Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Understanding that Excessive Growth in the Money Supply Causes High Inflation

In the long run, increasing the growth rate of the money supply has only one effect: higher inflation. Intuitively, the more money that’s circulating in an economy, the less scarce it is. People are then only willing to swap goods and services for money if more money is offered to them in exchange for goods and services: that is, the price of things is higher.

Here’s a simple way of thinking about this situation: imagine that the amount of money in an economy doubles suddenly, but the amount of goods and services produced remains unchanged. All that would happen is that the prices of everything (including wages) double – nothing changes in real terms.

This simple fact has an important implication: if a country wants to reduce its inflation rate, it needs to reduce the growth rate of the money supply.


Minimising Unemployment (Though Some Is Inevitable)

Eliminating unemployment completely is impossible, but you may be able to

reduce it. In essence, unemployment has two main causes:


Labour market frictions: Firms and workers have difficulty matching with each other. For example, you may want to work for Hawkin’s Saxophones Ltd, and it may want to employ you, but you don’t know that the firm is hiring and it doesn’t know that you’re looking for a job.


Structural problems stop the market clearing: These problems are things that stop the real wage from adjusting to ensure that labour supply and labour demand are equal.

Any attempt to reduce unemployment has to deal with these two underlying causes. Doing anything about frictional unemployment is very difficult, except perhaps improving the sharing of information about available jobs and workers. But here are some ways of reducing structural unemployment:

Not having a minimum wage above the market-clearing wage: A high

minimum wage is particularly harmful for young and inexperienced workers, because they tend to be the least productive workers (so the equilibrium wage can be a lot lower than the minimum wage) and also because a large part of their ‘salary’ is on-the-job training.

Deregulating protected industries so new workers can enter more


easily: A good example is training to be a Black Cab driver in London. To be one in Central London, you need to pass a test called The Knowledge, which takes about four years of full-time study. Economists are highly sceptical of the idea that memorising an A–Z for four years is necessary to drive a taxi well and find, say, Cheyne Walk in Chelsea; they think that the test really exists to make it very difficult for aspiring drivers to enter the market.


Having a little bit of inflation: Evidence suggests that a bit of inflation helps the labour market to clear, because sometimes the real wage needs to fall in a particular industry. Inflation allows the real wage to fall without requiring cuts to the nominal (cash) wage. For this reason, you hear economists speak of a bit of inflation ‘greasing the wheels’ of the labour market.

Stimulating Aggregate Demand Can