A2 Economics – Wage Price Spiral and the Long Run Phillips Curve

June 23, 2017 Leave a comment

Phillips CurvePart of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.

During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E.

Long Run PC

 

 

 

 

 

 

 

 

 

 

 

 

 

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

1980’s hyperinflation in Bolivia

June 19, 2017 Leave a comment

When you think of hyperinflation countries like post-war Germany and Zimbabwe come to mind. However Bolivia in the 1980’s seems to have been a forgotten example. Below is a very good video about the hyperinflation in Bolivia from the PBS Commanding Heights series. I use it teaching the impact of hyperinflation on an economy and policies that to try and control its impact. Some of the main issues from the video are:

  • Inflation reached 23,500%
  • 7 out of 10 Bolivians live in poverty – the poor get hurt by inflation
  • Inflation averaged 1% every 10 minutes
  • One of the causes of the inflation was government finances – they just printed money and didn’t collect taxes
  • How do you stop a hyperinflation or an inflation? Gradualist steps don’t work and as Jeff Sachs said: “All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”
  • Bolivia didn’t use highly sophisticated economic theory to deal with hyperinflation: Government spending was slashed – Price controls were scrapped – Import tariffs were cut – Government budgets were balanced. 

Inflationary Expectations

A lot of the inflationary problems in Bolivia were caused by inflationary expectations which accelerates the problem. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

 

Underemployment v Unemployment

June 13, 2017 Leave a comment

Underemployment is a measure of employment and labor utilization in the economy that looks at how well the labor force is being utilized in terms of skills, experience and availability to work. Labour that falls under the underemployment classification includes those workers who are highly skilled but working in low paying jobs, workers who are highly skilled but working in low skill jobs and part-time workers who would prefer to be full time. This is different from unemployment in that the individual is working but is not working at his full capability.

The unemployment rate, which receives the majority of the national spotlight, can be misleading as the main indicator of the job market’s health because it does not account for the full potential of the labor force. The U.S. unemployment rate was 4.3% as of May 2017, but at the same time, the U.S. underemployment rate was 8.4% – see graph below. The unemployment rate is defined by the Bureau of Labor Statistics (BLS) as including “all jobless persons who are available to take a job and have actively sought work in the past four weeks.” As illustrated by the engineering major who works as a delivery man, a measure of underemployment is needed to express the opportunity cost of advanced skills not being used.

Under v Unempl.pngFurthermore, the unemployment rate is calculated based solely off the labour force, which does not include persons who are not seeking a job. There are many instances in which a person is able to work but has become too discouraged to actively seek a job. Below is a very good video clip from PBS where the underemployment rate in Illinois was 10.3% last year.

Source: Investopedia

 

Categories: Unemployment Tags:

The Exchange Rate Mechanism and the Bank of England

June 8, 2017 Leave a comment

I was teaching managed exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM).

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in realtion to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Teaching why the Balance of Payments equals zero.

June 7, 2017 Leave a comment

A HT to colleague Nick Lloyd for this great explanation of the relationship between the current account and the capital and financial accounts. In theory the balance of payments should equal zero and this is one area that students find hard to comprehend. Hope you find it as useful as I did.

The Relationship between the Current Account and the Capital and Financial Account

A few starting points:

  1. Gross Domestic Product (GDP) = C + I + G + (X – M)
  2. Gross National Product (GNP) = GDP plus Net Income (Income Credits (Yc) – Income Debits (Yd))
  3. Saving/Investment Gap (S – I) = Balance on Capital and Financial Account (Capital Outflows (Ko) – Capital Inflows (Ki))
  4. Current Account Balance = Trade Balance (X – M) + Net Income (Yc – Yd)
  5. National Savings = GNP – (Private Spending (C) + Government Spending (G))

Now:

GNP                                      =               GDP + (Yc – Yd) =  C + I + G + (X – M) + (Yc – Yd)

GNP – (C + I + G)                 =               (X – M) + (Yc – Yd)

GNP – (C + G) – I                 =               (X – M) + (Yc – Yd)

S – I                                    =               (X – M) + (Yc – Yd)

Balance on Capital & Financial Account               =               Balance on Current Account

 

Another way to arrive at the same conclusion:

Assuming freely floating exchange rate is in equilibrium:

Demand for Currency = Supply of Currency

Demand comes from:     X + Yc + Ki

Supply comes from:        M + Yd + Ko

Thus when the forex market is in equilibrium:

Demand                         =               Supply

X + Yc + Ki                    =               M + Yd + Ko

(Ki – Ko)                        =               (M – X) + (Yd – Yc)

Balance on CFA               =               Balance on Current Account

 

So, if as a nation you earn more than you spend (current account surplus), you are in effect lending to the rest of the world (exporting savings) by accepting IOUs in the form of your increased holdings of foreign assets (shares, land, government bonds, etc.)

If as a nation you spend more than you earn (current account deficit), you must borrow from the rest of the world (import savings) in the form of increased foreign holdings of your domestic assets (shares, land, government bonds, etc.)

 

 

Categories: Trade Tags:

Economics Memes

June 2, 2017 Leave a comment

Thanks to A2 students Declan Forest and Ryan Hyde for this meme that they put together.

John Maynard Gains.png

Other memes from Sharon Li

17884542_278825812558574_9196889393385873361_n.jpg

18157028_285359485238540_358406746974573350_n.png

Categories: Uncategorized

Behavioural Economics and reclining airline seats

June 2, 2017 Leave a comment

I picked up this topic from Michael Cameron’s blog Sex, Drugs, and Economics which looked in detail at the economics behind reclining airline seats. The issue that he refers to is – who owns the space between reclining airline seats?

Externalities

The person (Recliner) who reclines their seat reduces the amount of space that the person (Reclinee) behind has especially if they have their tray table down and becomes a negative externality to them. Some airlines are worse than others with regard to space – American carriers tend to have very little room as do the low cost airlines. However carriers that operate more long haul flights especially Emirates seem to be more generous with the space between seats. However if there is nobody in the seat behind then there is no externality. This refers to the Coase Theory (see previous blog post) in which Ronald Coase stated that problems are jointly produced by the person who creates the externality and the person who is affected by it. He argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like the scares resource i.e. the space between airline seats.

An article on the site Evonomics by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law) looked at research into how much passengers would be willing to pay to recline their seat. They looked at the following scenarios.

Default – you have the right to recline your seat
Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands

Default – you don’t have the right to recline your seat and have to negotiate
Recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn’t start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

Note that endowment effects are working for the ‘reclinees’ as well – they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn’t start out with it.

The endowment effect means that this problem isn’t really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest – because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

%d bloggers like this: