Inflation and Unemployment

There can be no trade-off between inflation and unemployment whether in the short or the long run. Comment. Inflation is a major challenge; the world is facing today and has become an impediment to robust growth. However, this problem is not new. In 1981, The Gallup Organisation in the US conducted opinion polls asking people, what is the most important problem, their country was facing, and a majority named inflation. Although governments in different countries have been using policies to contain it, it’s not so simple.

Lowering inflation may lead to a rise in unemployment which could act as an obstacle to economic growth. This debate, whether there’s actually a trade-off between inflation and unemployment, has been puzzling the macro-economists for decades now, but we’ve still not been able to arrive at a concrete conclusion. Different schools of thought have their own viewpoints and their own theories to support those viewpoints. In this paper, I shall discuss briefly, the different schools of thought and their viewpoints and try to unravel this mystery by amalgamating the different viewpoints. I. ‘Old’ Classical school

The classical school including Adam Smith, David Ricardo, John Stuart Mill etc. that existed prior to the ‘Great Depression’, believed that the economy ultimately (in the long-run) reaches full employment. The disturbances, if any, would be temporary and very short-lived. There was no need for any countercyclical policy (whether fiscal or monetary) to boost the economy. According to them, there is perfect wage-price flexibility and thus, no possibility of involuntary unemployment. Their explanation was also backed by the well known ‘SAY’S LAW’, according to which, supply creates its own demand.

Thus, whatever is produced will be demanded, and therefore economy is always at full employment. A ‘glut’ can occur, but only temporarily. Therefore, we get a vertical (almost) AS curve (and correspondingly, a vertical Philips curve). Hence, there is no trade-off whatsoever, between inflation and unemployment, and therefore any type of countercyclical policy (fiscal or monetary) is impotent. AS According to the classicists, economy is always at full employment level, as shown by the vertical AS curve. Thus, there is no trade-off between inflation and unemployment even in the short run. II. ‘Orthodox’ Keynesian school

Keynes gained popularity during the Great Depression, through his ideas of using fiscal policies to avoid the slump, and he became a pioneering face in the macroeconomics field during the 1950s and early 60s. He was against the view that the economy always stays at full employment. He believed in wage price rigidity and therefore, a rigid real wage leading to an involuntary unemployment (ie. u>un). Now, this unemployment could only be controlled if some fiscal or monetary policy is used. Keynes called for a fiscal expansion during the Great depression that would stimulate the aggregate demand.

Thus, AD curve shifts rightwards. At the initial price level P, we have an excess demand, thus price level rises to P1 and now output, Y=Yf. Thus, there is a trade off between inflation and unemployment. Keynes gave the following insights to explain this trade-off: (a) The persistence of unemployment According to Keynes, persistence of unemployment was due to the failure of money wages to adjust with sufficient speeds to clear labour markets, and therefore a fiscal expansion is required to contain this unemployment, which would create inflation.

For him, absolute rigidity in money wage rates is not required; all that is needed is that wages fail to fall to market clearing levels. (b) The fluctuations in unemployment According to Keynes, investment is highly unstable and is driven largely by animal spirits. This leads to fluctuations in unemployment. However prices and interest rates, according to him, often fail to adjust to offset these fluctuations, as they did during the ‘Great Depression’, probably because of a highly interest-elastic money demand (the so-called liquidity trap situation).

Also, investment is influenced by real interest rate, not the nominal interest rates; therefore, it is often impossible to stabilize it, unless the inflation in the economy is controlled. III. Neo-classical school The Hicksian IS-LM under the neoclassical school tends to explain the trade-off between inflation and unemployment against the backdrop of the Philips curve equation. According to them, people have static expectations, and therefore ? te=0. Thus, the equation of Philips curve becomes: ?t=? (Ot-On)

Now, if output is below its natural rate, inflation is negative, or we have disinflation in the economy. Thus, price level is decreasing. Now, as the price level starts decreasing, in our basic IS-LM model, LM curve starts shifting rightwards, and keeps shifting, until, we reach full employment. Thus, according to the neo-classicists, the economy is self-equilibrating, and no counter cyclical policy is required to bring the output back to full employment. Neo-classicists did believe in a trade-off, but only in the short run. LM LM1 i LM2 LM3 i1 On Ot IS IV. ‘Orthodox’ monetarist school

The monetarists including Milton Friedman re-enforced the classicists’ viewpoint by explaining the ‘Quantity theory of money’, according to which a monetary expansion (contraction) would result in an expansion of the price level, nominal wages, and nominal interest rate , however, the real values in the system will remain unaffected. Therefore, ‘Money is neutral’. Quantity theory of money: MV=PY David Hume, in his essay of 1752, Of Money and Of Interest stressed on the irrelevance of changes in money stock on the behaviour of rational people (Quantity theory of money).

He explained this with the help of an example: When any quantity of money is imported into a nation, it is not dispersed into all the hands at first. It initially caters a few selected people (manufacturers or merchants). These people then, invest this additional stock to raise output (at least in the short run). Now, an increase in output enables them to employ more workmen and therefore employment increases, wages remaining the same. Now, suppose an artisan carries his money to the market, he’ll find everything at the same price, however, the number of things that he can buy has increased.

Also, the gardener would find all his output sold out, and therefore raise work effort and raise output further. This will ultimately lead to an increase in the overall price level and all the real effects would get nullified, thus leading to ‘money neutrality’. Thus, output always ultimately returns to full employment and long-run AS curve (and correspondingly, the Philips curve) is vertical. Thus, though there is a trade-off between inflation and unemployment in the short run, it gets eliminated in the long run.

This means that we need to bear unemployment only for a short period of time, if we want to contain inflation. In the long run, however, unemployment will come back to its natural level, even if there is deflation (falling prices). Monetarists believed in the Adaptive expectations approach, that means, people base their expectations about future prices on the last year’s prices and therefore might make wrong expectations in the short run, however, Friedman said that they cannot be fooled forever, and therefore in the long run, their expected price would reflect the actual price.

Equation of Philips curve: ?t-? t-1= (µ+z)-? ut ?: Inflation rate µ: Mark up (constant) z: Catchall variable (constant) u: Unemployment rate Now, if ? t=? t-1, ut is a constant, thus there will be no change in the unemployment rate. Hence, no trade-off. Empirical Evidence This explanation has been supported empirically as well. McCandless and Weber (1995), plots 30 year (1960-90) average annual inflation rates against average annual growth rates of M2 over the same 30 year period, for a total of 110 countries. The points lie roughly on the 45° line, as predicted by the quantity theory.

They also provide evidence on correlations between money growth and growth in real output, averaged over the 1960-90 period and find no correlation at all. Thus, monetary expansion has no real effects. Stockman (1996), plots inflation rate against unemployment rate (Philips Curve) for various sub periods of the years 1950-94, for the United States and find a downward sloping Philips Curve for each sub period. However, when the entire 44-year period is considered, we do not find any correlation between inflation and unemployment.

This also shows, that the trade-off exists, but only in the short run. V. New Classical school The new classical economists believed in the rational expectations. According to them, all agents are rational and base their expectations about inflation on the information set available to them and are on an average able to predict the actual inflation accurately. They believed in complete wage price flexibility, and there was no chance of involuntary unemployment and thus no trade-off at all between inflation and unemployment. Also, according to them, there was continuous market clearing.

They assumed perfectly competitive market structure, thus, all unemployment that existed, was voluntary. Robert Lucas’ viewpoint Lucas argued that if everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away? Probable reasons according to him could be: (a) People are committed, perhaps even contractually, to continue to offer goods at old prices for a time. (b) Sellers are ignorant of the fact that money has increased, and a general inflation is inevitable.