Friday, February 27, 2009

Is It Possible To Have Both Low Unemployment & Low Inflation At The Same Time?

The answer to above question is YES. Indeed, in early 1990s UK did witness a period of both low inflation & low unemployment. How could that have happened? Isn’t it there suppose to be a trade off between unemployment & inflation? In other word, we can’t have both at the same time. Policymakers will have to choose either to adopt low inflation or low unemployment economy

The Phillips curve is in recognition of A.W Phillips, a New Zealand economist who did a research using data from 1861-1957 for UK. The 96 years data confirmed that there was indeed a trade off between the 2. For policymakers, the relation seemed to be stable & as such they could choose which macroeconomics objective to fulfill. They could use expansionary monetary policy (cut interest rates) & fiscal policy (increase public spending & cut tax) to raise the real GDP & as such absorbing those unemployed. The price to pay is higher inflation!

Source: plusmath

Soon not long after he proposed this, the so called stable relationship between unemployment & inflation broke down in 1960s. Economists managed to gather more data that contradicts the relation. Unemployment & inflation is creeping up at the same time. So what went wrong?

Source: tutor2u
Later, economists by the name of Edmund Phelps (Nobel Prize Winner in 2006) became the center of attention when he successfully explained this relation.
Source: bized

Assume the economy begins from U where inflation rate is 0%. Say, the government wants to reduce unemployment rate. So it conducted expansionary fiscal policy e.g. building schools, hospitals, repairing roads & bridges etc to absorb more unemployed people. But in order to attract workers, wages must be increased. Unemployed people which made up of frictionally or structural will take up the job. Now unemployment is lower at the expense of higher inflation, 5%

Here those workers took up the job since they expect future inflation to be at 0%. In other word they supply their labour since they thought that their real wages had increased. This phenomenon is called money illusion. Once workers realised that they are not better off, they withdrew their labour service & become unemployed again. The economy moves from point V to point W. Unemployment backs to U again but inflation stays where it is since money wages do not fall back to its original level. Now the economy is on another SRPC with expected inflation to be at 5%

If the government intends to reduce unemployment once again, the cycle will repeat itself & the economy will land at higher price level each time. Unemployment at U consists of all those people who are voluntarily becoming unemployed. Frictionally unemployed could get a job any time but they are just taking their sweet time to look for the best job, with better benefits & higher pay. Structurally unemployed while their skills are becoming more irrelevant can actually move on e.g. North to South or learning new skills etc

Source: tutor2u

Possible reasons for low unemployment & low inflation in UK:

(1) High value of pound.
It had strengthened against many major currencies like dollar since 1996 (it became more volatile when the credit crunch started). Rising pound means any imported goods will become much cheaper for Britons, while at the same time causing UK manufactured goods to be relatively more expensive. This will reduce net exports which mean falling AD & therefore falling inflationary pressure. Also since oil price is quoted in dollar, strong pound had kept oil prices relatively low in UK thus avoiding the risk of stagflation (falling real GDP & rising price level)

(2) Independence of MPC. MPC (Monetary Policy Committee) has gained independence since May 1997. The main intention is to alleviate government intervention when it comes to interest rates decision which is often associated to inefficiency & implementation lags. Also MPC is given the task of maintaining inflation rate within the narrow band of CPI 2% +/- 1% (previously RPIX 2.5% +/- 1%). This shows how committed is UK government is combating inflation. These have physiological effect onto the market. If workers trusted MPC & believe that inflation is stable say, 2% they will not persistently demand for higher nominal wages. Also BOE can adjust for lower interest rates to stimulate the economy. This has helped to unemployment low

(3) Effectiveness of supply side policies. It is said that Margaret Thatcher’s policies begin to bear fruit after some lags. During her era, trade union was weakened & no longer demand for absurd high wages which puts much pressure onto the economy. Also many government entities were privatised during her time. With higher level of competition, firms will strive to become more cost efficient & this is reflected in lower prices. The present Labour government has also introduced New Deal in 1999 which provides training for those unemployed. As a result, millions of workers have managed to secure a job up to date with their newly acquired skills


Vipul said...

But then how does this show the "low inflation" with higher unemployment values. Over here, it's just the inflation increasing while the unemployment shifts temporarily?

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