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Internal Balance: Full Employment and Price Level Stability

When a country’s productive resources are fully employed and its price level is stable, the country is in internal balance. The waste and hardship that occur when resources are underemployed is clear. If a country’s economy is “overheated” and resources are overemployed, however, waste of a different (though probably less harmful) kind occurs. For example, workers on overtime might prefer to be working less and enjoying leisure, but their contracts require them to put in longer hours during periods of high demand. Machines that are being worked more intensely than usual will tend to suffer more frequent breakdowns and to depreciate more quickly.

Under- and overemployment also lead to general price level movements that reduce the economy’s efficiency by making the real value of the monetary unit less certain and thus a less useful guide for economic decisions. Since domestic wages and prices rise when the demands for labor and output exceed full-employment levels and fall in the opposite case, the government must prevent substantial movements in aggregate demand relative to its full-employment level to maintain a stable, predictable price level.

Inflation or deflation can occur even under conditions of full employment, of course, if the expectations of workers and firms about future monetary policy lead to an upward or downward wage-price spiral. Such a spiral can continue, however, only if the central bank fulfills expectations through continuing injections or withdrawals of money … .

One particularly disruptive result of an unstable price level is its effect on the real value of loan contracts. Because loans tend to be denominated in the monetary unit, unexpected price level changes cause income to be redistributed between creditors and debtors. A sudden increase in the U.S. price level, for example, makes those with dollar debts better off, since the money they owe to lenders is now worth less in terms of goods and services. At the same time, the price level increase makes creditors worse off. Because such accidental income redistribution can cause considerable distress to those who are hurt, governments have another reason to maintain price level stability.

Theoretically, a perfectly predictable trend of rising or falling prices would not be too costly, since everyone would be able to calculate easily the real value of money at any point in the future. But in the real world, there appears to be no such thing as a predictable inflation rate. Indeed, experience shows that the unpredictability of the general price level is magnified tremendously in periods of rapid price level change. The costs of inflation have been most apparent in the postwar period in countries such as Argentina, Brazil, Serbia, and Zimbabwe, where astronomical price level increases caused the domestic currencies practically to stop functioning as units of account or stores of value.

To avoid price level instability, therefore, the government must prevent large fluctuations in output, which are also undesirable in themselves. In addition, it must avoid inflation and deflation by ensuring that the money supply does not grow too quickly or too slowly.

(From International economics: theory & policy/Paul R. Krugman, Maurice Obstfeld, Marc J. Melitz. - 9th ed.)

X. Дайте письмові відповіді на запитання.

1. How do under- and overemployment influence the economy efficiency?

2. Which is another reason to maintain price level stability?

3. How can the government avoid price level instability?