Faculty of Humanities and Social Sciences

Mr. Sourav Basak

JRF (Economics)

Department of Economics
Nims University Rajasthan, Jaipur
 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 P = (V/y)M

or 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
P2

P1 AD3
AD2
AD1
Output
y1 y2 y3

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

Price AS4
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
 Interaction between demand and supply
AS3
AS2

P3 AS1

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?

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 for
Demand shock
goods increases

Demand for
labour increases

Supply shock: Wages increase

wage push
Cost-plus Real wage
pricing bargaining

Supply shock:
Prices increase
e.g. OPEC
 A dynamic model of inflation: the augmented
Phillips curve

Price inflation

p1

Inflationary expectations: high

0 Wage inflation
u1

Inflationary expectations: low

 The Phillips Curve ‘Trade-off’
Inflation

III
Unemployment
0
II

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
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
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

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?

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 and 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