X unemployment and Inflation

Figure X.16 Inflation and Unemployment, Australia, 1978-2013

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Figure X.16 Inflation and Unemployment, Australia, 1978-2013

Source: Australian Bureau of Statistics, Consumer Price Index and Labour Force.

The relationship between the annual inflation rate and the unemployment rate clearly shifted after the 1991 recession. The graph shows three particular points (September 1995, September 1996, and September 1997) as the Phillips curve was flattening and moving inwards. So over these years, the unemployment rate was stuck due to a lack of aggregate demand growth but the inflation rate was falling.

This has been explained, in part, by the fall in inflationary expectations. The 1991 recession was particularly severe and led to a sharp drop in the annual inflation rate and with it a decline in survey-based inflationary expectations.

The other major labour market development that arose during the 1991 recession was the sharp increase and then persistence of high underemployment as firms shed full-time jobs, and as the recovery got underway, began to replace the full-time jobs that were shed with part-time opportunities. Even though employment growth gathered pace in the late 1990s, a majority of those jobs in Australia were part-time. Further, the part-time jobs were increasingly of a casual nature.

Figure X.17 shows the relationship between unemployment and inflation from 1978 to 2012. It also shows the relationship between the underemployment estimates provided by the Australian Bureau of Statistics and annual inflation for the same period.

The equations shown are the simple regressions depicted graphically by the solid lines. The graph suggests the negative relationship between inflation and underemployment is stronger than the relationship between inflation and unemployment. More detailed econometric analysis confirms this to be the case.

Figure X.17 Inflation and Unemployment and Underemployment, Australia, 1978-2013

Source: Australian Bureau of Statistics, Consumer Price Index and Labour Force.

The inclusion of underemployment in the Phillips curve specification helps explain why low rates of unemployment have not been inflationary in the period leading up to the Global Financial Crisis. It suggests that shifts in the way the labour market operates – with more casualised work and underemployment – have been significant in explaining the impact of the labour market on wage inflation and general price level inflation.

Unemployment and Inflation – Part 12

Posted on Friday, April 5, 2013 by bill


X.9 Demand-Pull and Cost-Push Inflation

Economists distinguish between cost-push and demand-pull inflation although, as we will see, the demarcation between the two types of inflation is not as clear cut as one might think.

Demand-pull inflation refers to the situation where prices start accelerating continuously because nominal aggregate demand growth outstrips the capacity of the economy to respond by expanding real output.

Gross Domestic Product (GDP) is the market value of final goods and services produced in some period. We represent that as the product of total real output (Y) and the general price level (P), that is, GDP = PY.

We have learned from the National Accounts, that aggregate demand is always equal to GDP or PY. It is clear that if there is growth in nominal spending that cannot be met by an increase in real output (Y) then the general price level (P) has to rise.

Keynes outlined the notion of an inflationary gap in his famous 1940 article – How to Pay for the War: A radical plan for the Chancellor of the Exchequer.

While this plan was devised in the context of war-time spending when faced by tight supply constraints (that is, a restricted ability to expand real output), the concept of the inflationary gap has been generalised to describe situations of excess demand, where aggregate demand is growing faster than the aggregate supply capacity can absorb it.

When there is excess capacity (supply potential) rising nominal aggregate demand growth will typically impact on real output growth first as firms fight for market share and access idle labour resources and unused capacity without facing rising input costs.

There are also extensive costs incurred by firms when they change prices, which leads to a “catalogue” approach where firms will forecast their expected costs over some future period and set prices according to their desired return. They then signal those prices in their catalogues and advertising to consumers and stand ready to supply whatever is demanded at that price (up to exhaustion of capacity). In other words, they do not frequently alter their prices to reflect changing demand conditions. Only periodically will firms typically revise their price catalogues.

Further, the economy is also marked by social relations that reflect trust and reliability. Firms, for example, seek to build relationships with their customers that will ensure product loyalty. In this context, firms will not seek to vary prices once they are notified to consumers.

Firms also resist cutting prices when demand falls because they want to avoid so-called adverse selection problems, where they gain a reputation only as a bargain priced supplier. Firms value “repeat sales” and thus foster consumer good will.

The situation changes somewhat, when the economy approaches full productive capacity. Then the mix between real output growth and price rises becomes more likely to be biased toward price rises (depending on bottlenecks in specific areas of productive activity). At full capacity, GDP can only grow via inflation (that is, nominal values increase only). At this point the inflationary gap is breached.

An alternative source of inflationary pressure can arise from the supply-side. Cost-push inflation (sometimes called “sellers inflation”) is generally explained in the context of “product markets” where firms have price setting power and set prices by applying some form of profit mark-up to costs.

We learned in Chapter 9, that generally, firms are considered to have target profit rates which they render operational by applying a mark-up on their unit costs. Unit costs are driven largely by wage costs, productivity movements and raw material prices.

Take the case of an increase in wage costs with productivity and other unit costs constant. In this situation, unit costs will rise and prices will rise unless firms accept a squeeze on their mark-up. In other words, either prices rise and deflate the nominal wage (leading to a real wage cut) or the firms accept a real cut in their per unit returns.

This concept then led to economists asking the question – under what circumstances will firms and/or workers accept such a real wage cut? This, in turn, broadened the enquiry to include considerations of social relations, power and conflict.

Workers have various motivations depending on the theory but most accept that real wages growth (increasing the capacity of the nominal or money wage to command real goods and services) is a primary aim of most wage bargaining.

Firms have an incentive to resist real wages growth that is not underpinned by productivity growth because they would have to “pay” for it by reducing their real margins.

The capacity of workers to realise nominal wage gains is considered to be pro-cyclical – that is, when the economy is operating at “high pressure” (high levels of capacity utilisation) workers are more able to succeed in gaining money wage gains. This is especially the case if they are organised into coherent trade unions, which function as a countervailing force to offset the power of the employer.

When the employer is dealing with workers individually they are seen to have more power than when they are dealing with one bargaining unit (trade unit), which represents all workers in the workplace.

The pro-cyclical nature of the bargaining power held by workers arises because unemployment is seen as disciplining the capacity of workers to gain wages growth – in line with Marx’s reserve army of labour.

In this context, a so-called “battle of the mark-ups” can arise where workers try to get a higher share of real output for themselves by pushing for higher money wages and firms then resist the squeeze on their profits by passing on the rising costs – that is, increasing prices with the mark-up constant.

At that point there is no inflation – just a once-off rise in prices and no change to the distribution of national income in real terms.

It is here that the concept of real wage resistance becomes relevant. If the economy is operating at high pressure, workers may resist the attempt by firms to maintain their real profit margin. They may seek to maintain their previous real wage and will thus respond to the increasing price level by imposing further nominal wage demands. If their bargaining power is strong (which from the firm’s perspective is usually in terms of how much damage the workers can inflict via industrial action on output and hence profits) then they are likely to be successful. If not, they may have to accept the real wage cut imposed on them by the increasing price level.

At that point there is still no inflation. But if firms are not willing to absorb the squeeze on their real output claims then they will raise prices again and the beginnings of a wage-price spiral begins. If this process continues then a cost-push inflation is the result.

The causality may come from firms pushing for a higher mark-up and trying to squeeze workers’ real wages. In this case, we might refer to the unfolding inflationary process as a price-wage spiral.

The dynamic that drives a cost-push inflation is seen to arise from the underlying social relations in the economy. It is here that we can consider a general theory of inflation, which recognises that the two sides of the labour market are likely to have conflicting aims and seek to fulfil those aims by imposing real costs on the other party.

NB: Original conflict theory of inflation (from blog 5 April) removed as superseded in blog 12 April

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