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

303

possible wage increases from employers rather than focusing on addressing the needs of the unemployed, who are not part of their membership – an example of an insider–outsider model where ‘insiders’ look after their own interests. For non-unionized workers, their effective credible threat in negotiating wage increases is that of finding work elsewhere, which is only really credible in boom times if there are shortages of workers with their specific skills set.

As well as ‘standard’ inflation in average prices of consumer goods and services, wage inflation is also of interest to economists. If at all possible, economies should avoid creating an environment conducive to escalating price inflation where price rises used to argue for increases in wages are in turn used by firms to argue for increasing their prices to cover costs, which is used to argue for increases in wages, in an unending spiral of rising prices and wages that leaves no one any better off and wastes time and energy, which are scarce resources best spent on other more productive activities.

Furthermore, the pattern emerging from trends across several countries is that their inflation rates tend to move together. This indicates that countries’ economies are inextricably linked so that the tendencies for price rises often coincide across countries. Because countries trade with each other and given that capital flows across borders for investment and speculative purposes, many economic variables such as inflation tend to behave similarly across different countries.

8.3.3GOVERNMENTS’ CONTRIBUTION TO INFLATION

Reference was made earlier to government deficits where governments must borrow to make up for their overspending compared to their receipts. Governments that persist in running deficits can influence inflation in two ways: via aggregate demand and the money supply.

If a deficit is run because of a government increasing its expenditure (a rise in G) or because of a reduction in the tax rate (a fall in t), the result is an increase in aggregate demand, i.e. a rightward shift in the AD curve. This leads to an increase in the price level in the short run, presuming no change to aggregate supply. However, if consumers anticipate that a government running a deficit today may be likely to increase tax rates in the future to pay for the deficit, consumers may very well react to increased government expenditure or lowered tax rates by reducing their current spending. Savings would rise and, hence, some of the inflationary effects of a deficit can be reduced and maybe even eliminated, depending on consumers’ behaviour and expectations.

Sometimes when a government issues debt its central bank purchases the debt, thereby increasing the money supply. The central bank, through its open-market

304	T H E E C O N O M I C S Y S T E M

operations, releases money into the economic system as it buys the debt in the form of government bonds, for example. While the central bank is under no obligation to purchase the debt, it may choose to do so if it prefers to maintain the interest rate constant. Depending on the scale of the debt, if the general public bought the bonds the impact could be to increase the demand for credit and put upward pressure on interest rates. As we know from the quantity theory, any increase in the money supply results in an increase in the price level, hence the link between the deficit, money supply and inflation.

8.3.4ANTICIPATED AND UNANTICIPATED INFLATION – THE COSTS

Economic analysts regularly provide and publish forecasts on their inflation expectations. These can then be used by parties engaging in wage negotiations (for example) to use in supporting arguments for specific rises in wage rates: if inflation of 5% is predicted for each of the next two years, workers will want to earn increases of at least 5% each year to keep their real income levels constant. If workers expect profits to rise also then individually and through their trades unions they try to negotiate increases higher than expected inflation. Inflation forecasts can also be used by those with responsibility for setting interest rates in the knowledge that savers and investors are more likely to save and invest when positive real returns are possible, ceteris paribus. Any anticipated inflation can be taken into account to some degree, at least, but no matter how people attempt to plan for inflation, because its extent is uncertain, any adjustments will probably not be perfect (either overor under-predicting the rate) and any adjustments will take time to implement.

Anticipated inflation: expected inflation that is taken into account in economic decision-making.

Unanticipated inflation is inflation that takes people by surprise.

Governments and individuals dislike unanticipated inflation, because they have not allowed for it in interest rate changes, bond issues, wage-bargaining, etc. Anticipated inflation is built into people’s/governments’ terms of borrowing and lending, but unanticipated inflation is not. Both types of inflation are associated with certain costs, but the costs are more severe in the case of unanticipated inflation. Specifically, the costs of inflation are outlined in the text box. Points 1 to 3 occur with both anticipated and unanticipated inflation, being more severe when inflation is unanticipated. Points 4 to 8 are particularly relevant to unanticipated inflation.

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

305

C O S T S O F I N F L A T I O N

1.Loss of purchasing power : inflation lowers purchasing power, and people living on fixed incomes suffer a decline in living standards as a result.

2.Shoe-leather costs: during periods of inflation, people hold less currency. Therefore, they must make more trips to the bank to withdraw cash. These extra trips are known as ‘shoe-leather costs of inflation’, i.e. the extra time and effort that people put into transactions, when they try to get by with lower real money balances.

3.Menu costs: during periods of inflation, prices may change frequently. This imposes costs on firms and shops, which have to reprint price lists. Also, customers have to go to some trouble to keep up-to-date with price changes.

4.Effects on income distribution: inflation can result in a redistribution of income. Savers are penalized, borrowers gain by going into debt and repaying the loan in money which value has declined. This amounts to a transfer in wealth away from savers to borrowers.

5.Fiscal drag : when tax rates are not fully inflation-adjusted, fiscal drag occurs. This means that people are pushed into higher tax brackets in a progressive income tax system. A progressive income tax system is one in which individuals pay a higher percentage of their income in tax, the more they earn (alternative tax systems are either regressive or neutral).

6.Effects on international competitiveness: inflation can have serious effects on the ability of domestic firms to compete with international rivals if domestic prices are rising faster than for competitor firms in other countries. Exports may fall, causing growth and employment to fall also.

7.Balance of payments effects: countries with high inflation relative to others find their quantity of exports decline as the prices of their goods become less competitive and imports rise. In the national accounts, the value of exports falls while imports rise and a deficit on the trade account is possible. This might lead to a drop in demand for the country’s currency and have an effect on the exchange rate or interest rate.

8.Business uncertainty and lack of stability effects: inflation increases the complexity of making long-term plans, e.g. investment. Also, most people are generally risk-averse, and prefer to make plans and contracts in real terms, rather than in nominal terms. With unanticipated inflation, this may not be possible.

306	T H E E C O N O M I C S Y S T E M

8 . 4 L I N K I N G U N E M P L O Y M E N T A N D I N F L A T I O N

It may appear from the foregoing analysis that unemployment is a problem associated with recessionary periods in an economy while inflation is often associated with boom periods. Both unemployment and inflation appear to be linked, under a Keynesian approach to the economy, to aggregate demand and differences between short-run and long-run macroeconomic equilibrium. This implies that unemployment and inflation are problems that occur in the short run. Inadequate aggregate demand is associated with recessions and unemployment while excessive aggregate demand is associated with booms and inflation. From policy-makers’ point of view, they would either have to attempt to deal with unemployment or inflation. This pattern appeared to hold true for over 100 years until the mid-1960s but thereafter, it oversimplifies the inflation–unemployment relationship. Based on analysis of wage inflation and unemployment data from 1861 to 1957 (hence, not based on theory but observation) the economist William Phillips (in 1958) considered that inflation and unemployment tended to move in opposite directions. High wage inflation was associated with low unemployment and low inflation was associated with high unemployment. This relationship became known as the Phillips curve. A similar curve describes the relationship between price inflation and unemployment.

The relationship between unemployment and inflation, called the Phillips curve, is negative, meaning that high unemployment is associated with low inflation and vice versa.

Central to our understanding of the Phillips curve today is the role of the expected inflation rate predicted by the general public, based on their best guesses given all available information, including advice from inflation forecasters. The original Phillips curve made no mention of inflation expectations, however, following the work of other economists (Edmund Phelps and Milton Friedman) both inflation expectations and the natural rate of unemployment have been incorporated into the Phillips curve. The Phillips curve presented here is correctly called the expectationsaugmented Phillips curve.

The expectations-augmented Phillips curve explains inflation in terms of a negative relationship between inflation and unemployment and a positive relationship between actual inflation and expected inflation.

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

307

Think of the situation where people predict an inflation rate of, say, 2%, for both wages and general prices. If there is an increase in aggregate demand above the level producers expected so that demand for firms’ output is higher than firms envisaged, firms’ prices may be driven up by more than 2%, say by 4%. This would occur via a rightward movement of the aggregate demand curve, caused by rising consumption expenditure, leading to a new macroeconomic equilibrium.

However, wages are usually negotiated for relatively long periods so wages are fixed in nominal terms for some period of time. When nominal wages are fixed and are associated with rising price levels, the implication is that real wages decline. Since economic decisions are made on the basis of what happens to relative prices, a fall in real wages creates an incentive for firms to hire extra workers since labour costs have become cheaper, and with increased demand for firms’ output it makes economic sense for firms to hire additional workers. The result is a fall in unemployment associated with the increase in inflation.

The formula for the expectations-augmented Phillips curve is

Actual Inflation rate = expected rate of inflation + X (natural unemployment rate − actual unemployment rate)

where X denotes a positive number, which is different for different economies.

The actual rate of inflation in an economy will be the same as the expected rate if output and unemployment remain at their equilibrium levels so that unemployment is at its natural level. Where this is not the case, actual and expected inflation will differ.

If the natural rate of unemployment is 8%, if X is 0.75 and inflation is expected to be 4% then actual inflation is 4% if unemployment is 8%. If instead unemployment is 10%, inflation must be 1.5 points less than expected (since 0.75 (8–10) = −1.5) which would be 2.5%.

The negative unemployment/inflation relationship is logical in this case since with higher-than-equilibrium unemployment due to insufficient aggregate demand, producers have an incentive to moderate any increase in prices. Hence price inflation is less than expected although since nominal wages are fixed, wage inflation remains at the expected level. The effect is an increase in real wages (relative to what was expected) so that labour is more expensive and some workers lose their jobs. When inflation is lower than expected, unemployment goes up.

308	T H E E C O N O M I C S Y S T E M

Inflation
Inflation
expectations	Phillips Curve
	Unemployment
	Natural rate

F I G U R E 8 . 1 0 T H E P H I L L I P S C U R V E

The alternative would also hold that when inflation is higher than expected, unemployment would fall.

Graphically the Phillips curve as described above is shown in Figure 8.10. This figure shows a negative relationship between unemployment on inflation and vice versa. When inflation is in line with expectations, unemployment is at its natural rate. Since wages are sticky only in the short run but will be renegotiated in the light of actual inflation and expectations in the future, the inflation – unemployment relationship underlying the Phillips curve is something we expect to observe in the short term only and, hence, government intervention would require action to affect aggregate demand in the short run only.

The policy choice for government implied by the relationship described in the Phillips curve was in terms of trading off inflation for unemployment. The ‘cost’ of low unemployment would be higher inflation while low inflation would be associated with higher unemployment.

From the mid-1960s onwards, outcomes implausible under the Phillips curve relationship were observed across developed economies – both rising unemployment and rising inflation. Some economists argue that over time the Phillips curves of individual countries move around, the position being determined by factors unrelated to aggregate demand explanations of inflation and unemployment. Such explanations include frictional and structural unemployment and cost-push inflation and expectations-generated inflation. The Phillips curve moves to the left if any of these factors changes leading to falling inflation or unemployment (or to the right if the result is rising inflation or unemployment).

The next section on determinants of the natural rate of unemployment explains how it is possible to observe inflation and unemployment in certain circumstances.