After the first world war, Britain revalued pound sterling against gold. This was risky, especially since Britain relied on export earnings from manufactured goods in order to pay for import of food, clothing required for its citizens and raw materials required for manufacturing goods meant for export. The government hoped that by re-establishing the pound's parity with gold that existed prior to the war, British citizens would make up for the lost purchasing power with the revalued pound. A key to this assumption lay in adjusting wages downward, which was necessary for British goods to remain competitive in the export markets.
The monetary adjustment meant a higher real wage compared to the pre-adjustment level. In order to stay competitive, wages had to go down. But the unions wouldn't let it go. Nominal wages remained where they were. As a result, British exporters lost out to competition and exports plunged.
In several countries where labor markets have remained static, unions hold considerable influence in policy making. Governments succumb to union pressure to keep wage rates higher than market determined levels. If Britain had an unhindered labor market, its wage rate would have adjusted to market forces downwards, and yet employment levels would have remained the same. Moreover, its exports would have remained competitive. Rather, keeping wage rates obstinately high resulted in employers shutting down factories and causing mass unemployment.
Even in the face of continuing unemployment the labor market remained gridlocked. The unions wouldn't let the forces of the free market remedy the problem. Instead, the government made a stealth move. It devalued its currency. The devaluation made the pound attractive for exporters. But its citizens lost out as the purchasing power of the currency stood reduced. Even though nominal wages stayed the same, real wages were lower. The move was successful as British exporters now made profits. Workers hired for the factories drove down unemployment numbers.
Several countries followed suit with voluntary devaluation of their currencies. For countries with a peg currency, remaining competitive in export markets is significant for their overall economic well-being. In order to be politically palatable, nominal wages are not reduced, instead they deployed the 'cheat' method of currency devaluation.
Unfortunately, economics mainstreamed these isolated, desperate attempts into theory. It concluded that in the labor markets, wage rates were a non-adjusting factor. And as demand for labor decreases (factories require less workers), the supply of labor decreases as well, resulting in a persistent wage rate. Keynes justified devaluation of the currency as a legitimate method to avoid unemployment.
As a corollary, inflation was said to be necessary in order to maintain full-employment. Later, the Phillips curve claimed that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. The Keynesians were ready to sacrifice purchasing power of the currency in order to achieve full employment.
Being politically sound this found easy acceptance in many countries.
Despite its popularity, in the long run, countries cannot resort to inflation to solve issues. Apart from the inequity it creates, refer Understanding Inflation in Greater Detail, citizens end up losing confidence in the currency leading to bank runs run and the eventual forceful demonetization of the currency itself.
If inflation had no consequences governments would ceaselessly pursue it.
Full-employment can also be achieved by removing labor market frictions. In this scenario, wage rates would adjust to changes in the economy. When labor demand is high, the wage rate would rise. On the other hand, when demand is low, the wage rate would fall. Much like a commodity, which needs to be cleared at whatever rate a willing buyer is available, the wage rate too must be let to freely move around. Only in a free market devoid of unions, minimum wage laws, see previous article on The Effect of Minimum Wages on the Economy, and hidden employee costs (social security, insurance) would the wage rate move about freely and adjust to achieve full-employment.
Economic theory has wrongly set up the inflation versus unemployment debate. It should ideally be institutional-frictions-that-prevent-wage-adjustments versus full employment' that deserve attention. Currency devaluation and consequent inflation only help achieve the overt objective of keeping unemployment numbers low. Lately, inflation has also become a tool not only for achieving low unemployment numbers, but also to manage the high borrowings of the government.
But this policy must end.
Inflation creates mis-allocation of resources, refer The Causes of Business Cycles and The Role of Entrepreneurs, by misleading entrepreneurs through wrong signalling of interest rates. Retirees who depend on fixed annuity income or limited savings suffer. It encourages the government to subsidize favored groups (since money is available through printing), mandate minimum wages and support high priced locally produced goods by imposing tariffs on imports etc. All these cause inefficiencies and reduce the standard of living of its citizens.
Only a well-informed public can discern these policy devices. Preserving the purchasing power of money is the most important objective. Politically, this is the hardest thing to do. The public should play the role of keeping this check. Without a counter force, governments would pursue an inflationary policy that would end in a catastrophe.