Question

In 2010 , Ireland implemented a deliberate policy of linking pay rises to efficiency to induce deflation. (a) How did Ireland plan to achieve deflation by implementing such a policy? (b) Use an IS-LM diagram to show the consequences of negative inflation in Ireland.

Short answer

Ireland aimed to induce deflation by tying pay increases to productivity, limiting inflationary pressures. In the IS-LM model, deflation shifts the IS curve left, reducing output.

Step-by-step solution

Understanding Deflation through Pay and Efficiency

By linking pay rises to efficiency, Ireland aimed to control inflation. When pay increases only if there's an increase in efficiency, it limits the wage-push inflation (where wages drive price increases). This policy prevents prices from rising without accompanying productivity gains, making it possible to reduce or maintain stable price levels, thereby inducing deflation.

Constructing the IS-LM Framework

The IS-LM model consists of the IS curve, representing equilibrium in the goods market, and the LM curve, representing equilibrium in the money market. Begin by drawing the downward-sloping IS curve, which shows the inverse relationship between interest rates and output, and the upward-sloping LM curve, which shows the direct relationship between interest rates and output determined by money supply.

Shifting the IS Curve for Negative Inflation

Negative inflation or deflation results in expectations of lower future prices, which can reduce consumption and investment as people anticipate cheaper prices later on. This causes the IS curve, which reflects demand in the economy, to shift to the left, showing reduced output at any given interest rate.

Effects on the LM Curve with Stable Monetary Policy

If the central bank's monetary policy remains unchanged, the LM curve stays in its position. This is because the LM curve is a function of money supply and preference for liquidity, which are not directly affected by deflation in this analysis if the monetary policy does not change.

Identifying New Equilibrium

With the IS curve shifting left due to reduced demand, the new equilibrium is found where the new IS curve intersects the unchanged LM curve. This results in lower output and potentially lower interest rates depending on the exact positions of the curves. This intuitively captures Ireland's scenario of deflation leading to stagnant or reduced economic activity with potential changes in interest rates.

Key concepts

Wage-Push Inflation

Wage-push inflation is a type of inflation triggered by increasing wages. When workers receive higher salaries, they have more spending power. Businesses often raise prices to match these increased wage costs, leading to inflation. However, this cycle can be controlled by ensuring that pay rises are tied to efficiency gains. If employees are paid more only when they produce more, the additional costs to businesses are offset by increased productivity, which prevents prices from soaring. This strategy can effectively combat wage-push inflation by maintaining price stability without compromising on production or employment.

Deflation

Deflation is the opposite of inflation. It occurs when the price levels in an economy decrease over time. While it might sound beneficial, deflation can lead to reduced economic output and increased debt burdens. When prices fall consistently, consumers might delay purchases in anticipation of even lower prices, which can dampen demand and slow down economic growth. In Ireland, the policy of linking pay increases to efficiency was an effort to harness deflation, encouraging cost control and stable consumption patterns, thereby keeping prices steady or slightly declining.

Monetary Policy

Monetary policy encompasses the actions taken by a central bank to influence the availability and cost of money in an economy. It typically involves adjusting interest rates and changing the money supply to achieve macroeconomic goals. If there’s deflation, central banks might lower interest rates to encourage borrowing and increase money supply. However, in Ireland's case, if the monetary policy remains unchanged, it shows a commitment to maintaining current money supply and liquidity preferences, even in the face of deflation. This helps keep the LM curve in the IS-LM model stable during times of changing demand.

Economic Equilibrium

Economic equilibrium occurs when supply equals demand. In the context of the IS-LM model, it’s the intersection of the IS curve and the LM curve, indicating simultaneous equilibrium in the goods and money markets. Changes such as deflation can shift the curves. A leftward shift of the IS curve suggests decreased demand due to expectations of falling prices, while the LM curve may remain static if monetary policy is constant. The new equilibrium, resulting from these shifts, typically indicates lower output and possibly reduced interest rates, reflecting the challenges in maintaining sustained economic activity during deflationary periods.