The Relationship between Inflation and Unemployment - Assignment Example

Economics Name Institution Course Lecturer Date (a) Explain whether there is a relationship between inflation and unemployment. Should government interfere and reduce inflation and unemployment? Provide real life examples.  ( 8 marks) The evaluation of the aggregate economy entails, in part, a consideration of unemployment and inflation as two essential elements. The relationship between inflation and unemployment have been a topic of controversy over time. Different economists have had varying opinions supporting or opposing the existence of this relationship. Unemployment can be defined as a situation whereby people are ready to work but can’t find work to do (Ormerod, Rosewell & Phelps, 2013). Unemployment is usually measured by the rate of unemployment, also referred to as the labour force percentage. Inflation, however, refers to a rise in overall price levels in an economy. The Philip’s curve was postulated in 1958 by A.W. Philips who explained the existence of employment and inflation trade-off. Philips Curve The implication of the Philips curve was that low unemployment and low inflation could only be targeted separately but the policy makers but not together. The idea that was used to explain this was on the basis that the Labour force pushed for wages that were higher as the economy realised a fall in its employment level. The economy will have a build-up of inflation that results from the high prices. This happens as the consumers are made to carry the burden of higher costs of wages which the firms pass on to them. Job creation (low unemployment) was the major emphasis of the Keynesians, during the 1960’s, while price stability (low inflation) was the emphasis of the monetarists. (Hoogenveen & Kuipers, 2012) The earlier notion of an existing trade-off between unemployment and inflation that was stable began to be progressively discredited especially in the simultaneous rise in both in the 1970s. This stagflation made many economists shifted focus from the choice of either low inflation or low employment. The attention was directed towards achievement of a ‘natural’ rate in the economy. This was referred to as the NAIRU (Non-Accelerating Inflation Rate of Unemployment) (Levinson, 2013). There was a challenge in harmonising the unemployment level with an accurate estimation of the level of the natural rate and in the directing the economy towards rates of growth that maintained stability of price. There were extreme difficulties that occurred in relation to the reliance of the NAIRU in practice. The rate was identified to vary over time with additional complication resulting from the imprecision in its estimation. The level of unemployment in the United States (US), for example, was estimated at 4.6 per cent and the inflation was dormant at an estimation of 3 per cent in the latter half of the 1990s. This was a reversal of the trend from the earlier cases. The NAIRU had been earlier estimated at 7.2 per cent in the 1980s, 6.2 per cent in the 1970s, and 4.4 per cent in the 1960s. With the progressive decline of unemployment in the unemployment, it was feared that there could be an inflation that was accelerating. This growth, however, in these years never resulted to this condition. As such, there was a sustainable combination of an unemployment level that is low and inflation level that is low sustainably in a simultaneous manner. The figure below represents a graphical representation of the US Philips curve from 2000 to 2013. Inflation vs. Unemployment Rate in the U.S. from 2000-2013 The graph reveals that the prediction of the Philips curve generally didn’t hold for this period. There was stability in the curve earlier in many economies like the United Kingdom (UK) using the data from the 1950s and the 1960s. However, the description of the relationship was identified to be unstable and, therefore, unreliability in decision making. (Bruno & Shin, 2013) The government makes use of its fiscal policy in influencing various aspects of the economy. This policy is engaged where aggregate demand is constrained in case of inflation and stimulated in the face of unemployment and recession. It was expected that various response were to occur with increase in the aggregate demand and stimulus from the fiscal policies by the government. Some of these include: increased labour demand resulting from growth generated by the government spending; fall in unemployment level; nominal wages increase as firms compete for the reducing number of workers; the nominal wages would rise as labours gain a higher bargaining power; a rise in the costs of wages; and resultant high prices passed on by firms from the increases in the costs. Considering an analysis of the aggregate supply (AS) and aggregate demand (AD), the AD will increase following government spending. In the short term, there will be a fall in unemployment resulting from a rise in the income. This can be graphically represented as depicted in the following diagram. (Bruno & Shin, 2013) Despite the general unemployment levels persisted fall between 1993 and 2008, inflation levels did not rise as much as Philips’ curve suggested. There have been divergent explanations to this with a big number of economists explaining this in terms of successfully engaging the supply-side policies suggesting expansion of an economy without inflation. (Bruno & Shin, 2013) The relationship that existed between inflation and unemployment is seen to have diminished almost to a point of no existence for some countries. This can be supported by an analysing of prevailing data from the UK. Factors like labour immigration and improved flexibilities in the labour markets have aided in the reduction of labour market presssure in a growing period. Unemployment and Inflation in the UK (2008-2014) As the figure identifies, there are times that the relationship, as explained by the Philips curve, seemingly reappear e.g. between 2007 and 2009. However, there have been a fall of both inflation and unemployment from then. (b) Using your home country（CHINA） as a case study outline and analyse inflation, unemployment and growth trends. Identify what range of the aggregate supply curve your country is operating in.   (10 marks) There have been a swift economic expansion in China since 2000 with a rapid growth in the gross domestic product (GDP) of the country. Various factors have contributed to this. Some of the fundamental contributors to this state have been stability in the employment market and progressive increment in price. The value of the goods and services that are produced by the economy of China during a quarter is seasonally adjusted and used as a measure of the GDP rate of growth. The economy of the United States (US) is the largest followed by that of China. (Easterlin, Morgan, Switek & Wang, 2012) One of the main objective of any country is to ensure that the economy approaches full employment. The productivity of each country is important in the achievement of an economic growth that is strong. As such, high levels of unemployment is a likely outcome of a poorly performing economy. In addition, there is a reduction in the purchasing power of consumers and labour during periods of high inflation. This is as indicated by the Consumer Price Index (CPI). The GDP growth will be reduced in the situation where there is retrenchment or cutting down of the wages that the workers get (Li & Liu, 2012). This is triggered by the low demand for the goods and services which mean that the consumption level is very low. The chart above depicts Chinese trends of unemployment over time (1978-2011). As the graph reveals, over the period of 1978 to 2011, the GDP growth always surpassed that of the unemployment growth. There was a trough of unemployment in 1985 at the rate of 1.8 per cent after the peak of 5.4 per cent that it had attained in 1979. In comparison with the latter period, the period of 1984-1988 had a relatively stable unemployment rate (Zhu, 2012). There was an upward trend of unemployment rate from 1989-2014. This was corrected by the reduction policy of the unemployment rate that was introduced. (Amstad, Huan & Ma 2014) The GDP growth and unemployment rate are supposed to have an inverse relationship according to theory. For the case of China, especially for the period of 199-2011, the degree of unemployment is not impacted significantly affected by variations in the growth of GDP. The unemployment rate has been on a rising trend with a simultaneous rise in the trend of the GDP growth. As such, the economy of China has an unconventional situation where inflation rate, unemployment rate and GDP growth have grown simultaneously (USCC, 2012). Source: National Bureau of Statistics of China The fourth quarter of 2014 experienced a 1.50 per cent expansion over the third quarter of that year in the GDP of China. In the period 2010-2014, the GDP rate of growth in China was at an average of 1.94%. in the first quarter of 2012, it experienced a low of 1.40% after experiencing in the second quarter of 2011 an all-time high of 2.50 percent. There have been an identified increase in the inflation as the economy grows. (Nakamura, Steinsson & Liu, 2014) There have been a rapid growth in the private sector constituted in a growing market-oriented set-up during the last 30 years as the economy has experienced a shift from a system that had international trade largely closed and centrally planned. The average of 1986-2014 inflation rate in China was at 5.64 per cent. There was a record of low of -2.20 per cent in 1999 April and an all-time high of 28.40 per cent in 1989 February. The records of December 2014 showed that the inflation rate of China was at 1.50% Year Inflation Rate: all items Inflation: food 2005 1.8 2.9 2006 1.5 2.3 2007 4.8 12.3 2008 5.6 14.3 2009 -0.7 0.7 2010 3.3 7.2 2011 5.4 11.8 2012 2.6 4.8 Inflation accompanies economic growth. The economy of China has ascribed to this trend in some cases where low inflation rates have been accompanied by high economic growth and high inflation in case of a low economic growth. The inflation rate, for instance, was at 5.6 per cent in 2008 which was a dramatic increase following the global financial crisis. The GDP was at 9 per cent which was a decline from 11.9 percent. This is in comparison to the year 2005 where the inflation was at 1.8 per cent and the GDP rate was 9.1 per cent. (Li & Liu, 2012) The aggregate supply that China is operating in is identified through a consideration of the variables that are on the supply side. These include industrial profits and wages. The output gap computed by CQMM for the economy of China from the period 2001 to 2013 is presented below. This suggests that the output gap have been increasing over time since 2009 for China. There have been excess production capacity that has resulted from the response to the global financial crisis with both expansionary monetary and fiscal policies. The increased capacity is in the industrial sector and also in the economic aggregates. The current efforts relates to the achievement of an equilibrium in both the short-run and the long-run. Achievement of the equilibrium aggregate supply and the price is in relation to the aggregate demand at that particular price. (Nakamura, Steinsson & Liu, 2014) (c) Explain how monetary policy can influence an economy, including the exchange rate and employment levels.   (8 marks) The money that is in circulation in an economy is regulated through various means like adjusting the interest rates or the money in circulation. This constitutes the monetary policy endeavours. The monetary policy can be either expansionary or contractionary. A decrease in the money supply results from a contractionary monetary policy while an increase in the monetary policy results from an expansionary monetary policy. These policies are engaged for various macroeconomic reasons like stabilising output and inflation in an economy. The actual level of production of services and goods, in the short-run, can be affected by the changes in the money supply since there is normally no immediate adjustments in the wages and the prices. In the long-run, however, the gross domestic product (GDP) which is a measure of output is constant (Bruno & Shin, 2013). As such, only prices will significantly be affected by the operational changes in the money supply. The achievement of growth and inflation objectives will rely monetary policy as a policy tool that is fundamental. The central banks are the major institutions that conduct the monetary policies. Where ; r is the interest rates ; Md is money demand : Ms is money supply The output and price objectives must be balanced in the monetary policy endeavour. Bringing the economy to a state of full employment and having a stability of output go alongside the concern of regulating inflation. Taking an example of recession, the consumption levels decline; investment in new capacity by firms and workers’ lay off results from a declining business production; and the exportation level is negatively affected. All this lead to need for a policy that would address the declining aggregate demand. The monetary policy is used to regulate the condition. An expansionary monetary policy would result in expanded output and reduced level of unemployment. However, the resultant effect will be a rise in the price levels. Wages and other input costs will be forced to rise as demand increases. This is the case as full capacity production is approached by the economy (Sek, 2014). There is likely to be a generalised increase in the inflation level as wages are further bided up with as more goods and services are demanded by the workers who have obtained a rise in income. An expansionary monetary policy leads to an upward pressure on the exchange rate. The interest rates will reduce as a result of an increase in the money supply. The rate of return on a home economy’s assets will be reduced in relation to a foreign economy. The international investors will demand more of the home currency. This will result to an appreciation of the home currency as a result of the increased demand in a floating exchange rate. In a country operating a fixed exchange rate regime, the central bank responds to relieve the excess demand of the local currency. The demanded currency will be supplied in the economy through selling the local currency in exchange of the foreign currency at the fixed exchange rate. The final state will be maintenance of the original position. As such, it can be concluded that in a fixed exchange rate system, the expansionary monetary policy will not result to any effects after the occurrence of final adjustments. Increase in money supply under a floating exchange rate Decrease in the money supply that results from a contractionary monetary policy will have opposite effects as those described in the expansionary monetary rate policy. There will be a maintenance of the current account. The implication is that the monetary policy will be an ineffective tool in influencing the exchange rate in the case of a fixed exchange system. Monetary policy under fixed exchange rate However, in the short-run, the monetary policy in a flexible exchange rate system will either lower or raise the gross national product (GNP). The macroeconomic conditions in countries that have the floating exchange rate system can, therefore, be adjusted through the monetary policy. An expansion of the GNP, for example, can be facilitated by an increase in the money supply in the economies that are growing sluggishly or those that are contracting. The countries with a fixed exchange rate are thus seen lose monetary autonomy due to the limitation in influencing the level of GNP, the exchange rate and the interest rate. (Frenkel & Johnson, 2013) References Amstad, M, Huan, Y, & Ma, G 2014 Developing an underlying inflation gauge for China Bruno, V, & Shin, H S 2013 Capital flows and the risk-taking channel of monetary policy No w18942 National Bureau of Economic Research Easterlin, R A, Morgan, R, Switek, M, & Wang, F 2012 China’s life satisfaction, 1990–2010 Proceedings of the National Academy of Sciences, 10925, 9775-9780 Frenkel, J A, & Johnson, H G Eds 2013 The Economics of Exchange Rates Collected Works of Harry Johnson: Selected Studies Vol 8 Routledge Hoogenveen, V C, & Kuipers, S K 2012 The long-run effects of low inflation rates PSL Quarterly Review, 53214 Levinson, C 2013 Capital, Inflation and the Multinationals Routledge Revivals Routledge Li, C, & Liu, Z J 2012 Study on the relationship among Chinese unemployment rate, economic growth and inflation Advances in Applied Economics and Finance, 11, 1-6 Nakamura, E, Steinsson, J, & Liu, M 2014 Are Chinese Growth and Inflation Too Smooth? Evidence from Engel Curves No w19893 National Bureau of Economic Research Ormerod, P, Rosewell, B, & Phelps, P 2013 Inflation/unemployment regimes and the instability of the Phillips curve Applied Economics, 4512, 1519-1531 Sek, S K 2014 Interactions between monetary policy and exchange rate in inflation targeting emerging countries: the case of three East Asian countries International Journal of Economics and Finance, 12, p27 US-China Economic and Security Review 2012 The evolving China-US trade and investment relationship Hearing of One Hundred Twelfth Congress, retrieved from: http://wwwusccgov/hearings/2012hearings/transcripts/June-14-2012-USCC Hearing-Transcriptpdf Zhu, X 2012 Understanding China's growth: Past, present, and future The Journal of Economic Perspectives, 264, 103-124 Read More