EC566 Macroeconomics

EC566 MacroeconomicsEssay Discuss the role of government policy in reducing unemployment and inflation. In your discussion make use of the diagrammatic representation of the macro economy developed in lectures in Term 2.

To approach the topic it will first be considered the meaning of both inflation and unemployment by looking at the causes and tools that are used in order to reduce them. Furthermore a comparison between unemployment and inflation will be provided. To summarize, a critical opinion will state which of the two has a greater impact upon the economy, and whether inflation and unemployment can both be reduced at the same time.

Inflation represents the rate of increase in price for goods or services over a period of time, usually a year, which has majority of weight. It is measured in by the Consumer Price Index (CPI) which is based on the cost of a basket of necessities consumers are likely to buy per month. Inflation can be influenced by a growth in consumer-demand (demand-pull inflation), and increase in the costs of producing goods and services (cost-push inflation).There are many different influences that cause inflation, but as stated before the two main ones are the demand-pull and cost-push inflation. Demand-pull inflation appears when Aggregate Demand(AD) exceeds Aggregate Supply(AS), and it has an inverse relationship to unemployment. Such inflation might arise from any individual factor that is included in the AD equation, but the main ones are the excess of money supply and the government spending.Fig1

As seen in Fig1 AD shifted to AD1, increasing prices for goods or services (P0 to P1) and quantity (q0 to q1), while decreasing unemployment from L0 to L1, Ln representing the total number of people in work or actively seeking work. The decrease in unemployment is represented by the fact that firms are producing more, therefore they hire more employees, and at the same time, if GDP increases, fewer companies will go bankrupt meaning fewer job losses.An increase in wage rates or price of raw materials, higher costs of production and other increasing costs can result in cost-push inflation. Opposite to demand-pull inflation, cost-push inflation appears when there is a decrease in the Aggregate Supply. Due to the increased costs, firms lower their output and decrease the labour employed, therefore the unemployment gap in this case gets deeper. Cost-push inflation can be both internal such as increase in domestic service prices, or external, a rise in price of oil. As seen in Fig2, AS shifted to AS2 forcing the prices to increase from P to P2, while the total value of goods and services produced decreased from q to q2. At the same time, unemployment increased from L to L2 due to the fact that firms might cut costs in order to remain competitive.Fig2

Inflation control has become a major objective for the government economic policy in many countries and effective policies need to be implemented in order to stop or stabilize it. If the main cause of inflation is an excess in AD as in Fig1, the government should look to reduce the level of aggregate demand. If cost-push inflation is the cause as in Fig2, production costs need to be controlled for the problem to be reduced. Monetary and fiscal policies need to be put in place in order to get the economy balanced, and have the inflation under control. Since May 1997, the Bank of England for instance, has had operational independence in setting interest rates within the UK, the aim being to keep inflation under control for the next two years. This monetary policy can control the AD through an increase in the interest rates and a reduction in the money supply. As an example, in the late 1980s, interest rates went up to 15% because of the excessive growth this contributing to the recession of the 1990s. The result of higher interest rates is represented by a decrease in investment, disposable income, and borrowings by both households and companies. Higher interest rates can also be used to reduce monetary inflation, because a reduced demand for lending would result in a reduced growth of broad money. At the same time, an increase in the interest rates can result in the appreciation of the exchange rate which would make British exports more expensive. Furthermore, a stronger currency would reduce the import prices giving firms the ability to keep prices down by acquiring cheaper raw materials (Tutor, 2013). As a fiscal policy in order to reduce inflation, the government should increase the taxes, and reduce the government spending in order to lower the disposable income for households, which in return will result in a lower consumption. Moreover, increased taxes will mean fewer profits for the firms, meaning less investment, fact which will lower the AD within the economy. Unemployment rate can be defined as the number of people that are actively seeking or having a job, divided by the total amount of people that are having the legal working age. If there are 10 people of working age, out of which 8 are in work or actively seeking work, but just 7 of them are currently in work, the total rate of unemployment would be 12.5% because 8-7=1, therefore 1 unemployed person is divided by the total number of people looking for a job or in work.There are several facts that influence unemployment, but the main causes that can best describe it are the supply side policies: structural, frictional, seasonal, and cyclical type. The structural type of unemployment occurs when there is a decline in demand in an industry leading to a reduction in the number of people employed. Frictional unemployment can be translated as an transitional type and it refers to people that are moving between job because of various reasons, while the seasonal type refers to a predictable seasonal change in labour patterns in which some industries might be more or less affected than the others, depending the activity they are performing. At last, the cyclical type occurs when there is a lack in demand for goods and services, leading to a recession or a slowdown in economic growth. The best example for the cyclical type of unemployment is the recent financial crisis that increased the unemployment level to alarming figures, Greece being one of the most affected countries within the EU with a rate of 26.4% in 2013 (Tradingeconomics, 2013). Overall these supply side policies do not aim to boost AD, but seek to overcome flaws in the labour market in order to reduce the unemployment caused by the supply-side factors. Monetary and fiscal policies need to be implemented by the government in order for unemployment to decrease, stop, or stabilize at an acceptable level for the economy. On one hand, according to Keynisianism, government intervention in implementing fiscal policies can reduce unemployment. As mentioned earlier cyclical unemployment occurs in times of great economic depression, but it can be influenced in a positive way by increasing the AD. This can be achieved by cutting taxes and increasing government spending, resulting in an increased AD. Lower taxes could mean an increase in consumption due to the fact that prices are lower, thus people can afford more. Firms will produce more; therefore, an increased demand will be on the labour market as well. Increased government spending can result in creating more jobs ultimately this fact influencing the GDP to grow. On the other hand, monetary policy would involve cutting interest rates to decrease the cost of borrowings in order to encourage people to spend and invest more. This would increase the AD and the real GDP, and reduce the demand-deficient unemployment. At the same time, lower interest rates would result in a depreciation of the exchange rate which will make the exports more competitive. When comparing the government policies both for unemployment and inflation, it can be seen that are totally opposite, because when unemployment is low, inflation is high and vice versa. On one side, government spending needs to be cut in order to reduce inflation. On the other side, according to Keynisianism, government spending should increase during recessions or periods of financial uncertainty in order to create additional demand to reduce unemployment. This relationship between inflation and unemployment is represented by the Phillips curve (Fig3) where, inflation is inversely related to unemployment. According to Friedman in response to the Phillips curve, if the government uses expansionary fiscal and monetary policies to lower the unemployment rate, the result in increasing demand for labour and increasing consumption and spending, would encourage firms to raise their prices faster than people anticipated. With higher profits, firms would be willing to offer higher wages, and employ more people. Thus, the unemployment rate falls. For a short period of time, workers will suffer for what is known as money illusion, because they will think that with higher wages they can afford more, where the reality is that when wages increased, inflation increased as well. Over time the firms come to anticipate the higher rates of price inflation, therefore they will supply less labour in order to keep up with current inflation. The real wage is restored to its past level, and the unemployment rate goes back to its previous rate, while price inflation and wage inflation brought on by expansionary policies continue at the new higher rates (Econlib, 2013).Fig3

Some argue that where is a chance of deflation, government should seek to look for a higher rate of inflation (e.g.3-4%), in order to keep the economic growth sustainable and avoid a recession. But, even if inflation definitely has economic costs, however, others argue that costs of unemployment are far greater, because lower income will result in less consumption, lower tax revenue, increased government borrowings, and higher government spending on benefits. In the end, governments are limited in the number of objectives they can achieve on short-term. As a result, they cannot put pressure on all the aspects such as inflation, unemployment, economic growth and currency stability, all at the same time. This cannot happen, because the policies all together will end up being incoherent. Therefore when considering the fiscal approach they need to first look at the magnitude and risk it poses in the first place.

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