Liquidity, Monetary Policy, Inflation and Unemployement

Concepts of Liquidity Trap and Liquidity Preference

• Liquidity: The ease with which an asset can be converted into cash. Fixed assets generally have low liquidity, while liquid assets have high liquidity.

• Liquidity Trap:

  • A situation where interest rates are very low, and people prefer to hold cash rather than invest.
  • The rate of interest is too low to encourage investment in bonds, leading to investors holding only money.
  • An increase in the money supply results in additions to idle money balances.
  • Interest elasticity of demand becomes infinite.

• Liquidity Preference: The desire of individuals to hold wealth in cash form instead of assets.

Determinants of Liquidity Preference

• Level of Income:

  • Higher income leads to lower liquidity preference.
  • Lower income leads to higher liquidity preference.

• Interest Rates:

  • Higher interest rates lead to lower liquidity preference.
  • Lower interest rates lead to higher liquidity preference.

• Level of Transactions:

  • Higher transaction levels increase liquidity preference.
  • Lower transaction levels decrease liquidity preference.

• Price Levels:

  • Higher prices increase liquidity preference.
  • Lower prices decrease liquidity preference.

• Knowledge of Banking Facilities:

  • Greater knowledge reduces liquidity preference.
  • Less knowledge increases liquidity preference.

• Degree of Uncertainty in the Economy:

  • High uncertainty increases liquidity preference.
  • Low uncertainty decreases liquidity preference.

• Level of Infrastructural Development:

  • Developed infrastructure fosters saving, lowering liquidity preference.
  • Underdeveloped infrastructure increases liquidity preference.

• Possession of Real Assets:

  • Individuals with real assets have lower liquidity preference.
  • Individuals without real assets have higher liquidity preference.

• Level of Monetization/Size of the Subsistence Sector:

  • Higher monetization increases liquidity preference.
  • Lower monetization decreases liquidity preference.

• Expenditure Habits:

  • Spendthrifts have high liquidity preference.
  • Misers have low liquidity preference.

Keynes' Liquidity Preference Theory of Interest

• Keynes defines the interest rate as the reward for parting with liquidity for a specific period.
• The interest rate is determined by the demand for and supply of money.

Demand for Money: Motives for Holding Liquid Cash

• Transaction Motive:

  • Holding cash for current transactions.
  • Income Motive: Bridging the gap between income receipt and expenditure.
  • Business Motive: Meeting current business needs (raw materials, transport, wages).

• Precautionary Motive:

  • Holding cash for unforeseen contingencies (illness, accidents, unemployment).
  • Businessmen keeping cash in reserve for unfavorable conditions or unexpected deals.

• Transaction and precautionary motives are relatively interest inelastic but highly income elastic.
  $M1 = L1(Y)$, where $M1$ is money held for these motives and $Y$ is the income level.

• Speculative Motive:

  • Holding liquid resources to take advantage of future changes in interest rates or bond prices.
  • Bond prices and interest rates are inversely related. If bond prices are expected to rise (interest rates fall), people buy bonds. If bond prices are expected to fall (interest rates rise), people sell bonds.

• The speculative demand for money is expressed as $M2 = L2(r)$, where $L2$ is the speculative demand and $r$ is the rate of interest.

• Total liquid money is $M = M1 + M2$.

• Total liquidity preference function is expressed as $M = L(Y, r)$.

Supply of Money

• The total quantity of money in a country.
• Considered fixed by monetary authorities, represented by a perfectly inelastic vertical line.

Determination of the Rate of Interest

• Determined where the demand for money equals the supply of money.
• If the supply of money increases, the interest rate falls (if the liquidity preference curve remains the same).
• If the demand for money increases, the interest rate rises (given the supply of money).

Criticisms of Keynes' Theory of Interest

1. The interest rate is not purely a monetary phenomenon; real forces like productivity of capital and thriftiness also play a role.
2. Liquidity preference is not the only factor governing the interest rate.
3. The theory doesn't explain different interest rates prevailing simultaneously.
4. Keynes ignores saving as a source of investible funds.
5. The theory only explains interest in the short run.
6. The theory is indeterminate: speculative demand for money can not be calculated without knowing transaction demand.

Central Bank and Monetary Policy

• Monetary Policy: Deliberate attempt by the government (through the central bank) to regulate money supply to influence the economy and achieve objectives.
• Concerned with increasing or reducing money circulation and interest rates.
• Restrictive (contractionary) monetary policy aims to reduce money in circulation.
• Expansionary monetary policy aims to increase money in circulation.

Objectives of Monetary Policy

• Ensure price stability to avoid deflation or inflation.
• Foster and sustain a high employment level.
• Ensure a more equitable distribution of income.
• Attain a favorable balance of payments.
• Influence the level and nature of investment.
• Stimulate economic growth and maintain higher GDP levels.
• Ensure stability of exchange rates.
• Foster the creation, expansion, and growth of the financial sector.
• Create a wider market for government securities to sustain capital accumulation.

Tools of Monetary Policy (Methods of Credit Control)

• Bank Rate:

  • The rate at which the central bank lends to commercial banks.
  • High bank rate leads to high commercial bank rates, reducing lending and money supply.
  • Low bank rate does the opposite.

• Margin Requirements:

  • Difference between the loan advanced and the value of collateral security.
  • High margin requirements during inflation discourage borrowing.
  • Low margin requirements during deflation encourage borrowing.

• Open Market Operations:

  • Purchase and sale of government securities.
  • During inflation, the central bank sells securities to reduce money supply.
  • During deflation, the central bank buys securities to increase money supply.
  • Effective in developed money markets.

• Selective Credit Control:

  • Directing credit to vital sectors and denying it to others during inflation.
  • Relaxing these measures during deflation.

• Variable/Legal Reserve Requirements:

  • Commercial banks required to deposit a proportion of their deposits with the central bank.
  • Reserves are raised during inflation and reduced during deflation.
  • Cash and liquidity ratios are raised during inflation to control lending power.

• Rationing of Credit:

  • Prescribing the maximum amount commercial banks can lend or borrow from the central bank.
  • Limits liquidity in circulation.
  • Limits raised or waived during deflation.

• Special Deposits/Supplementary Reserves:

  • Commercial banks deposit an amount above legal reserve requirements.
  • Raised during inflation to reduce liquidity, lowered during deflation.

• Moral Suasion:

  • The central bank requests or persuades commercial banks to behave in a certain way.
  • Banks comply due to their dependence on the central bank's goodwill.

• Direct Action:

  • The central bank directs commercial banks to advance less or more credit.
  • Submission of periodic reports regarding lending and liquidity.
  • Issuing circulars on credit policy.

• Currency Reform:

  • Withdrawing existing legal tender and issuing new currency after devaluation.

Limitations to Monetary Policy in Less Developed Countries (LDCs)

• High liquidity preference: the public keeps cash instead of depositing in banks.
• Dominance of foreign commercial banks that follow instructions from parent banks abroad.
• Commercial banks keep excess liquidity due to lack of creditworthy borrowers.
• Poor and non-worthy credit borrowers make selective credit control ineffective.
• Underdeveloped money market limits open market operations.
• Conflicting objectives of economic growth and income improvement lead to easy credit extension.
• Poor distribution of commercial banks (mostly in urban areas) limits the policy’s reach.
• Poor lending habits of commercial banks (bureaucracy, high rates) discourage borrowers.
• Corruption in the banking system undermines selective credit control.
• Persistent inflation discourages deposits.
• Foreign interference (IMF conditionality) hinders monetary policy.
• Limited use of commercial banks; non-bank financial institutions exist.
• Political interference: politicians seek favors from commercial banks.
• Limited range and quantity of government securities for open market operations.
• Large subsistence sector/low levels of monetization restricts the policy’s effectiveness.

Inflation

• A persistent and appreciable rise in the general price level.
• Measured statistically as a percentage increase in the price index over time.

Inflationary Gap

• The amount by which aggregate demand exceeds aggregate supply at full employment.
• Represented as $Y<em>FA$ exceeding $Y</em>FB$ at full employment level, with AB being the inflationary gap.
• Leads to inflationary pressures due to excess aggregate demand.

The Consumer Price Index (CPI)

• The best measure of the inflation rate.

• Reflects increases in the price of a typical basket of goods and services.

• Some items may be replaced to reflect modern changes (e.g., computers replacing certain foods).

• Increases in the CPI indicate increased prices and consumer confidence.

• A periodic jump of 3% is generally accepted as the onset of inflation.

• Governments and wage payers use CPI to adjust wages to maintain purchasing power.

Causes of Rising Prices

• Demand-Side Factors:

  • Rapid population growth.
  • Increase in incomes.
  • Rising non-development expenditure by the government.
  • Increase in money supply.

• Supply-Side Factors:

  • Inadequate agricultural output.
  • Inadequate industrial output.
  • High-priced imports.

• The population growth rate has led to increased demand.

• Increased incomes of a part of the population added to demand.

• Deficit spending for development increases money supply.

• Rapid accumulation of foreign exchange assets led to money supply expansion.

• Inadequate agricultural output influences price levels.

• Industrial production is not adequate for certain essential products.

• High prices for imports (petroleum, fertilizers) raise costs.

Causes of Inflation

• Inflation arises when aggregate demand exceeds aggregate supply.

Factors Causing Increase in Demand

• Both Keynesians and monetarists believe inflation is caused by increased aggregate demand.

• Demand-Pull Inflation:

  • Occurs when aggregate demand exceeds supply at full employment.

• Excessive government expenditure to accelerate economic growth.

  • Persistent increase in population.
  • Increase in people’s income or wages.
  • Uncontrolled credit creation by banks.
  • Excessive printing of money.
  • Increase in capital inflow from abroad.

• Increase in Money Supply: higher money supply growth leads to higher inflation.

• Increase in Disposable Income: raises demand for goods and services.

• Increase in Public Expenditure: raises aggregate demand.

• Increase in Consumer Spending: due to conspicuous consumption.

• Cheap Monetary Policy: credit expansion increases money supply.

• Deficit Financing: government borrowing increases aggregate demand.

• Increase in Exports: raises earnings and demand for goods and services.

Factors Causing Shortage of Supply

• Cost-Push Inflation:

  • Persistent increase in production costs increases commodity prices.
  • High and rising wages and salaries.
  • High transport costs.
  • High cost of raw materials.
  • Increasing cost of fuel.
  • Increasing advertising costs.
  • High levels of taxation.
  • Increasing storage costs.

• Shortage of factors of production: reduces production.

• Industrial Disputes: strikes reduce industrial production.

• Natural Calamities: adversely affect agricultural supplies.

• Artificial Scarcities: hoarders reduce supplies and raise prices.

• Increase in Exports: creates domestic shortages.

• Lop-sided production: neglect of essential consumer goods.

• Law of Diminishing Returns: raises costs of production.

• International Factors: price rises in major industrial countries affect others.

How Inflation Affects the Functions of Money

• Four functions of money:

  1. Medium of exchange
  2. Store of value
  3. Standard of deferred payment
  4. Unit of account

1. Medium of Exchange:

   • Inflation reduces money's effectiveness as a medium of exchange.
   • High inflation makes it difficult to value goods.
   • Hyperinflation can render money worthless.
     • Examples: Hungary 1946, Germany 1922, Zimbabwe 2006-2009

2. Store of Value:

   • Inflation decreases the value of money.
   • A £10 note buys less over time.
   • Increased volatility of the inflation rate makes it harder to value money.

3. Standard of Deferred Payment:

   • High inflation erodes the real value of debt making it easier to repay.
   • Banks become less willing to lend money.
   • They will only lend if the interest rate is higher than the inflation rate.

4. Unit of Account:

   • High inflation causes greater menu costs which is the cost of updating price lists.

Measures to Control Inflation

• Control inflation by increasing the supplies of goods and reducing money income.

Monetary Measures

• Aim at reducing money incomes.

  (a) Credit Control:

  • Use methods to control the quantity and quality of credit.
  • Raises bank rates, sells securities, raises reserve ratio, and adopts selective credit control measures.

  (b) Demonetization of Currency:

  • Demonetize currency of higher denominations.
  • Used when there is abundance of black money.

  (c) Issue of New Currency:

  • The most extreme measure which replaces old currency with new currency.

Fiscal Measures

• Supplement monetary policy.

  (a) Reduction in Unnecessary Expenditure:

  • Reduce expenditure on non-development activities.

  (b) Increase in Taxes:

  • Raise personal, corporate, and commodity taxes.

  (c) Increase in Savings:

  • Encourage savings by giving incentives.

  (d) Surplus Budgets:

  • Adopt anti-inflationary budgetary policy.

  (e) Public Debt:

  • Stop repayment of public debt and borrow more to reduce money supply.

Other (Direct) Measures

• Aim at increasing aggregate supply and reducing aggregate demand directly.

  (a) To Increase Production:

  • Encourage production of essential consumer goods.
  • Provide help to consumer goods sectors (technology, raw materials, finance)

  (b) Rational Wage Policy:

  • Link wage increases to productivity.

  (c) Price Control:

  • Fixing an upper limit for the prices of essential consumer goods.

  (d) Rationing:

  • Distribute consumption of scarce goods to make them available to a large number of consumers.

Forms or Levels of Inflation

1. Mild/Gradual Inflation: Rate of increase is less than 3-5% per annum.

2. Creeping Inflation: Rate of inflation is less than 10% per annum.

3. Run-Away Inflation: High rate of inflation, increase in prices is weekly, daily, or monthly (greater than 10% per annum).

4. Galloping Inflation: Rapid rate of inflation, over 20% per annum.

5. Open Inflation: Inflationary tendencies are uninterrupted.

6. Partial/Sectoral Inflation: Prices of some goods increase due to temporary shortage.

7. Wage-Push Inflation: Workers' demands for wage increases satisfied leading to price increases.

8. Stagflation: High levels of inflation exist alongside high unemployment.

9. Structural/Bottle Neck Inflation: Arises from rigidities in supply and effects of structural adjustment programs.

   • Caused by:
     • Political instabilities
     • Scarcity of factor inputs
     • Total breakdown of industrial sector
     • Foreign funded projects with heavy foreign components
     • Frequent devaluation

10. Profit-Push Inflation: Producers seek high profit margins and persistently increase prices.

Causes of Inflation in Zimbabwe (1996-2009)

• Increased capital inflow from abroad
• Speculation about price changes
• Breakdown in infrastructure
• Expansionary monetary policy: establishment of microfinance
• Political instability
• Excessive government expenditure on social services, members of parliament, fines
• Effects of structural adjustment programs like privatization
• Supply rigidities like drought
• Greed by businessmen
• Rise in transport costs, insurance and high taxes
• Increased importation of goods from countries affected by inflation
• Shortage of goods and services due to smuggling
• Constant printing of more money
• Ever-increasing prices of petroleum/fuel

Solutions to the Problem of Inflation in Developing Countries (like Zimbabwe)

• Progressive direct taxes (PAYE)
• Sale of securities (treasury bills)
• Privatization drives
• Improvement in infrastructure
• Liberalization of the economy
• Improvement in the investment climate (reducing taxes)
• Reduction in bureaucracy
• Reduction in government borrowing from the central bank
• Tight monetary policy: high marginal requirements
• Reduction in government expenditure on non-productive ventures
• Currency reform
• Reduction in political instabilities
• Wage freeze for high income earners
• Importation of only central commodities
• Organizational controls (price controls, rationing)
• Encouraging trade unions to desist from wage demands

Circumstances Under Which Inflation May Be Desirable (Mild)

• During deflation
• When there are idle resources
• Need to stimulate labor mobility
• When people are relaxed towards work
• Need to revive and increase investment
• Need to accelerate economic growth
• Need to encourage forced savings
• Need to raise revenue for public expenditures
• Need to foster commercialization
• Government wants to promote innovativeness

Positive Impact of Inflation on the Economy

• Stimulates hard work
• Results in high output and high levels of investment
• Increased employment opportunities
• Encourages a country to adopt import substitution
• Results into increased revenue for government expenditure
• Encourages borrowing
• Encourages innovativeness and inventiveness
• Encourages forced savings
• Encourages labor mobility
• Fosters increased resource utilization
• Stimulates economic growth
• Helps an economy recover from an economic slump
• Fosters commercialization and monetarization of the economy

Negative Impact of Inflation in an Economy

Negative Impact of Inflation on Individuals

• Effects to Fixed Income Groups: The real value of his income being eroded by inflation.
• Taxpayer to Government:
• From Lenders to Borrowers:
• Wealth Holders of Cash, Bonds and Debentures

Effects on Business

• a) Effects on Production:

• b) Impact on Investments

• c) Effect on Output

• d) Farmers

• e) Investors

Impact on the National Economy

• Impact on Economic Efficiency
• Impact on Value of Money
• Impact on Reduced Savings

COSTS OF STAG INFLATION ON THE ECONOMY

• Decline in welfare.
• Social distress or tension between the poor who are unemployed and the rich.
• Increased costs of living for the population.
• Decline in savings level.
• Rising costs of borrowing (increase in foreign debt).
• Widening gap between the rich and the poor (increasing income inequalities).
• Erosion of people’s confidence in the country’s currency.
• Increased dependence burden on the working population.
• Brain drain and technological transfer where the skilled manpower who feel the pinch of poverty decide to go to other countries for better earning opportunities.
• Decline in the level of interest in the economy.

SOLUTIONS TO STAG INFLATION PROBLEM:

1. Reduction in taxes to leave people with sufficient disposable incomes.
2. Increase in government expenditure on medical services, infrastructure, and education in order to reduce on the dependence burden and brain drain.
3. Liberal monetary policy to raise the level of investment by easing accessibility to credit.
4. Reduction in importation and foreign loans in order to reduce on the size of the foreign debt.
5. Currency reform to revive people’s confidence in the country’s currency.

What is a Full-employment Economy?

• An efficient economy must not have significant underemployment nor underutilization of resources.
• A country is said to be developed if it has all the elements of an efficient and healthy economy operating within a socially civilized environment including the practice of the rule of law, democracy, and justice, especially for its less politically powerful social and economic groups.

UNEMPLOYMENT

Causes of Unemployment :

• Lack of Capital
• Overpopulation
• Seasonal Variations
• Lack of Effective Demand
• Lack of Skill
• Poor Performance of Agriculture Sector

CURES or REMEDIES OF REMOVE UNEMPLOYMENT

• Increase in Capital Formation
• Incentive for Private Sector
• Establishment of Small Scale Industries
• Technical Training Centers
• Control on Population
• Increase in Effective Demand
• Employment Exchange Offices
• Monetary and Fiscal Policy

TYPES OF UNEMPLOYMENT AND THEIR REMEDIES

• Seasonal unemployment:
• Frictional unemployment:
• Technological unemployment:
• Cyclical unemployment:
• Structural unemployment:
• Disguised unemployment

The Effects of Unemployment on Society and the Economy

• Unemployment occurs when there are people who are both willing and able to work but do not have a job.

MEASURES TO CONTROL UNEMPLOYMENT

1. Establishment of Employment Offices
2. Population Control
3. Capital Accumulation
4. Growth of Industrial Sector
5. Growth of Agricultural Sector
6. Technical Education and Training
7. Provision of Self-employment
8. Growth of Small-scale and Cottage Industries
9. Use of Labour Intensive Technologies
10. Reduction in Retirement Period
11. Subsidies to Private Sector
12. Job on Merit
13. Provision of Credit Facilities

SUMMARY OF IMPACT

• Expanding employment opportunities
• unemployment, among others, caused by labour force growth is too fast.
• Improved quality of workforce

THEORETICAL RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT

• High rates of inflation usually lead to rural urban migration which usually leads to rural-urban unemployment.
• High rates of inflation compel producers to use capital intensive techniques that result into unemployment.
• Attempts to control inflation by cutting down government expenditure leads to unemployment.
• High rates of inflation discourage savings and investment which leads to unemployment.
• High levels of inflation decrease real aggregate demand and the shrinking of the market leads to unemployment of all the resources.
• Restrictive monetary policy intended to control inflation leads to low levels of investment which results into unemployment.
• The higher the rate of unemployment, the higher the rate of inflation and the lower the rate of unemployment the lower the rate of inflation.
• Attempts to fight unemployment through reduction in taxes, interest rates, relaxed monetary policy usually leads to increase in money supply which leads to inflation.
• High unemployment levels leads to rigidities, low output and circulation on the market and leading to scarcity inflation.

Basic transmission Mechanism

1. Lower unemployment leads higher growth
2. Lower unemployment leads to higher inflation
3. Lower unemployment leads to worsening of current account deficit
4. Lower unemployment leads to deteriorating environment
5. Lower unemployment reduces income inequality
6. Lower unemployment leads to higher inflation
7. High inflation leads to lower growth
8. High inflation leads to increase in unemployment
9. High inflation leads to the worsening of current account deficit
10. High inflation leads to widening income inequality
11. High inflation leads to less deterioration of environment
12. Large current account deficit leads to lower inflation
13. Large current account deficit leads to rising unemployment