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Friday, January 15, 2021
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Inflation meets unemployment

Inflation is a major concern for government policymakers, companies, workers and investors. However, reducing inflation is not a relaxed process and is quite a multifaceted task.Inflation refers to the increase in the overall level of prices and hyperinflation refers to extraordinary high rates of inflation such as Germany experienced in 1920 and Zimbabwe in 2007.

Hyperinflation occurs in some countries because the government prints too much of money to pay for its spending. Unemployment is the total number of people who are of working age and who are able and available for work at current wage rates and who want a job.

 

Society faces a short term trade-off between unemployment and inflation. Aggregate demand refers to the total quantity of goods/services that individuals, households, firms and the government want to buy at each price level. If policymakers expand aggregate demand through expansionary monetary or fiscal policy, they can lower unemployment, but only at the cost of higher inflation.

If they contract aggregate demand through contractionary monetary or fiscal policy, they can lower inflation but only at the cost of high joblessness. Unemployment depends on various aspects including minimum wage laws, the market power of unions, the role of efficiency wages and the effectiveness of job search.

Inflation depends primarily on growth in the quantity of money, controlled by the central bank. In the 1970’s, policymakers faced two choices when OPEC cut output and raised the worldwide prices of oil: Fight the unemployment battle by expanding aggregate demand and accelerate inflation or fight the inflation battle by contracting aggregate demand and endure high levels of unemployment.

 In an advanced economy such as the UK economy inflation exceeded 20% per year in the mid-1970’s. In the late 1990’s and early 2000’s inflation in the UK had been low and stable at around 2% per year. When Margaret Thatcher was elected the prime minister of the UK in 1979, inflation was viewed as one of the nations’ foremost problems. Inflation was reduced from almost 20% in 1980 to about 5% in 1983, but at the cost of high unemployment at about 11%.How do policymakers win this lose-lose situation?

Inflation has various damaging effects on the economy. Inflation reduces the real value of money, which in turn gives people an incentive to minimise their cash holdings. Resources are wasted when inflation encourages people to reduce their cash holdings as the cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. During inflationary times, it is necessary to update price lists and other posted prices, which is a resource-consuming process that takes away from other productive activities. Inflation also exaggerates the size of capital gains and increases the tax burden on this type of income.

With progressive taxation, capital gains are taxed more heavily and saving becomes less attractive. Inflation also causes money to have different real values at different points in time and therefore makes it more difficult for businesses to compare revenues, costs and profits over time. Unexpected inflation tends to redistribute wealth among the population in a way that has nothing to do with either merit or need.

With an inflation rate of 5.91% and an unemployment rate of 25.5%, the question is, which battle should policymakers fight next?

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