Category: Inflation

Introduction

Inflation is a significant point of concern for all experts in the economy, as well as for ordinary citizens. The rise in consumer prices, which is not comparable to the values of the next few years, has a significant impact on consumer behavior and business. In order for society to survive this period most adequately and to create a favorable backdrop for the exit from inflation, the government and the Bank of England need to take many steps. All of the steps to be taken as part of economic policy include supporting real-asset businesses, targeting support for narrow groups of people, and creating a risk framework for each group of basic commodities.

Discussion

In order to understand how measures to combat inflation will work, it is necessary to consider the mechanisms of the latters impact on the countrys economy. Rising prices imply higher prices for raw materials, the need for higher wages for employees, and higher interest rates (Jiranyakul, 2020). A particularly noticeable effect of inflation has been how difficult it is now to build nonprofitable medium and small businesses in the UK. Researchers note that business confidence among residents has declined by 10% over the past year, which is also a record (Kidane and Woldemichael, 2020). If large entrepreneurs manage to offset the effect of rising commodity prices by the scale of their businesses, but smaller forms of business need support from the government.

The most obvious course of action from the government is to give entrepreneurs tax breaks for a period of up to 6 months. This would be enough time to track the effect of this measure on the entire economy. Moreover, special attention should be paid to those forms of entrepreneurship that are engaged in real assets (Bonaparte, 2022). The latter include real estate, work with energy, and commodities (Han, Ma, and Mao, 2020). These industries react quite quickly to inflation since rising prices directly affect the products they produce (Orchard, 2020). A useful measure on the part of the government in this case would be to authorize an increase in spending that exceeds inflation. This will enable managers to ensure that prices are kept in check for a period of time.

On the part of the Bank of England, there is a rather radical option to artificially restrain prices, but this step can only be effective in moments of discontinuous change. Since the international market environment does not currently suggest a change in the situation, one could argue for a prolonged inflation in which price controls on all goods would be untenable. Nevertheless, both the bank and the government can organize a joint effort to keep a close watch on the prices of specific groups of goods belonging to the sphere of necessities. The latter may include bakery products, dairy products, medicines, and repair equipment (Khan and Naushad, 2020). For each segment, the Bank of Englands financiers must define price limits within which prices can fluctuate without causing critical damage to consumer welfare.

In the event that the upper boundary is crossed, spot price regulation must be included. For this step to reveal its effectiveness, it is important that bank management fine-tune the financial analytics process. Moreover, this task can be partially delegated to various agencies, and there should be cooperation between the ready-made ones (Hanif et al., 2020). The relevant government agencies should each week form a forecast of the prices of certain segments of goods on the basis of the indicators of the world economy. From the above measure follows the idea of the necessity to develop forecasting processes in state economic organizations.

As part of the banks monetary policy, we should note the buying up of government liabilities through the additional issue of notes. As a consequence, banks will be more interested in issuing loans, while maintaining a high demand on the part of consumers. Such a policy is quite common and has repeatedly shown its effectiveness. One cannot ignore the option of government support for certain groups of the population, whose economic activity has been most significantly affected by inflation (Allen, 2022). Often residents of regions connected with the extraction or production of specific raw materials and without a large number of local factories and plants are forced to face a double or triple increase in prices compared to other areas (Grigoli and Pugacheva, 2022). For example, parts of the country that do not produce their own dairy products purchase this type of product at an increased cost due to transportation costs. With inflation, not only the cost of goods but also transportation, therefore, people are faced with even greater price increases.

Such a segment of the population needs special support from the state, and in this case, we can talk about subsidizing on a one-time or regular basis. The selection of population groups in need of financial support from the government can be made according to various criteria (Eberly et al., 2021). In addition to the region of residence, the sphere of activity can be taken into account (Ramlan, 2020). When the prices of construction materials are particularly high, professionals involved in this industry may be rewarded with additional payments, which will allow them to be motivated to stay in the profession and not leave the company.

The loss of peoples jobs due to the collapse of firms unable to withstand inflation is an important component that makes it more difficult to fight inflation in general. To ensure that unemployment does not develop in the face of rising prices, the government should provide for the introduction of insurance benefits for people who lose their jobs because of inflation (Eberly et al., 2021). This policy, applied several years ago in France, has shown its effectiveness, because thanks to such payments, it was possible to maintain a sufficient level of demand for goods and services.

A significant instrument of monetary policy is the refinancing rate. The refinancing rate is the amount of interest per annum payable to the countrys Central Bank for loans to credit institutions. These credits are the refinancing of a temporary shortage of financial resources. Such credits regulate the liquidity of the banking system in case credit institutions lack funds to credit their customers and fulfillment of assumed obligations (Murasawa, 2019). The refinancing rate of the Bank of England has traditionally been a tool of macroeconomic regulation, which is also used to curb inflation (Patel and Meaning, 2022). If the inflation rate increases, then the Bank increases the refinancing rate. If inflation falls, then the Central Bank lowers the refinancing rate. It is important to note that in the short term, anti-inflationary policies increase unemployment and reduce output. While the government reduces government spending and cuts the money supply, prices fall (Hall, 2021). However, wages remain unchanged. Under these conditions, firm profits fall, so the firm reduces output, and hence employment decreases.

When analyzing the anti-inflationary activity of the state, it is necessary to distinguish between the concepts of policy and strategy in the fight against rising prices. The latter has no direct impact on the economic life of society and does not affect consumer behavior in the short term. In terms of an anti-inflationary strategy, it is important for the government to ensure the reduction of inflation expectations (Goodhart and Pradhan, 2020). This measure can be achieved by issuing money, increasing the regulation of financial and economic activities by the state, stabilizing market mechanisms, as well as reducing the role of external factors affecting the economy.

As part of an anti-inflationary strategy, a program of measures, will describe in detail all the existing for a particular situation and analyze the expected results. For the current conditions in the UK, an important step to help reduce inflationary expectations will be to limit the flow of new finance into the economy. This requires that loans become unprofitable for large businesses, resulting in an increase in the number of funds on deposit. In order to avoid a global economic downturn, the credit activities of individual citizens can be on the contrary supported (Goodhart and Pradhan, 2020). In order to reduce the level of external interference in the economy, it is important for the government to organize control over the activities of exporters, which will help detain capital inside the country. The proposal should also include the above-mentioned measures to limit the maximum allowable price of socially important products.

In terms of short-term measures that would allow the government to reduce the impact of a price hike relatively quickly, the option of market imbalance can be highlighted. The latter consists of a sharp increase in demand without an increase in supply, or, conversely, an increase in supply with unchanged demand. The eye-opening tools for this type of measure would be various tax mechanisms, including tax cuts or increases, and changes in the way taxes are levied. Moreover, the elimination of the states debt to individual industries can be carried out, as well as changes in the distribution of funds among the various subjects of economic relations within the UK.

Conclusion

Thus, the development of anti-inflationary measures by the government and the Bank of England should be based on the principle of multifactoriality of this phenomenon. The main task should not be to reduce the rate of price increases in the shortest possible time but to create the most painless environment for citizens, within which the anti-inflationary measures will be carried out. Such phenomena as reduced solvency of a large percentage of the population and the unprofitability of small and medium-sized businesses must be taken into account. On this basis, the anti-inflationary strategy may include measures to stabilize market relations, taking into account social policy. It is necessary to timely monitor which groups of important products exceed the permissible price level, as well as which segment of the population is most affected by the consequences of rising prices. Only consistent and careful action by the Bank of England and the government will ensure a gradual, if gradual, but guaranteed and painless exit from years of record inflation.

Reference List

Allen, W.A. (2022). Inflation measurement and inflation targets: The UK experience. Review, 79(3). Web.

Bonaparte, Y. (2022). Transitory inflation and projection of future inflation. SSRN Electronic Journal. Web.

Eberly, J., Stock, J.H., Davis, S.J., Furman, J. and Romer, D.H. (2021). Brookings papers on economic activity: Fall 2020. New York: Brookings Institution Press.

Grigoli, F. and Pugacheva, E. (2022). Updating inflation weights in the UK and Germany during COVID-19. IMF Working Papers, 2022(204), p.1. Web.

Goodhart, C. and Pradhan, M. (2020). The great demographic reversal: Ageing societies, waning inequality, and an inflation revival. Cham, Switzerland: Palgrave Macmillan.

Hall, T.H. (2021). Dispute inflation. European Journal of International Relations, p.1354. Web.

Han, Z., Ma, X. and Mao, R. (2020). The Role of dispersed information in inflation and inflation expectations. SSRN Electronic Journal. Web.

Hanif, M.N., Iqbal, J., Ali, S.H. and Salam, M.A. (2020). Denoised inflation: A new measure of core inflation. Journal of Central Banking Theory and Practice, 9(2), pp.131154. Web.

Jiranyakul, K. (2020). The linkages between inflation and inflation uncertainty in selected asian economies: Evidence from quantile regression. SSRN Electronic Journal. Web.

Khan, N. and Naushad, M. (2020). Inflation relationship with the economic growth of the world economy. SSRN Electronic Journal. Web.

Kidane, D. and Woldemichael, A. (2020). Does inflation kill? Exposure to food inflation and child mortality. Food Policy, p.101838. Web.

Murasawa, Y. (2019). Measuring public inflation perceptions and expectations in the UK. Empirical Economics, 59(1), pp.315344. Web.

Orchard, J. (2020). Household inflation and aggregate inflation. SSRN Electronic Journal. Web.

Patel, R. and Meaning, J. (2022). Cant we just print more money? London: Random House.

Ramlan, H. (2020). The impact of monetary policy on inflation. International Journal of Psychosocial Rehabilitation, 24(4), pp.46654673. Web.

Introduction

This paper will cover the Real Estate industry in the United States. The Real Estate industry is part of the Real Estate and Rental and Leasing sector, which includes renting and leasing assets and services, such as cars, houses, computers, and other goods (NAICS, 1). The Real Estate subsector includes investing in real estate, renting and leasing properties, and the activities related to that. This is an industry that involves most of the American population in some capacity, as everyone needs housing.

Size and/or Growth of Industry

The real estate industry is a significant part of the United States economy. With a real gross output of 3148.2 billion dollars in 2019, this segment of the economy accounts for 9.1% of the total real GDP of the United States for the same year (BEA, 2). The real estate business is also a major part of the Real Estate and Rental and Leasing sector, providing over 90% of its output (BEA, 2). Being one of the most profitable private segments of the economy, the real estate business is usually capable of adapting to the changes in macroeconomic factors.

Macroeconomic Indicator or Policy and Its Importance and Impact

As mentioned previously, the real estate industry tends to be relatively resilient to changes in macroeconomic factors. This is mainly because the demand for housing grows with the population, and it cannot fall below certain levels. Although in some extreme cases, many people might be unable to pay their rent, causing the real estate market to plunge, stable long-term growth is not affected by these rare instances.

From the macroeconomic indicators that could affect the real estate industry, the most noteworthy seems to be inflation. Inflation is the gradual increase in prices naturally occurring in any economy when the amount of money exceeds the number of equivalent goods. It usually occurs when demand for goods is high, as people do not feel the need to save their money. The currency will naturally lose its value over time, but the changes depend on many factors in the domestic and global economy. To make the market more secure, the Federal Reserve sets a target for inflation, which is usually 2% per year and tries to maintain it at that level.

Recent Trend

In recent years, inflation has often been lower than 2%, especially with the recent COVID-19 crisis. The latest data chart from the United States Bureau of Labor Statistics shows a 1% overall price increase in 2020 (3). The most prominent decreases in prices can be observed in the energy sector, where inflation fell by as much as 11.2% in total, and 27.2% in the fuel oil segment (3). The apparel and transportation prices have also decreased substantially, although the effect of the pandemic was not as devastating for these industries. Opposing the overall trend, real estate prices have increased by 2.3%, confirming the fact that its resistance to crises is higher than average (3). The current trend of low overall inflation rates will likely continue for at least 6 months before the economy fully recovers from the pandemic.

(3) Once the current crisis ends, the inflation trends will likely change. As businesses reopen, people will have more money at their disposal, and having an income will motivate them to spend money rather than save it. People commuting to work will increase fuel and transportation prices, and other parts of the economy will also grow. Since inflation has been low for several years, the federal reserve will likely need to compensate for that by allowing higher inflation after the crisis. However, the real estate business might not be positively affected by the increased inflation rates, as the demand for housing will not increase as quickly. This would cause some short-term losses for real estate investors, but the value of their properties will increase over time and compensate for that.

Conclusion

The real estate industry will perform well during the remaining months of the current crisis. However, as the economy reopens, there is a chance that inflation rates will rise dramatically for a brief period. This will increase the overhead costs for real estate investors who profit from lending their property to consumers. As prices rise for utilities such as electricity, it will be challenging to maintain profits without increasing rent. On the other hand, finding tenants that could pay more for the same house or apartment might be easier when peoples income grows to match the inflation rates. In addition, people who used fixed interest loans to purchase their properties will benefit from inflation, as the value of their houses will grow, while their debt will remain the same. To sum up, the real estate industry will have to adapt to the probable changes to the macroeconomic landscape, such as inflation, but the long-term viability of this segment is not threatened by the current and predicted trends.

Sources

53  Real Estate and Rental and Leasing. NAICS Association. Web.

Interactive Access to Industry Economic Accounts Data: GDP by Industry. BEA. 2019. Web.

Consumer Price Index Summary (Chart). BLS. 2020. Web.

Introduction

Nominal anchor is the behavioral regulation used by Central Banks on the verge of alleviating nominal variables such as a countrys general price level. To be more precise, these mechanisms are adopted to check on either deflation or inflation in the country. The commonly used nominal anchors by the Central Banks include assets prices targets, monetary aggregate targeting, targeting the rate of exchange of currencies as well as inflation targeting. Each of these strategies comprises its own merits and demerits when used (Cole and Kocherlakota, 1998 p. 8).

This paper set out to explore various pros and cons of the three anchors commonly used by the central Banks namely monetary targeting, inflation targeting, and exchange rates targeting. The paper also addresses the need for embracing asset prices in monetary targeting as well as why their use may be a major setback.

Inflation targeting

Many countries and especially developing countries have been using this mechanism recently. Inflation targeting entails setting an inflation target by the central banks as well as the Bank giving accountability for achieving those targets. The central bank, therefore, is required to enhance its efficiency by being extremely vigilant and transparent in its operation as well as illuminating its decisions to the general public and providing inflation reports regularly (Cukierman, 1992 p. 120). Therefore, Inflation targeting consists of five fundamentals which include a commitment to ensure the stability of prices as the crucial and long-term aim of the monetary policy to attain inflation goal, making public announcements about the medium-term targets the Central bank sets to cub inflation, enhanced transparency in the strategies set out in the monetary strategies, as well as enhanced Central Bank accountability to achieve inflation objectives (Alesina, and Lawrence, 1993 p. 155).

Merits of inflation targeting

One advantage of inflation targeting is that it is easily understood by the members of the public which means transparency is enhanced. Outlining various monetary policy discussions concerning inflation goals makes it easier for Central Banks to communicate with the markets and the public easily. The benefit brought by this is that the aspect of uncertainty concerning future monetary progress is significantly eliminated. This in turn decreases volatility in the markets. In a nutshell, inflation targeting often reduces chances that Central Bank would find itself into a time discrepancy trap whereby it would only try to use expansionary monetary policy to expand output as well as employment in the short-run (Bernanke, Laubach, Mishkin, and Adam, 1999 p. 143).

Inflationary targets enhance Central Banks liability as well as being in line with the democratic principles. The consistent success of the inflation targeting conduct as an appraisal against a well-described inflation target could be influential in enhancing support from the Central Banks autonomy and as well as its policies (McCallum, 1994 p. 121).

Disadvantages of inflation targeting

These measures are very inflexible which might lead to an elevated fluctuation of output. This happens especially when the Central Bank centers so much on inflationary control. Inflationary targeting usually pays no attention to the stabilization of outputs. This brings controversies that make many economists pressure governments to use nominal income growth targets as an alternative to inflationary targeting (Svensson, 1999 p. 630). They argue that the nominal income growth target has similar characteristics as those of the inflationary target. In addition, many economists construe that it has many merits such as eliminating chances of velocity fluctuations as well as stumping time inconsistency challenges. This is the same as what happens when the central bank uses monetary targeting as well as fixed exchange rates (Bernanke and Frederic, 1997 p.103).

Inflation targeting could also be rigid at times since the Central Banks that focus on inflation targeting especially in developed economies in most cases approve more than two years inflation targets prospect. This at times may lead to a notion that the prospects for inflation targets are fixed. This would be construed that inflation targeting may not be flexible enough. In many cases, such economies hold the notion that there could be adjustments in the optimal monetary policy that would change the target prospect as well as the inflation path depending on the characteristics and persistency of fluctuations (Haldane, 1995 p. 182).

Monetary targeting

Monetary targeting is often used by the Central Bank on its verge of enhancing stability in the economy. Central Banks at times use monetary aggregates which include monetary base, M1, M2 as well as M3. The reason for using this is to enable them lower and stabilize inflation rates in the economies. The basic idea for this kind of target is that, whenever the velocity for money is constant, a growth target in the monetary aggregate is said to maintain nominal income at a stable path of growth which in turn enhances prices steadiness in the long run. In such circumstances, monetary targeting as a nominal anchor brings many merits (Levin and Piger, 2004 p. 65).

Advantages of monetary targeting

One significant merit of monetary targeting is that when there are narrower monetary aggregates, the Central bank gets in a position where it can easily control those aggregates. This enhances the banks operations as well as lessening its monitoring strategies. The results are increased stability of prices at a national level which stimulates economies (Stephen and Jan 2001 p. 140).

Another critical advantage of monetary targeting compared to other forms of nominal anchors is that monetary aggregates are easily measured with a high degree of accuracy within a short time. This is in contrast with inflationary targeting where a longer period has to pass to check the effectiveness of the mechanism. Monetary aggregates could be a measure even over three weeks (Stanley and Norbert, 1994 p. 301).

Since the aggregate is recognized when using monetary targeting, there is high transparency of the monetary policy which encourages the markets as well as the public. This stumps out an aspect of uncertainty in the economy of a country. Such monetary aggregate usually gives light to the markets about the plans of those making policies, therefore, helping them take part in fixing the inflation outlook. This means that the pressure which would be put on Central Bank to practice expansionary monetary policy when things are worst in the economy is significantly reduced (Mishkin, 2002 p. 219).

Disadvantages of monetary targeting

One great demerit about this mechanism is that it is only effective in situations where monetary aggregates have an elevated foreseeable relationship with nominal income. However, in many countries, there have been frequent and huge changes in the velocity over a long period such that the connection between goal variables and the monetary aggregates has faced major challenges. I the same as inflation targeting as well as fixed exchange rates targeting, monetary targeting is prone to the occurrences of time inconsistency (Orphanides, 2002 p. 119).

Exchange rates targeting

The use of exchange rates targeting as a nominal anchor has been a common phenomenon reported by numerous Central Banks. The main aim of exchange rate targeting is to allow a country to enjoy a low and steady inflation rate. Various exchange rate systems are adopted in many economies on the verge of endorsing international trade competitiveness (Darrell, 2001 p. 202).

Advantages of exchange rates targeting

One of the greatest merits of exchange rate targeting is that it enhances the stability of prices for the traded goods. In addition to this, a lower rate of inflation is enhanced due to the elimination of various shocks in the markets. Exchange rate targeting is an effective strategy for the more developed countries especially when the monetary targeting is not conducive. They also significantly help the countries with emerging markets where political instability thrives. This mechanism helps stabilize the economy of such countries (Calvo and Mishkin, 2003 p. 112)

Disadvantages of exchange rates

When a Central Bank uses this exchange rate targeting, it usually loses its autonomy in setting the monetary policies in an economy, therefore the rates have to follow the monetary policy trends. This makes the central Bank incapable of responding to the fluctuation of as well as disruptions created which might hinder economic growth in an economy. In addition, exchange rates which are usually pegged on monetary policies have been known to be useful n the short-run and not in the long run. The most affected economies by this phenomenon are developing ones. They are made to pay the price by forgoing their monetary policy independence rather than controlling inflation. On the other hand, richer countries can look for another states currency to anchor themselves to (Froot, and Thaler, 1990 p. 180).

The central Banks may become deficient in impulsion of a competent and appropriate discretionary monetary policy especially if it practices floating exchange rates. This is more so because if the floating exchange rates decline in the international export markets, a mechanical decline in a countrys currency value prevails (Kaminsky, 1996 p. 302).

Asset prices

Asset prices are usually used as the anchor of the household price level. Asset pricing entails pricing both financial and physical assets in a tentative economic atmosphere. There arise controversies especially among scholars concerning whether central banks should or should not use asset pricing in monetary targeting.

Reasons why assets shouldnt be used

Sometimes price stability may be connected to increased risks of financial volatility. This is usually the case especially after the repercussion of the widely corrected share prices. In some nations, appreciating assets value, as well as debt accrual, have led to stretched domestic and companies balance sheets which are susceptible to a kind of equity price rectification that has been witnessed in recent times. This makes everyone wonder whether the central bank should direct monetary policy towards maintaining price stability as well as the part it takes in combating financial insecurity (Ross, 1976 p. 349).

The use of asset prices in monetary targeting may also be unwarranted. The reason for this is that there is a lack of clarity as to whether an increase in the rates of interest would be able to stop any increase in asset prices. In addition, the essential alterations might be too large. Another reason is that central Banks should prevent occurrences of financial instabilities and a great interest rate trudge meant to avert asset prices from increasing may prompt financial instability. More often, the extreme concern of the monetary policy on the fall down of asset prices can generate moral hazard. The usual approach whereby monetary policy ignores the elevated asset prices especially when the bubble busts lessens the rate of interest thus making the bubble more likely to occur again (Lucas, 1978 p. 1434).

Another disadvantage of using asset prices is that targeting asset prices is equivalent to trying to fix prices. This creates misallocations as well as dislocations which may destabilize the markets for the assets as well as the entire economy (Schwert, 1990 p. 401).

Conclusion

Central Banks usually uses various anchors in their efforts to check on the inflationary and deflationary aspect. In practice each of nominal anchors, various advantages and disadvantages arise. Most governments in the third world usually use inflation targeting more than their development nations counterparts. It is more common that inflation usually affects the majority of developing countries.

Another more common mechanism that has been used for ages is exchange rate targeting. Countries using this method evaluate various aspects that could affect their currency and its competitiveness in the international markets. Monetary targeting on the other hand has been a commonly used tool by the Central Banks. Perhaps the reason for their popularity is that the aggregates are effective and can be measured over a short period.

Asset pricing is an anchor that has been the center of the debate for a long time. Some scholars advocate that central Banks should go ahead and use asset pricing in monetary targeting whereas others strongly oppose this notion.

List of References

Alesina, Alberto, and Lawrence H. Summers. 1993. Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence. Journal of Money, Credit, and Banking 25, no. 2: 151-62.

Bernanke, Ben S., and Frederic S. Mishkin. 1997. Inflation Targeting: A New Framework for Monetary Policy? Journal of Economic Perspectives 11, no. 2: 97-116.

Bernanke, Ben S., Laubach, Thomas, Mishkin, Frederic S. and Adam S. Posen, 1999. Inflation Targeting: Lessons from the International Experience. Princeton: Princeton University Press.

Calvo, G. and F. Mishkin, 2003. The Mirage of Exchange Rate Regimes for Emerging Market Countries Journal of Economic Perspectives, vol. 17, no. 4, pp. 99118

Cole, Harold L. and Kocherlakota, Narayana, 1998. Zero Nominal Interest Rates: Why Theyre Good and How to Get Them. Federal Reserve Bank of Minneapolis Quarterly Review, Spring, Vol. 22(2), pp. 2-10.

Cukierman, Alex. 1992. Central Bank Strategy, Credibility, and Independence: Theory and Evidence. Cambridge: MIT Press.

Darrell Duffie, 2001. Dynamic Asset Pricing Theory. Princeton: University Press.

Froot, K A and Thaler R. H, 1990. Anomalies: Foreign Exchange, Journal of Economic Perspectives, Summer, vol 4, no 3, pp 179-192.

Haldane, Andrew G., 1995. Targeting Inflation. London: Bank of England.

Kaminsky, Lewis, G., K., 1996. Does Foreign Exchange Intervention Signal Future Monetary Policy? Journal of Monetary Economics, Vol. 37, No. 2, pp. 285-312.

Kydland, Finn, and Edward Prescott, 1977. Rules Rather than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy, Vol. 85, no. 3: 473-92.

Levin, F Natalucci and Piger J., 2004. The macroeconomic effects of inflation targeting, Federal Reserve Bank of St. Louis Review, 86(4), pp 5180.

McCallum, B T., 1994. A reconsideration of the uncovered interest parity relationship, Journal of Monetary Economics, vol 33, pp 105-132.

Lucas R.E.J., 1978. Asset prices in an exchange economy, Econometrica, Vol. 46(6): 1429-1445.

Mishkin, Frederic S., 2002. The Role of Output Stabilization in the Conduct of Monetary Policy, International Finance, Vol. 5(2): 213-227.

Orphanides, Athanasios, 2002. Monetary Policy Rules and the Great Inflation, American Economic Review, vol. 92(2): 115-120.

Posen, Adam S., 1995. Declarations Are Not Enough: Financial Sector Sources of Central Bank.

Ross, Stephen, 1976. The arbitrage theory of capital asset pricing. Journal of Economic Theory 13 (3): 341-360.

Schwert, G. William, 1990. Indexes of United States Stock Prices from 1802 to 1987, Journal of Business, vol. 63: 399-426.

Stanley Fischer, and Norbert Schnadt, 1994.The Future of Central Banking: The Tercentenary Symposium of the Bank of England. Cambridge: Cambridge University Press.

Stephen F. LeRoy and Jan Werner, 2001. Principles of Financial Economics. Cambridge: Cambridge University Press.

Svensson, L, 1999. Inflation Targeting as a Monetary Policy Rule, Journal of Monetary Economics, vol. 43, no. 3, pp. 607654.

Vickers, John, 1999. Monetary Policy and Asset Prices, Bank of England Quarterly Bulletin, vol. 39 (4), pp. 428-435.

Of primary importance is the recognition that inflation is not an unnatural or harmful mechanism for a countrys economy. Certainly, from the point of view of an ordinary citizen who pays taxes and gives their private money for goods, it may seem that the absence of pre-election inflation or even deflation are good strategies to curb economic dynamics, and this is something to strive for. In fact, however, such an approach can cause a number of problems.

First of all, this problem concerns the consumer opportunities of citizens. If the Federal Reserve does not manipulate price changes  when inflation is at the zero level  the buyer has fewer incentives to consume. This means that total consumer spending is reduced because there is no change in price offers (Akerlof et al., n.d.). A citizen can give up savings and interest deposits: there is a state guarantee that tomorrows prices will be the same. The second consequence of zero inflation is a real increase in demand for goods and services of the U.S. economy, which creates an disproportion between supply and demand. In this case, the company should have increased its production capacity, but with zero inflation, it is problematic (Yellen, 2017). Companies will not be able to afford to hire new employees, and it will be necessary to re-evaluate existing HRs in a stable price environment. Thus, the companys management will have to cut salaries or fire some of its employees, which will lead to an expected increase in unemployment in the country.

Another consequence of maintaining inflation at 0% will be reducing real interest rates by the Central Bank. In theory, the real interest rate is defined as the nominal one minus the inflation rate, but if inflation is zero, mathematically, it means that the actual debt burden increases. This is especially dangerous if there is already a large accumulated level of debt in the economy. Furthermore, with zero inflation, the dollar is cheapening, which will eventually increase the real value of national currencies. However, it should be recognized that most multinational companies are oriented towards the U.S. dollars, and hence the growth of national currencies is unlikely to be positive news for them.

The reduction of the free money supply, which is equivalent to removing 6% of cash from the turnover, produced by the Federal Reserve, entails a number of circumstances both in the short and long term. In particular, a sufficient 3 percent unemployment rate creates a liquidity deficit in which consumers lack the money to pay for goods and services of the U.S. economy (Chappelow, 2019). This, in turn, reduces consumer spending and overall aggregate demand. Given the supply and demand nexus, low demand stimulates a reduction in production capacity. In order for citizens to survive, stores and manufacturers are likely to have to lower prices, driven by lower inflation, as the Phillips curve postulates (Barnier, 2020). A reduction in the money supply also responds to an upsurge in the real interest rates value, which reduces investment interest and the attractiveness of the Central Bank.

In the long run, the reduction in the money supply will result in higher unemployment, currency appreciation, and, if we look at a very distant period, a smooth recovery of the economy with the current level of GDP. The fall in wages, which means a growth of the unemployment rate, is stimulated by the mismatch between the total and nominal output. Moreover, after a regression in the money supply, the exchange rate upsurges in the long run. This is because the decline in national income reduces domestic demand for imported products, forcing local consumers to show less demand for foreign currency to buy imported goods. In addition, the domestic real interest rate makes domestic assets more attractive to foreign investors, increasing their demand for national currency. In the long run, the 6% reduction has the potential to reduce price levels, but over time the economy is expected to reach a balance.

Reference

Akerlof, G. A., Perry, G. A., & Dickens, W. T. (n.d.). Low inflation or no Inflation: Should the Does the Federal Reserve pursue complete price stability? Brookings. Web.

Barnier, B. (2020). Phillips curve. Investopedia.

Chappelow, J. (2019). Liquidity crisis. Investopedia.

Yellen, J. (2017). Nobody seems to know why theres no US inflation. Financial Times. Web.

Abstract

The paper outlines the primary challenges of Zimbabwe economic system and provides a consistent account of inefficient economic strategies that disrupt the countrys well-being. The notion of Mugabenomics is reviewed in the case study.

Due to the findings of the case, there is a threat of Zimbabwe becoming the country with the highest level of inflation. Therefore, this study emphasizes the major problematic strategies that lead to a currency crisis. Finally, some recommendations on the possible development of Zimbabwes economy are provided.

Introduction: Zimbabwe Deviant Macroeconomics

As a field of study, macroeconomics regards the major issues that target a countrys general economic performances, decision-making and structural distributions. Since the indicators of Zimbabwe economy constitute a threatening picture, it is an undertaking task to outline any specific directions within the countrys macroeconomics.

Therefore, due to the Mugabes reign of terror, which predetermines every decision that is made in Zimbabwe, the term of macroeconomics can not be applied to regard the countrys policies. Instead, the notion of Mugabenomics was devised as an illustrator of Zimbabwes authoritarian politics.

The Notion of Mugabenomics

Due to the fact that Zimbabwe economic principles do not fall into any existing scientific theory, the term of Mugabenomics is used to emphasize its irrational direction.

The problem that disrupts the countrys economy is stipulated by an enormous inflation. According to Roger Bate (2008), consumer expenses are constantly going up in Zimbabwe. Thus, it became impossible to indicate the prices for food in the country, for they change every day. Consequently, the term Mugabenomics was coined to reveal a control-oriented character of Zimbabwe tragic economy decadence.

Analysis of the Economy Development in Zimbabwe

Zimbabwe Economic School of Thought

In general, there are several existing economic schools of thought that determine the essence of any macroeconomic system: Smyths classical economic school, Keynesian and Monetarist economic schools (Simpson, 2014, para. 2). In the case of Zimbabwe economics, it is not possible to indicate any features of existing economic school thoughts that could influence its development.

Strategies that Target Zimbabwe Economy

The sole strategy that directs the development of Zimbabwe economy was established by the countrys ruler, Robert Mugabe, and is based upon a centralized decision making and absolute control over the countrys resources.

Despite the fact that Zimbabwe possesses a huge economic potential, due to its fertile lands and valuable mineral resources, the country is precluded from any rational development. The socialistic economic strategy that was adopted by the president of Zimbabwe is rooted at the public policy purpose of equal distribution of resources. However, such strategy results in a decrease of economic stability.

The Major Threats of Mugabenomics

Mugabenomics is a deeply-rooted program that concerns every sphere of Zimbabwe life. Zimbabwe economics is not disrupted only due to the presidents desires. The ruler of the country managed to involve the major governmental forces into his authoritative political plan.

Thus, according to Higgins (2008), Gideon Gono who is Zimbabwes principal bank governor, follows the lead of Robert Mugabe, dwelling on the Bible laws. He claims that it is strictly forbidden to contradict the wishes of ones president (para. 14). Consequently, a disastrous economic politics is a multidimensional concept that embraces logical, moral and religious assumptions. That is why, Mugabenomics may be regarded as one of the most threatening world institutions, since it forces people to rebut their own opinions.

Conclusion: Recommendations and Possible Development Strategies

Lately, the Zimbabwean government has accused the major business leaders of creating the economic problems that disrupt the countrys economy (Olson, 2007, para. 7). Therefore, the crisis of Zimbabwe economy is stipulated by the governments deceiving politics.

Consequently, any alternative strategy that might contribute to Zimbabwes rise has to start from a complete substitution of the governmental structures and an embracement of a consistent economic strategy. Mainly, Zimbabwe economy can benefit from Keynesian economic school of thought, which is based on the implementation of effective fiscal policies and directed upon an inflation decrease.

References

Bate, R. (2008). How inflation may topple Mugabe. The Wall Street Journal.

Higgins, A. (2008). World news: Zimbabwe central banker answers to Mugabe, Bible; loyalty steers Gono while ruling party destroys economy. The Wall Street Journal.

Olson, P. (2007). Zimbabwe falters under Mugabenomics. Forbes.

Simpson, S. (2014). Macroeconomics: Schools of thought. Investopedia.

Introduction

Inflation is a highly contentious issue. This is due to its economic implications. For instance, if not regulated, inflation has the potential of crippling a countrys economy. As a result of this, governments are always coming up with policies and strategies to ensure that it remains at manageable levels, meaning low and steady levels. The United Kingdom has faced its fair share of economic problems resulting from fluctuating inflation rates which have in turn had their effects on economic factors such as employment rate, consumer price index, value of the currency, general consumption trends and in effect the standard of living of people in the country. Most of the time government efforts always give varying results.

Causes of Inflation

Inflation refers to the general increase of price levels in the economy usually measured as a percentage referred to as the inflation rate, which represents the pace at which prices are increasing (Musgrave & Kacapyr, 2006). This rate is normally based on the prices of different goods and services measured over a certain period of time. Continued inflation usually erodes the purchasing power of money since when the prices of commodities increase; the same unit of money purchases less and less commodities (Hoag & Hoag, 2006). The causes of inflation differ as presented by different schools of economic thought and they include the following:

Demand Pull Inflation: Demand Pull Inflation refers to the type of inflation that occurs when the aggregate demand in the economy exceeds the aggregate supply. This means that when the demand for certain commodities goes up and all other factors such as the supply of commodities remain fairly constant, the commodities prices rise. The situation is as a result of demand pulling up the prices of the commodity because the level of supply in the economy cannot match up to the level of demand (Geetika, Ghosh & Choudhary, 2008). The increase in demand for commodities may be as result of an increase in peoples disposable income, an increase in a countrys populations as well as an increase in peoples aggregate spending. According to Grahame & Grant (2000), the demand pull inflation that occurred in the United Kingdom between 1986 and 1989 was as a result of an increase in the level of consumer spending which was warranted by the low cost of borrowing, the availability of funds for borrowing and the high level of confidence among the business community due to the reducing levels of unemployment.

In the diagram below, the Y axis represents the level of inflation while the X axis represents the level of national income. The initial level of demand is AD1; the supply is SRAS1, the income Y1 and the price P1. When the level of income moves from Y1 to Y2, it leads to an increase in aggregate demand to AD2. This increase in Aggregate Demand pushes the price level to P2 which is higher than the initial P1. Economic forces come into play pushing the price to P3, which shows a general increase in price levels from P1 to P3 and thus inflation.

Cost Push Inflation: Cost push inflation occurs from a continued increase in costs within the economy. It originates from the supply side of the economy which shifts the aggregate supply in the economy to higher levels (Macdonald, 1999). This kind of inflation is warranted by a persistent increase in the cost of production over a certain period of time which in turn leads to a high level of aggregate supply. The increase in aggregate supply may occur as a result of rising wage levels, increase in commodity prices, rising profits as well as increase in taxation levels. In the United Kingdom, a considerable number of employees work for the government. An increase in their wage levels is normally emulated by the private sector meaning that the general wage level rises. Though in recent years, the public sector wages have continued to be lower than those of the private sector. According to Macdonald, (1999) the period between 1973 and 1979 was characterised by an increase in oil import prices. Since oil is a widely used commodity, the rising prices led to an increase in costs which different businesses transferred to consumers in the form of high prices for commodities, causing a persistent increase in price levels in the economy. These factors combined contributed to the inflation that was experienced at the time.

Money Supply: This theory as a cause of inflation is mostly fronted by monetarists who believe that an unwarranted increase in the level of money supply in the economy lead to high levels of inflation. The high rates of inflation witnessed in the United kingdom during the 1970s was blamed on the rise in the supply of money in the economy as fuelled by the government as they offered increased wages to their employees and the strength of trade unions which pushed for high wages for their members (Floud & Johnson, 2004). The level of money supply was therefore at an all time high meaning that people had a lot of disposable income on their hands. This increased the level of demand for commodities in the economy above that of the supply led to an increase in the level of commodity prices. Due to the prevalence of this situation, the levels of inflation went up leading to one of the countrys major economic crisis.

United Kingdom Government Inflation Control Policies

The United Kingdoms fight against effects of inflation dates back to the Second World War. Successive governments have come up with different measures to curb the problem and at times its policies have failed to achieve their intended objectives. The 1970s period saw many countries experience an economic transformation due to a major economic down turn with most of them operating at GDP rates way below what they did in the previous years (Parkin & Sumner, 1978). According to Floud & Johnson (2004), it is during this period that the United Kingdoms monetary system collapsed leading to unprecedented high inflation rates and rising levels of unemployment. Different views have been presented as to what caused the turmoil experienced in this period. Some argued that it was the rising cost levels which created an out of control cost versus price versus cost spiral. The rising wage levels due to pressure from trade unions and the increase in oil prices around 1973 have often been blamed for pushing up costs in the economy. Monetarists argued that the high supply of money in the economy led to the problem. These and other inflation cases elicited different reactions from the countrys government which include the following:

Monetary Policy: In the earlier years the British economies were dominated by post war effects. These effects were recession and inflation. There were high rates of unemployment that affected adversely the GDP of the country. The average rate of inflation under successive business increased remorselessly under the previous government before the Thatcher government took over. Unemployment also rose from (Howe 2001, 43). All kinds of shocks affected prices; his brought the urge to control inflation through the rate of monetary growth. Thatchers government which took over in 1979 came up with various policies to curb the problem. Monetary policy is aimed at keeping inflation below 2½ per cent by the end of this Parliament. She placed emphasis on economic policies that reduced government intervention and also made it clear that fiscal policies were necessary to combat inflation in the country. The first step Thatchers government took was to push up interest rates whose intended effect was to decelerate the increase of money supply in the economy and in effect lower inflation. The inflation target approach to monetary policy and how the institutional changes to the framework of monetary policy. This was designed to enhance the transparency and openness of policy. The policy reduced the control of the government over the economy, opting for a more liberal, market oriented economy. By 1980 the inflation rate had fallen to 8%, down from18% and by 1990 the economic growth was higher than any other large EU economies. Despite this fact, the period was characterised by low standards of living. This policy did not help in any way to reduce the level of unemployment but rather it led to its increase. This affected the output growth a good example is where the manufacturing output was no higher than in 1950sthis deteriorated its international competitiveness.

The government also established a macroeconomic policy. This was the combination of monetary and fiscal policies which were to help deal with the problem of unemployment. Britain macro economic have poor performance compared to the otheG7 countries. There has been a frequent inflation and growth fluctuation this has affected business and consumers ability to plan ahead. Under the Medium Term Financial Strategy which identified specific targets for money supply. It has since undergone various transformations targeting the money supply, the exchange rate, interest rates and fiscal policies. To reduce government control over the economy, privatisations, weakening of the power of trade unions, deregulation and public expenditure restrain policies were adopted. According to Dow (2000), privatisation was meant to reduce the capacity of the public sector while at the same time trimming down government borrowing. He is also of the opinion that the then governments actions failed to achieve the desired results since increasing the level of interest rates were not able to control bank lending. This macro economic polices were strainers to deal with the unemployment problem they opted for another policy.

The policy of exchange rate was also accepted amid 1990 and 1992. It comprised mostly on the regulation of foreign currency to sustain a standard rate with the foreign currency. This also failed to work and was done away with after the Thatcher regime was out of office. There lacks a link between the theory and reality of UK executive action. The pattern has been developed to singular around two key players of the late 1990s and 2000s then fractured in what became in effect dysfunctional government.

The Relationship between unemployment and Inflation in the United Kingdom

There always exists a relationship between the level of employment in an economy and the rate of inflation. This relationship is represented in a Phillips Curve which shows that when the level of unemployment in a country is low, the nominal wages tend to go up leading to an increase in the level of inflation.

United Kingdoms Government Success in Controlling Inflation Between 1997 and 2010

When the New Labour party took over in 1997, it pretty much continued to concentrate on the market oriented policies but with various improvements such as new State roles which included demand management, setting inflation targets (inflation targeting) and use of the interest rate as the only monetary policy control tool (Floud & Johnson, 2004). These policies were to be implemented by an independent monetary policy authority which was the Bank of England (Stevens & Periton, 2009). Floud & Johnson are of the opinion that during the period in which the New Labour party was in office, the countrys economy grew thus changing the downward trend that it operated on before, leading to declining rates of unemployment and manageable inflation levels.

Since the year 2000, the United Kingdoms inflation rates have been managed from the point of view of interest rates (Press Association, 2007). This point was backed by Lomax & Greenspan from the Bank of England in their 2004 Low Inflation and Business Pamphlet. Until 2007, the inflation rates were fairly constant but the economic recession that hit the globe in 2008 saw an increase in the countrys inflation rates as shown in the table below (Trading Economics, 2010). In fact, the period between the late 1990s and the early years of 2000 is mostly referred to as the Nice Decade as it was characterised by low rates of inflation and positive growth in the countrys economy (Chrystal, 2008). This period proved good to the countrys economy as the level of employment was at an all time high and the financial markets experienced very low volatility. It represented a move away from the economic woes experienced by the country in the previous decades.

According to a speech by Andrew Sentance (2009), the United Kingdom experienced the effects of the global economic recession and the Bank of England was expecting a fall in the countrys GDP (Gross Domestic Product) which would pick later on meaning that the levels of inflation would also come down. The Monetary Policy Committee maintained inflation levels at 2% up from a previous 5%. The Committee was also forced to relax its monetary policies in order to accommodate the effects of the recession for example by lowering lending rates.

The effects of the economic recession as experienced in the United Kingdom were also caused by the down turn in the economies of other countries as a result of globalisation which has greatly led to the intertwining of different countries economies (Hunt, 2007). According to Sentance (2007), the United Kingdom financial services sector is largely influenced by global economic events due to the existing interrelationship between the local and global international financial markets. Due to this, the effects of the economic crisis are inevitable and have a great deal of effect on the United Kingdom economy. According to him, such occurrences influence to a large extent the decisions that the Monetary Policy committee takes in their quest to keep inflation levels low and stable and as per the target of the committee which stands at 2% based on the countrys consumer Price Index. The United Kingdoms open economy allows room for the influences of the global economic forces and in effect has to contend with the fluctuations this causes to the countrys inflation rates both in the short and long term. Rising prices for various commodities and oil as a result of an increase in global demand for the products over the past have led to demand oriented inflation in the country. The economic recession as witnessed also has an effect on the global demand for products meaning that the resultant fall in demand will most likely weaken demand in the country and as such exert a downward pressure on inflation.

The biggest challenge the monetary policy committee had in 2007 involved adjusting the countrys interest rate accordingly so as to avoid veering away from the set inflation rate target. In order to contain the situation, the monetary policy resorted to three decisions which included tightening monetary policy in such a way that it would push up the currency exchange rate which would in effect reduce the price of imports countering a rise in global inflationary pressures. The second decision was to influence the domestic demand in terms of consumer spending and private sector investment through interest rates. The third decision was to play into the expectations of the people concerning inflation rates. If inflation rates are expected to remain stable then the set out monetary policies would be able to counter the influences of the global economic shocks, but if they are expected to fluctuate then it would be easier for external shocks to set off a wage spiral as was the case in the 1970s and 1980s.

In another of his speeches on the 18^th of March 2010, Sentance admitted that the policies put in place in 2007 failed to work as the influence of the global crisis proved too much and the countrys inflation rate was pushed to levels above 5% in the later half of 2008 and early 2009. This was as a result of the recessions impact on the levels of employment and output where many people lost their jobs and the level of unemployment went up and the level of output also went down due to reduced investments (Sentance, 2010). Due to the returning confidence by investors and consumers and the stable trends in the global financial systems, the country is starting to recover from the negative impact of the recession as evidenced by the recovery in the equity markets compared to the two previous years. Though the countrys inflation rates have gone down, the Bank of England expects them to remain above 2% for the better part of the year due to the low recovery pace of output levels (Bank of England, 2010).

According to the bank of Englands Governor, the fact that the level of money supply in the United Kingdom is growing at a slow pace will help prevent an increase in inflation and therefore maintain it at the targeted 2% (Ryan, 2010), making the undesirable rate of inflation at the moment a temporary situation. The fact that bond rates dropped, makes it a challenge for policy makers to determine when it will be desirable to increase the level of interest rates. The budget deficit in the country also plays into the difficult decision the bank has to make as it will depend on how fast the budget deficit can be reduced. This affects the countrys monetary policy and in effect the effectiveness monetary policies as the conditions remain highly uncertain. The rate of inflation increase suggests that the pound is weak against other major currencies, a situation that is not favourable to the countrys economy since it affects imports as well as other commodity prices.

Conclusion

From the discussion above it is fair to conclude that the successive governments policies have had mixed results as far as combating inflation is concerned. While the government policies in the 1970s failed to work, those between 1997 and 2007 worked but were undermined by the global economic crisis. They were however able to help stabilise the countrys economy and there is hope that they will still do so and that the countrys economic stability will be recaptured. High rates of inflation are detrimental to a countrys economy and in effect the standard of living of the citizens of such a country and thus the government and other bodies charged with the duty of ensuring inflation rates are maintained at low and stable levels should ensure that they come up with effective policies, whether monetary or fiscal.

Reference list

Bank of England. Overview of the Inflation Report February 2010, Bank of England, 2010, Web.

Chrystal, A, Monetary Policy Independence: The First Ten Years of the UK Monetary Policy Committee& and The First Year of the Not-Nice Decade, 2008, Web.

Dow, C. Major Recessions: Britain and the World, 1920-1995, Oxford, Oxford University Press, 2000.

Floud, R. & Johnson, P. A. The Cambridge Economic History of Modern Britain: Structural Changes & Growth, 1939-2000, Cambridge, Cambridge University Press, 2004.

Geetika, T., Ghosh, P. & Choudhary, R. P. Managerial Economics, New Delhi, McGraw Hill Company Limited 2008.

Grahame, C. B. & Grant, S. The UK Economy in a Global Context, Oxford, Heinemann Education Publishers, 2000.

Hoag, J. A. & Hoag, J. H. Introductory Economics, 4^th Edition, New Jersey, World Scientific Publishing Company Limited, 2006.

Howe, L. Postscript: The 364 EconomistsAfter Two Decades. In Policy

Makers on Policy, ed. Forrest Copier and Geoffrey Wood, 2001.

Hunt, B, U.K. Inflation and Relative Prices over the Last Decade: How Important was Globalisation? Europe, IMF Working Paper, 2007.

Lomax, A. & Greenspan, A, Low Inflation and Business Pamphlet, Bank of England, 2004, Web.

Macdonald, T. N. macroeconomics and Business: An Interactive Approach, London, International Thompson Publishing, 1999.

Musgrave, F, & Kacapyr, E, How to Prepare for the AP Microeconomics/Macroeconomics, 2^nd Edition, New York, Barrons Educational Series, 2006.

Parkin, M, Sumner, T, M, Inflation in the United Kingdom, Manchester, Manchester university press, 1978.

Press Association, The Nice Decade: 10 Years of Stability, This Is Money, 2007, Web.

Trading Economics, UK Inflation Slows, Trading Economics. 2010, Web.

Riley, G, AS Macroeconomics/International Economics: Inflation, 2006, Web.

Sentance, A, Monetary policy and the Current Recession, Monetary Policy Committee, Bank of England, 2009, Web.

Russel, M, & Heathfield, D, F, Inflation & UK Monetary Policy, 3^rd Edition, Oxford, Heinemann Education Publishers, 1999.

Ryan, A, King Says Undesirably Low U.K. Money Supply to Curb Inflation, 2010, Web.

Sentance, A, The Global Economy and UK Inflation, 2007, Web.

Sentance, A, Monetary Policy and the Current Recession, 2009, Web.

Sentance, A, Prospects for Global Economic Recovery, Bank of England, 2010, Web.

Stevens, A, & Periton, P, CIMA Official Learning System Fundamentals of Business Economics, Massachusetts, Elsevier Publishers, 2009.

In the introduction, the video introduces the history of paper money, talking about gold and tobacco. Then, it moves to discuss inflation in the United States. Between 1972 and 1978, wages grew, but the increase in income tax lowered the buying power of people  this is called taxation without representation (Common Sense Capitalism, 2010). Inflation leads to increased prices; although wages grow, taxes increase. In the end, people do not have more money to spend on goods.

Inflation gets blamed on many factors, including the work of labor unions  they cannot react quickly to wage changes. Some also put the responsibility on imported goods, saying that buying items abroad leads to inflation because of currency exchange rates. A major example is oil exported from Arab countries  but the speaker argues that Japan and Germany import all of their oil, while the US produces half of its oil, and their inflation does not depend as much on imports (Common Sense Capitalism, 2010). Therefore, inflation comes from other sources, such as government wages and price controls.

The video suggests that strict controls put on the prices of goods and services lead to increased inflation and poverty and decreased economic growth. In contrast, political and economic freedom reduce inflation and help the economy improve by itself. Friedman suggests a slow-growth strategy without printing too much money, as increased money supply leads to inflation (Common Sense Capitalism, 2010). The government needs to be small, and it should not interfere with business transactions.

The second part of the video is a long discussion between economists and researchers from different countries about the free market economy. The specialists use Germanys example to show how the free-market economy helped the country rebuild after the war. Germanys decisions focus on avoiding inflation  this is the main factor in all government actions. In contrast, the US economy is based on the history of depression, and the government makes economic choices out of fear of future recessions.

Reference

Common Sense Capitalism. (2010). Free to choose Part 9: How to cure inflation featuring Milton Friedman [Video file].

Introduction  stating the problem

The Office of National Statistics (ONS) says that the rate of inflation has risen to 0.2% in December 2015. It was surprising because it became the first month when the number exceeded 0.1% of January 2015. The primary causes of this increase are seen in the rise of transport costs, particularly airfares, and to a lesser extent motor fuels (Collinson 2016, par. 2). Nevertheless, the mentioned rate of inflation falls within the 2% target set by the Bank of England and is still one of the lowest levels in the history of the United Kingdoms economy.

Causes of the problem

The chosen article refers to the concept known as cost-push inflation when inflation is the response to the increase in prices where there is stable demand in the economy (Amadeo 2016). This rate was caused by transportation and fuel costs. However, as it was noted by Maike Currie, investment director, the emerging world experiences a continuous slowdown in the economy and the demand is extinguished by the global manufacturing sector (Collinson 2016). It means that there is no threat of skyrocketing inflation rates in the longer run. Moreover, the Bank of England does not change the interest rates, so the inflation will remain stable and within the planned 2%.

Problem evaluation

Nevertheless, if there were a risk of the inflation rates exceeding the set target, the Bank would have to intervene in the economy to fix the situation. In the case of cost-push inflation, the aggregate supply curve moves to the left, thus, increasing the level of prices (Cartwright 2016). In the long run, it leads to establishing the new equilibrium in the economy  one with a higher level of prices and a lower level of national income (see Figure 1). In a similar situation, the government usually takes a wide range of actions including the contractionary fiscal policy with higher taxes and lower spending and raises the interest rates. The primary purpose of the mentioned activities is to reduce the aggregate demand that would stop the growth of prices. What is also beneficial for reducing cost-push inflation is carrying out supply-side policies including such measures as better infrastructure, education, and training, deregulation, etc. Another option is to tighten the monetary policy introducing higher interest rates that will have the same effect in the long run.

Solving the problem

Even though these steps have a positive impact on the inflation rate in the long run as the AS curve moves back to the left, they can be a source of negative outcomes in the short run. For example, raising interest rates will stop the growth of inflation but as well lead to a fall in gross domestic product or push the economy in the recession because both ordinary consumers and firms could not comply with the new economic conditions. In addition to it, they will affect the exchange rate and lead to unemployment in the short run.

Conclusion

Another way to analyze the economy is to define whether it operates on its production possibility frontier (PPF). PPF can also be used for estimating the inflation rate and the state of the economy. That said, if the economy is pushed far outside PPF, it will experience inflation or even hyper-inflation (See Figure 2).

What should be done in practice is, first, targeting the inflation, i.e. defining the desired and acceptable inflation rates. Second, in the case, if it exceeds the set target, it is vital to define the nature of factors. If they are temporal such as price shocks or natural disasters (Amadeo 2015), there is no need for the government to take any actions because the economy will return to normal functioning without intervention. It is what happened in the example provided in the article. The demand for fuel is inelastic because no matter what the price is, people and companies will buy it. But there are no other signs of reasons for higher inflation rates. That is why the government should remain neutral.

References

Amadeo, K 2015, What Is Cost-Push Inflation?

Amadeo, K 2016, Causes of Inflation: 3 Real Reasons for Rising Prices.

Cartwright, B 2016, Low and Stable Rate of Inflation Series: Cost-Push Inflation, video, channel Brad Cartwright Economics.

Case, K E, Fair, R C & Oster, S M 2013, Principles of macroeconomics, 11th edn, Prentice Hall, Upper Saddle River, NJ.

Collinson, P 2016, UK Inflation Rises Unexpectedly, The Guardian.

Margetts, S 2013, Inflation and Deflation.

Today, as thirty and forty years ago, economists debate how much unemployment is voluntary, how much involuntary, how much is a phenomenon of equilibrium, how much a symptom of disequilibrium; how much is compatible with competition, how much is to be blamed on monopolies, labor unions, and restrictive legislation, how much unemployment characterizes ‘full’ employment. A concept of full employment more congenial to economic theory is labor market equilibrium, a volume of employment which is simultaneously the amount employers want to offer and the amount workers want to accept at prevailing wage rates and prices. Forty years ago theorists with confidence in markets could believe that full employment is whatever volume of employment the economy is moving toward, and that its achievement requires of the government nothing more than neutrality, and nothing less After Keynes challenged the classical notion of labor market equilibrium and the complacent view of policy to which it led, full employment came to mean maximum aggregate supply, the point at which expansion of aggregate demand could not further increase employment and output. With a deflationary gap, demand less than full employment supply, prices would be declining or at worst constant. Expansion of aggregate demand short of full employment would cause at most a one-shot increase of prices. Postwar experience destroyed the identification of full employment with the economy’s inflation threshold. The natural rate is another full employment candidate, a policy target at least in the passive sense that monetary and fiscal policy makers are advised to eschew any numerical unemployment goal and to let the economy gravitate to this equilibrium. Full employment is once again nothing but the equilibrium reached by labor markets unaided and undistorted by governmental fine tuning. The presumption he challenged is that in competitive labor markets actual employment and unemployment reveal workers’ true preferences between work and alternative uses of time, the presumption that no one is fully or partially unemployed whose real wage per hour exceeds his marginal valuation of an hour of free time.

Orthodox economists found the observed stickiness of money wages to be persuasive evidence that unemployment, even in the Great Depression, was voluntary. Keynes found decisive evidence against this inference in the willingness of workers to accept a larger volume of employment at a lower real wage resulting from an increase of prices. His expected expansion to raise prices and lower real wages, but this expectation is not crucial to his argument. If it is possible to raise employment without reduction in the real wage, his case for calling the unemployment involuntary is strengthened. Why is the money wage so stubborn if more labor is willingly available at the same or lower real wage? Consider first some answers Keynes did not give. He did not appeal to trade union monopolies or minimum wage laws. Instead, Keynes emphasized the institutional fact that wages are bargained and set in the monetary unit of account. Money wage rates are, to use the Keynesian term, ‘administered prices’. That is, they are not set and reset in daily auctions but posted and fixed for finite periods of time. This observation led Keynes to his central explanation: Workers, individually and in groups, are more concerned with relative than absolute real wages. They may withdraw labor if their wages fall relatively to wages elsewhere, even though they would not withdraw any if real wages fall uniformly everywhere. Labor markets are decentralized, and there is no way, money wages can fall in any one market without impairing the relative status of the workers there. A general rise in prices is a neutral and universal method of reducing real wages, the only method in a decentralized and uncontrolled economy. Inflation would not be needed, we may infer, if by government compulsion, economy-wide bargaining, or social compact, all money wage rates could be scaled down together. Keynes apparently meant that relative wages are the arguments in labor supply functions.

Alchian and other theorists of search activity have offered a somewhat different interpretation, namely that workers whose money wages are reduced will quit their jobs to seek employment in other markets where they think, perhaps mistakenly, that wages remain high. Keynes’s explanation of money wage stickiness is plausible and realistic. All equilibrium prices, including money wage rates, should differ in the same proportion, while all real magnitudes, including employment, should be the same in the two equilibriums. The resistance of money wage rates to excess supply is a feature of the adjustment process rather than a symptom of irrationality. The other side of Keynes’s story is that in depressions money wage deflation, even if it occurred more speedily, or especially if it occurred more speedily, would be at best a weak equilibrator and quite possibly a source of more unemployment rather than less. What relevance has this excursion into depression economics for contemporary problems of unemployment and wage inflation? The issues are remarkably similar, even though events and Phillips have shifted attention from levels to time rates of change of wages and prices. Phillips curve doctrine is in an important sense the postwar analogue of Keynesian wage and employment theory, while natural rate doctrine is the contemporary version of the classical position Keynes was opposing. Let us adapt Keynes’s test for involuntary unemployment to the dynamic terms of contemporary discussion of inflation, wages, and unemployment. Associated with it is a path of real wages, rising at the rate of productivity growth. Consider an alternative future, with unemployment at first declining to a rate one percentage point lower and then remaining constant at the lower rate. Associated with the lower unemployment alternative will be a second path of real wages. Eventually this real wage path will show, at least to first approximation, the same rate of increase as the first one, the rate of productivity growth. The growth of real wages will be retarded in the short run if additional employment lowers labor’s marginal productivity. In any case, the test question is whether with full information about the two alternatives labor would accept the second one whether, in other words, the additional employment would be willingly supplied along the second real wage path. For Keynes’s reasons, a negative answer cannot necessarily be inferred from failure of money wage rates to fall or even decelerate. Actual unemployment and the real wage path associated with it are not necessarily an equilibrium. Rigidities in the path of money wage rates can be explained by workers’ preoccupation with relative wages and the absence of any central economy-wide mechanism for altering all money wages together. According to the natural rate hypothesis, there is just one rate of unemployment compatible with steady wage and price inflation, and this is in the long run compatible with any constant rate of change of prices, positive, zero, or negative. Only at the natural rate of unemployment are workers content with current and prospective real wages, content to have their real wages rise at the rate of growth of productivity. Along the feasible path of real wages, they would not wish to accept any larger volume of employment. Lower unemployment can arise only from economy-wide excess demand for labor and must generate a gap between real wages desired and real wages earned. The gap evokes increases of money wages designed to raise real wages faster than productivity. This intention is always frustrated, the gap is never closed, and money wages and prices accelerate. Older classical economists regarded constancy of money wage rates as indicative of full employment equilibrium, at which the allocation of time between work and other pursuits is revealed as voluntary and optimal. Their successors make the same claims for the natural rate of unemployment, except that in the equilibrium money wages are not necessarily constant but growing at the rate of productivity gain plus the experienced and expected rate of inflation of prices.

There are two conflicting interpretations of the welfare value of employment in excess of the level consistent with price stability. One is that additional employment does not produce enough to compensate workers for the value of other uses of their time. The alternative view, which I shall argue, is that the responses of money wages and prices to changes in aggregate demand reflect mechanics of adjustment, institutional constraints, and relative wage patterns and reveal nothing in particular about individual or social valuations of unemployed time vis-a-vis the wages of employment. On this rostrum four years ago, Milton Friedman identified the noninflationary natural rate of unemployment with “Equilibrium in the structure of real wage rates”. “The natural rate of unemployment”, – he said, “… is the level that would be ground out by the Walrasian system of general equilibrium equations, provided that there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of getting information about job vacancies and labor availabilities, the costs of mobility, and so on”. Presumably this Walrasian equilibrium also has the usual optimal properties; at any rate, Friedman advised the monetary authorities not to seek to improve upon it. In fact, we know little about the existence of the Walrasian equilibrium that allows for all the imperfections and frictions that explain why the natural rate is bigger than zero, and even less about the optimality of such an equilibrium if it exists. In the new microeconomics of labor markets and inflation, the principal activity whose marginal value sets the reservation price of employment is job search. It is not pure leisure, for in principle persons who choose that option are not reported as unemployed; however, there may be a leisure component in job seeking. Members of our own profession are adept at seeking and finding new jobs without first leaving their old ones or abandoning not-in-labor-force status.

In surveys of job mobility among blue collar workers in 1946-47, 25% of workers who quit had new jobs lined up in advance. A considerable amount of search activity by unemployed workers appears to be an unproductive consequence of dissatisfaction and frustration rather than a rational quest for improvement. Reynolds found that quitting a job to look for a new one while unemployed actually yielded a better job in only a third of the cases. Lining up a new job in advance was a more successful strategy: two-thirds of such changes turned out to be improvements.

Today, according to the dual labor market hypothesis, the basic reason for frequent and long spells of unemployment in the secondary labor force is the shortage of good jobs. In any event, the contention of some natural rate theorists is that employment beyond the natural rate takes time that would be better spent in search activity. Why do workers accept such employment? An answer to this question is a key element in a theory that generally presumes that actual behavior reveals true preferences. The answer given is that workers accept the additional employment only because they are victims of inflation illusion. One form of inflation illusion is overestimation of the real wages of jobs they now hold, if they are employed, or of jobs they find, if they are unemployed and searching. If they did not underestimate price inflation, employed workers would more often quit to search, and unemployed workers would search longer. The force of this argument seems to me diluted by the fact that price inflation illusion affects equally both sides of the job seeker’s equation. He over-estimates the real value of an immediate job, but he also overestimates the real values of jobs he might wait for. As a first approximation, inflation illusion has no substitution effect on the margin between working and waiting. It does have an income effect, causing workers to exaggerate their real wealth. In which direction the income effect would work is not transparent. Does greater wealth, or the illusion of greater wealth, make people more choosy about jobs, more inclined to quit and to wait? Or less choosy, more inclined to stay in the job they have or to take the first one that comes along? I should have thought more selective rather than less. Natural rate theory must take the opposite view if it is to explain why underestimation of price inflation bamboozles workers into holding or taking jobs that they do not really want. Workers are myopic and do not perceive, that wages elsewhere are, or soon will be, rising as fast as the money wage of the job they now hold or have just found. Consequently, they underestimate the advantages of quitting and searching. This explanation is convincing only to the extent that the payoff to search activity is determined by wage differentials. The payoff also depends on the probabilities of getting jobs at quoted wages, therefore on the balance between vacancies and job seekers. Quit rates are an index of voluntary search activity. The new microeconomics of job search, is nevertheless a valuable contribution to understanding of frictional unemployment. Does the market produce the optimal amount of search unemployment? Is the natural rate optimal? I do not believe the new microeconomics has yet answered these questions. An omniscient and beneficent economic dictator would not place every new job seeker immediately in any job at hand. The hypothetical planner would prefer to keep a queue of workers unemployed, so that he would have a larger choice of jobs to which to assign them. He would not make the queue too long, because workers in the queue are not producing anything. Of course, he could shorten the queue of unemployed if he could dispose of more jobs and lengthen the queue of vacancies. With enough jobs of various kinds, he would never lack a vacancy for which any worker who happens to come along has comparative advantage. Because of limited capital stocks and interdependence among skills, jobs cannot be indefinitely multiplied without lowering their marginal productivity.

Our wise and benevolent planner would not place people in jobs yielding less than the marginal value of leisure. Given this constraint on the number of jobs, he would always have to keep some workers waiting, and some jobs vacant. He certainly would be in efficient if he had fewer jobs, filled and vacant, than this constraint. This is the common sense of Beveridge’s rule-that vacancies should not be less than unemployment. Is the natural rate a market solution of the hypothetical planner’s operations research problem? According to search theory, an unemployed worker considers the probabilities that he can get a better job by searching longer and balances the expected discounted value of waiting against the loss of earnings.

A worker deciding to join a queue or to stay in one considers the probabilities of getting a job, but not the effects of his decision on the probabilities that others face. He lowers those probabilities for people in the queue he joins and raises them for persons waiting for the kind of job he vacates or turns down. Too many persons are unemployed waiting for good jobs, while less desirable ones go begging. Empirically the proposition that in the United States the zero-inflation rate of unemployment reflects voluntary and efficient job-seeking activity strains credulity. If there were a natural rate of unemployment in the United States, what would it be? It is hard to say because virtually all econometric Phillips curves allow for a whole menu of steady inflation rates. Estimates constrained to produce a vertical long-run Phillips curve suggest a natural rate between 5 and 6 % of the labor force. So let us consider some of the features of an overall unemployment rate of 5 to 6 %. First, about 40% of accessions in manufacturing are rehires rather than new hires. Their unemployment is as much a deadweight loss as the disguised unemployment of redundant workers on payrolls. This number declines to 25-30%, when unemployment is 4% or below. A 5-6% unemployment rate means that voluntary quits amount only to about a third of separations, layoffs to two-thirds. The proportions are reversed at low unemployment rates. Second, the unemployment statistic is not an exhaustive count of those with time and incentive to search. An additional 3% of the labor force are involuntarily confined to part-time work, and another 3-4% are out of the labor force because they ‘Could not find job’ or ‘Think no work available’ – discouraged by market conditions rather than personal incapacities. Third, with unemployment of 5-6% the number of reported vacancies is less than 1/ 2 of 1%. Vacancies appear to be understated relative to unemployment, but they rise to l2% when the unemployment rate is below %. At 5-6% unemployment, the economy is clearly capable of generating many more jobs with marginal productivity high enough so that people prefer them to leisure. The capital stock is in limitation, since 5-6% unemployment has been associated with more than 20% excess capacity. When more jobs are created by expansion of demand, with or without inflation, labor force participation increases; this would hardly occur if the additional jobs were low in quality and productivity. As the parable of the central employment planner indicates, there will be excessive waiting for jobs if the roster of jobs and the menu of vacancies are suboptimal. In summary, labor markets characterized by 5-6% unemployment do not display the symptoms one would expect if the unemployment were voluntary search activity. The only reason anyone might regard so high an unemployment rate as an equilibrium and social optimum is that lower rates cause accelerating inflation.

In other words, the economy has an inflationary bias: when labor markets provide as many jobs as there are willing workers, there is inflation, perhaps accelerating inflation. One rationalization might be termed a theory of stochastic macro-equilibrium: stochastic, because random inter sectorial shocks keep individual labor markets in diverse states of disequilibrium; macro- equilibrium, because the perpetual flux of particular markets produces fairly definite aggregate outcomes of unemployment and wages. It is an essential feature of the theory that economy-wide relations among employment, wages, and prices are aggregations of diverse outcomes in heterogeneous markets. The myth of macroeconomics is that relations among aggregates are enlarged analogues of relations among corresponding variables for individual house-holds, firms, industries, markets. Money wages do not adjust rapidly enough to clear all labor markets every clay. Excess supplies in labor markets take the form of unemployment, and excess demands the form of unfilled vacancies. At any moment, markets vary widely in excess demand or supply, and the economy, as a whole, shows both vacancies and unemployment.

Higher aggregate demand means fewer excess supply markets and more excess demand markets, accordingly less unemployment and more vacancies. In any particular labor market, the rate of increase of money wages is the sum of two components, an equilibrium component and a disequilibrium component. The first is the rate at which the wage would increase were the market in equilibrium, with neither vacancies nor unemployment. Why aren’t they eliminated by the very adjustments they set in motion? Workers will move from excess supply markets to excess demand markets, and from low wage to high wage markets. The overlap of vacancies and unemployment-say, the sum of the two for any given difference between them is a measure of the heterogeneity or dispersion of individual markets. The amount of dispersion depends directly on the size of those shocks of demand and technology that keep markets in perpetual disequilibrium, and inversely on the responsive mobility of labor. A central assumption of the theory is that the functions relating wage change to excess demand or supply are non-linear, specifically that unemployment retards money wages less than vacancies accelerate them. Nonlinearity in the response of wages to excess demand has several important implications. Linear wage response, on the other hand, would mean a linear Phillips relation. Second, given the overall state of aggregate demand, economy-wide vacancies less unemployment, wage inflation will be greater the larger the variance among markets in excess demand and supply. Of course, the rate of wage inflation will depend not only on the overall dispersion of excess demands and supplies across markets but also on the particular markets where the excess sup- plies and demands happen to fall.

An unlucky random drawing might put the excess demands in highly responsive markets and the excess supplies in especially unresponsive ones. Full long-run equilibrium in all markets would show no unemployment, no vacancies, and no unanticipated inflation. With unending sectorial flux, zero excess demand spells inflation and zero inflation spells net excess supply, unemployment in excess of vacancies. Both criteria automatically allow for frictional unemployment incident to the required movements of workers between markets; the no-inflation criterion requires enough additional unemployment to wipe out inflationary bias. I turn now to the equilibrium component, the rate of wage increases in a market with neither excess demand nor excess supply. It is reasonable to suppose that the equilibrium component depends on the trend of wages of comparable labor elsewhere. A ‘competitive wage’, one that reflects relevant trends fully, is what employers will offer if they wish to maintain their share of the volume of employment. TI his will happen where the rate of growth of marginal revenue product the com pound of productivity increase and price inflation is the same as the trend in wages. In some markets the equilibrium wage will be rising faster, and in others slower, than the economy-wide wage trend. A ‘natural rate’ result follows if actual wage increases feed fully into the equilibrium components of future wage increases. Phillips tradeoffs exist in the short run, and the time it takes for them to evaporate depends on the lengths of the lags with which today’s actual wage gains become tomorrow’s standards. Suppose there is a floor on wage change in excess supply markets, independent of the amount of excess supply and of the past history of wages and prices. Suppose, for example, that wage change is never negative; it is either zero or what the response function says, whichever is algebraically larger.

So long as there are markets where this floor is effective, there can be determinate rates of economy-wide wage inflation for various levels of aggregate demand. Markets at the floor do not increase their contributions to aggregate wage inflation when overall demand is raised. Nor is their contribution escalated to actual wage experience. The frequency of such markets diminishes, it is true, both with overall demand and with inflation. The floor phenomenon can preserve the Phillips tradeoff within limits, but one that becomes ever more fragile and vanishes as greater demand pressure removes markets from contact with the zero floor. It will be objected that any permanent floor independent of general wage and price history and expectation must indicate money illusion. The answer is that the floor need not be permanent in any single market. It could give way to wage reduction when enough unemployment has persisted long enough. With stochastic inter sectorial shifts of demand, markets are always exchanging roles, and there can always be some markets, not always the same ones, at the floor.

During the great contraction of 1930-33, wage rates were slow to give way even in the face of massive unemployment and substantial deflation in consumer prices. Finally in 1932 and 1933 money wage rates fell more sharply, in response to prolonged unemployment, layoffs, shutdowns, and to threats and fears of more of the same. I have gone through this example to make the point that irrationality, in the sense that meaningless differences in money values permanently affect individual behavior, is not logically necessary for the existence of a long-run Phillips trade-off. In full long-run equilibrium in all markets, employment and unemployment would be independent of the levels and rates of change of money wage rates and prices. But this is not an equilibrium that the system ever approaches. The economy is in perpetual sectorial disequilibrium even when it has settled into a stochastic macro-equilibrium. I suppose that one might maintain that asymmetry in wage adjustment and temporary resistance to money wage decline reflect money illusion in some sense. Such an assertion would have to be based on an extension of the domain of well-defined rational behavior to cover responses to change, adjustment speeds, costs of information, costs of organizing and operating markets, and a host of other problems in dynamic theory. These theoretical extensions are in their infancy, although much work of interest and promise is being done. Meanwhile, I doubt that significant restrictions on disequilibrium adjustment mechanisms can be deduced from first principles. Why are the wage and salary rates of employed workers so insensitive to the availability of potential replacements? One reason is that the employer makes some explicit or implicit commitments in putting a worker on the payroll in the first place. The employee expects that his wages and terms of employment will steadily improve, certainly never retrogress. He expects that the employer will pay him the rate prevailing for persons of comparable skill, occupation, experience, and seniority. He expects such commitments in return for his own investments in the job: arrangements for residence, transportation, and personal life involve set-up costs which will be wasted if the job turns sour. The market for labor services is not like a market for fresh produce where the entire current supply is auctioned daily. It is more like a rental housing market, in which most existing tenancies are the continuations of long-term relationships governed by contracts or less formal understandings. Employers and workers alike regard the wages of comparable labor elsewhere as a standard, but what determines those reference wages? There is not even an auction where workers and employers unbound by existing relationships and commitments meet and determine a market-clearing wage. If such markets existed, they would provide competitively determined guides for negotiated and administered wages, just as stock exchange prices are reference points for stock transactions elsewhere. In labor markets the reverse is closer to the truth. Wage rates for existing employees set the standards for new employees, too. The equilibrium components of wage increases, it has been argued, depend on past wage increases throughout the economy. In those theoretical and econometric models of inflation where labor markets are aggregated into a single market, this relationship is expressed as an autoregressive equation of fixed structure: current wage increase depends on past wage increases. The same description applies when past wage increases enter indirectly, mediated by price inflation and productivity change. The process of mutual interdependence of market wages is a good deal more complex and less mechanical than these aggregated models suggest. Reference standards for wages differ from market to market. The equilibrium wage increase in each market will be some function of past wages in all markets, and perhaps of past prices too. But the function need not be the same in every market. Wages of workers contiguous in geography industry, and skill will be heavily weighted. Imagine a wage pattern matrix of coefficient describing the dependence of the percentage equilibrium wage increase in each market on the past increases in all other markets. The coefficients in each row are non-negative and sum to one, but their distribution across markets and time lags will differ from row to row.

Part I. Considering how the data may be generated using economic theory.

• The quantity theory of money suggests a relationship (in the long run) between money growth and inflation. Explain the economic intuition behind this relationship.

In the long run,

The quantity theory of money (M) means an increase in the quantity of money brings an equal percentage rise in the price level. Velocity of circulation (V) is the average number of times money is used annually to buy goods and services that makeup GDP. GDP is the price level (P) multiplied by real GDP (Y): GDP = PY. V is determined by: V = PY/M.

The equation of exchange becomes M if the quantity of money does not influence V or Y. This tells us that the price level in the long run is determined by M: P = M(V/Y), where (V/Y) is independent of M, meaning a change in M equals a proportional change in P.

The equation of exchange can also be expressed in growth rates: Money growth rate + Rate of velocity change = Inflation rate + Real GDP growth rate. The rate of velocity change, in the long run, is not affected by the money growth rate. The rate of velocity change is approximately zero. Therefore, in the long run: Inflation rate = Money growth rate – Real GDP growth rate.

In the long run, with full employment, real GDP equals potential GDP, so the real GDP growth rate equals the potential GDP growth rate. The growth rate might be influenced by inflation but is likely small and therefore assume it is zero. Inflation is correlated with money growth as the real GDP growth rate is given and does not change when the rate changes.

Part II. Describing the data

• Describe the two variables (i.e. Inflation and money growth). For each variable, use an appropriate chart (i.e. histogram) and the following descriptive statistics to support your answer: mean, standard deviation, maximum, minimum.

Money growth is defined as Money growth = Inflation + Real GDP growth. Money growth is a direct cause of inflation.

The diagram above shows a histogram of Money Growth from the Coursework Data for 2019-20. One measure of central location is the mean. The mean for money growth is 14.95(424) to 2 decimal places. The standard deviation, a measure of dispersion, for the money growth data is 6.80 (2. d.p), which indicates a low amount of variation, meaning the values tend to be close to the mean for money growth. The maximum number in the data recorded for money growth is 33.34 (2. d.p). While the minimum number for money growth is 4.34 (2. d.p).

Inflation is defined as a constant increase in the general price level in an economy, resulting in a rise in living costs as the prices of goods and services increase. This means the price level is constantly rising as money loses value.

The diagram above shows a histogram of Inflation from the Coursework Data for 2019-20. One measure of central location is the mean. The mean for inflation is 5.98 to 2 decimal places. The mean for inflation is significantly lower than the mean calculated for money growth above. The standard deviation for inflation is 3.81 (2. d.p), which indicates a low amount of variation, so the values tend to be close to the mean. The standard deviation is also lower than the standard deviation for money growth. The maximum and minimum for inflation are also substantially lower than for money growth.

Produce an XY scatter chart with inflation on the y-axis and money growth on the x-axis. Describe the key features of this chart. Calculate (and interpret) the correlation between the two variables.

The correlation between inflation and money growth is 0.73, therefore, the XY scatter chart above shows the relationship between inflation and money growth has a positive correlation. The correlation is positive when the values increase together, and the correlation is negative when one value decreases as the other increases. The XY scatter chart is suitable for examining the relationship between pairs of variables and in this instance the relationship between inflation and money growth from the data set ‘Coursework data 2019-20’.

Part III. Exploring relationships within your data

4. Consider the linear equation below.

• Where is inflation, is money growth, and are fixed parameters, and is a standard error term. Using the economic theory outlined in (1), explain the statistical hypotheses that would be sensible for the values of the parameters where the dependent variable, is the independent variable, and the growth rate of inflation expected if money growth () was zero. Would expect a positive relationship for the parameter.

Estimate the parameters and using observed values of Y and X and obtain a generalized relationship between Y and X. We identify estimates for, and as, respectively, and. To analyze whether X determines Y, need to test the hypothesis that. is essentially the value of Y when X=0 and is the unit change in Y for a unit increase in X.

A two-sided test, where, if I can reject the hypothesis that, then X explains Y. Testing at a 95% confidence interval. If the confidence interval does not include 0 – we can reject the hypothesis at a 5% significance level.

5. Run a regression for the equation displayed in (4).

• Interpret the results of this regression. Your answer should consider relevant economic theory, the estimated parameters, the t-statistics/p-values for the estimated parameters, the hypotheses you stated in (4), and the statistics.

The hypothesis stated above is a two-sided test, testing at the 95% confidence interval.

The confidence intervals are as stated:

As 0.334 (lower 95%) > 0.0000, we can reject at the 5% significance level as the 95% confidence interval does not include 0. This means that Y, inflation, explains X, money growth.

Coefficients’ estimate

Standard error

t-statistic

p-value (Sig.)

Lower 95%

Upper 95%

Constant

• -0.162
• 0.629
• -0.257
• 0.798
• -1.410
• 1.087

Money growth

• 0.410
• 0.038
• 10.708
• 0.000
• 0.334
• 0.487

Both and rejecting at the 5% significance level suggest a positive and significant relationship. Therefore, is consistent with the expectation from the quantity theory of money that there is a relationship, in the long run, between money growth and inflation. The coefficients’ estimate, is 0.410, which means that one unit of change in inflation represents a 0.41 % change in money growth.

This means the linear equation becomes. For example, if: And if: Therefore, the difference, 0.41, represents the change in Y when you change one unit of X. This is the change in inflation when there is one unit of money growth.

To examine if a single explanatory variable has explanatory power, the t-statistic test is used. However, to test if all the explanatory variables have any explanatory power for the dependent variable, the test is used. This is done through the p-value.

The p-value can also be used to work out the confidence level: The p-value can be used to determine if the relationship observed in the sample can exist in the larger population. The F-statistic is 114.658 and the P-value is 0.000, and therefore below the 5% significant level, so evidence to reject the null hypothesis and conclude. Thus, no correlation is made, so there is no association between the changes in inflation and the shifts in money growth, meaning there is insufficient evidence to conclude there is an effect at the population level.

Provides an assessment of the model’s explanatory power. Adding (potentially) relevant variables into a model would tend to increase as more of the variation in Y would be explained. The statistic is 0.537, which measures the fit of the regression model, The fit of the regression model is good as it is closer to 1 than to 0. The variation in X, money growth, explains 53.7% of the variation in Y, inflation. If so, then X does not have any explanatory power for Y. However, as the model above shows, there is some explanatory power at 53.7%. Although a high obtained from a few observations might not be of significance, a low from many observations might indicate a small but genuine explanatory power.

Part IV. Reflect upon your analysis

• 6. Identify and briefly discuss potential limitations of your econometric model (e.g. aspects related to sample size, possible omitted variables, etc.)

The sample should be representative of the population, so be as large as possible. The sample size is 101 countries, however, there are more than 101 countries in the world. The sample size will affect how close is to as having more data points will improve the accuracy of the estimation. The problem with the statistical properties, which should be representative of the population, is unknown so we can only estimate and make assumptions. However, by calculating the confidence interval and hypothesis tests we can gauge how accurate our estimates are. The spread of prediction errors will affect how close is to as smaller errors will improve the accuracy of the estimates. The spread of values of the explanatory variable (X) will also affect how close is to as having a larger spread improves the accuracy of estimation.

References

1. Koop, G., 2013. Analysis of Economic Data. 4th edition.
2. Parkin, M., Powell, M., and Matthew, K., 2014. Economics. 9th edition. Harlow: Pearson Education UK.
3. Sloman, J., Garratt, D., and Guest, J., 2018. Economics. 10th edition. Harlow: Pearson Education Limited.
4. Inflation and Money Growth relationship