Modelling Inflation

Question 1

can we have both low inflation and low unemployment

Answer 1

no

politicians are more likely to be elected when either are low

Question 2

inflation

Answer 2

increase in the general price level

deflation is the opposite

Question 3

disinflation

Answer 3

decrease in the rate of inflation

Question 4

Fisher equation

Answer 4

real interest rate(r) = nominal interest rate(i) - inflation rate (pi)

nominal interest rate is rate quoted by banks

real interest rate is rate adjusted for inflation

Question 5

you lend 1000 for a year, nominal interest rate at 3.53%

Answer 5

you get 1000 x 1.0353
let pi = 1.5%

PV of repayment = 1035.5/(1+0.015) = 1020 today

therefore real interest rate = 2%

Question 6

Cons of inflation

Answer 6

• People on fixed nominal income (pensioners) higher inflation means lower real value of income
• inflation reduces the real value of debt

which is good for borrowers (eg govs with debts) but bad for creditors as opposed to the nominal interest rate inflation is only known at the time of repayment

• high rate of inflation makes economy work less well:
• High uncertainty: high inflation often volatile
• Noisy signal: harder for producers to distinguish between relative prices and inflation
• Menu costs: firms have to update their prices more frequently

Question 7

Whats wrong with deflation?

Answer 7

• when prices are falling, households will postpone consumption as they expect goods will be cheaper in future (similar negative shock to aggregate demand)
• deflation increases the real debt burden which may lead households to cut consumption to return to their target wealth (e.g Japan has faced persistent deflation, low growth and ageing population

Question 8

Pros of inflation (as long as it remains stable)

Answer 8

• process of innovation and change that characterises a dynamic economy means that workers in some firms and sectors may be more in demand than others
• with rising prices, a fall in real income among the losers masked by the fact that nominal incomes are rising
• with some low inflation, the adjustment of workers and resources between different firms and industries in response to changes in relative wages can take place without losers experiencing falling nominal wages
• gives monetary policy more room to manoeuvre

Question 9

Causes of inflation

Answer 9

• increases in bargaining power of firms over their consumers
• increases in bargaining power of workers over firms

Question 10

increases in bargaining power of firms over their consumers (lower competition, higher markup)

Answer 10

downward shift of price-setting curve

Question 11

increases in bargaining power or workers over firms (eg stronger unions)

Answer 11

upward shift of wage setting curve

unemployment falls

Question 12

Phillips curve

Answer 12

Inflation against employment

• higher employment may result in inflation
• increases workers bargaining position
• higher wages
• higher costs of production
• higher prices

Question 13

Wage-price spirals

Answer 13

real wage(w) = W(nominal wage)/P(price level)

• an upswing in business cycle is often associated with rising inflation
• higher aggregate demand
• higher employment
• higher wages (employees with higher bargaining power)
• higher costs of production
• higher prices
• price and wage inflation but the real wage hasnt increased
• constant real wage means that employment stays constant
• the wage-price spiral continues

Question 14

real wage against employment

Answer 14

initial equilibrium where WS and PS curves intersect

• when employment increases, the real wage require to make workers work hard increases so real wage rises

claims of workers for wages and owners for profits sum to more than labour productivity

• if employment decreases, workers are in a decreasing bargaining position

claims for workers and owners for profits sum to less than labour productivity - downward pressure on wages and prices

Question 15

Bargaining gap

Answer 15

= the difference between the real wage required to incentivise effort, and the real wage that gives firms enough profits to stay in business

= wage on WS curve - wage on PS curve divided by wage on PS curve

= (Wws - Wps)/Wps

Question 16

Bargaining gap and inflation

Answer 16

• if unemployment below equilibrium, there’s a positive bargaining gap and inflation
• if above equilibrium, negative bargaining gap and deflation
• at labour market equilibrium, bargaining gap is zero and the price-level is constant

bargaining gap leads to increase in wages, leads to increase in unit costs, leads to increase in prices and hence inflation

Question 17

Introducing a policymaker to inflation and employment tradeoffs

Answer 17

• indifference curves show the policymakers preferred tradeoffs between inflation and unemployment (MRS is the slope)
• the Phillips curve is the policymakers feasible set
• target inflation is around 2%
• above the target, indifference curves are positively sloped: getting employment closer to full employment is worth accepting above-target inflation
• below target, they’re negatively sloped: getting employment closer to full is worth accepting below target inflation
• when inflation and employment are lower, the indifference curves are steeper so policymaker more willing to accept inflation for employment
• when they are high, indifference curves are flat, so diminishing marginal returns
• indifference curve is horizontal when employment = labour supply (won’t accept inflation for employment)

Question 18

Can policymaker choose a point on the Phillips curve?

Answer 18

No as the curve moves over time

there’s always a temporary tradeoff between inflation and employment, no permanent one

Question 19

Why does the Phillips curve shift?

Answer 19

• labour market Nash equilibrium is the only unemployment rate which inflation is stable
• policymakers can’t push unemployment lower without risking rising inflation (Phillips curve not a stable feasible set)
• people are forward-looking - they take action now in anticipation of things - treat prices as messages, and changes in them as to what will happen in future

Question 20

Phillips curve can shift with shocks

Answer 20

Demand shock

• unexpected change in aggregate demand
• positive demand shock can reduce unemployment and increase inflation

Supply shock

• shocks in labour market shifting the PS or WS curve
• negative supply shock (eg oil shock) can increase unemployment and inflation

Question 21

Demand shocks - the role of expectations

Answer 21

effect of a boom = demand shock

take bargaining gap at 2% and expected inflation at 3%

• demand shock causes unemployment to reduce by 3% and inflation rate to increase by 2%
• inflation rate increases from 3 to 5%
• workers are unhappy as they expected a 2% real wage increase from their nominal pay rise of 5%
• Inflation = expected inflation + bargaining gap
• workers didn’t get this as firms raised prices by 5%
• expected inflation for next year now 5%
• if unemployment still low, wages must increase next year by 7%
• the Phillips curve has shifted up because expected inflation has increased

Question 22

Inflation path over time

Answer 22

• if unemployment remains below the inflation stabilising rate, inflation rises in each period because the previous periods inflation feeds into expected inflation and therefor wage and price inflation
• as long as bargaining gap remains unchanged, inflation rises each year and real wage doesn’t change

Question 23

Supply shocks

Answer 23

• oil price increases and shifts the PS curve down

inputs for firms = capital goods, labour, imported materials (oil)

Question 24

Output per worker equation

Answer 24

= wage + profit per worker + imported material costs per worker

= value added per worker + imported materials costs per worker

without imports, value added per worker = output per worker

Question 25

Markup (mew)

Answer 25

= share of price that represents profits to the firm

= (P - unit cost)/P

costs include both labour and imported material

unit cost = unit labour cost (ulc) + imported material costs (imc)

Question 26

Markup equation expanded

Answer 26

unit labour costs depend on wages and output

ulc = w/q. where q = output per worker

mew = (P-umc-imc)/P = 1 - imc/P - ulc/P

thus, mew = 1 - imc/P - (w/q)/P

after an oil shock, imc goes up, so PS curve goes down

• without imports: w/P = lamda(1 - mew)

Question 27

Inflation, unemployment and supply shocks

Answer 27

• Inflation goes up
• firms increase prices to compensate for higher costs
• if employment unchanged, bargaining gap of 2%
• inflation increases from its pre-existing by 2% and expected inflation adjusts
• the Phillips curve shifts up
• unemployment goes up
• as long as employment remains at pre-oil shock level, inflation will increase every period
• eventually, new labour market equilibrium with higher employment

so as expected, recession with rise in both unemployment and inflation: staglation

Question 28

How can we reduce inflation?

Answer 28

• a reduce in the bargaining gap

if employment below equilibrium, inflation falls

• a fall in expected inflation: role of the central banks

Question 29

Cost of disinflation

Answer 29

• costly in terms of unemployment
• not bringing down high inflation can be even more costly
  e. g hyperinflation in Germany after WWI