9 - Employment And Inflation: EAPC

Question 1

Supporters of the competitive net-classical model considered what

Answer 1

Government intervention as problematic

• Instead believed self-regulating free market would generate optimal outcomes (full employment)

Question 2

EAPC

Group of economists (the monetarists) asserted that: 3 things

Answer 2

• No permanent (long-run) trade-off between inflation and unemployment
• The market would ensure unemployment rate was stable around its so-called natural rate
• Attempts by Government to push unemployment rate below its so-called natural rate would lead to accelerating inflation (accelerationist hypothesis)

Question 3

Government can reduce what in the short run, however it’ll eventually return back to its natural rate in the long run

Answer 3

Unemployment rate

Question 4

When was the accelerationist hypothesis advanced and by who

Answer 4

1968 by Milton Friedman

Question 5

2 basic propositions that Friedman asserted in his attack on the Phillips Curve

Answer 5

• Natural rate of unemployment (NRU)
• Price expectations

Question 6

According to Friedman, like the classics, what was the relevant object of concern from the perspective of firms and workers

Answer 6

Real wage was the concern, over money wage

• In classical labour market, workers supplied labour based on the price of leisure (I.e. the real wage)
• If money wage (nominal) Increased, and inflation increased, then real wage has stayed the same

Question 7

Should accept the job if there’s an increase in what during inflation

Answer 7

Real wage

Question 8

Firms hiring rule for profit maximisation

Answer 8

Keep hiring workers until you reach the point where the output of the worker (marginal product) equals the cost of the worker (real wage) to profit maximise

Question 9

For Friedman, Phillips Curve is, at best, a what

Answer 9

A short run relationship that can only be exploited as long as workers suffer from money illusion

Question 10

What is money illusion

Answer 10

When people believe a money wage increase or price increase represents a real increase

• In other words they ignore or underestimate inflation

Question 11

If price level increases and money wage increases the same amount there’ll be no motivation to do what

Answer 11

No motivation or incentive to hire people

Question 12

Difference between price expectations in PC and EAPC

Answer 12

There’s no role for price expectations in the Phillips Curve, but there is in the Expectations Augmented Phillips Curve

Question 13

When do we have incentive and motivation to hire people

Answer 13

If inflation rate increases more than money wage (decrease in real wage) as the firm is getting profit by selling at higher price but the costs haven’t increased as much

• Example, inflation rate increases by 2% and money wage (nominal wage) Increase 1%, then overall decrease in real wage

Question 14

Why shouldn’t people accept the job offer but they do anyway

Answer 14

Because real wage has decreased, however they don’t know what happened to the price level (inflation), they only recognise the change in money wage (nominal), Therefore overall they thing their real wage has improved which isn’t the case, as they ignore the change in price level, which is called money illusion, misleading expectation

Question 15

Summarise money illusion and accepting job offer

Answer 15

Overall, firm increase money (nominal) wage, but not as much as price level (inflation), therefore more profit, as people ignore the rise in price level (inflation), accepting job offer, decreasing unemployment

• Short-run

Question 16

Money illusion only happens in the long or short run

Answer 16

Short run

Question 17

Friedman argues, workers will eventually realise what

Answer 17

They’ll eventually realise real wages was being eroded as inflation outstripped money wages growth

Question 18

When workers start to realise their real wage was being eroded, what do they start forming

Answer 18

Expectations of continuing inflation

Question 19

What will workers do when they start forming expectations of continuing inflation

Answer 19

They’ll start demanding higher wages, putting firm under pressure

Question 20

What will firms do in response to workers demanding higher wages and why reducing workers real wages is only a temporary benefit

Answer 20

• In response they will increase wages, increasing their costs therefore the profit they made in the short run during money illusion will not appear in the long run
• Change In price will equal change in nominal wage so no extra profit
• Meaning firms will start firing people, to cut costs
• Overall, firms benefit from this negative relationship (inflation and unemployment) in the short run (money illusion) however temporary
• Will return to previous unemployment rate (NRU)

Question 21

Short run aggregate supply graph explanation

Answer 21

• Government uses expansionary Policy to increase output and reduce unemployment rate
• Output increases as well as price however unemployment decreases
• AD curve shifts upwards
• People accept job as they have money illusion

Question 22

Long run aggregate supply graph explanation

Answer 22

• When people correct their expectations, start asking for higher wages, increasing cost for firms, aggregate supply shifts upwards
• Output decreases and unemployment increases as firm starts to fire workers
• Output and unemployment rate end up at same position, however at a higher price level (higher inflation rate) (accelerationist hypothesis)

Question 23

Why is the long run Phillips Curve a vertical line

Answer 23

Because there’s a negative relationship between inflation and unemployment in the short run, but in the long run there’s no relationship it just shows the different price levels (inflation)

Question 24

Why does the government have to repeat the expansionary Policy

Answer 24

Because reducing unemployment is temporary because of money illusion and every time you reduce unemployment, price level increases

• Unemployment level always returns eventually back to NRU, then expansionary Policy happens again

Question 25

Why does price level increase every time expansionary Policy occurs

Answer 25

Because it will decrease real wage causing (allowing) them to hire more people

Question 26

Why is repeating expansionary Policy bad for the economy

Answer 26

As inflation will get very high which isn’t good for economic stability, therefore only beneficial in the short run

Question 27

EAPC: Implications of Friedman’s natural rate hypothesis are:

3 things

Answer 27

1) No permanent or stable trade off between inflation and unemployment

2) Unemployment can be kept below (above) the natural rate only by accelerating inflation (deflation);

3) Long-run EAPC is vertical and consistent with real forces and accurate expectations

• Which is why Friedman wanted a free-market, already motivation hire people, increase profit

Question 28

Why did Friedman want a free market

Answer 28

• Any attempt to decrease unemployment rate will only lead to inflation in the long-run, and decrease in unemployment will be temporary
• This is why Friedman suggests to not use expansionary Policy, don’t try increase aggregate demand; he says keep the free market, reduce power of trade-unions, this will encourage the firm to hire more people, as firms want to increase profit, therefore already have motivation to hire people
• Without trade unions and minimum wage (institutional rigidities), there’ll be even more of an incentive to hire