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flexibility in the labour market, however, unemployed workers can move to the other country experiencing the boom.

In the absence of high labour mobility, sufficient transfers of income enable redistribution from higher-income areas that can help ease the plight of countries experiencing recession.

7.10.1CONSIDERING THE EURO

The euro was launched by 11 European countries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain) at the beginning of January 1999. When euro notes were introduced in 2002, Greece also ‘joined’ the euro zone. For some this was the culmination of the post-World War Two attempts by European countries to ensure a repetition of the causes and consequences of war was not possible through the strengthening of economic and political ties between them.

Some of the main European events that preceded the euro were:

•1951: The European Coal and Steel Community (ECSC) was set up, with six members: Belgium, West Germany, Luxembourg, France, Italy and the Netherlands. This organization was proposed by the French Foreign Minister Robert Schuman to integrate the coal and steel industries of Western Europe.

•1957 : The same six countries signed the Treaties of Rome and European Economic Community creating the European Atomic Energy Community (EURATOM) and European Economic Community (EEC) respectively. The aim of the EEC was to remove trade barriers to form a ‘common market’.

•1967 : The institutions of the three European communities (ESCS, EURATOM and EEC) were merged to create one European Commission, one council of ministers as well as the European parliament.

•1973: Expansion of Community to Denmark, Ireland and the United Kingdom.

•1981: Expansion of Community to Spain and Portugal.

•1987 : Single European Act (SEA) came into operation in July. The goal was to create a single market in goods, capital, labour and services by 1992.

•1992: The Treaty of Maastricht (1992) introduced new forms of intergovernmental co-operation, for example on defence, and in the area of ‘justice and home affairs’ thus creating the European Union (EU).

•1995: Expansion of Union to Austria, Finland and Sweden.

•2003: Given past and future expansions of the Union, the Treaty of Nice came into force laying new rules governing the size of EU institutions and how they work.

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•2004: Expansion of Union to Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia.

By adoption of the SEA, members of the EC confirmed their aim to realize an economic and monetary union (EMU). The Delors Report on EMU of 1989 proposed how this might be achieved in a series of stages in a process to coordinate economic and monetary policy. A European system of central banks would take charge of monetary arrangements via a committee of central bank governors. The final stage would be the irrevocable fixing of exchange rates and introduction of a single currency.

Phase 1 began in earnest in 1990 when increased economic cooperation was required by the submission of currencies to the European Monetary System’s exchange rate mechanism (ERM). The EMS had been created in 1979, before the road to EMU was begun. Its aims were to assist the maintenance of stable currencies by keeping currencies within exchange rate bands. The bands were altered from time to time and realignments occurred.

Realignments are simultaneous and coordinated devaluation or revaluation of currencies of several countries.

Stability was not always achieved. The UK joined in 1991 but withdrew along with Italy in 1992. In September 1992, there was widespread uncertainty on the outcome of the French referendum on the Treaty of Maastricht. This contributed to speculation on the weakest ERM currencies, sterling and the lira. Despite substantial increases in domestic interest rates, the markets were subject to intense speculation and sterling left the EMS in 1992. Over the four months that followed, the interest rate in the UK was cut by four percentage points to meet the requirements of a country dealing with a recession. The currency had depreciated by over 15% but subsequently appreciated as the economy recovered. The French franc, thanks to substantial intervention by the German central bank, the Bundesbank, survived speculative pressure in September 1992. The Irish pound succumbed to pressure from speculators and was devalued by 10% in January 1993.

ERM bands had to be widened to 15% in August 1993. In hindsight it appears currencies had been over-valued in the sense that their exchange rates were out of line with a sustainable balance of payments and devaluations were required.

The balance of payments is one account in a country’s national accounts. It includes transactions between domestic residents and the rest of the world over a specified period. It consists of a current account and a capital account.

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The current account includes all trade transactions where the balance of trade might be in surplus or deficit. It also includes all income and current transfers.

The capital and financial account tracks transactions relating to ownership of financial assets, including inward and outward direct investment.

Devaluations lead to increased competitiveness for export goods, boosting the balance of payments through the balance of trade. Import goods become less attractive as they are more expensive following devaluation.

The German economy had been a source of uncertainty in the EMS also because of its need to finance unification on the one hand and a desire not to increase taxes to fund it on the other. The increased demand for money to fund reunification meant the German interest rate was driven up. Through the EMS links, interest rates in other countries were also high.

Over time, the credibility of the EMS was re-established and by the end of 1996 all but Ireland were within 2.25% bands.

The EMS survived largely because many governments wished to fulfil requirements to qualify for EMU under the Maastricht criteria. These included:

•Inflation: a country’s inflation rate (CPI) could be no higher than 1.5 percentage points above the three best performers for one year.

•Interest rate: a country’s average nominal long-term interest rate (e.g. on government bonds) could be no more than two percentage points higher than the same three best performers above.

•Budget deficit: a country’s current budget deficit could not be ‘excessive’ taken to mean it should not be higher than 3% of GDP.

•Currency stability: a country’s exchange rate should have operated normally within the ERM for two years with no pressure to devalue against other members.

•Public debt: although not specifically mentioned it was considered that it should be no higher than 60% of GDP.

These specific convergence criteria are not supported by objective rationale or theory, e.g. why not choose 65% of GDP? No mention of unemployment is made, although what is happening in the labour market helps to determine success or failure of OCAs. (Indeed, as we will see in Chapter 8, the relationship between inflation and unemployment should not be overlooked in focusing solely on inflation.) Rather the 60% and 3% deficit figures were the trends or averages at the time. The need for movement toward convergence, in the light of the OCA discussion above, is however unquestionable if the currency is to be successful.

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The advantages of one European currency include:

•Elimination of currency conversion costs associated with buying foreign exchange.

•Competition and efficiency improvements as prices of the same goods in the euro zone would be more comparable and create incentives for arbitrage and be pro-competitive and pro-consumer especially for high-cost markets.

•Removal of exchange rate volatility within the euro zone that results in enhancing trade and reducing possibility for speculation on individual currencies (as occurred in 1992 and 1993). Investment by foreign-owned companies is also sensitive to exchange rate volatility effects on their potential costs and revenues. The experience of the UK post-euro has been a decline in its share of EU-destined inward investment from 39% in 1999 to 24% three years later.

•Lower inflation and interest rates are possible once the European Central Bank is perceived as independent and achieves credibility. This boosts the market’s impression of the euro as a strong currency, which can maintain low long-term interest rates, stimulating domestic and foreign investment in the EU.

Despite these potential advantages, the difficulties in meeting some of the OCA criteria remain too significant for some countries to concede that joining is optimal for them, or that on economic grounds the adoption of the euro made sense.

Clearly, adoption of the euro is not the result of economic decisions but political decisions also.

H O W D O E S T H E E U R O S C O R E I N T E R M S O F T H E F O U R O C A F A C T O R S ?

•In terms of the euro, member countries conduct between 55% and 75% of their trade with other euro-zone members.

•Belgium, France, Germany, Italy and the Netherlands display highly correlated GDP growth patterns. The business cycles of other countries including Finland, Greece, Ireland and Portugal indicate lower correlations which implies they may find the transition to the single currency more difficult. Relatively speaking, the correlation appears higher among all euro-zone members than among all states of the USA, which has its single currency.

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•European labour markets tend to be less flexible and labour less mobile than in the USA. (More on this in Chapter 8.) The language barrier explains much of this as well as historical relatively low labour mobility rates.

•Fiscal transfers between euro-zone member states are quite small and do not compare to the federal tax and expenditure system of the USA.

Not all four factors are fully satisfied. It does not follow, however, that the costs of the euro outweigh its benefits.

Some explanation is provided for the alternative stances taken by countries on the euro. The UK appears to follow a different business cycle to its European partners. France, Germany and the Benelux countries trade highly and follow similar business cycles. Greece and Italy may benefit from lower inflation under the euro than if they followed independent national monetary policies (such as with Ireland following its membership of the previous European monetary system).

The more problematic factors may become less important over time if/as the single market becomes more developed.

7 . 1 1 S U M M A R Y

•To qualify as money, three specific functions must be served: medium of exchange, unit of account and store of value.

•The supply of money is regulated by each country’s monetary authority (central bank or Federal Reserve), which operates monetary policy focused on maintaining a sound financial system in which people have confidence. Open-market operations are the main way that money supply is increased or reduced. Another mechanism is via the required reserve ratio.

•The banking system creates money according to the money multiplier relationship between deposits, the required reserve ratio and loans offered by banks.

•The demand for liquid money can be specified as precautions, transactions and speculative demands.

•Interest rates are determined in the money market (by money supply and money demand).

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•The real interest rate is the difference between the nominal rate and inflation. Both nominal and real interest rates are taken into account for consumption, saving and investment decisions, hence they affect aggregate demand.

•The quantity theory of money describes the relationship between money supply and inflation. Inflation expectations also have a role in the determination of ex-ante real interest rates used for decision-making.

•Credibility of central bank policies matter for the stability of a country’s financial system.

•Exchange rates are determined in the foreign exchange market (by currency supply and demand).

•Speculation in money and other asset markets is widespread in the economic system. There are costs and benefits associated with speculation.

•Monetary policy can focus on a variety of targets.

R E V I E W P R O B L E M S A N D Q U E S T I O N S

1.Show, by using your own examples, that you understand the three functions of money.

2.Fill in the following table to consider the impact on money creation of deposit of £1000 according to the method explained in Table 7.2 taking into account here a required reserve ratio of 10%.

Deposit £

Required reserves £

Loan £

Moneybags 1000

Grandon’s

Next customer

Next customer

. . .

. . .

. . .

. . .

Total

3.Use supply and demand curves to explain how equilibrium emerges in the money market to determine the interest rate – the price of money. Explain the impact of open market operations (if the government sells bonds) on equilibrium.

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4.What are the nominal and real interest rates? How do changes in i) nominal and ii) real interest rates affect:

•borrowers;

•savers;

•consumers?

5.What is the quantity equation and what relationship does it describe?

6.Use the demand and supply model to show:

a.how exchange rates are determined;

b.causes of fluctuations in exchange rates.

7.What is a bond and what is the bond market? What is the relationship between the price of a bond and the rate of interest?

8.Explain using some examples what you understand by the term ‘monetary policy’. Using the example of controlling inflation, what difficulties may arise in implementing monetary policy?

F U R T H E R R E A D I N G A N D R E S E A R C H

•For an insight into how cigarettes fulfilled the main functions of money in a prisoner-of-war camp, see Radford, 1945.

•In relation to the Asian currency crisis see Nouriel Roubini’s Global Macroeco-

nomic and Financial Policy Website at http://www.stern.nyu.edu/globalmacro/ See also Krugman, 1998.

• For more on the European exchange rate mechanism see El-Agraa, 2001, pp. 124–48; and Mayes, 2001.

R E F E R E N C E S

DeLong, J. and L. Summers (1993) ‘Macroeconomic policy and long-run growth’ in Federal Reserve Bank of Kansas City. Policies for Long-run Economic Growth.

El-Agraa, A. (ed.) (2001) The European Union, Economics and Policies. 6th edn, Pearson. Krugman, P. (1998) Whatever happened to Asia? Mimeo; online at http://web.mit.

edu/krugman/www/

Mayes, D. (2001) ‘The European monetary system’, in El-Agraa, A. (ed) The European Union, Economics and Policies, 365–87.

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Radford, R. (1945) ‘The price system in a microcosm: a POW camp’, Economica, 12, 189–201.

Roubini, N. Global Macroeconomic and Financial Policy website at http://www.

stern.nyu.edu/globalmacro/

Taylor, J. (1993) ‘Discretion versus policy rules in practice’, Carnegie-Rochester Con-

ference Series on Public Policy, 39(0), 195–214.

C H A P T E R 8

C H A L L E N G E S F O R T H E

E C O N O M I C S Y S T E M :

U N E M P L O Y M E N T A N D

I N F L A T I O N

L E A R N I N G O U T C O M E S

By the end of this chapter you should be able to:

Explain why unemployment and inflation periodically emerge as short-run economic problems.

Describe alternative definitions and categories of unemployment.

Use the labour demand and supply model to examine the effects of minimum wages on employment and wage rates.

Apply the aggregate demand and supply model to compare/contrast alternative approaches to unemployment and how an economy deals with it.

Explain the recessionary gap approach to unemployment.

Outline the main costs associated with unemployment.

Apply the aggregate demand and supply model to compare and contrast alternative approaches to inflation and how an economy deals with it.

Explain the inflationary gap approach to inflation.

Describe recent trends in international rates of inflation, and their causes.

Outline the main costs associated with inflation if it is anticipated or not.

Describe what the Phillips curve predicts for unemployment and inflation.

Explain the alternative perspective to the Phillips curve offered by the natural rate of employment model.

8 . 1 I N T R O D U C T I O N

We have seen that in the context of economies experiencing business cycles over the short to medium terms, there is the possibility that an economy can find

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itself in an equilibrium situation where aggregate demand intersects with aggregate supply at a point where the economy is at less than full employment. Another potential macroeconomic equilibrium is possible where the average level of prices is unstable which, as we will see below, is possible with increasing aggregate demand or decreasing aggregate supply in the short run. In the case where the price level rises over time inflation can be a feature of the shortto medium-term experience for an economy. The two issues of unemployment and inflation have focused the minds of many economists over the years as they attempt to argue how economies should best deal with the challenges created by either unemployment or inflation, or sometimes both together.

In this chapter we consider the issues separately initially (in sections 8.2 and 8.3) and examine the causes of unemployment and inflation using standard economic theory based on both the microeconomic demand and supply and the aggregate demand and aggregate supply concepts and tools introduced in earlier chapters. We examine some alternative explanations for unemployment and inflation and in section 8.4 discuss the logic behind theories that hold that the one is a trade-off for the other and consider what implications that view has for government policy. We also examine the causes of different equilibrium rates of unemployment and find in sections 8.5 and 8.6 that it is possible under certain circumstances to observe both inflation and unemployment in the short run.

8 . 2 U N E M P L O Y M E N T

In any economy a number of individuals are willing and able to work. The number of people aged 16 (or in some countries 15) and over who are employed plus the number of people unemployed – those who do not have jobs but who are actively looking for work – makes up an economy’s labour force. Not every individual in an economy falls into either the employed or unemployed category. For example, retired people, people who choose to take on home or childcare duties, and discouraged workers are not included in the calculation of the labour force.

Discouraged workers have tried to find work in the past and are willing to take on a job but have given up on looking for work because they feel, or know, that nothing suitable is available.

The unemployment rate measures the percentage of the labour force that cannot find work.

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If 9 million people are employed in an economy and 1 million are unemployed, the unemployment rate is:

1

× 100 = 10%

9 + 1

Across the countries of the OECD a standardized unemployment rate is reported as the measure of unemployment. This measure is also used by the International Labour Organization (ILO).

The standardized unemployment rate measures those unemployed as people of working age without work who are available to start work within two weeks and who are actively seeking employment.

Some recent statistics for unemployment (using the standardized rate) are shown in Table 8.1. France and Germany’s performances have been poor relative to the other countries shown.

Countries report standardized unemployment statistics based on labour force surveys conducted on a regular basis (often each quarter). An alternative measure of unemployment is found by counting all those who receive unemployment payments; however, those unemployed but ineligible for benefits are excluded in

T A B L E 8 . 1 U N E M P L O Y M E N T R A T E S , % , S E L E C T E D C O U N T R I E S 1 9 9 8 – 2 0 0 3

Year	Germany	France	Japan	Sweden	Ireland	UK	USA
1998	9.1	11.4	4.1	8.2	7.5	6.2	4.5
1999	8.4	10.7	4.7	6.7	5.6	5.9	4.2
2000	7.8	9.3	4.7	5.6	4.3	5.4	4.0
2001	7.8	8.5	5.0	4.9	3.9	5.0	4.7
2002	8.6	8.8	5.4	4.9	4.4	5.1	5.8
2003	9.3	9.4	5.3	5.6	4.6	5.0	6.0

Source: Excerpted from Table A, OECD, 2004.