X unemployment and Inflation

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Unemployment and Inflation

Chapter Outline

In this Chapter, we will introduce the concept of inflation and discuss various approaches that seek to explain it. We will differentiate between inflationary pressures that arise from nominal demand (spending) growth outstripping the real capacity of the economy to react to it with output responses and, inflation that may arise from supply shocks – such as a rise in an imported raw material (for example, oil).

The first type of inflation has been termed demand-pull because excess nominal demand (relative to real output capacity) pulls up the price level. Sometimes you will encounter the expression “too much money chasing to few goods” as a crude simplification of this type of inflation.

The public debate about whether expansionary fiscal policy causes inflation, which we will deal with specifically in Chapters 13 and 19, are also predicated on the claims that fiscal stimulus runs the danger of causing the economy to overheat.

The second type of inflation is termed cost-push inflation because it originates from the costs of production increasing and pushing up the price level. We will learn that the mechanisms through which the supply shocks manifest as inflation are different to those that operate under demand-pull inflation.

However, both forms of inflation can be understood within a general framework whereby different claimants on real GDP and national income struggle to assert their aspirations. In this sense, we cast inflation within the general distributional struggle or conflict, that is elemental in capitalist economies, between workers seeking to maintain and achieve a higher real wage and firms seeking to maintain and expand their profit rate.

In other words, we situate the problem of inflation as being intrinsic to the conflicting relations between workers and capital, which are mediated by government. This mediation varies over the course of history and in more recent times has been biased towards protecting the interests of capital, particularly financial capital, at the expense of workers’ real wage aspirations. We will consider the consequences of that policy stance in this Chapter.

In the pre-Keynesian era the concept of full employment only allowed for voluntary unemployment: employment was determined at the intersection of labour demand and supply which was the outcome of maximising, rational and voluntary decision making by workers and firms.

However, in the immediate Post World War II Keynesian era, the concept of full employment was recast and the emphasis became one of providing enough jobs to match the work preferences of the available labour force.

Any remaining unemployment (frictions aside) was considered involuntary and due to the failure of the monetary economy to generate demand sufficient to meet the saving preferences of the private sector. The notion of involuntary unemployment was at the heart of this conception of full employment. That is, full employment coincided with zero involuntary unemployment.

This Post World War II consensus was steadily eroded away over the next 40 odd years. By the early to mid-1970s, mainstream macroeconomics reverted back to the pre-Keynesian notions of voluntary unemployment and effectively abandoned the concept of true full employment.

However, the process of abandonment began in the 1950s when the discussion turned to inflation and the trade-off between the twin evils of unemployment and inflation. This was the era in which the Phillips curve literature emerged, named after the New Zealand economist Bill Phillips who “discovered” what was then considered to be a statistically reliable, inverse relationship between unemployment and inflation – the so-called trade-off between unemployment and inflation.

For the concept of true full employment, however, it was the subsequent Monetarist and New Classical reinterpretation of the trade-off that was devastating. The Classical (pre-Keynesian) notions of a natural unemployment rate (understood as being equivalent to full employment) was revived and this led economic theory to reject demand management policies which aimed to limit unemployment to its frictional component.

In this Chapter, we will explore the evolution of the Phillips Curve and the way in which the idea that there might be a trade-off between the twin-evils of unemployment and inflation has changed as ideological dominance has shifted from those who see a profound role for government to play in maintaining low levels of unemployment and those, of neo-liberal persuasion, who eschew the intervention of government and consider the “market” will generate full employment without government.

We will see how more recent developments in history, such as the augmentation of the Phillips curve with inflationary expectations and the so-called “natural rate of unemployment” models, which have sought to resurrect the Classical theory believe that the free market delivers optimal outcomes and were discredited during the Great Depression (see Chapter 11 Keynes and the Classics), are paradigmatically different to the original conception of the Phillips curve.

The more recent literature has sought to deny the existence of a stable trade-off between unemployment and inflation and can be traced back to the American economist Irving Fisher who was a prominent and influential exponent in the last century of the Neoclassical approach.

In this Chapter we are building on the analysis presented in Chapter 11 where we outlined the debate between Keynes and the Classics. We will draw on your understanding of the standard Classical labour market and the conclusion that is drawn from that body of theory, that unemployment arises when the real wage is excessive.

We will also extend the discussion of the Keynesian view on unemployment and the fundamental distinction between voluntary and involuntary unemployment. We have seen that the latter is caused by deficient aggregate demand which can be solved by demand policies.

A thorough understanding of the debate between Keynes and the Classics allows for more deeper understanding of the so-called Phillips curve, which came to prominence in the late 1950s, but which, in fact, had been conceived by economists earlier than this.

The focus of this discussion on the question as to whether there is a trade-off between inflation and unemployment and whether governments can use expansionary fiscal policy to reduce unemployment to some irreducible (frictional) minimum.

[Note: the Chapter order has been a juggled a little. This was formerly going to be Chapter 11 but we will probably take the Keynes and the Classics material out of this chapter and run it as a stand-alone Chapter 11 or even 10 - decisions are still to be taken]

X.1 What is Inflation?

There are many misconceptions as to what inflation actually is. Many media commentators, for example, think that a pay rise for workers constitutes inflation. Others (of perhaps a different political persuasion) think that when companies increase the price of a good or service they are offering that this is inflation.

Some people think inflation occurs, when following an exchange rate depreciation the local price of imported goods and services rise. A depreciating exchange rate means that the local currency becomes less valuable in relation to other currencies and foreign-sourced goods and services typically become more expensive to local buyers. But is this inflationary?

Similarly, some commentators think inflation occurs when the government increases a particular tax (say, a value-added tax on goods and services or GST) by x per cent and this is passed on by firms in the form of higher prices for goods and services.

None of these examples constitute inflation. Given they all involve a rise in prices, each example would constitute what we would call a necessary condition for an inflationary episode. But none of these examples represent a sufficient condition. Observing a price rise alone will not be sufficient to justify the conclusion that one is observing as being an inflationary episode.

Inflation is the continuous rise in the price level. That is, the price level has to be rising each period that you observe it.

If the price level rises by 10 per cent every month, for example, then we would be observing an inflationary episode. In this case, the inflation rate would be considered stable – a constant or proportionate increase in the price level per period.

If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in month three and so on, then we would be observing an accelerating inflation. Alternatively, if the price level was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating inflation.

If the price level starts to continuously fall then we call that a deflationary episode. The term hyper-inflation is reserved for inflationary episodes, which rapidly exponentiate. There have been few instances of this problem in recorded history.

Thus, a price rise can become inflation if it is repeating, but a once-off price rise is not considered to be an inflationary episode.

We might also define a normal price level as being the prices firms are willing to supply at when they are operating at normal capacity. This is the price that satisfies the desired mark-up, which aims to generate a profit rate that will satisfy the strategic aspirations of the firms. Refresh your memory of the discussion of mark-up pricing in Chapter 9 if you are uncertain of the way in which firms relate their pricing to other targets.

However, the economic (business) cycle fluctuates around these “normal” levels of capacity utilisation and firms not only adjust to the flux and uncertainty of aggregate demand by adjusting output, but in some cases, will vary prices. This is particularly the case during a recession.

When there are very depressed levels of activity, firms might offer discounts or sales in order to increase capacity utilisation. They thus temporarily suppress their profit margins as a means of maintaining their market share. As demand conditions become more favourable, the firms start withdrawing the discounts and the frequency of sales decrease and prices return to those levels that offer the desired rate of return to firms at normal levels of capacity utilisation.

We would not consider these cyclical adjustments in prices, where they occur to constitute inflation.

X.2 Inflation in Practice


X.3 Early Historical Views About Inflation and Unemployment

The early English classical economists considered the relationship between inflation and unemployment within the context of the convertibility of the currency note issue into gold. Such convertibility was suspended in 1794 at the outset of the Napoleonic War and did not resume until 1819-1821.

The intervening period of inconvertible paper was initially marked by rampant inflation. Subsequently, in the period between 1814 and 1816, many country banks in England failed and this led to a destruction of country-bank paper (a form of money) and a sharp contraction in the money supply.

The deflation that resulted imposed harsh effects on the unemployed and members of the working class which became worse with the resumption of cash payments (at the gold parity, which existed prior to the suspension).

Somewhat earlier (1752), the Scottish economist, David Hume wrote an essay entitled – Of Money – and outlined a theory that is very reminiscent of what we later called the Phillips curve relationship – the trade-off between inflation and unemployment.

Hume said that the expansionary effect of an increase in money supply begins via a rise in cash balances in the economy. There is a presumption that the economy is at less than full employment and, with excess capacity in the labour market, the higher spending leads to firms increasing output. The expansion lowers unemployment but eventually the excess demand for labour forces up production costs (via money wage increases) and prices rise as a result.

There was thus a very clear argument being set forth linking monetary developments (increased money supply) to the improvement in the real economy. Several other English economists supported this view at the time, including Henry Thornton and Thomas Attwood.

Attwood, in particular, based his theory of inflation on his real world observations of the consequences for the working class of the deflationary strategies of the Bank of England after the Napoleonic Wars. He observed that the attempts by the Bank of England to bring the currency notes back to parity with gold – that is, the sharp reduction in the money stock – came at the expense of economic activity and caused unemployment to rise.

The harsh deflationary policies adopted by the Bank of England in 1815 and 1816 – as it tried to bring the currency notes back to parity with gold (that is, sharply reduce the money stock) – saw many brass and iron workers in the Birmingham area, who were largely occupied in the armaments industry, lose their employment. Economic activity collapsed in England during this period of monetary contraction.

Attwood also opposed the view that an unfettered labour market would maintain full employment by real wage adjustments, which became the central idea of Classical employment theory.

These early views were strongly opposed by the Classical economists who came after them. In particular, the evolution of Classical employment theory, which Keynes opposed in the 1930s, denied the existence of a trade-off between inflation and unemployment.

X.4 The Quantity Theory of Money

Posted on Friday, February 8, 2013 by bill

The Classical theory of employment, that we analysed in detail in Chapter 11, was based on the view that the real variables in the economy – output, productivity, real wages, and employment – were determined by the equilibrium outcome in the labour market.

The real wage was considered to be determined in the labour market, that is, exclusively by labour demand and labour supply. Labour demand was inversely related to the real wage because they asserted that marginal productivity was subject to diminishing returns and the supply of labour was positively related to the real wage because workers would prefer to work more hours as the price of leisure (the real wage) rose.

The real wage is construed in this theory as being the price of leisure in the sense that it represents the other goods and services foregone (via lost income) of an hour of non-work (leisure). The real wage is thus a relative price – of leisure relative to other goods and services.

As we have learned in Chapter 11, the important Classical result is that the interaction between the labour demand and supply functions determines the real level of the economy at any point in time. Aggregate supply of goods and services is determined by the level of employment and the prevailing technology, which maps how much output is forthcoming for a given level of employment. The more productive is labour the higher will the output supply be at each level of employment.

Say’s Law, which follows from the loanable funds doctrine, is then invoked to assume away any problems in matching aggregate demand with this supply of goods and services. The loanable funds doctrine posits that saving and investment will always be brought into balance by movements in the interest rate, which is construed as being the price of today’s consumption relative to future consumption.

The theory thus assumes that two relative prices – the real wage in the labour market and the interest rate in the loans market – ensure that full employment occurs (with zero involuntary unemployment). Knowledge of the general price level was thus irrelevant to explaining the real side of the economy.

This separation between the explanation for the determination of the real economic outcomes and the theory of the general price level is referred to as the classical dichotomy, for obvious reasons. The later Classical economists believed that if the supply of money was, for example, doubled, that there would be no impact on the real performance of the economy. All that would happen is that the price level would double.

The classical dichotomy that emerged in the C19th stands in contradistinction to the earlier ideas developed by economists such as David Hume that there was a trade-off between unemployment and inflation that could be manipulated (in policy terms) by the central bank varying the money supply.

It is of no surprise that the Classical employment model relied, in part, on the notion of a classical dichotomy for its conclusions. It origins were based on a barter model where there is an absence of money and owner producers trade real products. Clearly, this conception of an economy has no application to the monetary economy we live in.

The development of Classical monetary theory was only intended to explain the level and change in the general price level. The main attention of the Classical economists was in trying to understand the supply of output and the accumulation of productive capital (and hence economic growth).

The theory of the general price level that emerged from the classical dichotomy was called the Quantity Theory of Money. The Quantity Theory of Money, had its origins in the work of French economists in the sixteenth century, in particular, Jean Bodin.

Why would we be interested in something a French economist conceived in the sixteenth century? The answer is that in the same way that the main ideas of Classical employment theory still resonate in the public debate (for example, the denial that mass unemployment is the result of a deficiency of aggregate demand), the theory of inflation that arises from the Quantity Theory of Money is still influential and forms the core of what became known as Monetarism in the 1970s.

Economics is not a unified discipline and different schools of thought advance conflicting policy frameworks. Monetarism and its more modern expressions form one such school of thought in macroeconomics and relies on the Quantity Theory of Money for its inflation theory.

We will also see that the crude theory of inflation that emerges from the Quantity Theory of Money has intuitive appeal and is not very different to what we might expect the average lay person would believe – that growth in the money supply causes its value to decline (that is, causes inflation).

The Quantity Theory of Money was very influential in the nineteenth century. The theory begins with what was known as the equation of exchange, which is, at first blush, an accounting identity.

We write the equation as:

(X.1) MV = PY

PY is the nominal value of total output (which you will relate to as the definition of nominal GDP in the national accounts) given P is the price level and Y is real output. Consistent with that definition you will understand that PQ is a flow of output and expenditure.

M is the quantity of money in circulation (the money supply) and V is called the velocity of circulation, which is the average circulation of the money stock. V is thus the turnover of the quantity of money per period in making transactions.

To understand velocity, think about the following example. Assume the total stock of money is $100, which is held by the two people that make up this economy. In the current period (say a year), Person A buys goods and services from Person B for $100. In turn, Person B buys goods and services from Person A for $100.

The total transactions equal $200 yet there is only $100 in the economy. Each dollar has thus be used “twice” over the course of the year. So the velocity in this economy is 2.

The money supply is a stock (so many dollars at a point in time). Any given stock of money might turnover several times in any given period in the course of all the myriad of transactions that are made using money.

As we learned in Chapter 4 when we considered stocks and flows, flows add to or subtract from related stocks. But it makes no sense to say that a stock of say $100 is equal to a flow of $100. They are incommensurate concepts in this regard.

The velocity of circulation converts the stock of money into a flow of money and renders the left-hand side of Equation (X.1) commensurate with the right-hand side.

As it stands, Equation (X.1) is a self-evident truth because it is an accounting statement. It is obvious that the total value of spending (MV) will have to equal to the total nominal value of output (PY). In other words, there is no theoretical content in the relationship as it stands.

We thus need to introduce some behavioural elements into Equation (X.1) in order to use it as a theory of the general price level.

In this regard, it is important to see the Quantity Theory of Money and Say’s Law as being mutually reinforcing planks of the Classical theory. The latter was proposed to justify the presumption that full employment output would be continuously supplied and sold, which meant that the former would ensure that changes in the stock of money would only impact on the price level.

As Keynes observed, price level changes did not necessarily correlate with changes in the money supply, which led to his rejection of the Quantity Theory of Money.

In turn, his understanding of how the price level could change without a change in the money supply was informed by his rejection of Say’s Law – that is, his recognition that total employment was determined by effective demand and the capitalist monetary economy could easily fall into a state where effective demand was deficient.

But the Classical theorists considered that a flexible real wage would ensure that full employment was attained – at least as a normal state where competition prevailed and there were no “artificial” real wage rigidities imposed.

As a result, they considered Y to be fixed at the full employment output level.

Additionally, they considered V to be constant given that it was determined by customs and payment habits. For example, people are paid on a weekly or fortnightly basis and shop, say, once a week for their needs. These habits were considered to underpin a relative constancy of V.

Figure X.1 depicts the resulting causality that defines the Quantity Theory of Money is explanation of the general price level. The horizontal bars above the V and Y indicate they are assumed to be constant. It follows that changes in M will directly and only impact on P.

Figure X.1 The Quantity Theory of Money

To understand this theory more deeply it is important to note that the Classical economists considered the role of money to be confined to acting as a medium of exchange to free people from the tyranny of a double coincidence of wants in barter. That is, to overcome the problem that a farmer who had carrots to offer but wanted some plumbing done could not find a plumber desiring any carrots.

Money was seen as lubricating the process of real exchange of goods and services and there was no other reason why a person would wish to hold it.

The underlying view was that if individuals found they had more money than in the past then they would try to spend it. Logically, it followed that they considered a rising stock of money to be associated with higher growth in aggregate demand (spending).

As Figure X.1 shows, monetary growth (and the assumed extra spending) would directly lead to price rises because the economy was already assumed to be producing at its maximum productive capacity and the habits underpinning velocity were stable.

In Chapter 14, we will consider the evolution of monetary theory and see that one of the central ideas that Keynes used to discredit the Classical theory of prices related to the role of money as a store of value, which allowed individuals to manage uncertainty about asset prices by holding their wealth in its most liquid form.

For now it is worth noting two empirical facts. First, capitalist economies are rarely at full employment. The fact that economies typically operate with spare productive capacity and often with persistently high rates of unemployment means that it is hard to maintain the view that there is no scope for firms to expand real output when there is an increase in nominal aggregate demand growth.

Thus, if there was an increase in availability of credit and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing real output to maintain market share rather than pushing up prices.

Second, the empirical behaviour of the velocity of circulation demonstrates that the assumption that it is constant is not plausible. Figure X.2 uses US data provided by the US Federal Reserve Bank and shows the velocity of circulation, constructed as the ratio of nominal GDP to the M2 measure of the money supply.

The US Federal Reserve says that this measure:

… can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.

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