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.

Unemployment refers to the situation of a jobless worker. The unemployment rate measures the number of unemployed workers as a percentage of the labour force. Massive unemployment levels are the result of situations of economic crisis followed by depressions, and are the result of a large economic readjustment studied in business cycles theory. During the Great Depression, 1929-1939, unemployment insurance benefits were introduced in the U.S. in order to reduce the consequences of high unemployment levels. This measure was introduced to prevent workers’ misery, and as a way of maintaining effective demand, as stated by the Keynesians’ fiscal policy proposals.

Unemployment can be divided into different types depending on its cause and depending if it is involuntary or voluntary:

Involuntary Unemployment

Classical unemployment is explained as the situation that exists in the labour market when the number of people able and willing to work at the prevailing wage levels exceeds the number of vacancies available. In simple words, demand and supply do not meet. This occurs when real wages are higher than those corresponding to equilibrium at full employment levels. This type of unemployment was explained by the Classical school (hence its name) as those cases in which certain imperfections prevent unemployed people from reducing their aspirations to lower their wages so that firms will believe it is interesting to create new jobs and hire people.

Frictional unemployment, also referred to as searching unemployment, happens when a person is temporarily unemployed between jobs. This is the unemployment in its theoretical lowest possible level. It occurs even in full employment conditions because a considerable number of people are moving from one job to another. The only way to reduce this kind of unemployment is for economic institutions to make information more available.

Structural unemployment occurs when people are unable to find jobs in which their skills can be useful because their skills are no longer demanded, and thus creating an excess of labour supply generally at well-defined locations. As structural unemployment is not caused as a result of a general decline in demand, it cannot be softened with reflationary type measures, but instead ad hoc economic policies are needed. These types of policy include retraining of workers and reallocation of industries. The main difference between structural and frictional unemployment relies on the time horizon, as the former is a long lasting phenomenon while the latter a short term one.

Seasonal unemployment is generally of short duration and it is generated on a regular basis as a result of the different seasonal activities through the year, especially regarding agriculture activities and tourism.

Disguised unemployment is not actually unemployment. It refers to a characteristic situation of countries that are both underdeveloped economically and highly bureaucratized, in which there is a high number of workers with low levels of productivity that would be employed if the country had a better organisation or better technology levels.

Voluntary Unemployment

Voluntary unemployment consists of workers that are jobless as they are reluctant to work due to economic, sociological or psychological reasons.

Reducing unemployment and stimulating the economy has been one of the biggest, if not the only, concerns of governments since the dawn of economic science. Economic policies have been very much theorized, and by many doctrines.  As a result, a rich and plentiful literature has been developed on this topic. We will discuss the main economic policies:

1. Policies in order to reduce labour supply:

By reducing labour supply the government is reducing the number of people that are legally suitable to work, what is known as the labour force, and by doing so it indirectly reduces unemployment. This kind of policy is mostly effective when targeted over a group that has a higher unemployment rate than the average. If a country suffers from high unemployment amongst the young population, by increasing the minimum age of employment, governments will decrease unemployment levels. It will also be useful even if the targeted group has a low level of unemployment, as there will be new vacancies that unemployed can fill.  Other examples of this policy include retirement age reduction and the increase of military service duration. However, as it can be easily seen, these policies are what Frenchmen would call “trompe-l’oeil”, that is, they reduce or eliminate the symptom (unemployment), but without treating the disease (the economy malfunction).

2. Policies to stimulate labour demand:

There are different policies depending if they affect demand of labour by using demand-side policies or supply-side policies.

-Demand-side policies stimulate the economy by increasing the demand for goods and services, thus incentivising firms to produce more, which will result in firms hiring more workers. Expansive fiscal and monetary policies are the tools that governments can use. This kind of policies is considered by their different advocates (Keynesian economists would implement fiscal policies whilst monetarists would implement monetary policies) to be most effective at reducing cyclical unemployment during economic depression.

-Supply-side policies focus on firms and their production of goods and services, in order to increase the supply (output) of the economy. These policies aim at the costs of labour and the production function.  If the cost decreases there will be more money available to increase the workforce. This kind of policies is nowadays regarded by the latest economic doctrines as the only real possibility to ensure a perdurable economic growth. However, they are less attractive than demand policies since they need time to be implemented and to generate actual effects on unemployment and growth.

3. Structural reforms:

These policies aim at reducing real wages. With lower wages, the firms will be able to hire more workers. Examples of this policy are: minimum wage reduction, unemployment benefit reduction and removing differences between insiders and outsiders.

4. Income policies:

A pact between the firm and its workers allow for reduction of real wages, this way firms can hire more labour force, which reduces unemployment levels.

5. Labour distribution policies:

Employees will work fewer hours, they will earn less, and so a greater amount of employees will be able to be hired. Marginal productivity is also increased by these policies. However, these policies are not really popular.

It is important to notice that not all policies are effective in the same time frame nor their effects remain over the same period. While supply-side policies and structural reforms have an effect in the long term, the rest have an effect in a shorter time, being this the reason why they were thoroughly studied by Keynesians and monetarists. However, contemporary economic doctrines, such as New Classical Macroeconomics and New Keynesian Economics have proven their inefficiency, thus turning back to supply-side policies as the only plausible solution.

Fiscal policies are demand-side economic policies through which the government acts over its income and expenditure in order to influence the levels of income, output and unemployment of the economy. The government may do this via income taxes and unemployment benefits, or by discretionary measures, such as taxes on spending and increasing public spending. By increasing demand, firms are incentivized to produce more and therefore to hire more workers.

Keynesianism believed fiscal policies as the best tool to control the economy of a country, especially to reduce cyclical unemployment.  Monetarism and following economic doctrines as New Classical Macroeconomics and New Keynesian Economics consider them to be ineffective in the long run, as demand cannot be increased continually.

Monetary policies are demand-side economic policies through which the central bank of a country acts on the amount of money and interest rates in order to influence on the income levels, output and unemployment in the economy, being the interest rate the link binding money and income. The main tools used by monetary policies are open market operations, loans to commercial banks, and the use of reserve requirements. Ceteris paribus, an increase (decrease) in the money supply or a decrease (increase) in interest rates will have a positive (negative) ripple effect on private spending (consumption and investment). This will finally increase (decrease) production and employment. However, this will increase prices, which may lead to rapidly increasing inflation.

Monetarism is the main economic doctrine that defended this kind of policy. However, Keynesianism, New Classical Macroeconomics and New Keynesian Economics, criticize it and do not believe in their effectiveness as it has been demonstrated that increasing money supply will result in inflation and counteracting the positive effects of this policy. As Milton Friedman said, “inflation is always and everywhere a monetary phenomenon”.

The purpose of supply-side economic policies is to increase the amount of supply and therefore the productive potential that the economy is able to produce.  This kind of policies shift rightward the long-run aggregate supply curve and outward the production possibility frontier.  They can be divided in policies that act over the production function, and those that act over the cost of labour.

On the one hand, the former are targeted at increasing production levels and examples of this kind of policies include incentives to technological improvement and capital stock increase. On the other hand, the latter are targeted directly on decreasing the cost of labour and this way more workers can be hired. Examples of these policies include reduction of social security contributions, increase of subsidies for firms, reduction of indirect taxes etc.

Supply-side policies have been praised by many economists including Nobel laureate Robert Mundell. There have been many studies regarding their effectiveness, and although it is true that they take effect in the long run, they are the only ones that can lead to perdurable economic growth. Furthermore, critics coming from monetarists and Keynesians have questioned the effectiveness of other policies, such as fiscal and monetary, respectively, pointing out how they are only useful in the short run, but are useless or even harmful for the economy in the long run. In fact, the last two great economic doctrines, New Classical Macroeconomics and New Keynesian Economics, have proven the ineffectiveness of fiscal and monetary policies, leaving supply-side policies as the only ones that are useful.