Economics

Boosting the economy using inflation: analysis of the risks of this vicious circle

The Phillips curve (named after A.W. Phillips, an economist from New-Zealand) displays a positive link between higher inflation and lower unemployment:

Phillips Curve (1958)

It argues that if businesses hire more people their production costs increase as they have more salaries to pay. Consequently they raise the prices of their products to keep constant margins.

Conversely, if unemployment increases consumers have less disposable income and demand for products decrease.  Therefore businesses have to lower the price of their product in order to sell it.

So would inflation help to stimulate employment? This is what many economists of Keynesian tendency assert.

However other economists belonging to the monetarist tendency have modified this model and have reached the conclusion that inflation can stimulate unemployment but only in the short term.  

The Phillips curve in the model by R. Barro (1983)

U = the rate of unemployment.

Un = the  “natural” unemployment rate (this takes into consideration, amongst other things, the time-lag between losing a job and finding another)

π = the real inflation.

πe =the inflation expected by the population.

So, π – πe = the unexpected inflation. When π = πe, then the unemployment rate is at its long-term level (Un). Usually, inflation is correctly foreseen in the long term (LT).

α = the parameter, or degree, of sensitivity of the unemployment rate to the unexpected inflation rate.

The formula U = Un – α (π – πne)  therefore expresses the fact that the unemployment rate evolves contrary to the unexpected inflation rate: when one increases, the other decreases.

So why does inflation not help to reduce unemployment in the long run?

If π > πe (i.e. part of the real inflation is unexpected), then purchasing power (real salaries) will decrease, as nominal salaries (the one indicated on your pay-roll) won’t have increased at the same rate as inflation.

As real salaries are lower than expected, production costs are also lower, and businesses are encouraged to hire more people. This is shown by the curve from A to B on the graph above (higher inflation, lower unemployment).

But employees will eventually realize that their purchasing power has decreased, so at the next round of pay negotiations, they will ask for nominal wage rises in order to offset the prior decrease of their purchasing power. So, real salaries will increase, as well as production costs. Businesses will then cut their workforce in order to keep constant margins. This is shown as B to C on the graph (same inflation, higher unemployment).

And so the pattern follows: C → D; D → E etc.

Conclusion

Some countries, such as Germany, are very credible in implementing low-inflation policies, so that the expected inflation (πe) remains low and the Phillips curve (in blue on the graph) does not go up too high. So, real inflation remains low.

Other countries, such as Italy, are historically less credible in controlling inflation, so that expected inflation is much higher and this leads to a higher real inflation. This has huge consequences for the economy and for society.

Another conclusion that we may draw from this model is that unemployment cannot be decreased by resorting to inflation: structural reforms of the labour market are necessary to reduce it in the long run.

So, it appears  unnecessary to ask the ECB to solve the crisis in the absence of satisfying political initiatives.

Pierre-Antoine KLETHI

(edited by Jessica Bethom)

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s