Understanding Inflation: Key Terms and Issues

Key Terms on Inflation

• Inflation is an increase in the general price level.
• Zero inflation is a constant price level from year to year.
• Deflation is a decrease in the general price level.
• Disinflation is a decrease in the rate of inflation.
• Zero inflation means that the car is stationary.
• Constant inflation means that the car is moving at a constant speed.
• Disinflation means that the car is decelerating, such as when you brake.
• Deflation means that the car is moving backward.
• Rising inflation is an increase in the rate of inflation.
• Rising inflation is like a car accelerating when gas is applied.

Issues With Inflation

• Higher inflation reduces the real value of income for people on fixed nominal income like pensioners.
• Inflation reduces the real value of debt, which is beneficial for borrowers but unfavorable for creditors.
• High inflation rates can make the economy function less efficiently.
  • Firms face "menu costs" requiring frequent price updates.
  • Erratic prices obscure scarcity and profitability signals, hindering producers from distinguishing between relative price changes and inflation.
  • Uncertainty increases, discouraging investment.

Issues With Deflation

• Falling prices will cause households to postpone consumption, particularly of durables, due to expectations of lower prices in the future, having a similar effect to a negative shock to aggregate demand.
• Deflation increases the real debt burden, which may lead borrowing households to cut consumption further reducing aggregate demand.
• High inflation and deflation are undesirable.
• Economists in the U.K. agree that the ideal rate of inflation is 2% per year.
• The Bank of England aims to maintain a 2% rate of inflation.

Real Versus Nominal Wage

• Real wage is the nominal wage (W) divided by the price level (P).
• Workers prioritize real wage.
• Both the price setting and wage setting curves feature real wage on the vertical axis.

Labour Market Equilibrium

• Labour Market Equilibrium is where the price-setting curve intersects the wage-setting curve.
• At Labour Market Equilibrium employment is equal to N*.
• At Labour Market Equilibrium Workers' claims to real wages + firms' claims to real profits = total productivity.
• The claims on output by workers and firms need to be consistent.

The Bargaining Gap

• The bargaining gap is the difference between the real wage required to incentivize effort (wage setting curve) and the real wage that gives firms enough profits to stay in business (price setting curve).
• At labour market equilibrium, the bargaining gap is zero because the wage setting curve intersects the price setting curve.
• When claims on output are consistent (bargaining gap is zero), inflation is also zero.

Positive Inflation

• Positive inflation results when employment is above N*.
• With Positive Inflation Workers' claims to real wages + firms' claims to real profits > total productivity .
• A positive bargaining gap comes from the wage setting curve lying above the price setting curve.
• Lower unemployment makes it easier for employees to leave their job.
• Motivating workers requires paying higher nominal wages (shown by the wage setting curve).
• The cost of production is higher
• Firms pass increased production costs onto consumers through higher prices due to firm unwillingness to reduce their profit margin
• Positive Inflation occurs when firms raise prices.
• Resultant inflation equals the bargaining gap in percentage terms.
• Real wages do not change when prices and wages both rise by the same percentage (equal to the bargaining gap), and the process restarts.

Factors That Can Cause a Positive Bargaining Gap

• An increase in bargaining power for firms over consumers (reduction in competition).
• The price setting curve shifts downwards, indicating higher profit margins.
• An increase in bargaining power for workers over firms.
• The wage setting curve shifts up.
• In each case, positive inflation results.
• Suppose the government adopts protectionist policies.
• Markets become less competitive, so firms can charge a higher mark-up over costs.
• Firms raise prices.
• Workers lack the motivation to work, since real wages will fall.
• To build up motivation, workers need higher nominal wages
• Production costs increase and firm will pass the higher costs on to consumers with higher prices.
• The result is positive inflation.

Deflation

• Deflation takes place when employment is below N*.
• With Deflation Workers' claims to real wages + firms' claims to real profits < total productivity .
• This results in a negative bargaining gap.
• The output per worker is more than enough to satisfy the claims of workers and firms.
• The deflation that results is equal to the negative bargaining gap.

The Phillips Curve

• When employment is N*, inflation is zero.
• When employment is is above N*, inflation is positive.
• When employment is below N*, inflation is negative.
• There is a relationship between inflation and employment.
• There is a negative relationship between inflation and unemployment.
• This relationship is referred to as the Phillips curve.
• The Phillips curve can be derived from the price-setting and wage setting curves.
• The Keynesian cross diagram can be added to the Phillips curve.
• Labor productivity is assumed to be 1, which implies that output and employment are the same.
• High aggregate demand leads to low unemployment and inflation.
• Low aggregate demand leads to high unemployment and deflation.
• A.W. Phillips published a comparison of annual wage inflation and unemployment in the British economy from 1861 to 1913.
• Studies show a negative relationship between inflation and unemployment.
• Policymakers can select low unemployment and high inflation or high unemployment and low inflation.
• A Phillips Curve does not exist from 1960 to 2010 in the U.S.
• The Phillips curve shifted upwards over time.
• Milton Friedman explained this at an American Economic Association address in December 1967.

Wage Price Spirals

• Milton Friedman argued against the Phillips Curve, stating that it was not stable and shifts upwards over time.
• High unemployment rates will coincide with greater inflation.
• Since 1966 unemployment had been steady at 3.7% but inflation had increased from 3% to 4.2%.
• This is accelerating or rising inflation.
• Inflation rises because the government tried to keep unemployment “too low", or employment “too high".
• Keeping employment above N* would cause high inflation and rising inflation.
• Rising or accelerating inflation is called a wage-price spiral.
• Wage-price spirals can be explained incorporating two additional features:
  • Non-zero inflation in labour market equilibrium
  • Adaptive expectations
• Even at equilibrium inflation is not zero but positive.
• Wages are indexed for inflation in advanced economies, so wages rise at the same rate as prices.
• There is a constant (but positive) inflation in equilibrium.
• People expect future inflation to be the same as the previous year.
• Both wages and prices grow at 3% in a labour market equilibrium.
• Equilibrium unemployment is 6%.
• A boom takes the economy with 3% unemployment
• A bargaining gap exists where the distance between wage setting and the price setting curve is 2%.
• Workers expect prices to rise by 3% and require a 3% nominal wage increase to keep their real wages unchanged.
• Since they require an additional real wage increase of 2%, nominal wages would rise by 3%+2%=5%.
• Employers will increase prices by 5% to maintain profit margins.
• The inflation rate increases from 5% to 7%.
• In year 2 workers expect prices to rise by 5%
• Workers need a 5% nominal wage increase to keep their real wages unchanged
• Since workers require an additional 2% actual wage increase, nominal wages increase by 7%.
• To keep margins intact, employers increase prices, which increases inflation from 5% to 7%
• Inflation keeps rising every year.
• inflation rate (%) = expected inflation (%) + bargaining gap (%)
• Inflation rate (inflation last year (%) + bargaining gap (%).
• Evolution of inflation can be shown at labour market equilibrium (unemployment is 6%) and in a boom (unemployment is 3%).
• N*, the unemployment rate in labour market equilibrium is called the non-accelerating inflationary rate of unemployment rate (NAIRU).
• N* is the natural rate of unemployment.
• Rising inflation results if employment rate rises above N*.
• Falling employment rate below N* causes deflation and disinflation.
• An alternative method to illustrate the Phillips curve is plotting output rather than employment on the horizontal axis.
• The curves would look identical if labor productivity = 1.
• VPC, represents the fact that there is no long term trade off between inflation and unemployment.
• The long run Phillips' curve (LRPC) is the vertical Phillips' curve.
• Phillips curve (PC) curve(SRPC, Phillips curve short run) expresses the short run trade off between inflation and unemployment.

Disinflation Strategies

• A country can counter a wage-price spiral with two strategies.
  • "Gradualist”
  • “Cold turkey" approaches.
• Policy should increase the unemployment rate.
• First, pursue contractionary monetary policy.
• Unemployment increases to NAIRU.
• This stabilizes high inflation.
• The central bank wants to bring it down to 2% using the gradualist approach.
• The central bank raises unemployment and reduces output.
• In the next period the Phillips' curve shifts downwards.
• The economy is guided to a spot over periods of time.
• A monetary rule is the path joining central bank preferences.
• Monetary policy is a more inflation averse central bank, known as "cold turkey".
• The central bank wishes to bring inflation down in just one period choosing a new output level.
• In the next period, the central bank can cut interest rates to stabilize output
• The economy shifts, which monetary policy dictates.

Monetary Rules

• Monetary rules emerge from central bank preferences.
• Central bank preferences can be expressed by indifference curves.
• Indifference curves show policymaker's preferred tradeoffs between inflation and unemployment (MRS).
• The Phillips' curve determines the feasible set.
• The Phillips Curve determines the feasible trade-offs between inflation and unemployment (MRT).
• An optimal inflation rate happens which MRS = MRT.
• Optimal inflation rate is the points of tangency between indifference curve and Phillips' curve.
• The line joining these points of tangency is the monetary rule.

Modern Monetary Policy

• Modern monetary policy is called “inflation targeting monetary policy”.
• Inflation is taken much more seriously than recession.
• Inflation targeting involves the central bank using policy instruments to keep the economy close to an inflation target.
• Central bank independence is another quality of modern monetary policy.
• To prevent an inflation spiral, central bank independence give inflation credibility.