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September 24, 2012 | by  | in Opinion | [ssba]

C.R.E.A.M. – Cash Rules Everything Around Me

I would love to see wages drop

The Federal Reserve in the United States has recently launched the third round of quantitative easing since the Great Recession began (hence the term QE3). But will it work to decrease unemployment and jumpstart the economy?

The answer I think is yes. Many not familiar with macroeconomics have a natural disdain for printing money to try and solve
any economic problem. This belief is quite understandable. While money is cheap and easy to produce, goods and services are the actual measure of our standards of living and they cannot be so easily printed. And printing money can lead to inflation, and just look what happened in Zimbabwe!

But sometimes inflation can be good. To think about why we need to understand the problem of unemployment and what it tells us about the economy. Unemployment is not caused by a country being poor, it is caused by failures in the labour market. Like any other market it can be thought of in terms of supply and demand—at the right price (wage), equilibrium is achieved and the market will clear. Being wealthier simply means that that equilibrium wage is higher. Putting the labour market in equilibrium would achieve what is called the ‘natural rate of unemployment’, which would be lower than the current 6.8 per cent in New Zealand or 8.1 per cent in the US.

So unemployment being too high suggests that wages are too high. But how could wages become too high in a relatively unregulated labour market? Nominal rigidities, more commonly known as ‘sticky wages’, are the problem. Wage contracts and collective agreements are often set for long periods of time, and are usually designed to promote a steady increase wages over that period.

The wage growth will take into account the expected growth in the economy as well as the expected level of inflation. As market crashes and recessions ever since the great depression have demonstrated market conditions can deteriorate far more quickly than wages. If wages can’t adjust to the new equilibrium quickly enough then sustained unemployment is the result. Perhaps this is what John Key was thinking when he allegedly said in 2008 that “We would love to see wages drop”.

So where does inflation come in? Higher inflation can do what the labour market fails to do quickly: reduce real wages. Essentially the Fed has announced that they will buy $40 billion worth of mortgage securities per month until certain economic indicators begin to recover. The goal is to free up cash on private sector balance sheets to be lent out, boosting economic activity. But the mere promise to continue to do this may be enough because of the magical self-fulfilling prophecy of expectations. If business believes that the Fed commitment to do whatever it takes to save the economy is credible, then they will invest and hire of their own accord.


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