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INFLATION AND UNEMPLOYMENT INFLATION 1. Historical experience of inflation 2. Causes of inflation 3. Costs of inflation: why is inflation a problem? 4.

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Presentation on theme: "INFLATION AND UNEMPLOYMENT INFLATION 1. Historical experience of inflation 2. Causes of inflation 3. Costs of inflation: why is inflation a problem? 4."— Presentation transcript:

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 AS AD 1 AD 2 P2P2 P1P1 y1y1 y2y2 AD 3 y3y3 Price Output 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 AD AS 1 AS 4 AS 3 AS 2 Price Output P4P4 P3P3 P2P2 P1P1 y1y1 y2y2 y3y3 y4y4 Supply-side: increase in wages increase in import prices price-fixing by suppliers

7 Interaction between demand and supply P1P1 P2P2 P3P3 y* AD 1 AD 2 AD 3 AS 1 AS 2 AS 3 Govt policy is to keep y at y*: - increase in costs offset by govt expansionary policy But what about continued increase in prices?

8 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

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

10 A dynamic model of inflation: the augmented Phillips curve Price inflation Wage inflation Inflationary expectations: low Inflationary expectations: high p1p1 0 u1u1

11 Inflation Unemployment 0 The Phillips Curve Trade-off I II III 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 1921July1 1922July7 1923Jan 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 Fiscal balance Inflation Growth (% GDP) 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

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