THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)

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Introduction to Economics ECO401

Lesson 11.2

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED.......)

The Monetarists' Views about Unemployment:

The Monetarists viewed unemployment essentially in its natural rate context, and thus as a

problem that could not be cured through wage decreases or demand injections. According to

them, the economy usually operated around the full employment level, and thus the only type

of employment to worry about the natural rate kind. Attention, therefore, needed to focus on

the horizontal distance between the AJ and LF curves at the market-clearing wage rate, w*. If

this distance could be reduced, by shifting the AJ curve to the right (i.e. closer to the LF curve),

the unemployment rate could be reduced.

According to monetarists, the reason why people on the labour force might not be willing to

accept jobs, was located in frictional (search), structural and seasonal reasons.

Frictional unemployment was defined as unemployment caused by delays in matching job-

seekers to jobs. Delays were seen as being essentially caused by a lack of information, and

thus job centers newspapers etc. with better information on jobs etc. could help.

Structural unemployment was associated with changes in the structure of an economy:

changes in demand patterns (tastes, fashion etc.), changes in methods of productions (capital

vs. labour intensive production techniques being adopted, the replacement of some jobs with

computer-based solutions). Also, if industrial or business activity were reduced in a particular

region of the economy due to environmental or law and order reasons, or if a geographical

area suffers a natural calamity, the resulting unemployment would also be categorized as

structural unemployment. Both market-friendly and interventionist policies have been

suggested to address this type of unemployment. Among the market-friendly policies are

encouraging people to i) retrain themselves (for e.g., facilitate training of mine workers for

computer jobs), ii) get on their bikes and look for jobs. Interventionist policies included directed

government action to match jobs with skills. Thus the government could give financial grants

for training a certain group of people for a certain type of job etc.

Seasonal unemployment relates to certain types of workers going out of job due to seasonal

factors. Thus crop producers in cold countries would have little to do when the fields are

covered with snow from December till March. The policies that could address this problem

would be to facilitate labour migration in winter months, or to develop alternative tasks for the

winter (holding winter games in the region and developing it as a tourist spot for e.g.!)

Monetarists also suggested supply side measures which generally reduced the incentive to

work. One example is lowering income tax rates and thus increasing the incentive for people

to work the extra hour and earn the extra dollar.

Hysteresis:

Hysteresis refers to the permanent effects of a temporary change. In the context of

unemployment, for example, a temporary fall in demand in the economy which leads to lower

economic activity and hence lay-offs by firms may have more permanent effects given the

search behaviour of workers (laid off workers become disheartened as time goes by and if

they fail the first few job interviews; they become lazy, their skills rust, they become used to

unemployment benefit and are therefore less likely to find jobs) and the recruitment behaviour

of firms (by the time firms need to re-hire, their own motivation and speed of recruitment has

slowed; they're not putting up enough job adverts and hence the likelihood of instant

recruitment decreases). The result could well be longer spells of unemployment. Generally, it

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has also been seen that the likelihood of a person leaving the unemployment state falls as the

duration of his/her unemployment spell lengthens.

INFLATION

Definition of Inflation and deflation:

Inflation is a situation in which there is a continuous rise in the general price level. Deflation is

the opposite of inflation and occurs when the general level of prices falls. The rate of inflation

is the percentage annual increase in average price level.

Pure inflation is a special case of inflation in which the prices of all the goods and services in

the economy are rising at the same rate. So if an economy produces three goods: apples,

shirts and cars, and they cost Rs. 5, Rs. 100 and Rs. 400,000 respectively in 1992, while the

prices in 1993 are Rs. 6, Rs. 120 and Rs. 480,000, and the prices in 1994 are Rs. 9, Rs. 180

and Rs. 720,000, respectively, then we can say that there was pure inflation of 20% in 1993

(over 1992) and pure inflation of 50% in 1994 (over 1993).

Measurement of Inflation:

More generally, inflation (in % p.a.) is measured as

[(Pt - Pt-1)/Pt-1]*100

Where Pt refers to the average price level prevailing in year t, and Pt-1 is the average price

level prevailing in period t-1. The term average price level usually refers to the value of an

index, like consumer price index or producer price index etc., which weights the prices of

goods according to their share in the total nominal GDP.

Ideal Inflation Rate for an Economy:

It is difficult to say what the ideal inflation rate for an economy is. But it is not usually zero. A

small positive inflation rate of about 3% is considered healthy for mature HICs while 7% is

quite acceptable for fast growing emerging economies. Inflation rates above 10% are generally

considered undesirable.

Some countries, esp. in Latin America, have recorded inflation rates in 100s and 1000s of

percentage p.a. these episodes were known as hyper inflation episodes. The first country to

suffer hyperinflation, and perhaps in its severest form, was Germany in the 1920s. The country

was burdened with very high debt linked to obligations taken on as a result of being defeated

by the allies in the 1st World War. The German government could not find the resources to

pay off the debt or the interest thereon and resorted to printing money. This, however, plunged

the local economy into hyperinflation.

The Choice of price Index:

There are important statistical challenges to resolve in the definition of inflation. The choice of

price index often affects what one can say about inflation. Thus it might be that overall inflation

is high, but food inflation is low. Similarly, there can be a price index for students, the health

sector, housing and each has a different meaning attached to it. When talking about inflation, it

should be clear which index is being referred to. The most commonly used index when

referring to overall inflation in the economy is the retail or consumer price index (CPI).

The CPI and PPI:

CPI measures the cost of a fixed basket of consumer goods in which the weight assigned to

each commodity is the share of expenditures on that commodity by consumers. The producer

price index (PPI) is the price index of goods and raw materials sold at the wholesale level to

producers: examples of goods in the wholesale basket are steel, wheat, cotton etc.

However, all these indices are measures of price inflation. A slightly different but related

concept is that of wage inflation, which measures the rate of increase of average wages in the

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economy. Since real wages are nominal wages adjusted for prices, it is straightforward to see

that if wage inflation is greater than price inflation, real wages are rising, and vice versa.

Countries where price inflation is very high often keep track of wage inflation rates to ensure

that the real wage (which measures the purchasing power of workers) remains constant. The

practice of linking wages to prices is called "index-linking" and is the norm in many Latin

American countries.

Costs of inflation:

a. Inflation redistributes income away from those on fixed incomes (or who do not have

the bargaining power to renegotiate wages) towards owners of land, property or assets

whose prices are generally quite sensitive to the general price level. Traders also raise

prices faster when they see a rise in the inflation rate. But the salary class is often

constrained from doing so. In many African and South Asian countries, the problem

has been quite acute. Wage earners, esp. in the government sector, had lost (by the

1990s) up to 90% of the purchasing power of their incomes from the 1960s. The

reason, a gradual but persistent decline in real wages what could not be reversed. This

has led to corruption and inefficiency in many countries.

b. High inflation increases uncertainty for firms, thus impacting investment rather

negatively. The point to note here is that inflation is most volatile at high levels (thus

the fluctuation of the inflation rate around 25% will be much higher than its fluctuation

around 2%). Thus high inflation translates into uncertainty about prices, which means

inability to accurately forecast firm revenues and expenditures, which means lower

investment ex-ante.

c. Balance of payments problems are also often a result of high domestic inflation. Rising

prices in a country, if not offset by equally offsetting depreciation of the exchange rate,

can lead to the domestic currency becoming overvalued and therefore to a decline in

exports and a rise in imports in other words to a deterioration of the current account.

d. Resource wastage is high when inflation is high. Extra resources (time and money) are

dedicated, both by individuals and firms, merely to hedge against the purchasing power

erosion effects of inflation. Restaurants have to change their menus frequently; price

lists have to be issued more frequently.

Summing up in the words of Hazrat Ali (AS), "high inflation together with a deteriorating law

and order position are hallmarks of the worst possible government."

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