The second largest economy in Europe, the fifth largest economy in the world, and the fourth most-heavily taxed nation in the EU, France in home to over 63.5 million residents. France is a member of the G8, OECD, EU, and the EMU and its habitants enjoy a very high standard of living. France has a mixed economy, in which both government and business are heavily involved. It has a large public sector, relative to other industrialized countries: industries, like energy distribution, air-transport, and telecommunications are under state control (MSN Encarta). Perhaps the greatest weakness of he French economy is its inflexible labour market, characterized by strong employment protection legislation (EPL), persistent wage rigidity in the labour market, largely due to a high minimum wage (the SMIC), early retirement policy at age 55, and to generous government support programs targeted at the unemployed. All of the above make it difficult for firms to reduce labour costs in periods of recession, causes a high level of structural unemployment, and keeps inflation at a higher level during economic downturns. This paper will analyze the pattern of inflation over the years 1989 to 2004, the reaction and impact of policy on inflation fluctuations, and the effects of other macroeconomic factors on the inflation rate (such as foreign demand, exchange-rate, unemployment rate (u-rate), money supply, and domestic expenditure, for example). In addition, this paper will assess the impact of labour market, deregulation, and other measures taken by government to improve the economy and their long-term impact on the path of inflation. Based on inflation data (Diagram 3), inflation was kept low during the entire 16-year period (below 4%). Furthermore, inflation had been on a downward trend since 1991 through to 1999. The turning point from which inflation began to decline was caused by an exogenous shock that had a prolonged adverse impact on consumer and business expectations. After reaching the trough in 1999 (at 0.54%), inflation began to increase from 2000 onward, initially due to a global rise in oil prices. Based on the data, inflation variability significantly decreased since the introduction of the euro in 1999 and, especially, after it replaced the franc in January 2002. In 1989, the French economy experienced high economic and employment growth due to several factors: an improvement in the terms of trade, accelerated growth in the global economy, decline in real interest rates, depreciation of the franc and a less restrictive fiscal policy stance. The high level of unemployment (9.4%) restrained real wage increases and kept inflation at a moderate level of 3.5% (OECD 89/90, p.14). The acceleration of growth in the global economy and the depreciation of the franc have both added to the increase in real GDP through an increase in net exports. Inflationary pressures stemming mainly from export-demand pressures and moderate gains in labour productivity were suppressed by tight monetary policy adopted by the monetary authorities (the Bank of France (BF)), which followed a so-called “Competitive Disinflation” policy. The policy was targeted at reducing the inflation rate below that seen in France’s main trading partners, in order to enhance the competitiveness of the French economy (OECD 89/90, p.43). In accordance to this policy, the BF had decelerated the growth in M3 money supply, which gradually raised short-term interest rates by 3.25%, starting from the third quarter of 1989. Nevertheless, French firms increased their investment by 7.6% in response to increased demand from abroad. New corporate borrowing rose and manufacturing sector investment grew substantially (OECD 89/90, p.29). Despite he improvement in terms of trade, the trade balance decreased by 16 billion FF (Table X), largely due o a slowdown in activity in the US and the UK (OECD 89/90, p.35) and to a smaller extent, to a worsening in French exporting firms’ competitiveness, as a result of slowing growth in labour productivity. Economic activity declined somewhat, with real GDP amounting to 2.75% in 1990, and inflation was reduced due to the competitive disinflation policy and to the strong credibility of the BF in achieving its inflation targets. The year 1990 marked a turning point for budgetary policy, which implemented active tax reductions, after having attained its targeted reduction in the budget deficit. The decline in aggregate demand, notably consumption expenditure, was the result of deterioration in business and consumer confidence, caused by the crisis in the Persian Gulf (OECD 90/91, p.9). As a result of this event, and also in response o the past monetary policy move to raise interest rates, inflation fell somewhat to 3.2%. The decrease in demand was partly cushioned by the achievement of German unification, which, although contributing o the increase in French exports to that area, had more of a potential long-term effect of “creating a bigger market for French exports” (OECD 90/91 pp. 12-3). Furthermore, there was upward pressure on inflation due to a sudden rise in oil prices from $15/barrel to nearly $40/barrel following the Kuwait invasion (OECD 90/91, p.13). Real investment fell in the fourth quarter, as businesses became more uncertain about future developments in oil prices ad as real interest rates remained at their high levels. Overall, consumer prices remained relatively constant and inflation was lower. Declining inflation, he appreciation of the franc, and the decline in aggregate demand prompted the BF to lower rates by 0.75% and to lower banks’ required reserve ratios, thereby renewing buoyancy in corporate sector borrowing (OECD 90/91, pp. 39, 45). However, private sector borrowing was still low, due to the high level of interest rates, despite the reduction. The enhanced credibility and the resolve of the BF to fight inflation had caused a decline in inflationary expectations through 1990-1991 and a decrease in long-term maturity rates. This also reflects the increased credibility of the BF in achieving its inflation targets. After the desired government budget deficit reduction was attained, the government implemented reductions in taxes amounting to 26 billion FF (0.4% of GDP). However, the government sector deficit was kept in balance, as government expenditure fell markedly by 6.6 billion FF from the previous year (OECD 90/91, pp. 46-8). Therefore, the impact of the government sector deficit on inflation was slightly negative and negligible. A more important factor driving the decrease in the inflation rate was the implemented deregulation of public air-transport, telecommunications, and road freight sectors: disentanglement of public monopolies. This improved price competition, due to undercutting by new firms entering the markets and collectively reducing prices down to marginal costs (OECD 90/91, pp. 73-5).
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