Module 20 Inflation and Unemployment

Introduction

National Income (Y)	=	Potential Output (Q)	Result:	Full Unemployment rate*

National Income (Y)	<	Potential Output (Q)	Result:	Demand deficient Unemployment rate**

National Income (Y)	>	Potential Output (Q)	Result:	Over Full Unemployment rate***

*Unemployment confined to frictional, structural, and seasonal unemployment.

** Can be caused by fiscal and/or monetary policy.

*** Deflationary policies of reduced Government expenditure (G) , increase taxes (T) and/or a reduction in the money supply (M) can take us back to full employment.

The inflation rate increased from 4% to 10% within a year as predicted by leading economists and the business community.

Static expectations means tomorrow will be like today thus the static would be today’s inflation rate of 4%.

Rational expectations assumes everyone has the same information and if all economists and the business community using such information expect 10% then so will the ‘rational expectations’ newspaper

Keynesian

Believe monetary factor critical in determining equilibrium income/output and equilibrium interest rate

Do not ascribe a central role to monetary factors in determining price level.

Philips curve missing link

it show fixed relationship between unemployment rate and inflation rate, albeit with a lag

trade-off between inflation or unemployment

Monetarist

Unhampered by government and other disruptive forces would lead to

Full employment national income

Maintain the money is of prime importance,

Not in determining real variables such as Level of Employment and National income but in determine the price level

Cause and Effects of Inflation

1) Inflation impairs the efficiency of the price mechanism and raises the costs of buying and selling because money becomes less reliable as a standard of value

2) Inflation penalizes people on ‘fixed’ incomes and favors those whose money incomes adjust quickly to price changes.

3) Inflation favours borrowers and penalizes lenders so long as it is unanticipated.

4) Given a system of unindexed taxes, namely one where tax thresholds are specified in money terms rather that real terms, inflation will redistribute resources from the private to the public sector.

5) A continuing higher rate of domestic inflation than that experienced in other economies can lead to increased imports and reduced exports and can create potential problems for stable exchange rates.

Demand Pull

Prices rise as a consequence of excess demand for goods and services, mainly demand that exceeds the capacity output of the economy at current prices.

Real output cannot increase significantly beyond potential out excess demand ‘pulls up’ the prices of final goods and services.

Keynesian approach difficulties:

Analysis does not incorporate monitory factors – causing inflation

Does not incorporate possible role of monetary factors – curbing inflation

Income-expenditure model regarding money wages as essentially passive, reacting to, rather than causing price inflation.

Cost Push

Prices rise as a consequence of bargains struck in the factor market, raise production costs of employers, who pass on higher cost in form of higher prices.

Prices and costs are ‘administered’ rather than responsive to market forces of demand and supply.

Business set prices on cost-plus basis – full cost of production + some markup for profits.

Bargaining over wages and salaries primary emphasis as the ‘motor’ of inflation

High wage costs push up prices – initial change in wage erode

Occur in economies where prices and wages are not flexible downwards.

Increased Product cost will reduce Product required reduce output and employment

Reaction of wages and prices asymmetrical

Excess demand will raise prices and wages

Deficient demand will not lower prices and wages

Price inflation consequence not of excess aggregate demand but of excess demand in particular markets, and failure of prices and wages to adjust downward were demand was deficient in particular markets.

Monetary Policy

Faces with an increase in money wages, monetary authorities can either

1) hold money supply constant or prevent it rising at the rate as wages, with consequent falls in output and more unemployment,

2) Increase money supply allow a sufficient level of monetary demand to sustain the same output at higher prices.

The later will be chosen because Monetarist prefer higher prices to higher unemployment

– money supply considered endogenous

In these circumstances Monetary policy is said to be ‘permissive’. Instead of controlling the money supply to prevent inflation, they condone cost-push inflation by allowing the money supply to increase, ‘ratify’ higher price levels without imposing cost on employers and employees through lost output and employment.

Two additional factors

1) imported goods relative price or income-inelastic then a rise in the price of imported goods will be reflected in higher inflation rates

2) Three most common assumptions include expectations:

a. Expectations are static

b. Expectations are adaptive

c. Expectations are rational

Cost push inflation would be higher than it otherwise would have been if the prices of imported goods increase and

If the demand for imported goods were inelastic with respect to price and/or income then a rise in the prices of imported goods and/or a fall in income will be reflected in higher inflation rates, i.e. the imported goods now more expensive will continue to be bought.
If inflationary expectations are static people will assume next year’s inflation rate will equal this year’s, i.e. it will not increase

Anti-Inflationary Policies

Important to distinguish between demand-pull and cost-push inflation.

Cost-push

Change the institutional framework within which wages and prices are determined.

Expectations are the cause of inflation; they expectations have to be changed in the long run

Income-expenditures and monetarist and Keynesians agree – inflation can only be curbed by reducing demand

However Keynesians and Monetarists disagree on how to demand should be constrained

Keynesians	emphasize	fiscal policy
Monetarist	emphasize	need to control the money supply

Determining cause of inflation

Use Phillips curve makes it possible, by interpreting the results as either demand-pull or cost push.

Demand push explanation

three steps necessary to produce the observed relationship between unemployment and changes in money wages These were:

a stable, inverse relationship between the unemployment rate (U) and excess demand for labour, where Unemployment Rate (U) was therefore a proxy for the excess demand for labour, rising when the excess demand for labour fell and falling when the excess demand for labour rose.

Ý demand for labour	ßExcess demand for labour
ß demand for labour	ÝExcess demand for labour

a stable, positive relationship between the excess demand for labour and the rate of change of money wages (W) rising when the excess demand for labour rose and vice versa;

Ý rate for wages	ÝExcess demand for labour
ß rate for wages	ßExcess demand for labour

If step 1 and 2 had been taken then there would be a stable inverse relationship between unemployment and the rate of change of money wages, money wages rising more rapidly when unemployment fell and rising more slowly when unemployment rose.

Ý slowly rate for wages	Ý demand for labour	Ý Unemployment
Ý rapidly rate for wages	ß demand for labour	ßUnemployment

Cost Push explanation

Low levels of unemployment, unions more militant in demanding increases in money wages, and employers more willing to pass on increases in money wages in higher prices in the expectation that price increases would have little adverse effect on sales.

Macroeconomic policy cannot affect the long-run rate of unemployment, only the long-run rate of price inflation.

Natural rate of unemployment as unemployment that is not due to deficient demand.

The Modern Quantity Theory versus Keynes Policy Implications

Quantity Theory MV = PY change in money supply cause changes in price level

Modern Quantity Theory – control of the money supply is the key to control of prices, so that if price inflation occurs, it orignaes in the failure of the central monetary authority (rather than in the activities of organizations such as trade unions, ad advocated by supporters of the cost-push hypothesis)

Essential difference between Keynesian economist and the Monetarist

Monetarist	Keynesian
Demand for money is stable function of a number of variables, such as level of income, expected rate or return on money and other assets, and the rate of change in prices implies the velocity of circulation of money (V) will be constant and will be subject only to modest predictable fluctuation.	Change in the velocity of circulation may offset and frustrate monetary policy, in that when Money supply (M) rises Velocity (V) will fall and vice versa,

Demand and supply for money are in large degree independent of each other The supply of money is held exogenously to the economic system by the central monetary authority.	The supply on money is endogenously that is it may be responsive to economic variables. Central monetary authority unable to control the money supply effectively.

Change in the money supply have been the chief cause of substantial fluctuation in national income, causing both major inflations and major recessions. Monetary policy can have an impact on the level of real income and employment Discretionary Monitory policy is not recommended Do not believe money supply should be lowered or raise to regulate demand and therefore the level of real income and employment.. Believe monetary policy should follow an automatic rule, allowing an annual change in the money supply to match the long-run growth rate of the economy

The proper and only role of Monetary policy is price stability, achieved by the application of the one simple automatic, rule..

1) There is no recorded example of any major inflation occurring without an accompanying substantial increase in the money supply.

2) There is no recorded example of any substantial increase in the money supply which has not been accompanied by a major inflation.

3) Given 1 and 2 a high rate of inflation cannot be sustained unless the money supply is expanded significantly.

Higher wage costs lead to higher prices and these can only be sustained if the money supply is increase. –

Accepted by both Monetarists and Keynesians: If the money supply does not increase, the result will be higher unemployment.

Disagreement between Monetarists and Keynesians: assessment of the amount and duration of unemployment that would be necessary to contain inflation, and of the long-term benefits relative to the short-term costs of a restrictive monetary policy.

Monetarist	Keynesian
Any attempt to push the rate of unemployment below the natural rate by demand management accompanied by an expansionary monetary policy will be self-deflating.	Argue that modern government are regarded as having a major responsibility to ensure full employment

Might be said to operate with longer economic and political time horizons	Might be said to operate with shorter economic and political time horizons than monetarist

Differences partly based on different Technical assessments and partly on value judgments.

Technical – rest on different views of how markets operate, how expectations and behaviour adjust to different situations.

Value Judgment – reflect different social and political priorities.

National Goals: Policy Implications

Good		Bad
	Consumption Expenditure (C) : Ý better off in material terms	Balance of payment

	Investment Expenditure (I) 0 Investment capital stock would decline through depreciation and future flow of goods and services, could not invest in latest technology, new capital good, larger flow of goods and services in future.	Unemployment – normally associated with unused capacity, resulting in a lower GNP that could be achieved.

	Government Expenditure (G) certain amount necessary .	Inflation · if it makes current GNP or future GNP lower than it otherwise would be. · Produces less desirable income distribution that income distribution without inflation · Makes political system in market economie sunstable

	International Trade Exports (X), Imports (Z), Currency on Foreign exchange market,

	Balanced Budget	Budget Deficit Budget Surplus

Determinant of Inflation

Monetarist	Keynesian
. Monetary phenomenon alone	Many factors can affect the price level

Believe equilibrating forces at work in the economy	There is no inherent tendency for an economy to return to full employment with price stability.

While Monetarists argue that the price level is a function of the money supply Keynesians, prior to Phillips, could not explain what caused the price level to change. They had identified that the unemployment rate over and above frictional and structural elements was a function of the gap between potential and actual output. The Phillips Curve purported to show a fixed relationship between the unemployment rate and the inflation rate.

Monetarists believed that strong equilibriating forces exist in market economies and only the interference of government prevented market clearing price and quantities being achieved. They would argue, for instance, that full employment national income would result through market forces.

The Quantity Theory, MV = PT, with V constant and T proportional to national income meant P was a function of M; M had no direct influence on T

Policy makers believe zero/low inflation should be a policy goal for economic efficiency reasons. Inflation they argue

Inflation raises the costs of buying and selling because money becomes less reliable as a standard value and as a consequence affects the efficiency of the price mechanism.
Many people on fixed incomes e.g. social security recipients and others with little/no bargaining power and/or not involved in the labour market will experience a loss in real income if nominal income is constant and prices of goods and services are increasing. This however is an issue of economic equity and not economic efficiency.

In the demand-pull model of price inflation

When aggregate demand exceeds potential output the excess demand causes prices of goods and services to rise. Simultaneously excess demand in factor markets ‘pulls up’ wages and salaries. Thus demand pull inflation as the name suggests is caused by excess demand pulling up prices

Which of the following contains Keynes’s cure for demand pull inflation? Decrease government expenditure/raise income taxes

The cause of demand pull inflation according to Keynes was excess demand pulling up prices, i.e. aggregate demand in excess of potential output. The cure was to reduce aggregate demand by either raising taxes or reducing government expenditure. Monetary tools played no part in either the cause or cure of demand pull inflation.

In the cost push explanation of inflation, price rises

In the cost push model bargaining determines money wages and salaries; business firms find that labour costs have risen and pass on these higher costs by marking up the prices of goods and services.

I. originate in collective bargaining in labour markets

II. in factor markets are passed on in administered higher prices of goods and services

Comparing the demand pull model with the cost push model only in the latter will

I. wage rates rise in industries where unemployment rates also are rising

II. wage rate increases lead to increases in the prices of goods and services

In the cost push model linkage effects are prominent. Equity and justice are often cited in wage demands and the desire to keep existing wage structure and salary differentials can lead to wage increases, granted in strongly unionised sectors, being imitated in sectors where employment opportunities may be decreasing.

In the demand pull model excess demand in goods markets leads to price increases and excess demand in factor markets leads to wage increases. In the cost push model however firms will attempt to pass on cost increases in the form of higher prices

Given a high employment rate a government decided to increase the money supply by 20%. The inflation rate increased from 4% to 10% within a year as predicted by leading economists and the business community.

Two newspapers had predicted what would happen to the inflation rate according to their expectations, static and rational. Which of the following contains the predictions of the newspapers.

Static expectations means tomorrow will be like today thus the static would be today’s inflation rate of 4%.

Cost push inflation would be higher than it otherwise would have been if the prices of imported goods increase and

I. the demand for imported goods became price inelastic

II. the demand for imported goods became income inelastic

the demand for imported goods were inelastic with respect to price and/or income then a rise in the prices of imported goods and/or a fall in income will be reflected in higher inflation rates, i.e. the imported goods now more expensive will continue to be bought.

If inflationary expectations are static people will assume next year’s inflation rate will equal this year’s, i.e. it will not increase.

Expectations are rational The Efficient Market Hypothesis which argues that markets utilise all information to produce prices which reflect equilibrium incorporates which of the following assumptions?

Two elements in the cost push hypothesis of inflation are ‘imported inflation’ and ‘expectations inflation’

For imported goods and services to have an impact on the inflation rate (domestic) the demands for imports must be relatively price or income inelastic. An inflation rate is the rate of change of a price index in which the quantities of goods purchased are weighted by their prices. If the price of imported goods rose and the demand for those goods were completely price inelastic, the same quantities would be purchased and with a given budget less would be spent on domestic goods and the inflation rate would increase. This is what occurs in many oil importing countries when the price of oil increases significantly. In the short run the demand for commodities such as oil are price inelastic because using alternative sources of energy may not be economically viable, e.g. converting an oil furnace to an electrical source of heat.

Expectations rise when businesses deal in futures markets, i.e. have to make deals today for the future delivery of goods/services/commodities. If you are in the oil refinery business selling gasoline to gas stations throughout the country and you are informed that the price of crude oil is expected to increase by 50% in each of the next three years and you have to give ‘fixed’ delivery prices to your gas stations for each of the next three years, to avoid making losses, you will quote prices which reflect these expected increases in the price of crude. You will assume competitive suppliers will have to do the same to remain in business and the higher you expect the price of crude to be the higher will be the refined oil price which you quote to customers in the gas stations.

If uncertainty exists about future prices and you wish certainty in your life you can buy it by entering the ‘futures’ market. In the oil example you would sign a contract committing you to buy a specific amount of oil at some given future date at some agreed upon price. When that date rolls around if the market price is greater than the agreed price you made a ‘good deal’ in the futures market. If the reverse occurs you paid a price for certainty. In either case someone assumes your risk - at a price.

Again assuming full employment would be maintained what will be the impact on

i. the budget

ii. the exchange rate

iii. the inflation rate

iv. each of the components of GNP, i.e. C, I, G, X and Z

if monetary policy is chosen instead of the tax cut?

The Suggested Answer

Utilising ISLM analysis an increase in the money supply compared to a tax cut will shift the LM to the right; Y will be the same whether monetary (MP) or fiscal policy (FP) is adopted but with the former the interest rate (R) will be lower.

Had the tax rate been adopted, disposable income would have risen and consumption expenditure (C) would have increased. Thus since MP was used C will be lower than it would have been under the tax cut.

i. BudgetConsider a simple balanced budget where

In both the MP and FP situation Y, G and TRANSFER will be common. In the FP case the tax rate will be 2% lower; thus if MP would produce a balanced budget, the FP will result in a deficit; if MP would produce a surplus, FP could produce a deficit balance or a smaller surplus.

ii. Exchange rateMP will produce a lower R will attract a smaller capital inflow or cause a capital outflow. Assuming X and Z are independent of which policy is adopted, the lower R will make the Balance of Payments surplus (deficit) lower (higher) than it would have been and cause a depreciation of, or a smaller appreciation of, the currency and in due course will make exports higher and imports lower than they otherwise would have been had FP been adopted.

iii. Inflation rateSince the QY relationship would be the same under both policies there is no reason to believe the inflation rate will change.

iv. ComponentsThe impact on C is unclear. While a tax cut would have caused an increase in C, the lower interest rate also will affect positively some consumer expenditures especially housing and durables.A lower interest rate will make some investment at the margin now profitable and thus a higher I can be expected unless negative expectations prevail.G should not be affected unless some local governments’ borrowings are a function of R.With a lag, as discussed above, exports will be higher and imports lower than they would have been had FP been enacted.

One weakness of the Phillips Curve is that it provides empirical evidence which can be used by supporters of the demand pull theory of inflation and also by supporters of the cost push theory

Explain how this is possible.

The Suggested Answer

In the demand pull theory as the economy approached full employment excess demand for goods and services appeared in some markets; when aggregate demand exceeded potential output excess demand appeared in all markets ‘pulling up’ the prices of all goods and services, i.e. demand pull inflation. To cure demand pull inflation was simple - lower aggregate demand below potential output and the prices of goods and services would fall. In the labour market economic forces would also make themselves manifest. As the economy approached full employment labour shortages would appear in some labour markets and wages in those markets would rise. When aggregate demand exceeded potential output labour shortages would exist in all labour markets and all wages would rise.

Thus an inverse relationship would exist between the unemployment rate and the rate of change of money wages. When the unemployment rate fell money wages would rise the rate of increase being dependent upon how close the economy was to full employment.

In the cost push model unions would be more militant in pressing for high wage increases when the unemployment rate was low and employers would be much more likely to accede to such wage demands in boom times. In such times employers would pass on the wage increases in the form of higher prices with little adverse effect on sales because of the high wages being earned by customers.

It was argued that the evidence of the 1970s and 1980s in which ‘high’ unemployment rates existed alongside ‘high’ inflation rates cast serious doubts upon the efficiency of the Phillips Curve. High wages were pushing up prices and high wages persisted in the presence of unemployment; this was possible in many countries because of government interference in labour markets which prevented economic forces from operating effectively, e.g. minimum wage laws, social contracts, unfair dismissal clauses, etc. Phillips supporters however argued that the inverse relationship between wage rates/inflation rate and the unemployment rate still held only in somewhat less favourable trade offs i.e. the Phillips Curve had moved outward because of expectations and would continue to move as expectations changed. If very high rates of unemployment were caused by governments in an attempt to curb inflation this would affect expectations and ultimately the inflation rate.

For the past two years the economy has experienced both full employment and close to zero inflation; the budget deficit is expected to become a budget surplus next year. Despite a continuing trade deficit the currency has appreciated in each of the last two years. Some economists are optimistic that the outlook remains promising and predict full employment, zero inflation, a small budget surplus and a stable exchange rate. Other economists, however, citing the historical record argue that is not possible for an economy to achieve all those desirable objectives for an extended period of time. Do you agree with the ‘other economists’? Why or why not?

The Suggested Answer

If aggregate demand (Y), in a given year, precisely equals potential GNP (Q), full employment will result, by definition.

The budget would be balanced if total receipts [e.g. TAX RATE × Y = G + Transfers (simplified model)]. The currency would appreciate if there were a Balance of Payments (BP) surplus; the BP = Trade balance + net capital flows. Thus if the currency appreciates despite a trade deficit the surplus in the capital account must have exceeded the trade deficit (we are ignoring expectation effects).

The question is can this state of affairs continue?

Consider next year - year t + 1. Given the above starting position if Y just equals Q then Y_t+1 will equal Q_t+1 and the economy will remain at full employment.

With the same tax rate and assuming no increase in government outlays a budget surplus is possible given the Y; even with an increase in government outlays a surplus is possible if the Y is sufficiently larger than the G expenditure.

What about inflation? Much will depend upon the initial position. If there were deflationary expectations in the economy in Year t it might be possible to run an economy at full or even over full employment for several years before inflationary forces made themselves manifest.

The value of the currency is subject to a variety of forces - the trade balance, capital flows and expectations being major. A trade imbalance can be offset by a capital inflow which in turn, ignoring expectation effects, can be ‘manipulated’ by a ‘high’ interest rate policy attracting foreign funds.

There are several problems however for policy makers to resolve.

i. anticipating exogenous shocks

ii. predicting consumer (C) and firm (I) behaviour and being able to control government expenditure (G)

iii. estimating exports (X) and imports (Z)

iv. (ii) and (iii) are necessary because Y C + I + G + X - Z and a precise Y_t+1 is required to equal Q_t+1.