Macro Unit 4 Flashcards
Define inflation, deflation and disinflation and explain how the rate of inflation is calculated
Inflation is the general rise in prices in the economy.
Deflation is the general decrease in prices.
Disinflation is when the rate of inflation falls.
Inflation is measured by the consumer price index (CPI) which measures the general prices of a basket of good that reflect typical household spending.
The cost of the basket is calculated. A base year is chosen whose value is set to 100. Inflation in following years can be computed by comparison to the base year.
CPI = basket price/basket price in base year * 100
Inflation = CPI this year - CPI last year/CPI last year * 100
How does inflation affect real income?
- Wages are set annually. Firms normally adjust their prices following the wage setting round. In an inflationary environment, this means the real wage, what can be bought with the nominal wage, often falls so workers lose out.
- Net debtors (owe more money than what is owed to them) benefit because inflation reduces the burden on debt payments, given that the nominal interest rate set by the bank is fixed.
- Net debtors may lose out if their wages take longer to increase following inflation than for the interest rate to rise which creates liquidity issues
- Net lenders lose out because the fixed nominal repayments can buy fewer goods and services.
- Poorer and richer households consume different baskets of goods. Poorer households tend to be proportionally more affected by inflation as a higher proportion of their income goes towards expenditure on common goods, ie electricity, gas, food
How does inflation impact uncertainty?
Prices convey information that guides resource allocation, ie a higher priced good suggests more resources should be directed to producing more of it
If prices are rising for most goods firms may be uncertain over which sector to invest in and consumers may be uncertain over whether some goods have become relatively more expensive than others.
High uncertainty brings about more risk in decision-making, reducing wellbeing and confidence.
Firms must update their prices more frequently which requires time and resource (menu costs).
Why can low inflation be a good thing?
Economists believe low and stable inflation is good because:
- it gives the central bank more scope for using monetary policy to cut the interest rate and stabilise falling AD
- the process of innovation and change that characterises a dynamic economy means that in any given year, workers in some firms and sectors will be in more demand than in others, so some wages will need to rise
- the necessary change in relative wages can be achieved by cutting nominal wages for less-in-demand jobs or increasing wages for higher demanded jobs
- inflation means that firms don’t have to cut nominal wages (which is unpopular) because they can mask a decrease in real wage for low demand jobs by increasing nominal wages at a lower rate than inflation
What is the issue with deflation?
A sustained fall in the price level is undesirable because when prices are falling, households will postpone consumption because they expect future price cuts. This causes weak aggregate demand and typically a prolonged recession.
When inflation is high, the central bank can raise interest rates to control it but when deflation is high, the central bank cannot set interest rates below 0% so they hit a zero lower-bound.
Explain how the supply-side equilibrium of the economy is reached
- According to the WS model, HR departments set the nominal wages at the level to recruit and motivate workers. When divided by the price level, this is the real wage on the WS curve at the prevailing unemployment rate
- According to the PS model, marketing departments in each firm set the price as a markup over marginal cost to maximise its profits. Profit max occurs where markup is inversely proportional to PED. This outcome ca be expressed as a ratio of the nominal wages to the price set which is the price-setting real wage
- If enough workers are hired and profits are maximised, wage and prices setters are satisfied and there is no reason for wages or prices to change, and at this unemployment level, wage and prices inflation are zero.
- This is the rate of unemployment at which WS=PS the Nash or supply-side equilibrium
- At this equilibrium, the real wage on the WS curve is equal to the wage share, (1−𝜎)𝜆 on the PS curve and the real profit per worker is 𝜎𝜆
How does the WS-PS model explain causes of inflation?
- Conflict of interest between workers and owners over the share of output per worker (wage and profit share)
- On WS-PS, this conflict is resolved at WS=PS
- Here, the unemployment rate is called structural unemployment
- To the right of the intersection, unemployment is lower than the structural rate and wages and prices rise
- To the left of the intersection, unemployment is higher than the structural rate and wages and prices fall
- When the economy is not in supply side equilibrium, particularly when unemployment is below the equilibrium level (WS>PS), inflation occurs
- If workers get the real wage on the WS curve which is now above PS, real profit per worker will be squeezed below 𝜎𝜆
- At lower unemployment, HR departments will increase nominal wages, which increases firms’ costs
- Marketing departments will pass on the higher costs as higher prices to restore the profit share
- Nominal wages and prices rise which is a symptom of the conflicting claims of workers and owners
How is AD linked with unemployment and inflation?
By combining the multiplier model with the WS-PS model, we can see how AD, unemployment and inflation are linked.
When output rises because of a rise in demand, unemployment falls.
From the assumptions of the WS-PS model, labour is the only input to production and output per worker is a constant, lambda.
The production function is Y=𝜆𝑁 which means output and employment are directly proportional to each other.
When output rises, employment rises in proportion and unemployment falls. The resulting chains occurs:
Rise in AD > rise in output > unemployment below equilibrium > WS>PS > increase in wages (wage inflation) > increase in firms’ costs > increase in prices (price inflation)
What is the Phillips curve
This curve shows the relationship between inflation and unemployment rate.
On the y axis is inflation and on the x axis is unemployment rate, going from high to low
The curve is upwardly sloping, showing that lower unemployment rate is associated with higher inflation, as explained in our model.
How can the Phillips curve relationship be derived graphically from the WS-PS model?
- Begin with the economy at supply-side equilibrium, WS=PS, constant prices and wages and inflation is zero.
- A rise in AD reduces unemployment. HR departments need to set higher wages to recruit and motivate workers. Wages rise by, say, 2%, hence firms’ costs rise by 2%.
- The marketing department raises prices by 2% to cover the higher costs (profit share is constant, competition same)
- So there is no change in real wage (W/P) as prices and wages increased by 2%, w is at its initial level
- There is a gap between the real wage workers get, wPS on the PS curve, and what they had expected, wWS on WS curve
- This is the bargaining gap (= wWS-wPS/wPS = 102-100/100 = 2, so wage and price inflation is 2%
- The level of inflation is equal to the bargaining gap each year
- By plotting a Phillips curve below the WS-PS curve, we can join together points by matching the bargaining gap. Ie in this case, on the Phillips curve the bargaining gap, at the given level of employment, is 2% (2% on inflation axis)
- The Phillips curve is the same shape as WS curve
How can the rate of inflation be derived from the bargaining gap?
Bargaining gap % = rise in wages % = rise in costs % = rise in prices % = inflation %
Inflation (%), pi t = gap t (bargaining gap%) where t is the year
Explain expected inflation
Expected inflation, denoted 𝜋𝐸, is the belief formed by wage setters and price setters about the level of inflation in the next period
Consider an economy in supply-side equilibrium with a real wage of 100 and unemployment of 6%.
Everyone expects the inflation rate to be 3%. There is no bargaining gap, each year wages and prices are raised by 3% and the real wage remains at the intersection of WS=PS
So at WS=PS, inflation is 3% not 0.
Thus the economy can be in supply-side equilibrium with prices rising, as long as they’re rising at the expected rate. Actual inflation = expected inflation and unemployment is constant at 6% - this is the inflation-stabilising unemployment rate (structural unemployment)
What happens with expected inflation if unemployment falls?
- AD rises and unemployment falls from 6% to 4%.
- workers expect prices to rise by 3% and will require a normal wage increase of 3% to keep real wage unchanged
- they require an additional 2% rise to give them an expected real wage rise on the WS curve so wages rise by 5%
- with costs rising by 5%, prices will rise by 5%
- bargaining gap is 2% and the Phillips curve takes it’s shape
- with low unemployment continuing, workers are disappointed with this outcome as they didn’t achieve their expected real wage
- workers expected a 2% real wage increase from their nominal pay rise of 5%, but this didn’t happen because firms raised their prices by 5%, eliminating the real wage increase
How is inflation calculated when expected inflation is not 0?
Expected inflation(%) + bargaining gap (%) > increase i wages > increase in costs > increase in prices = inflation (%)
Inflation (%), pi t = gap t + piE
Inflation = expected inflation + bargaining gap
What happens to inflation as a result of low unemployment, considering expected inflation?
- we model expected inflation assuming workers expect inflation over the year ahead to equal inflation last year (5%)
- at the next wage-setting round, HR takes into account that their employees expect prices to rise by 5%
- to achieve a real wage increase of 2% (the size of the bargaining gap), HR sets a nominal wage increase of 7%
- the marketing department will increase prices to compensate for the higher costs, and the rate of inflation continues to rise
- expected inflation increases each year as it is equal to inflation of the previous year which = expected inflation + bargaining gap
- inflation rate, pi t = gap t + piE but piE (expected inflation) is equal to the previous year’s inflation, so:
Pi t= gap t + pi t-1 - the Phillips curve shifts up because in the next period, expected inflation is equal to last period’s inflation
- this is the wage price spiral which explains why at low unemployment, inflation increases year after year
By combining aggregate demand and the supply side, how can we see how recessions and booms impact inflation?
Combining the WS-PS model and the multiplier model allows us to explain how the economy fluctuates around the supply-side equilibrium over the business cycle.
On the WS-PS diagram, the x axis is N (no. Of workers) and on the multiplier diagram, the x axis is output
By assuming output per worker = 1, so that Y=N, we can place the multiplier diagram below the WS-PS model so that their axes are the same
We start at supply side equilibrium where WS=PS and Y=AD.
During a boom, AD shifts up, the economy moves to higher employment where WS>PS and there is a positive bargaining gap so inflation is higher.
During a recession, AD shifts down, the economy moves to lower employment where PS>WS and there is a negative bargaining gap so inflation is lower
How does the business cycle model account for negative demand shocks?
- draw a Philips curve above an AD curve, again AD has output on the x axis and the Philips curve has employment
- Consider a fall in planned investment spending
- The AD curve shifts down, reducing the level of employment below the supply-side equilibrium
- There is cyclical unemployment and we assume low demand persists
- With higher unemployment, the HR departments can employ workers at a lower real wage, captured by the negative bargaining gap (-1%)
- Workers expect prices to rise by 3% as they did in the previous year but there is a -1% bargaining gap, so HR choose a 2% nominal wage increases, thus a 1% fall in real wage
- inflation falls from 3% to 2% (3%-1%) There is a leftward movement on the Phillips curve
- if the investment shock is expected to have a sustained impact on AD, workers will expect prices to rise by 2%, the Phillips curve will shift down and inflation will fall from 2% to 1%
- so long as demand remains low, the model predicts high cyclical unemployment and falling inflation as long as the negative bargaining gap persists and expected inflation falls, shifting the Phillips curve down
How does the business cycle model account for supply-side shocks?
- Here we keep the demand side of the economy constant, so the AD curve remains unchanged and hence output and employment do not change
- Consider that the government adopts protectionist policies making it more difficult for foreign firms to compete.
- Lower competition means firms can charge higher markups, shifting the PS curve downwards
- this creates a positive bargaining gap at the pre-existing level of employment on the WS-PS curve
- the reduction in competition enables firms to increase their prices by 2% on top of the 3% that covers the rise in wages
- so at each level of employment, inflation is 2% higher than before, so the Phillips curve shifts up by 2%
- the economy moves from 3% to 5% inflation
- prices increased by 5% while workers expected a 3% rise. The real wage reduced by 2%, at the initial employment level, the PS curve is blow the WS curve
- at the next wage setting round, expected inflation is 5% and the Phillips curve shifts again
- to motivate workers, HR need to raise the nominal wage by another 2% (to 7%)
