The real wage that employees care about is their nominal wage relative to the economy-wide level of prices, and is defined as: It is the real wage on the vertical axis in the labour market diagram in Question 15.4. When unemployment is above equilibrium it leads to downwards pressure on wages and prices, or a declining wage-price spiral. The opportunity cost of the loan is the goods you have to give up, not the money you have to give up. During the expansion phase, the economy experiences relatively rapid growth, interest rates tend to be low, production increases, and inflationary pressures build. Euros became cheaper relative to the GBP over the year, so goods imported from Europe also became cheaper. Figure 15.3 While there is no evidence that moderate inflation is bad for the economy, when inflation is high it is often also volatile and therefore hard to predict. In Unit 13 we saw that unemployment undermines our wellbeing, but inflation worries us too. There is an inflation-stabilizing rate of unemployment, and a wage-price inflation spiral develops if unemployment is kept lower than this. This is far from the case! Under the policy of inflation targeting, whenever the economy was experiencing lower unemployment than the inflation-stabilizing rate (moving to the northeast on a Phillips curve and on to a less favourable indifference curve), the central bank would raise the interest rate and dampen aggregate demand. It explains why, at low unemployment, the price level rises, not just in the year that unemployment fell, but year after year. Making the central bank independent, with an explicit inflation target, makes it easier for the central bank to resist political pressure. Looking backward: Baristas and bread markets, 10.2 Borrowing: Bringing consumption forward in time, 10.3 Impatience and the diminishing marginal returns to consumption, 10.4 Borrowing allows smoothing by bringing consumption to the present, 10.5 Lending and storing: Smoothing and moving consumption to the future, 10.6 Investing: Another way to move consumption to the future, 10.9 The central bank, the money market, and interest rates, 10.10 The business of banking and bank balance sheets, 10.11 The central bank’s policy rate can affect spending, 10.12 Credit market constraints: A principal–agent problem, 10.13 Inequality: Lenders, borrowers, and those excluded from credit markets, 11—Rent-seeking, price-setting, and market dynamics, 11.1 How people changing prices to gain rents can lead to a market equilibrium, 11.2 How market organization can influence prices, 11.4 Prices, rent-seeking, and market dynamics at work: Oil prices, 11.6 Changing supply and demand for financial assets, 11.9 Non-clearing markets: Rationing, queuing, and secondary markets, 12—Markets, efficiency, and public policy, 12.1 Market failure: External effects of pollution, 12.3 External effects: Policies and income distribution, 12.4 Property rights, contracts, and market failures, 12.6 Missing markets: Insurance and lemons, 12.7 Incomplete contracts and external effects in credit markets, 12.9 Market failure and government policy, 13—Economic fluctuations and unemployment, 13.2 Output growth and changes in unemployment, 13.4 Measuring the aggregate economy: The components of GDP, 13.5 How households cope with fluctuations, 14.1 The transmission of shocks: The multiplier process, 14.3 Household target wealth, collateral, and consumption spending, 14.5 The multiplier model: Including the government and net exports, 14.6 Fiscal policy: How governments can dampen and amplify fluctuations, 14.7 The multiplier and economic policymaking, 14.9 Fiscal policy and the rest of the world, 15—Inflation, unemployment, and monetary policy, 15.2 Inflation results from conflicting and inconsistent claims on output, 15.3 Inflation, the business cycle, and the Phillips curve, 15.4 Inflation and unemployment: Constraints and preferences. ‘The Role of Monetary Policy’. Since many voters will prefer lower unemployment even if it comes with higher inflation, as we saw in Section 15.1, how can central banks credibly commit not to deviate from their announced inflation target? The economy moves back along the Phillips curve to point C. The 25 years before the global financial crisis in 2008 came to be known as the great moderation. The Phillips curve shifts up year by year. To complete the picture, we include the multiplier model beneath the labour market and Phillips diagrams to bring the short- and medium-run models together. The Phillips curve and the policymaker’s preferences. If you provide a similar 9% to 28% discount to the 10-year bond yield to come up with a safe withdrawal rate back in 1998, then the safe withdrawal rate in 2021+ is equal to 10-year bond yield X 72% – 90%. We now explain why the Phillips curve shifts: why does inflation keep rising when governments try to keep unemployment too low? If the exchange rate of the Australian dollar then depreciates to 1.25, what happens to the price of exports and imports of T-shirts in Australia? Living standards, as measured by GDP per capita, went from less than one-fifth of the level in the US in 1950 to more than 70% by 1980. But it also helps to explain the role that high unemployment played in bringing inflation down. Explain why a negative bargaining gap arises. Finally it calculates the nominal policy rate. This shifts aggregate demand down. Which point on the Phillips curve would this policymaker choose? We can also see that when prices are expected to fall over the year ahead—that is, expected inflation is negative, or deflation is expected—it raises the real interest rate above the nominal interest rate. A peak refers to the pinnacle point of economic growth in a business cycle before the market enters into a period of contraction. Austrian economists argue that the manipulation of credit and interest rates by the central bank creates unsustainable distortions in the structure of relationships between industries and businesses which are corrected during a recession. When explaining the process of inflation, economists often simplify by setting aside changes in the degree of competition so as to focus on the ways that increasing costs contribute to price increases. The central bank will try to achieve the inflation-stabilizing unemployment rate of 6%, as this is the labour market equilibrium. The real interest rates for the four periods are: 3.4%, 2.3%, 1.8%, and –0.4% respectively. The figure shows the inflation and unemployment combinations for the US for each year between 1960 and 2014. When the cycle hits the downturn, a central bank can lower interest rates or implement expansionary monetary policy to boost spending and investment. Consider an aggregate demand shock that increases unemployment. Now, where we have inputs other than labour, we define q as the units of output per worker, which is not the same thing as labour productivity because output now exceeds value added by the value of imported inputs. There is a strong negative correlation between the two variables. Figure 15.9 Remember that for the bargaining gap to be negative, unemployment has to rise above the new higher inflation-stabilizing unemployment rate. Figure 15.20 When, for whatever reason, business sentiment turns gloomy and investment slows, a self-fulfilling loop of economic malaise can result. A rise in the oil price creates a bargaining gap and triggers a wage-price spiral through its effect on the price level. At a higher level of aggregate demand (a boom), there is a positive bargaining gap and inflation is positive. In Figure 15.4a, it is only at point (A), where the real wage on the wage-setting curve coincides with the real wage on the price-setting curve, that the labour market is at a Nash equilibrium. The economy moves to a situation with higher unemployment and lower inflation (from point C to point D). In that example, owners of firms in the home economy became more powerful because the government adopted policies that made it more difficult for foreign firms to enter the economy. For example, when the Reserve Bank of Australia reduces the interest rate, there is less demand for three-month or ten-year Australian government bonds. In this example, a bargaining gap of 2% opens up between the wage-setting curve and the post-shock price-setting curve. For example, due to a business cycle upswing (short- to medium-run effect). As long as the bargaining gap remains unchanged, inflation rises each year. As we saw at the end of Section 15.1, the policymaker is likely to prefer low (stable) inflation to zero. 15.5 What happened to the Phillips curve? Stagflation is my best guess for the future, where the economy grows only 1-1.5% over the next decade, yet real prices go up 3-6% on things we need, not manipulated hedonic CPI smoke and mirror equations that fool a majority of people into thinking everyone else is doing just fine, and they just need to work harder to catch up. Sarwat Jahan. Expansion is the phase of the business cycle where real GDP grows for two or more consecutive quarters, moving from a trough to a peak. Therefore the central bank should lower interest rate to put upward pressure on inflation, in order to bring it back up to the target rate. Note that the real wage does not change, but remains on the price-setting curve. We can summarize the causal chain from the last period’s inflation rate to this period’s inflation rate like this: We can show the data in the table in Figure 15.8 and in the Phillips curve and labour market diagrams in Figure 15.9. Fiscal policy is complicated to adjust and inflexible. Figure 15.21 depicts the Phillips curve and the indifference curves of an economy. It is important to remember that it is the real interest rate that affects spending. The following diagram depicts the model of the labour market: Suppose now that the government adopts policies that make it difficult for foreign firms to enter its markets. Julia the borrower and Marco the lender (in Unit 10) have a conflict about the interest rate at which Julia borrows. There is a new labour market equilibrium at B with higher unemployment. They do not give a complete recipe for effective stabilization. Based on this information, which of the following statements are correct? Factors such as … If U is below 3%, then there would be an even larger positive bargaining gap than with U = 3 and even higher inflation. Deflation leads the economy out of recession . Similarly, a wage-price spiral can begin if the power of employees increases relative to owners—as would be the case if trade unions become more powerful and exercise that power to achieve higher wage increases from the HR department. Since 1966 unemployment had been steady, averaging 3.7%, but inflation had increased from 3.0% to 4.2%. Draw the Phillips curves and write a brief explanation of your findings. If we want to know μ in this case, we ask what the extra $0.30 is as a share of the total price, rather than as a share of the cost. 1991. Another way to say this: more inflation is the opportunity cost of lower unemployment, and more unemployment is the opportunity cost of less inflation. An increase in the unemployment level along a given wage-setting curve results in a fall in the real wage required to motivate to work, to below the price-setting curve. In his presidential address to the American Economic Association in December 1967, Milton Friedman provided an explanation for why the Phillips curve is not stable. The expectations and asset price effects will shift the investment function as we saw in Figure 14.5, and the consumption function, by changing c₀ (Figure 14.11a). This happened in Japan. If you are a lender, what you really want to know is how many goods you will get in the future in exchange for the goods you don’t consume now. At the level of the economy as a whole, the national pie to be divided between owners and employees shrinks when more has to be paid for imports. With the unemployment rate stable at 3%, the bargaining gap remains at 2%. In the 1960s, the Phillips curve suggests a trade-off of a 2% fall in the unemployment rate and a 2–3% rise in the inflation rate. Japan experienced a persistent period of disinflation between 2010 and 2013. Identify some evidence (for example, data or commentary in the economics press) that is consistent with the hypothesis proposed. Before doing so, we need to recall how monetary policy affects the economy. They lose nothing by raising prices in these conditions. However this also means that a relatively large fall in the unemployment rate is associated with only a small rise in the inflation rate. a fall of 6.1%. This is also why economies that were badly hit by the global financial crisis introduced a new kind of monetary policy called quantitative easing (QE). Fiscal policy uses government spending and tax policies to influence macroeconomic conditions, including aggregate demand, employment, and inflation. Explain your answers. During times of contraction, investors look to purchase companies that thrive during recessions such as utilities, financials, and healthcare. Based on this information, which of the following statements are correct? But at the same time, the real saving necessary to finance these investments gets suppressed by the artificially low rates. Assuming m remains constant, the percentage change in the price is equal to the percentage change in total unit costs: We now divide both the numerator and the denominator of the first term on the right hand side by umc, and the second term by ulc: In words, the percentage change in P is equal to the percentage change in umc times umc’s share of unit costs, plus the percentage change in ulc times ulc’s share of unit costs. The following table shows the annual inflation rate (the GDP deflator) of Japan, the UK, China and Nauru in the period 2010–2013 (Source, World Bank): Based on this information, which of the following statements is correct? We looked at how shifts in demand or supply for a good resulted in a change in its price relative to other goods and services, and how this signalled a change in the relative scarcity of the good or service. If an aggregate demand shock reduces unemployment below 6%, inflation rises along the Phillips curve. In the boom shown, the upward shift in the aggregate demand curve reduces the unemployment rate, which in turn creates a bargaining gap of 1%. Figure 15.7 What will happen to inflation? At the initial employment level this opens up a bargaining gap between the real wage on the price-setting curve and the real wage on the wage-setting curve. The nominal wage increase has raised the cost of production to firms and they will use this as the basis of their markup pricing, leading to a further increase in prices and a fall in the real wage, which the HR department will correct by again raising the nominal wage. Refer to the given information. Figure 15.4c This is because of the way that wage- and price-setters form their views about what will happen to inflation, which is called expected inflation. Would households and firms be better off with falling prices? The economy is hit by a recession at the beginning of period 1 and unemployment remains at a constant high level until the beginning of period 6. Iwata, who is the president of the Japan Center of Economic Research, also believes the pandemic will cause the country to experience deflation into 2022. As we first saw in Unit 10, when inflation is forecast to be higher or lower than this, the central bank can take action to adjust the level of aggregate demand and employment so as to steer the economy toward a 2% target. Then the markets facing the firm become less competitive, so that the firm can charge a higher markup on its costs. ↩, A. W. Phillips. A positive bargaining gap opens up and wages and prices will rise. Now, we assume that workers expect inflation next year to be equal to inflation last year. For example, if a T-shirt in Australia costs 20 AUD, and the exchange rate with the USD is 1.07 (remember this is the number of AUD for one USD), then the T-shirt costs 20/1.07 = 18.69 USD in the US. There are two ways that the increase in the bargaining power of workers could take place: We studied reasons for the shift in the wage-setting curve, such as improved generosity of unemployment benefits or stronger trade unions, in Unit 9. This leads to a rise in the price of the assets and a fall in the interest rates (yields) on those assets. After the price rise, if the workers are able to continue demanding the initial real wage as the minimum level required to motivate them to work, the wage rises again, increasing the real wage to the level on the wage-setting curve. The end of the boom of the late 1990s, during which firms had been over-optimistic about the profits to be made on investment in new technology and had overestimated the need for new capacity in ICT-producing industries, triggered the slowdown (see Unit 11 for more about the tech bubble and Figure 14.5 for the model of investment with supply and demand effects shifting the investment function). Inflation and conflict over the pie: Stable price level at labour market equilibrium. 1 GBP bought more euros on 24 Nov 2015 than one year earlier, so the GBP appreciated against the euro. In the late 1990s to the present, the Phillips curve is low and flat. In the recession shown, the downward shift in the aggregate demand curve increases the unemployment rate, which in turn creates a bargaining gap of 0.5%. What happens next? However, there is wide variation in the length of cycles, ranging from just 18 months during the peak-to-peak cycle in 1981-1982, up to the current record-long expansion that began in 2009. The policymaker chooses from the feasible set on the Phillips curve. But while the owner of an individual firm is happy with the higher price that the marketing department can now charge, the workers are unhappy with the fall in the real wage. Inflation is due to the fact that the economy is no longer at the intersection of the two curves. This prevents a wage-price spiral. There were many complaints that the ECB’s monetary policy remained too restrictive for too long for the needs of the latter countries. The economy then entered a quick period of growth, and in the first three months of 1981 grew at an 8.4 percent annual rate. In this example, the policymaker prefers a combination of unemployment of 3% and inflation of 5% to another feasible combination of unemployment of 6% and a stable price level (zero inflation). Unemployment is higher at the new labour market equilibrium where the post-shock price-setting curve intersects the wage-setting curve. If it lowers the policy rate and explains its reasoning, this can lead firms to expect higher demand, who will therefore increase investment. The unemployment rate of Britain's young black people was 47.4% in 2011. As the Federal Reserve under Paul Volcker raised interest rates to fight inflation, the economy dipped back into recession (hence, the "double-dip") from July 1981 to November 1982. Inflation means rising prices. By contrast, Friedman, supported by evidence from many countries from the late 1960s, showed that if a government tries to keep unemployment ‘too low’ the result will be not just higher inflation, but rising inflation as well. Remember that the real interest rate is equal to the nominal interest rate minus inflation. The Phillips curve (PC) for the 1960s shows the economy was in a good state. 19.3 What (if anything) is wrong with inequality? The commitment meant that even if the inflation rate rose temporarily, no one expected it to last because the central bank was committed to preventing it. Similarly, deflation increases the debt burden of borrowers, for the same reason that inflation reduces it. When might the government have no choice but to use fiscal policy? Businesses and investors also need to manage their strategy over economic cycles, not so much to control them but to survive them and perhaps profit from them. There were two important features of the 1990s and 2000s prior to the crisis: Why make central banks independent and give them inflation targets? Draw a diagram with years on the horizontal axis and the price level on the vertical axis. The reason was the phrase the campaign workers used: ‘The economy, stupid!’. What happens to the bargaining gap in each case? Then μ = $0.30/$3.30 = 0.09 or 9%. With rising prices, a fall in real income among the losers may be masked by the fact that nominal incomes are rising, or at least not falling. Bookmarks are saved in your cache. Labour supply, labour demand, and bargaining power, 9.10. ‘The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957’. At lower unemployment, the bargaining gap is 2%. Typically when drawing indifference curves, a choice further from the origin is preferred since more of what is on each axis is preferred. ​​​​​​​. The process of innovation and change that characterizes a dynamic economy means that, in any given year, workers in some firms and sectors will be more in demand than in others. Initially the marketing department in each firm is setting prices based on the markup that maximizes its profits, given the degree of competition in the markets in which it sells (as we saw in Units 7 and 9). With increased costs for oil, the firm’s profits can only remain unchanged if real wages fall. Labour unions: Bargained wages and the union voice effect, 9.11 Labour market policies to address unemployment and inequality, 9.12. The wage-setting curve rises if workers’ bargaining power increases. But you cannot advise me about what I decide is politically expedient to say to an election rally in front of 10,000 Ruhr miners in the Westfalenhalle in Dortmund.’. Summarize your findings. A negative shock that increases it by 2 percentage points. Unstable Phillips curves: Expected inflation and the bargaining gap. Instead of fitting Phillips curves to the observations, as in Figure 15.6, the points are joined and dated. The big message from the model of inflation and conflict over the pie is that if employment is above or below the labour market equilibrium then the price level is either rising or falling. Upward shifts of the Phillips curve represent a rising inflation rate for a given unemployment rate. Many central banks hit the zero lower bound for nominal interest rates, leading to a renewed interest in fiscal policy as a stabilization tool. Inflation expectations and Phillips curves. Voters want the economy to operate with low unemployment and low but positive inflation. Policymakers were wrong to think of the Phillips curve as a feasible set from which they could simply select the most electorally popular combination of inflation and unemployment. Inflation and central bank independence: OECD countries. MONIAC had tanks for each of the components of domestic GDP, such as investment, consumption, and government expenditures. At point B unemployment is below the labour market equilibrium, creating a positive bargaining gap. The fall in consumption will induce a drop in aggregate demand and economic activity. This correction occurs through a period of contraction when growth slows, employment falls, and prices stagnate. This economy has an independent central bank with an inflation target of 2%. Moreover, the economy is subject to shocks that can make both inflation and unemployment worse, limiting the set of feasible outcomes. But why is this unemployment rate so special for the rate of inflation? So in order to achieve another real wage increase of 2%, the HR department sets a wage increase of 7%. We write this function I(r). When employment and inflation are very high, the indifference curve is flat. We have shown how monetary policy can be used by the central bank to stabilize the economy in a recession. Draw a labour market diagram where the economy is at labour market equilibrium with stable prices. 20.9 Why is addressing climate change so difficult? At the start of year 1 following the opening up of the bargaining gap and after wages and prices have been adjusted, inflation is equal to the bargaining gap (2%) plus expected inflation (3%). In this example, the bargaining gap opens up in year 1 because of the move to low unemployment. ↩. As we saw in Unit 9, at this point both workers and firms are doing the best that they can, given the actions of the other. The policymaker prefers low inflation and high employment, and those preferences can be represented in the usual way in the form of indifference curves. So the extra $0.30 charged above unit costs is equal to 10% of those costs. Because of this, the cut in the interest rate leads to a depreciation of the Australian dollar, which means that it will buy a smaller number of US dollars, Chinese yuan, euros, or any other currency. The percentage bargaining gap is equal to the wage on the wage-setting curve, minus the wage on the price-setting curve, divided by the wage on the price-setting curve.