Chapter 7 - inflation ,unemployment and underemployment for BBA

Inflation, Unemployment and Underemployment

Chapter 7

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Inflation

“ There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

-John Maynard Keynes

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Definition of inflation

Inflation is defined as a persistent rise in the general price level over a period of time. It is a situation where a rise in general level of prices is accompanied by an increase in output.

Disinflation, deflation, and stagflation are also associated with inflation.

Disinflation is a reduction in the rate at which prices are increasing. For example, if prices rise at 5% compared to earlier 7% rise, this is disinflation.

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Deflation is a decrease in the overall level of prices. This means aggregate price rise rate is negative.

Stagflation is situation of twin evils. In this situation, prices rise, output falls and unemployment rises.

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Inflation is the percentage change in the overall price level.

Rate of inflation in year ‘t’:= price level (year t)- price level (year t-1) x100

price level (year t-1)

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Three strains of inflation

Like disease, inflations exhibit different levels of severity. It is usually classified into three categories: low inflation, galloping inflation, and hyperinflation.

1. Low inflation: a situation in which prices rise slowly and predictably. In general, this is a situation of single-digit annual inflation. When prices are relatively stable, people trust money. People are willing to hold money and long term contracts between parties in business take place given the price predictability.

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Three strains of inflation Low inflation sometimes also classified into: creeping,

and walking inflation. Inflation below 3% a year is termed creeping inflation and inflation between 3% to 9% a year is termed walking inflation.

2. Galloping inflation: According to Samuelson and Nordhaus, inflation in the double or triple digit range of 20, 100, or 200 percent a year is called galloping inflation. In this situation, serous economic distortions take place in economy. Money loses its value very quickly, financial markets wither away as capital flees abroad, people hoard goods, buy houses and never lend money at low nominal interest rates.

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Three strains of inflation

3. Hyperinflation: A third and deadly strain takes hold when the cancer of hyperinflation takes place. In this case, inflation is immeasurable and absolutely uncontrollable. A case of hyperinflation was in Germany where the price index rose from 1 in January 1922 to 10,000,000,000 in November 1923. This was on average was a 500 percent price rise per month.

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A situation of hyperinflation

“We used to go to the stores with money in our pockets and come back food in our baskets. Now we go with money in our baskets and return with food in our pockets. Everything is scarce in except money! Prices are chaotic and production disorganized. A meal that used to cost the same amount as an opera ticket now costs twenty times as much. Everybody tends to hoard “things” and try to get rid of the “bad” paper money, which drives the “good “ metal money out of circulation. A partial return to barter inconvenience is the result.” (Mentionings during the civil war)

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Measurement of inflation

There are various measures of inflation: Consumer Price Index (CPI), Wholesale Price index (WPI), GDP deflator, Import price index, export price index etc. Mainly used are the former three. In Nepal, CPI is used to measure (calculate) the rate of inflation.

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Consumer Price Index (CPI) A measure of the overall level of prices Published by the Nepal Rastra Bank in Nepal Uses:

tracks changes in the typical household’s cost of living

adjusts many contracts for inflation allows comparisons of dollar amounts over time

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How the NRB constructs the CPI1. Survey consumers to determine composition of

the typical consumer’s “basket” of goods.

2. Every month/week, collect data on prices of all items in the basket; compute cost of basket

3. CPI in any month equals

Cost of basket in that month

Cost of basket in base period100

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How CPI is developed? Assume that consumers buy three

commodities: food, shelter and medical care. A hypothetical budget survey finds that consumers spend 20% of their budget on food, 50% on shelter and 30% on medical care. Using a year as the base year, say 2005, we rest the price of each commodity 100 so that difference in units of commodity will not affect the price index. This means CPI is also 100 in the base year= (0.2x100)+ (0.5x100)+(0.3x100) 13

How CPI is developed? Assume that in 2006, food prices went up

by 2%, thus food price index reached 102, shelter prices rise by 6% to 106, and medical care prices by 10% to 110.

Now, CPI for 2006 will be :

=(0.2x102)+ (0.5x106)+(0.3x110)=106.4

Now you can calculate the rate of inflation using the formula.

See how it is calculated by NRB14

Inflation in NepalSeparation of CPI into its major groups (Based on Five Year Average)

Period CPI Inflation FBG Inflation NFS Inflation

1976 - 80 5.22 4.76 6.75

1981 - 85 9.69 9.40 10.37

1986 - 90 11.62 12.55 10.02

1991 - 95 11.26 11.47 10.92

1996 - 00 7.85 8.31 7.32

2000 - 05 3.72 2.62 5.00

2006 7.97 7.82 8.11

Food and beverages group (FBG) and non-food and services group (NFS).

Source: NRB

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Wholesale price index

The producer price index or wholesale price index measures the prices at the wholesale or producer stage.

The fixed weights used to calculate the PPI are the net sales of each commodity.

The procedure to calculate the WPI is same that of CPI.

See how it is calculated by NRB

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Causes of inflation

Causes of inflation can be categorized into:Demand pull factors: The early quantity theory approach The Keynesian approach of inflationary gap The general equilibrium approachCost push factors Wage-push inflation Profit-push inflation Increase in the price of raw materialsStructural factors

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The quantity theory of money (QTM)

Classical and neoclassical economists believe that the only way to price rise, and hence inflation, is through the over-supply of quantity of money in an economy. If money is doubled, price also doubles in full employment situation where money plays as a means of transaction only. The well known equation that explains QTM is:

M V PT where, M is money supply; V is the velocity of money,

which is the measure of number of times one unit of money crosses the hands from one transaction to another; P is the general price level; and T represents the real volume of transactions.

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Causes of inflation:QTM In classical system, both V and T are assumed to be constant

in the short run and Y (output) is the proxy for T. Hence the above equation can be rewritten to yield a price equation for the economy as follows:

M V PY It simply states that doubling the money supply doubles the

price level, proportionate relationship between quantity of money and price

The modern QTM accepts that inflation occurs when the rate of growth of the money supply exceeds the growth rate of the real aggregate output in the economy. According to the monetarists, the QTM implies that inflation is always and everywhere a monetary and demand-side phenomenon.

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Causes of inflation:QTM

Money supply as the sole cause of inflation:P

M

M1

P

M2

P2

P=f(M)

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Causes of inflation:QTMMonetarists’ assumptions are: Vertical aggregate supply curve at full employment

level Increase in money increases AD, increase in AD

increases the price.

Q

P

P

DD1

P1

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Keynesian approach-inflationary gap

According to this theory, inflation is generated by pressure of excess demand of goods and services for the available supply in the economy, especially when the economy approaches to the full employment level If aggregate demand rises, the multiplier effect of the increase in aggregate demand becomes disabled due to supply constraint and hence the only way to clear the goods market is through raising the money prices of the goods.

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Y

AD YAD=C+I

YP Output

Pric

e

Inflationary gap

P

Q

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The demand-pull inflation is shown in the figure in next slide. If the aggregate demand curve of the economy shifts upward, the price level rises. If the economy is in less than full equilibrium there is output effect as well. However, if the aggregate demand increases beyond AD2 as shown in figure, it will be adjusted by increase in prices only without affecting the output.

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General equilibrium approach This approach combines the real factors and monetary

factors to explain the inflationary process. This is often called the ISLM approach. IS curve refers to goods (real) market equilibrium and LM refers to money market equilibrium.

Real factors such as change in government expenditure and taxes shift the IS curve and monetary factors such as change in money supply shift the LM curve.

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Causes of increase in AD

The main causes of increase in aggregate demand are the following - some are related with Keynesians and others with Monetarists:

Depreciation or devaluation of the exchange rate: This increases the price of imports and reduces the foreign price of economy's exports. If consumers buy fewer imports while foreigners buy more exports; or if export is more elastic than imports, the aggregate demand in the economy will rise. If the economy is already at full employment or there is supply bottleneck, it is hard to increase output and so prices are pulled upwards.

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Causes of increase in AD Reduction in taxation: If taxes are reduced (either by

lowering the rate or by escaping the people from tax-net), consumers will have more disposable income causing demand to rise. A reduction in indirect taxes (taxes on goods and services such as VAT) will mean that a given amount of income will now buy a greater real volume of goods and services than it would be before its reduction.

Deficit financing of the government: It results increase in money supply and then aggregate demand of the economy, whatever be the sources of financing.

Faster economic growth in other countries - It may accelerate the exports of goods and services of the economy. Since exports are counted as an injection of aggregate demand, it causes demand-pull inflation in the economy.

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Cost push theory of inflation

Cost-push theories of inflation largely attribute inflation to non-monetary, supply-side effects that change the unit cost and profit markup components of the prices of individual products. Cost-push inflation occurs due to increase in cost of production of goods and services in the economy. Main factors pushing the cost of production are:

Wage-push inflation Profit-push inflation Increase in prices of raw mateials

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Main causes of increases in the cost: Wages: The trade unions may be able to push

wages up without increasing the productivity of labours. Firms, then, are forced to increase their prices to pay the higher claims and maintain their profitability.

Profits: Firms having more power and ability to raise prices, independently to demand, can make more profit and result cost-push inflation. This is most likely to occur, when markets become more concentrated and move towards monopoly or perhaps oligopoly.

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Cost push theory of inflation Main causes….. Imported inflation: In a global economy, firms import a

significant proportion of their raw materials or semi-finished products. If the cost of these imports increases for reasons out of domestic control, then once again firms will be forced to increase prices to pay the higher raw material costs.

Exchange rate changes - If there is depreciation in the exchange rate, then exports will become cheaper abroad, but imports will appear to be more expensive. Firms will be paying more for their overseas raw materials leading to increase prices of domestic economy.

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Cost push theory of inflation Main causes…… Commodity price changes - If there are price increases

on world commodity markets, firms will be faced with higher costs if they use these as raw materials. Important markets would include the oil market and metals markets.

External shocks - This could be either for natural reasons or because a particular group or country will gain more economic power. An example of the first was the Kobe earthquake in Japan, which disrupted world production of semi-conductors for a while. An example of the second was the case of OPEC which forced up the price of oil four-fold in the early 1970s.

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Cost push theory of inflation Main causes…… Exhaustion of natural resources: As resources run out,

their price will inevitably gradually rise. This will increase firms' costs and may push up prices until they find an alternative source of raw materials (if they can). For example, in many countries such problem occurred because of land erosion when forests were cleared. The land quickly became useless for agriculture.

Taxes: Increase in indirect taxes (taxes on expenditure) increases the cost of living and push up the prices of products in the shops.

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Structural factors

The structuralists argue that change in AD and AS are not only the factors causing inflation particularly in developing countries. The theory suggests that structural bottlenecks such as lack of transportation, black marketing, inefficient regulatory mechanism, artificial shortages, subsistence level of production, and government regulation on prices are the main reasons for inflation in developing countries.

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Meaning of unemployment What is Unemployment?

- In economics one who is willing to work at a prevailing wage rate but is unable to find a paying job is considered to be unemployed.

What is Unemployment rate? - The unemployment rate is the no. of unemployed

workers divided by the total civilian labor force. According to the ILO, a person is said to be unemployed

if the person is:1. Not working2. Currently available for work3. Seeking work

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Types of Unemployment

Economists have found it useful to classify unemployment into four different categories

Frictional unemployment Seasonal unemployment Structural unemployment Cyclical unemployment

Each arises from a different cause and has different consequences

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Frictional Unemployment

Arises because of transactions costs associated with normal entry and exit from the labor market, voluntary job changes, or lay offs or firings. Also called search unemployment. Mainly in industrial countries because of the frequent change in technology or because of dynamic economy.

By definition, it is short-term, it causes little hardship to those affected by it.

By spending time searching rather than jumping at the first opening that comes their way. People find jobs for which they are better suited and in which they will ultimately be more productive.

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Seasonal Unemployment

Joblessness related to changes in weather, tourist patterns, or other seasonal factors.

A common phenomenon is developing countries and specially in agriculture economies.

Mainly occurs in agriculture, construction and tourism business-a demand driven situation.

Also in supply side, teenage unemployment rises during vacations.

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Structural Unemployment

Joblessness arising from mismatches between workers’ skills and employers’ requirements

Generally a stubborn, long-term problem Often lasting several years or more because it

can take considerable time to relocate or acquire new skills.

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Unemployment Frictional, structural, and seasonal unemployment arise

largely from microeconomic causes, they cannot be entirely eliminated since they are attributed to changes in specific industries and specific labor markets.

Some amount of microeconomic unemployment is a sign of a dynamic economy.

When there is no cyclical unemployment, it is called natural rate of unemployment.

Thus, the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation. It is thus an equilibrium rate of unemployment towards which the economy moves in the long – run.

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Cyclical Unemployment

When the economy goes into a recession and total output falls, the unemployment rate rises

Since it arises from conditions in the overall economy, cyclical unemployment is a problem for macroeconomic policy

It is caused by the business cycle hence called ‘cyclical’ Macroeconomists say we have reached full employment

when cyclical unemployment is reduced to zero But the overall unemployment rate at full

employment is greater than zero Because there are still positive levels of frictional,

seasonal, and structural unemployment

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Inflation and Unemployment Trade-off (The Phillips Curve) Okun’s law states that 1 extra point of

unemployment costs 2 percent of GDP. The Phillips curve examines the relationship between the

rate of unemployment and rate of money wage changes. The wage push inflation is simply given by:

Rate of inflation = Rate of wage growth – Rate of labor productivity growth.

This formula shows that if the rate of money wage change is faster than the rate of labor productivity growth (change), it causes the inflation. In this case, the Phillips curve shows the relationship between the rate of unemployment and the rate of money wage changes or the rate of inflation. Thus, Phillips curve depicts the trade–off relationship between unemployment rate and inflation rate.

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Inflation and Unemployment Trade-off (The Phillips Curve) The Phillips curve is so named because it was

popularized by a New Zealand economist, A. W. Phillips, when he was working at the London School of Economics in the 1950s.

A Phillips curve is a curve showing the relationship between inflation and unemployment. There are two time-frames for Phillips curves:

The short-run Phillips curve The long-run Phillips curve

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Inflation and Unemployment Trade-off (The Phillips Curve)

Following Figure Shows Short – Run Phillips Curve.

Unemployment Rate (%)

O 2 3

B

C 4

2

PC

Infla

tion

rate

(%

)

Expected inflation rate 4%Natural unemployment rate 2%

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Inflation and Unemployment Trade-off (The Phillips Curve) The short-run Phillips curve (SRPC) shows the

relationship between inflation and unemployment at a given expected inflation rate and given natural unemployment rate. With an expected inflation rate of 4 percent a year and a natural unemployment rate of 2 percent, the short run Phillips curve passes through point ‘c’. An unanticipated increase in AD lowers unemployment and increases inflation-a movement up the SRPC. An unanticipated decrease in AD increases unemployment and lowers inflation-a movement down the SRPC.

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Inflation and Unemployment Trade-off (The Phillips Curve) The long-run Phillips curve (LRPC) is a curve that shows

the relationship between inflation and unemployment, when the actual inflation rate equals the expected inflation rate. The LRPC is vertical at the natural unemployment rate. The LRPC tells us that any anticipated inflation rate is possible at the natural unemployment rate. When inflation is anticipated, real GDP remains at potential GDP. Real GDP being at potential GDP is equivalent to unemployment being at the natural ate.

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Infla

tion

rate

Unemployment rate

LRPC

6

10

SRPC

SRPC1

7

9

a

dc

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Inflation and Unemployment Trade-off (The Phillips Curve) The LRPC is a vertical line at the natural

unemployment rate. A fall in inflation expectations shifts the SRPC downward by the amount of the fall in the expected inflation rate. In the figure of the previous slide, when the expected inflation rate falls from 10 percent a year to 7 percent a year, the SRPC shifts downward. The new SRPC intersects the LRPC at the new expected inflation rate-point d. With the original expected inflation rate (10 percent), an inflation rate of 7 percent a year would occur at an unemployment rate of 9 percent-point c.

Remember change in the natural rate of unemployment shifts both SRPC and LRPC.

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Following Figure Shows Tobin's Phillips Curve. O Uc

PS

Unemployment Rate %

Infl

atio

n R

ate

%

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Tobin’s view

According to this view, there is a Phillips curve within the limits but as the economy expands and employment grows, the curve becomes even more fragile and vanishes until it becomes vertical at some critically low rate of unemployment. The Phillips curve is kinked – shaped, a part like a normal Phillips curve and the rest vertical, as shown in the previous slide.

The unemployment rate at which the Phillips curve is vertical is called critical unemployment rate.

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Costs of inflation The problems of a wage-price spiral – price rises can

lead to higher wage demands as workers try to maintain their real standard of living. Higher wages over and above any gains in labour productivity causes an increase in unit labour costs. To maintain their profit margins they increase prices. The process could start all over again and inflation may get out of control.

Higher inflation causes an upward spike in inflationary expectations that are then incorporated into wage bargaining. It can take some time for these expectations to be controlled. Higher inflation expectations can cause an outward shift in the Phillips Curve.

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Costs of inflation Inflation can also cause a reduction in the real

value of savings - especially if real interest rates are negative. This means the rate of interest does not fully compensate for the increase in the general price level. In contrast, borrowers see the real value of their debt diminish. Inflation, therefore, favors borrowers at the expense of savers.

Consumers and businesses on fixed incomes will lose out. Many pensioners are on fixed pensions so inflation reduces the real value of their income year on year. The state pension is normally uprated each year in line with average inflation so that the real value of the pension is not reduced.

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Costs of inflation

Inflation usually leads to higher nominal interest rates that should have a deflationary effect on GDP.

Inflation can also cause a disruption of business planning – uncertainty about the future makes planning difficult and this may have an adverse effect on the level of planned capital investment.

Budgeting becomes a problem as firms become unsure about what will happen to their costs. If inflation is high and volatile, firms may demand a higher nominal rate of return on planned investment projects before they will go ahead with the capital spending.

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Costs of inflation

Inflation usually leads to higher nominal interest rates that should have a deflationary effect on GDP.

Inflation can also cause a disruption of business planning – uncertainty about the future makes planning difficult and this may have an adverse effect on the level of planned capital investment.

Budgeting becomes a problem as firms become unsure about what will happen to their costs. If inflation is high and volatile, firms may demand a higher nominal rate of return on planned investment projects before they will go ahead with the capital spending.

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Costs of inflation

Cost-push inflation usually leads to a slower growth of company profits which can then feed through into business investment decisions.

Inflation distorts the operation of the price mechanism and can result in an inefficient allocation of resources. When inflation is volatile, consumers and firms are unlikely to have sufficient information on relative price levels to make informed choices about which products to supply and purchase.

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Costs of inflation Two further costs of inflation are often mentioned in

the textbooks: Shoe leather costs - when prices are unstable

there will be an increase in search times to discover more about prices. Inflation increases the opportunity cost of holding money, so people make more visits to their banks and building societies (wearing out their shoe leather!).

Menu costs -extra costs to firms of changing price information. This can be important for companies who rely on bulky catalogues to send price information to customers. (Note there are also significant menu costs associated with any future transition to the European Single Currency)

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Anticipated and unanticipated inflation When inflation is volatile from year to year, it becomes

difficult for individuals and businesses to correctly predict the rate of price inflation that will happen in the near future. When people are able to make accurate predictions of inflation, they can anticipate what is likely to happen and take steps to protect themselves. For example, people can bid for increases in money wages so as to maintain their real wages. Savings can be shifted into accounts offering a higher rate of interest, or into assets where capital gains might outstrip general price inflation. Companies can adjust their prices; lenders can adjust interest rates.

Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations.

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Inflation targeting

Inflation-targeting is one of the operational framework for monetary policy aimed at attaining price stability. In contrast to alternative strategies such as money or exchange rate targeting, which seek to achieve low or stable inflation through targeting intermediate variables-for example the growth rate of monetary aggregates or the level of the exchange rate of an “anchor” currency-inflation targeting directly targets inflation.

Inflation targeting has two main characteristics that distinguish it from other monetary policy strategies:

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Inflation targeting

1. The central bank is mandated, and commits to, a unique numerical target in the form of a level or a range for annual inflation. A single target for inflation emphasizes the fact that price stabilization is the primary focus of the strategy, and the numeric specification provides a guide to what the authorities (central bank) intend as price stability.

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Inflation targeting

2. The inflation forecast over some horizon is the de facto intermediate target of policy. For this reason inflation targeting is sometimes referred to as “inflation forecast targeting”. Since inflation is partially predetermined in the short term because of existing price and wage contracts and/or indexation to past inflation, monetary policy can only influence expected future inflation. By altering monetary conditions in response to new information, central banks influence expected inflation and bring it in line over time with the inflation target, which eventually leads actual inflation to the target.

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Inflation targeting

Inflation-targeting regimes generally identify price stability as the primary objective, usually in the context of a hierarchical mandate.

They set an explicit numerical target for inflation and set a period over which any deviation of inflation from its target is to be eliminated, although some regimes provide escape clauses and others flexibility related to the pace of return to price stability.

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Inflation targeting

Targeting the inflation as the sole objective of central bank requires:

Central Bank legal framework (Instrument Independence, Mandate for Price stability)

Design of the inflation target (CPI Measure or GDP Deflator Measure)

The Target Horizon: When is the target set? Point Target or Target Range Transparency and Accountability:

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Pre-conditions for successful inflation targeting Strong fiscal position and entrenched macroeconomic

stability Well developed financial system Central bank independence and a legal mandate to

achieve price stability Reasonably well developed transmission mechanism

between monetary policy instruments & inflation Sound methodology for constructing inflation forecasts Transparency of policies to build accountability &

credibility

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Current International IT Scenario

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Industrial Countries Emerging Market Countries

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Chapter 7 - inflation ,unemployment and underemployment for BBA

Education

Transcript of Chapter 7 - inflation ,unemployment and underemployment for BBA