inflation and unemployment

• As we saw last week, Governments can use fiscal policy e.g. spending, taxation to stabilize the economy during recessions
• Besides unemployment, fluctuations in GDP also affect prices
• Inflation, Unemployment & Monetary Policy
• Reading: CORE Unit 15 and 13.8
• Inflation = an increase in the general price level in the economy
• Inflation tends to be lower during recessions (high unemployment)
• Inflation


  An increase in the general price level in the economy
• Zero inflation


  A constant price level from year to year
• Deflation


  A decrease in the general price level, or a negative inflation rate
• Disinflation


  A decrease in the rate of inflation
• Real interest rate


  Nominal interest rate - Expected inflation (The Fisher equation)
• Nominal interest rate


  The rate of interest on a loan
• Higher inflation


  Benefits people borrowing for loans (decreases the amount of "real money" they have to pay) and harms people who loan out money
• Real interest rate


  Represents how many goods in the future one gets for the goods not consumed now
• What we generally care about in the economy is the "real terms" i.e. how many goods and services we can purchase – prices of goods and services after discounting the effect of inflation
• Consumer Price Index (CPI)


  Measures the general level of prices that consumers have to pay for goods and services, including consumption taxes
• CPI basket of goods

  A representative bundle of consumer goods - "cost of living"
• Common measure of inflation

  Change in CPI
• CPIH


  The CPI basket of goods and housing costs
• GDP deflator


  A measure of the level of prices for domestically produced output (ratio of nominal to real GDP)
• Trends in inflation: Upward spikes in inflation during economic crises, General downward trend since 1970s, Between 2000-2020 we had very stable inflation levels compared to previous decades, Inflation tends to be higher in poor than in rich countries
• Trends in Inflation – UK Specific: Since the end of the 1980's we have seen a general trend of relatively low levels of inflation, In some periods we had very low levels of inflation (very close to 0) during the mid-2010's which can be an issue for the economy – CB limits to Monetary policy, However, in recent years we have seen very high levels of inflation – Also limits CB's ability to use Monetary Policy
• What's wrong with inflation?

  For people on fixed nominal income (e.g. pensioners), higher inflation means lower real value of income, Workers will have to bargain for higher wages to maintain current standard of living – leads to strikes, reduction in production etc., Inflation reduces the real value of debt – good for borrowers, bad for creditors, High rate of inflation makes the economy work less well (distortionary costs), High inflation is often volatile which leads to uncertainty
• What's wrong with deflation?

  Deflation could have even more dramatic consequences than high inflation, Deflation increases the real debt burden, which may lead households to cut consumption to return to their target wealth
• Natural Causes of Inflation – Endogenous: Increases in bargaining power of firms over their consumers (e.g. reduction in competition), Increases in the bargaining power of workers over firms, due to higher bargaining power or employment
• Inflation in an economy may be due to:

  1. Increases in bargaining power of firms over their consumers (e.g. reduction in competition) – Firms can increase their prices

  2. Increases in the bargaining power of workers over firms, due to higher bargaining power or employment – Workers can demand higher Nominal wages
• In the Short-to-Medium run, we could observe the business cycle improve and cyclical unemployment effects


  Firms want to hire more workers, employee bargaining power increases and nominal wage rises
• The Phillips Curve


  Describes an implicit, inverse relationship between inflation and unemployment
• Higher inflation is associated with lower unemployment and vice versa
• High employment (low unemployment)


  May result in inflation, It increases workers' bargaining position → higher wages → higher cost of production → higher prices
• An upswing in business cycle


  Is often associated with rising inflation
• Inflation and Aggregate Demand:

  1. Higher aggregate demand → higher employment → higher wages

  2. Higher cost of production → higher prices

  3. AD Shock

  4. Short-run increase in workers hired (higher employment) to increase production

  5. Positive Bargaining gap for workers

  6. Firms agree to higher nominal wages

  7. That leads to higher production costs for firms, so they increase prices to maintain the same mark-up and profits

  8. Since wages increased by the same amount prices increased, workers are no better off in real terms, so will demand further nominal wage increases next year

  9. The economy experiences price and wage inflation, but the real wage has not increased

  10. Constant real wage means that employment stays high
• Prices are stable when the labour market is in equilibrium
• Unemployment below equilibrium


  Puts upward pressure on wages and prices – Workers have bargaining power, demand higher wage, firms know unemployment is low, so they agree to increases in wage demands and increase prices to compensate - the claims of workers for wages and owners for profits sum to more than labour productivity
• Unemployment above equilibrium


  Puts downward pressure on wages and prices – Firms have bargaining power and can easily replace workers, lower real wage on average
• Bargaining gap


  The difference between the real wage required to incentivize effort, and the real wage that gives firms enough profits to stay in business (or how much they are willing to pay)
• Labour market equilibrium: the bargaining gap is zero and the price level is constant
• Unemployment is below equilibrium: a positive bargaining gap and inflation
• Unemployment is above equilibrium: a negative bargaining gap and deflation
• The short-and medium-run models: Aggregate demand, employment, and inflation