Unit 15 Inflation, unemployment and monetary policy
15.1 What’s wrong with inflation?
Due to inflation, nominal debt will benefit, and nominal assets will drop in value.
Real interest rate % = nominal interest rate % - inflation %.
High (volatile) inflation makes it hard to predict, investors might not know what to invest in.
Deflation causes spending postpones and debt increases, lowering consumption.
Menu costs are the costs for setting and changing prices.
Moderate inflation can be good because it gives monetary policy room to manoeuvre.
It is also good because
15.2 Inflation results from conflicting and inconsistent claims on output
The government can take protectionist policy measures, like limits to trading/import to
protect locals. This causes less competition, higher prices and thus lower real wages. To
prevent demotivation, nominal wages are increased. Prices/wages are higher inflation.
Firms make less profit, higher prices are set, lower real wages and so on (wage-price spiral).
As long as:
Firms are powerful enough to increase markups.
Workers have enough power to increase wages.
o Upward shift in wage-setting curve.
o Increase in employment.
Inflation can also occur when unemployment lowers, prices/wages increase.
Wage inflation is the increase in nominal wage.
Philips curve: inflation has a negative relation with unemployment.
15.3 Inflation, the business cycle, and the Philips curve
Nominal wage = W/P
The bargaining gap is the difference between real wages the firms wish to offer for worker
incentive, and the real wage for maximum profit.
Unemployment > equilibrium = positive bargaining gap and inflation.
Unemployment < equilibrium = negative gap and deflation.
Labour market equilibrium = 0 gap constant price level.
Higher AD causes low unemployment, so there is a positive gap and inflation.
Lower AD causes high unemployment, so there is a negative gap and deflation.
15.5 What happened to the Philips curve?
Inflation means rising prices, therefor rising inflation
means that the Phillips curve must keep shifting
upwards.
, Unit 15.6 Expected inflation and the Philips curve
Despite governments trying to keep inflation low, inflation keeps rising:
People anticipate for the future government policies to smoothen their income,
making it less affective.
People treat prices as messages for the future.
Wage/price-setters set their wages/prices by looking after the expected inflation.
At the equilibrium, inflation is 3%,
why not 0% like before?
If the setters expect inflation of 3%,
and they increase the wages by 3%,
the real wage will remain the same,
at the equilibrium.
In a boom, employment will go to B.
Workers expect a 3% inflation and
want 3% more wage just to keep up
and + 2% more wage for their new
real wage. So their wages, and thus
prices will increase with 5%.
Because of the price increase of 5%,
and the wage increase of 5% the real
wage didn’t change, to
disappointment of the workers.
‘Both parties claims add up to more
than the size of the pie’.
So we went from 3% inflation, to 5% and next year will be 7% because people expect 5%
inflation + 2% for the real wage and so on, thus the Philips curve shifts upwards.
The inflation-stabilizing rate of unemployment is the unemployment rate where inflation is
constant. The rate of unemployment always stays below this rate.
15.7 Supply shocks and inflation
Shocks that move the Phillips curve by changing labour are supply shocks, unlike demand
shocks where investment or consumption (AD) shift the curve.
An increase in the oil price leads to a one-off increase of inflation and rising inflation over
time.
