Tradeoff between unemployment and inflation

By | July 13, 2013

1.1    Rationalize the tradeoff between unemployment and inflation

1.1.1            Phillips Curve

 

Figure Phillips Curve: relationship between unemployment and inflation

Source: Glanville, A. and Glanville, J. 2011. Economics from a global perspective. Winkleigh, EX: Glanville Books. p.255

 

In 1958, a New Zealand economist, A. W. Phillips, published a study of the relationship between the unemployment rate and the rate of change in wages in England. He found that over the period from 1826 to 1957, there had been an inverse relationship between the unemployment rate and the rate of change in wages. The unemployment rate fell in years when there were relatively large increases in wages and rose in years when wages increased relatively little. Phillips’s study started other economists searching for similar relationship in other countries. In those studies, it became common to substitute the rate of inflation for rate of changes in wages (Boyes & Melvin 2009 p.346). The founding of the Phillips Curve carries a relatively negative message to the government policy makers because reducing the unemployment below a certain level would probably result in the increase the inflation in the economy, i.e. a point move from C to B would reduce the unemployment rate from 5.5 per cent to 4 per cent but it pushes up the inflation rate from 0 per cent to 2 per cent. Similar scenario could also be found during the movement from point B to point A. Therefore, there is an inverse relationship between inflation and unemployment. When the unemployment rate is low, inflation tend to increase. Inflation tend to decrease when the unemployment rate is high. In the next section, we will analyze the evidence of the Phillips Curve.

 

1.1.2            Evidences of Phillips Curve

 

Figure 6 A Philips Curve for the United States

Source: Baumol, W. & Blinder, A. 2011. Economics: Principles and Policy. Natrop Boulevard: South Western Cengage Learning, p. 673

 

As we have analyzed, if fluctuations in economic activity emanate from the supply side, higher rates of inflation will be associated with higher rates of unemployment, and lower rates of inflation will be associated with lower rates of unemployment. In the US, the supply shocks of the 1970s stand out clearly in the figure above. With food prices soared from 1972 to 1974, and again in 1978. Energy prices skyrocketed in 1973 to 1974, and again in 1979 to 1980. Obviously, the inflation and unemployment data generated by the US economy in 1972 to 1974 and in 1978 to 1980 are consistent with the model of supply side inflation and result in the increase of the unemployment rate.

 

1.2    Factors policymakers need to consider

 

1.2.1            Tolerance of the residents, in particular the poor people

 

Though many government are hoping that with the cost of high inflation, the faster economy growth would be sustained which in the longer term benefit the people eventually. But one factor that any governments with this plan need to consider is the tolerance of the residents, in particular the poor people to the higher price. Take China as an example, its rapid economy has been widely admired by other nations, and the unemployment rate has been kept in a lower level in particular considering the fat the fact that more and more labor from the rural areas are entering into the labor market, but this comes at the cost of higher inflation rate as the figures below indicate. .

 

Figure 7 China inflation rate

Source: tradingeconomics.com 2012

 

 

Figure 8 China unemployment rate

Source: tradingeconomics.com 2012

 

Analysts say the causes of inflation are complex, but key factors include a surging money supply — up 47 percent since 2009, according to Jing Ulrich of J.P. Morgan. The continual positive inflation have resulted in the difficult life of many people in particular the poor. One of the indicators of this fact is the Gini Index, officially, it is somewhere around 0.45-0.5, similar to the United States. But a landmark study in 2010 on unreported income, by the economist Wang Xiaolu at the China Reform Foundation, found that hidden income totaled $1.5 trillion, with 80 percent in the hands of the richest 20 percent. That would put China’s Gini index at over 0.5, on par with many South American countries, and, if trends continue, headed for the income inequality of much of Africa (nytimes.com 2010). And in reality, many people in China are still struggling to buy a house in the large cities such as Beijing, the million worth houses could take up saving of more than three generations in a typical Chinese family, and life of the middle class is also not easy nor to mention the low income class.

 

1.2.2            Economy plan of the government

 

Planning is an economic mechanism for resource allocation and decision-making held in contrast with the market mechanism. Economic planning can apply to productioninvestmentdistribution or all three of these functions. Because usually economy plan are scientifically designed according to the industrial cycle as well as the investment cycles, therefore the economic planning should be adhered accordingly if there should not be any big changes. Therefore, we will say that if the economic development causes a little inflation during an economic cycle, it would not be advisable that the government control the price immediately after the raise of the inflation rate because the control of such inflation would discourage the companies in their initial investment stages. In a word, the government not only should take care of the price fluctuation but also it should take into consideration of the business cycles and ensure that the continual business activities would not be hardly interrupted by the price control methods.

 

1.2.3            The gap between the rich and poor

 

As we know the gap between the rich and poor in many counties grew at the same pace as the economic growth. And as discussed above, those with fixed incomes who are usually relying on salaries to live would also face challenges from the inflation in particular when their salaries would not increase after the happening of the inflation, but in contrast, inflation is welcomed by entrepreneurs and business men as they stand to profit from the raising prices. As a result, the inflation would also redistribute the fortune among the people and the rich people become richer while the poor people become poorer. This will certainly contribute to the increase of the gap between the rich and poor. Since the side effects of the enlarged gap between the rich and poor would bring a number of social and economical issues, the government should also take into consideration of the gap between the rich and poor.  

 

 

Reference

 

Bls.gov 2010. Producer Price Indexes: Frequently Asked Questions (FAQs). Viewed on 25th Jun 2012 [online] via: http://www.bls.gov/ppi/ppifaq.htm

 

Boyes, W. & Melvin, M. 2009 Fundamentals of Economics. Natrop Boulevard: South Western Cengage Learning. p.346

 

channelnewsasia.com 2010. Malaysia unveils bold plan to transform economy. Viewed on 25th Jun 2012 [online] via: http://www.channelnewsasia.com/stories/afp_asiapacific_business/view/1082499/1/.html

 

Delaney, P. R., Whittington, R. & Delaney, P. R. 2012, Wiley CPA Exam Review 2012, Business Environment and Concepts. New Jersey: John Wiley & Sons. p.132

 

Source: Baumol, W. & Blinder, A. 2011. Economics: Principles and Policy. Natrop Boulevard: South Western Cengage Learning, p. 673

 

cmsfx.com 2008, Lesson 6: Fundamental Analysis. Viewed on 25th Jun 2012 [online] via: http://www.cmsfx.com/en/forex-education/online-forex-course/chapter-2-fundamental-factors/fundamental-analysis/inflation-indicators/

 

Deepashree & Agarwal, V. 2007, Macroeconomics. New Delhi: Tata McGraw Hill. p.6

 

ezinearticles.com 2009. The Four Economic Benefits of Inflation. Viewed on 25th Jun 2012 [online] via: http://ezinearticles.com/?The-Four-Economic-Benefits-of-Inflation&id=2102601

 

ft.com 2012. Caution over easing Asian inflation. Viewed on 25th Jun 2012 [online] via: http://www.ft.com/cms/s/0/fd7d3376-3cfc-11e1-8129-00144feabdc0.html#axzz1zKrv4iB7

 

Glanville, A. and Glanville, J. 2011. Economics from a global perspective. Winkleigh, EX: Glanville Books. p.255

 

Greylin, C. 2008, X-kit FET Grade 12 ECONOMICS. Cape Town: Pearson South Africa, p.164

 

Gwartney, J. D., Stroup, R. L., Sobel, R. S. and MacPherson, D. 2009 Macroeconomics: Public and Private Choice. Natrop Boulevard: South Western Cengage Learning. p.183

 

Lipsey, R. G. & Harbur, C. 2004, First Principles of Economics. Oxford: Oxford University Press. p.430

 

nytimes.com 2010. Cost of Living Increasingly a Struggle for China’s Poor. Viewed on 25th Jun 2012 [online] via: http://www.nytimes.com/2010/12/10/world/asia/10iht-letter.html?pagewanted=all

 

Shaikh, S. 2010, Business environment. New Delhi: Pearson Education India. p.323

 

Stonecash, R., Gans, J., King, S. & Mankiw, G. 2011, Principles of Macroeconomics. Natrop Boulevard: South Western Cengage Learning, p.162

 

tradingeconomics.com 2011. Money and quasi money (M2) (current LCU) in Malaysia. Viewed on 25th Jun 2012 [online] via: http://www.tradingeconomics.com/malaysia/money-and-quasi-money-m2-current-lcu-wb-data.html

 

tradingeconomics.com 2012. Malaysia Inflation Rate. Viewed on 25th Jun 2012 [online] via: http://www.tradingeconomics.com/malaysia/inflation-cpi

 

uobgroup.com 2011. Asian Fuel Subsidies Cuts: Impact on Inflation, Interest Rate & FX Policies. Viewed on 25th Jun 2012 [online] via: http://www.uobgroup.com/assets/pdfs/research/Asia-Focus_3q08.pdf

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