Persistent High Inflation Prices Reflect Changes in the Real Economy

The inverse relationship between inflation and unemployment has been shown to be temporary-short-term and does not stem from inflation per se, but from unexpected inflation, which contributes to maintaining inflation. By the fact that inflation can contribute to the development of an economy, we mean the positive relationship between rising inflation, that is, the increase in the level of prices of goods and services, and the increase in output-total supply.

The strength of this positive relationship between the increase in inflation and at the same time the increase in production on the part of companies, ie the growth of the economy, depends on whether and to what extent the four imperfections of the markets are valid, which are:

1. the rigidity of wages and salaries, 2. the delusion of the workers, 3. the price rigidity, 4. and the incomplete information.

The rigidity of wages and salaries

The fact that the salary is considered rigid means that the nominal salary received by the employee does not decrease, but can remain constant or increase. Given the rigidity of the nominal wage, an increase in the level of prices, ie inflation, reduces the real wage – the purchasing power of the wage, making labor cheaper for entrepreneurs, who, for this reason, are looking for more employees in their companies. .

More employment means more production – supply, higher GDP – economic growth. After all, GDP, by definition, is the total of goods and services in value produced in a year, in an economy. Whether or not the economy maintains its growth rate depends on whether the reduction in real wages is maintained and continues to be less than the real wage target set by workers.

The longer the difference between the two real wages is maintained as a result of the real price level and the expected price level, the more sustainable the growth of the economy.

Τhe delusion of the workers

The second disadvantage of the markets, that of the “workers’ delusion”, exists because there is a misconception on the part of employees, due to their inability to distinguish the nominal from the real wage. This error is due to the fact that employees perceive an increase in their nominal salary, as an increase in their real salary, ie the purchasing power of their salary. This is the “illusion of money”.

Demand for employment by entrepreneurs is the inverse function of the real wage. As the real wage decreases (increases) so do entrepreneurs increase (decrease) the demand for labor.

Employee supply, however, is a positive function of the actual expected wage. As the actual expected wage increases (decreases) so does the labor supply increase (decrease). The higher the real price level than the expected price level, ie what employees expect, the lower the real wage will be compared to the expected real wage and the more sustainable the increase in production-supply of companies and growth will be. of the economy.

Τhe price rigidity

The third market imperfection, that of “price rigidity”, exists due to the fact that some large and dominant companies in each sector do not automatically adjust the prices they charge to their customers, so as not to disrupt the relationship between them. This adjustment is made at the end, in time, of the price list they have issued.

In every industry and in every market there are two types of business. Those that have flexible prices and make an immediate adjustment of their prices and those that have rigid, fixed prices, which adjust their prices at the end of their price list. This adjustment will depend on the level of the general price level as well as on the change of the total income and the increase or decrease of the demand of their products, due to the increase of the prices.

When businesses expect a higher price level they also expect higher costs. A high expected price level leads to a higher real price level.

Τhe incomplete (asymetrical) information

The fourth shortcoming of the markets, that of “incomplete information”, is observed due to the misunderstandings, regarding the prices, on the part of producers-suppliers. Every producer-supplier in the economy produces one good, but consumes a multitude of other goods. Producers generally monitor the prices of the products they produce closely, but not so closely the prices of the products they consume.

Due to this incomplete information there is confusion between changes in the general price level and changes in the relevant or actual prices. Relative to the actual price of a product A is not the nominal price of that product, but its spare relation to another product B.

This confusion influences the decisions of entrepreneurs regarding how much they will produce and offer to the market, which leads to a short-term positive relationship between price level and production-supply. When the general price level rises unexpectedly, then the majority of producers increase the prices of the products it produces.

Everyone logically concludes, but nevertheless erroneously, that the relative prices of the products they produce have increased. So they decide to increase the production of their products.

In all four of the above market failures, when there is a discrepancy between the actual price level and the expected price level, and there is no rapid compensation of wages to restore the lost purchasing power of the workers, opera means that the real wage is less than the actual expected salary, then every entrepreneur increases his production. In this way the overall supply and development of the economy as a whole increases.

Βut the question that arises is why in the end inflation is considered such a bad event?

This question cannot be easily answered by the average consumer or entrepreneur. After all, even among economists, opinions differ. A large number of economists are of the opinion that persistently high inflation rates reflect changes in the real economy. It has been observed that, after every economic crisis, as a result of some endogenous and exogenous factors, such as the pandemic we are experiencing today, the phenomenon of unexpected inflation arises, which contributes to the maintenance of inflation.

The maintenance of inflation is prolonged by the fact that governments strengthen the economically weaker classes, which, due to the high marginal momentum for consumption, channel directly into the market in the form of demand, which they receive financial assistance. Thus, the increased production-supply of companies is maintained.

The sure result after every crisis is the turmoil in the markets and the contraction of almost all sectors of the economy. Thus, the markets become more imperfect and in the sense that they tend to become more oligopolistic, since the number of companies in each sector is drastically reduced.

Many businesses and small and medium-sized enterprises, ignoring how to deal with unexpected inflation as a result of the financial crisis, are deeply concerned about whether or not they will absorb or pass on price increases to the final consumer, and at the same time want to return to the original calm state.

The knowledge, on the part of the company, of the shortcomings in the market where it operates and how to exploit them will not only help the company to emerge unscathed from the crisis and remain in the market, but will be the starting point for its development.

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Trust Economics is a specialized independent economic research, analysis and consultancy business. Our team provides ingenious analysis in the macro & micro economic field, in the field of financial market, regional and sectoral analysis equally, forecasts, consultancy, specialized studies-research/projects from its headquarters in Athens, Greece.

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