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Unemployment and Inflation: Their role in economy and their relationship
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Macro-economics Most of the nations of the world today have a free economy. A free economy is one which operates automatically. However, this automatic regulation of the economy is actually achieved by the price level. Price level can be defined as the weighted average of all the final goods and services produced in an economy. A healthy economy is characterized by a stable price level. Fluctuations in price level affect the economy’s real domestic output (RDO), unemployment and its growth. A high increase in price level can bring down a nation’s output by affecting the aggregate demand. It will lower total spending and increase the unemployment level. Similarly a decrease in price level will increase the real income of the masses, investment will increase and unemployment will fall. This decrease and increase in price level along with the fluctuations in unemployment, interest rates and output forms the business cycle that characterizes all market economies. The BUSINESS CYCLE is an irregular and non-repeating up-and-down movement of business activity that takes place around a generally rising trend and that shows great diversity. It is also sometimes referred to as a trade cycle. A trade cycle can be Kitchin (3-4 years), Medium Term (7-11 years) or Long-run (50-55 years). The picture below illustrates a framework in which business cycle theories were often constructed. Starting at point T, the economy grew very rapidly in a self-feeding growth. Because of this "self-feeding" process, the economy would develop momentum. Once started, growth would continue until the system hit a limit or boundary that would stop it. The economy would then turn around and enter a contraction that was also self-feeding. This downswing would continue until a lower boundary was encountered, which would stop the contraction and start a new upswing i.e. expansion. Notice that the 2nd swing is always at a higher rate and the economy is never in equilibrium, but perpetually adjusting. Figure 1 Typically a business cycle is divided in four phases: • Depression • Expansion • Contraction • Recession DEPRESSION: Let us assume that the economy is in depression. Depression is defined as an unusually severe recession. This is when things are at their very worst and look as if they'll never get any better. Production is falling, incomes are falling, there are fewer jobs, and there are more unemployed workers. Pessimism and hardship are widespread. Firms try to survive as they can sell off the inventory on hand. More bankruptcies are observed, but the number and the size of the bankrupt firms are bottoming out. All prices, interest rates and wages are at their lowest. Unemployment is ubiquitous. The unemployed are ready to take any job. The contraction has run its course. The economy has reached its trough. In this phase the general price level has fallen to its lowest possible point. In fact, the prices are so low that they are not remunerative. However this does not persist for a very long time and the recovery starts. Having sold off their inventories, companies start to place orders for new supplies. Thus, effective demand is created in some industries to replenish their inventories. This will mark the beginning of the expansion phase. Consumers have postponed some purchases and made do with cars or appliance by repairing them. But this has gone long enough, it is time to buy at least the indispensable; moreover credit is cheap. Families have saved up in hard times. As new investment begins the economy begins to prosper. Bank reserves are plentiful and bankers are eager to lend anew, even at very low rates. Interest rates are indeed so low that some company projects become attractive again. New sales are observed in all sectors. Companies start rehiring at the low wages first. New businesses are started. Bankruptcies are less noticeable. This is due to the combined effect of the accelerator and the multiplier as proposed by the real theory of trade cycle. Accelerator and Multiplier Effects a) The multiplier effect There is a relationship between investment and consumption. New investments have what is called a multiplier effect—that is, investment money paid to wage earners and suppliers becomes income to them and then, in turn, becomes income to others as the wage earners or suppliers spend most of their earnings. An expanding ripple effect is thus set into motion. b) The accelerator effect This principle says that small changes in consumer spending can cause big percentage changes in investment. The accelerator model is based on the truism that, if the capital/output ratio is held constant, an increase in output can only be achieved though an increase in the capital stock. Firms need a given quantity of capital to produce the current level of output. If the level of output changes, they will need more capital. This change in capital will be given by the equation: Change in capital = accelerator ´ change in output But firms can only increase their capital stock by (positive) net investment. Net investment = accelerator ´ change in output Thus, Accelerator = Change in Capital/Change in Output The accelerator thus depends on capital-output ratio. It played a role in many business-cycle theories and is still used today to explain some of the fluctuation in investment. According to this principle, an increasing level of income spent by consumers has an accelerating influence on investment. Higher demand creates greater incentive to increase investment in production, to meet that demand. This increase in investment would in turn further increase the income and spur the economy. Combined effect of multiplier and accelerator: This combined effect of the accelerator and the investment multiplier helps the economy to quickly move from depression to expansion. Both of these factors also can work in a negative way, with reduced investment greatly diminishing aggregate income, and reduced consumer demand decelerating the amount of investment spending. However to remove depression, the accelerator and the multiplier can only come into play if investment is increasing. According to Keynes, the government can increase investment and remove depression by formulating the relevant fiscal and monetary policies. Keynes’ analysis of depression: Keynes argued that if the aggregate demand is too low, governments should intervene to boost aggregate demand. According to him, there are two policy weapons they can use: Fiscal Policy The fiscal policies are particularly useful for bringing an economy out of depression. It is where the govt. alters taxes and spending to control the aggregate demand. Faced with a recession, it should raise its spending and/or lower taxes. It can increase spending by investing in schools, hospitals etc. This money is injected in the economy and an accelerator-multiplier effect follows. Govt. spending ↑ or Taxes ↓ → Injections > Withdrawals → National Income ↑ Monetary Policy: Now the government’s monetary policies regarding the supply of money bring the economy to its peak. The govt. alters the supply of money in the economy or manipulates interest rates. If it increases the supply of money, there would be more money available for spending in the economy. This would lead to a fall in interest rates and the aggregate demand would rise. However, Keynes deemed the monetary policy to be less effective than the fiscal policy since some of the extra money could be used for speculating in paper assets rather than spending on real goods and services. It is indeed most effective if both the policies are used together e.g. if the govt. invested in a new school (fiscal policy) and financed it through increases in money supply (monetary policy), there would be a significant rise in output an employment. These policies, together with the multiplier-accelerator effect will push the economy to the expansion phase. EXPANSION In an economic expansion, businesses experience record sales and profits. They can hardly keep up with demand. In anticipation of a continued sales growth, inventories are built up and production facilities are expanded. This creates demand for suppliers of raw material and equipment. The equipment takes time to be built and installed. The demand-deficient or cyclical unemployment is fairly low. Banks are willing to lend given the bright predictions of continued cash flows. A large number of loan applications push banks to raise interest rates which companies can afford to pay. Companies find it difficult to hire all the employees they need, and are forced to pay higher wages, for instance, for overtime hours. But, that is not a serious problem in light of healthy sales and profits. Furthermore, a strong consumer demand justifies raising prices for many products. With higher wages, employees are still able to buy in spite of higher prices; moreover, anticipation of continued employment encourages them to use consumer credit if their income is insufficient. The overheating of the economy is evident in shortages of employees, materials, equipment, loanable funds and products. These shortages imply inflation. Because of difficulties in obtaining resources, this is no longer a good time to start a business even if sales appear encouraging. Prices, wages and interest rates continued rise puts eventually a stop to further expanding product demand, new hiring and new lending. The economy has reached its peak. CONTRACTION: Now the economy moves on to the next phase i.e. contraction. Sales are no longer expanding. The economy starts slowing down. The slow down is mild at first. As sales stop increasing, inventories pile up. Companies can adjust to that by reducing orders for raw materials, avoiding overtime and resorting to sales promotions. Suppliers start to feel the pinch and are forced to lay off a few workers. These lay-offs are seen as a signal of potential hard times ahead. Employees prefer to set aside some wages, and reduce their consumption. Sales start to drop as consumer demand shies away. On the other hand, when the banks become conscious that their cash reserves are falling they stop further lending and start recalling their loans. Companies are now burdened by the loans they took out to install new equipment. Their profits shrink with decreasing revenues, still high employee salaries, and a large overhead. The hardest hit are the manufacturers of equipment who see their orders dwindle. Fewer and fewer businesses are started. Often, plans to open business are canceled. Some firms go out of business. Nervousness spreads in the economy, the pressure of sale increases and prices fall. RECESSION: The slow down becomes a serious contraction i.e. recession. Surpluses are everywhere: product inventories are bulging, excess capacity causes newly purchased equipment to turn idle, banks have loanable moneys that no project justifies, raw materials are not needed, and employees are too many. Lay-offs become widespread. Shrinking revenues force companies to replace full-time employees by lower paid part time and temporary workers (if labor unions do not intervene), or even to ask for wage concessions from the existing staff. Decreasing disposable income causes even more reduction in product demand. As output falls, inflation slows down, wages and prices of services are unlikely to fall but they tend to rise less rapidly in downturns. Revenues disappear and profits turn to losses. Businesses default on their loans. Highly leverages companies close down. These are bankruptcies of large operations. In turn, these bankruptcies can cause some banks to close as well. However, prices are only cut if recession becomes severe. As discussed above, inflation is present in almost every phase of the business cycle. A fall in price level in recession is a very important indicator of depression. On the other hand, a high increase in inflation in the economy affects the total demand and total spending forcing the economy into recession. Let us now discuss the mechanism behind the fluctuations in the economy. BUSINESS CYCLE THEORIES There is no simple explanation for the causes of the business cycle. However, many theories have been proposed by economists to ascertain the source and mechanism of a business cycle. We can broadly divide the business cycle theories into two main categories: 1. External theories 2. Internal theories EXTERNAL/EXOGENOUS THEORIES These theories find the root of the business cycle in the fluctuations of factors outside the economic system. The 2001-02 mild recession in United States brought about by the September 11 attacks is an example. Some of these theories are: • Sunspot Theory/Climatic Theory • Political Theory • War Theory INTERNAL/ENDOGENOUS THEORIES These theories look for mechanisms within the economic system itself that give rise to self-generating business cycles. This approach relies on the theory that a business cycle is accumulative in nature and that it feeds on itself. Every expansion breeds recession and contraction and vice versa. Some of the important internal theories are: • Keynesian Theory/ Psychological Theory The Keynesian theory of the business cycle regards volatile expectations as the main source of economic fluctuations. Keynesian Impulse The impulse of the business cycle is a change in expected future sales and profits. This changes the level of investment in new capital. Keynes reasoned that news or rumors of future tax changes, interest rate changes, advances in technology; global economic and political events (for example) affect expectations and investment. It is often referred to as “animal spirits”. The Keynesian Cycle Mechanism It is caused by changes in expectations or “animal spirits” that change direction and set off a process that ends at equilibrium e.g. businessmen’s optimism increases investment during the depression and spurs the economy into the expansion phase. • Monetarist Theory This theory was proposed by Milton Friedman. The monetarist theory of the business cycle regards fluctuations in the money stock as the main source of economic fluctuations.
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