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

likely that this will cause the economy to shift upwards to SRPC1,

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).