Control Of Inflation Essay, Research Paper
The governments of most
developed economies now appear to be primarily concerned with inflation and how
to keep it down as opposed to maintaining full employment or restricting the
money supply. However, unlike in other areas of the economy, the actions the
government can take to control inflation are quite limited. This is because
people and firms behave according to their expectations not only of inflation
but also of what they consider the government will do. As a result of these
implications, governmental actions to control inflation may not have the
desired results. If the actions of the government are consistent, though, it
will be possible for people?s expectations to be built around what they believe
the government will do.
To illustrate an example of this, consider the
following model. The short-run Phillips curve is believed to show the trade-off
between jobs and inflation, although since the early 1960s the relationship is
not as clear as it once was. Monetarists like Friedman, though, believed that
in the long-run the natural rate of unemployment is static: shifts in inflation
and employment will always return to this level. In other words, it is the
equilibrium that will be returned to when the level of inflation is correctly
anticipated. The long run Phillips curve (LRPC) is drawn in figure one with a
number of short-run curves crossing it (each labelled SRPCx), which
represent short-term fluctuations causing trade-offs between levels of
inflation and levels of unemployment[1].
Suppose the government in the long run wishes to keep inflation at 0%, which is
at point A, giving a level of unemployment at U*, which is the natural rate.
The government is able to set this target because in the long-run there can be
no trade-off (the UK currently has an inflation target of 2.5%: recognising the
practical difficulties in holding prices completely stable as this model is
supposing). At point C, the government could try to reduce inflation, which
will temporarily increase unemployment as inflation moves along SRPC2 ,
but eventually the shifts in aggregate supply and demand will cause
unemployment to return to U* . Given that the government has a declared policy
of keeping inflation at 0%, firms and presuming it to have been successful,
trade unions will set prices and wage claims appropriately, to account for
this, and SRPC0 will be the short-run curve that is used. Now, suppose that the
government, fearing electoral defeat, wants to increase unemployment above the
natural rate for short-term gain. By following an expansionary fiscal policy,
it would be possible to move up SRPC0?
and reach point E, which offers far lower unemployment than point
U*, but at a higher level of inflation.?
However, if this is done, the government will lose its credibility,
because wage claims? and price levels
will have been settled expecting inflation at 0%. Once it is seen that the
policy has been abandoned, firms and trade unions will have to settle wage
claims and price levels to account of the new, increased, inflation rate. It is
which puts long-run equilibrium at point B, offering inflation at y% for the
natural rate of unemployment. At point B, there is less chance of the
government trying to temporarily increase the level of employment for short
term gain, as shifting along this short-run curve will cause inflation to be even
higher. The -government is expected to renege on its promises, so its attempts
to control inflation will therefore depend on whether or not it is believed. A government may desire
to have a good reputation for keeping its promises, and therefore it may
deliberately constrain itself into a policy to enable it to try to resist the
temptation to renege on them for short-term gain. By giving the power to set
interest rates to the Monetary Policy Committee of the Bank of England and
giving them a level of inflation to try and reach, the Labour Government is not
only less able to manipulate the economy for political advantage, but also able
to send a signal out to the country that they mean what they say. Likewise,
joining the Exchange Rate Mechanism was an earlier attempt to commit the
country to a certain inflation policy. The latter, though, had to be abandoned
due to the inability of the economy to hold itself at the entry rate without
having levels of unemployment that would have been political suicidal. However,
when the UK was pulled out after Black Wednesday in 1992, the credibility of
that government was lost, and thus the private sector lost faith in the
government?s policies. In this way, control of inflation can be said to depend
on what action the government actually takes as opposed to what people believe
they will do, as when changing policies for short-term gains destroys their
credibility. The government may
attempt to control inflation through pursuing controls on prices and incomes.
Income controls usually tend to relate to wages, as opposed to dividends and
other forms of income, as it is easiest to implement. However, to be effective
they need the support of both employers (represented in the CBI) and the
workers (in the TUC). These bodies, though, only have limited control over
their members and so it may be hard to enforce. Even in the public sector,
where the government is able to intervene directly, there will have to be a
large degree of acceptance, otherwise opposition (and even strikes) will be
faced. Evasion of wage controls, either through recognised exemptions which may
be too broadly or vaguely defined, or negotiated secretly at the local level,
is also a problem. Moreover, if a maximum level is set, all workers may
consider themselves entitled to receive it. Such controls were tried in the
1970s but were not very successful. The Thatcher government in the early 1980s
managed to reduce inflation at the expense of rapidly rising unemployment
through refusing to give in to wage demands and increases in the manner which
governments of both colours had done in the past. [1] These curves have been drawn
as straight lines in order to make the diagram clearer. Phillips curves are
usually considered to be curved (hence the name).
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