The visible hand in economics

Should we be pleased to have a tight labour market?

Posted on: August 10, 2007

Over at no right turn, they seem to believe that economists sour reaction to the low unemployment figure is ridiculous. After all, a low unemployment rate implies that people have jobs, and a secure income, which is of course valuable to society.

They seem to believe that if we accept a little more inflation we can keep this low level of unemployment, and society will be better off. However, in this doesn’t hold. As an economist would say, in the long-run there is no trade-off between inflation and unemployment. If we accept higher inflation now, then in the future unemployment will rise to its natural rate, and we will be stuck with a higher rate of inflation.  The unemployment level is a problem now because it is lower than the NAIRU implying that the upward pressure on wages is too strong, and as a result the price level will increase.

Now government policy should be focused on decreasing the natural rate of unemployment. If the government can help improve the function of the market, they can make sure that in the long-run, unemployment will be lower. One of the things the government can do to make sure the market functions better, is keep price growth low, so that firms and buyers are more certain of the price level, and savers (whose money gets invested into firms) have more incentive to say (and so there is more investment). So who knows, maybe there is a long-run relationship between inflation and unemployment, lower inflation leading to less unemployment!

4 Responses to "Should we be pleased to have a tight labour market?"

Hmmm, shouldn’t the relationship be between the rate of change of inflation and unemployment? Other than the menu costs and so on that are associated with inflation, the real problem is certainty and predictability of future prices. If the inflation rate stays constant then future prices are equally as predictable as if there were no inflation. Obviously, there are other costs associated with inflation, but they shouldn’t significantly affect the employment market.

I think what the No Right Turn blog post really shows though is the appalling way that economists ‘market’ their ideas. I don’t know what context the BNZ economist was speaking in, but we need to be clearer about the implications of economic theory if people are to sympathise. Everyone wants to hear that unemployment is low, but they can’t be expected to know about Phillips curves and the difference between short-run and long-run effects unless economists tell them about it.

Well the second link I attached was the article with the BNZ economist. Also the article was written to institutional investors, who would understand the phillips curve. The firms that read these reports don’t have the time to wade through a bunch of explanation they already know, they just want the facts.

I agree that, when talking to the public, many bank economists don’t give enough depth in issues they discuss. But this specific guy is pretty good when he does public addresses. In this case he wasn’t though.

I do agree with you that the rate of change in inflation is an important factor when dealing with certainty. The thing is, when inflation rates are higher they are more volatile. Furthermore, we can’t forget that people are bounded rational, and often use their nominal income and nominal prices as stores of value, rather than looking at them in real terms.

Actually, I’m more attacking the reaction of certain economists to people being secure and happy – and their implied policy prescription that they must be made insecure and unhappy in order for the market to work “properly” (an idea which I think gets things exactly arse-backwards) – than really expressing any opinion on relationships between inflation and unemployment.

that said, if economics tells us that the price of a properly functioning market economy is that some people must be thrown out of work and made insecure and unhappy, then so much the worse for economics.

I understand that New Zealand economists can be very off-hand and cold with the way they make policy prescriptions, and I agree that this piece would have sounded cold to workers, as it was written for a business audience. However, the interests of workers and businesses are not diametrically opposed, both are interested in economic growth as it improves wages and profits.

I wouldn’t say that “the price of a properly functioning market economy is that some people must be thrown out of work”. The fact is that if businesses fail because wage and other input costs are too high, then unemployment will rise, and strongly. If economists believed that the current level of unemployment was sustainable, we would be very happy about it. However, our concern is that if unemployment falls significantly, then it will rise significantly later, throwing a whole lot of people out of work.

Like I said in the post, if we keep inflation low (which entails some sacrifices now), we help the market function, we help improve productivity, and we might just lower the natural rate of unemployment.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Add to Google
%d bloggers like this: