Inflation versus Unemployment - Case Study Example

Inflation versus Unemployment Unit: Name: Professor: Submission Date: Mankikar & Paisley (2002 p 373) inflation is defined as the persistent price level within a period of one year. Inflation results from cost push and demand-pull factors. Basically, in demand-pull inflation what happens is that when the economy surpasses its capacity of productivity the price-level also raises. On contrary, cost-push inflation impacts on the production costs subsequently raising the prices. Studies show that inflation of 3-6% in any country affects the economy positively. This is because it creates jobs, gives opportunity for wages growth, and encourages production and investments. Unfortunately Harcourt (2001 p1), when inflation crosses realistic threshold its effects is usually negative. In regards to this it reduces money value in reference to foreign exchange; it declines growth of economy and investments. Consequently, it leads to resources allocation scarcity therefore reducing economic growth potentiality. Inflation brings about raised levels of cost on societies and economies. Inflation also affects the fixed and poor income groups severely and overall the economy remains uncertain as well as weakening the stability of the macroeconomic. History shows that elevated inflation levels affect the affluent groups less than the poor. According to Pettinger (2012 p1) unemployment refers to the number of persons that want to work, but are jobless. In other words, unemployment is the rate of the number of people searching for jobs compared to the total of those in the work environment. Unemployment theory shows that unemployment and inflation have a negative correlation. This follows because unemployment increases with increase in uncontrolled inflation. Unemployment and inflation go together. It is the goal of every country to maintain low rates of unemployment. Both low unemployment and low inflation rate in any country call for a great concern. A country with full employment means it has minimum employment rate. A country that maintains minimum unemployment rate during periods when rates of inflation is stable it is thus said to adhere to the natural unemployment rate. That is natural unemployment rate is the sustainable minimum unemployment rate. This analysis looks into correlation of unemployment in reference to UK. Inflation and Unemployment The Philips curve William Philips is an economist and founder of the Philips curve. According to his suggestion in relation to unemployment and inflation, shows that in the event that there is a high inflation rate, there is low unemployment rate. Subsequently, when there is a low inflation rate, there is high unemployment rate. However, in the long run the Philips shows that inflation is not inversely correlated to unemployment (Driver 2007 p208). Sudden increase in inflation increases wages rates. At the same time, the rate of unemployment decreases. The rate of unemployment remains less so long as the workers can bear the impacts of the inflation increase. However, if for workers to compensates for commodities price increase means that the wages have to to be amplified then the rate of unemployment is likely to go up to a considerable levels. The wages demand increase has been found to increase unemployment curve. It is a fact that inflation rate and unemployment naturally adjust themselves to attain a common acceptable state (equilibrium state). Thus means high rate of inflation does not mean there is permanent rate of unemployment reduction (Harcourt, 2001 p5). UK did suffer from economic volatility in 1980s see figure1. Recession followed with increase in unemployment rate as the government worked hard to bring down inflation (Pettinger 2012 p1). Figure 1 Pettinger (2012 p1) In the genesis of 1980 most countries including UK suffered cost push inflation. By late 1970s the inflation hit 20% (Pettinger 2012 p1). The main causes were wage push inflation and rising prices of oil Figure 2. Figure 2 According to Pettigner (2012 p1)the UK government worked hard to tackle inflation through: controlling money supply using pursued monetarist policies, cuts in spending and higher taxes to reduce budget deficit and increased interest rates. The unemployment in UK in 1980s shot up following severe recession arising from inflation reduction strategies. Through 1980s more than 3 million persons remained unemployed with the rate persisting during the 1980s. The UK government in 1990 joined ERM (Exchange Rate Mechanism) to help bring inflation under control. During this time the economy slowed down. The UK government increased rates in interest and in the long run lost about £3.5.-£21bn buying sterling in the ERM. The predicted unstable rates in interests led to mortgage value increment. Spending was reduced to curb the inflation pressure Figure 3. From 1971-2015, in UK unemployment rate averaged 7.24%, with high rates recorded in 1984 at 12% and at low levels in 1973 of 3.4% Figure 4. Figure 3 Graph showing in % inflation and economic growth annual change. The inflation shot up to 10% and economic reached 5% in late 1980s. Sharp decline in economic growth followed this in 1990 and 1991. Figure 4 Accessed http://www.tradingeconomics.com/united-kingdom/unemployment-rate Research Analysis When in a country central banks and the government inflate easy credit and the extra money enter the economy in different times and places, the prices of the assets are affected differently. The credit and the money influx sends false notion resulting to over-investment in various producer goods. The short term effect is that there is increased unemployment rate providing the inverse relationship (Driver 2007 p 208) (Figure 1 and Figure 4). During this period people anticipate inflation and hence change their behavior in accordance. Upon stopping the extra spending the long-term natural unemployment rate reorganizes itself. What comes out of this is that the government is not likely to prevent unemployment. This state distorts the economy and will in future lead to unemployment when the reality of economy reasserts itself. The government on the other hand cannot use a lot of monetary inputs to prevent cyclical downturns. In this case the government is likely to benefit if it succeeds in helping people know to deal with social consequences of the inflation rate rather than preventing economic downturns. Unemployment natural rate depends on a range of labor market features. Such include the job search effectiveness, the efficiency wages roles, the unions’ market power, and wage laws. Basically, inflation rate depends on money quantity growth. Both the unemployment and inflation rat e measure the economy health (Harcourt, 2001 p1). Short run of inflation: Following high rate of inflation the society may suffer from a short-run tradeoff arising between inflation and unemployment. This explains why the Unemployment can be lowered if the aggregate demand is expanded by the policymakers Figure 3. This is only possible, however creating higher rates of inflation cost Figure 3. Contracting aggregate demand means the inflation can be lowered. However this will arise to temporarily higher unemployment cost (Harcourt, 2001 p2). When there is high rate of services and goods demand aggregate so is the economy’s output and hence the overall price level increase rate. A higher output levels leads to a lower unemployment levels. Reducing inflation the cost An economy has to face a period of low output and unemployment to reduce inflation. The economy will therefore experience lower rates of inflation at the expense of increased unemployment. According to Harcourt, (2001 p11), the sacrifice ratio is said to be the number of points of percentages of yearly output lost in the event of reducing inflation only by 1%. For example in 1979-1981 to bring down inflation from 10% to 4% called for about an annual output sacrifice of 30%. If this is overdone the country is likely to face losses in economy decline as is in Figure 3. Why expectations on inflations matters Mankikar and Paisley (2002 p 373) in the 1970s and part of 1980s United Kingdom experienced high inflation periods. Higher prices are known to cut down spending power for a certain nominal wage. If employee expects inflation to continue for a longer period of time they may seek for increased in their nominal wages. This is likely in-turn to lead to increased pressure on firms’ output prices, and subsequently consumer prices would go high. Driver (2007 209) the expectation on inflations may influence pricing behavior of the companies therefore affecting inflation directly. For instances companies may foresee that inflation may generally continue to be higher and as a result increase their prices with no output demand expense. This explains why unemployment persistent in 1980s with higher rates recorded in 1984. Also inflation impacts investment and consumption decisions. Conclusion Inflation and unemployment aggregates remain essential in economic growth sphere. Increased inflation affects prices of goods and services. According to Philips curve inflation affects unemployment rates. The short term impacts can be felt by employment firms as wages are likely to increase. An attempt to bring down inflation abruptly without considering the adverse effects is likely to put a country to a recession state. The inflation rates in UK in 1980s and subsequent abrupt and tight measures to bring down the inflation rate remain a good example. The studies show that inflation sustained over a longterm may not positively affect unemployment. Therefore, this analysis shows that there exist weak relationship between unemployment and inflation in UK. References Driver, R. 2007. public attitudes to inflation and interest rates. Inflation Report and Quarterly Bulletin, pp 208-224. Harcourt 2001. The Short-Run Trade of Between Inflation and Unemployment. Harcourt: Harcourt College Publishers pp1-19. Mankikar, A. & Paisley J. 2002. What do measures of core inflation really tell us? Bank of England Quarterly Bulletin pp373-384. Pettinger T. 2012. UK Economy in the 1980s. Economics pp 1. Read More