Wednesday, April 07, 2010

Economy's Excess Capacity Keeps Inflation Low

See the WSJ article titled Economy's Excess Capacity Reins In Prices: Latest Data Give Fed Room to Maintain Rock-Bottom Interest Rates; Initial Jobless Claims Decline for Third Straight Week. Here are the first three paragraphs:
"The vast economic slack left over from the recession continues to keep inflation in check, leaving companies and workers with little leeway to ask for price or wage increases.

Consumer prices were flat in February—and even with volatile food and energy removed from the equation, the needle barely moved: Prices ticked up a scant 0.1%, the Labor Department said Thursday. Over the past year, prices have increased 2.1%, or 1.3% omitting food and energy, the smallest rise in six years.

Behind these numbers stands a huge excess—of workers, factory space and homes. Until more of the nation's productive capacity comes into use and starts pulling workers off the unemployment line, the sellers of everything from golf clubs to paving machines have little ability to raise prices. The problem is exacerbated by continued tightness in credit, which makes it harder to rev up economic growth through bank lending to soak up the economy's lingering slack."

We can see how this works in the following graph:

A GDP of $9 trillion is the "full-employment" GDP (QF). That gives us the lowest rate of unemployment compatible with "price stability" (price stability is an an annual inflation rate of 3% or less). As GDP increases, more workers are hired, so unemployment falls. But if GDP is below QF, firms cannot raise prices, as the article states. There is slack or "excess capacity" in the economy. That means that there will be very little pressure on prices. Resources are not very scarce and product prices don't have to be increased (or increased very much) to call them back into service.

But as GDP increases, resources become more scarce as more bidders want them. The more GDP increases, the faster prices increase. Also, less efficient resources get called into service and less efficiency means greater cost. The higher costs get passed along to the consumer in higher prices. But the graph and the article suggest that as GDP increases and the unemployment rate falls, we will not see much inflation soon.

Also, interest rates won't have to be increased since there is little danger of AD going past QF. Sometimes the FED will raise interest rates to slow down private spending (both consumption and investment) to keep AD from moving too far to the right. But the article suggests that this will not happen.

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