The Impacts of Unemployment and Inflation in UK - Case Study Example

The Impacts of Unemployment and Inflation in UK A Review: Contents Introduction 2. The UK Economy and Bank of England 3. Impact of Inflation on the Economy 4. Inflation, Unemployment and Phillips Curve 5. Research Question 6. Conclusion The Impacts of Unemployment and Inflation in UK Introduction The broad purpose of this study is to conduct a research based analysis which will not only bring to light the literature review behind the impacts of unemployment and Inflation in an economy like UK, but also try to contribute to the existing literature. The purpose of this study will also cover the overall impact on the economy and the way things change in the economy as a result of an undue rise in inflation, while emphasizing the results of such a change in the economy. The purview of the study covers the effects created by unreasonably high inflation and also the total effects of such effects on the economy. The UK Economy and Bank of England To have a look at how exactly the UK economy functions, we will have a look at the way the economy is regulated. Any government has the power to regulate the economy of a country and not only does it regulate the economy, it has a vital role to ensure that the economic condition remains stable. It is the responsibility of the government to ensure that all the aspects of economy maintain a stable level so that the country can grow and expand. Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. Government of England has entrusted the job of determining the monetary policy, in the hands of Bank of England. Bank of England looks into many other big issues. One of the most important issues is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Bank comes out with the monetary policy in order to ensure a certain key objectives like, delivering price stability with a low inflation level coupled with an objective to support the Government's economic objectives of growth and employment. Price stability is taken care of, by the Government's usual inflation target of 2%. There is a need to contemplate the crucial and critical role played by price stability in achieving the aforesaid economic stability, and in providing just the right conditions for a sustainable and longer living growth in output and employment. Chancellor of the Exchequer announces the Government's inflation target every year in the annual Budget statement. Though The 1998 Bank of England Act enables it to set interest rates independently, however, The Bank does hold accountability to the parliament and the wider public, which can not be refrained from. The legislation provides the government the power to instruct the bank on the interest rates issues for a limited period of time during emergency, for the sake of national interests. (How Monetary Policy Works) The inflation target of 2% depicts the target in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The government's intention is definitely not to achieve the lowest possible inflation rate, as a low inflation is supposed to be equally bad as a high one and for that matter inflation below the target of 2% is judged to be as worse as inflation above the predefined target. The inflation target is therefore very symmetrical. (How Monetary Policy Works) If the Bank misses the target just by a margin of more than 1 percentage points on any side, be it up or down, the Governor of the Bank is required to write an open letter to the Chancellor explaining all the reasons as to why it happened and why inflation increased or fell to such an extent and what are the proposals to ensure that inflation comes back to the target and is retained, however, A target of 2% does in no way mean that inflation will be held at this rate constantly. That would be neither possible nor in any way desirable. Interest rates would be changing all the times, causing unnecessary volatility in the economy. Even then it would neither be possible nor feasible to keep inflation at any predetermined level, say 2% in each and every month continuously. Instead, the committee aims to set interest rates so that inflation can be brought back to target within a reasonable and imaginable span of time without creating undue instability and volatility in the economy. The Committee has its own way of functioning and it entrusts the job of taking all interest rate decision with a nine member committee. The committee's predominantly focuses on meeting the inflation target by setting an interest rate. (How Monetary Policy Works) Impact of Inflation on the Economy The Bank of England has a monetary policy and it uses the same to regulate mechanism of the economy. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. The bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. This step is of indispensable importance to the economy, as this is very widely used to contain inflation. The only purpose behind such a step is just to contain undue inflationary levels prevailing in an economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices through out the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in UK will yield better returns to the investors compared to their overseas ventures. The diagram given below explains better The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works) Another very important point related to inflation and its overall effects on an economy is that any increases in oil prices is expected to feed through into inflation over the next few years, and the gap between the value of imports and exports is growing to record levels, prompting expectations of a decline in the value of sterling, which is a welcome sign for the exporters but will hit the importers, as they will have to shell out more money for importing their raw materials leading to a further increase in inflation. Any decision is taken after considering the condition of the whole economy and all sections of the society at large and there are several other methods to tackle the prices of properties, but it will always be better to increase the rates at a slower but steady pace, rather than giving a monetary shock. Rising Inflation, if not tackled properly and at the right time may create a cycle, wherein the inflation keeps rising due to no change in interest rates. Inflation, Unemployment and the Phillips Curve Phillips curve shows the inverse relationship between unemployment and inflation. (Phillips Curve), where Nairu stands for non-accelerating inflation rate of unemployment. The PC, which is the long red line, changes in the long run because of the change in expectations and thus only a single rate of unemployment was consistent with the inflation rate. If the unemployment rate stays behind the red line inflationary expectations will rise, which will tale the short term PC upwards as indicated by B. Economists attribute this inverse correlation to the errors that people make while forecasting price levels. These forecasting errors of public were manipulated by the economists to generate better performance of economy. As discussed by Hall Robert below: The benefits of inflation derive from the use of expansionary policy to trick economic agents into behaving in socially preferable ways even though their behavior is not in their own interest.... The gap between actual and expected inflation measures the extent of the trickery.... The optimal policy is not nearly as expansionary [inflationary] when expectations adjust rapidly, and most of the effect of an inflationary policy is dissipated in costly anticipated inflation. (Qtd in Rational Expectations) Research Question Having discussed the causes of high inflation, interest rates and having understood the Phillips curve and the inverse relationship between inflation and unemployment, we will now try to find a balance between unemployment and inflation. How much is inflation inversely related to unemployment' To what extent is the trade-off existent' We will also look at the possible causes behind the inverse relationship between unemployment and inflation. As discussed above, Phillips curve is the historical inverse relationship between unemployment and inflation. Higher the unemployment, lesser the inflation and lower the unemployment, higher the wages paid to the labor of the economy, which results in a better flow of currency within the economy, which eventually leads to inflation. American economist Irving Fisher pointed to the same kind of Phillips curve inverse relationship long back in the 1920s, whereas, Phillips' original curve described and showcased the behavior of money wages and for this reason some economists believe that the Phillips curve should be called the "Fisher curve." (Phillips Curve) In the years after his 1958 paper, many economists in advanced industrial countries believed that Phillips' results showed a permanently and stable relationship between inflation and unemployment. One of the critical implication of this concept for government policy was that governments could control unemployment and inflation within a policy. They could tolerate a pretty reasonable rate of inflation on the higher side, as this would definitely lead to lower unemployment because there would be a trade-off between inflation and unemployment. For example, monetary policy (deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. So the governments always had this choice to manipulate this pay-off and make things favourable in the economy. Consequently, this would lead to a higher inflation rate, the cost paid to have a lower unemployment rate. (Phillips Curve) One would notice that there are several other reasons behind the fact that the unemployment rate can actually go down without much change in the interest rate scenario. Unemployment rate basically depends on many other factors like, there can be a slowdown in the rate of growth of labor supply, which can be directly responsibe for the unemployment rate to come down, if there is not a pick up in demand for labor. The unemployment rate in the UK had actually climbed up because of the fact that the labor supply in 2005-06 picked up because of inward immigration, which the country witnessed. The anomaly got corrected in late 2006 when the labor supply saw a decline. Though the present scenario is not very favourable because the workforce still remains a plenty, but given the fact that its rate of growth has fallen down, we have witnessed unemployment rates stabilizing pretty fast, however, it remains to be seen, as to how long the scenarion does not change, as there is plenty of inward immigration prevalant in the economy. Another possible factor that explains the rise in unemployment from 2005 was an adjustment by businesses around the country to the sharp rises in energy and import prices. Eventually, that adjustment requires a temporary slowing down of the growth of real take-home pay packets to match the growth in companies' real labor costs with productivity. If this adjustment remains incomplete, for example, if employees resisted the decline in real pay, companies may have cut back on employment growth. In the recent past, though there has been a fall in the real consumption wage, like, employees' take-home pay relative to the price of goods and services they purchase compared with productivity, but it remains to be seen whether this process of adjustment to the past sharp rises in energy and import prices is complete yet. (Output and supply) Phillips curve established a clear cut relationship between unemployment and inflation that worked pretty well in the late 1980s up to even late 1990s. The relationship still remains strong except the fact that the balance in the trade-off has now changed a little, as shown below (Phillips Curve) As shown in the diagram, the interest rates having stabilized these days, inflation is much lesser volatile than it used to be, but if the unemployment were to fall to a reasonable extent, inflation would not follow suit to the same extent, the way it used to till late 1990s. Conclusion The apparent reason behind a lesser inverse correlation between unemployment and inflation is the fact that in early 1970s, the UK economy was not as open as it got with the passage of time and also, the interest rates were abnormally high at above 25 percent, but later when the new monetary policy came out and there was pressure on government to bring down interest rates, the economy witnessed the scenario get better and the trade-off between unemployment and inflation also went through a change because of the change in unemployment for the reasons given above and a separate targeting of inflation by the monetary policy committee. The example given above makes one thing very clear that there used to be a very deep inverse relationship between unemployment and inflation but that has changed with time as the economy expanded. Works Cited "How Monetary Policy Works" bankofengland. 24Apr.2007. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/how.htm "INFLATION TARGETING IN THE UNITED KINGDOM (1992-2000)" tcmb. 24 Apr.2007 http://www.tcmb.gov.tr/yeni/evds/yayin/kitaplar/enf_kitap/3-William_Allen.pdf "Output and supply" bankofengland 24Apr.2007. Bank of England http://www.bankofengland.co.uk/publications/inflationreport/ir07feb3.pdf "Phillips Curve" Wikipedia 24 Apr. 2007. Encyclopedia Wikipedia. 24 Apr. 2007 http://en.wikipedia.org/wiki/Phillips_curve "Phillips Curve" tutor2u 24 Apr. 2007. Tutor 2 u. http://www.tutor2u.net/economics/content/topics/inflation/philips_curve.htm Sargent J. Thomas, "Rational Expectations" The Library Of Economics And Liberty. 24 Apr.2007 The Library Of Economics And Liberty. http://www.econlib.org/library/enc/RationalExpectations.html Read More