Economics/Inflation / unemployment
Can it be that a country with high unemployment levels, by expanding its money supply, could, instead of increasing real GDP, generate inflation and not solve its unemployment problem? why or why not?
ANSWER: Hi Luis,
I am sorry to reply late as I was a little too busy.
Your question is rather simple, but it can also be dealt with very technically.
Please let me know if you want (A) a non-technical answer or (B) a technical answer which will require you to have a good grounding in advanced mathematics. A nontechnical answer can be brief or lengthy.
Please write to me, if possible giving your academic background, which may help me answer to your question tailored to your best undestanding.
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QUESTION: Hi again Eklimur Raza,
Thank for your time.I´m undergraduate in Management, so I´m familiar with economic and business subjects (both macro and microeconomics), although not in deeply mathematical detail, so I would choose option (A). I´m interested in understanding the main fundamentals that could (our not) cause inflation under expansionary monetary policies (increasing money supply) but with moderates to high levels of unemployed labor.
I can follow up to further questions if you feel like It could foster our discussion and understanding.
ANSWER: Hi Luis,
Thank you for your feedback.
On the basis of your very nicely stated feedback, I have decided to give you a nontechnical, yet sufficiently analytical, answer to your question about expansionary monetary policy and its impact on the relationship between inflation and levels of unemployment. For the sake of clarity, I would rather address the question with emphasis on simplicity, without compromising the minimal analytical rigor, which I believe will provide you with a clear grasp on a technical scale intelligible to you. This may best be presented under the following rubrics.
(1) INFLATIONARY MONETARY POLICY: A PREVIEW
At the outset, let us make one point clear. Monetary policy is one of the two policies used for dealing with problems associated with macroeconomic phenomena, the other being fiscal policy. Though a country may follow one or the other at certain time, usually both these types of policies come to play a significant role in management of economic phenomena a nation finds itself up against. Even when we say a country lays stress on monetary policy, we don’t mean that fiscal policy is totally disregarded, and vice versa. The only point to remember is that, when we consider monetary policy, we simply bring it into focus, all else assumed unchanged. In other words, the big role is assumed to be played by monetary policy.
Monetary policy –which could either be contractionary or inflationary –is inflationary when the policy followed by a country’s central bank, such as the Fed in the U.S.A., is meant to create economy-wide demand for goods and services, thereby influencing inflation, through its influence on financial conditions facing households and firms. The Fed employs a variety of tools to manage inflation, most of which involve the supply of money in circulation.
The Fed normally follows a modestly inflationary policy to promote stable growth and stave off deflation (make no mistake, however, that deflation is hugely worse than inflation). Sometimes the Fed seeks to increase the rate of inflation in order to beef up growth or reduce relative debt. The Fed in the U.S., as well as Bank of Canada, generally considers ideal a modest rate of inflation in the range of 1 to 3 percentage points a year. That promotes growth only slightly, warding off deflation. An aggressive inflationary policy may be pursued under some circumstances than under others. When a country is under extreme economic duress, the Fed comes to the fore, bringing about profoundly inflationary policies with a view to ameliorating the deep distress the economy is undergoing.
When an economy is under duress, a riskier form of inflationary policy may take the form of expanding the currency supply, printing money [which you also alluded to in your initial question] or debasing metallic currency to produce more money.
(2) IS MONETARY POLICY NEEDED? IF SO, WHY INFLATIONARY POLICY?
First, when money supply is increased, the interest rate falls, thereby raising the levels of investment spending. The increase in spending will increase the level of aggregate demand. This will push the economy to full employment and beyond. As a result, real GDP would be unable to rise any further and the full impact of the increase in money supply would be on the price level.
This tells us one side of the story: IF MONEY SUPPLY IS INCREASE TOO MUCH, THE RESULT WILL BE DEMAND-PULL INFLATION –too much money chasing too few goods.
History is replete with examples of such serious inflation. Even when seventeenth- and eighteenth-century European nations were tied to the amount of gold reserves held by their governments, shiploads of Spanish gold bullion from the New World [where you and I are sitting] continued to spur inflation. Germany in the 1920s, or Russia in late 1998, also experienced serious inflation.
Second, since we know normal economic growth results in increased demand for money, if in such a situation we keep money supply constant at the same time, the result will be higher interest rate. This will reduce investment spending and crimp aggregate demand, causing economic growth to screech to a halt, maybe resulting in fall in real GDP. Suchlike situation occurred in the U.S. in the 1930s, when the Fed contracted the money supply in the face of falling aggregate demand. And you must have heard from your business studies background about the depression of the 1930s.
This tells us the other side of the story: IF MONEY SUPPLY IS NOT INCREASE SUFFICIENTLY, THE RESULT WILL A RECESSION AND LOW ECONOMIC GROWTH.
Therefore, monetary policy is needed. Sometimes it must go hand in hand with fiscal policy. Monetary policy can be either contractionary (deflationary) or expansionary (inflationary). Expansionary or inflationary policy aims at broad control over an economy for getting the economy out of distress and for spurring growth.
(3) INFLATIONARY MONETARY POLICY: THE MONEY-CREATION TOOL
The Fed resorts to open-market operations, buying bonds in open market with the view of contracting money supply with its tight-money policy, or selling bonds in open market with the view of expanding money supply through deposit creation . The Fed can influence increase in money supply by modulating the “reserve ratio” [call it z]. As a business student you already know that, when the Fed buys Treasury bonds R, that R is deposited in commercial banks, (1-z)R is loaned out by commercial banks at first go, then that (1-z)R is deposited, and the chain reaction is set in motion, till “in the limit” the change in money supply is wrought out by the “multiplier effect” to:
dM = (1/z)dR
where d stands for “a positive change in” or “an increment in,” M for “money supply,” and dR for “initial reserve increase.” [If you don’t get it, skip this, and you won’t lose much.]
The Fed may pursue something called “target for the overnight rate” which is closely related to the “bank rate.” This is just for your reference, and don’t worry about this if that doesn’t seem familiar to you.
Sometimes, the Fed may simply inform the financial community, by way of pronouncements, by public or private discussions, and by other means, of the direction it would like to go. This is given the euphemistic title “moral suasion.”
Hence, broadly, the four tools of monetary policy –be that contractionary or expansionary –are taken up by the Fed:
1. Open-market operations
2. Setting the bank rate
3. Switching government deposits
4. Moral suasion.
(4) THREE APPROACHES TO MONETARY POLICY
First, Keynesian Monetary Policy. This is to regulate credit and currency in the best interests of the nation, and to mitigate by its influence fluctuations in the general level of production, trade, prices, and employment. Here your question of expansionary monetary policy towards taming inflation and creating employment comes into picture only indirectly, as Keynesian monetary economics fails to give a straightforward solution.
Second, the Phillips Curve: Criticism of Keynesian Monetary Policy. You may by now already know that the British economist Phillips found out that it is almost impossible to reduce unemployment and reduce inflation simultaneously. His econometric studies have stood the test of times and corroborated by economists in subsequent times. Nobel-laureates Samuelson and Solow gave the name “Phillips Curve.”
Third, Monetarist School. They believe that monetary changes have an uncontrollable impact on the economy, and as such the money supply should not be left in the hands of central bank authorities, to be changed at their whim in an effort to fine-tune the economy. They argue that the interventionist role of the central bank should be replaced by monetary rules: that the bank be restricted to following certain established rules so as to create a stable and predictable economic climate which will be beneficial for all.
(5) EXPANSIONARY MONETARY POLICY: INFLATION AND UNEMPLOYMENT
Yes, Luis, here we have to bring into our discussion a simple graph showing the relationship between inflation and unemployment on the one hand, and between wages and unemployment on the other, as given by the Phillips curve. Please refer to the first Image.
The short-run Phillips curve shows inverse relationship between inflation and unemployment. The wage-change scale on the right-hand vertical axis is higher than the left-hand inflation scale by the assumed 1 percent rate of growth of average labour productivity.
The relationship between prices, wages and productivity gives is the following:
[Rate of inflation] = [rate of wage growth] – [rate of productivity growth]
The above Samuelson equation shows the relationship between price inflation and wage inflation.
(6) THE RELATIONSHIP BETWEEN PHILLIPS CURVE AND AD-AS EQUILIBRIUM
Let’s see why the Phillips curve behaves the way it does. That is, what’s the raison d’étre of The shape of the Phillips curve in terms of Aggregate Demand and Aggregate Supply, as we have already stated under the rubric (1) above.
Take a look at the second Image. The rust-coloured Phillips curve simply shows the combinations of inflation and unemployment that arise in the short run as shifts in the blue-coloured aggregate-demand curve (such as from low AD to high AD) move the economy along the purple-coloured short-run aggregate-supply curve(SRAS).
Suppose a price level of 100 for year 2015 and possible outcomes for year 2016.
The left panel shows the model of aggregate demand and aggregate supply. If AD is low, the economy is at X, Output Q=7500, and P=102. If AD is high, the economy is at point Y, Q=8000, and P=106.
The right-hand panel shows the implications of the Phillips curve. At X, when AD is low, there is high employment (7%) and low inflation (2%). At Y, as AD is high, there is low unemployment (4%) and high inflation (6%).
You can also relate it to similar macroeconomic reasoning that, when aggregate demand goes up, more is produced; to produce more, firms employ more workers; that leads to higher income; that, in turn, leads to even higher demand. A multiplier effect is set in motion. On the other hand, as demand increases, prices also increase. That leads to higher cost of production as workers demand higher wages, thereby goading price level higher up.
The relationship between inflationary monetary policy and unemployment depend on many variables and parameters, and the appropriate monetary policy to be pursued has to be well thought out in terms of the goals to be pursued by the country.
I hope, Luis, I have been able to give you a full-dress explanation of your query. Best of luck.
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QUESTION: I deeply appreciate your incredibly detailed explanation. I don´t want to take much more of your time but I´d like to note the following:
You wrote " The increase in spending will increase the level of aggregate demand. This will push the economy to full employment and beyond. As a result, real GDP would be unable to rise any further and the full impact of the increase in money supply would be on the price level. " I agree with your statement. However, we have examples of countries with high unemployment levels and still fairly high inflation levels (take Mozambique and other developing countries for instance). So, even if labor is not in full employment levels, it may happen that expansionary policies result in high inflation (which may, in turn, I believe, decrease real GDP in extreme cases). Is that due to lack of real investment? high uncertainty levels, high country risk, and/or lack of faith in the currency of the country? Or, maybe, lack of labor skills and education which creates a form of structural unemployment? Or even a mix of all these factors?
Thank you once more
Thank you for your agreement with my statement and for your overall understanding of the topic under question.
I can understand you have got a mature and in-depth grasp of the many-sided complexity of the somewhat elusive macro-dynamic phenomenon – the negative correlation between inflation and unemployment as typified in Phillips curve vis-à-vis the positive correlation between inflation and unemployment embodied in stagflation –that, by its variegated visitations on divergent economies of the world, has plagued economists, Keynesians and non-Keynesians alike. And I am glad to assist a perceptive student like you.
In my previous answer to your question, I presented you with somewhat detailed analysis of “usual and econometrically tenable” positive relationship between inflation and unemployment. That is what today in general a nation is up against, especially when the “double whammy” of inflation and unemployment doesn’t appear to haunt the economic landscape. However, transitory or even evanescent as this twin monster of economics may be [by the way, Mozambique seems to have got over it], that is a real phenomenon overhanging unwary nations. So, though that should be construed as not normal, it is worthwhile to have a quick rundown on it in view of your follow-up question.
To begin with, you are right that here may be “high unemployment levels and still fairly high inflation levels.” The reasons you have put forth are admissible under specific circumstances, no doubt. The germ of this new economic malady facing industrial world in fact lies in the perturbation of our same economic apparatus we applied in explication of the answer to your question – some in-place and queasy disturbance in our model of aggregate demand and aggregate supply. This we term “supply shock.” Let’s see how it turns out in view of what you have asked.
SUPPLY SHOCKS AND STAGFLATION
Supply shock is characterized by a sudden change in conditions of cost or productivity that shifts aggregate supply. As Samuelson tells us, supply shocks occurred with particular virulence in 1973, called the “year of seven plagues” (crop failures, shifting ocean currents, massive speculation on world commodity markets, turmoil in foreign-exchange markets, and a Mideast war that led to the quadrupling of the price of crude oil).
That caused wholesale prices to rise dramatically. Inflation mounted sharply. Real output fell. The U.S. experienced stagflation –a dismal combination of stagnation (with consequent rise in unemployment) and inflation. Have a look at the attachment. The fall in aggregate supply (AS), shown by a leftward shift of the AS schedule, causes output Q to decline and price level P to rise. The rise in price level is inflation, and the fall in Q results in reduction in employment, and a negative multiplier effect comes into play.
The Fed under Paul Volcker applied the strong medicine of “tight money” in a contractionary monetary policy, and by 1980, the stock market fell and credit was hard to find, slowing spending by consumers and businesses. There was overall decline in housing construction, automobile purchases, business investment, and net exports. Well, the reward for these austere measures was a dramatic decline in inflation, from 12% to 4%, bringing to an end the age of inflation. But the U.S. paid for this achievement through higher unemployment and lower output during the period of tight money. This, Luis, may give you an inkling of how inflation and unemployment can move in the same positive direction.
Make no mistake, that resolute stand set the stage for long economic expansion from 1982 through 1997, real GDP growing at an average rate of 3% a year, with price inflation averaging slightly above 3%. True, the growth is also attributable to growth in inputs of capital, labour, and even land, with enhancement of efficiency. And the fiscal policy was also to play a role in tandem.
Luis, this is a deep topic, and one can even go into a Ph. D. dissertation. Suffice it to say that “a mix of all these factors,” as you have referred to, could be the omnibus black sheep behind such seemingly intractable macroeconomic problem. I hope I have been able to introduce you to the basic food for further munching and cutting into this extraordinarily fascinating economic imbroglio. [By the way, I like your correct style of English, with good punctuation, which is rare among students asking me questions.] Bon appetite!