Wednesday, 31 October 2018

Who Pays For Tariffs? The Economist:

Essential light analysis of tax incidence and impact of trade restrictions. Note the amount of currency depreciation that gets passed on as a lower price - really solid context for you:

Who pays for tariffs?

Americans, probably

Print edition | United States

Sep 8th 2018| WASHINGTON, DC

PRESIDENT Donald Trump reckons foreigners will pay the cost of the $200bn in tariffs he plans on Chinese goods. Others disagree, claiming that tariffs will bite into budgets at home. Duties are payable by importers, but the question of who bears their burden is more complicated.
Foreigners can end up paying for tariffs if the prices they charge slump in response. For example, Douglas Irwin of Dartmouth College found that in 1897 foreign exporters absorbed at least 60% of an increase in sugar tariffs, as they dropped their prices to maintain access to the mighty American market. (That tale may sound familiar to soyabean farmers hit by Chinese duties.)

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Consumers might also avoid part of the bill if the yuan depreciates against the dollar; it has done so by 8% since tariffs were formally announced in March. Although almost all imports from China are priced in dollars and contracts can be slow to adjust, Gita Gopinath of Harvard University suggests that firms may use the tariffs as an excuse to renegotiate.
So far, though, it is hard to see clear signs that prices are falling much, either in response to the tariffs or the yuan depreciation. Perhaps that is no surprise. Ms Gopinath points out that only around 30% of exchange-rate movements get passed through to prices. Chinese exporters use inputs priced in dollars that become more expensive when the yuan depreciates.
If prices do not fall, Americans can still sidestep the tariffs by switching to alternative suppliers. At first, the Trump administration seemed to be encouraging this approach, singling out products for which there were plenty of available alternatives. If alternatives comparable in price and quality were available, though, companies would presumably already be buying them. And so, as well as the hassle of switching suppliers, buyers will almost certainly face some sort of extra cost. As the tariffs turn from a chiselled list into one bludgeoning all imports from China, that sort of adjustment will be harder to make.
For many companies, switching may be easier said than done. Around half of the products threatened with tariffs are intermediate goods, used by companies to make other stuff. Mary Lovely of Syracuse University points out that the early tariff lists may have been designed this way to protect consumers. Yet given how customised intermediate goods can be, importers may struggle to find a ready alternative.
Supply chains can be complex beasts, requiring each component to be checked and tested. According to the Census Bureau, around a quarter of American imports from China come from a “related party”, which could include an affiliate, a subsidiary or a parent company. Where two companies are embedded in a supply chain or part of the same company, dodging duties may require moving premises.
If the tariffs stick around, then in time trade will adjust. Reports are emerging of companies considering moves to Vietnam. In response to the proposed tariffs on $200bn of Chinese imports, Greg Kirkpatrick, who works for a company making fancy shopping bags, said he was in favour overall. But as orders for the Christmas shopping season have long since been placed, he cannot renegotiate with his Chinese suppliers and is having to tell his customers that their prices will be anywhere from 10% to 25% higher. For now, at least, it seems Americans like him will pay.

Thursday, 25 October 2018

Article challenging givens of imposition of tariffs post-Brexit

Obviously not 100% objective, but great for both sides of a free trade argument - tariff price & world price, who absorbs the tariff?

The protectionist car lobby should not be dictating the terms of Brexit to the rest of us

Now that negotiations with the EU appear truly to be at an impasse, the President of Toyota, Mr Akio Toyoda, produced yet another Project Fear blast in last Saturday's Telegraph with lots of conditional 'ifs' and 'maybes' aimed at scaring us from daring to consider leaving the EU without a trade deal. Of course, the particular trade deal to which he refers is Mrs May's plan to keep us in a customs union and, through the 'common rulebook,' effectively in the Single Market.

As evidence mounts that the auto industry secretly has long been promised such a deal by the Government, Mr Toyoda (who also is head of the Japanese auto manufacturers' trade association) naturally does not like this - he sees the promised prize slipping from his grasp.

In any case, Mr Toyoda is wrong on every point he makes.

Mr Toyoda claims there will be "price rises for motorists if trade tariffs kick in". He is comprehensively wrong about this - the reverse is true. When the UK leaves the EU with a Clean Brexit, trade barriers currently facing non-EU countries will be eliminated or substantially reduced via the UK agreeing either FTAs or taking unilateral actions to reduce such trade barriers. Doing so will open up our market so we can trade with the rest of the world at world market prices, which are significantly lower than those in the protectionist EU.

Economists for Free Trade estimate that consumer prices inside the protectionist wall of the EU average about 20 per cent higher than prices in the rest of the world. In the case of autos, the EU imposes a 10 percent tariff on cars imported from the rest of the world before taking into account the additional price impact of non-tariff barriers and quotas imposed by the EU.

Thus post-Brexit auto prices will drop sharply in the UK and consumers will likely be offered an increased variety of cars from places like the US and Asia. This is what worries Mr Toyoda.

Even if the UK imposes tariffs against the EU (which it might not), his claim that higher prices will follow is vacuous. Because there will be international competition in the UK auto market, auto prices will reflect (lower) international market prices. Consequently, EU-based auto manufacturers will not be able to sell their cars at higher prices and will have to swallow the UK tariff. This is the whole point of free trade and why it is so important that the UK be out of any customs union following Brexit.

He worries about "declines in revenue" and "the spectre of job losses". He is quite right to be worried about potential declines in revenue as consumers will be paying lower prices, as explained above. However, the fact that unit revenues will be lower does not necessarily translate into total revenues being lower, as demand could be stimulated by lower product price points and by increased export volume.

Following Brexit, there will be many factors potentially affecting auto industry profitability - some negatively, some positively. Economists for Free Trade has analysed the combined impacts of these factors, assuming that there is no change in volume as mooted above. This analysis shows that industry profitability is unlikely to decline and potentially could increase, driven by lower component costs as a result of eliminating/reducing import tariffs, new opportunities to source components from more competitive suppliers in the UK and Asia, enhanced productivity opportunities once outside of the more restrictive EU regulatory environment, and continuing benefits of a lower currency. This is before taking into account the enhanced export opportunities afforded by new FTAs.

It probably is fair to say that the advent of new technologies - such as electric and driverless cars - will have a much greater impact on the industry's sustainability than Brexit. An example of this is the announcement by Dyson that they will build their electric car in Singapore, even though the design and engineering will remain in the UK. Leaving the protectionist and highly regulated EU that is suspicious of new technologies places UK auto manufacturers in a much better position to capitalise upon them.

He predicts "production line stoppages if imports are held up at borders by the imposition of customs checks". Note the 'if'! For starters, a report from Boston Consulting Group shows that a representative UK auto manufacturer imports only 36 per cent of its components from the EU - 21 per cent are imported from non-EU countries and the largest proportion (43 per cent up from 36 per cent in 2011) are sourced from the UK. Post-Brexit, the proportion of components sourced from the EU is likely to decline sharply - particularly as the new technologies mentioned above take their place in the supply chain.

The 21 per cent currently imported from non-EU countries already undergo customs and other border checks and self-evidently do not create problems with just-in-time supply chains. Such just-in-time supply chains operate globally across customs borders without difficulty - eg, throughout Asia, or amongst South American, North America, Europe, and Asia. What makes these supply chains work are modern computer-based logistics systems and border procedures mandated by WTO rules and procedures that dictate 'frictionless trade' - particularly for high volume, regular shipments such as those of the auto industry.

It is often said that delays on the M25 would have a greater impact on just-in-time shipments than any border delays.

This past summer, when extreme temperatures forced cancellations and delays of trains through the Chunnel for several days, did anyone hear a whisper of auto production lines shutting down? Last week, Jon Thompson, Chief Executive of HMRC, was asked before the Brexit Select Committee, "Could just-in-time delivery take place from outside the European Union". His single word answer was, "Yes".

Finally, post-Brexit it will be within the power of the UK to eliminate tariffs and border checks on auto components and such moves are being discussed.

Aside from being wrong on all his assertions, Mr Toyoda - in his protectionist zeal - demonstrates a breath-taking lack of perspective. The UK auto manufacturing industry - based on his own estimate of industry employees - accounts for only about 0.5 per cent of all UK employees (that is less than half the number of farmers). Its gross value added to the UK economy is just 0.8 per cent of GDP.

The Government's supine attitude to this protectionist, rent-seeking industry lobby played a big part in spawning the Northern Ireland border issue onto which EU negotiators were only too pleased to anchor the Northern Ireland backstop requirement. Without this, there would be more enthusiasm to explore a SuperCanada FTA or to embrace a World Trade Deal - the two outcomes Mr Toyoda and his cronies in Germany fear.

Why should this small, largely foreign-owned, industry be allowed to dictate the terms of Brexit to the rest of us?

Monday, 22 October 2018

Current account deficits, surpluses and more

The first section looks at the German c/a surplus, in a readily digestible way. It also explains Target2 - how the ECB balances out surpluses & deficits within the Eurozone - removing the requirement for individual central banks to hold large reserves. The last section looks at the storm clouds looming in Europe; take from that what you will - the author is a eurosceptic:

Last week I wrote about the inter-relationship between Italy’s financial plight and its underlying economic difficulties, now finding expression in its government’s conflict with the EU. It has been told by the EU to come up with a different budget. If its budget isn’t modified, the EU will probably reject it. We shall see if the Italians bend the knee to Brussels.

But the Italian difficulties represent only one side of the euro problem. The flip side is to be seen in Germany and, contrary to popular misconceptions, it isn’t rosy either. On the face of it, Germany is an amazing economic success story. The economy is growing strongly and unemployment is only 3.4pc.

Yet recent German economic performance is not outstanding. Since the formation of the euro in 1999, Germany’s economy has grown by about 32pc while the poor old UK has grown by 43pc. Meanwhile, the figures for the US and Canada are 49pc and 53pc respectively. In the same period, Sweden has grown by 56pc and Switzerland by 46pc.

Yet it is when you look at the figures for consumption that it really dawns on you that things aren’t quite right. Since 1999, spending by German consumers has risen by only 20pc. How come the discrepancy between GDP and consumption? This is explained largely by the shift in the trade balance. Since the euro was formed, Germany has gone from a small deficit of about 1pc of GDP to a whopping great surplus of almost 8pc of GDP.

The explanation for relatively weak consumption is largely not more saving by German consumers, whose caution is legendary; rather, German workers have not been paid that much. Since the formation of the euro, the average real pay of German workers has risen by only 23pc, or 1.2pc per annum. It is German companies that have done spectacularly well, largely thanks to strong exports, greatly helped by subdued wage increases and the competitive euro. Meanwhile, the government’s budget is in surplus to the tune of 1.3pc of GDP. The German economy is completely lopsided with excessive reliance on exports and domestic demand too weak.

But some day German workers will benefit, won’t they? Perhaps. The counterpart to these huge current-account surpluses is the build-up of claims on other countries. These are effectively IOUs from countries that have bought German goods, well in excess of what Germany has bought from them. But debts aren’t always repaid, as Germany should know.

Within the euro system there is a special sort of IOU. These are the so-called Target2 balances, representing claims by one central bank on another as a result of imbalances in the flow of money between member countries.

This is how it works. Suppose someone withdraws euros from an Italian bank and deposits them with a German bank. The German bank now has surplus euros and the Italian bank has a shortage of euros. Through their respective central banks and the ECB, the euros are recycled from the German bank to the Italian bank.

But someone has replaced a claim on an Italian bank with a claim on a German bank. Matching this switch, the German central bank has acquired a claim on the ECB and the ECB has acquired a claim on the Italian central bank. That doesn’t sound to me like an equal exchange.

The scale of these claims is staggering. Germany has net claims on other countries within the Target2 system of some €1,000bn. That amounts to roughly 30pc of German GDP. The Target2 liabilities of the Bank of Italy come to almost half that figure. The stock of both German claims and Italian liabilities is far greater now than it was at the height of the euro crisis in 2012.

If Italy were to leave the euro, would it fully honour these debts? The lawyers will tell you that legally it must. But then that’s why they are lawyers. If I were the ECB I would not want to bank on it – as it were. What will happen if the stand-off between the Italian government and the euro authorities continues and the Target2 balances get ever larger? And suppose that there is a run on the Italian banks. The Bank of Italy cannot issue euros. It would be the ECB that would have to provide the dosh. Would it? These problems for Germany and Europe have arisen from the abolition of the Deutschmark. The exchange rate is a hinge that allows countries as different as Germany and Italy to be different, yet to remain connected. Without it the union must break.

The replacement of the Deutschmark by the euro has also been responsible for a significant global problem, namely the fact that the eurozone as a whole is running the largest current-account surplus in the world, thereby acting as a deflationary force and contributing to the growth of protectionist sentiment, especially in the US.

The solution is obvious: bring back the Deutschmark. But I wouldn’t hold your breath. Germany does not want to be the cause of another major European upset. If Germany doesn’t leave the euro, then Italy should. As and when either of these happens there will be financial mayhem across Europe. But carrying on with the current system would be worse.

Apparently the UK’s policy establishment wants us to stay in the EU, if not permanently then at least for as long as possible. If we leave without a deal on a continuing close relationship they are worried about “disruption”. Disruption? Has anyone in Whitehall noticed the storm gathering across the channel? I would have thought that the sensible thing for us would be to clear off out of it PDQ, before the balloon goes up. Still, I am a humble economist, not one of our Olympians charged with the task of managing Brexit. They evidently understand these complex European economic matters in a unique way.

Roger Bootle is chairman of Capital Economics

Thursday, 18 October 2018

Tax working less, not more:

According to figures from the Organisation for Economic Co-operation and Development, the Japanese work far more hours than the French, Spanish, or the British

Our culture is different. We enjoy a more leisurely pace of life. We take more holidays, and family and religious traditions mean that we spend more time away from the factory or the office. Over the years, lots of reasons have been put forward for the fact that Europeans – including the British – work less than people in the rest of the world.

But in fact, the explanation is much simpler than that. According to a fascinating new paper from the St Louis Fed, we are just taxed too highly. Over five decades, it found the taxes imposed on labour steadily went up in Europe compared to everywhere else. Not very surprisingly, we decided to work less, while everyone else worked a bit harder. The result? Europe steadily put fewer hours in than the rest of the world, and became relatively poorer as well. There is lots of fashionable talk about four-day weeks, and robotics, destroying jobs. But the simple truth remains that if we cut the taxes on work, we would all be a lot richer.

There are not many economic league tables where Europe takes a comfortable lead. Not on growth, or stock market performance, or tech start-ups, or much else. But when it comes to shortening the working week, the continent has some real champions. The Germans only put in an average of 26 hours a week, according to figures from the Organisation for Economic Co-operation and Development, although admittedly they are probably getting a lot done in their relentless Teutonic way in that time. The French come in next at 28 hours, while the Spanish and the British are putting in 32 hours. The Americans, Japanese and the South Koreans are all doing significantly more hours than that.

But it has not always been like that. In a recent paper the St Louis Fed, which does a lot of the original research for the Federal Reserve, crunched the numbers on long-term trends in working hours across the world. Rewind to 1950, and it turns out that Europe was the hardest-working continent. The average person put in slightly over 1,000 hours each per year, compared with only slightly over 800 for the US and the rest of the world. Over the next 50 years, however, that went into steady decline. By the close of the 20th century, the average European had managed to cut his or her working year down to around to 700 hours. Everywhere else, by contrast, it was going up. In the US, it had increased to 850 hours a year by the year 2000 and has stayed around that level ever since, and for the rest of the world it went up to close on 900 hours a year. From the top of the table, Europe had dropped right down to the bottom.

As they became richer during the long post-war boom, it is possible that Europeans had decided they would rather take longer holidays, or enjoy a little more leisure time.

Maybe that was part of the story. But the paper found a much more obvious explanation for what was going on over those five decades. Over that time, taxes on labour rose steadily in Europe, but not elsewhere. “High taxes on wages and salaries can discourage people from working,” it argues. “Labour taxes have generally increased in Europe from 1950 to the mid-Nineties, and we see that per capita hours worked declined during this same period.” After controlling for factors such as labour regulations, social security benefits and trade union power, all of which could potentially play a role, the paper concluded that we “can attribute most of the changes in hours worked to taxes and not to other factors”. Indeed, significantly, from the mid-Nineties taxes on labour started to level off in Europe, and – surprise, surprise – the decline in working hours levelled off as well. In the last few years, it has started to rise again, suggesting that as those social charges come down, people are rediscovering their appetite for work.

In fact, Europe has some punishing taxes on labour. The OECD calculates the “tax wedge” every year, which measures the percentage of every salary that is taken in taxes and payroll charges. For a single worker without children, it has reached an extraordinary 53pc in Belgium, and not much less in France and Germany. By contrast, in countries such as Mexico or New Zealand it is less than 20pc, and the average for the OECD as a whole is only 35pc. There is a lot of talk about how artificial intelligence and robotics will destroy traditional jobs. John McDonnell, the shadow chancellor, is the latest politician to jump on that bandwagon with support for a four-day working week. In Sweden there have been experiments with a six-hour day, and France has a maximum 35-hour week, and for all President Macron’s reforming zeal it appears untouchable. There is a constant demand for yet more rules and regulation to make us all work a bit less.

In fact, as the St Louis paper makes clear, the best way to make us all richer would be to work harder. How can we do that? If we taxed labour a little less, hours worked and output would soar. There is no real reason why Europeans should not be working the same hours as Americans or everyone else in the world. The evidence already shows that when they started being taxed a little less, they started working a bit more as well. Crushing taxes on labour have destroyed the work ethic of what half a century ago was the hardest working continent in the world. We could turn that around if we wanted to, and make all of us richer in the process – but the only way to do that would be to reduce the taxes on clocking into the office or factory.

Thursday, 11 October 2018

Against the Phillips Curve

The Phillips Curve is the very basis of monetary policy. Is it actually valid? Many economists would argue not - you have to see both sides:

The Phillips Curve Myth

38 COMMENTS

10/09/2018Frank Shostak

It is a well-known belief that by means of monetary policy, the central bank can influence the rate of real economic expansion. It is also held that this influence however, carries a price, which manifests itself in terms of inflation.

For instance, if the goal is to reach a faster economic growth rate and a lower unemployment rate then citizens should be ready to pay a price for this in terms of a higher rate of inflation.

It is held that there is a trade-off between inflation and unemployment, which is depicted by the Phillips curve. (William Phillips described a historical relationship between the rates of unemployment and the corresponding rates of rises in wages in the United Kingdom,1861-1957, published in the quarterly journal of Economica,1958).

The inverse correlation between the rate of inflation and the unemployment rate has become an important element in the theory of price inflation. The lower the unemployment rate the higher the inflation rate. Conversely, the higher the unemployment rate the lower the inflation rate is going to be.

The events of the 1970’s came as a shock for most economists. Their theories based on the supposed existing trade-off suddenly became useless. During the 1974-75 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labelled as stagflation.

In March 1975, US industrial production fell by nearly 13% while the yearly growth rate of the consumer price index (CPI) jumped to around 12%.

Likewise, a large fall in economic activity and galloping price inflation was observed during 1979. By December of that year, the yearly growth rate of industrial production stood close to nil while the growth rate of the CPI stood at over 13%.

Again the stagflation of 1970’s was a big surprise to most mainstream economists who held that a fall in real economic growth and a rise in the unemployment rate should be accompanied by a fall in the inflation rate and not an increase.

Some economists such as Milton Friedman and Edmund Phelps were questioning the popular view arguing that there cannot be trade-off between economic growth and inflation in the long-term. They were suggesting that this could only occur in the short term. Based on this way of thinking they have formulated the stagflation theory.

The Friedman-Phelps (FP) Explanation of Stagflation

Starting from a situation of equality between the current and the expected inflation rate the central bank decides to lift the rate of economic growth by lifting the growth rate of money supply.

As a result, a greater supply of money enters the economy and each individual now has more money at his disposal. Because of this increase, every individual is of the view that he has become wealthier.

This raises the demand for goods and services, which in turn sets in motion an increase in the production of goods and services. All this in turn lifts producers demand for workers and consequently the unemployment rate falls to below the equilibrium rate, which both Friedman and Phelps labeled as the natural rate.1

According to FP, the increase in people’s overall demand for goods and services and the ensuing increase in the production of goods and services is of a temporary nature. Once the unemployment rate falls below the equilibrium rate this starts to put upward pressure on the rate of price inflation.2

Because of this, individuals begin to realize that there was a general loosening in the monetary policy. In respond to this realization, they start forming higher inflation expectations.

Individuals are now realizing that their previous increase in the purchasing power is starting to dwindle. Consequently, all this works to weaken the overall demand for goods and services.

A weakening in the overall demand in turn slows down the production of goods and services while the unemployment goes up – an economic slowdown emerges.

Observe that we are now back with respect to unemployment and real economic growth to where we were prior to the central bank’s decision to loosen its monetary stance but with a much higher inflation rate.

What we have here is a fall in the production of goods and services – a rise in the unemployment rate – and an increase in price inflation i.e. we have stagflation.

From this, Friedman and Phelps have concluded that as long as the increase in the money supply growth rate is unexpected the central bank can engineer an increase in the economic growth rate.

Once, however, people learn about the increase in the money supply and assess the implications of this increase they adjust their conduct accordingly. Consequently, the boost to the real economy from the increase in the money supply growth rate disappears.

In order to overcome this hurdle and strengthen the economic growth rate the central bank would have to surprise individuals through a much higher pace of monetary pumping.

However, after some time lag people will learn about this increase and adjust their conduct accordingly. Consequently, the effect of the higher growth rate of money supply on the real economy is likely to vanish again and all that will remain is a much higher rate of inflation.

From this, Friedman and Phelps have concluded that by means of loose monetary policies the central bank can only temporarily create real economic growth. Over time however, such policies will only result in higher price inflation. Hence, according to Friedman and Phelps there is no long-term trade-off between inflation and economic growth and unemployment.

Can Money Grow the Economy?

We have seen that according to FP loose monetary policy can only grow the economy in the short-term but not in the long-term. In this way of thinking, because of the increase in the money supply growth rate a greater supply of money enters the economy and each individual now has more money at his disposal. This is, however, not a tenable proposition.

When money is injected, there must always be somebody who gets the money first and somebody who gets the new money last. Money moves from one individual to another individual and from one market to another market.

The beneficiaries of this increase are the first recipients of money. With more money in their possession, (assuming that demand for money stays unchanged) and for a given amount of goods available, they can now divert to themselves a bigger portion of the pool of available goods than before the increase in money supply took place. This means that less goods are now available to those individuals who have not received the new money as yet (late recipients of money).

This of course means that the effective demand of the late recipients of money must fall since fewer goods are now available to them. Observe that because of the fact that people are not identical, even if their respective money holdings have risen by the same percentage, as implied by Friedman-Phelps analysis, their response to this will not be identical. This in turn means that those individuals who spent the new money first benefit at the expense of those who spend the new money later on.3

Hence an increase in money supply cannot cause a general increase in overall effective demand for goods. Only through an increase in the production of goods this can be achieved. The more goods an individual produces the more of other goods he can secure for himself. This means that an individual’s effective demand is constrained by his production of goods, all other things being equal. Demand therefore, cannot stand by itself and be independent - it is limited by production, which serves as the mean of securing various goods and services.

Increases in Money Supply Actually Weaken Economic Growth

Money permits the product of one specialist to be exchanged for the product of another specialist. Alternatively, we can say that an exchange of something for something takes place by means of money. Things are, however, not quite the same once money is generated out of “thin air” because of loose central bank policies and fractional reserve banking. Once money is created out of “thin air” and employed in the economy it sets in motion an exchange of nothing for something. This amounts to a diversion of real wealth from wealth generators to the holders of newly created money. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy. So contrary to Friedman-Phelps way of thinking, money cannot grow the economy even in the short-run. On the contrary, an increase in money only undermines real economic growth .

What Causes Stagflation?

We have seen that an increase in the money supply out of “thin air” results in an exchange of nothing for something. As a result, the process of real wealth formation weakens and this in turn undermines the economic growth rate. The increase in the money supply growth rate, coupled with the slowdown in the growth rate of goods produced results in the increase in price inflation. (Note that a price is the amount of money paid for a unit of a good). Observe that what we have here is a faster increase in price inflation and a decline in the growth rate in the production of goods. However, this is exactly what stagflation is all about i.e. an increase in price inflation and a fall in real economic growth. Stagflation is the natural outcome of monetary pumping which weakens the pace of economic growth and at the same time raises the rate of increase of the prices of goods and services.

The fact that a strengthening in monetary growth may not always manifest itself as visible stagflation does not refute what we have concluded with respect to the consequences of increases in the rate of monetary pumping on economic growth and prices.

Consider the following situation. On account of past increases in the growth rate of money supply and the consequent softening in the growth rate of goods produced the rate of price inflation is going up.

Now, because the underlying bottom line of the economy is still strong notwithstanding the damage inflicted by a stronger money supply growth rate, the growth rate of the production of goods only weakens slightly. Within such a situation, the unemployment rate could continue falling. What we have here is an increase in price inflation and a fall in the unemployment rate.

Any theory, which concludes from this inverse correlation that there is a trade-off between inflation and unemployment, will be false since it ignores the true consequences of increases in the money supply growth rate. Hence, we can conclude that the Phillips curve cannot be a basis for a sound theory of inflation.

Conclusion

The events of 1970’s have unsettled the view that there can be a trade-off between inflation and unemployment.

During the 1974-79 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labeled as stagflation.

Milton Friedman and Edmund Phelps have shown that a trade-off between inflation and unemployment can exist in the short term but not in the long-term. By Friedman and Phelps the phenomena of stagflation depicts the lack of the long-term trade-off.

Given the fact that monetary pumping undermines the process of real wealth formation, however, it is not possible to have trade-off neither in the long term nor in the short term. Hence, we can conclude that the Phillips curve cannot be a basis for a sound theory of what sets in motion price inflation.

Quote of the day

Wednesday, 31 October 2018