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## Analyze the growth of aggregate demand using the Philips curves

In order to understand what happens to the course of inflation and unemployment in reality, it is necessary to add to this picture a means of analyzing the growth of aggregate demand.
There are really two separate relationships that can be identified between aggregate demand growth and inflation/unemployment. These are illustrated in Figure 7.6. Let us assume for simplicity that there is no productivity growth, so that output is constant at the NAIRU. With output fixed, it follows that the long-run budget constraint (LRBC) of the economy is determined by the nominal growth in aggregate demand. This is no more than an accounting identity- hence the use of the term 'budget constraint Thus the inflation rate (at a constant NAIRU output level) will be equal to the growth rate of aggregate demand. If aggregate demand in money terms 15 growing at 10 per cent per annum the long-run budget constraint will be a horizontal line at a 10 per cent inflation rate (or lower if the productivity assumption is changed).
Naturally, there is no reason why the economy should be on the long-run budget constraint in each period. It will only be on LRBC w the economy is on the long-run aggregate supply curve, that is, when output is not changing. Take the growth rate of money income as being exogenously fixed by policy. Then the short-run budget constraint that h to be satisfied is given by the fact that the rate of growth of money income) equal to the sum of the rate of growth of real income and the rate of inflation. Again, this is a matter of accounting that must hold by definition. So if there is some real income growth during the current period the inflation rate must be lower than the growth rate of money income. Let also presume that there is a one-to-one relationship between real income (output) and unemployment. (A specific form of this relationship is known as Okun's Law.) Higher output will be associated with lower unemployment. This means that we can express the short-run budget constraint as relationship between inflation and unemployment.
To see what the short-run budget constraint must look like, start point 4 in Figure 7.6 on LRBC. If there is no real income growth, inflation will equal the growth of money income so the economy will stay at A However, if there is real income growth in the current period, unemployment will fall and inflation will necessarily be less than the rate of growth of money income. The economy will go to a point like B. The short-run budge constraint is, therefore, positively sloped in inflation/unemployment space, SBC,
Notice that point B is not sustainable for a second period. The move from A to B required real income growth and, therefore, a fall in unemployment from U, to U₂. If unemployment now stays at U₁, real income must be unchanged and so in the second period inflation must be equal to the rate of growth of money income- the economy would then be at C. This demonstrates that the short-run budget constraint for the second period must pass through C. In general, the SBC for a specific period cuts LRBC at the unemployment level at the end of last period. This is because it depends upon the growth of real income when the base from which growth is measured is last year's level of real income. Each level of real income is associated with a specific level of unemployment.
Of course, if there is a change in aggregate demand policies, LRBC itself will shift and the exercise will start again at a point such as A on the new LRBC curve. The location of A is determined by the level of unemployment at the beginning of the period. However, in order to determine the actual course of inflation and unemployment we need to combine the budget constraints with the Phillips

## Consider the course of inflation and unemployment that would occur if the economy were initially at the NAIRU with zero inflation and zero growth of aggregate nominal demand and the growth rate of aggregate demand is raised to 10 per cent. What happens?

The long-run budget constraint becomes a horizontal line at the inflation rate of 10 per cent, as depicted in Figure 7.7. The new short-run budget constraint SBC passes through the long-run budget constraint at the initial level of unemployment, i.e. at G. The short-run Phillips curve is PC, so the economy moves from the initial position (U, p-0) to 4. Next period, the new short-run budget constraint will be SBC, and, if the short-run Phillips curve did not shift, the economy would go to B and then converge on C. However, expected inflation will now start to shift the short-run Phillips curve up to the right. If it now intersects SBC, at the budget constraint will stay put for one period but the short-run Phillips curve will continue to move to the right.
Once the intersection of PC and SBC is above the long-run budget constraint, the SBC curve will now start to shift back down to the right. Once the economy is to the right of the long-run Phillips curve, the PC curve will start to shift back down to the left. Thus from a point such as E which is on PC, and SBC, we move to F on PC, and SBC, From F both the SBC curve and the PC curve will shift down, so the next position could well be southeast of G. Clearly, the economy will home into the long-run equilibrium point G in a clockwise cycle, presuming, that is, that the expectations feedback is reasonably stable, so that the economy does not explode.
It is important to notice that, while we have conducted the simplest possible experiment of raising demand growth from zero to 10 per cent, we have discovered a pattern of response which includes periods of rising inflation and rising unemployment, falling inflation and rising unemployment, as well as rising inflation and falling unemployment. The economy has moved through a clockwise convergent cycle from the initial position through A, D, E and F, and eventually to G.
Figure 7.8 plots the actual course of the UK economy during its in cycle of 1971-76. The movement from 1971 to 1972 be regarded a tail of the previous cycle. From 1972 there is a clear clockwise cycle which entirely consistent with a demand-induced inflation as above, p factors such as the oil price rise and incomes policies will no doubt has w The influence on the numerical size of various shifts, but it is hard to these specific factors could explain the pattern as a whole. For example the 1973 oil crisis had struck at the initial position in Figure 7.7 and the authorities had maintained the level of domestic demand constant, the economy would initially have moved north-east to a point like J.
On the basis of Figure 7.8 the NAIRU looks to be of the order of or per cent. Indeed Sumner (1978) estimated it at 3.2 per cent for this period and Bachelor and Sheriff (1980) estimate the 'equilibrium level for the period to be 4 per cent." More recently, Layard, Nickell and Jackmas (1991) estimate the rate to be around 3 per cent for the period 1969-1 (using Organization for Economic Co-operation and Development (OECD) definitions of unemployment). As a result of this analysis one would have concluded that the economy should home in on an unemployment rate of 3-4 per cent at some stable inflation rate. The latter should have been reasonably low given the adoption of fairly restrictive aggregate demand policies in late 1976.
This, of course, did not happen. The above analysis has been deliberately retained from the first (1979) edition of this book because it is instructive about the conventional wisdom of the time. The policies pursued by both the Labor Government of James Callaghan after 1976 and the Conservative Government of Margaret Thatcher after its election in May 1979 should have had a better effect on the British economy. Subscribers to the above view of the world should not have viewed their policies with total disfavor. It should have been possible to have unemployment in the region 4 per cent, with inflation below 10 per cent by 1980.

Figure 7.6 Budget Constraints

Figure 7.7 Short- and long-run Philips curve and budget constraints

Figure 7.8 Retail price inflation and UK unemployment: 1971-76

## Explain using a graph how inflation and unemployment impacted the economics of 1978-82

As Figure 7.9 graphically demonstrates, the economy did not home in on 4 per cent unemployment. Rather, unemployment accelerated dramatically from early 1980 to reach a level of nearly 12 per cent in early 1983. It is true that inflation had also come down to about 5 per cent by early 1983, but on the basis of previous patterns this should have been possible at very much higher levels of employment. The rise in inflation from 1978 to 1980 may be explicable in terms of a number of temporary factors such as the 1979 oil price rise and the increase in VAT resulting from the June 1979 Budget. The real problem, however, is to explain the massive rise in unemployment. Earlier in this chapter we set out a bargaining model of the labor market which is now more or less the conventional view. It offers a synthesis of demand and supply-side effects; we can analyze changes in unemployment in terms of either demand or supply-side forces. For example, if the demand for output and therefore labor collapses and if wages do not immediately respond to the changed conditions, then unemployment will rise. Alternatively, if (say) there were an increase in the mismatch between the unemployed and vacancies, then the natural, NAIRU and subsequently actual rates would rise. Which factors matter is an empirical question? The most comprehensive (and comprehensible) account of the UK experience is given in Layard, Nickell and Jackman (1991), where the results from the Centre for Economic Performance) research into the causes of unemployment are set out LSB Centre for Labor Economics (now Broadly speaking, a given rise in unemployment can be broken down into three components: a rise in equilibrium unemployment (the NAIRUS in demand, and dynamic effects (which can be very long lived, more so the United Kingdom than in many other countries). Table 7:1 summaries their findings with respect to the first component.

The table shows that one popular explanation of the rise in unemployment can be dismissed straightaway. That is, that high unemployment benefits shifted the natural rate of unemployment so that millions of workers chose to be out of work, the utility of not working being greater than that in work. This explanation, although popular, was always preposterous. It is undoubtedly true that the level of benefits has a marginal effect on the level of measured unemployment, but it is absurd to suggest that this can explain job losses in Britain in recent years. As the table shows, the effect is absolutely minimal; but other supply-side effects do not really add up to much either. There appears to be a small effect arising from mismatch and from an improvement in the terms of trade (import prices) which drive a wedge between producer and consumer prices, but the total effect (comparing the period 1974-80 to 1980-87) is less than per cent, compared to a rise of nearly 6 per cent in the actual 10

This means we must look elsewhere for an explanation of the rise. On the unemployment rate. Supply side, Layard, Nickell and Jackman (1991) believe that their econometric results exclude two crucial variables. First, they argue that there has been an increase in the degree of skill mismatch in the 1980s which is not picked up by their indicators. As evidence, they give the ratio of firms reporting shortages of skilled to unskilled labor (from the Confederation of British Industry (CBI) survey). This ratio was 2.73 in the 1960-74 periods, but rose to 6.92 in 1981-87.

Table 7.1 A breakdown of changes in the UK NAIRU

 Percentage Points 1967-73 to 1974-80 1974-80 to 1980-87 1974-80 to 1980-87 -0.28 -2.58 mismatch 0.55 1.54 import prices 1.49 1.27 benefits -0.29 0.48 unions 0.82 0.08 tax wedge 0.03 -0.32 Total Effect 2.32 0.46 Actual Rise 1.84 5.91

The other factor is the treatment of the unemployed. They believe that compared with the 1950s and 1960s, the unemployed were treated more leniently by the social security and unemployment registration systems in the 1970s. Society was also more tolerant towards individuals who found themselves unemployed. These changes were due partly to institutional changes like the separation of unemployment benefit administration and registration for job search; the former is administered by the DSS, while the latter takes place at Department of Employment job centre. Another hard to quantify factor is the insidious effect of the growth in unemployment itself, eroding the work ethic (and also general skills)." So unemployment became less of a threatening experience, and less pressure was placed on the unemployed to search for new jobs.

Yet no-one argues that the exceptionally rapid rise in unemployment between 1979 and 1981 was mainly caused by supply-side phenomena. The culprit must be demand. This raises the question of where the impetus came from. One suggestion is that Britain suffered from a decline in world trade. There is a modicum of truth in this, but it can explain only a tiny fraction of the problem. World trade in manufactures, in fact, continued to grow in volume terms until sometime in the middle of 1981. Indeed, British exports of manufactures in volume terms were virtually constant in the four years 1977-80, and declined by only about 4 per cent in 1981 to then level off for 1982. The events of importance for employment precede this drop in exports by between one and two years.

Another explanation which has more widespread support is that the British economy suffered a massive ('Monetarist') deflation of domestic aggregate demand through cutbacks of domestic expenditures. Perhaps surprisingly, this is also hard to sustain. Table 7.2 shows the breakdown of expenditures in constant (1985) prices. The two major categories of spending -personal consumption and government current expenditure on goods and services - have a rising trend throughout the period. Investment declines but only latterly and there are a running down in the last two years of the stocks built up in the 1976-79 period.

Table 7.2 Expenditure (m 1985 prices)

 Year Total Consumers expenditure Government expenditure Investment expenditure Change in stocks 1974 300 057 178 216 63 598 54 465 2980 1975 294 668 177 500 67 147 53 383 -3402 1976 302 547 178 279 67 977 54 277 1622 1977 301 583 177 483 66 855 53 307 3416 1978 314 247 187 510 68 400 54 914 2867 1979 325 813 195 664 69 776 56 450 3328 1980 316 602 195 825 70 872 53 416 -3371 1981 311 634 196 011 71 086 48 298 -3200

It could be argued that this shows that the 'transmission mechanism is through high real interest rates causing a fall in investment and a rundown of stocks. This is certainly contributory, but it is not the main event. Notice that the volume of demand in 1981 is about the same as in 1978 and yet between those two dates unemployment more than doubled. Notice also that the rundown of stocks in 1980 and 1981 was still less than the build-up in the previous four years. This suggests that we look to these earlier years consumption was rising steadily and yet domestic manufacturers were and ask why it was that stocks of unsold goods were building up. Domestic producing more than they could sell. How can these apparent inconsistencies be reconciled?

A major part of the answer turns out to be remarkably simple. It is that there was a substantial shift of domestic demand away from domestic manufactured goods towards imported manufactured goods. This is graphically illustrated by Table 7.3. There was a 66 per cent increase in the volume of imports of manufactures between 1975 and 1982, with the bulk of the rise coming before the end of 1979. Notice that manufactured imports and exports move together until after 1977 when exports level off and imports accelerate. The switch does not produce an immediate decline in production by domestic industry. Rather, they build up stocks of unsold products, as we have seen. As Figure 7.10 reveals, the production pattern changes dramatically after 1979. Between late 1979 and the end of 1980 there is a massive fall in industrial production of the order of 15 per cent. This fall is largely over by 1981, though the annual average figures look like they continue to fall (the average index for 1980 is higher than the index at the end of the year). This fall in production is clearly correlated with the period of rapidly rising unemployment and precedes it by some months Production starts to dive in late 1979 and unemployment starts to accelerate in early 1980.

Table 7.3 Imports and Exports of fuel and manufacturers (1985=100)

Imports

Exports

Year

Fuels

Manufactures

Fuels

Manufactures

1973

227.9

45.2

22.5

74.1

1974

21301

48.3

21.0

79.2

1975

173.7

43.5

19.3

76.8

1976

174.0

48.3

23.2

83.2

1977

143.7

52.3

32.1

88.3

1978

139.1

59.7

40.4

89.8

1979

137.0

69.1

58.4

88.5

1980

115.4

65.1

58.2

87.2

1981

94.3

68.3

70.2

84.7

1982

86.0

75.9

77.6

85.2

The speed of this adjustment presumably owes something to high interest rates, but it should be clear by now that this is not the major cause. There had been overproduction for some years. The problem was that domestic firms had, over successive years, lost their grip on the home market. There was no compensating expansion of exports. This increase of import penetration was not due to an upsurge of incompetence on the part of domestic producers. Rather, the explanation is to be found in the fact that this is the period of maximum expansion of North Sea oil production. Table 7.3 shows the steady decline of fuel imports and rise in fuel exports. This is associated with a substantial appreciation of sterling as we saw in Chapter 6. This appreciation of sterling, remarkably, had only a minor effect on the volume of manufactured exports, but it had a substantial effect on imports of manufactures. Domestic producers were squeezed out of the home market. The effect on employment lagged behind output somewhat. The reason is that producers failed to appreciate what was happening to demand; the CBI survey of output expectations shows that expectations were consistently over-optimistic throughout this episode. This also explains why firms found themselves building up stocks at such a rate. Despite the fall in stocks in 1980 and 1981, the ratio of stocks to output was higher throughout 1982 than in any period in 1977 or 1978.