Question

Read "A Welcome Revival; Inflation." which is found on line then explores why, even though the unemployment rate has dropped, wages have been slow to increase. Explain the three key drivers of this phenomenon discussed in the article. Which of these three do you think offers the most convincing explanation? Explain your answer.

Answer 1

The three factors are:

1. IMPORTED INFLATION
2. DOMESTIC ECONOMY'S CAPACITY PRESSURE
3. INFLATION EXPECTATIONS

The most convincing reason is that of inflation expectations.

Explanation:

Unemployment refers to the situation in which there are workers who are willing to work at the prevailing wage rate, but are unable to find jobs.

The given article is about the fall in unemployment rate in various countries, while there is no simultaneous increase the wage rate. There are three factors which are given that attribute to this behavior of unemployment level, and the wage rate.

IMPORTED INFLATION:

Inflation refers to a rise in the price level in the economy, which results in the decline in the purchasing power of money because goods and services become more expensive.

It is given that the in the past few years, the economies were moving towards recession, where many major economies in the world witnessed a decline in their economic activities. Then the economies moved towards stabilization, which lead to an increase in the imports by the countries.

Larger imports and exports increased the income in the countries, and reduced unemployment. The wages have still remained lower as before.

The imports have caused the producer surplus to increase in the exporting countries, along with increase in prices. This case is witnessed in China, where there was a decline in the supply glut. But the increase in demand, and prices has caused the currency to appreciate, keeping the wages constant.

DOMESTIC ECONOMY'S CAPACITY PRESSURE:

Capacity of a country refers to the ability of a nation to produce, given the amount of resources and technology. Majority of countries in the world are working below their maximum capacity, which can be seen as the full employment, or potential level.

United States is seen as a nation which is working near its full capacity, with the level of unemployment around 4.7%. The rise in the wage rate in the year 2009 was about 2.9%, and the productivity growth reached around 1%.

Other than United States, the countries of Euro zone are working below less than full capacity. The job markets in these countries are rigid, and the production has greater slack.

Even when the production is increased, the wages, and prices remain sticky, which restricts the increase in wages.

Same is the case with countries like Spain, and Italy.

The firms in Germany have absorbed the increase in production, which should have increased the wages by not changing the prices, and keeping the inflation intact.

INFLATION EXPECTATIONS:

Expectations about inflation are based on the past experiences of the individuals. The countries have witnessed constant, or falling price level in the past few years due to recessionary pressures, or economic downturn in the economy. This has restrained the individuals from keeping expectations about high inflation in future.

The inflation expectations plays a very important role, which helps the country is stimulating itself.

In Japan, and Euro areas, the past years concentrated around deflation in the countries. Now despite the fact that the countries were growing, individuals, households, firms, and other entities have all kept their inflation expectations low.

THE MOST CONVINCING REASON:

The most convincing explanation for lowering of unemployment, but a very slow increase in wages can be explained through inflationary expectations of the nation's entities.

The inflation expectations are likely to change the scenario of the country, and they push the country towards what is expected in future.

The past experiences of the people regarding lower prices, and wages have induced them to not demand higher wages because they had the believe that even if the prices rise some what, they will eventually fall.