Causes of Low Inflation and Whether It Is the Most Important Macroeconomic Aim

Question

Inflation in many economies has been low over the last two years, despite a recovery in economic activity. The reasons include the lingering impact of the 2007–2009 financial crisis, foreign competition affecting trade, as well as rapid technological changes. (The World Bank, 2017)

(a) Explain how the factors mentioned above have resulted in low inflation in an economy. [10]

(b) Discuss whether low inflation is the most important internal macroeconomic aim for a government. [15]

Answer

Part (a) — How the factors produced low inflation [10]

Inflation is a sustained rise in the general price level; low inflation means prices are still rising, but slowly. The factors named affect both aggregate demand and aggregate supply, and their combination yields a modest, not a large, rise in the price level.

On the demand side, the economic recovery raised real output, income and hence consumption (C), and lifted business confidence and so investment (I), both raising aggregate demand. But stronger foreign competition worked the other way: export demand (X) fell as foreigners switched to more competitive goods, and import demand (M) rose as domestic agents switched to cheaper imports, both lowering aggregate demand. The net rise in aggregate demand was therefore small. Crucially, because economies were still operating far below full employment after the 2007–2009 crisis — along the horizontal Keynesian range of aggregate supply — a rise in aggregate demand raises output with little upward pressure on prices. Finally, rapid technological change raised productivity and shifted aggregate supply to the right, further restraining the price level. The combination of a modest demand rise along the Keynesian range with a rightward supply shift yields the small price rise — low inflation, not high.

Part (b) — Is low inflation the most important internal aim? [15]

The overarching aim of macroeconomic policy is to raise the standard of living. Serving it are three internal aims — low inflation, low unemployment, and sustained (actual and potential) growth. The thesis defended here is that, while all three matter and a government should pursue them concurrently, low inflation has a defensible claim to primacy because of its asymmetric capacity to undermine the other two.

Why low inflation is important. With nominal income fixed, inflation erodes real purchasing power and so material standard of living. It reduces the incentive to save, since future savings lose value, starving investment and long-run growth. It hurts the poor disproportionately — they are low-skilled, with weak wage-bargaining power, and hold few assets whose values rise with inflation. And at the extreme, hyperinflation destroys money’s function as a medium of exchange and store of value, the price mechanism breaks down, and economic activity contracts sharply. Below roughly 2%, by contrast, households do not build inflation into wage demands, wages lag prices, profitability and production rise; as inflation climbs, expectations set in and an inflationary wage-price spiral becomes self-feeding — which is why central banks target inflation at or below 2%.

Why the other aims also matter. Economic growth raises household income and material standard of living, generates jobs, raises firms’ profits and so investment and potential growth, and improves the government’s budget position through higher tax revenue. Unemployment does the reverse: households lose wage income and curtail consumption; long-term unemployment demoralises workers, harms mental health and breeds social problems, lowering non-material standard of living; scarce labour lies idle, so the economy operates inside its production possibility curve, productively inefficient. Unlike the inflation target, the target level of unemployment differs across countries, since the extent of voluntary (frictional and structural) unemployment varies.

Judgement. Because all three aims are important, a government should try to achieve them concurrently, and in normal times the most important aim is simply whichever associated problem is most severe at the moment. But when two equally severe problems conflict, a ranking is forced — and here inflation has the stronger claim. Once an inflationary spiral sets in it is increasingly hard to curtail, and if left unattended inflation will cripple the economy, dragging down both growth and employment. Weak growth and high unemployment, though they too can spiral downward, do not in turn cause inflation to escalate. Given this asymmetry — inflation can wreck growth and employment, but not the reverse — low inflation is, on balance, the most important of the three internal macroeconomic aims.