Level Of Inflation example essay topic

The governments of most developed economies now appear to be primarily concerned with inflation and how to keep it down as opposed to maintaining full employment or restricting the money supply. However, unlike in other areas of the economy, the actions the government can take to control inflation are quite limited. This is because people and firms behave according to their expectations not only of inflation but also of what they consider the government will do. As a result of these implications, governmental actions to control inflation may not have the desired results. If the actions of the government are consistent, though, it will be possible for peoples expectations to be built around what they believe the government will do. To illustrate an example of this, consider the following model.

The short-run Phillips curve is believed to show the trade-off between jobs and inflation, although since the early 1960's the relationship is not as clear as it once was. Monetarists like Friedman, though, believed that in the long-run the natural rate of unemployment is static: shifts in inflation and employment will always return to this level. In other words, it is the equilibrium that will be returned to when the level of inflation is correctly anticipated. The long run Phillips curve (SRPC) is drawn in figure one with a number of short-run curves crossing it (each labelled Srpc), which represent short-term fluctuations causing trade-offs between levels of inflation and levels of unemployment [1]. Suppose the government in the long run wishes to keep inflation at 0%, which is at point A, giving a level of unemployment at U, which is the natural rate.

The government is able to set this target because in the long-run there can be no trade-off (the UK current has an inflation target of 2.5%: recognising the practical difficulties in holding prices completely stable as this model is supposing). At point C, the government could try to reduce inflation, which will temporarily increase unemployment as inflation moves along SRPC 2, but eventually the shifts in aggregate supply and demand will cause unemployment to return to U. Given that the government has a declared policy of keeping inflation at 0%, firms and presuming it to have been successful, trade unions will set prices and wage claims appropriately, to account for this, and SRPC 0 will be the short-run curve that is used. Now, suppose that the government, fearing electoral defeat, wants to increase unemployment above the natural rate for short-term gain. By following an expansionary fiscal policy, it would be possible to move up SRPC 0 and reach point E, which offers far lower unemployment than point U, but at a higher level of inflation. However, if this is done, the government will lose its credibility, because wage claims and price levels will have been settled expecting inflation at 0%.

Once it is seen that the policy has been abandoned, firms and trade unions will have to settle wage claims and price levels to account of the new, increased, inflation rate. It is likely that this will cause the economy to shift upwards to SRPC 1, which puts long-run equilibrium at point B, offering inflation at y% for the natural rate of unemployment. At point B, there is less chance of the government trying to temporarily increase the level of employment for short term gain, as shifting along this short-run curve will cause inflation to be even higher. The -government is expected to renege on its promises, so its attempts to control inflation will therefore depend on whether or not it is believed.

A government may desire to have a good reputation for keeping its promises, and therefore it may deliberately constrain itself into a policy to enable it to try to resist the temptation to renege on them for short-term gain. By giving the power to set interest rates to the Monetary Policy Committee of the Bank of England and giving them a level of inflation to try and reach, the Labour Government is not only less able to manipulate the economy for political advantage, but also able to send a signal out to the country that they mean what they say. Likewise, joining the Exchange Rate Mechanism was an earlier attempt to commit the country to a certain inflation policy. The latter, though, had to be abandoned due to the inability of the economy to hold itself at the entry rate without having levels of unemployment that would have been political suicidal. However, when the UK was pulled out after Black Wednesday in 1992, the credibility of that government was lost, and thus the private sector lost faith in the governments policies.

In this way, control of inflation can be said to depend on what action the government actually takes as opposed to what people believe they will do, as when changing policies for short-term gains destroys their credibility. The government may attempt to control inflation through pursuing controls on prices and incomes. Income controls usually tend to relate to wages, as opposed to dividends and other forms of income, as it is easiest to implement. However, to be effective they need the support of both employers (represented in the CBI) and the workers (in the TUC). These bodies, though, only have limited control over their members and so it may be hard to enforce. Even in the public sector, where the government is able to intervene directly, there will have to be a large degree of acceptance, otherwise opposition (and even strikes) will be faced.

Evasion of wage controls, either through recognised exemptions which may be too broadly or vaguely defined, or negotiated secretly at the local level, is also a problem. Moreover, if a maximum level is set, all workers may consider themselves entitled to receive it. Such controls were tried in the 1970's but were not very successful. The Thatcher government in the early 1980's managed to reduce inflation at the expense of rapidly rising unemployment through refusing to give in to wage demands and increases in the manner which governments of both colours had done in the past. [1] These curves have been drawn as straight lines in order to make the diagram clearer. Phillips curves are usually considered to be curved (hence the name).