Sunday, January 17, 2010

The Inflation Unemployment Tradeoff.

Phillips curve framework is the most suitable for the task of estimating the relationship between inflation and unemployment rate because it provides a direct link to the relationship and is consistent with a variety of structural approaches (Richardson et al., 2000; Laubach, 2001).

After posting More Record Profits for the Banks. More Pain and Suffering For Us, "Anonymous" asked me, "What's that about 10% unemployment rate deflationary tool?" So, rather than respond to "Anonymous", I (not an economist) thought I'd post it.

Keep in mind, the real unemployment rate is well over 10% and closer to 17%, when you account for the long-term jobless, those exiting the job market, and the underemployed or part-time Americans unable to get full-time work. Currently, that works out to be twice the rate of unemployment at the time of the Great Depression. Ryan Sweet, a senior economist at Moody’s Economy.com said, “The exodus from the labor force can’t contain the unemployment rate indefinitely.”

An exodus of discouraged workers from the job market kept the U.S. unemployment rate from climbing above 10 percent in December, economists said.
Anyway, we know that inflation and unemployment are closely related, at least in the short term as shown in the Philips curve above. Therefore, walking a tightrope with inflation on one side and unemployment on the other is unavoidable, because in a fiat monetary system such as ours, inflation is a result of the interaction between the supply of and the demand for money. Therefore careful fine-tuning is required.

In the long run there is a minimum unemployment rate that is consistent with steady inflation. This is called the Non Accelerating Inflation Rate of Unemployment (NAIRU) which is the lowest unemployment rate that can be sustained without upward pressure on inflation or the level of unemployment at which labor and product markets are in inflationary balance.

So, in order to keep inflation low, contractionary fiscal and monetary policies should be adopted by tightening the amount of money allowed into the market, raising the amount of reserves, banks need to keep on hand and raising the bank rate. However, Ben Bernanke's cheap monetary (near-zero interest rates) policy continues to dominate regardless of its effects. This means the unemployment rate must remain above the estimated natural rate of unemployment in order to keep inflation low.
"...rising labor costs are usually the biggest contributing factor to inflation -- and the weak job market has kept salaries in check. So it's understandable that the Fed may be reluctant to start worrying about inflation until there is a return to job growth and a noticeable decline in unemployment."
The near zero-rate that propels asset prices higher isn't exactly trickling down to normal jobs and small businesses. So, rather than allowing it to create new bubbles, wouldn't it be better to direct the capital that is now going into bubbles into the economy and jobs?

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