unit 15 - inflation, unemployment and monetary policy

inflation

an increase in the general price level of an economy

deflation

a fall in the general price level of the economy

disinflation

a decrease in the rate of inflation

inflation in the credit market

borrowers benefit → value of debt decreases in real terms

lenders lose → the value of what is being repaid is decreasing in real terms

real interest rate or Fisher equation

= nominal interest rate - the inflation rate

• measures the buying power of the repayement of a loan

menu costs

takes time for investors to adjust prices

impact of government imposing protectionist policies on inflation

• Market becomes less competitive (lower imports) -> firms can charge a higher markup

• Increase in price level

• Lower real wages -> lower motivation of workers

• Increase in wages -> increase in prices

• Inflationary spiral

what leads to rising wages and prices

• Firms being powerful enough to charge a higher markup

• Workers have enough bargaining power at the given unemployment rate to demand the initial real wage

how bargaining power of workers could take place

• Upward shift in wage-setting curve

• Increase in the level of employment -> movement along wage setting curve

real wage equation

= nominal wage / price level

wage-price spiral

when wages go up due to low unemployment therefore prices go up

• to keep the same markup

  • operates in reverse during a recession when unemployment is high

what does point A,B and C show

A → market is at equilibrium → Nash equilibrium → both employers and employees are are doing the best they can given the response of the other player

B → unemployment is lower → real wages for workers to work just as hard increases → workers have more bargaining power due to lower unemployment

C → unemployment is higher → workers are in a weaker bargaining position → claims of worker and owners sum to less than labour productivity

bargaining gap

when the real wage given by the wage-setting curve and that given by the price setting curve are not equal

• vertical distance between the 2 curves

Phillips curve

shows the trade off between inflation and unemployment

• acts as a feasible set from which policy makers can choose from

Friedman analysis of Phillips curve

argued there was a temporary trade-off between unemployment and inflation

• no trade off in the long run

expected inflation

the way wage and price setters form their views of what will happen to inflation is through expected inflation