Problem with Inflation

When the economy is at maximum output the only way there can be economic growth is for there to be an increase in LRAS.

According to classical economists, policies to increase AD are only going to cause inflation in the long run. There needs to be supply side policies to increase efficiency and the maximum possible output.

If there are successful supply side polices then:

What problems arise because of inflation:

Reduced real wages

Reduced real savings

Reduced competitiveness

Inflation increase price of exports so value of exports decrease

However, inflation can also decrease at the same time this is due to the high prices in the economy with high inflation this means individuals may start purchasing goods and services from abroad which can decrease inflation as AD decreases

The uncertainty arises because inflation can mean the price mechanism fails- prices stop acting like a signal to producer and consumers. This means firms cannot predict demand accurately and therefore invest less. Inflation, especially high inflation can destroy the functioning of the market leading to allocative inefficiency. Less investment will lead to lower AD and Lower AS a long term fall in economic growth.

Shoe leather costs. Relating to uncertanity, consumers are going to withhold from consumption and spend time looking for the best deal. This will reduce consumption as people take time to look for better prices (and their shoes wear out) Lower consumption means lower profit for firms.

Menu costs- Inflation costs money for firms- they need to spend more to administer higher prices: more meetings/ changing predictions about demand/changing.

Wage-price spiral- If there is inflation and a higher demand for wages, then one of 2 things will happen.

There might be industrial destruction such as strikes and over time bans.

If wage demands are succesful there will be higher costs and cost push inflation inflation.

During a recession firms who lack workers might have workers who demands an increase in wages and if they accept it they put up the prices to reach the profit margin. This price causes the workers to demand for a higher rise.

Causes of Unemployment

Structure of an economy of a country’s production changes over time. A steel builder loosing job cuss of change in industry. Can’t be employed cuss no skills.

Frictional unemployment- in search of a job

N.A there will always be people unemployed due to a skills mismatch and due to search unemployment.