Wages and Inflation - Purchasing Power Factors

Many economies have gone to great lengths, many times excessively, to achieve economic objectives. One of the most focused and discussed, other than unemployment and economic growth, is inflation. The magic number '2.0' is commonplace knowledge among those who follow economic news closely, which refers to universal inflation target of 2%. Governments have introduced numerous policies in order to achieve this target; they are so obsessed with this figure that the Bank of England even organised a policy competition called 'Target 2.0' where contestants devise policies based on the use of monetary policies (interest rates and money supply).

"Target 2.0" - Unanimous target inflation rate of 2%

Why is the target inflation rate 2%? Taken from an extract in the offcial website for the Federal Reserve, "[t]he Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment." I do not know whether this target is derived mathematically or intuitively, but I do know that inflation is a pro-cyclical with the business cycle, meaning that inflation moves in line with GDP growth. Ultimately, economic growth is the main objective of the government regardless of the complex economic situations; modest inflation, low unemployment, positive balance of payments, and sensible fiscal and monetary policies are key determinants of GDP growth.

What affects inflation? Monetary policy. Monetary policy is a set of government policies that focus on the use of interest rates and money supply. The 2007/08 financial crisis, which led to one of the worst recessions in history since the Great Depression through multiple defaults on subprime mortgages that triggered the fall in value of mortgage-backed securities, destroyed $26 trillion U.S. Dollars worth of the financial markets; to put that figure into perspective, it is the equivalent to more than 5 times the UK economy! Policy makers had to act fast amidst the chaos and generate an effective response to the recession. The unanimous decision was to stimulate the economy's consumption and spending through Quantitative Easing (QE), an unconventional monetary policy which aims to keep long term interest rates low. QE first started in Japan back in 2001, when the Bank of Japan tried to fight of a decade of deflation for reasons including aging population, low-priced imported goods, fallen asset prices, and insolvent banks. Low interest rates generate very cheap credit, thus aiming to increase lending by financial institutions and borrowing by consumers and investors that were hit hard by the crisis. It steered America back on course for economic growth, inflation, and low unemployment. After five years of QE, the Federal Reserve decided to halt its asset purchase program after injecting around $4.5 trillion U.S. dollars into its economy. QE is still adopted in the EU and Japan, to fight of economic weakness and deflation respectively.

"Continuous flow of money" - Quantitative Easing has allowed for much cheaper credit

I would like to direct everyone's attention to the idea of purchasing power and real income. Purchasing power is the value of a currency expressed in terms of the number of units of goods and services that one unit of money can buy. Real income is the amount of income an individual earns adjusted for inflation. These concept is important in showing why the effects of inflation can be countered with increases in wages. For the consumers, the effects on inflation will not have any effect on nominal income (expressed in terms of currency), but would reduce their real income (expressed in terms of purchasing power). In the inflated price environment, consumers would purchase fewer goods with their current income. The only way to reverse this drawback is to increase wages and likewise real income which enables the consumer to continue purchasing its original basket of goods.

This is very similar to the Long Run Phillips Curve, an economic theory which shows that any expansionary policy that aims to lower unemployment would have inflationary effects when unemployment reverts back to its natural rate. Let us look at the correlation in the US economy:

• QE is an expansionary monetary policy
• Unemployment rate increased to 10.8%, the highest since the 1980s. Therefore, one of the Federal Reserve's main objective was to lower unemployment rate.
• Unemployment rate gradually lowered because 10.8% is greater than its estimated rate of 5.2%.
• US experienced deflation throughout the majority of 2009. Inflation fluctuated between 1% and 4% between 2010 and 2014, with an average of 2%.

This also applies, probably even more so, for the EU as it produced weak economic figures throughout 2014, with the European Central Bank already setting up another flood of money into the European countries.

Increases in income can become pointless when the inflation increases. So why is inflation still relevant? The logic behind inflation is that it implies that people are consuming, which further implies a higher standard of living and economic growth. While I have no doubts about inflation and its correlation to economic growth, a proportional and simultaneous increase in wages for the consumer gives the same purchasing power and real income, and hence the standard of living should, in principle, remain the same. The Central Bank can print virtually infinite supply of fiat money and inject into the economy whenever its not doing well, so standard of living can remain at the same level in the long term with equal and simultaneous increases in wage while keeping technology constant. Furthermore, inflation does not necessarily imply demand-pull inflation, but maybe cost-push inflation in which prices increase due to shortages in supply for the commodity. For example, the price of agricultural goods such as coffee beans and cocoa are expected to increase due to bad weather conditions, more so in the future with stronger climate change effects.

Of course, this principle is not completely accurate because the consumption goods' price are influenced by many other factors, such as protectionism policies (tariffs and quotas)  (e.g. Sales Tax, Import Tax, Environmental Tax, Red tape etc.) and other barriers to free trade. Another argument could be that quality of goods are improving, hence the higher prices may not be a result of either supply or demand shocks.

On a side note, has anyone ever experienced going to another country, for holiday, business or academic purposes, find that particular goods were significantly more or less expensive than the goods back at home? Depending on which country you go, the price of foreign goods to your domestic equivalent can vary greatly. There are too many reasons behind the price difference, but what changes can we make to avoid this? For argument's sake, let us assume that there is free trade and no transport costs, for true equality in the world, identical goods should be the same in terms of purchasing power with regards to the country's wage and exchange rate. Queue in the economic theory of purchasing power parity (PPP). PPP is a theory that aims to determine the necessary exchange rate adjustments of two particular currencies in order to make the purchasing power on par with each other. In a perfect world, this economic theory supplemented with the strong assumptions would be an ideal representation of equality in purchasing power of identical goods in different countries across the world.

To conclude, I would like to address a more worrying issue is whether this cycle can be sustained; prices keep increasing due to inflation, then wages also keep increasing to counter this effect and maintain real income levels. In face of an ever increasing human population in our world economy with an ever scarcer amount of resources, maintaining the standard of living for everyone is incredibly difficult. Eventually, inflation would have to outpace wages, meaning that only the strong will survive in the next generation economy. This is not an easy problem to solve...