Economic Effects of High Inflation

Consequences of High Inflation

• High inflation is often volatile, leading to uncertainty
• It is harder for producers to distinguish between changes in relative prices and inflation
• Menu costs arise as firms must update their prices more frequently
• The inflation experience is not always even across the income distribution, with the poor more affected by price increases of essential goods

Consequences of Deflation

• Deflation could have even more dramatic consequences than high inflation
• When prices are falling, households may postpone consumption, particularly of durables, expecting goods to be cheaper in the future
• Deflation increases the real debt burden, leading households to cut consumption to return to their target wealth

Labour Market Equilibrium

• In the labour market equilibrium, all parties are doing the best they can, given what everyone else is doing
• The labour market equilibrium is characterized by:
  • Firms offering a wage that ensures workers' effort at the lowest possible cost
  • Employment being the highest it can be, given the wage offered
  • No reason for the wage and price level to change, resulting in no inflation pressure

Consequences of Inflation: The Distributive Nature

• Who wins from inflation:
  • Borrowers, as they pay back money with less purchasing power
  • Flexible-income recipients, who may experience lower personal inflation rates
  • Those who rent out homes, as rental income grows with inflation
• Who loses from inflation:
  • Creditors, as they may receive money back from debtors that has less purchasing power
  • Fixed-recipients, such as those with private pensions that are not adjusted for inflation
  • Savers, if the rate of return from their investments is less than the annual inflation rate

The Phillips Curve

• The Phillips Curve shows that higher employment may result in inflation, leading to a wage-price spiral
• The only way to stop this cycle is for the unemployment level to decrease to the level associated with the labour market equilibrium
• Prices are stable (inflation is 0) when the labour market is in (Nash) equilibrium

What Happens if Labour Market is NOT in Equilibrium?

• Unemployment below equilibrium: workers' claims to real wages + firms' claims to real profits > total productivity, leading to upward pressure on wages and prices
• Unemployment above equilibrium: workers' claims to real wages + firms' claims to real profits < total productivity, leading to downward pressure on wages and prices

The Bargaining Gap

• The bargaining gap is 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

The Phillips Curve and the Business Cycle

• A positive bargaining gap in a boom → inflation
• A negative bargaining gap in a recession → deflation

The Phillips Curve Over Time

• The trade-off between inflation and unemployment is not stable: the Phillips Curve shifts over time
• Keeping unemployment "too low" leads to higher prices and rising inflation
• People are forward-looking, taking actions now in anticipation of things they expect to happen, making expected inflation key

The Role of Expectations and the Phillips Curve

• Expectations of future prices can cause the Phillips Curve to shift
• If people expect inflation to be 5% next year, they will ask for a raise of at least 5% for next year