lOMoARcPSD|9890064
;/[[[UNIT 15: INFLATION, UNEMPLOYMENT, AND MONETARY POLICY:
15.1: Whats wrong with inflation?
What is the difference between inflation, deflation, and disinflation?
Zero inflation: A constant price level from year to year means that inflation is zero. This is like a stationary car:
the car’s location is constant and the distance travelled per hour is zero.
Inflation: Now, consider a rate of inflation, such as 2% per year. This means that the price level goes up by 2%
each year. This is the case of a car travelling at a constant speed: a car travelling at 20 km per hour means
that the distance from the initial location increases by 20 km each hour. After two hours, the car is 40 km
away from its initial location; after another hour, it is 60 km away, and so on.
Deflation: Deflation is when the price level falls. This is equivalent to the car travelling backward at 20 km per
hour. After an hour, the car is 20 km behind its initial location, and so on.
Rising inflation: If the rate of inflation is increasing, the price level is increasing at an increasing rate. Suppose
now that the rate of inflation increases from 2% to 4% to 6% in successive years, so the economy experiences
rising inflation. This is the case of a car accelerating: the distance travelled from the starting point is
increasing at an increasing rate, for example from 20 km per hour in the first hour to 40 km per hour in the
second hour, and so on. After two hours, the car is 60 km away from its initial location.
Falling inflation: This is called disinflation and is equivalent to a car reducing its speed, for example from 60
km per hour to 40 km per hour to 20 km per hour. Once the speed reaches zero, the car’s location does not
change. The equivalent in the economy is that when inflation falls to zero, the price level does not change.
Why do people dislike inflation?
For some people in the economy, such as some pensioners, incomes are fixed in nominal terms, meaning that they
receive a fixed number of yuan or dollars or euros. If prices rise during the year, these households can buy fewer
goods and services at the end of the year than they could at the beginning. They are worse off and will tend to vote
against a party they believe will permit higher inflation.
Whether one loses or benefits from inflation also depends on which side of the credit market one is on.
inflation means that:
Borrowers with nominal debt will benefit: Those with mortgages on fixed nominal interest rate
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.
Very high inflation will wipe out the value of nominal assets
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
Fisher equation :The relation that gives the real interest rate as the difference between the nominal interest rate and
expected inflation: real interest rate = nominal interest rate – expected inflation.
The real interest rate
measures the buying
power of the
repayment of a loan at the prices that exist when the loan is repaid. To see what this means, let’s suppose 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%.
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. Large price changes create uncertainty, and make it more difficult for
individuals and firms to make decisions based on prices.
Negatives of high and volatile inflation:
, lOMoARcPSD|9890064
it is hard to separate the signal about the scarcity of resources (sent by relative prices) from the noise of
erratically rising prices.
Firms might find it harder to know which sector to invest in
Individuals would find it harder to find out if products are more expensive or not, and which are
Firms have to keep updating their prices, this requires time and resources, referred to as menu costs.
Negative of deflation:
Same reasons as inflation but could be even more dramatic
When prices fall, households will postpone their consumption because they expect goods to become
cheaper
Deflation also increases the debt burden of borrowers
This fall in consumption will lead to lower AD, leading to further price drops and a spiral effect (This
happened in Japan)
Economists generally think low and stable inflation is good.
15.2: Inflation results from conflicting and inconsistent claims on output:
Imagine firms set their wages and prices consistent with the maximising profit rate, then there will be no reason for
prices or wages to change, at this unemployment rate the price level is constant. This is the labour market nash
equilibrium from unit 9.
Suppose now government adopts protectionist policies, which make it difficult for foreign firms to enter its markets.
Then markets facing the firm become less competitive, so firm can charge higher mark-up. This results in increasing
price levels which lower real wage of workers. So, workers lack motivation to work, so HR departments raise nominal
wage. Both prices and wages rise and economy experiences inflation.
The nominal wage increase leads to raised cost of production, so mark-up increases, and prices rise. So real wage
falls, and HR then raises nominal wages again, this will continue as long as:
Firms are powerful enough to charge the higher mark-up
Workers at given unemployment rate have enough bargaining power to require the initial real wage in order
to motivate them to work
Inflation can rise also when degree of competition remains constant but level of employment rises. At new lower
level of unemployment firms would want to pay workers a higher real wage to keep them. This induces prices to rise,
to maintain mark-up, leading again to inflation.
To summarise, inflation may result from:
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 mark-up. It is a downward shift of the price-setting curve.
An increase in the bargaining power of workers over firms: This allows them to get a higher wage in return
for working hard.
Bargaining power of workers can increase in 2 ways:
A shift upward of the wage-setting curve: The wage they would receive is higher at every level of
employment.
An increase in the level of employment, moving along the wage-setting curve: In this case, the wage-setting
curve is unchanged.
;/[[[UNIT 15: INFLATION, UNEMPLOYMENT, AND MONETARY POLICY:
15.1: Whats wrong with inflation?
What is the difference between inflation, deflation, and disinflation?
Zero inflation: A constant price level from year to year means that inflation is zero. This is like a stationary car:
the car’s location is constant and the distance travelled per hour is zero.
Inflation: Now, consider a rate of inflation, such as 2% per year. This means that the price level goes up by 2%
each year. This is the case of a car travelling at a constant speed: a car travelling at 20 km per hour means
that the distance from the initial location increases by 20 km each hour. After two hours, the car is 40 km
away from its initial location; after another hour, it is 60 km away, and so on.
Deflation: Deflation is when the price level falls. This is equivalent to the car travelling backward at 20 km per
hour. After an hour, the car is 20 km behind its initial location, and so on.
Rising inflation: If the rate of inflation is increasing, the price level is increasing at an increasing rate. Suppose
now that the rate of inflation increases from 2% to 4% to 6% in successive years, so the economy experiences
rising inflation. This is the case of a car accelerating: the distance travelled from the starting point is
increasing at an increasing rate, for example from 20 km per hour in the first hour to 40 km per hour in the
second hour, and so on. After two hours, the car is 60 km away from its initial location.
Falling inflation: This is called disinflation and is equivalent to a car reducing its speed, for example from 60
km per hour to 40 km per hour to 20 km per hour. Once the speed reaches zero, the car’s location does not
change. The equivalent in the economy is that when inflation falls to zero, the price level does not change.
Why do people dislike inflation?
For some people in the economy, such as some pensioners, incomes are fixed in nominal terms, meaning that they
receive a fixed number of yuan or dollars or euros. If prices rise during the year, these households can buy fewer
goods and services at the end of the year than they could at the beginning. They are worse off and will tend to vote
against a party they believe will permit higher inflation.
Whether one loses or benefits from inflation also depends on which side of the credit market one is on.
inflation means that:
Borrowers with nominal debt will benefit: Those with mortgages on fixed nominal interest rate
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.
Very high inflation will wipe out the value of nominal assets
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
Fisher equation :The relation that gives the real interest rate as the difference between the nominal interest rate and
expected inflation: real interest rate = nominal interest rate – expected inflation.
The real interest rate
measures the buying
power of the
repayment of a loan at the prices that exist when the loan is repaid. To see what this means, let’s suppose 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%.
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. Large price changes create uncertainty, and make it more difficult for
individuals and firms to make decisions based on prices.
Negatives of high and volatile inflation:
, lOMoARcPSD|9890064
it is hard to separate the signal about the scarcity of resources (sent by relative prices) from the noise of
erratically rising prices.
Firms might find it harder to know which sector to invest in
Individuals would find it harder to find out if products are more expensive or not, and which are
Firms have to keep updating their prices, this requires time and resources, referred to as menu costs.
Negative of deflation:
Same reasons as inflation but could be even more dramatic
When prices fall, households will postpone their consumption because they expect goods to become
cheaper
Deflation also increases the debt burden of borrowers
This fall in consumption will lead to lower AD, leading to further price drops and a spiral effect (This
happened in Japan)
Economists generally think low and stable inflation is good.
15.2: Inflation results from conflicting and inconsistent claims on output:
Imagine firms set their wages and prices consistent with the maximising profit rate, then there will be no reason for
prices or wages to change, at this unemployment rate the price level is constant. This is the labour market nash
equilibrium from unit 9.
Suppose now government adopts protectionist policies, which make it difficult for foreign firms to enter its markets.
Then markets facing the firm become less competitive, so firm can charge higher mark-up. This results in increasing
price levels which lower real wage of workers. So, workers lack motivation to work, so HR departments raise nominal
wage. Both prices and wages rise and economy experiences inflation.
The nominal wage increase leads to raised cost of production, so mark-up increases, and prices rise. So real wage
falls, and HR then raises nominal wages again, this will continue as long as:
Firms are powerful enough to charge the higher mark-up
Workers at given unemployment rate have enough bargaining power to require the initial real wage in order
to motivate them to work
Inflation can rise also when degree of competition remains constant but level of employment rises. At new lower
level of unemployment firms would want to pay workers a higher real wage to keep them. This induces prices to rise,
to maintain mark-up, leading again to inflation.
To summarise, inflation may result from:
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 mark-up. It is a downward shift of the price-setting curve.
An increase in the bargaining power of workers over firms: This allows them to get a higher wage in return
for working hard.
Bargaining power of workers can increase in 2 ways:
A shift upward of the wage-setting curve: The wage they would receive is higher at every level of
employment.
An increase in the level of employment, moving along the wage-setting curve: In this case, the wage-setting
curve is unchanged.
