922 July 7 1923 Jan 195 July August Sept Oct Nov 15 5, 230 66, 017 1, 674, 755 496, 209, 790 54, 448, 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 1988 1989 1990 1991 1992 1993 1994 Fiscal balance (% GDP) -5. 6 -0. 6 +1. 4 +1. 7 +2. 2 +1. 1 Inflation 340 3000 2300 170 24 10 3 Short-term pain = long-term gain? Growth -1. 9 -6. 2 0. 1 8. 0 8. 7 6. 0 4. 5

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 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