Price Level vs Unemployment - Essay Example

Relationship between price level & increase in total spending with different stages of unemployment in an economy: Price level is an important factordetermining the total spending of an individual. When there is a rise in price of a particular good you want to buy, it affects your spending level. In the short-term view, inflation and unemployment are inversely proportional to each other. That means when unemployment is high, price level keeps low and when inflation goes high, unemployment takes a down turn. The problem with this phenomenon is that the government and the regulators of an economy would ideally want to keep both the unemployment level and inflation at as low as level possible. This relationship between inflation and unemployment is called the Phillips curve. The short term Phillips curve is a declining one as shown below. (Inflation and Unemployment). However, this is only an approximate representation of the short-term Phillips curve. In long-term, Phillips curve shows a lot of significant differences. Economists have noted that in long run, inflation and unemployment becomes increasingly unrelated to each other. That means a change in the unemployment seems to have little or no effect on the inflation and vice versa. Inflation is also inversely proportional to the total consumer spending. As inflation goes up consumers are wary of spending and hold their purchases as dearly as possible. This is due to the fact that when prices rise there is also a hike in the expected price levels in the future that has an adverse effect on the consumer spending. When prices increase the consumer spending power comes down and disposable incomes are significantly lower. (Cashell 2008). When unemployment is low and there is an increase in price level, wages will rise in response to higher prices. This is because in low unemployment situation, employees can successfully demand full compensation for the higher prices. This has spiralling effect on both the wages and general input costs along with the rate of inflation. All these factors tend to leapfrog each other under low unemployment. When unemployment is moderate, however, the employees will not be compensated in full and will have to settle for less, and so the wage costs do not rise as fast as prices when unemployment is high. This will stop the rise of the prices and rate of increase in inflation. Under full unemployment, the wage costs will be sufficiently low to hold the prices down and unless the regulatory authorities step in the market will go into a deflationary mode. In between the full and low rate of unemployment there is a certain level that's just high enough that costs and prices rise at the same level, so that inflation remains a stable level. (Pettinger). This unique rate of unemployment is called the non-accelerating-inflation rate of unemployment or NAIRU in short. Economists note that in developed economies such as Australia, the tendency of the rate of unemployment automatically has a tendency to reach the NAIRU rate of employment. Whenever there is inflationary pressure, the unemployment in the long term adjusts itself towards NAIRU rendering the short term Phillips curve invalid. The below figure shows that "an extra one percentage point of unemployment pushes the inflation rate down by about 0.4 percentage points in the following year--more in some years, less than others." (DeLong, 2002). Expectation of a price rise' & its impact on consumption spending: When inflation is on the rise and prices of commodities increases, it raises the expectation of the price level also. Initially higher inflation expectations can have an emotional effect because when consumers expect a generalized rise in prices across essential goods and services, then it makes them accelerate their spending to prevent paying higher prices later, providing a near-term increase in consumption. However provided the interest rates are not changed, the consumptions comes down as people adjust their spending to match their dispensable income until they get wage compensation. Since the inflation expectation is high above 4% from in Australia there is higher consumer spending that leads to higher consumption. This has a spiral effect as the increased demand for goods and services would make the market to raise prices in reaction making the actual inflation go up because of higher expected inflation. This essentially happens because; retailers try to cash in on the higher spending sentiments in the market by consumers. Price rise and its impact on consumption spending also depend on production capacity. How much to consume and how much to work' depends on opportunity available for turning labour into consumption and their personal tastes towards work and consumption. The figure below shows the equilibrium level of consumption and production function. (Rush & J 1998). Increase in interest rates & its impact on expenditure in the Australian economy: Australian economy is one of the strongest in the world, with over twenty years of continuous growth. The unemployment rate is also at its lowest level. As a result of structural and policy reforms the Australian economy has become one of the most flexible, resilient and globally integrated economies. Interest is what saver earns for deferring consumption to a later date. It's also the cost paid by borrowers for current spending. In a two-sector economy the government takes an active participation in the economy along with the private sector in production and general out put of the economy. When the Reserve Bank of Australia (RBA) announces an increase in interest rate the following effects is likely in the Australian economy. 1. The general economic growth will be hampered, as investment of public into various projects will come down. 2. Consumer spending will decrease due to the fact that consumers will look to save to earn the extra interest available. Since the interest in higher there will be less purchase on credit and household tend to save more and borrow less. 3. Firms will lower their borrowings which will lead to lower investment in projects. 4. Government will have to step in and increase spending on segments such as construction to increase the investor confidence in the economy in order to offset the setbacks affected by the increase in interest rates. 5. Public investment increases consumption and welfare in the short run, even as resources are attracted towards government investment. In a two-sector economy, since both the private and public active in the market place, even a one percent increase in the spending will result in more than one percent increase in the output of the economy. Interest rate hike is a weapon used by the authorities to curb inflation when it increases exponentially and seems out of control. When interest rates go up there is spurt in saving and investment, which will take the excess money out of circulation. (Australia Economy). Bibliography Australia Economy. [Online]. Trading Economics. Last accessed 10 July 2008 at: http://www.tradingeconomics.com/Economics/Economic-Analysis-Summary.aspxSymbol=AUD CASHELL, Brian W (2008). Inflation and Unemployment: What is the Connection. [Online]. Cornell University: Digital Commons: ILR School. Last accessed 10 July 2008 at: http://digitalcommons.ilr.cornell.edu/key_workplace/180/ DELONG, Brad (2002). The NAIRU: Non Accelerating Inflation Rate of Unemployment. [Online]. Semi-Daily Journal. Last accessed 10 July 2008 at: http://www.j-bradford-delong.net/movable_type/archives/000381.html Inflation and Unemployment. [Online]. Think Quest: Macro. Last accessed 10 July 2008 at: http://library.thinkquest.org/C004323/low/macro4.html PETTINGER, T. Unemployment- A Price worth Paying for Lower Inflation. [Online]. Economics Help. Last accessed 10 July 2008 at: http://www.economicshelp.org/2008/03/unemployment-price-worth-paying-for.html RUSH, Mark., & J, Robert (1998). Study Guide to Accompany Macroeconomics, 5th: Chapter 2: Chapter Review. P.10. [Online]. The MIT Press. Last accessed 10 July 2008 at: http://books.google.co.in/bookshl=en&id=f-ZS36GpVPwC&dq=Study+guide+to+accompany+macroeconomics&printsec=frontcover&source=web&ots=nAGFEIxCH3&sig=BDzY0ZyH1WInoIEXVqB0RA6o6CA&sa=X&oi=book_result&resnum=1&ct=result#PPA10,M1 Read More