Will Low Unemployment Cause Accelerating Inflation?
In August the US unemployment rate closed at 4.4% against 4.3% in the month before. The relatively low unemployment rate seen by some commentators as implying that the US is almost at the so-called natural rate, which believed to be at around 4.5%.
It is held that once the unemployment rate falls below an "optimal" rate —called the Non-Accelerating Inflation Rate of Unemployment (NAIRU) —it sets off an inflationary spiral. This acceleration in the rate of inflation takes place through increases in the demand for goods and services.
It also lifts the demand for workers and puts pressure on wages, reinforcing the growth in the rate of inflation.
The NAIRU is an arbitrary measure, derived from a statistical correlation between changes in the consumer price index and the unemployment rate.
What matters in the NAIRU framework is whether the theory "works", i.e., whether a decline in the unemployment rate below the NAIRU results in the acceleration in the rate of inflation.
Using statistical correlation as the basis of a theory means that "anything goes." For example, let us assume that a high correlation has been found between the income of Mr. Jones and the rate of growth in the consumer price index. The higher the rate of increase of Mr. Jones’ income, the higher the rate of increase in the consumer price index.
Therefore we could easily conclude that in order to exercise control over the rate of inflation the central bank must carefully watch and control the rate of increases in Mr. Jones’ income. This example is no more absurd than the NAIRU framework.
The purpose of a theory is to present the facts of reality in a simplified form. The theory must originate from the reality and not from some arbitrary idea that is based on a statistical correlation.
Contrary to popular thinking, strong economic activity does not cause a general rise in the prices of goods and services and an economic overheating labelled as inflation.
Regardless of the rate of unemployment, so long as every increase in expenditure supported by production, no "overheating" can actually occur.
The overheating emerges once expenditure rises without being backed up by production, a situation that occurs when the money stock is increasing.
Once money increases, it generates an exchange of nothing for something, or consumption without preceding production.
As a rule, increases in the money stock are followed by general increases in the prices of goods and services. Prices are another name for money that people spend on goods they buy.
When money injected it never goes to all the markets instantly but by stages — there is a time lag. Hence the reason for the time lag between changes in money and changes in prices.
If the amount of money in an economy increases while the amount of goods remains unchanged, more money will be spent on the given amount of goods, i.e., prices will increase.
Conversely, if the stock of money remains unchanged, it is not possible to spend more on all the goods and services; hence no general rise in prices is possible.
By the same logic, in a growing economy with a growing amount of goods and an unchanged money stock, prices will fall.
Observe in a free unhampered economy with minimal government involvement in economic activity and in the absence of money generation out of “thin air” — an efficient use of resources will take place.
In such an environment no one would require to establish the so called NAIRU. Such an environment will be conducive for real wealth expansion, a low unemployment rate and a declining rate of inflation.
Also note that in properly functioning market economy any form of unemployment will be of a voluntary nature.
Individuals in a free unhampered market paid in accordance with their contribution to the production of wealth.
Any one insisting on a wage rate above his or her contribution to the wealth generation will be unemployed.