Inflation & Unemployment I: Inflation

Inflation is the economic term that refers to a continuous general rise in the level of prices over a period of time. This will consequently be translated into a fall in the value of money and a loss in purchasing power. The main measures to calculate inflation are Consumer Price Indexesand the Gross National Product deflator. Oil prices can be an alternative inflation indicator as this product is used throughout the world for many different purposes and it virtually affects all of the elements of an economy’s price formation. It is important to understand that when inflation rates remain constant in a positive figure, e.g. 1%, over a period of time e.g. 10 years, and even if inflation didn´t change, purchasing power would ultimately be lost.

As an economic phenomenon, inflation can be the result of a different set of causes. The conventional distinctions made between these causes are:

Demand-pull inflation

Demand-pull inflation occurs as a result of an increase in aggregate demand and the inability of an economy to produce enough to meet the demand increase. Aggregate demand is formed by consumer spending, government spending, investment and net exports, and any increase in one of these components without its correlative effective response will create inflation. Demand-pull inflation is more likely to occur when employment of resources is closer to its full usage and the short run aggregate supply is most inelastic.  Therefore, inflation is mainly caused by the inability of the economy of attending an increase in demand. Increases in aggregate demand might be caused by:

-Expansive monetary policies: when monetary authorities conduct an expansion of money supply, there is more money available, consumption is incentivized and thus there is an increase in aggregate demand that creates inflation. If economic growth is below money growth there will be inflation. Monetarists defend monetary policies as a way to efficiently control inflation rates counteracting economic growth.

-Expansionary fiscal policies: this kind of policies could indirectly increase aggregate demand by increasing consumers’ disposable income or directly through government intervention.

-Increase in exports: exports may rise for two main reasons. The first one is the result of a country’s currency depreciation; there will be an increase in exports, as these products will seem cheaper to foreign countries, thus increasing aggregate demand. The second one is caused by an increase of wealth in the foreign countries, which will allow them to import more of other countries products.  Both of these will result in an increase in the aggregate demand and consequently cause inflation.

-Consumers’ confidence increase: whenever consumers feel confident on the economic situation they will tend to decrease their level of savings and consume more and hence increase aggregate demand.

Cost-push inflation

Cost-push inflation occurs as a response of agents raising prices to maintain their profit margins if there are higher production costs. Production costs may increase because of:

-Rising labour costs: new government measures can imply an increase in the costs of hiring (adjustment costs, see Cahuc’s adjustment costs model) or increases in the payroll taxes. Trade unions can also force firms to increase workers’ wages by using negotiation powers, as explained by the Layard-Nichell NAIRU model.

-Rising raw materials costs: raw material costs rise can result from different causes. Depreciation of their own currency can affect firms which depend on imported raw material for their productive process, as buying the same materials will cost them more of their domestic currency. Government regulations once more play an important part as subsides, policies and taxes can affect both raw material prices and the overall prices. Raw materials costs can also increase as a result of natural catastrophes. It is also important to remember the part that the price of oil plays in price formation, as the current world economy is highly dependent on it.

Built-in inflation

Built-in inflation, sometimes referred as wage price spiral or expectations-induced inflation (explained by the expectations-augmented Phillips curve), is the consequence of agents previous years’ experience and their ability to build rational expectations. In an inflationary price rates tendency, agents will try to anticipate the following price increase. On one side, workers will demand higher wages as a measure to avoid losing purchasing power. On the other side, firms will increase prices in order to maintain their profit margins. This is sometimes referred to as the wage price spiral as one will lead to the other, resulting in inflation inertia.

It’s important to see that inflation plays a key role in the economy. As seen in the Phillips curve, governments face a trade-off between different levels of unemployment and inflation. In pre-elections time, governments may be tempted to decrease unemployment levels at the cost of a higher inflation, in order to make it appear as if the economy is better than it is, and so gain votes. This is why monetary policies should be held by an independent authority, which in most countries translates into a central bank.