Does Inflation Cause Unemployment?

Readers Question: does inflation causes unemployment?

There are a few different scenarios depending on the rate of inflation.

Inflation can cause long term unemployment if the uncertainty of inflation leads to lower investment. An economic boom can lead to inflation but a also period of falling unemployment. However, if this boom is unsustainable, the inflation will at some time lead to higher unemployment.

If the economy has deflation and the monetary authorities target a modest rate of inflation, then this may help boost growth and reduce unemployment without causing a boom and bust.

 

Inflation Creates Uncertainty and lower investment.

One argument is that a period of high and volatile inflation discourages firms from investing. Because inflation is high, firms are less certain investment will be profitable. It is argued that countries with higher inflation rates tend to have lower investment and lower economic growth. Therefore, if there is poor levels of investment this could lead to higher unemployment in the long term. (see: costs of inflation)

Inflationary Boom Causes Recession.

If the economy overheats; if the rate of growth is faster than the long run trend rate, then we will tend to get demand pull inflation. Firms push up prices because demand is growing faster than supply. In the short term, this higher growth may lead to lower unemployment as firms take on more workers. However, this rate of economic growth is unsustainable; and concerned by high inflation the monetary authorities will seek to reduce inflation by increasing interest rates. Therefore an economic boom is often followed by a recession. The UK was said to have many ‘boom and bust’ economic cycles. As the economy went into recession, unemployment rises.

An example, is the Lawson boom of 1980s. We had high economic growth, high inflation and falling unemployment. But, in 1991, the economic boom ended and policies to reduce inflation led to higher unemployment.

Unemployment

uneployment

Inflation

Optimal Rate of Inflation.

However, if an economy has a very¬† low rate of underlying ‘core inflation’ e.g. 1%, then this is a sign that the economy is growing too slowly.¬† This level of inflation means there is spare capacity and there is an output gap. Therefore, with slow growth, unemployment is likely to be higher. In this case, pursuing expansionary monetary policy which involves a higher inflation rate could help to boost economic growth and lead to lower unemployment.

Arguably, the ECB’s insistence on keeping inflation below 2% in the current economic climate is leading to higher unemployment within the Eurozone. If they allowed a slight increase in inflation, then unemployment could fall without causing an inflationary boom.

A key issue is what rate of inflation and economic growth causes unsustainable growth. If the economy experiences deflation (like in 1920s and 1930s) then a positive inflation rate will help reduce unemployment.

But, if growth is already close to long run trend rate (2.5%) and there is no output gap, then expansionary monetary policy that leads to higher inflation will be unsustainable and we will be liable to experience a boom and bust that leads to higher unemployment.

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5 Responses to Does Inflation Cause Unemployment?

  1. PNO September 26, 2011 at 6:04 pm #

    Are we in a situation of inflation or deflation? Is there a term called biflation? If the prices of food is rising and prices of property is falling, does that mean overall we have deflation, and that the fed is correct in printing money?

  2. PNO September 28, 2011 at 6:41 pm #

    If central banks collectively and continuously print money, does this mean there will never be a financial crisis and recession? How will this financial crisis end? Is there any scenarios where collective central banks action will be useless, since they have essentially unlimited supplies of money to print at essentially no cost?

  3. PNO September 28, 2011 at 6:44 pm #

    Is it possible for central banks to fail in devaluing their currency since they can print unlimited amounts of money e.g like in the Swiss bank intervention. Do their losses matter, since they can write off their losses at essentially no cost?

    Why is it easier for a central bank to devalue instead of strengthening their currency?

  4. PNO September 29, 2011 at 5:41 pm #

    What is the effect of future contracts, CDOs, on the prices of shares, commodities, and currency?

    In this current market, many people recommend buying hard assets like properties, gold and oil, because quantitative easing will increase the prices.

    However without knowing how many off market futures contracts, and these contracts are not based on actual demand and supply, is it fair to say it is dangerous to speculate on these commodities, and even these prices will fall in a deflation due to forced liquidation?

  5. PNO September 29, 2011 at 5:44 pm #

    What is the effect of a collapse in the US dollar on China? Since the Central Bank of China holds trillions of USD treasuries, if the USD collapses, the central bank will suffer massive losses. However, this will also mean the Yuan will be higher relatively to the USD. How do we calculate the net effect to China in terms of currency gains to the country and its citizens?

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