Lincoln County News | Newcastle, ME
Sunday, May 1, 2016 Serving Maine and Lincoln County for over a century. Volume 141 Issue 17

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2/26/2014 2:00:00 PM
Coastal Economist

The baby-boomer generation, to which I and many of you belong, is already a fair ways down the road to retirement. Once we leave the stress, strain, and security of full-time employment, most of us face a long period of life financed through pensions, social security and savings.

Some of our sources of income, such as Social Security, will rise with inflation. Others are fixed payments, the real value of which erodes as the general price level of our economy rises. As such, inflation becomes the number one financial enemy of the retired.

Fortunately this financial foe is easily contained using the tools we have in our economy. Our central bank, the Fed, is in charge of this aspect of the economy. On Feb. 3, Janet Yellen was sworn in as the Fed's new chairman.

What, if any impact might this have on our economy and inflation? How will her chairmanship differ from Ben Bernanke's?

Before addressing this, it is necessary to understand how macroeconomists view inflation and its role in the economy. First note that inflation, which is a rise in the general price level of all goods and services, erodes the value of our savings and our currency.

If inflation is easily contained, why would most macroeconomists as well as the Fed advocate strategies to target inflation at two to four percent? Why not place inflation at zero?

There are a few reasons for this. Let us concentrate on one important consideration, which is typically not well understood by the well-educated non-economist public. To get our hands around this issue we ask another question: How does inflation typically come about?

Most inflation in an economy arises through what economists call "demand pull." At an auction, a large number of bidders can pull prices up as they strive to out bid each other. In a sense, this is what happens during times of inflation. However, the process is a bit more complicated.

Here is one typical scenario, which can illustrate the point in question. Suppose that households decide to spend more by reducing savings and/or taking out additional home loans. Let us assume this increased spending is general throughout the entire economy.

The new consumption causes businesses to increase production. Soon, businesses find it necessary to hire additional workers. This puts into motion several forces: businesses hire the unemployed. Wages are now on the rise so they also hire those individuals who work when jobs are plentiful, but opt out of the labor force when jobs are scarce.

In addition, businesses find it advantageous to place workers with special skills and education in jobs requiring such, paying them higher wages accordingly. These workers might have been underemployed in jobs they took when times were tougher.

As the spending spree continues, workers are offered overtime. Companies begin to act like the bidders at auctions as they attempt to hire additional workers by taking them from other companies through offers of higher wages.

All of this adds to income and spending. It also adds to the wage bill of companies. The increased wage bill is passed on to consumers in the form of increased prices. Thus, inflation picks up.

The increased prices do not stop the party because the overtime and new higher wages allow households to pay more for the goods and services they desire. Higher prices mean workers demand higher pay, which puts more upward pressure on prices, and so forth.

So what is the moral of this story? What do we take from this? The answer is simple: Some amount of inflation results from a strong labor market. If we want high overall employment, and low under-employment, we must be willing to tolerate a degree of inflation.

In other words, when spending in the economy is quite strong, the labor market becomes more efficient. Higher spending levels place marginal workers in good jobs, place workers with special skills in more advantageous employment, and reduce overall unemployment.

However, this virtuous labor market can only occur within an environment of rising wages where employers compete for workers. Rising wages necessarily brings inflation.

Put yet another way, inflation is the grease that helps lubricate the labor market. When we target zero inflation, we are putting into place what Arthur Okun called a "low-pressure" economy. In such an environment, there is little spending "pressure" pushing corporations to expand.

In contrast, when the Fed and the federal government put into place lending and spending policies which place higher "pressure" on businesses to increase production, employment benefits from this, but inflation is an unavoidable by-product of the process.

Economic theory as well as many many decades of experience have shown that without the demand-pull pressures which result in at least a small amount of inflation, higher levels of employment, output, and income are not achievable.

This trade-off between unemployment and inflation is the well-known "Phillips Curve" named for the New Zealand economist William Phillips who first published this theory in 1958. Since then countless papers and no less than seven Nobel prizes have been awarded to economists who have identified, defined and refined the inflation-unemployment relationship.

So what is the optimal mix? Are a few percentage points of inflation so onerous as to make it worthwhile to give up a portion of our income and employment to achieve a zero inflation target? Or can we deal effectively with a two to four percent inflation rate and reap the rewards of increased output, employment, and income?

What has been the historic experience in the US? Have we had a "high-pressure" regime in place or a "low-pressure" Fed chairman? What approach is Ms. Yellen likely to pursue? Further, are there other factors which argue that a small amount of inflation is helpful to our economy?

We will examine theses questions next week.

(Marcus Hutchins, MA, M. Phil., Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)



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