Chapter 15 Notes

Inflation, unemployment, monetary policy

 When unemployment is low, inflation tends to rise. When unemployment is high, inflation
falls.
 Policymakers and voters prefer low unemployment and low inflation (but not a falling price
level).
 There is an inflation-stabilizing rate of unemployment, and a wage-price inflation spiral
develops if unemployment is kept lower than this.
 Monetary policy affects aggregate demand and inflation through a variety of channels.

inflation targeting – monetary policy regime where the central bank changes interest rates to
influence aggregate demand in order to keep the economy close to an inflation target, which is
normally specified by the government
inflation – price levels going up at a constant rate – ex. 2% each year
deflation – prices are falling
disinflation – inflation rate is falling; when inflation decreases, the price level decreases at a
decreasing rate. For example, first year it decreases with 1%, 2 nd year with 2% more => in total
3%
rising inflation – opposite of falling inflation (disinflation)

Effects of inflation on economy:

 Borrowers with nominal debt will benefit: Those with mortgages on fixed nominal interest rate
(interest rate that is uncorrected for inflation) loans will benefit from inflation because the debt
stays the same in nominal terms, and so becomes smaller in real terms.
 Lenders with nominal assets will lose: Banks or others who have loaned money at fixed
nominal interest rates will lose, because when the sum is repaid it will be worth less in terms of
the goods or services it can buy.

real interest rate – the interest rate corrected for inflation (that is, the nominal interest rate
minus the rate of inflation). It represents how many goods in the future one gets for the
goods not consumed now. 
 Fisher equation:

real interest rate (% per annum) = nominal interest rate (% per annum) − the inflation rate (% per
annum)

ex: If Julia were to borrow $50 from Marco with a repayment of $55 next year, the nominal interest
rate is 10%. But if next year’s prices were 6% higher than this year’s (6% inflation rate), then what
Marco could buy with the repayment is not 10% more than he could have bought with the sum he
loaned to Julia, but instead only 4%. The real interest rate is 4%.

Reasons for inflation

1) An increase in the bargaining power of firms over their consumers: This is caused by a
reduction in competition, which allows firms to charge a higher markup. It is a downward
shift of the price-setting curve.
2) An increase in the bargaining power of workers over firms: This allows them to get a higher
wage in return for working hard.
 A higher markup implies a downward shift in the price-setting curve.
 If the firms are able to continue charging the new higher markup, now applied to the new
higher wage, the price rises again, lowering the real wage to the price-setting curve.
 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.

Real wage w is the nominal wage W relative to the economy-wide level of prices P; measures
what the customer can actually buy

Wage-price spiral (an increase in wages is followed by an increase in prices, and this cycle
repeats itself  leads to inflation)
 When unemployment is low, the HR department needs to set higher wages: The cost
of job loss is low and workers expect higher real wages if they are to work effectively.
 Higher wages mean higher costs for firms: The marketing department will raise prices
to cover the higher costs. As long as competitive conditions have not changed, the
firm’s markup will be unchanged.
 The price level will have gone up: Once all firms in the economy have set higher prices,
the economy has experienced wage and price inflation. And real wages have not
increased: the percentage increase in W equals the percentage increase in P, so W/P
is unchanged.

Nash equilibrium in the labor marker

- point A – the real wage on the wage-setting curve coincides with the real wage on the
price-setting curve  the labor market is at a Nash equilibrium
- inflation would be 0 at point A (look at graph below)
 bargaining gap – the difference between the real wage that firms wish to offer in order to
provide workers with incentives to work, and the real wage that allows firms the mark up that
maximizes profits given the degree of competition; vertical distance between the two curves
 If unemployment is lower than at the equilibrium: There is a positive bargaining gap and
there is inflation.
 If unemployment is higher than at the equilibrium: There is a negative bargaining gap and
there is deflation.
 If there is labor market equilibrium: The bargaining gap is zero and the price level is
constant.
 inflation (%) = increase in prices (%) = increase in costs per unit of output (%) = increase in wages
(%) = bargaining gap (%)
 inflation (%) = bargaining gap (%)
 If the bargaining gap is 1%, prices and wages will rise by 1%

 At a higher level of aggregate demand (a boom), there is a positive bargaining gap and
inflation is positive
 At a lower level of aggregate demand (a recession), there is a negative bargaining gap
and deflation (seen below)
!!! The Phillips curve shows a positive correlation between employment and the inflation rate, which
means a negative correlation between the unemployment rate and the inflation rate !!!

 In the boom, the upward shift in the aggregate demand curve reduces the
unemployment rate, which in turn creates a bargaining gap of 1%.
 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%

1) High employment and inflation  indifference curve is flat

2) Low employment and inflation  indifference curve is steeper
3) Inflation at 2%  the indifference curve is vertical
  Full employment and 0 unemployment  the indifference curve is horizontal as
employment = labor supply

- Point F  the policymaker’s preferred combination of inflation and unemployment

- The policymaker chooses from the feasible set on the Phillips curve  point C

Expected inflation
- Expected inflation: 3%
- Bargaining gap: 2%

 New rate of inflation: 5%

 Inflation = Expected inflation
+ Bargaining gap
- In the labour market equilibrium
occurs at 3% inflation on the lower
of the two Phillips curves. The
Phillips curve will not shift up when
the economy is at labour market
equilibrium

- Upward shifts of the Phillips curve represent a

rising inflation rate for a given unemployment
rate. The Phillips curve continues to shift
upwards as long as there is a positive
bargaining gap, caused by the low
unemployment rate.
 inflation-stabilizing rate of unemployment – the unemployment rate (at labour market
equilibrium) at which inflation is constant

Market interest rates

- central bank sets the policy interest rate (the interest rate set by the central bank, which
applies to banks that borrow base money from each other, and from the central bank)
- commercial banks set the market interest rate (the bank lending rate) that households
and firms pay when they take out loans
- sometimes banks lower market interest rate in order to stimulate investment and
increase aggregate demand

 Market equilibrium – The economy starts in goods market equilibrium at point A

 Recession – Consumption then falls, which shifts the aggregate demand line down and the
economy enters a recession, moving from point A to point B
 Monetary policy – To stabilize the economy, the central bank stimulates investment by
lowering the real interest rate from r to r′. This policy shifts the aggregate demand curve
upward, pulling the economy out of recession and back to its starting point

zero lower bound – this refers to the fact that the nominal interest rate cannot be
negative, thus setting a floor on the nominal interest rate that can be set by the central
bank at zero.
 The central bank can set the real interest rate to below zero by setting the nominal
interest rate below the inflation rate. However, they are unable to set the nominal
interest rate below zero, so the real interest rate cannot go below minus the inflation rate.
 quantitative easing (QE) – central bank purchases of financial assets aimed at reducing
interest rates on those assets when conventional monetary policy is ineffective because
the policy interest rate is at the zero lower bound:
 The central bank buys bonds and other financial assets: It creates additional base
money for this purpose.
 This raises demand for bonds and other financial assets: So the central bank shifts the
demand curve for those assets to the right, which pushes up the price. This also
decreases the yield and interest rate on bonds (Unit 10).
 This boosts spending: Particularly on housing and consumer durables, because both the
cost of borrowing and return to holding financial assets has gone down.

Fisher`s equation
 𝑟=𝑖−𝜋𝑒
real interest rate(annual %) = nominal interest rate (annual %) – inflation expected
over the year

Exchange rate, depreciation and lowering interest rate

Central bank independence does help to reduce inflation

- 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 favorable indifference curve), the central bank would raise the
interest rate and dampen aggregate demand.
- Following a fall in aggregate demand (as a result of a fall in business confidence, for
example) and facing the threat of recession, the central bank would cut the interest rate
and bring the economy back toward its inflation target.
 Phillips curve and indifference curves for an economy with an inflation-targeting central bank
- The economy has stable inflation at point X, where inflation is at the policymaker’s 2%
target and unemployment at labor market equilibrium is 6%
- If an aggregate demand shock reduces unemployment below 6%, inflation rises along the
Phillips curve. In response, the central bank would raise the interest rate to reduce
aggregate demand and raise unemployment.
- Unless the central bank acts promptly, a wage-price spiral can begin, with the Phillips
curve shifting upward. Likewise, if inflation should fall below target, the central bank will
lower the interest rate to put upward pressure on inflation.

 Conclusion

Voters want the economy to operate with low unemployment and low but positive inflation. But
achieving this outcome is not easy. In the short run there is a trade-off between inflation and
unemployment, which means that policy makers could choose to reduce unemployment at a cost of
higher inflation. But this can lead to higher inflation expectations and a wage-price spiral, which
means that inflation is not just temporarily higher, but continues to rise over time.

That`s where central banks play a crucial role. Many countries have adopted inflation targeting with
independent central banks, who rely on the nominal interest rate as their policy tool in response to
both supply and demand shocks.

The new macroeconomic policy framework of inflation targeting seemed to be working well when
tested by the oil shock in the 2000s. Then came the global financial crisis, which rocked the
consensus. Many central banks hit the zero lower bound for nominal interest rates, leading to a
renewed interest in fiscal policy as a stabilization tool.

Notes from Lecture – 4th March

1. The WS/PS Model, aggregate demand and inflation

 Cyclical unemployment
В
 Fluctuations in aggregate demand
around equilibrium
С unemployment
cause changes in cyclical
unemployment
 At B, upward pressure on wages and
prices
 At C, downward pressure on wages
and prices
 At A, no pressure on wages and prices
 The key role of the ‘bargaining gap

WS curve – the minimum wage the employer can pay and get sufficient effort for production
to take place; this wage will be higher when unemployment rate is lower
PS curve – maximum the worker can get given the firm`s profit maximizing price (and given
competitive conditions, i.e µ and productivity λ)

The conflict:

 The employer wants more effort at low wage

 The worker wants high wage at lower effort.

The 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.
  Unemployment is below equilibrium: a positive bargaining gap and inflation.
 Unemployment is above equilibrium: a negative bargaining gap and deflation.
 Labour market equilibrium: the bargaining gap is zero and the price level is constant.

Understanding inflation:

∆P
π=
P

The model of inflation therefore begins with wage-setting

 hence with the WS/PS model and the bargaining gap between the initial real wage (W/P) on
the PS curve and the real wage (W/P) on the WS curve → % increase in W

 Then price-setting given the % increase in W, the % increase in P is the same so as to keep
the profit margin unchanged:

 Looking from a different perspective – conflicts of interest

Example 1. Constant price level

 If real wage per worker + real profit per worker = λ, then the bargaining gap = 0 (i.e. we are at a
WS/PS intersection, at the Nash equilibrium of the labour market)

 At the WS/PS intersection, claims on the division of output per head

o by employees (minimum wage to get workers to work, shown by the wage setting curve) and
o by owners on output per head (paying maximum wage consistent with profit margin, on price
setting curve)
o are consistent (means they add up to output per head, which is λ)

Example 2. In a business cycle upswing, rising price level = inflation

2. The Phillips curve and the bargaining gap

3. The Phillips curve and expected inflation
  The inflation-stabilizing rate is the
unemployment rate which keeps
inflation constant.
 Expectations of future prices can cause
the Phillips curve to shift.

 Inflation = expected inflation +

bargaining gap

 If economy is at the intersection of WS and PS then U = inflation-stabilizing rate and

bargaining gap= 0, PC remains stable and inflation remains constant; no wage-price spiral
 If U < inflation-stabilizing rate, then bargaining gap >0, PC shifts each period and inflation
rises each period
 If U > inflation-stabilizing rate, then bargaining gap
 4. The policy maker: constraints and preferences

o The policy maker’s ‘bliss point’ is at F

o Indifference curves show policymaker’s preferred trade-offs between inflation and
unemployment. (MRS)
o Phillips Curve determines the feasible trade-offs between inflation and unemployment.
(MRT)
 Best response inflation rate: MRS = MRT

5. The inflation-targeting central bank as policy maker

To set the policy interest rate, the central bank

will work backwards:

1. Choose the desired level of

aggregate demand so that the
economy is at equilibrium
unemployment (otherwise
inflation will either be rising or
falling)
2. Estimate the real interest rate
that will produce this level of
aggregate demand (using the
investment function and the
multiplier model)
3. Use the Fisher equation and
calculate the nominal policy rate set by the MPC that will produce the appropriate
market interest rate, i.e. the lending rate

 To stabilize the economy

back at A after a
consumption shock took it to
B, the central bank
 stimulates investment by lowering the real interest rate. This shifts the aggregate demand
curve upward.

Monetary Policy: Limitations

1. The short-term nominal interest rate (policy rate) cannot go below zero (“zero lower
bound”)
 when the economy is in a slump, a nominal interest rate of zero may not be low
enough to stabilize the economy
 Quantitative easing = Central bank purchases of financial assets aimed at increasing
investment by reducing yields.
2. A country without its own currency does not have its own country-specific monetary
policy
 E.g. countries of the eurozone

Summary

A. Inflation

1) Inflation is constant only at equilibrium unemployment (WS/PS intersection).

2) The rate of inflation at equilibrium unemployment is equal to the central bank’s inflation target.

3) When the economy is away from equilibrium unemployment , inflation rises or falls because
there is a bargaining gap (between WS and PS)

4) This trade-off between inflation and unemployment is shown in the Phillips Curve diagram

5) The trade-off isn't stable: expectations matter (see checklist)

B. Central banks

1. Central banks can stabilize the economy, keeping it close to target inflation, by changing the
policy rate

2. This changes the level of aggregate demand – remember that only when Y=AD at equilibrium
unemployment will inflation be constant
 3. 4 channels of monetary transmission mechanism: interest rate, asset prices, profit expectations,
exchange rates

4. Zero lower bound puts a limitation on how effective monetary policy is at changing AD

MULTIPLE CHOICE QUESTIONS:

 The interest rate advertized for savings accounts and mortgages is a NOMINAL
INTEREST RATE
 Private expenditure and therefore aggregate demand in the economy is NEGATIVELY
related to the REAL INTEREST RATE