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Module 20 Inflation and employment

National income Y
Potential output Q
Q=Y unemployment rate is full employment unemployment rate.
Y < Q demand deficient unemployment
Y > Q - deflationary policies needed to prevent inflation. Inc tax or red G. or reduce
Provide choice for politics and policies INF vs EMP
Zero Inf requires 8% unemp.
Full emp( at natural unemp of 4.5) it costs 2% inf.
20.2 Causes and effects of inflation
Varies but persistence. Undesirable social and economic
First, inflation impairs the efficiency of the price mechanism and raises the costs of
and selling because money becomes less reliable as a standard of value.
Second, inflation penalises people on fixed incomes and favours those whose
incomes adjust quickly to price changes.
Third, inflation favours borrowers and penalises lenders so long as it is
Fourth, given a system of unindexed taxes, namely one where tax thresholds are
in money terms rather than real terms, inflation will redistribute resources from the
to the public sector
Fifth, a continuing higher rate of domestic inflation than that experienced in other
can lead to increased imports and reduced exports and can create potential
for stable exchange rates.
Continued inflation
will lead to an adjustment in behavior patterns which can mitigate some of the
consequences, but inflation can never be fully anticipated.
Thus, economic agents have to anticipate the relative price changes that
any general price inflation, and a failure to anticipate these relative price changes
will have
distributional effects and impair the efficiency with which markets operate.
Previously normal cycles of growth and inflation and stability with some recession in
business cycle.
After WW2 sustained global inflation.

2 schools of explanations;
The demandpull explanation sees price rises as a consequence of excess demand
goods and services. Cannot increase output so prices increase. Increase in salary
caused extra demand.
costpush models - The costpush explanation of inflation sees price
rises as a consequence of bargains struck in the factor market, which raise the
costs of employers, who then pass on higher costs in the form of higher prices.
Costpush inflation is more likely to occur in economies where prices and wages are
flexible downwards
Excess demand will raise prices and wages, but deficient demand will not
lower prices and wages.
In short, faced with an increase in money wages, the monetary authorities can
either hold
the money supply constant or prevent it rising at the same rate as wages, with
falls in output and more unemployment, or they can increase the money supply to
allow a
sufficient level of monetary demand to sustain the same output at higher prices. A
version of the costpush hypothesis is that the latter policy will be chosen because
authorities prefer higher prices to higher unemployment that is, the money supply
considered to be endogenous, reacting to the wage levels set in the labour market
allowing these to work through to higher prices without reducing output and
In these circumstances, monetary policy is said to be permissive. Instead of
controlling the
money supply to prevent inflation, the monetary authorities condone costpush
inflation by
allowing the money supply to increase and thus ratify higher price levels without
costs on employers and employees through lost output and employment.
Two additional factors can be added to the costpush hypothesis; imported inflation
expectations inflation.
First, if the demand for imported goods is relatively price- or income-inelastic, then
a rise
in the prices of imported goods will be reflected in higher inflation rates.
Second, economists have long been aware of expectations but it is only

recently that they have incorporated expectations into economic models. The three
common assumptions used in building models including expectations are:
(a) expectations are static;
(b) expectations are adaptive; and
(c) expectations are rational.
Thus when a government is faced with an inflation rate of, say, 10 per cent, it would
useful to know how much of the 10 per cent is due to demandpull factors and how
much is
due to costpush expectations and imported factors. Why? The answer is because
policies appropriate for dealing with one case of inflation may be very different from
appropriate for other cases.
20.3 Anti-Inflationary Policies
The difficulty of determining the cause of inflation can be illustrated by reference to
Phillips Curve shown in Figure 20.4. Given an unemployment rate of 23 per cent
and a rate
of wage change of 2 per cent, price stability will result. The rate of change of prices
is shown
along the right-hand axis. If productivity is rising at 2 per cent, then it follows that a
2 per cent increase in money wages will be consistent with price stability. Given a
Curve as shown, such a rate of increase of money wages would occur at a level of
of 23 per cent.

Pg 11.