Monday, September 11, 2006

Appropriate Policies to achieve Higher Employment with Low Inflation

Situation 1: Stagflation - High Inflation + High Unemployment

A term used in the 1970s to refer to the combination of stagnation (low real GDP growth and high unemployment) and high inflation. It is caused by cost-push inflation or imported inflation.

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Cost Push Inflation

Oil prices: Between 1973 and 1974, the price of oil rose from $3 to $12 per barrel, and between 1978 and 1980, it rose from $13 to $31 per barrel. This not only raised cost of production, thus causing cost-push inflation, but also caused recession in 1975 and 1979-81 as business climate became uncertain and governments throughout the world deflated (right move?) to the inflation.

Domestically generated cost-push pressures: Cost-push inflationary pressures can also increase as a result of the following: growing trade union power and militancy; the desire for real wage increases each year in excess of the economy's real growth; low productivity growth.

Appropriate Policy

Prices and Incomes Policy: It is a policy aimed at regulating the prices of goods & services and the wages of the economy by the use of legislation. For example, by legislation, the government fixes the prices of goods especially essential goods and all producers and sellers are to stick to these officially fixed prices. In Singapore, the incomes policy, in addition to other policies, was used to fight the recession in 1985. The NWC, with the consensus of the government, trade unions and employers association, recommended and was accepted by all, a freeze on wage increases for 2 years in order to prevent the cost of production from further rising in Singapore. This caused the cost of production to fall, shifting the AS curve down from AS2 to AS1, resulting in lower inflation and also higher level of real output and employment (shown as Y2 to Y1 above)

Situation 2: Near full employment - High Inflation + Slow Growth

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Demand Pull Inflation

As economy nears full employment (Y1 to Y2), excessively high levels of aggregate demand (such as rising consumption of the people and excessive government expenditure) from AD1 to AD2 would only cause general price level to rise and demand pull inflation results. The economy cannot increase its real output further without higher and higher levels of inflation.

Appropriate Policy

Supply-side Policy: Focuses on expanding the productive capacity of the economy (click for more info and refer to your Compact Revision Notes 2006). Supply-side policy is the only long term means by which the economy can keep expanding (rise in AD) without rising rates of inflation. As shown below, a rightward shift of AS lowers the price from P2 to P1 while increasing real output and employment from Y1 to Y2.

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