10 - Employment And Inflation: PC vs EAPC Flashcards
In the short run what do people have
Their own expectation (money illusion)
What do people have in the long run
Adaptive expectation
What is adaptive expectation
Use last year inflation rate to correct their expectation
What is rational adaptation
They correct their expectation immediately, as soon as the expansionary Policy occurs, by using other sources of information.
- Therefore, no short-run benefit, unemployment rate will remain at U* (NRU)
- No money illusion
- No benefit at all, only inflation
Nominal wage formula (wage determination)
Expected price level (unemployment level, variables that affect wages)
- Unemployment rate is high = Wages are low
Variables that affect wages
- Unemployment benefits = If there is high unemployment benefits firms should offer higher wages to create incentive to work, otherwise people will just not work and claim benefits
Price of a unit of output: Assume labour is the main cost for firm
- P = (1+m) W
- W = nominal wage (the cost) , positive relationship as if wages are high, costs are high therefore prices will be high
- M = mark-up of the price over the cost (marginal profit) , for example: wage = 100 , M = 0.1 (10%) , so the price will be £110
- M = 0 if goods markets were perfectly competitive
- M > 0 if firms have market power (Limited competition), Price (P) will exceed the cost W by a factor equal to (1+m)
What did Phillips Curve focus on
The relationship between inflation and unemployment
Why does increase in expected inflation rate lead to an increase in actual inflation
Because workers ask for higher wages to protect their purchasing power, therefore higher cost for firms, leading to increase in prices
Why does increase in mark-up (M) or increase in variables affecting unemployment rate/ wage determination (Z) lead to an increase in inflation
- Higher mark-up (M) means less competition, higher price (inflation), more profit
- Factors (Z) like unemployment benefits are high, firms have to offer higher wages to encourage people to work, meaning higher costs, and therefore firms will increase their prices (inflation)
What does an increase in unemployment rate lead to
Leads to a decrease in inflation rate
The period Phillips, Samuelson and Solow were studying what was the inflation rate
Close to zero
- This is why people didn’t expect changes in prices
- So expected inflation rate was zero
What’s the equation for inflation
Expected inflation rate + (M + Z) - aut (alpha, unemployment)
Difference between using expansionary Policy in EAPC and in PC
- EAPC Government will have to use expansionary Policy every year to keep unemployment rate below U* (NRU) as there is expectations
- PC Government can use expansionary Policy once and till create permanent change as there are no expectations
Why did Phillips Curve vanish
- US hit twice with large increase in price of oil in 1970’s. Effect of this was to force firms to increase their prices relative to wages they were paying - in other words their markup (m)
- Increase In M leads to increase in inflation, even at a given rate of unemployment (unemployment increased as well as inflation)
- Also, inflation rate became persistent since 1970, improving expectation. Explains change from PC to EAPC
