Theme 2: The UK economy – performance and policies Flashcards
What is GDP
value of all newly produced final goods and services produced in an economy within a given time period
How is economic growth measured by rates
It is measured by rates of change of real GDP
What is a real value
a value without the effect of inflation
What is a nominal value
A value with the effect of inflation
What is the difference between total and per capital values
total is the total some
per capita is total/population
How can real and nominal values be described as
Real values can be described as the volume of national income i.e. the size of the basket of goods
nominal values represent the value of the national income i.e. the monetary cost of this basket of goods
What is GNI (Gross National Income)
GDP + net overseas intrest payments/ dividends
adds what a country earns from overseas investments and subtracts what foreigners earn in a country and send back home from the GDP
How do we make comparisons about growth over time and between countries
Data is compared to other countries to put figures in context while using real,per capita figure
What is Purchasing Power Parities (PPP)
the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries’ currencies.
e.g. the exchange rate needed for say $100 to buy the same quantity of products in each country
What is PPP useful for
Comparing countries as it takes into account the cost of living
For example, in Kenya £2 a day in their own currency is enough to survive on, whilst it isn’t in the UK.
What are some of the problems of using GDP to compare standard of living
- inaccuracy of data; inaccuracy of collecting data, diifferent methods, black market
- Inequality; growth in gdp doesnt equal higher living standards
- Quality of g/s; may cause lower price
- different currencies
- Spending: some types of expenditure such as defence doesn’t increase standard of living but will increase GDP
What is the Easterlin Paradox
if you are poor and your income increases, you will be happier, but higher levels of income aren’t associated with increases in happiness
How does income and happiness depend on the people around you
if you are the richest out of everyone you associate yourself with, then you will be happier than someone who has the exact same income but is the poorest out of everyone they associate with
What is inflation
general progressive increase in prices of goods and services in an economy
What is deflation
decrease in the general price level of goods and services
What is disinflation
decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation’s gross domestic product over time
What measure is used in the UK to measure inflation
Consumer Price Index (CPI)
How is the CPI calculated
- A representative shopping basket is created each year
- government officials collect 120,000 separate price quotations in 141 locations of around 600 products
- average household spending is worked out through the Living Costs and Food Survey, where around 5,500 families keep diaries of what they spend over a fortnight.
- the weighted price changes are then totalled to calculate the inflation rate
What are the limitations of the CPI
- not fully representative
- doesnt include housing
- overstimation as improved quality of goods led to price increase
- Hard to respond to new products
How is the RPI different to the CPI
● RPI includes housing costs such as mortgage and interest payments and council tax
● CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore, the CPI is generally lower than the RPI.
● RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes.
How is the RPI different to the CPI
● RPI includes housing costs such as mortgage and interest payments and council tax
● CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore, the CPI is generally lower than the RPI.
● RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes.
What are the 4 main causes of inflation
- cost push inflation
-
demand pull inflation
-
growth of money inflation
expectations
-
growth of money inflation
Draw a diagram (using AD-AS) for the growth of an economy
- expansion of AS and AD
- Leads to expansion of LAS
What is cost push inflation and draw a diagram
When businesses find their costs have risen (decrease in AS) , they will put up prices to maintain their profit margins
caused by anything that reduces AS e.g. increase in tax, depreciation in exchange rate, rising wages
What is demand pull inflation
caused by an unsustainable rate of increase in aggregate demand (AD) leading to a positive output gap (actual GDP> potential)
when the economy is close to full capacity
What is growth of money supply inflation
there being too much money in the economy. If people have access to money they will want to spend it but if there is no increase in the amount of goods and services supplied, then prices will have to rise.
What is the effect of inflation on consumers
- Less to spend = fall in living standards
- Those in debt will be able to pay it off cheaper, but inverse for those who are owed. Consumers who have saved will see their money is worth less
- Psychological effects on consumers of price rising
What is the effect of inflation on firms
- If inflation in Britain is higher than other countries, British goods will be more expensive and less competitive
- Have to calculate new prices
What is the effect of inflation on governments
- If government fails to change excise taxes in line with inflation then government real revenue will fall
- However, if they fail to change personal income tax allowances (the amount a worker can earn tax free) then real government income will increase and taxpayers will have less money
How does inflation effect workers
- If workers do not recieve yearly pay rises of inflation
How can some effects of inflation be anticipated
indecation - wages increased in line with predicted inflation
however this can make it difficult to control inflation by the government
What are the demand-side causes of deflation
-
Deep fall in AD causing a persistent recession / depression
- Large negative output gap – i.e. high level of spare capacity
What are the supply-side causes of deflation
- Improved productivity
- Technological advances
-
Significant fall in wage rates
- High exchange rate causing import prices to fall
What are the consequences of price deflation
- Holding back on consumer spending
- real value of debt rises with deflation
- The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.
- Lower profit margin so reduced revenue
- Deflation can make exporters more competitive
What are the economic policies to avoid deflation
Low interest rates and quantitative easing
-
Other measures to stimulate aggregate demand
- Attempts to lower the value of the exchange rate (perhaps via central bank intervention to sell their currency in the market)
- Higher taxes on savings to encourage consumption
What are the main measures of unemployment
- Claimant count
- the International Labour Organisation (ILO) and the UK Labour Force Survey
What is the claimant count
number of people receiving benefits for being unemployed provided on a monthly basis
What is the labour force survey (LFS)
sample of people living in households and asking questions about personal circumstances to class people as employed, unemployed, or inactive according to the ILO definitions
What are the comparisons between the LFS and the Claimant Count
- some people arent elligble for benefits but are classed as unemplyoed so LFS is typically higher
- both seen as underestimating as they don’t recognise the hidden unemployed
What is the hidden unemployed
- working part time but would like to work full time
- on government training schemes who would prefer employment
- classed as sick or disabled
- who aren’t actively looking for jobs but would take a job if offered or are in education because they can’t get a job
What is unemployment and employment rate
employment rate is the percentage of the population of working age who are employed, and the unemployment rate is the percentage of the economically active who are unemployed.
What are the activity and inactivity rates
activity/participation rate is the percentage of the population of working age who are economically active whilst the inactivity rate is percentage of the population of working age who are inactive
What is under-employment
- underemployed are those who are in part time or zero hour contracts when they would prefer to be full time and people who are self-employed but would rather be employees.
- It also includes those who are in jobs which do not reflect their skill level
What is the effect of changes in inactivity
● Increases in inactivity will decrease the size of the labour force, therefore causing a fall in productive potential of the country . There will be a lower GDP and lower tax revenues as less people are working.
● However, decreases in inactivity could just result in more people being unemployed if there are no jobs available to them.
What is Frictional Unemployment
- People moving between jobs
- Isn’t serious and mostly short term
What is seasonal unemployment and what can be done to prevent it?
- Employment that is strongly seasonal in demand, requiring large numbers of people at specific times
-
Little can be done to prevent this in a free market economy
*
What is cyclical unemployment
- Unemployment due to a general lack of demand, also known as a Keynesian ‘demand deficient’ unemploymenyt
- Falls in demand, lowers profits and forces business to cut unemployment in order to control costs
What is real wage inflexibility
- Unemployment due to real wages being above their market clearing level which creates an excess supply of labour
- Caused by minimum wages and unemplyed workers refusing to take low paid jobs because of welfare benefits
What is structural unemployment
a mismatch of skills between the unemployed and available jobs
What are some causes of structural unemployment
- Decline of manufacturing….loss of skilled jobs (e.g. car industry in Birmingham)
- Occupational immobility…people with a lifetime of skills in the shipbuilding industry would find it difficult learning computer skills.
- Geographical immobility….people may be unable to move due to housing costs or unwilling due to family ties.
- Long term regional decline…certain parts of Britain have experienced decline (e.g. South Wales)
-
Foreign competition – rising imports
- Outsourcing of production overseas…relocation of the textile industry from Yorkshire to the Far East.
What are the 3 types of structural unemployment
- Regional unemployment is where certain areas of a country suffer from very low levels of employment due to industry closures
- Sectoral unemployment is where one sector (primary, secondary and tertiary) suffers a dramatic fall in employment.
- Technological unemployment is where an improvement in technology means that jobs are replaced.
What are some labour scarring effects from high unemployment
- Loss of work experience
-
Loss of current/future income
- changing pattern of jobs in the economy
What are some policies to increase demand for jobs
- Infastructure investment projects
- Financial support for apprenticeships
- Entreprise policies to life the rate of new business start ups
How to reduce occupational immobility
- Funding apprenticeships and training programmes
- improving interregional links
How to reduce geographical immobility
- Rise in house-building will help to keep property prices lower and encourage more affordable rents
- Active regional policy to create new jobs and businesses
- enterprise zones
What is the impact of unemployment on Firms
● There will tend to be a decrease in demand for their goods (but this depends on the YED) and so this could lead to a fall in profit.
● Long term unemployment can lead to loss of skills and reduce employability of workers, so firms have a smaller pool of skilled people to employ.
● They can offer low wages as people will take the job anyway because they know there is a lack of jobs so have few options.
What is the effect of unemployment on consumers
● Consumers suffer from less choice. The quality of goods may also decrease.
● The unemployed consumers lose out as they have less available to spend.
● However, firms may lower prices and put on sales in order to increase demand for their product.
What is the effect of unemployment on the government
● The reduced income results in a fall in tax revenues and higher spending on welfare payments for families with people out of work, incurring an opportunity cost as the money could be better spent elsewhere.
● This will result in an increase in the budget deficit. It will be likely that the government will have to raise taxation or scale back plans for public spending on public and merit goods, such as the NHS or education. They may need to increase borrowing.
What is the effect of unemployment on society as a whole
● Rising unemployment is linked to social deprivation. There is a relationship with crime and social dislocation
● It results in a loss of potential national output and represents an inefficient use of scarce resources. If people chose to leave the labour market permanently, then this will have a negative effect on LRAS
.● Taxpayers paying money to the unemployed is not a loss for the economy as it is a transfer payment but the economy is affected because there is a fall in national output and the social costs of the unemployed e.g. violence and crime.
What is the effect of unemployment on society as a whole
● Rising unemployment is linked to social deprivation. There is a relationship with crime and social dislocation
● It results in a loss of potential national output and represents an inefficient use of scarce resources. If people chose to leave the labour market permanently, then this will have a negative effect on LRAS
.● Taxpayers paying money to the unemployed is not a loss for the economy as it is a transfer payment but the economy is affected because there is a fall in national output and the social costs of the unemployed e.g. violence and crime.
What is the effect of migration on jobs
- Leads to increased jobs due to a circular flow of income
- Also leads to lower wages due to higher competition; people with low motivation and low skill are most affected
- Fill in shortages where skilled labour is needed
What are the 4 components of the Balance of Payments Accounts
- Current Account
- Financial Account
- Capital Account
- Balancing Item
What is the current account made up of
- Balance of trade in goods
- Balance of trade in services
- Net primary income (interest, profits, dividends and migrant remittances)
- Net secondary income (transfers i.e. contributions to EU, military aid, overseas aid)
What is the capital account
- Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts (example would be international buying and selling of land by businesses)
- Debt forgiveness/cancellation (forgiving debt counted as a negative)
- Capital transfers of ownership of fixed assets (i.e. international death duties)
What is the financial account
- includes transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-residents
- Net balance of foreign direct investment flows (FDI)
- Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity)
- Balance of banking flows (e.g. hot money flowing in/out of banking system)
- Changes to the value of reserves of gold and foreign currency
What is the balancing item
it gets rid of estimated errors and omissions to get the BOP=0
In a floating exchange rate what is the demand for curreny and BOP equivalent to
- demand = supply for currency
- BOP=0
Why is the BOP=0
- If there is a deficit on the current account there will be a surplus on the financial account
If there was an increase in interest rates this would cause hot money flows to enter the UK
What are key causes of Current Account Defecit
- Poor price and non-price competitiveness
- Strong exchange rate affecting demand for exports and imports
- High currency value increases prices of exports
- Appreciating currency also makes imports cheaper
- Recession in one or more major trade partner countries
- Volatile global prices (e.g. soft and hard commodities)
Conseqeuences of a current account defecit
- Loss of aggregate demand if there is a trade deficit (M>X) which causes weaker real GDP
- cause the currency to depreciate
- a loss of investor confidence, leading to capital flight
- Need to cut spending in the future. For example, during 2012-16, many countries in the Eurozone sought to reduce their budget deficit to comply with EU rules.
- Opportunity cost of debt interest payments.
- Potential rise in bond yields. may struggle to attract sufficient investors to buy bonds. If this happens, bond yields will rise causing the deficit to be more expensive to finance.
Reasons to not worry about current account defecit
- If financed by long-term capital inflows, it can increase the productive capacity
- In globalisation, it is easy to attract sufficient capital flows
- If defecit gets too large it will cause a devaluation which helps reduce the defecit
- Provides an outlet for domestic demand and prevent inflation
How can a current account defecit be financed
The financing of a deficit is achieved by:
- Selling reserves ( gold/ forex )
- Borrowing
- FDI
- Hot Money Flows
What are the causes of a current account surplus
- A large and persistent surplus of savings (S) over investment (I) for households, firms and the government.
- A large gap between exports (X) and imports (M), when net income balance and net transfers are small
- An export surplus may be the result of very high prices for exports of commodities such as oil and gas.
Consequences of a Current Account Surplus
- A surplus on the current account would allow a deficit to be run on the capital account e.g. surplus foreign currency can be used to fund investment in assets located overseas
- Current account surplus countries nearly always have fairly strong exchange rates as a result
What is the defintion of AD
Total level of planned real expenditure on the goods and services produced within a country
What are the components of Aggregate Demand
AD = C + I + G + (X-M)
What are the 4 reasons why the AD slopes downwards
- The Wealth Effect
- The Interest-Rate Effect
- The Exchange Rate Effect
- Real Balance Effect
What is the Wealth Effect
Price Level falls –> purchasing power increases –> higher consumption –> higher AD
What is the Interest-Rate Effect
Price Level falls –> More disposable income –> rise in loanable funds supply –> fall in interest rates –> lower cost of borrowing –> more investment in economy
(price of loanable funds is the real IR)
What is the Exchange-Rate Effect
fall in price level –> domestic goods cheaper –> more exports and less imports –> (X-M) increases so AD increases
What is the Real Balance Effect
Rise in prices –> savings have less value –> savings offer less security –> People will want to save more –> Fall in consumption so fall in AD
What is the difference between a shift in AD and a movement along AD
- Movement along the AD is caused by a change in prices (inflation/deflation)
- A shift of the AD is caused by any other variable independent of the price level
What is the marginal propsenity to consume
how much an increase in income affect consumption
Is MPC higher among the rich or poor
Poor tend to have a higher MPC
What is the relationship between savings and consumption
- Savings is what is not spent out of income
- An increase is consumption decreases savings
What are the 5 main influences on consumption
- Interest Rates
- Consumer Confidence
- Wealth Effects
- Distribution of Income
- Tastes and attitudes
How do interest rates influence consumer spending
- Major expenditures are bought on credit
- Interest rates affect the cost of credit
- High IR increase mortgage repayments
- Also decreases value of shares; as the MES compared to Treasury is smaller
How does consumer confidence influence consumer spending
- Confidence in the future increases spending.
- Lack of confidence increases savings
- Consumers might also expect higher prices and rush stores or factor in higher taxation (Ricardian Equivalence)
What is the Ricardian Equivalence
consumers anticipate the future so if they receive a tax cut financed by government borrowing they anticipate future taxes will rise. Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged.
What are the problems with the Ricardian Equivalence
- Consumers are not rational
- Consumers do spend at least some of the tax cuts
- Tax cuts can boost growth and diminish borrowing requirements for governments
- Multiplier Effect
What are the problems with the Ricardian Equivalence
- Consumers are not rational
- Consumers do spend at least some of the tax cuts
- Tax cuts can boost growth and diminish borrowing requirements for governments
- Multiplier Effect
How do wealth effects affect consumer spending
Greater wealth improves a consumer’s confidence and thus leads to greater spending
e.g. a higher house prices means a consumer can borrow more on the house. higher share prices mean some can be sold
How does the distribution of income affect consumer spending
If money is moved from the rich to the poor, consumption is likely to increase as the poor have a higher MPC.
How do tastes and attitudes affect consumer spending
a strong materialistic drive that encourages people to have the newest and the best and therefore spending can be very high, in some cases even above income. If people were less materialistic, consumption would decrease.
Define investment
the addition of capital stock to the economy
What is the difference between net and gross investment
Gross Investment - amount of investment carried out and ignores the level of depreciation
Net Investment - Gross Investment minus the value of the depreciation
`
What are the 6 main influences on investment
- Rate of economic growth
- Business expectations and confidence
- Interest Rates
- Access to Credit
- Retained profit
- Technological Change
How does the rate of economic growth influence investment
- A growing economy spurs on confidence hence investment
What is Investment a derived demand of
Confidence
How does Animal Spirits affect investment
Confidence makes Buisnesses want to preapre for the future
How do Interest Rates affect investment
- High IR increase the cost of borrowing
- Therefore the marginal efficiency of capital needs to be more attractive
What does Keynes’ Marginal Efficiency of Captial graph show
displays the expected rate of return from an investment at a particular given time. If interest rate is at 10% then firms need an expected rate of return which is at least equal to 10% to make it worthwhile.
How does access to credit affect investment
- High Risk investments mean less access to credit
- Recessions can make credit harder to acces with a risk awareness premium
How does retained profit affect investment
- Higher retained profit makes investment more attractive due to the opportunity cost of keeping it
What is the evaluation for the factors that affect investment
- Time Lags
If a firm has started a project a rise in IR is unlikley to change the decisions but can impact future projects and decisions
- Magnitude of Other Factors
IR can be outweighed by economic conditions
e.g. 2009 IR 5% –> 0.5% but investment still fell because of the deep recession and unwillingnes to lend (liquidity trap)
What is the accelerator effect
Suggests that capital investment is a function of output
An increase in demand and output, investment will rise to meet the expected demand
What are the 3 main influences on government spending
- The Trade Cycle
- Fiscal Policy
- Age distribution of the population
How does the trade cycle influence government spending
- Decisions made to manage AD and thus regulate trade cycle
- Automatic stabilisers cause Government spending to rise in recession
What are automatic stabilisers
An automatic way to blunt off the worst extremes in the economic cycles and buy time for discretionary government policy
What are 2 examples of automatic stabilisers
- Welfare Benefits
In Recession Government spending automatically increases through transfer payments, this increases AD
- Progressive Income Tax
in a Boom, Higher incomes makes workers be pushed into another tax band so tax regulates AD
How does fiscal policy influence government spending
- Level of government spending is dependent on what is laid out in the fiscal policy
How does the age distribution of the population affect government spending
- An ageing population leads to increased government expenditure on pensions, social care
- A young population leades to an increased spending on education
What is crowding out
a process where an increase in government spending
leads to a fall in private sector spending.
What is financial crowding out
If the government increases it’s spending – say through selling bonds – The demand for money will increase, which, ceteris paribus, raises interest rates.
At higher interest rates, both consumer spending and investment spending are likely to fall.
The aggregate effect on the economy is that financial resources are diverted from private firms to be used by the public sector.
How does financial crowding out lead to a fall in GDP
Initially, via a multiplier effect, national income increases, but as a result of the government selling securities in the financial markets, the demand for scarce loanable funds increases.
This drives up interest rates, which causes a contraction in the demand by the
private sector for investment goods (capital) as well as reducing the demand for
consumer goods. This, in turn, leads to a fall in GDP.
Draw the Keynesian LRAS
What does the Keynsian LRAS agree with at point B
It is vertical as with the classical view; this is the PPF
When there is high unemployment (anything under A) what do firms do
They do have to offer high wages to attract staff as the LRAS is perfectly elastic at this point
What happens between points A and B on the Keynsian LRAS
Labour becomes scarcer so firms have to offer higher wages
These higher wages lead to a higher average price level.
Output becomes more price inelastic until it reaches point B, where an increase in prices no longer affects output as the PPF has been reached.
Portray +ve and -ve output gaps using a classical LRAS diagram
In the diagram, there is an equilibrium where AD=SRAS=LRAS. However, at AD1 , there is a negative output gap because the SRAS equilibrium is less than the LRAS equilibrium, so the full capacity of the economy is not being met. At AD2 , there is a positive output gap as SRAS is higher than LRAS.
How would a classical economist argue these output gaps would be fixed
Classical economists would argue that this positive output gap would be filled by long-run economic growth moving the LRAS curve, a recession which would decrease AD or a rise in the costs of production which would decrease SRAS. They would also argue that the negative output gap would be brought back to equilibrium by rising AD or a fall in SRAS due to lower costs of production.
What does this diagram show
The economy returns to Yf (full employment/equilibrium) following a period of deflation. There was no need to intervene justifying a laissez faire approach.
What is an example of a paradox of thrift
High savings ratio in 2008 contributed to recession
Draw and explain effects of a positive output gap
· R.GDP is now above trend and this can occur because with the rising demand firms will offer overtime/stay open longer etc.
· However this puts upward pressure on the price level (demand pull) and cost push. WHY?
· The SRAS curve now shifts in as COP rises. (please draw SRAS2)
· The economy returns to YFE but now at a higher price level (inflation)
There may be an increase in inflationary expectations also (why?)
What does this diagram show
Fiscal Policy + Multiplier can lead to demand push inflation
What are Growth Pessemists
What is the supply-side effect of decreasing coporation tax
This should create the incentive to invest. As well as influencing AD, the SRAS will be influenced through greater productivity and LRAS increases through increased productive capacity.
What is the Laffer Curve
The Laffer Curve states that if tax rates are increased above a certain level, then tax revenues can actually fall because higher tax rates discourage people from working.
Equally, the Laffer Curve states that cutting taxes could, in theory, lead to higher tax revenues.
Equally increasing tax rates could yield lower tax revenue due to decreased economic activity, incentives to evade and avoid, brain drain effect
Explain this diagram
Fiscal policy is cumbersome and can overshoot targets.
If the negative output gap is less than expected and or the multiplier stronger than expected a negative output gap could turn positive leading to inflationary expectations.
Monetarists believe that expansionary FP is essentially inflationary.
Why is context so key to fiscal policy
· A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity (e.g. AD3 to AD4), then the increased government borrowing is likely to cause crowding out and/or contribute to higher inflation – but little increase in real GDP.
In a deep recession, with spare capacity in the economy, expansionary fiscal policy won’t cause crowding out or inflation. (AD1 to AD2 causes real GDP to rise from Y1 to Y2.)
What are the benefits of supply-side policies
- Lower inflation.
-
Lower unemployment; help reduce structural,
frictional and real wage unemployment. - Improved economic growth.
- Improved trade and balance of payments. By making firms more
competitive, they will be able to export more.
What are the general limitations of supply-side policy
- Productivity growth depends largely on private enterprise and trends in technological innovation
- Market Based: equity
- Can be counterproductive
e.g. Since 2009, UK has seen a fall in structural unemployment due to more flexible labour markets- but productivity is almost stagnant - In a recession, supply side policies cannot tackle the fundamental problem which is lack of aggregate demand
- Time. All supply side policies take a long time to have an effect e,g, education spending may not influence the economy for 20-30 years
- Expensive –> large opportunity cost
- Government failure due to assymetric information
What is the policy conflict between inflation and unemployment
Phillips found the existence of an empirical regularity, which said that the rate of change in money wages increased as the rate of unemployment fell. This was then generalised into a relationship
between unemployment and inflation
e.g. Lawson Boom, 1989 2.3% GDP Growth, 7.8% inflation
Evaluate the policy of inflation and unemployment
However, during the 1970s , we saw high levels of unemployment
and low inflation, called stagflation; short-run relationship not right
The Great Moderation 1993-2007, had a long period of economic expansion (36 consecutive quarters)
Relationship has returned to the long-run position
What is the monetarist view of the Phillips curve
argue that in the long run there is no trade-off as Long Run AS is inelastic.
Monetarists argue that if there is an increase in aggregate demand, then workers demand higher nominal wages. When they receive higher nominal wages, they work longer hours because they feel real wages have increased.
but when they realise real wages are the same as last year, they change their price expectations, and no longer supply extra labour and the real output returns to its original level.
Therefore, unemployment remains unchanged, but we have a higher inflation rate. The short-run Phillips curve shifts upwards to SRPC 2
