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IB Economics (and, not only)

economics is a dirty job but someone’s got to do it

Tuesday, August 22, 2017

Where is the trade-off?

Economics answers

This inverse relationship was first detected by a New Zealand economist (first a crocodile hunter then an electrical engineer and later an economist at the LSE – see Wikipedia) when studying the UK annual unemployment rate and the annual percentage change in money wages: when the labor market was tight (so unemployment was low) then money wages would tend to rise. If prices were a mark-up on costs / wages, then if unemployment decreased, prices would tend to increase. This pattern was detected for many countries but if the trade-off was stable then policymakers could ‘choose’ the most desirable unemployment-inflation combination and with demand side policies try to achieve it. Some started talking even about ‘fine-tuning’ the economy which was anathema to Milton Friedman and the monetarists (this always sounds to me like a band. ). In any case, Friedman’s ingenuity came up with the ‘expectations-augmented Phillips curve’ where there is no trade-off in the long run (defined as when expected inflation and actual inflation are equal). In the long run there is only one rate of inflation compatible with non-accelerating inflation and that is the ‘equilibrium’ unemployment rate which (again, ingeniously) Friedman called the ‘natural rate of unemployment’.

To make a long story short, the US unemployment has been steadily decreasing for some time and for many has approached or even exceeded the NRU so many have been expecting increases in money wages as well as increases in the average price level i.e. inflation.

But. not the case! The question is what should the Fed do? Should it slowly tighten monetary policy to avoid a jump in inflation and thus a greater increase in interest rates? But if there is still no risk of inflation for whatever reason? Then growth would just slow down and people who could have found a job will remain unemployed. The Fed has increased interest rates a bit but unemployment was still deceasing while inflation was still below the (totally arbitrary – see this excellent article) 2% goal!

Which bring us to this New York Times editorial Why is the Fed so scared of inflation which is definitely worth reading.

Economics answersAs Fed officials try to make sense of how low unemployment, which should drive up wages and prices, persists side by side with low inflation, most simply assume that inflation will rise by next year as labor demand lifts wages and higher wages lead to rising prices. This belief has led to two interest rate increases so far this year, in effect tapping the brakes on growth to fight inflation, with another rate increase expected this year. A more plausible view is that persistently low inflation shows the economy is more fragile than policy makers want to admit, and needs to be helped, not handicapped. (the photo is from an FOMC meeting) A simple exposition of the basics of the Phillips Curve for the IB HL Economics candidate can be found at my Economics Study Guide here or here or here (Oxford University Press)


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