Wednesday, March 5, 2008
Stagflation?
This editorial discusses the possibility of stagflation - that is, both rising unemployment AND rising inflation. How can both of these occur at the same time? Specifically, think about the AD/AS diagram. How can you generate both falling output and rising prices? Think about how rising commodity prices may be changing the SRAS curve.
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There has been a continuing gap between the headline inflation rate and the core inflation rate in the United States for years. Headline inflation for 2007 was 4.3% in the US and 3.1% in the European Union. However, the gap between headline and core inflation rate is much larger in US than in EU. The core rate excludes volatile-priced items as food and energy.
The worldwide increase in commodity prices is the pointed cause for this rise in headline inflation. This is evidenced by the Goldman Sachs broad commodity index increase by 288% over the last six years, with the energy and industrial metals indexes exhibiting the same trend and increasing by 358% and 263%, respectively. Moreover, the recent devaluation of the dollar intensifies the impact of commodity price increases on headline inflation. This relative rise in commodity prices may indicate inflationary pressures and may even cause inflation. If you deflate the rise in commodity prices by the unit value of exports of manufactures from high income countries one concludes the relative real prices for commodities, energy, and industrial metals would have increased by 147%, 192 % and 131 %.
There is therefore a global surge in the relative prices of commodities, especially energy, compared with manufactures. Probable assumptions include increasing demand for industrial raw materials and oil in emerging economies, especially China, increased demand for agricultural products from biofuels production pressures, supply cuts from bad harvests, higher costs, and insufficient investment, and higher agricultural production cost from rising energy cost. This huge commodity price increase has implications for drafting monetary policy to include raised inflation measure and decreased output, demand, and aggregate real income.
Though the predominating effect is unknown, the general rules for monetary policy-drafting include three different options. First, monetary policy cannot return the eroded real income resulting from higher prices. Second; the banks should ignore temporary price fluctuations to prevent economic instability and third; a response is necessary for prolonged, constant price increases to contain inflation expectations.
Higher inflation expectations might result to the failure of or negative impact of aggressive monetary policy. Short-term rates have been lowered to avert a probable crisis but long-term rates have risen instead of followed the downward trend. Expected inflation is actually soaring and the Fed cannot cut rates further without any consequences. To prevent an economic downturn, central banks should cut rates if commodity prices are predicted to be unchanged or fall, something the growth of emerging economies cannot promise.
If inflation is an on-going phenomenon which is anticipated by the majority of people, the SRAS curve will be steeply upward-sloped in the vicinity of its intersection with LRAS and AD. The SRAS curve may even converge with the vertical LRAS curve if inflation is universally anticipated. The implication of the alternative slopes of the SRAS curve is that increases of aggregate demand (rightward shifts of AD) will in the short run elicit more output expansion and smaller price level increases the shallower is the SRAS curve, i.e., to the extent that inflation is unexpected. But an increase of aggregate demand can be expected to elicit a smaller output expansion and a larger price level increase the steeper is the slope of the SRAS curve, i.e., if inflation is an on-going and fully anticipated phenomenon.
“Life in a tough world of high commodity prices” by Martin Wolf hopes the economy does not return to the 1970’s where commodity prices and headline inflation increase and the economic growth stalled. For the US, there is a huge long-term gap between the headline inflation and core inflation because commodity prices are rising in the global market. Energy relative to manufactures is leading the rise of commodity prices in the global market.
The rise of commodity prices should not be confused as inflation though the increases reflect the pressure of inflation and may cause them as well. Emerging economies seem to be the main cause of these increases. As a country’s economy grows, so does their demand for industrial raw materials. China accounts for much of the demand. However, commodity prices are also rising due to a series of supply restrictions. Harvests could be bad and with rising energy costs, agricultural expenses follow suit. Sometimes investments are insufficient and there are mandates for biofuel production that affect the demand for agricultural commodities. Central banks should reduce the rate if they know the commodity prices will not change. However, the central bank cannot be confident with many country’s economies growing rapidly.
The output of the commodity also decreases. The right monetary policy to use is unclear, because it is hard to determine whether the sectors, aggregate real income, or real demand direct this change. However, there are three general rules that follow. First, the central banks must make it clear to people that they cannot gain back what they lost in real income due to the rising commodity prices. Second, to avoid creating economic instability, banks should look past the temporary relative price fluctuations. Aggressive monetary policy against these temporary changes would hurt or weaken the economy than help in a perceived crisis. Third, banks should take action when the relative prices continue for a long period. Otherwise, the inflation expectations and the inflation-risk premium in interest rates will increase.
Reducing the supply of a commodity in the global market increases the world price causing stagflation. Due to the supply shock, prices rise and output falls causing an increase in unemployment. With aggregate demand moving up in response to stop output from falling, prices are permanently higher. Prices increase in the short-run, because prices are sticky, but gradually shift up in the long run. Much like in the 1980’s, the US eventually became less prone to shocks from oil with conservation efforts and technological changes. However, even as there are many country’s economies emerging, they demand oil or energy in spite of the rising costs.
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