Inflation, Unemployment, and Economic Growth: An In-Depth Analysis
Inflation and its Causes
What is Inflation?
Inflation refers to a sustained increase in the general price level.
Demand-Pull Inflation
Demand-pull inflation is caused by higher aggregate demand (AD). For example, in 2011-2012, the increase in tourism brought by mainland China’s free-visit policy increased Hong Kong’s export revenue of services. As exports (X) are a component of AD, this caused AD to increase. The increased competition for resources drove up factor costs, leading to a rise in the aggregate price level (APL).
Cost-Push Inflation
Cost-push inflation is caused by an increase in the cost of production. For example, the increase in the minimum wage in Hong Kong in 2013 increased labor costs, a significant part of production costs for many firms. This caused the short-run aggregate supply (SRAS) to shift left, leading firms to charge higher prices to maintain profitability.
Is High Inflation Always Undesirable?
Arguments for High Inflation Being Undesirable
High inflation can lead to a loss of export competitiveness as higher prices make exports more expensive in the global market. For example, Hong Kong’s high inflation in 2013/14 potentially discouraged tourism. High inflation also creates uncertainty for businesses, making it difficult to estimate production costs and potentially discouraging investment. Additionally, inflation reduces the purchasing power of savings, discouraging saving and potentially reducing loanable funds available for investment. It also reduces the purchasing power of households, especially impacting lower-income earners.
Arguments Against High Inflation Always Being Undesirable
Demand-pull inflation can be associated with economic growth and lower unemployment. Moderate inflation may be inevitable as the economy approaches full employment. The significance of inflation depends on its size, duration, and the relative inflation rate compared to trading partners. If inflation is temporary and not significantly higher than in other countries, its negative impacts may be less severe.
Limitations of the Consumer Price Index (CPI) in Measuring Inflation
What is the CPI?
The CPI measures the price change of a basket of goods and services consumed by a typical household.
Limitations of the CPI
- Ignores differences in consumption patterns: The CPI uses an average consumption basket, which may not accurately reflect the spending habits of different income groups (e.g., higher-income earners spend more on luxury goods).
- Ignores changes in consumption patterns over time: The CPI’s consumption basket is updated periodically, but may not capture rapid changes in consumer preferences due to factors like technological advancements.
- Ignores improvements in product quality: Price increases may sometimes reflect improvements in product quality rather than pure inflation (e.g., a more expensive smartphone may have better features).
Challenges in Maintaining Low Inflation Near Full Employment
As the economy approaches full employment, further increases in AD can lead to demand-pull inflation. Reducing AD to combat inflation can lead to a decrease in real GDP and potentially higher unemployment. Increasing AS can be challenging and may not fully offset inflationary pressures. This creates a trade-off between inflation and unemployment.
Unemployment and its Consequences
Types of Unemployment
- Structural unemployment: Decrease in demand for labor in specific sectors.
- Cyclical unemployment: Caused by a decrease in AD.
Consequences of Unemployment
- Loss of GDP: Resources are not fully utilized, leading to a negative output gap.
- Loss of income: Reduced consumption can further decrease AD.
- Social problems: Increased crime rates and stress levels.
Factors Affecting the Severity of Unemployment
- Size of unemployment: Higher unemployment rates have more significant negative impacts.
- Duration of unemployment: Long-term unemployment has more severe consequences.
- Types of unemployment: Natural unemployment (seasonal, structural, frictional) is inevitable and may not be as problematic as cyclical unemployment.
The Trade-off Between Inflation and Unemployment
The Phillips Curve
The Phillips curve illustrates the inverse relationship between inflation and unemployment in the short run. Increases in AD can lead to lower unemployment but higher inflation. However, in the long run, there is no trade-off as the economy adjusts to the higher inflation rate, and the unemployment rate returns to its natural level.
Prioritizing Low Unemployment
While high unemployment has significant economic and social costs, prioritizing low unemployment can lead to higher inflation. The optimal policy approach depends on the specific circumstances, including the types of unemployment, the potential costs of inflation, and the importance of other economic objectives.
Hidden Employment and Hidden Unemployment
Hidden Employment
Hidden employment refers to individuals who claim to be unemployed but are actually employed, potentially to receive unemployment benefits. This can lead to an overestimation of the unemployment rate.
Hidden Unemployment
Hidden unemployment refers to individuals who have been unemployed for so long that they have given up searching for jobs and are no longer counted as part of the labor force. This can lead to an underestimation of the true unemployment situation.