Economics IA - Macroeconomics PDF

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Submitted IA about Czech inflation and interest rates, relating to the Macroeconomics section of the course....

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Macroeconomics IA Monetary Policy and Inflation in Czechia (the Czech Republic)

General Price Level in Czechia

This article describes Czechia’s inflation after an economic boom. The economy is working at close to full capacity as the labour market becomes saturated with only 2.3% unemployment, resulting in ‘rapid wage growth’ and inflation - increasing average price levels in the economy. The solution implemented by the CNB is raising interest (repo) rates. This use of contractionary monetary policy - ‘when a central bank uses its monetary policy tools to fight inflation’1 - affects aggregate demand (AD), consequently affecting not only inflation but also Czechia’s economic growth.

Figure 1. Inflationary Spiral in Czechia (the Czech Republic) LRAS SRAS2 SRAS1

P4

P3

P2

P1

AD 3

AD 1

0

Yf

Y2

AD 2 Real Gross Domestic Product in Czechia

Figure 1 shows the short-run effect of a boom on Czechia’s economy. At point ‘a’ there is a fixed equilibrium where levels of demand and supply are stable. During the boom, AD increases and shifts right (AD1-AD2) because confidence in the economy rises and therefore consumption, a component of AD, increases. Thus, at point ‘b’ prices have been pulled up (P1-P2), due to demand-pull pressures. Cost-push inflation also occurs as workers negotiate for higher wages and production costs rise. Supply falls and shifts left (SRAS1SRAS2) to reach equilibrium ‘c’, where GPL rises again (P2-P3). However, households’ resulting disposable income increase could give the illusion of higher spending power, increasing their marginal propensity to consume. Consumption increases again, resulting in another increase in AD (AD2-AD3). This cycle causes an inflationary spiral. ‘A’ is at full 1 https://www.thebalance.com/contractionary-monetary-policy-definition-examples-3305829, accessed 03/11/2018

General Price Level in Czechia

employment, and in this neoclassical perspective firms can only meet excess demand by paying higher wages. The inflationary output gap (Yf-Y2) shows that wage increase is shortterm, as the equilibrium point always returns to the LRAS curve. This is reflected in Czechia’s problem, as any economic growth (Yf-Y2) is restricted by the existing LRAS curve.

Figure 2. Effect of Increasing Interest Rates in Czechia LRAS

P1 P2

AD 1 AD 2

0

Y2

Y1 YFE

Real Gross Domestic Product in Czechia

Figure 2 shows the effect of CNB’s increased interest rates on AD. At point ‘a’, LRAS is inelastic and employment is high (Y1). Spare capacity (yellow) is very small, threatening Czechia’s economic stability as it will soon be working at full capacity. AD will continue shifting along the LRAS curve, increasing GPL above P1 with no corresponding growth in RGDP (stuck at YFE). Conflict between macroeconomic objectives (low unemployment, balance of payments and stable inflation) occurs because (close-to) full employment means labour shortages, especially during a boom. With higher wages to attract trained workers, production costs are passed on to consumers as firms protect profit margins. This reduces competitiveness of exports, as well as increasing import consumption. As interest rates are hiked, AD shifts left (AD1-AD2) as the cost of borrowing increases for firms and individuals, so overall borrowing falls. This is bad for growth: longterm loans like mortgages increase, meaning people spend more of their income repaying those debts. Hence, less disposable income circulates in the economy. Additionally, circular flow is disrupted as increased interest rates incentivise people to save (due to high returns). Thus, the consumption component of AD - and AD itself - decreases, meeting LRAS at ‘b’ and the reduction in circular flow, due to reduced purchasing power of wages, and leakages such as saving and spending on cheaper imports, means GDP falls (Y1-Y2). GPL also falls (P1-P2) because firms cut prices as demand falls, reducing inflation - the CNB’s goal. However, the application of the theory is limited by key assumptions (like confidence and

saving). These are unpredictable as people can make irrational decisions. Raising interest rates is problematic because it doesn’t solve the root of the problem a tight labour market. Investment is affected in the short-term - more expensive borrowing could lead to economic stagnation, with smaller firms and startups unable to afford loans, thus reducing research and development, innovation and entrepreneurship. Use of this demand-side policy is unsustainable, limiting economic growth. In the long-term, reduced consumer confidence as a result of high interest rates could lead to a recession as AD and therefore growth falls. Amongst stakeholders like pensioners, without mortgages, this policy would be beneficial as saving would be more rewarding. However younger working people would be disproportionately affected as unpaid debt could create an unmotivated workforce. Additionally, young people’s difficulty in paying mortgages could potentially lead to a housing crisis. This is damaging as effects appear months after changes are made, making reversing them harder. A more lasting solution involves supply-side policies increasing Czechia’s production potential, shifting LRAS to the right. Encouraging immigration would fill labour gaps, helping firms cope with growing demand. Increased education spending would make industries more efficient, improving labour productivity. Because supply-side policies take longer to work, perhaps a combination of demand and supply-side policy could have the most impact in reducing inflation in Czechia....