Demand Pull inflation occurs when total demand for goods and services exceeds total supply. This type of inflation happens when there has been excessive growth in aggregate demand and there is an inflationary gap. Demand-pull inflation is often monetary in origin this is because the authorities allow the money supply to grow faster than the ability of the economy to supply goods and services.
Demand-pull inflation occurs when demand is high relative to supply, inflation exceeds expectations. We can illustrate demand-pull inflation using the aggregate demand and supply model. For instance a rise in aggregate demand from AD → AD1 (i.e. A to B) will see a general rise in prices as we approach full employment.
We can infer unemployment by virtue of the fact that at Yf the economy experiences an increase in demand for goods which will lead to an increase in demand for labour (derived demand).
A rise in aggregate demand for goods will cause aggregate demand for labour to shift from ADL1 → ADL2. Unemployment will decrease from Qn to Qx2. This would lead to a reduction in demand deficient unemployment.
Nevertheless there appears to be a strong relationship between demand-pull inflation and demand deficient unemployment. A.W. Phillips discussed this relationship and designed the Phillips curve. Even though there is not a very stable relationship between unemployment and inflation, most economists believe that inflation will speed up when unemployment is low and slow down when it is high. The downward sloping nature of the curve suggests that in theory there is a trade-off between inflation and unemployment. “There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation” (Friedman)
It seems therefore, that there may be reason to believe that the unemployment rate in the labour market should be negatively or inversely correlated with the level of price inflation in product markets.
Economic growth is an increase in a countries national income. It is a measurement of a countries output, expenditure or income, all of which should come to the same total. In the UK growth is measured using GDP and GNP.
A growing economy means there will be more goods and services available for consumption. Governments therefore would like not only to achieve high long run rates of growth, but also achieve stable growth and avoid recession. Economic growth leads to an increase in resources such as labour and capital. An increase in efficiency, with which these resources are used, through advances in technology, improved labour skills or improved organisation. The distinction between actual and potential growth should be made;
- Actual growth is the percentage annual increase in national output (the amount actually produced).
- Potential growth is the percentage annual increase in economy capacity to produce. (The rate of growth in potential output).
It should also be noted that high levels of growth tend to result in low levels of unemployment.
The balance of payments is a record of one country's trade dealings with the rest of the world. Countries need to pay for all the products that are not domestically produced. They also borrow and lend money abroad or buy property or businesses in other countries.
Balance of Payments = Total Exports – Total Imports
In terms of Balance of Trade, inflation can have a big impact. Imports affect the relative price of domestically produced goods. For instance if the UK is experiencing inflation, the demand for imports may increase and the quantity demanded for domestic goods would decline. This concept is known as trade deficit.
E.g. the price of a pen in UK compared with France.
UK: £1.00 France: £1.00
If the UK experiencing inflation of 12%
UK: £1.12 France: £1.00 France has no inflation.
The quantity of domestically produced pens decreases and import from France increases.
X > M = Trade deficit (-ve)
The relationship between the four objectives has been summarised in the table below.
Aggregate Demand
A B
Question 2: Give examples of two key supply-side policies pursed by UK governments in recent years and consider whether these have helped to reduce both inflation and unemployment simultaneously.
(50 marks)
Supply-side policy is designed by the government in the attempt to alter the level of aggregate supply directly rather than through changes in aggregate demand. We will focus on the supply-side policies pursued by the Conservative government of 1979.
The Conservative party came into power in May under the leadership of Mrs Thatcher, trumpeting the virtues of her new right-wing supply-side policy which was largely unchallenged.
Cost-push pressures are responsible for inflation, but this can be reduced or controlled using supply side policies.
Many policies were implemented by the Thatcher Government; which looked at tackling 5 key areas.
- Reducing government expenditure.
- Reducing taxes.
- Reducing the monopoly power of labour.
- Reducing welfare.
- Policies to encourage competition.
The focus here will be on only two of these key areas, firstly the reduction of the power of labour.
Deregulation of labour markets meant for the Tories, destroying the power of trade unions to affect wages and inhibit labour mobility.
The Thatcher government took a number of measures to weaken the power of labour. These included restrictions on union closed shops, restrictions on secondary picketing, financial assistance for union ballots, and enforced secret ballots on strike proposals. Legislation to restrain the unions was enacted in the 1980 and 1982 Employment Acts and in the 1984 Trade Union Act. These policies can be seen as quite successful as most of the 1980s and early 1990s was a period of relative calm with only two major strikes. However it can be argued that the real reason for this is the high rate of unemployment during the period.
The Conservative government also attempted to diminish ‘distortion’ in the labour market by means of wage councils. The purpose of these independent bodies was to set conditions and various rates of pay for the generally low paid industries. These industries had weak union representation or were very weak e.g. catering and retail industries.
If the power of trade unions to push wage rates up (to W1), were eliminated, assuming there is no change in the demand for labour, wage rates will fall to We. Disequilibrium unemployment (Q2-Q1) would disappear. Employment will rise from Q1 to Qe.
These measures were put in place to decrease unemployment and set wage limits therefore reducing cost push inflation and avoiding the wage price spiral. This means the aggregate supply curve will shift to the right accordingly increasing output at any given price. This may also shift the Phillips curve to the left, reducing the rate of unemployment for any given rate of inflation.
When the Thatcher government came into power one of their main aims was to cut down the marginal rate of income. In 1979 the basic rate of income tax was 33% with higher rates rising to 83%. In 1988 the Thatcher government had managed to cut down the basic rate to 25% and the maximum rate to 40%. There are several benefits associated with the increasing cuts to the marginal rate of income tax including; people work longer hours, more people wish to work, people work more enthusiastically, employment rises and unemployment falls. The model below illustrates the effect of a tax cut on total unemployment.
Monetarists emphasize one of the main problems with the natural (equilibrium) unemployment rate as being the safety guard provided by the unemployment benefits. When income tax was cut during the 1980s there was a bigger difference in the after tax wage rates and the unemployment benefits, therefore more of the unemployed became motivated to look for and secure work.
Supply side policies implemented in the 1980’s by Mrs Thatcher and the Conservative government did not take immediate effect. There seems to be a time lag as these policies can be seen to be making an impact through the late 1990s where unemployment and inflation are simultaneously declining. However, overall the graph seems to show that inflation and unemployment are opposites. A longer time series of data showing flat or falling inflation and unemployment is required to fully support the supply-side theory.
Bibliography
Sloman, J. - Essentials of Economics (Second Edition), 2001, Prentice Hall
Sloman, J. - Economics (Fourth Edition), Prentice Hall
Cleaver, T. - Understanding the World Economy (Second Edition), 2002, Prentice Hall
Friedman, Milton, 1968, “The Role of Monetary Policy,” American Economic Review, No. 58, March, p11
Orchard, E.W, Glen, J. - Business Economics, 1997, Blackwell Publishers
Appendix
This model shows demand deficient unemployment.
Qn Qx U/E
100 50 50
100 60 40
This model shows the production possibility curve.
Refer to demand deficient unemployment model in appendix
Friedman, Milton, 1968, “The Role of Monetary Policy,” American Economic Review, No. 58, March, p11
Refer to figures 1a, 1b and 2a, 2b in appendix. Source: Tony Cleaver, Understanding the world economy - 2nd edition
Refer to production possibility model in appendix.
See figure 1a, 1b in the appendix. Source: Tony Cleaver, Understanding the world economy - 2nd edition