Chapter 12

UNEMPLOYMENT AND INFLATION.

Introduction.

  • The two main economic problems that economists and politicians are concerned with in western developed economies are unemployment and inflation.
  • In this chapter we are going to study:

-How they are connected and whether or not there is a tradeoff between the two of them.

-Why they are considered major economic problems.

12.1 The Phillips Curve.

  • In 1958, a British economist, A. W. Phillips, published a paper where he showed that there was an empirical connection between inflation and unemployment in Great Britain.
  • He was interested in studying how higher wages will increase unemployment but he could not get access to good data about wages.
  • Instead he chose to study the connection between unemployment and the price level (that ultimately determines the purchasing power of our wages.)
  • His results were very solid and convincing, and soon everybody else was testing the same premise in a multitude of countries. In the US, what henceforth was named the "Phillips curve" looked like this:

(See Figure 12.1)

  • The Phillips curve proposes the existence of a negative relationship between inflation and unemployment, a tradeoff, in fact.

-Low unemployment levels are associated with high inflation.

-Low inflation levels are associated with high unemployment.

  • This empirical conclusion is also reflected in our theoretical model of the economy, the AS / AD model:

-Expansionary fiscal or monetary policies can shift the AD to the right and raise economic activity above the full employment level.

-Unemployment is thus reduced but at the cost of higher prices.

  • The existence of this regularity was a very attractive fact to many governments around the world. It gave them the option of lowering unemployment at only the cost of higher inflation.
  • Ever increasing budget deficits or a constantly expanding money supply would bring home the desired results.
  • If it is so, then, why don't we see that happening nowadays? When did the Phillips curve break down? Did it ever break down?

(See Figure 12.2)

The breakdown of the of the Phillips curve.

  • Two American economists, Milton Friedman and Edmund Phelps studied the Phillips curve and concluded that the only relationship that could exist will be between unanticipated inflation and cyclical unemployment.
  • In other words, that only when firms and households were "surprised" by higher prices the unemployment level would fall, but eventually it returns to the natural rate of unemployment.

-If the inflation rise is expected by firms it will immediately be transmitted to the selling prices and production costs will increase. The unemployment rate will not change.

(See Figure 12.3)

-If the inflation rise is unexpected by firms, it will take awhile to be acknowledged, registered and transmitted to selling prices and production costs. The unemployment rate will decrease while this adjustment takes place.

(See Figure 12.4)

  • This is known as the expectations augmented Phillips curve:
  • According to this analysis, the inflation - unemployment tradeoff will no longer be true if:

-The economy experiences high inflation for a long period of time and households and firms develop expectations of future high inflation.

-The natural rate of unemployment increases due to adverse supply shocks, therefore requiring larger inflation increases to produce unemployment reductions.

  • In both cases the Phillips curve will be shifting up. This will explain why during some decades the tradeoff is not apparent:

-During the 70s, inflation expectations were high due to the large fiscal expansions of the 60s.

-Simultaneously, the oil shocks affected productivity negatively and increased the natural rate of unemployment.

-The dramatic Vockler deflation of the early 80s brought down inflation expectations and subsequent productivity increases have allowed us to have low inflation and low unemp.

  • Finally, both the classical school and the Keynesians agree that the existence of this tradeoff can not be used as an argument to promote expansionary (inflationary) policies in order to reduce long-run unemployment.
  • The long-run Phillips curve is thus vertical. The full employment level of output, and so the natural rate of unemployment, do not depend on the price level.

12.2 The Problem of Unemployment.

  • Why is unemployment a national problem (in case somebody wonders)?
  • High unemployment means that we are not fully utilizing one of the factors of production (labor) and that prevents us from being at the full employment level of output.

-The relationship between higher unemployment and lower output is known as Okun's law and states that for every 1% that unemployment increases, output falls by 2.5%.

  • Unemployment per se reduces the income levels of those not working and therefore their living standards. It is also stressful and causes other social problems, such as crime.
  • How can we know what is the natural rate of unemployment?
  • This is a very difficult concept to appraise. During many years it was considered to be around 5% or 6% but changes in productivity can affect it.
  • Notice that since 1995 the actual rate of unemployment has been below the estimated natural rate. That fact, according to the expectations augmented Phillips curve should have produced high inflation, but that has not been the case.

(See Figure 12.9)

  • What are the demographics of unemployment?
  • Unemployment does not affect all age, gender and racial groups in the same way:

-Women experience higher unemployment than men.

-Minorities experience higher unemployment than whites.

-Teenagers experience higher unemployment than adults.

  • Why is this the case? Because cultural pressure and racial discrimination have kept these groups for many years from attaining the educational and job experience levels required to be successful in the job search process.
  • Is unemployment in other countries as low as in the US?
  • No, in many European countries the unemployment rates are between two and three times the US level.
  • Different explanations have been offered to the question of why unemployment in Europe did not return to its low values previous to the oil shocks:

-Unemployment can be hysteretical (temporary shocks can have permanent effects)

-The longer the worker remains unemployed, the lower the probability of being re-hired because her/his working skills deteriorate from lack of practice and update.

-Regulations that restrict how firms can lay-off and fire workers affect how (and how many) are hired in the first place.

-Unions are more extended and popular than in the US and their wage-setting negotiations tend to benefit mostly the employed members. This is known as the insider-outsider theory.

-Unemployment compensation and unemployment insurance are very generous (and used to be universal), a fact that reduces the incentives for some workers to look for jobs.

  • What can be done to reduce unemployment?
  • Keep in mind that we are interested in reducing the natural rate of unemployment, not just the cyclical rate (the one that oscillates with the business cycle)

-Government support for worker training and relocation, so that unemployed workers can easily take on new jobs wherever those may appear and whatever skills they may require.

-Reduction of government regulations on wages and firing practices. The more flexible the process of hiring and firing the less reluctant firms will be to increase their staffs.

-Reduction of unemployment insurance, that keeps unemployed workers from actively looking for jobs. Keep in mind that this social welfare program serves a social purpose and that it is only inefficient if it lasts too long or if it too generous.

12.3 The Problem of Inflation.

  • The monetary authority, the Fed, is very concerned about inflation picking up speed in the country because inflation destroys the value of money as a medium of exchange and as a store of value.
  • Inflation can be anticipated or unanticipated by economic agents.
  • Anticipated inflation is not such a big problem for workers if they make provisions for their nominal wages to increase at the same ratio as inflation does. This is called indexation.
  • Our savings need not to suffer either because banks will prop up nominal interest rates to keep on attracting depositors and also to prevent losses from lending at devaluated rates.
  • Nonetheless, all the adjustments to wages, prices and nominal interest rates are time-consuming (shoe leather costs) and resource consuming (menu costs)
  • Unanticipated inflation is a much bigger problem because it eats up the purchasing power of our wages and makes both saving and lending unattractive.
  • Low-qualification workers that don't index their wages will suffer the most, as will lenders that collect fixed-amount payments (like rent.)
  • Most importantly, prices are the signaling system for the economy (telling firms how much to produce and consumers how much to spend) and when they start being out of sync with the real economy they become useless.
  • Hyperinflation is an extreme case of ever growing unanticipated inflation.
  • In all historical cases, very high and unpredicted inflation makes money unattractive for conducting transactions and households and firms revert to barter or to use foreign currencies (generally the US$) instead of the domestic currency.
  • The financial system collapses because nobody wants to save and no foreign investor wants to lend to a country in financial disarray.
  • Lastly, tax collection crumbles down because taxpayers try to postpone as much as possible the payment of taxes and the revenue collected has little purchasing power.
  • Since the number of factors affecting inflation at any given moment in time can be numerous, we may need a combination of the following inflation-reduction policies:

-Reductions in excessive growth of aggregate demand caused by excessive consumption or expansionary fiscal policy (that will cause demand-driven inflation)

-Reductions in money supply, the ultimate cause of inflation, although this may cause a recession. Governments tend to print too much money in order to finance the budget deficit.

-Reductions in inflation expectations by households and firms, that should accompany reductions in actual inflation. If expectations are not lowered, expectation-indexed prices will continually drive inflation up.

  • All these policies have serious implementation problems:

-It is not clear if the reductions in aggregate demand (or money supply) should be implemented gradually or in a dramatic one-shot move (what is called cold turkey.)

-The use of wages and price controls is very tempting in order to affect expectations and lower the economic costs of inflation but their setting and management is very difficult. Besides, these are not solutions to the underlying motives for the existence of inflation.

-In many case, hyperinflation is caused by mismanagement of macroeconomic policies by the government and it is very doubtful that the same persons that caused the problem are going to come up with the solution, and be able to apply it.

-Monetary authorities in high inflation countries tend to lack all credibility when proposing, yet again, a new reform package because they have bad reputations as lousy managers.

-Building reputations and credibility is a difficult process and we will study in more detail how monetary policy is conducted on chapter 14.