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.