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What causes the price of things to rise?
Think back to when you were a kid (or if you’re one, ask your parents or grandparents). No doubt you remember that things were much cheaper in the past. After school you could walk into a newsagent and buy a chocolate bar, fizzy drink and a magazine and still have change from a pound (or even less, depending on how old you are…); oh, those were the days!
When prices rise on average in an economy, it’s called inflation. In the recent past in developed economies, inflation has only been a few per cent per year, but some decades ago double-digit inflation, even in developed economies, wasn’t unusual. One of the reasons that inflation has come under control is that economists now have quite a good understanding of what causes it and how countries can go about reducing it.
Although inflation (increasing prices) is the norm, some countries (such as Japan) have experienced prolonged deflation, that is, falling prices, which mean that people and firms often put off spending in order to wait for a lower price. This behaviour puts more downward pressure on prices. (We discuss the case of Japan in more detail in Chapter 5.)
Other countries (at times) have experienced such extremely high inflation that economists have a special name for it: hyperinflation. Germany after the First World War is the classic example of hyperinflation, but it also occurred more recently in Zimbabwe where – at the peak – prices doubled every day!
The reason why inflation occurs is quite straightforward: an increase in the amount of money in the economy. But many nuances apply, which we go into in Chapter 5.
What causes unemployment?
Economists really dislike unemployment. Seeing people sitting at home who want to work and have nothing to do makes them sad. But most important, the unemployed could be working and thereby helping to produce goods or services that people value.
When large numbers of people are unemployed, the economy isn’t producing as much ‘stuff’ as it could, and therefore living standards are lower than they could be.
Some countries have succeeded in keeping unemployment relatively low. In Figure 2-1, you can see that in the US, before the 2008 crisis, unemployment hovered around the 5 per cent mark. After the crisis it increased to around 10 per cent but has been falling since then to the pre-crisis level of 5 per cent.
© John Wiley & Sons
Figure 2-1: US unemployment.
Spain, on the other hand, had a ‘reasonable’ unemployment rate of 10 per cent before the crisis only for it to balloon to around 25 per cent post-crisis – and over 50 per cent for under-25s. Clearly, if over half of all young people who want to work can’t find jobs, something is going deeply wrong in the Spanish economy.
Economists have come up with a number of answers to explain the marked difference between the unemployment rates in different countries (we look at these aspects in more detail in Chapter 6):
Labour market flexibility: This phrase refers to how able the labour market is to respond to ‘shocks’; for example, if the economy isn’t doing so well, are wages able to easily adjust downwards to ensure that unemployment doesn’t rise too much?
Economists also think that making it too hard for firms to fire workers isn’t a good idea. This may seem harsh, but if getting rid of someone is difficult, firms become reluctant to hire new people and this increases unemployment.
Level of out-of-work benefits: In many developed countries, the government provides money and other benefits (for example, housing subsidies) to the unemployed to ensure that people don’t experience undue hardship. Economists start to worry if unemployment benefits look overly generous compared to the wages from working. They expect that the higher out-of-work benefits are, the higher the rate of unemployment will be, because high benefits reduce people’s incentives to search for work.
Trade union power: These organisations exist to support their members and negotiate on their behalf with their employers. They serve an important function, for example by ensuring that people are treated fairly at work. Trade unions are typically allowed to organise strikes (subject to certain legal requirements) in order to improve their members’ pay and conditions.
Economists worry when trade unions lobby for much higher wages than the going market wage. Many people would be willing to work for those high wages but are unable to because firms aren’t willing to hire as many workers at the higher wage. In these circumstances economists say that trade unions benefit insiders (those currently employed) to the detriment of outsiders (those not employed in the industry but who’d like to be). By effectively restricting the number of jobs in an industry, powerful trade unions can mean higher unemployment.
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