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Keynesian LRAS: China's Inevitable Inflation

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Friday, August 20, 2010

Keynesian LRAS: China's Inevitable Inflation

Lately the media has been flooded with news of China’s workers demanding higher wages. A spate of strikes at factories has forced firms to raise the wages of their employees. In Guangdong province alone (the manufacturing hub of China) there were 36 strikes in 38 days (Source: The Economist, 31/7/2010-6/8/2010). All this has rightly lead to speculation that there will be cost-push inflation in the near-term in a range of consumer goods as firms raise prices to maintain already low profit-margins.

Explaining this recent rise in wages is a simple case of supply and demand. With China having adopted the role of the world’s workshop, demand for its goods (and hence, its workers) is high. On the other hand, China’s ageing population means that the aggregate supply of labour is shrinking. It follows that in such a scenario, the wage level should rise.

As mentioned above, rising wages equals higher costs for firms, contributing to cost push inflation. When taking a long-term view (see graph below), we see that China’s inflation has only really picked up in the last seven years or so. Another observation that can be made from that graph is that it has a striking resemblance to the Keynesian Long-run aggregate supply curve (see top diagram). We can see that at all points to the left of Y1, output (x-axis) can be increased with minimal effect on the price level. This is because factors of production (labour, in China’s case) were so abundant that it was relatively cheap to employ them and hence employing more factors hardly changed the price level. This phase is reflected in the time span from about 1950 to 2000 in China’s history. However, now with a shrinking supply of labour, it has become more expensive to employ labour and any increase in output has an inflationary effect. By noting the steep price level rise that accompanies an increase in output from Y1 to Y2, we can see that China’s future growth will lead to even more inflation.
Worryingly, it seems as if China is reaching the Y2 level of output – it’s maximum. At Y2, output cannot increase any further and any outward shift in demand will have a purely inflationary effect. The implications of this are serious. By looking at the recent wage rises and historical inflation rates in this way, one can conjecture that China’s role as the world’s manufacturer may be under threat in the not-too-distant future. The only way to avoid the seemingly inevitable inflation is to shift the aggregate supply curve (LRAS) to the right. Unfortunately, with the supply of labour dwindling this is looking increasingly difficult to do.


At August 19, 2010 at 5:25 AM , Blogger panzerbjorne said...

A lot of your analysis depends on the assertion that the supply of labour in China is decreasing. Do you have any data to support that?

I might be wrong but my intuition tells me that its not overall supply of labour thats decreasing (still a few 100mln peasants willing to leave the farmlands for the cities). However, what might be causing the same effect is that the skills required to be a worker in China are getting higher as industry moves towards higher value added goods. As the average technical skill level is quite difficult to change in large numbers over a span of a few years, we are seeing a large proportion of workers being cut out of the effective "supply" - creating the same affect as the LRA discussed above.

Would be happy to be refuted!

At August 20, 2010 at 2:45 AM , Blogger Deep Vaze said...

Hey Arvind,

In today's SCMP paper there is a comment article by Tim Holland. As you suspected, Holland says that there is currently a pool of '80 million likely migrants still in the countryside' who want to move to the cities. At the same time he says the supply of labour in China will fall 'by around 30 million by 2020 even as the demand for workers in the country's cities grows by an estimated 40 million'. The reason for the contradictory nature of these statements is that the former is referring to the 'labour force' while the latter is talking about the 'aggregate supply of labour'.

When I was learning about the labour market, I was taught that 'labour force' means the total number of people who are 'of working age' (i.e. 18-60) and that the 'aggregate supply of labour' means the total number of people who are 'willing and able to work' (i.e. have the desire and skills to work).

Hence, when I talked about the 'supply of labour' in the article, I was referring to those who are 'willing and able' to work - a number which is decreasing (as evident from the figs above). In other words, while there are millions of peasants who are unemployed and part of the labour force, they don't qualify as part of the agg. supply of labour as they aren't willing and/or able to work (for reasons such as their lack of skills - a point which you mentioned and I should have included - or geographical/monetary barriers).

Thanks a lot for commenting! - I'll try and be clearer about the distinction between 'labour force' and 'supply of labour' in the future.

At August 20, 2010 at 6:36 AM , Blogger panzerbjorne said...

Thanks - a fine point - but glad you cleared it up. The overarching point of the article of course is quite valid and well made.


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