Unemployment and Inflation – Part 12

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

This is the continuation of the Chapter on unemployment and inflation – the series so far is:

• Unemployment and inflation – Part 1
• Unemployment and inflation – Part 2
• Unemployment and inflation – Part 3
• Unemployment and inflation – Part 4
• Unemployment and inflation – Part 5
• Unemployment and Inflation – Part 6
• Unemployment and Inflation – Part 7
• Unemployment and Inflation – Part 8
• Unemployment and Inflation – Part 9
• Unemployment and Inflation – Part 10
• Unemployment and Inflation – Part 11

I am now continuing the discussion of the Phillips Curve …

Chapter 12 – Unemployment and Inflation

MATERIAL HERE NOT REPEATED

[PICKING UP FROM HERE]

12.X Demand-pull and Cost-push inflation

Economists distinguish between cost-push and demand-pull inflation although, as we will see, the demarcation between the two types of inflation is not as clear cut as one might think.

Demand-pull inflation refers to the situation where prices start accelerating continuously because nominal aggregate demand growth outstrips the capacity of the economy to respond by expanding real output.

Gross Domestic Product (GDP) is the market value of final goods and services produced in some period. We represent that as the product of total real output (Y) and the general price level (P), that is, GDP = PY.

We have learned from the National Accounts, that aggregate demand is always equal to GDP or PY. It is clear that if there is growth in nominal spending that cannot be met by an increase in real output (Y) then the general price level (P) has to rise.

Keynes outlined the notion of an inflationary gap in his famous 1940 article – How to Pay for the War: A radical plan for the Chancellor of the Exchequer.

[REFERENCE: Keynes, J.M. (1940) How to Pay for the War: A radical plan for the Chancellor of the Exchequer, London, Macmillan]

While this plan was devised in the context of war-time spending when faced by tight supply constraints (that is, an restricted ability to expand real output), the concept of the inflationary gap has been generalised to describe situations of excess demand, where aggregate demand is growing faster than the aggregate supply capacity can absorb it.

When there is excess capacity (supply potential) rising nominal aggregate demand growth will typically impact on real output growth first as firms fight for market share and access idle labour resources and unused capacity without facing rising input costs.

There are also extensive costs incurred by firms when they change prices, which leads to a “catalogue” approach where firms will forecast their expected costs over some future period and set prices according to their desired return. They then signal those prices in their catalogues and advertising to consumers and stand ready to supply whatever is demanded at that price (up to exhaustion of capacity). In other words, they do not frequently alter their prices to reflect changing demand conditions. Only periodically will firms typically revise their price catalogues.

Further, the economy is also marked by social relations that reflect trust and reliability. Firms, for example, seek to build relationships with their customers that will ensure product loyalty. In this context, firms will not seek to vary prices once they are notified to consumers.

Firms also resist cutting prices when demand falls because they want to avoid so-called adverse selection problems, where they gain a reputation only as a bargain priced supplier. Firms value “repeat sales” and thus foster consumer good will.

The situation changes somewhat, when the economy approaches full productive capacity. Then the mix between real output growth and price rises becomes more likely to be biased toward price rises (depending on bottlenecks in specific areas of productive activity). At full capacity, GDP can only grow via inflation (that is, nominal values increase only). At this point the inflationary gap is breached.

An alternative source of inflationary pressure can arise from the supply-side. Cost-push inflation (sometimes called “sellers inflation”) is generally explained in the context of “product markets” where firms have price setting power and set prices by applying some form of profit mark-up to costs.

We learned in Chapter 9, that generally, firms are considered to have target profit rates which they render operational by applying a mark-up on their unit costs. Unit costs are driven largely by wage costs, productivity movements and raw material prices.

Take the case of an increase in wage costs with productivity and other unit costs constant. In this situation, unit costs will rise and prices will rise unless firms accept a squeeze on their mark-up. In other words, either prices rise and deflate the nominal wage (leading to a real wage cut) or the firms accept a real cut in their per unit returns.

This concept then led to economists asking the question – under what circumstances will firms and/or workers accept such a real wage cut? This, in turn, broadened the enquiry to include considerations of social relations, power and conflict.

Workers have various motivations depending on the theory but most accept that real wages growth (increasing the capacity of the nominal or money wage to command real goods and services) is a primary aim of most wage bargaining.

Firms have an incentive to resist real wages growth that is not underpinned by productivity growth because they would have to “pay” for it by reducing their real margins.

The capacity of workers to realise nominal wage gains is considered to be pro-cyclical – that is, when the economy is operating at “high pressure” (high levels of capacity utilisation) workers are more able to succeed in gaining money wage gains. This is especially the case if they organised into coherent trade unions, which function as a countervailing force to offset the power of the employer.

When the employer is dealing with workers individually they are seen to have more power than when they are dealing with one bargaining unit (trade unit), which represents all workers in the workplace.

The pro-cyclical nature of the bargaining power held by workers arises because unemployment is seen as disciplining the capacity of workers to gain wages growth – in line with Marx’s reserve army of labour.

In this context, a so-called “battle of the mark-ups” can arise where workers try to get a higher share of real output for themselves by pushing for higher money wages and firms then resist the squeeze on their profits by passing on the rising costs – that is, increasing prices with the mark-up constant.

At that point there is no inflation – just a once-off rise in prices and no change to the distribution of national income in real terms.

It is here that the concept of real wage resistance becomes relevant. If the economy is operating at high pressure, workers may resist the attempt by firms to maintain their real profit margin. The may seek to maintain their previous real wage and will thus respond to the increasing price level by imposing further nominal wage demands. If their bargaining power is strong (which from the firm’s perspective is usually in terms of how much damage the workers can inflict via industrial action on output and hence profits) then they are likely to be successful. If not, they may have to accept the real wage cut imposed on them by the increasing price level.

At that point there is still no inflation. But if firms are not willing to absorb the squeeze on their real output claims then they will raise prices again and the beginnings of a wage-price spiral begins. If this process continues then a cost-push inflation is the result.

The causality may come from firms pushing for a higher mark-up and trying to squeeze workers’ real wages. In this case, we might refer to the unfolding inflationary process as a price-wage spiral.

The dynamic that drives a cost-push inflation is seen to arise from the underlying social relations in the economy. It is here that we can consider a general theory of inflation, which recognises that the two sides of the labour market are likely to have conflicting aims and seek to fulfill those aims by imposing real costs on the other party.

12.X The Conflict Theory of Inflation

The Conflict Theory of Inflation beds the analytical approach in the power relations within the capitalist system. It brings together social, political and economic considerations into a generalised view of the inflation cycle.

The conflict theory derives directly from cost-push theories referred to above. Conflict theory recognises that the money supply is endogenous, which is in contradistinction to the Monetarist’s Quantity Theory of Money that erroneously considers that the money supply is exogenously controlled by the central bank.

The conflict theory assumes that firms and trade unions have some degree of market power (that is, they can influences prices and wage outcomes) without much correspondence to the state of the economy. They are assumed to both desire some targetted real output share and use their capacity to influence nominal prices and wages to extract that real share.

In each period, the economy produces a given real output (real GDP), which is shared between the groups with distributional claims in the form of wages, profits, taxes etc. In the following discussion, we assume away the other claimants and concentrate only on the split between wages and profits. Later, we will introduce a change in an exogenous claimant in the form of a rise in a significant raw material price.

If the desired real output shares of the workers and firms is consistent with the available real output produced then there is no incompatibility and there will be no inflationary pressures. The available real output is distributed each period in the form of wages and profits, which satisfy the respective claimants.

The problem arises when the sum of the distributional claims (expressed in nominal terms – money wage demands and mark-ups) are greater than the real output available. In those circumstances, inflation can occur via the wage-price or price-wage spiral mechanisms noted above.

[TO BE CONTINUED]

Conclusion

I had a day of meetings and administrative matters to attend to today. I am in the process of developing a new Economics Program at CDU, which should be offered for the first time in 2014 – both face to face and via on-line learning. It will situate economics in a liberal arts tradition without the business school bias. I will write about it once the design is complete (in the coming week or so) and things have progressed enough for me to start talking about it publicly.

Next week I will finish this Chapter (which might once Randy and I have an editorial meeting be split into various new chapters).

End of Week Humour

I posted this link in a reply to a comment yesterday, but it is worth sharing here.

It is an interview with a “senior ECB official” about Cyprus. Have a fun weekend.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be a little more difficult than last week! (I am sick of you all boasting :-))

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.