A Politico-economic Model of the United Kingdom - Essay Example

Name: Tutor: Course Date For a time economists have believed there has been a quid pro quo between unemployment and inflation that is reduced inflation would lead to more inflation and vice versa. This relationship was explained using a simple Keynesian model. The model was developed in the 1930s when there was large-scale unemployment which led Keynes to focus on the problem of the “deflationary gap”. This situation in which aggregate spending is less than that required to employ all those who wish to work at the prevailing wage level. This is illustrated in the by the aggregate demand function AD1. (Kposowa 2009)Here the equilibrium level of national income is Y. If aggregate demand is increased by an additional injection or reduced by fewer withdrawals the aggregate demand function can be shifted upwards. This extra demand encourages investment and via the multiplier additional demand and hence employment until aggregate demand reaches AD2 and helps to produce full employment YF. Beyond the point of full employment where all resources are committed, any increase in aggregate demand to say AD3 cannot increase real output and thus an inflationary gap occurs in which it can only be filled by using prices. In the simplified Keynesian model then, the relationship between inflation and unemployment is as follows. Which it can only be filled by using prices. In the simplified Keynesian model then, the relationship between inflation and unemployment is as follows. If there are resources which aren’t employed in the economy and aggregate demand increases then unemployment will be reduced and prices will remain steady. If whenever the economy is already at the full employment level, any additional increase in aggregate demand will force up prices but have little effect on the level of real output and employment. In the 1950s the nature of the relationship between inflation and unemployment was stated in more precise form by Prof. A. W. Philips. He studied the relationships between the variables over the period 1862 and 1958 for the UK. The statistical relationship he found can be represented in diagrammatically or else explained empirically. The negatively sloped curve indicates that the lower the rate of unemployment, the higher the rate of inflation. At a lower rate of unemployment l, when aggregate demand is high and there are inflationary pressures, the Philips curve suggests there will be a high rate of inflation. When unemployment rise the inflation falls too(Savouri 2008). Finally when unemployment falls to the rate of inflation has fallen to zero and any further increase in unemployment is predicted by this model to give negative inflation/falling prices. Because of the empirical evidence in support of this relationship over a long period, in most countries, politicians and their economic advisors felt confident during the 1950s and 1960s that they could by appropriate demand management exercise a degree of control over unemployment. They could then trade off lower unemployment for a little more inflation. The comportment of inflation and redundancy in the 1970s however, casts doubts on what had seemed to be a well-established relationship. In contrast with previous experience both inflations and unemployment increased during the 1970s giving rise to the phenomena labelled “stagflation”. Though inflation came down in many countries in the 1980s and 1990s, the level of unemployment remains alarmingly high. In brief, the relationship predicted by the Philips model no longer held. A new theory, or at least a significant amendment to the existing theory was required to explain the relationship between the variables. This was supplied by monetarists and the neo-classical. This amended theory attributes a major role to expectations which various key groups within the economy have about future levels of inflation and redefines the concept of full employment from the Keynesian one of demand deficient on labour and unemployment economics It supports the notion that involuntary unemployment occurs at the rate at which there exists no inflationary pressure on wages. This „natural rate of unemployment‟ exists where the demand and supply of labour are in rough overall balance in the labour market. The magnitude of this natural rate of unemployment depends, it is claimed, on such factors as the effectiveness of the labour market, the strength of trade unions, the level of social security benefits and the extent of competition or monopoly. The amended model of the relationships between inflation and unemployment can be elaborated upon more easily by the use of a diagram similar to that below and widely referred to as the „expectations-augmented Philips curve. If a country like the United Kingdom produce small output it will definitely lead to unemployment increase and decrease of employment. The reason for this to happen is that the price level is high thus the inflation rate is also very high compared to previous years. Hence if aggregate supply shifts ,it will lead higher inflation coupled with high levels of unemployment Definitely the short run inflation and unemployment trade off shifts to the right .Supposing there have been an adverse aggregate supply shift, policy makers will be faced with a difficult task to choose between curbing higher inflation or fighting high unemployment. If they are obliged to contract demand curve in order to fight inflation they will be creating a proxy of raising the unemployment. On the other hand if they take on expansion of demand to curb unemployment they will make inflation rise further .In other words decision and policy makers are faced with a trade of between inflation and unemployment that’s not favourable than they had before aggregate supply had shifted. The aftermath is that they have to live with a higher rate of inflation for minimal unemployment, or a higher unemployment level with high inflation rates. The important aspect in the Philips curve is determine whether the shift in it is permanent or temporary. How people adjust to inflation is the rationale that will be used to determine the nature of the shift. Supposing that people view the increase in inflation caused by supply shock as a temporary change, the expected inflation doesn’t change thus the Philips curve return back to its former position.(Jack man 2008)But if people believe the shift in supply shock is a permanent change, new inflation will be experienced thus lowering the unemployment levels. According to the Office of National statistics of the United Kingdom, during the 1970s expected inflation rose noticeably .When measured using RPI it rose above 24 percent when in just three previous years it had rose to around 7 percent. To compound the problem in 1979 the Oil processing Exporting Countries started to flex their muscle in the market. This lead to prices of oil doubling .In the same year the United Kingdom inflation hit 14 percent which was almost three times than the previous year’s .The Central bank tried to per sue contractionary monetary policy to reduce inflation. Due to this the outcome was that the economy moved along the short run Philips curve thus raising unemployment. Over those times the citizens expected inflation to fall thus shifting the short run Philips curve down wards. Empirical studies from the Office of National statistics of the United Kingdom, suggests that for a nation to, lower the rate of inflation it must be ready to endure some form of unemployment and a period of low productivity. This is a detrimental cost to the economy of that particular nation. Over time the slope of Philips curve determines the size of the cost endured. Also it determines the period it will take to inflation expectations to adjust to introduction of new monetary or fiscal policies. Studies has been carried out extensively on ways to examine data on inflation unemployment in order to come up with methods of reducing inflation. A study always have findings. On the basis of our study a statistic known as the sacrifice ratio have been used to summarize these phenomena. When defining the sacrifice ratio we can say it’s the number of percentage units lost in the process of lowering unemployment by one percent. Typically the ratio of inflation reduced is 3 to 5 percent of output produced annually that must be sacrificed in the process of transition. Such estimates aide the United Kingdom government to confront the task of reducing the rate of inflation while maintaining a manageable level of unemployment in the early years of 1980s(Barro 2013) .During those years inflation was running at an average of 22% in 1982.To reduce it to be 5 % per every year ,it meant that each year inflation was expected to be reduced by an average of 17%.Using the sacrifice ratio it meant that each percentage unit point would cost at least 3 % of the annual, output of the economy, thus reducing unemployment by 17% would definitely mean 40 units are sacrificed in the annual output .In relation to the Philips curve unemployment would rise by roughly 30% due to fall of annual output by 40 percent. The most efficient decision and policy makers should make sure that the sacrifice ratio should be equivalent to zero. Thus if the government is obliged to make reliable commitment to a policy of lowering inflation, people would be rational enough on their side to lower expectations of inflation with immediate effect. Therefore the short run Philips curve will shift downwards thus economy would reach to low inflation quickly without causing any low output nor high unemployment. Regarding data from Office of National statistics of the United Kingdom Prime Minister Margaret Thatcher failed to reduce inflation. Inflation reduced from about 5% in 1983 and 1984.However Thatcher disinflation wasn’t accompanied much by high unemployment .In year 1982 and 1983 the level of unemployment was about 11 percent which was about to double its level when Thatcher took the helm of government. At the same moment production of goods and services quantified by real GDP was below the drift level (Frey 2013). Does this experience go against the possibility of disinflation that is costless as suggested by some of rational economists? Some of policy makers have answered this question by decisive ‘yes’ answer. Therefore it goes without saying that to make an overhaul change from a point of high inflation to a point of low inflation the economy has to undergo a period of unemployment .From the empirical evidence from the Office of National statistics of the United Kingdom its evident that there exist a correlation between unemployment and inflation. REFERENCES Barro, R. J. (2013). The Ricardian approach to budget deficits. Frey, B. S., & Schneider, F. (2010). A politico-economic model of the United Kingdom. The Economic Journal, 243-253. Jackman, R., & Savouri, S. (2008). Regional migration in Britain: an analysis of gross flows using NHS central register data. The Economic Journal, 1433-1450. Kposowa, A. J. (2009). Unemployment and suicide: a cohort analysis of social factors predicting suicide in the US National Longitudinal Mortality Study. Psychological medicine, 31(01), 127-138. Read More