An increase in the unemployment level along a given wage-setting curve results in a fall in the real wage required to motivate to work, to below the price-setting curve. Price responses to rising employment and capacity utilization. The only differ­ence is that inflation at labour market equilibrium is 3% rather than zero. There is no inflation when the unemployment rate is zero. By plotting the path of inflation over time in Figure 15.10 we can see the distinctive contributions of the bargaining gap and expected inflation to inflation. Labour market equilibrium and the distribution of income, 9.9. Firms in the economy use both the products of other firms in the economy and imported products as inputs. A cut in the interest rate and fiscal stimulus via tax cuts and increased government spending shifts the aggregate demand line back to its starting position. There are two ways that the increase in the bargaining power of workers could take place: We studied reasons for the shift in the wage-setting curve, such as improved generosity of unemployment benefits or stronger trade unions, in Unit 9. We have shown how monetary policy can be used by the central bank to stabilize the economy in a recession. Interest rates cannot be set in a currency union. Above target inflation, the indifference curves are positively sloped, as getting employment closer to full employment is worth accepting higher (above target) inflation. Businesses and investors also need to manage their strategy over economic cycles, not so much to control them but to survive them and perhaps profit from them. Note first some important features of the diagram. Shocks to the world oil price are a major source of macroeconomic disturbance. In 1985, the exchange rate between the U.S. dollar and the Japanese yen was $1 = 262 yen; in 2003, the rate was $1 = 110 yen. This means the indifference curves become vertical at, say, 2% inflation. Shocks that move the Phillips curve by changing the labour market equilibrium are described as supply shocks, because the labour market represents production or supply in the economy. While there is no evidence that moderate inflation is bad for the economy, when inflation is high it is often also volatile and therefore hard to predict. In this diagram the labour market equilibrium occurs at 3% inflation on the lower of the two Phillips curves. Economic Policy 6 (13): pp. The recession could have been much worse in the absence of the strong response from monetary and fiscal policy. Figure 15.14 Figure 15.11 We can summarize the causal chain from the bargaining gap to inflation like this: Remember, the triple bar indicates that inflation is defined as the percentage increase in prices. But at the labour market equilibrium of 6% unemployment, inflation will be constant whatever level it starts at. The real interest rates for the four periods are: 3.4%, 2.3%, 1.8%, and –0.4% respectively. The 1991 recession meant that many Americans lost their jobs, and the Clinton campaign slogan brought this issue to the attention of the voters. At an election rally in 1972, he claimed that: ‘Five per cent inflation is easier to bear than five per cent unemployment.’ He promised that his party would prioritize lower unemployment while keeping inflation low and stable. In the UK the inflation rate remained stable. We compare the situation over a three-year period with unemployment at two levels: 6% and 3%. 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. Firms might find it harder to know which sector to invest in, or which crop would be better to plant (quinoa or barley, for example); individuals would find it harder to decide whether quinoa has become more expensive relative to other sources of protein. 52–82; CPI after 1950: Federal Reserve Bank of St. Louis. UK GDP growth and real oil prices (1950–2015). Updated 21 September 2013. What would the policymaker’s indifference curves look like if the policymaker cared only about low unemployment? Figure 15.18 Helmut Schmidt (1918–2015) was West German Chancellor from 1974 until 1982. The cost of these inputs will be affected by wage costs and costs of imported materials. The following day Professor Otto Schlecht, head of the economics policy department at the Federal Ministry of Economics, said to Schmidt: ‘Herr Minister, what you said yesterday, which is in the newspapers this morning, is false.’, Schmidt replied: ‘I agree that what I said was technically wrong. Another important reason to prefer a bit of inflation to none is that it gives monetary policy more room to manoeuvre. Moreover, in an inflationary environment, firms have to update their prices more frequently than they would prefer. A. W. (‘Bill’) Phillips (1914–1975) was an unusually colourful character for a world-renowned economist. The four stages of the economic cycle are also referred to as the business cycle. The aim of QE is to increase aggregate demand by buying assets, even when the policy interest rate is zero. Inflation, expected inflation, and the bargaining gap. At A, the claims of owners for profits and of workers for wages add up exactly to the size of the pie (the sum of the double-headed arrows showing the profits per worker and real wages is equal to output per worker, which is shown by the red dashed line). In Figure 15.4a, it is only at point (A), where the real wage on the wage-setting curve coincides with the real wage on the price-setting curve, that the labour market is at a Nash equilibrium. Will it end there? The curve shifts up again in the late 1970s. The real interest rate in 1996–2000 was –0.4%. ‘1789–2012 Presidential Elections’. The unemployment rates and the bargaining gaps at different states of the economy are shown. In the UK the price of goods and services remained stable between 2010 and 2013. The empirical evidence suggests that the effects of QE in boosting aggregate demand are positive but small. The following table shows the annual inflation rate (the GDP deflator) of Japan, the UK, China and Nauru in the period 2010–2013 (Source, World Bank): Based on this information, which of the following statements is correct? No. For example, when the Reserve Bank of Australia reduces the interest rate, there is less demand for three-month or ten-year Australian government bonds. By signalling its willingness to support growth, the central bank also aims to influence the confidence of decision-makers in firms and households and help shift the economy from the low-investment equilibrium illustrated in the coordination game in Figure 13.17 to a high-investment equilibrium. The Reserve Bank of Australia responds to this by cutting the interest rate. Next period, with unemployment still low at 3%, inflation is equal to expected inflation plus the bargaining gap. Inflation is zero in the diagram only when the unemployment rate is 6%. The stable inflation case is at point A with unemployment of 6% and inflation of 3%, year after year. Monetary policy may not be available to a country. More generally, using the same logic as we used when discussing the government’s debt in the previous unit, inflation means that: To take account of inflation when analysing borrowing and lending, we use what is termed the real interest rate, which is defined as follows and is also known as the Fisher equation: The real interest rate measures the buying power of the repayment of a loan at the prices that exist when the loan is repaid. In fact, many central banks around the world have policies to target an inflation rate of 2%. The Best Investing Strategy for Recessions, Characteristics of Recession-Proof Companies, Investors Profiting from the Global Financial Crisis. F marks the policymaker’s preferred combination of inflation and unemployment. China has been experiencing disinflationary pressure (a falling inflation rate), not deflationary pressure (falling price levels). The Phillips curve shifts up year by year. For example, if your business general follows the same economic cycle as the rest of the economy, then warning signs of an impending recession suggest that it is not a good time for you to expand your business ad you might instead be better served by building up a cash reserve against tough times ahead. The US could achieve combinations of relatively low inflation and unemployment. Inflation is equal to expected inflation plus the bargaining gap. The process of innovation and change that characterizes a dynamic economy means that, in any given year, workers in some firms and sectors will be more in demand than in others. The markup price-setting equation says that if unit costs are $3.00 and the markup m is 10%, the price will be $3.30. The Economist. Would households and firms be better off with falling prices? It was like the hydraulic economy model produced by Irving Fisher half a century earlier (mentioned in Unit 2), but much more elaborate. The big message from the model of inflation and conflict over the pie is that if employment is above or below the labour market equilibrium then the price level is either rising or falling. Expected inflation over the year ahead is based on the previous year’s inflation. Look at the boxes in the first column of Figure 15.14. Helmut Schmidt was called the ‘super minister’ in the West German government of Chancellor Willy Brandt because he was both minister of economics and minister of finance. Now, we assume that workers expect inflation next year to be equal to inflation last year. A Phillips curve sketched through the observations in the 1960s gives a reasonably good picture of the inflation-unemployment trade-off in that decade. The real interest rates for the four periods are: 3.4%, 2.3%, 1.8%, and –0.4% respectively. For this it is useful to have an equation describing how firms will set different prices as their costs change, assuming that the degree of competition in product markets (and therefore μ) is unchanged. A depreciation of the home country’s exchange rate makes their exports cheaper, and imports from abroad more expensive. Figure 15.6 shows the inflation and unemployment combinations for the US for each year between 1960 and 2014. The bargaining gap is zero and inflation is zero. ↩, ‘Controlling Interest’. What would the policymaker’s indifference curves look like if the policymaker cared only about low inflation? Firms raise their prices to protect their profit margins when the cost of imported oil rises. In the boom, inflation will be 5%. Firms will judge which investment projects are worth undertaking using real interest rates, and lenders will charge a higher level of interest on their loans if inflation is expected to erode their lending margins in the future. The labour market model and the Phillips curve can explain why a one-off increase in the world oil price can lead to a combination of: To do this, we show that a rise in the oil price: An increase in the oil price pushes down the price-setting curve. After the initial increase in the workers’ bargaining power, the firms adjust the wages and prices by shifting the wage-setting curve, creating inflation. But they require an additional 2% rise to give them an expected real wage rise on the wage-setting curve, so wages increase by 5%. As we first saw in Unit 10, when inflation is forecast to be higher or lower than this, the central bank can take action to adjust the level of aggregate demand and employment so as to steer the economy toward a 2% target. Phillips had engineering know-how, and while studying sociology in London in 1949, he built a hydraulic machine to model the British economy. As the Federal Reserve under Paul Volcker raised interest rates to fight inflation, the economy dipped back into recession (hence, the "double-dip") from July 1981 to November 1982. So far, the answer is that when unemployment is high in the economy, employees face a high cost of job loss, and employers will be able to get workers to work conscientiously at a lower wage than would be the case when unemployment is lower. The resulting Phillips curve shows a positive correlation between the unemployment rate and inflation rate. Starting from a price index of 100, sketch the path of the price level for the 5 years that follow, assuming the bargaining gap remains at –1%. Monetary policy relies on the central bank being able to control interest rates, and on changes in interest rates influencing aggregate demand. If this is the case across the economy, the resulting increase in the price level will lower the real wage of the workers. This means that the HR department will have no reason to raise wages, and with no increase in costs, the marketing department will keep prices unchanged. A look back at Figure 15.12 tells us why. Many governments have given responsibility for monetary policy—often described as inflation targeting—to central banks. If there is no permanent trade-off, then the Phillips curve is not a feasible set in the same way as the feasible consumption frontier was: the feasible consumption frontier stays in place when a different point on it is chosen. We define the markup, μ, as the share of the price that represents profits to the firm (what is left over after subtracting unit costs): Note that umc/P is the imported materials cost as a share of the price of a unit of output, while ulc/P is the wage cost as a share of the price of a unit of output. Figure 15.17 showed that this is what happened in the US after the tech bubble ended. Finally it calculates the nominal policy rate. We now use the labour market diagram to show what happens in a boom, when unemployment is lower than at A. Draw the Phillips curves and write a brief explanation of your findings. This implies that when the outcome is further from the inflation target but closer to full employment, the indifference curve is flatter because the policymaker places more value on getting closer to the inflation target. When capacity utilization rises as we move to the right along the horizontal axis, fewer machines are idle, there are fewer empty tables in restaurants, and other indicators (for example, more people working overtime shifts) show a reduction of spare capacity in factories and shops. MONIAC had tanks for each of the components of domestic GDP, such as investment, consumption, and government expenditures. The Eurozone is called a common currency area (or currency union) because all the members use the euro. It fell in 2001, pulling the economy into recession. The economy then entered a quick period of growth, and in the first three months of 1981 grew at an 8.4 percent annual rate. At the start of year 1 following the opening up of the bargaining gap and after wages and prices have been adjusted, inflation is equal to the bargaining gap (2%) plus expected inflation (3%). Workers’ bargaining power can increase due to an increase in the unemployment level along a given wage-setting curve. In the Unit 9 Einstein, λ represented value added per worker, or labour productivity. From the 1950s to the present day, U.S. economic cycles have lasted about five and a half years on average. We know that both parties cannot be satisfied with the outcome at low unemployment, because their claims add up to more than the size of the pie. The Phillips curve shifted higher until the 1980s, but shifted lower in the 1990s-2010s. With the fall in the unemployment rate to 3%, the Phillips curve shifts up immediately. Economic cycle refers to the overall state of the economy going through four stages in a cyclical pattern. The labour market equilibrium occurs at zero inflation and 6% unemployment rate. Answer the question on the basis of the following information. Refer to the given information. A. Typically when drawing indifference curves, a choice further from the origin is preferred since more of what is on each axis is preferred. In the multiplier diagram, the intercept of the aggregate demand line with the vertical axis includes investment, which means that the line shifts whenever the interest rate is changed by the central bank, or when business confidence changes. Look at Figure 15.7. As long as employment remains above the labour market equilibrium, employees will be disappointed at the end of the year. Making the central bank independent, with an explicit inflation target, makes it easier for the central bank to resist political pressure. At A, the economy is at labour market equilibrium. Work through the steps of the analysis in Figure 15.5 to see how the policymaker’s preferences are described by indifference curves. By contrast, Friedman, supported by evidence from many countries from the late 1960s, showed that if a government tries to keep unemployment ‘too low’ the result will be not just higher inflation, but rising inflation as well. 20.9 Why is addressing climate change so difficult? The Phillips curve will not shift up when the economy is at labour market equilibrium. To stabilize the economy, the central bank stimulates investment by lowering the real interest rate from r to r′. But there is a second reason for the relationship between low unemployment and high inflation. The trough of the cycle is reached when the economy hits a low point and growth begins to recover. From Unit 10, the interest rate tells you how many dollars (or euros, pounds, or the currency you use) you will have to pay in the future in exchange for borrowing $1 today. One tool at the government’s disposal is fiscal policy. The Phillips curve has shifted up because expected inflation increased. 4.13 Social interactions: Conflicts in the choice among Nash equilibria, 5—Property and power: Mutual gains and conflict, 5.2 Evaluating institutions and outcomes: The Pareto criterion, 5.3 Evaluating institutions and outcomes: Fairness, 5.7 Economically feasible allocations and the surplus, 5.8 The Pareto efficiency curve and the distribution of the surplus, 5.10 Bargaining to a Pareto-efficient sharing of the surplus, 5.11 Angela and Bruno: The moral of the story, 5.13 A policy to redistribute the surplus and raise efficiency, 6—The firm: Owners, managers, and employees, 6.1 Firms, markets, and the division of labour, 6.2 Other people’s money: The separation of ownership and control, 6.6 Work and wages: The labour discipline model, 6.7 Wages, effort, and profits in the labour discipline model, 6.8 Putting the model to work: Owners, employees, and the economy, 6.9 Another kind of business organization, 6.10 Principals and agents: Interactions under incomplete contracts, 7.2 Economies of scale and the cost advantages of large-scale production, 7.3 Production: The cost function for Beautiful Cars, 7.4 Demand and isoprofit curves: Beautiful Cars, 7.5 Setting price and quantity to maximize profit, 7.6 Look at profit maximization as marginal revenue and marginal cost, 7.9 Using demand elasticities in government policy, 7.10 Price-setting, competition, and market power, 7.11 Product selection, innovation, and advertising, 8—Supply and demand: Price-taking and competitive markets, 8.1 Buying and selling: Demand and supply, 8.5 Competitive equilibrium: Gains from trade, allocation, and distribution, 8.10 Price-setting and price-taking firms, 9—The labour market: Wages, profits, and unemployment, 9.1 The wage-setting curve, the price-setting curve, and the labour market, 9.2 Measuring the economy: Employment and unemployment, 9.3 The wage-setting curve: Employment and real wages, 9.5. Members of the currency union lose their ability to set the interest rate nationally. Iwata, who is the president of the Japan Center of Economic Research, also believes the pandemic will cause the country to experience deflation into 2022. In the event of a financial crisis, would it be preferable for the government to stabilize the economy using fiscal or monetary policy? No. What will happen to inflation? The bottom two rows in Figure 15.17 show that the slowdown led to rising unemployment and falling inflation, exactly as we would expect from a negative demand shock. The central bank can set the real interest rate to below zero by setting the nominal interest rate below the inflation rate (recall the Fisher equation). At the level of the economy as a whole, the national pie to be divided between owners and employees shrinks when more has to be paid for imports. 1991. As a result, the high-inflation countries granted much more independence to their central bank, with a low inflation target embedded in official statutes. Oxonomics 1 (1): pp. The European Central Bank (ECB) in Frankfurt sets the policy interest rate, because it controls the base money used by all banks in the Eurozone. Back then, anything with a whiff of exposure to real estate was at the centre of speculation. For example, if a T-shirt in Australia costs 20 AUD, and the exchange rate with the USD is 1.07 (remember this is the number of AUD for one USD), then the T-shirt costs 20/1.07 = 18.69 USD in the US. During times of expansion, investors seek to purchase companies in technology, capital goods, and basic energy. As a result, the firm’s costs include not only wages but also the costs of purchasing these imported materials. We will observe lower unemployment and higher inflation as in Phillips’ original empirical scatter plot. Why monetary policy, and what are its limits?
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