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Does inflation cause unemployment?

Readers Question: Does inflation causes unemployment?

There are a few different scenarios where inflation can cause unemployment. However, there is not a direct link. Often we will notice a trade off between inflation and unemployment – e.g. in a period of strong economic growth and falling unemployment, we see a rise in inflation – see Phillips Curve.

Also it is important to bear in mind, (especially in the current climate) If the economy has deflation or very low inflation and the monetary authorities target a modest rate of inflation, then this may help boost growth and reduce unemployment.

Inflation can cause unemployment when:

  1. The uncertainty of inflation leads to lower investment and lower economic growth in the long term.
  2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
  3. Inflation leads to decline in competitiveness and lower export demand, causing unemployment in the export sector (especially in a fixed exchange rate).

 

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 therefore lower economic growth. Therefore, if there are poor levels of investment this could lead to higher unemployment in the long term.

It is argued that countries with low inflation rates, such as Germany have enabled a long period of economic stability which helps to attain a long term low unemployment rate. Low inflation in a country like Germany also helps them to become more competitive within the Eurozone, which also helps create employment and reduce unemployment.

See also: costs of inflation

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Unemployment Stats and Graphs

A selection of graphs and statistics on UK measures of unemployment. Also, looking at factors that explain UK unemployment and why unemployment has fallen in recent years.

UK unemployment-rate

Current UK Unemployment rate

  • Unemployment rate of  6.2%, (July 2014) –  the lowest since late 2008. (page updated Sept 18th, 2014)
  • 2.02 million – (ONS)  (a fall of 468,000 since 12 months ago – biggest fall since 1988)
  • (Scottish unemployment of 6%)
  • Average Eurozone unemployment – 11.5%

Recent Unemployment Trends

UK-unemployment

Raw data:  Labour market data  | ILO unemployment % rate at ONS

UK Employment Rate

  • 73.0% of people aged from 16 to 64 were in work (May to July 2014) up from 71.6% for a year earlier.
  • There were 30.61 million people in work.

Participation Rate

  • 22.1% per cent inactivity rate for those aged from 16 to 64. 8.95 million economically inactive people aged from 16 to 64. In activity means that people are either not working or not seeking employment (e.g. students, parents bringing up children, early retirement, long term sickness) See also: Participation rates

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European unemployment crisis

Unemployment in many European countries has risen sharply due to the credit crunch and global recession. The worst hit countries include Spain (ES) and Greece (EL), who both have unemployment rates of over 24%. In the past few months, there has been a slight reduction in European unemployment, but, the prolonged period of mass unemployment is leaving significant social and economic problems for the whole Eurozone.
  • Unemployment rate in the Eurozone area: 11.5% (July 2014)
  • EU-28 Unemployment is slightly lower at 10.2% (July 2014)
  • Total unemployment in the EU-28 is 24.850 million (July 2014)
  • The Eurozone  (EA-18) jobless total is now 18.409 million. (link) The highest since records began.
  • Youth unemployment rates in the EU 27 is 21.8% (July 2014)
  • The lowest unemployment rates are in Austria (4.9 %) and Germany (4.9 %). The highest rates are in Greece (27.2 % in January 2014) and Spain (24.5 %).
  • By comparison, unemployment in Japan is 3.6%, and in US 6.8%. UK unemployment is 6.5%
  • Eurostat unemployment figures

EU unemployment

Source: ECB

 Causes of European unemployment crisis

After falling to 7.5% in 2008, the prolonged recession of 2008-13, has caused a sharp rise in unemployment.  The continent seems to be stuck in a deflationary spiral and is facing a prolonged double dip recession. Hardest hit debtor countries, such as Spain, Greece, Portugal and Italy are facing stringent budget cuts – which are depressing demand.

Will Eurozone break up?

But, in the Eurozone, there is little relief available to boost demand. Countries are unable to devalue. Monetary policy set by the ECB has been unflinching in targeting low inflation and offering little monetary easing – despite the prolonged recession. Also, depressed demand throughout the region is making it difficult to grow through increasing exports. Even northern Europe, which has had large current account surpluses are engaging in modest austerity. The result is that demand has remained depressed across Europe.

Despite its potentially damaging social and economic impact, throughout the 2008-13 European crisis, unemployment has had a relatively low profile –  European policy makers have always given the impression they are more concerned about appeasing bond markets and low inflation than tackling the more pressing problem of unemployment. There has  been a reluctance to tackle the fundamental deficiency of aggregate demand which is leading to lower growth and falling employment. Efforts to reduce unemployment have centred on talk of more flexible labour markets. This may be part of the solution for structural unemployment, but increasing labour market flexibility alone cannot deal with the cyclical unemployment.

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Should low inflation be the primary objective of economic policy?

The UK government has given the Bank of England an inflation target of CPI 2 % +/-1. The Bank of England are responsible for using monetary policy (e.g. interest rates)  to achieve this goal of low inflation. But, as well as targeting inflation, the Bank of England also have a wider remit of considering objectives such as economic growth.

Summary – Should we aim for low inflation as the primary objective?

Since the spikes in inflation during the 1970s and 1980s, many economies have prioritised low inflation as the primary objective of monetary and economic policy. Low inflation has many benefits for an economy; it is seen as a building block for stability and encouraging investment. The hope is that by keeping inflation low, the economy will avoid boom and bust economic cycles and provide a framework for economic stability and prosperity. If inflation gets out of hand, the economy will experience various costs of uncertainty, menu costs and loss of international competitiveness.

However, since the crisis of 2008, some economists have become increasingly critical of monetary / economic policy which targets low inflation and  ignores other economic objectives such as full employment and economic growth. Critics argue that inflation targets can become too rigid, and recently (especially in Europe) the goal of low inflation has caused unnecessarily high unemployment and a prolonged recession.

Reasons why low inflation is a primary macroeconomic objective

There are many benefits of low inflation. Firstly, if inflation is low and stable, firms will be more confident and optimistic to invest; this will lead to an increase in productive capacity and enable higher rates of economic growth in the future.

Inflationary boom caused recession of 1991

If inflation is allowed to increase because monetary policy is too lax, there could be an economic boom. But if this rate of economic growth is above the long run trend rate of growth, it is likely to be unsustainable and the boom will be followed by a bust (recession). This occurred in the UK in the late 1980s and 1990s. Economic growth was too fast, causing demand pull inflation. By the time inflation increased to 10%, it was too late, and the UK needed a rapid increase in interest rates, which caused the recession of 1991/92. Maintaining low inflation will help avoid these cyclical fluctuations in the economy which can cause booms and recessions

If inflation in the UK is higher than other countries, UK goods will become uncompetitive causing a fall in exports and possibly a deterioration in the current account of the balance of payments. This is particularly important if a country is in a single currency or fixed exchange rate because they can’t devalue to restore competitiveness. Keeping inflation low, will help the UK to be competitive. Low inflation will also help to increase the value of the Pound and maintain living standards. Continue Reading →

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The depth of the European recession

Interesting graph which shows the depth of the EU recession compared to the great depression of the 1930s.

depth-euro-recessionSource stats | via Krugman

UK recession compared

This graph is from the start of 2013. Since, then the UK economy is showing signs of  picking up. But, it is still worth bearing in mind the length of the decline in GDP since the start of the recession.

recessions-different-recoveries

Comparing different recessions

For the first 15 months, the decline in real GDP is comparable to the great depression of the 1930s. The great depression shows a bigger fall in GDP (-8.0%) from peak. But, during the 2008- recession, GDP stagnated the longest.  Continue Reading →

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Impact of Immigration on UK Economy

In the past two decades, the UK has experienced a steady flow of net migrants into the economy. Net migration is a significant factor in the growth of the UK population. But, does this net migration help or hinder the UK economy?

net migration into UK

In 2011, long-term net migration was +215,000 – slightly down from over +250,000 in 2010. It means that in the past five years, the UK population has been boosted by net migration of around 1,000,000.

Inflows and Outflows

net-migration-outflows-inflows

  • In 2011, the top 3 countries for source of migrants was India, China and Pakistan.
  • The top 3 destinations for people emigrating from  the UK was Australia, India and US.

Impact of Net Immigration on UK Economy.

1. Increase in Labour Force.

Migrants are more likely to be of working age – such as, students, and those looking for jobs. They may  bring dependants, but generally net immigration leads to an increase in the labour force and increases the potential output capacity of the economy.

2. Increase in aggregate demand and Real GDP

Net inflows of people also lead to an increase in aggregate demand. Migrants will increase the total spending within the economy. As well as increasing the supply of labour, there will be an increase in the demand for labour – relating to the increased spending within the economy. Ceteris paribus, net migration should lead to an increase in real GDP. The impact on real GDP per capita is uncertain.

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UK Unemployment Target

The new Bank of England governor, Mark Carney, has implemented a type of unemployment target.

As part of forward guidance, the Bank of England state that:

Interest rates won’t rise from 0.5% until unemployment falls below at least 7%.

Essentially, the bank are committing to expansionary (loose) monetary policy until there is a stronger economic recovery and unemployment has fallen. The hope is that the commitment to low interest rates will encourage firms to invest and consumers to spend.

However, this unemployment target of 7% has a few caveats.  The unemployment target and forward guidance on interest rates can be ignored if:

  • Inflation is forecast to breach a 2.5% target over a 24 month horizon.
  • If there is a sharp rise in the public’s expectations of inflation
  • If low interests are likely to imperil the stability of the financial system, e.g. low interest rates could fuel an asset bubble.

UK unemployment-past-5-years-percent

Under the Bank of England’s latest targets, it does not expect unemployment to fall below 7% until 2016. According to the ONS, unemployment is currently 7.8%. It would require the creation of nearly 750,000 new jobs for the rate to fall below 7%

Equilibrium Unemployment

The Bank of England also mentioned the term ‘equilibrium unemployment’. They believe the equilibrium unemployment rate is around 6.5%. The equilibrium rate means that if unemployment falls below 6.5% it might start causing inflation (e.g. competition for employers pushes up wages). If unemployment is above the equilibrium rate of 6.5% then there is slack in the economy (demand deficient unemployment) and this will keep inflation low.

This equilibrium rate of 6.5% is therefore composed of structural factors / supply side factors (the natural rate of unemployment) Continue Reading →

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The UK Unemployment Mystery

A strange feature of the past two years, has been a largely unexpected fall in UK unemployment. Recently, the ONS said there were 2.49 million people unemployed,  185,000 less than on a year earlier. It is the lowest unemployment rate since spring 2011. Usually, in a recession, you would expect a rise in unemployment because falling demand causes firms to get rid of surplus workers. (see: demand deficient unemployment)

For example, after the much milder 1981 recession, UK unemployment rose to over 3 million (around 11%) and remained high well until the mid 1980s. After the 1991 recession, unemployment again rose sharply, to just over 3 million.

unemployment

Also, in Europe, unemployment has recently risen to record levels. Only in the US, has unemployment shown a similar fall,  but the US has seen much stronger economic recovery than the UK.

In the 2007-13 recession, we have seen UK unemployment rise at a slower rate than previous recessions, and it has also been quicker to fall – even though evidence points to a unique triple dip recession. Why has unemployment been falling, when the economy is so weak?

1. Flexible Labour Markets. Evidence suggests that UK labour markets are more flexible. For example, it is easier to cut hours and keep people employed on shorter working hour contracts.

under-employment

This is illustrated by a rise in under-employment during the long recession. More people are reporting working fewer hours than they would like. However, flexible labour markets can also mean it’s easier to hire and fire workers. You would expect if labour markets were very flexible, firms would be quick to make redundancies, but this doesn’t seem to be occurring. (flexible labour markets)

2. Flexible Pay. Related to flexible labour markets have been the recent trends in pay. We have seen five years of falling living standards, with average pay rates rising at a lower rate than inflation. If unions were powerful, and workers could bargain for higher wages, it is likely that unemployment would be higher. The fact that wage growth has been stagnant has encouraged firms to keep holding onto workers, rather than let them go because they are too expensive. The headline rate of average earnings growth excluding bonuses is 1.4%, meaning that with CPI inflation or around 2.5%, real pay is falling at an annual pace of more than 1%.” (UK wages)

wages-inflation-2007-2012

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The Luddite Fallacy

The Luddites were a group of English textile workers who engaged in violently breaking up machines. They broke up the machines because they feared that the new machines were taking their jobs and livelihoods. Against the backdrop of the economic hardship following the Napoleonic wars, new automated looms meant clothing could be made with fewer lower skilled workers. The new machines were more productive, but some workers lost their relatively highly paid jobs as a result.

luddites

A Luddite is a term used (usually pejoratively) to describe people who oppose the introduction of new technology. Yet, the idea that new technology leads to job losses has persisted, despite the fact that economists are almost universally united in stating that new technology will not increase the long-term unemployment rate.

The Luddite fallacy is the simple observation that new technology does not lead to higher overall unemployment in the economy. New technology doesn’t destroy jobs – it only changes the composition of jobs in the economy.

Why Do Economists say that new Technology does not cause Unemployment?

Firstly, rapid technological change may cause some short-term temporary unemployment. However, economic theory suggests that jobs lost as a result of technological change will be created in different, new industries.

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