Inflation, Unemployment and Monetary Policy

Question 1

Inflation formula

Answer 1

((CPI2024 - CPI2023)/CPI2023)*100

Question 2

What is wrong with inflation

Answer 2

Some people on fixed nominal incomes, pensioners
Higher inflation = decrease real value of income

Inflation decreases the value of real debt
Good for borrowers, bad for creditors, inflation is only known at the time of repayment

No evidence that low and stable inflation is bad
But high inflation makes the economy works less well

Higher uncertainty = volatile
Noisy signal = harder to distinguish between price signals
Menu costs = firms have to update prices more frequently

Question 3

What is wrong with deflation

Answer 3

Postpone consumption, as prices keep decreasing, negative shock to aggregate demand

Real debt burden increases, leads households to cut consumption to return to wealth

Question 4

What is okay with inflation

Answer 4

Little bit is good as long as it is stable:
Process of innovation and change that characterises a dynamic economy, some workers are more in demand in some sectors - fall in real income among losers marked by nominal increase

Means monetary policy is able to be used

Question 5

Causes of inflation

Answer 5

Increased bargaining power from worker’s side shifts up the wage setting curve, strong union or unemployment benefits

Firms are able to increase the prices of their products, which increases the price level in the economy, P = (1 + markup)*MC

When aggregate demand levels increase, Y increases to increase supply
- Firms have to increase workers and employment, which shifts the wage setting curve upwards, creating a wage price spiral

Question 6

Phillips curve

Answer 6

Lower unemployment leads to higher inflation
Workers have higher bargaining power, request higher wages then lead to higher prices
High unemployment = low inflation

Question 7

Wage price spiral

Answer 7

Workers care only about real wages

Real wages = nominal wages/Pl

An upswing in the business cycle is often associated with higher inflation

Higher AD ==> Higher employment ==> Higher Wages

Higher Prices Higher Prod costs

Real wage has not increased, employment stays constant, wage-price spiral continues

Question 8

Bargaining gaps

Answer 8

Wage at wage setting - wage at price setting curve

Unem is below equil = positive bargaining gap

Unem is above equil = negative bargaining gap

At equilbrium the bargaining gap is zero and Pl is constant

Question 9

Demand Shock

Answer 9

unexpected change in aggregate
demand (e.g., investments or exports)
* A positive demand shock can reduce
unemployment and increase inflation

Question 10

Supply Shock

Answer 10

shocks in the labour market shifting
the price-setting curve or the wage-setting curve
* A negative supply shock (e.g., oil shock) can
increase both unemployment and inflation

Question 11

Role of central banks

Answer 11

Banks need money to operate (e.g., providing loans &
services, to make transactions).
* Some banks have excess money, while others not
enough.
* Banks borrow from each other: interbank market
(textbook: money market)
* The central bank:
* Lends whatever amount is demanded by banks at the
interest rate it chooses (policy rate)
* This affect the commercial banks’ lending rate to
firms and households (policy rate + markup)
* Accepts deposits from banks at the interest rate it
chooses

Question 12

Market interest rates

Answer 12

To set the policy rate, the central bank will work
backwards
1. Given the target inflation, estimate a target for the total
aggregate demand Y based on the labour market
equilibrium and the Phillips curve
2. Estimate the real interest rate r producing this level of
aggregate demand, based on the multiplier model (Unit 14)
3. Calculate the nominal policy rate, i, that will produce the
appropriate market interest rate

Question 13

Expectations and confidence

Answer 13

Good and consistent communication from central bank
matter ➡ build confidence in the Central Bank
This can lead firms to expect higher demand and
therefore increase investment
Households may be confident that they will not lose
their jobs, and they may increase their consumption

Question 14

Fisher equation with expectations

Answer 14

Real interest rate = Nominal interest rate –
Expected inflation rate

r = i - pi^e

• Nominal interest rate: interest rate quoted by banks
• Real interest rate: interest rate adjusted for inflation

Question 15

Exchange rate

Answer 15

Country’s central bank lowers the interest rate
Ø Return to that country’s bonds declines
Ø Decline in demand from international investors
Ø Demand for the currency to buy those bonds
declines
Ø Depreciation: decline in the currency price in
terms of other currencies
Ø Goods sold abroad are now cheaper,
imported goods more expensive
Ø Higher export demand for home-built
products (X), lower demand from
imported goods and services (M)
Ø Raise in aggregate demand

Question 16

Monetary policy in a boom

Answer 16

How should the central bank react to a consumption
boom?
* A boom will shift the aggregate demand line upwards,
so the central bank must raise the interest rate to
dampen demand and return the aggregate demand
line back to its starting point
* But why would it want to curtail a boom?
* From the Phillips curve, we know that a boom leads
to higher inflation, and, if expectations adjust to past
inflation, to rising inflation

Question 17

Is it that easy?

Answer 17

Timing is everything
* Difficult to decide whether a downturn is a temporary
blip or signifies a long-term weakness
* Difficult to judge whether an increase in inflation is
temporary, or whether a boom is a bubble or
motivated by fundamentals
* Difficult to predict whether and how the Phillips curve
will move
* The government could also play a role in a recession by
cutting taxes, or by boosting spending
* But fiscal policy is complicated to adjust and inflexible
* During the Covid crisis, central banks around the
world were faster at reacting (and at coordinating)

Question 18

Zero lower bound

Answer 18

One limitation of monetary policy is that the short-term
nominal interest rate cannot go below zero
* If the policy interest rate were negative, people would
have to pay the bank for holding their money
* People would simply hold cash rather than put it in
the bank
* When the economy is in a slump, a nominal interest
rate of zero may not be low enough to stabilize the
economy

Question 19

Quantitative easing

Answer 19

Alternative strategy in recession: quantitative easing
Ø How does it work?
Ø The central bank buys bonds and other financial
assets
Ø This raises demand for bonds and other financial
assets, thus increasing prices
Ø This boosts spending
Ø Particularly on housing and consumer durables,
because both the cost of borrowing and return to
holding financial assets has gone down

Question 20

Monetary union

Answer 20

Monetary policy may not be available to a country
* Members of the Eurozone gave up their own
monetary policy when they joined the currency union
* Main issue: interest rate set by the European Central
Bank may be more appropriate for some members
than for others
* After the financial crisis, unemployment was low
and falling in Germany but in countries such as
Spain and Greece, it was high and rising fast

Question 21

Central bank independence

Answer 21

Why do governments hand over the task to independent
institutions rather than controlling inflation themselves?
Ø Remember: unexpected inflation redistributes
wealth from creditors to borrowers
Ø Governments are the largest borrowers
Ø We need an institution with more credibility
(less incentive to generate inflation)

Question 22

Why control inflation?

Answer 22

Why control inflation? (and not unemployment or output
for example)
* Unemployment depends on structural features of the
labour market, some of which are hard to change/take
long time to change
* In general, real variables are slower to react than
nominal variables
* Just because inflation is targeted doesn’t mean that
other variables are not affected
* Bringing down inflation rapidly can increase
unemployment just as fast
* A central bank that is given a dual mandate can be
less inclined to act (so less credible)

Question 23

Capacity constraint

Answer 23

When capacity utilization rises, usually firms increase
investment to expand their ability to meet orders
Ø However, building new plants and installing new
equipment takes time
Ø Firms have more orders than they can fill (capacityconstrained)
Ø Firms lose nothing by raising prices. Firms
producing similar products are capacityconstrained too. All firms face less competition,
demand curves are now steeper (Units 7-8)
Ø Firms respond to higher capacity utilization by
raising the markup
Ø Wage-price spiral