inflation and unemployment Flashcards
Define:
Zero inflation
Inflation
Deflation
Disinflation
Zero inflation: Price level constant (0% change).
Inflation: Price level rises (e.g., 2% annually).
Deflation: Price level falls.
Disinflation: Inflation rate declines (e.g., 6% → 4%).
Why do voters dislike inflation?
Fixed-income groups (e.g., pensioners) lose purchasing power.
Borrowers benefit (debt shrinks in real terms), lenders lose.
How does inflation create conflict between borrowers (Julia) and lenders (Marco)?
Julia (borrower): Repays loan in “cheaper” dollars (real debt ↓).
Marco (lender): Repayment buys fewer goods (real value ↓).
What is the Fisher equation, and how is it used?
Real interest rate = Nominal rate − Inflation rate.
Example: 10% nominal − 6% inflation = 4% real interest rate.
Why is volatile inflation harmful?
Uncertainty: Hard to predict prices → inefficient investment.
Menu costs: Firms spend resources updating prices.
Why is deflation dangerous?
Postponed spending: Consumers wait for lower prices → ↓ demand.
Debt burden ↑: Real value of loans grows → defaults rise.
Deflationary spiral: Falling demand → lower prices → economic stagnation.
Compare inflation vs. deflation effects on debt.
Inflation: Helps borrowers (real debt ↓), hurts lenders.
Deflation: Crushes borrowers (real debt ↑), benefits lenders.
What are menu costs?
Resources wasted on frequent price adjustments (e.g., printing new menus).
Reduces firm efficiency.
How can deflation trigger a vicious cycle?
Prices fall → consumers delay spending.
↓ Demand → firms cut production → unemployment ↑.
Economic slump → further price drops.
What causes inflation in the conflicting claims model?
Inconsistent claims: Firms (via markup pricing) and workers (via wage demands) make mutually incompatible claims on output.
Bargaining power shifts:
Firms: ↑ Market power → ↑ markups → inflation.
Workers: ↑ Bargaining power → ↑ wages → inflation.
How does reduced competition trigger inflation?
Firms ↑ markups (price-setting curve shifts down).
Real wages fall → workers demand ↑ nominal wages.
Firms pass wage costs to prices → wage-price spiral.
What happens at the Nash equilibrium unemployment rate?
Zero inflation: Wages/prices are consistent with profit maximization (wage- and price-setting curves intersect)
How does higher employment cause inflation?
Moves along wage-setting curve: Workers demand ↑ real wages.
Firms ↑ prices to maintain markup → inflationary spiral.
What are the two sources of worker bargaining power increases?
Wage-setting curve shifts up (e.g., higher unemployment benefits).
Employment rises (movement along existing curve).
What is the Phillips curve relationship?
Negative correlation: Low unemployment ↔ High inflation (and vice versa).
If worker bargaining power rises (e.g., via ↑ benefits), what happens?
Wage-setting curve shifts up (initial wage hike).
Firms raise prices → real wages fall back.
No curve shift: Inflation continues until claims reconcile.
Why does inflation persist in conflicting claims?
Feedback loop:
Wages ↑ → costs ↑ → prices ↑.
Prices ↑ → real wages ↓ → workers demand ↑ wages.
Continues until bargaining power or policy intervenes.
How do protectionist policies affect inflation?
↓ Competition → ↑ firm markup power → price-setting curve shifts down.
Triggers wage-price spiral (workers resist real wage cuts).
What triggers the wage-price spiral?
Low unemployment → workers demand higher nominal wages (cost of job loss ↓).
Firms raise prices to maintain markups → inflation.
Workers demand further wage hikes (real wages unchanged) → cycle continues.
Define the bargaining gap and its link to inflation.
Gap = Wage-setting curve wage − Price-setting curve wage.
Positive gap (low unemployment): Inflation (claims > productivity).
Negative gap (high unemployment): Deflation.
Zero gap (equilibrium): Stable prices.
How does the Phillips curve relate unemployment and inflation?
Negative short-run relationship: Low unemployment ↔ High inflation (and vice versa).
Shifts over time: No permanent trade-off
What happens in a boom (low unemployment)?
Positive bargaining gap → wage-price spiral → rising inflation.
Claims of workers + firms > labor productivity.
What happens in a recession (high unemployment)?
Negative bargaining gap → falling wages/prices → deflation.
Claims of workers + firms < labor productivity.
Why is there no permanent inflation-unemployment trade-off?
Attempts to keep unemployment below equilibrium cause accelerating inflation (Phillips curve shifts up).
How do central banks use interest rates to control inflation?
Raise rates → ↓ AD → ↑ cyclical unemployment → ↓ wage pressure → inflation ↓.
Lower rates → opposite effects.
What causes the Phillips curve to shift over time?
Inflation expectations: Workers/firms anticipate future inflation → demand higher wages/prices.
Supply shocks: E.g., oil price hikes shift curve upward (1970s stagflation).
Compare inflation vs. rising inflation.
Inflation: Prices increase at a constant rate (e.g., 2% yearly).
Rising inflation: Inflation rate accelerates (e.g., 2% → 4% → 6%).
What is the key policy lesson from the Phillips curve?
Short-run: Trade-off exists (can reduce unemployment with higher inflation).
Long-run: No trade-off; unemployment returns to equilibrium, inflation adjusts
What is the inflation-stabilizing unemployment rate?
The Nash equilibrium unemployment rate where inflation remains constant (no bargaining gap).
Example: 6% unemployment with 3% stable inflation (Point A).
How does expected inflation affect wage/price setting?
Workers demand nominal wages = expected inflation + desired real wage increase.
Firms set prices = expected inflation + markup → fuels inflation spiral.
What is the inflation equation with expected inflation?
Inflation (%) = Expected inflation (%) + Bargaining gap (%)
Example (Point B): 5% = 3% (expected) + 2% (gap).
Why does the Phillips curve shift upward over time?
Low unemployment → persistent bargaining gap → workers raise inflation expectations → next year’s inflation = last year’s + gap.
Example: 3% → 5% → 7% inflation at 3% unemployment (Points B → C).
What happens if unemployment stays below equilibrium?
Rising inflation: Each year, inflation = previous inflation + bargaining gap.
Real wage unchanged: Stays on price-setting curve despite nominal hikes.
Compare stable vs. accelerating inflation:
Stable (Point A): 6% unemployment, 3% inflation (expected = actual).
Accelerating (Points B/C): 3% unemployment, inflation rises yearly (5% → 7%)
Why can’t policymakers permanently reduce unemployment via inflation?
Short-run: Trade-off exists (lower unemployment → higher inflation).
Long-run: Workers adjust expectations → Phillips curve shifts up → rising inflation for same unemployment.
What is the key takeaway from shifting Phillips curves?
Only one stable unemployment rate (Nash equilibrium).
Attempts to keep unemployment below equilibrium cause ever-rising inflation.
What is a supply shock?
A disturbance (e.g., oil price hike) that shifts the price-setting curve down, reducing real wages and creating a bargaining gap.
Example: 1970s oil crisis → stagflation (↑ inflation + ↑ unemployment).
How does an oil price shock trigger inflation?
Firms’ costs ↑ → price-setting curve shifts down.
Real wages fall → workers demand ↑ nominal wages (bargaining gap).
Wage-price spiral: Firms raise prices → inflation rises (e.g., 3% → 5% → 7%).
Why do supply shocks shift the Phillips curve up?
Higher expected inflation: Workers/firms anticipate continued price hikes.
Persistent bargaining gap: Low unemployment or high import costs sustain pressure.
What is stagflation?
Rising inflation + rising unemployment (e.g., due to oil shocks).
Occurs when AD policy keeps employment at pre-shock level despite ↓ price-setting curve.
How can inflation be stabilized after a shock?
↑ Unemployment: Must exceed new equilibrium (negative bargaining gap).
↓ Expected inflation: As actual inflation falls, expectations adjust.
Cost: Prolonged high unemployment (“disinflation”).
What role do capacity constraints play in inflation?
Low unemployment → high capacity utilization → firms:
Raise markups (less competition).
Invest less (short-term profit focus).
Trigger wage-price spirals.
Compare demand vs. supply shocks:
Demand shock (e.g., ↓ investment):
↑ Unemployment + ↓ inflation.
Supply shock (e.g., oil crisis):
↑ Unemployment + ↑ inflation (stagflation).
Why do firms raise markups during booms?
Capacity constraints: Fewer idle resources → steeper demand curves (less elastic).
Reduced competition: Firms exploit pricing power.
What is the policy dilemma of supply shocks?
Option 1: Tolerate stagflation (high inflation + unemployment).
Option 2: Raise rates → deep recession to curb inflation.
