1) Explain what is meant by the "wage-price" spiral.
The wage-price spiral refers to the effects of low unemployment on inflation.
Specifically, when the unemployment rate falls, the nominal wage will rise. As
W rises, firms' costs increase causing them to increase prices. As prices rise,
workers will later ask for increases in the nominal wage. This increase in W
again causes firms' costs and prices to rise and the process repeats itself.
2) Based on the 'early incarnation' of the Phillips curve, explain what effect an
increase in the unemployment rate will have on the inflation rate.
An increase in u will cause a reduction in W. As W falls, firms' costs fall. As
firms' costs fall, they will reduce the price level. This reduction in the price level
represents deflation.
3) Explain how the original Phillips curve differs from the expectationsaugmented Phillips curve.
The original Phillips curve did not take into account the effects of changes in
expected inflation on inflation. The expectations-augmented Phillips curve did
allow for changes in expected inflation to affect actual inflation.
4) Based on your understanding of the Phillips curve, explain what happens to
actual inflation (relative to expected inflation) when the actual unemployment
rate is either above or below the natural rate of unemployment.
When the actual unemployment rate is equal to the natural rate of
unemployment, we know that actual inflation and expected inflation must be
equal. In such a case, all else fixed, inflation will not change. If the actual
unemployment rate were to fall below the natural rate, inflation would
increase. So, the natural rate of unemployment rate may also be referred to
the non-accelerating-inflation rate of unemployment. If the opposite occurs,
inflation will fall below expected.
5) Briefly comment on the predictions of economists Milton Friedman and
Edmund Phelps about the ability to exploit a trade-off between inflation and
unemployment.
Both Friedman and Phelps (separately) argued that there might be a
temporary trade-off between inflation and unemployment. However, both
argued that this trade-off could not be exploited permanently. Eventually,
expectations of inflation would adjust.
6) A number of factors are believed to have caused changes in the natural rate
of unemployment in the United States during the 1990s. Briefly comment on
each of these factors.
There are a number of candidates here: decrease in monopoly power,
decreasing role of unions, aging U.S. population, increased prison population,
increased number of workers on disability, and unexpectedly high rate of
productivity growth.
7) Based on your understanding of the Phillips curve, is it possible for the
unemployment rate to increase while inflation increases? Explain.
This can occur when negative supply shocks occur. That is, we would observe
this when factors cause the natural rate of unemployment to rise (e.g. during
the 1970s). This would cause an increase in u and an increase in inflation.
8) Explain how a reduction in the proportion of contracts that are indexed
affects the relationship between changes in the unemployment rate and
inflation.
As the proportion of labor contracts that are indexed falls, the effects of
changes in unemployment on inflation would fall. A reduction in u will cause an
increase in inflation. When inflation rises in a period, some contracts (those
that are indexed) will call for an immediate increase in wages further increasing
inflation within that period. As indexation becomes less prevalent, that
secondary effect (caused by the indexed contracts) on inflation will be reduced.
9) Explain how the unexpectedly high rate of productivity growth at the end of
the 1990s affected inflation and unemployment during this period.
The unexpectedly high rate of growth of productivity would cause firms' costs
to drop. This would cause (if unexpected) a reduction in unemployment. So, we
would observe a simultaneous drop in u and drop in inflation.
10) Explain how changes in the proportion of contracts that are indexed affect
how a given change in monetary policy will affect economic activity.
An increase in nominal money growth will increase the real money supply
causing an increase in economic activity. As the proportion of labor contracts
that are indexed increases, the effects of changes in unemployment on inflation
would increase. A reduction in u will cause an increase in inflation. When
inflation rises in a period, some contracts (those that are indexed) will call for
an immediate increase in wages further increasing inflation within that period.
As indexation becomes more prevalent, that secondary effect on inflation will
be magnified. This magnification of the inflation effect will cause the real
money supply to increase by a smaller amount and, therefore, reduce the
output effects of a given monetary expansion.
11) Based on the 'early incarnation' of the Phillips curve, explain what effect a
decrease in the unemployment rate will have on the inflation rate.
A decrease in u will cause a rise in W. As W rises, firms' costs increase. As firms'
costs increase, they will raise the price level. This increase in the price level
represents, in this case, inflation.
12) Why has the U.S. natural rate of unemployment fallen since the early
1990s?
Researchers have offer a number of explanations: Increased globalization and
stronger competition between US and foreign firms may have led to a decrease
in monopoly power and a decrease in the markup; The nature of the labor
market has changed; the aging of the US population; an increase in the prison
population and the increase in the number of workers on disability.
13) Explain the natural unemployment rate and its relationship to inflation rate.
The natural unemployment rate is the unemployment rate at which the
inflation rate remains constant. When the actual unemployment rate exceeds
the natural rate of unemployment, the inflation rate typically decreases; when
the actual unemployment rate is less than the natural unemployment, the
inflation rate typically increases.
14) What is the difference between deflation and disinflation?
Deflation refers to a decrease in the price level, or equivalently, negative
inflation. Disinflation is a decrease in the inflation rate.
15) How will the crisis affect the natural rate of unemployment?
There is an increasing worry that the increase in the actual unemployment rate
may eventually translate into an increase in the natural unemployment rate.
Workers who have been unemployed for a long time may lose their skills, or
their morale, and become unemployable, leading to a higher natural rate.
