Wednesday, October 19, 2011

Inflation v Unemployment

Is inflation a lesser evil than unemployment?

Central Banks and governments often face a choice between reducing inflation or reducing unemployment. Which imposes the greatest cost on society - inflation or unemployment?

Firstly, it depends on the magnitude of inflation. If we are talking about hyperinflation (over 10,000% a year) then inflation can definitely devastate an economy leading to a breakdown in normal economic transactions. But, generally when we talk about high inflation in the UK / Europe, we mean an inflation rate of 5-20%. Off the top of my head, I believe the highest rate of inflation in UK since 1945 is around 27% in the 1970s.

It is also possible inflation is too low. Inflation or 0 or 1% would be most likely to cause economic stagnation. Some argue in climate where there is chance of deflation, we should target a higher rate of inflation (e.g. 3 or 4%)

Inflation imposes several costs on Society

  • Inflationary growth is unsustainable. High inflation is often a sign the economy is overheating (demand growing faster than supply). This kind of boom is often followed by a bust (recession) This occurred in UK in Lawson boom of 1980s - inflation rose to 10% due to high growth and when the government tried to reign in inflation, it lead to the 1991 recession and higher unemployment. Therefore, an inflationary boom can lead to a recession. Targeting a low rate of inflation helps to keep economic growth sustainable. Therefore, low inflation can help avoid recession and prevent a sudden rise in unemployment.
  • Inflation discourages investment. High and volatile rates of inflation can discourage firms from taking long-term investment decisions. This is because of the uncertainty and confusion around future revenues and profits. Therefore, it is argued countries with higher inflation rates tend to have lower growth rates over time. In the post war period, it was often argued Japan and Germany had better growth rates because of their low inflation.
  • Decline in international competitiveness. High inflation is likely to make your goods and services less competitive leading to a fall in exports and current account deficit. Often this high inflation will be offset by a fall in the exchange rate to restore competitiveness. But, in the case of countries in the Euro, they can't devalue, so inflation and higher wage costs have been very damaging to their economy.
  • Inflation can reduce real incomes. If inflation is above income growth, we can experience a fall in real incomes. This is an issue in 2011. High cost-push inflation of 5% is above wage growth leading to falling real wages.
  • Inflation can erode savings. If inflation is higher than interest rates, then inflation can wipe away people's savings. Inflation reduces the value of money, so people who rely on income from savings see a reduction in their living standards. This is often a problem for pensioners who rely on savings. Therefore inflation can cause a redistribution of income in society from old to young and from savers to borrowers.
  • Legacy of Inflation. If people suffer from inflation, (e.g. lose savings, become worse off) then it will impact their future decisions. For example, people may be reluctant to buy government bonds because they fear the government will effectively default through inflation. People will be more reluctant to save, leaving less room for investment.
See also: other costs of inflation

Economic Costs of Unemployment

Inflation definitely has economic costs, however arguably the costs of unemployment are far greater. Some of the costs of unemployment:
  • Much lower income. The unemployed have to rely on unemployment benefits and they will see a drastic fall in income. Unemployment is one of the biggest causes of home repossessions (when you fail to keep up with mortgage payments) Losing your home is one of most traumatic events.
  • Psychological costs. Unemployment is one of the biggest causes of stress. Without work, people feel a lack of purpose and low self-esteem. This can precipitate health and psychological problems.
  • Social Problems. Unemployment can create a feeling of alienation from society. When you have a high unemployment rate amongst a particular group (region, ethnicity, age). feelings of social exclusion can be exacerbated. High unemployment rates are certainly one factor behind riots in cities in Spain, France and UK. It is not to excuse rioting, but if you have high unemployment and poor economic prospects it can only increase the risk of crime and vandalism.
  • Higher Government Borrowing. A rise in unemployment leads to lower tax revenue (less income tax) and higher government spending on benefits. This may require lower spending elsewhere in economy.
  • Negative Spiral. Higher unemployment will lead to lower spending in the economy leading to lower growth. The threat and fear of unemployment may be sufficient to reduce spending.
Which Has been the Biggest Cost To Society?

It is usually assumed inflation makes savers worse off. But, in the post war period, this hasn't occurred, interest rates have been higher than inflation meaning most savers don't lost out. They still get an interest rate higher than inflation. Even now with base rates at 0.5% and CPI close to 5%, their are still saving accounts with a respectable interest rate. Also the inflation is caused by temporary cost push factors and is likely to decline soon.

The economic and social costs of unemployment are far greater. However, it is not incompatible to have both low inflation and low unemployment. But, sometimes Central Banks (especially ECB) have made the mistake of focusing on reducing inflation at the expense of lower growth and higher unemployment.

Trade off Between Unemployment and Inflation


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