Case 1

Disinflation in Europe and Japan

An erosion of market power?

Compared to their US and Japanese rivals, European businesses used to have a reputation for
raising prices to make more profits. In an economic environment where inflation was
endemic, business could easily hide from its inefficiencies and adopt this short-term strategy.
However, following the recession of the early 1990s – Europe’s worst recession since
the war – attitudes and practices seem to have changed, and potentially for the better.
European business seemed to be adopting a more competitive way of doing business. The
result, especially in the early 2000s, when demand was growing relatively slowly again, was
that prices fell in many sectors.
This process was known as ‘disinflation’. It resulted largely from changes in the external
business environment. Here slow growth, financial restraint by central banks attempting to
keep inflation within limits, and fierce global competition led many firms to question whether
price rises are necessary or justifiable.
One of the main sources of competition was from low-cost countries, such as China and
India. Cheap imports from these countries put downward pressure on competing industries in
Europe. What is more, outsourcing call-centre, back-office and IT work to developing
countries put downward pressure on wages. This downward effect on prices and wages has
been dubbed the ‘China price’ effect.
Japanese business found itself in a very similar position to many European countries.
It too experienced a lengthy recession, in which prices fell as businesses tried to shift
unwanted stocks. In addition, the high value of the yen and the subsequent reduction in the
cost of imports stimulated a huge rise in foreign competition, which succeeded in forcing
prices down yet further.

The benefits of disinflation

Are general reductions in prices a good thing or a bad thing? The answer to this largely
depends upon whether you are a consumer or producer, whether you are looking at the short
or long term, and whether any price reduction is met by higher productivity gains and not
redundancies.
In the short term, consumers will clearly benefit from lower prices: in effect, their real
income will rise (assuming no corresponding fall in wages). Over the longer term, both
producers and consumers are likely to gain as lower underlying rates of inflation enable
governments to reduce interest rates. For business this means cheaper capital and greater
opportunities for investment and growth.
The down side to disinflation is whether it can be achieved without a massive impact
upon levels of income and employment. If businesses simply respond to lower prices, and
hence profit margins, by making workers redundant, income levels may begin to fall,
stimulating a downward spiral of demand. Thus the key to successful disinflation is to offset
falling prices with greater efficiency. Those firms unable to meet these new stringent
efficiency goals will not be able to generate profits from higher prices, and will invariably
become ripe for takeover by those that can.
A return of inflation?
The US and other OECD economies staged a rapid recovery after 2003. Between 2004 and
2006, OECD countries’ economic growth averaged 3.1 per cent. These rates, however, were
dwarfed by China and India, which experienced growth rates of 10.1 per cent and 8.4 per cent
respectively over the same period.
The rapid growth in aggregate demand in many OECD countries put upward pressure
on prices and wages. At the same time Chinese prices were no longer having the same
downward effect on prices in the rest of the world. Indeed, rapid growth in the Chinese
economy was beginning to reinforce this upward pressure. As The Economist of 24 June
2006 stated:
China's excessive growth is not only of domestic concern. With much of the world
increasingly worried about inflation, questions arise about what an overheating Chinese economy
could do to global prices. It seems strange to worry about China exporting inflation – as Mervyn
King, governor of the Bank of England, did recently – when the country's consumer-price inflation
is less than 1.5% and its vast manufacturing (over)capacity has led to a steady drop in global
goods prices from shoes to electronics. For the past few years, China's deflationary impact on
manufactured goods – known as the “China price” – has outweighed its inflationary effect on
commodities and capital goods.
But that balance may be changing, argues Jonathan Anderson, an economist at UBS in Hong
Kong. “Current data [in China] show that we are on the verge of an inflationary correction that will
have a cyclical impact at home and abroad,” he says. After being squeezed between rising input
costs and falling factory-gate prices, China's manufacturers are starting to raise prices to rebuild
margins – and getting away with it because both domestic demand and exports are still far
stronger than they were two years ago. Add in higher domestic food and energy prices and
surging labour costs, and the China price may soon be a good deal higher.

So is the effect of globalisation no longer having a disinflationary effect? The answer is a

qualified no. It is true that the rapid growth in China and many other developing countries is
helping to drive up commodity prices and also helping manufacturers to raise prices
somewhat. But the world economy is generally becoming more competitive. Manufacturers
in Europe, Japan and North America are still acutely aware that their scope for raising prices
is very limited and many are still being undercut by cheaper imports.

Questions
1. If prices and wage rates are forced downward, who are likely to gain and who are likely
to lose?
2. What attitudes should trade unions take in such an environment if they are seeking to
maximise the interests of their members?
3. What new strategies have businesses been forced to adopt in order to maintain profits in a
low-inflation economy?
 Case 2
Technology and Employment
Does technological progress create or destroy jobs?

Does technological progress destroy jobs? The obvious answer may seem to be yes. After all,
new technology often involves machines taking over jobs that were previously done by
people.
There is another view, however. This argues that a failure to introduce new technology
and ultimately to remain competitive will offer an even worse long-term employment
problem. Markets, and hence employment, will be lost to more efficient competitors.
The relative merits of each of these views are difficult to assess, since they depend
greatly upon the type of technology, its organisation in the workplace and the market within
which it is located.
We can identify four stages in the effects of new technology on jobs.

Stage (1) Design and installation. Here labour requirements grow as first designers and
then construction workers are employed. As construction/ installation is completed,
employment from this source will then disappear.

Stage (2) Implementation. Here labour requirements decline, especially if the

technology is concerned with improving existing processes rather than creating new
products.

Stage (3) Servicing. Maintenance and repair may have positive employment effects.
This may gradually decrease over time as ‘teething troubles’ are eliminated, or it may
increase as the stock of initially new machines begins to grow older.

Stage (4) Market expansion. This represents the long-term impact of technology on
employment levels as the improved and/or cheaper products lead to more sales.

The optimistic view holds that, historically, technology has generated more jobs than it has
destroyed. Total employment today is much higher than a hundred years ago, and yet
technological progress has allowed many goods and services to be produced with far fewer
workers. What has happened is that increased output has more than compensated for the
growth in labour productivity. There is no reason, say the optimists, why this process should
not continue.
The pessimists, however, are less certain about the potential employment benefits of new
technology. Even in growth industries, such as pharmaceuticals, electronics, optical
technology and high-value plastics, there has been a decline in employment.
But cannot workers who are displaced from high-tech industries simply find jobs in parts
of the economy? There are two problems here. The first is that of structural unemployment.
Displaced workers may not have the skills to take up work elsewhere. Clearly what is needed
is a system of retraining that enables workers to move to alternative jobs. The second is that
of income distribution. If the only alternative jobs are relatively low-skilled ones in the
service sector (cleaners, porters, shelf-packers, check-out assistants, etc.), the displaced
workers may have to accept a considerable cut in wages.
 Questions
1. In what areas of the economy are jobs growing most rapidly? Is this due to a lack of
technological innovation in these areas?
2. Why have rural areas generally seen a smaller decline in high-tech employment than
urban areas, and in some cases seen an increase?

Case 3
Do People Volunteer
to be Unemployed?
The distinction between voluntary
and involuntary unemployment

A distinction made by some economists is that between voluntary and involuntary

unemployment. Many economists would regard equilibrium unemployment as voluntary. If
people choose not to accept a job at the going wage, even though there are jobs available,
then in a sense they could be said to have voluntarily chosen to be unemployed.
Disequilibrium unemployment, according to these economists, would be classed as
involuntary. Workers want to work at the current wage, but there are not enough jobs
available.
Some economists would also include classical unemployment as voluntary. If people,
through their unions, have chosen to demand a higher wage than the equilibrium wage, then
they could be said to have collectively ‘volunteered’ to make themselves unemployed.
According to these economists, then, only demand-deficient unemployment would be classed
as involuntary.
Some economists go even further and argue that all unemployment should be classed
as voluntary. If the cause of disequilibrium unemployment is a downward stickiness in real
wage rates, then workers, either individually or collectively, are choosing not to accept work
at a lower wage.
Other economists would go to the other extreme and claim that all disequilibrium
unemployment and most equilibrium unemployment is involuntary. Structural
unemployment, for example, results from changes in demand and/or supply patterns in the
economy and a resulting mismatching of unemployed workers’ skills to the person
specifications of vacant jobs. Workers can hardly be said to have volunteered for these
changes in demand. True, people can be retrained, but retraining takes time, and in the
meantime they will be unemployed. Similarly with frictional unemployment, if the cause of
some people being unemployed is initial ignorance of job opportunities and hence the time it
takes to search for a job, they cannot be said to have volunteered to be initially poorly
informed.
 The terms ‘voluntary’ and ‘involuntary’ unemployment are not only ambiguous, they
are also unfortunate because they have strong normative overtones. ‘Voluntary’
unemployment tends to imply that the blame for unemployment lies with the unemployed
person and not with ‘market forces’ or with inadequate government policies. While in one
sense, at a low enough wage rate there would probably be a job for virtually any unemployed
person, the unemployed cannot be said to be voluntarily unemployed if they are choosing to
turn down jobs at pitifully low wages.
Although the concepts of voluntary and involuntary unemployment are commonly
used, for the above reasons we shall avoid them.

Question
If I offered a job to someone to clean my house at 1p per hour, and unemployed people chose
not to take the job, should they be classed as ‘voluntarily’ unemployed?

Case 4
Classical Remedies for Unemployment
Or how to make the problem worse!

Keynes rejected the classical remedies for unemployment. According to Keynes, they were
more than just useless: they actually made the problem worse. So what were the classical
remedies? And why would they make unemployment worse?

‘People should be encouraged to save. This would reduce interest rates and encourage more
investment, more growth and more jobs’. But if people save more, they spend less. Firms will
therefore sell less. They will thus have idle capacity and will lay off workers. Unemployment
will rise. What is more, firms will be discouraged from investing. After all, what is the point in
installing extra machines when you are not using all of the existing ones?
Keynes called this the paradox of thrift. If the nation becomes more thrifty, it will
thereby become poorer.
‘People should be prepared to take wage cuts. This would reduce firms’ costs and allow them
to take on more labour.’ But workers are also consumers. If people are paid less, they will
spend less and firms will sell less. Firms will thus want to employ less workers, not more.
‘The government should attempt to balance its budget. If the government were currently
running a budget deficit, then it should attempt to eliminate it. This would release resources for
private-sector investment. More investment would lead to more employment.’ But if the
economy is in recession and unemployment is already high, the budget deficit may be quite
large. There are two reasons: a) the government will be spending a lot of money on
unemployment benefit; b) if incomes and consumption are low, tax receipts will be low. To
eliminate the deficit then, the government would either have to raise taxes or have to reduce its
expenditure, for example by reducing the level of benefits. Either way, aggregate demand
would fall and firms would sell less. This would merely encourage them to lay off more
workers. Unemployment would rise, not fall.
‘Reduce the supply of money. This would reduce prices. This in turn would make British goods
more competitive overseas and would lead to a recovery in the export industry. Employment
would rise.’ But reducing the money supply would raise interest rates and reduce investment.
The economy would slide further into recession and unemployment would rise.

So if all these classical remedies were wrong, what was Keynes’ answer? That was simple.
There must be more spending, not less. Aggregate demand must be boosted, either directly
through a programme of public works, or indirectly by giving tax cuts and thus encouraging
more consumer expenditure. Either way it would mean a policy of a deliberately unbalanced
budget. According to Keynes, therefore, budget deficits were highly desirable in recessions.

Questions
1. How would a classical economist reply to each of Keynes’ criticisms?
2. Would each of the above classical policies be suitable if there were a problem of excess
demand and inflation?

Case 5
The Great Depression and the
Return to the Gold Standard
A time of great hardship and sacrifice

The Great Depression was closely associated with Britain’s return to the gold standard, a
system that it had left in 1914 at the outbreak of the war. From 1918 to 1925 Britain adopted
a flexible exchange rate system, a system felt necessary because of the disruption to foreign
trade following the war and the monetary chaos in Europe. In 1925, however, Britain
returned to the gold standard.
Britain’s prosperity before the First World War was crucially dependent on its
international trade and its position as provider of international financial services. Classical
economists and bankers in the 1920s believed that free trade must be encouraged, and that the
best way of doing this was to return to the gold standard. Moreover, the experience of
international inflation in the years after the war made many people anxious to return to a
system that forced countries to keep inflation under control.
The government and the Treasury felt it was important to return at the old rate to create
confidence in the strength of sterling and to protect the value of sterling reserves held by
various countries round the world. In 1925 Winston Churchill, who was Chancellor of the
Exchequer at the time, made the fateful announcement: Britain was returning to the gold
standard and at the pre-war rate of £1 = $4.86.
But this was way above the equilibrium rate. Britain had developed a large balance of
payments deficit. Export markets had been lost during the war and industries had been
diverted away from exporting to producing for the war effort. Imports were high, as post-war
reconstruction took place. Also high inflation immediately after the war had reduced the
competitiveness of Britain’s exports.
 Returning to the gold standard at the old rate therefore required harshly deflationary
policies: to lower wages and prices, and to restore Britain’s competitiveness. There followed
a period of great pain. The (current account) balance of payments remained in severe deficit.
At such a high exchange rate, prices and wages could not be forced downwards rapidly
enough to restore the competitiveness of exports or to stem the flood of imports. The result
was that gold poured out of the country.
Eventually, with the collapse of world trade following the Wall Street crash of 1929, and
a resulting further decline in Britain’s exports, there was simply not enough gold left in the Bank
of England to support the exchange rate. Britain left the gold standard in 1931. The pound was
allowed to depreciate.

Question
Would wage flexibility have allowed the balance of payments to be corrected under the Gold
Standard without leading to a depression?

Case 16.2
The Relationship between
Income and Consumption
Three alternative views of the consumption function

The absolute income hypothesis

This is the title of the Keynesian theory of consumption that we have been looking at so far.
It assumes that people’s consumption depends on their current disposable income. It also
assumes that people spend a smaller and smaller proportion of their income as income rises.
This theory fits quite well with the evidence on short-run consumption behaviour.
Unfortunately, it fits much less well with long-run consumption behaviour. The evidence
suggests that, over the long term, consumption as a proportion of disposable income remains
roughly constant. This gives a long-run consumption function that is a straight line out from
the origin, as in Figure 16.4 in the textbook.
How can we explain short-run consumption that tails off as income rises, but long-run
consumption that rises proportionately with income? Two alternative theories of consumption
provide such an explanation.

The relative income hypothesis

This theory was put forward by J. S. Duesenberry in 1947.1 It assumes that people’s
consumption behaviour is influenced by others. If your friends have videos or CDs or a
second car, then you will probably buy these items too, even if you are poorer. If, on the other
hand, your income is high relative to others, you will not need to spend such a large
proportion of your income.
This explains the discrepancy between the short-run and long-run consumption functions.
In the short run, if people have a rise in their incomes, they will feel relatively better off
compared with others. They will therefore increase their consumption by only a modest
amount.
In the long run, if national income increases, people will not feel better off relative to
others. As average incomes increase, people generally consume more as they see others
consuming more.

The permanent income hypothesis

This was put forward by Milton Friedman in 1957.2 Friedman divided a person’s income into
two types: permanent and transitory.
Permanent income is the average (discounted) income that a person expects to receive
over his or her lifetime. To estimate this, people look at their current wages and what they are
likely to be earning in the future. It is on this that people base their normal planned spending.
The permanent income hypothesis has been extended by various economists, especially
Franco Modigliani, who have looked at the typical patterns of income that people earn over
their life span. (These are known as ‘life cycle theories’.)
Transitory income is defined as temporary, unexpected income. People do not base their
consumption plans on this. If people have an unexpected rise in income, they are likely to
save most, if not all of it.
How can this distinction be used to explain the difference between short- and long-run
consumption functions?
In the short run, a rise in national income may well lead to unexpected rises in
individuals’ incomes. For example, a boom in the business cycle can lead to unexpected
overtime for many workers. Since this is transitory income, it is largely saved. Consumption
rises only slightly.
In the long run, if higher incomes persist, people are likely to adjust their expectations of
their permanent income upwards. They will thus adjust their standard of living upwards and
spend more.

Question
Is it a reasonable assumption that consumption does not depend on transitory income? If it did,
what would this do to the shape of the short-run consumption function?
1
J. S. Duesenberry, Income, Saving and the Theory of Consumer Behaviour (Harvard University Press, 1949).

2
M. Friedman, A Theory of the Consumption Function (Princeton University Press, 1957).