8 - Employment And Inflation Nexus; QTM and PC

Question 1

Relationship between inflation and unemployment is a controversial topic which has been debated by economists (3 theories)

Answer 1

• Classical (Quantity theory of money (QTM))
• Keynesian (Phillips Curve)
• New-classical

Question 2

What do classical economists base their analysis of inflation on what

Answer 2

On quantity theory of money (QTM)

Question 3

What does QTM state

Answer 3

Theory states that general level of prices (P) in the economy depends on the supply of money (M)

• P = f(m)

M1 = Amount of Cash in the economy
M2 = The Cash In economy (M1) + Money in the current account
M3 = M2 + money in other accounts, like the savings account

• Most common money supply is M2

Question 4

Higher money supply means what

Answer 4

Means higher price level (inflation)

Question 5

QTM: Equation of exchange

Answer 5

Theory is expressed by: MV = PY (M x V = P x Y)

• M = Money stock
• V = Velocity of circulation (How much we use each unit, e.g. £1, £2
• P = Price level
• Y = Output (transactions)

Question 6

QTM assumptions

Answer 6

1) Y is fixed at the full employment output level (AS curve is a vertical line at full employment)

• Only way Y (output) will increase is if employment rate increases

2) V is constant given that it was determined by customs and payments habits

Question 7

Inflation can increase with what

Answer 7

Inflation can increase with M (money supply) or decrease depending on monetary policy, but Y (output) or employment rate will not change

Question 8

Overall QTM suggests what

Answer 8

QTM suggests that there’s no relationship between unemployment and inflation

Question 9

QTM implications: What’s did economists and politicians suggest to do in 1920’s and 1930’s

Answer 9

They suggested to enhance public work like building roads, hospitals, houses, as this will reduce unemployment and enhance output and employment rate

• This programme of public works would be funded by either: Extra taxation, extra government borrowing (from banks), or printing extra money (expansionary policies)

Question 10

Why could the 3 ways of funding (expansionary policies) the public works be bad

Answer 10

• Extra taxation = Would lead to a Reduce in private sector demand
• Government borrowing = Would reduce private investment as government borrowing from banks will cause interest rates to increase, causing people to save
• Printing extra money = Only increases inflation, as increase in money supply, increases inflation, real wage will decrease, reducing private consumption

Question 11

According to QTM, changing money supply (m) (expansionary policy, contractionary policy) will affect what

Answer 11

• Affect general price level
• Does not affect output (Y)

Question 12

QTM implications

What policy will cause AD curve to shift up (

Answer 12

• Expansionary Policy will cause AD curve to shift up
• Will cause inflation without changing output (or employment), therefore no relationship

Question 13

QTM criticisms

Answer 13

1) Capitalist economies are rarely at full employment - Have unlimited aggregate demand, always can increase output

2) Empirical behaviour of the velocity of circulation demonstrates that the assumption that it is constant is not plausible - More technology, people, other factors, therefore V is not constant. More advertisement so it encourages people to spend more

Question 14

QTM Example: Fiscal Policy in the 1930’s

Answer 14

• Government Budget must be balanced (expenditure = Government revenue)
• Spending on unemployment benefits increased
• Other spending had to be cut
• More Unemployment, More Unemployment benefits
• Treasury officials and classical economists called for cuts in unemployment benefits
• Keynes argued, its not saving that was necessary to cure the unemployment, but spending. Government deficits were desirable. Attempts to balance the budget merely deflated the economy further and deepened the problem of unemployment

Question 15

Describe the Phillips curve

Answer 15

• Trade off between inflation and unemployment is recognised
• 1960s and 1970s
• Phillips found a negative relationship between inflation and unemployment rate

Question 16

Phillips suggests what

Answer 16

• Inverse (Negative) relationship
• Non-linear relationship

Question 17

What does Phillips curve show the relationship between

Answer 17

Rate of growth in price level (inflation) and unemployment rate

Question 18

How can u replace wage with inflation

Answer 18

Money wage costs represent a high proportion of total costs, so movements in money wage rates would drive movements in the general price level

Question 19

When did the Samuelson-Solow Phillips curve come about

Answer 19

1960-61 when the US economy was in a deep recession and unemployment rate was rising

• They introduced an idea of a policy trade-off (‘menu of choice’) between unemployment and inflation
• Government to sustain lower unemployment rates then cost of that policy decision would be higher inflation

Question 20

What will happen during expansionary Policy and when will expansionary Policy occur

Answer 20

Expansionary Policy will enhance aggregate demand (AD) by increasing government expenditure or decrease taxes which will cause inflation but decrease unemployment rate

• Would occur during a boom

Question 21

What will happen during contractionary Policy and when will contractionary Policy occur

Answer 21

Reduce aggregate demand (AD), reducing inflation rate, and increasing unemployment rate

Question 22

Phillips curve implications - what did policy makers believe they could do

Answer 22

Despite the warning, policy makers thought they could manipulate demand (employment) and exploit this trade-off to achieve a socially optimal level of unemployment and inflation

Question 23

Phillips curve implications

How’s Phillips curve different to QTM

Answer 23

• QTM has a vertical supply curve, means that at full employment, any change in aggregate demand will require inflation
• Phillips Curve, aggregate supply is not a vertical line, its upwards sloping meaning all the time we have increased aggregate demand which does cause increase in inflation but also unemployment decreases

Question 24

Phillips curve criticisms (stagflation)

Answer 24

• Stagflation = High inflation combined with high unemployment and stagnant demand in a country’s economy

-US government continued with Vietnam war, through 1960’s, demand-pull inflationary pressures associated, with war spending began

• Sharp rise of oil prices in 1970’s (OPEC was formed)
• Positive relationship between inflation and unemployment (stagflation)