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

2. 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

3. 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

4. Excess demand model of inflation If AD > AS……….prices rise if AD < AS……….prices fall Price AS P2 P1 AD3 AD2 AD1 Output y1 y2 y3 But can output continue to rise?

5. 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

7. 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

9. 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 Supply shock: e.g. OPEC Prices increase

10. A dynamic model of inflation: the augmented Phillips curve Price inflation p1 Inflationary expectations: high 0 Wage inflation u1 Inflationary expectations: low

11. The Phillips Curve ‘Trade-off’ Inflation III Unemployment 0 II I Inflation = Expected inflation - U

12. 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)

13. costly to reduce inflation: dis-inflation => unemployment • hyper-inflation is economically and politically disastrous • - complete collapse of market economy • - political instability

14. 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

15. 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

16. 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

17. 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

18. 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)

19. 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?

21. 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

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

23. 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

24. 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

25. 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)

26. 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

27. 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