While everyone is raving about how well the economy is doing, in terms of job growth and lower unemployment numbers, I was wondering about the outcome of such a state... When the unemployment numbers are low, it is obvious that the salary should rise since the demand for an employee grows. If salaries were to raise, then the company is forced to either increase the price of the product or increase the productivity of the employees. In a perfect competition, prices have high sensitivity. So, the only way for a company to increase productivity is by firing employees. When enough companies start firing employees, the demand for an employee will go down and the system will achieve stability... The above situation also explains why inflation is high these days. When job market is strong, the buying power is strong which explains why inflation is high. This is one of the reasons why housing market didnt go down as much as it was thought to be. Also, this is why Fed is very careful with the interest rates. If they increase it, there might be a huge surge of unemployment. At the same time, if they reduce the interest rates, it will further the inflation.... So, a good economy need not necessarily be good for the masses....
Wednesday, February 14, 2007
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@ Mindframes: At the basic level your argument rests primarily on the premise of perfect competition. But we know that perfect competition is only a text book case. Though we do not have monopolies, most industries are characterized by oligopolies. Even otherwise we can argue otherwise. I will come up with a more detailed comment a lil later in the day.
I thought that perfect competition is a easy way to visualise the stuff...I do agree that the market is oligopolistic. But then, I do think that the price wars do exist. I also believe that most of the consumer goods are always in a price-sensitive region...
@mindframes: I'm really wet behind the ears in economy- so let me prefix my question with "This may sound stupid but...."- I followed your arguement till the part where you mention if Fed increases the interest rates the umemployement will surge... why is this an obvious and direct result of higher interest rates? I mean I understand that with high interest rates the borrowing costs increases and businesses may not expand... but shouldn't they be able to keep the current size ?
@ Manohar: At a basic level this is the expected chain of events...generally the federal reserve will reduce liquidity in the financial system by pulling out dollars...when they pull out dollars, the result is that the cost of borrowing will shoot up, as short term interest rates will react...note that most firms have floating rate debt and hence short term interest rates matter...therefore when short rates go up, dollar denominated bond prices should go up because of the inverse relationship between bond prices and interest rates...further a rise in interest rates leads to a negative stock market response...now this attracts foreign capital into the US, which means that the exchange rate for the US dollar will start appreciating against other currencies...
Now the rise in interest rates directly links to an appreciation in USD...rising interest rates pulls down investment activity in the real economy and hence there is a reduction in spending and consquently output...further given the increase in the value of the dollar, the economy will now depend more on imports rather than exports..
Cumulating the effects, we should see a drop in profitability for domestic firms as sales slows down...this affects domestic liqudity and firms are forced to slow down...expected output falls and as a result, to maintain equilibrium, people have to be laid off...hence the unemployment rate should rise...
thats kind of the logic behind the argument
Thanks mad-max !
@mano: as you economy is really fragile in a lot of aspects, as a system. Fed chairs like bernanke (now) and alan greenspan play a very major role in giving statements about outlooks to tilt the economy one way or another to establish stability. The fundamental problem with a good economy is that there are side effects. When fed wants to control such side effects, it again feeds back to the stability of the economy and that is inevitable..
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