UNIT15-无代写
时间:2024-03-20
THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
19: Inequality
21: Innovation
22: Politics and policy
UNIT 15
INFLATION, UNEMPLOYMENT,
AND MONETARY POLICY
HOW THE RATE OF UNEMPLOYMENT AND THE
LEVEL OF OUTPUT IN THE ECONOMY AFFECT
INFLATION, THE CHALLENGES THIS POSES TO
POLICYMAKERS, AND HOW THIS KNOWLEDGE CAN
SUPPORT EFFECTIVE POLICIES TO STABILIZE
EMPLOYMENT AND INCOMES
• 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).
• They typically cannot have both and face a trade-off instead.
• 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.
• Adverse shocks, such as an oil price increase, can lead to higher
unemployment and higher inflation.
• Many governments have given responsibility for monetary policy—often
described as inflation targeting—to central banks.
Before his successful 1992 US presidential campaign, Bill Clinton’s
electoral strategists had decided that two of their campaign issues should be
health policy and ‘change’. But it was the third focus of his campaign—the
recession of 1991—that resonated with the public. The reason was the
phrase the campaign workers used: ‘The economy, stupid!’
The 1991 recession meant that many Americans lost their jobs, and the
Clinton campaign slogan brought this issue to the attention of the voters.
When the ballots were counted in November 1992, Clinton received almost
6 million more votes than George H. W. Bush, the incumbent president.
In a democracy, election outcomes are always affected by the state of the
economy, and how the public judges the economic competence of the gov-
Sonoma County Hot Air Balloon Classic, California, USA
641
ernment and the opposition. Two important measures of this economic
performance are unemployment and inflation. In Unit 13 we saw that
unemployment undermines our wellbeing, but inflation worries us too.
Figure 15.1 shows that in US presidential elections, the margin of victory of
the ruling party is higher when inflation is lower.
So if you are a politician worrying about your citizens’ concerns as well
as your own career, you should minimize both unemployment and
inflation. Is this possible?
We get an insight by looking at how a German minister of finance,
trained as an economist, handled his dual role as a politician (at an election
rally in the evening) and as an economist (in his office the next day).
Helmut Schmidt was called the ‘super minister’ in the West German gov-
ernment of Chancellor Willy Brandt because he was both minister of
economics and minister of finance.
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.
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. But you
cannot advise me about what I decide is politically expedient to say to an
election rally in front of 10,000 Ruhr miners in the Westfalenhalle in
Dortmund.’
Helmut Schmidt’s commitment at the rally and his explanation
afterward, show two things about the relationship between economics and
politics. The first is that politicians are elected to office, and so respond to
the views of voters. The second is that politicians as policymakers face con-
straints on their choice of policies. They can’t just promise the economic
outcomes that voters care about—in Schmidt’s case: low unemployment,
Helmut Schmidt (1918–2015) was
West German Chancellor from
1974 until 1982. In 1972, inflation
in West Germany was 5.5% (up
from 5.2% the previous year) and
unemployment was 0.7% (up from
0.5% the previous year). By 1975,
inflation was 5.9% and unemploy-
ment was 3.1%.
Line of best fit R2 = 0.30
1924
1940
1996
1912
1976
1916
1948
1980
1920
−16
−12
−8
−4
0
4
8
12
16
0 4 8 12 16
Annual inflation (%)
Ru
lin
g
pa
rt
y
m
ar
gi
n
of
vi
ct
or
y
or
de
fe
at
(%
)
Figure 15.1 Inflation and presidential election victory in the US (1912–2020).
View this data at OWiD https://tinyco.re/
3226355
Note: In the chart, two years in which
deflation occurred have been omitted. If
the two observations in which deflation
(falling prices) occurred are included in
the regression in absolute values—
reflecting the fact that it is changes in
prices that are unpopular—then the
relationship shown in the figure is
stronger. The R-squared is 0.43
compared to 0.30, and the coefficient on
inflation is still negative and significant.
Inflation before 1950: Michael Bordo,
Barry Eichengreen, Daniela Klingebiel,
and Maria Soledad Martinez-Peria. 2001.
‘Is the crisis problem growing more
severe?’. Economic Policy 16 (32) (April):
pp. 52–82; CPI after 1950: Federal
Reserve Bank of St. Louis. 2021. FRED
(https://tinyco.re/3965569); Electoral
results: US National Archives. 2021.
‘1789–2021 Presidential Elections’
(https://tinyco.re/6521380). US Electoral
College.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
642
opportunity cost When taking an
action implies forgoing the next
best alternative action, this is the
net benefit of the foregone
alternative.
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 An increase in the general
price level in the economy. Usually
measured over a year. See also:
deflation, disinflation.
deflation A decrease in the general
price level. See also: inflation.
disinflation A decrease in the rate
of inflation. See also: inflation,
deflation.
and low and stable inflation. The economist in Schmidt was well aware of
the constraints but, at the rally, he was speaking as a politician.
While the policymaker wants to deliver both low unemployment and
low inflation, the economy operates in such a way that when unemploy-
ment goes down, inflation tends to go up. And when inflation falls,
unemployment tends to go up. This is a problem we have seen before:
policymakers must deliver what is feasible, and this involves trading one
objective off against the other. Another way to say this: more inflation is the
opportunity cost of higher unemployment, and less inflation is the oppor-
tunity cost of lower unemployment. Moreover, the economy is subject to
shocks that can make both inflation and unemployment worse, limiting the
set of feasible outcomes. And experience from the late 1960s showed that
inflation would carry on rising if unemployment were too low. This was the
setting for Helmut Schmidt’s reflections on his election promise.
Following the experience of rising inflation across the world, during the
late 1980s there was a rethinking of how macroeconomic policy should be
designed. In the 1990s, the policy known as inflation targeting by central
banks was widely adopted. Many governments delegated the management
of fluctuations in the economy to the central bank, with fiscal policy
playing a lesser role, and recognized that policies to improve the supply side
of their economies—such as increasing competition and better functioning
labour markets—were necessary if they wanted to achieve a lower rate of
unemployment compatible with low and stable inflation.
As we saw in Unit 11, prices are messages. They send signals about
scarce resources. We looked at how shifts in demand or supply for a good
resulted in a change in its price relative to other goods and services, and
how this signalled a change in the relative scarcity of the good or service. In
this unit, we look not at relative prices but at inflation or deflation: a rise or
fall in prices in general. We begin by asking how inflation got a bad name.
•15.1 WHAT’S WRONG WITH INFLATION?
Before we turn to the question, we need to clarify a few terms.
What is the difference between inflation, deflation, and disinflation?
A car analogy is a useful way to think about these differences. We can
compare what happens to the price level in the economy with a car’s initial
location and the speed at which it travels:
• 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 con-
stant and its speed 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, for example 20 km/h.
• Deflation: Deflation is when the price level falls.
• 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: it
travels for a period of time at 20 km/h, then at 25 km/h.
• Falling inflation: This is called disinflation and is equivalent to a car
reducing its speed, for example from 20 km/h to 15 km/h and then 10
km/h. Once the speed reaches zero, the car’s location does not change.
15.1 WHAT’S WRONG WITH INFLATION?
643
DESCRIBING A CHANGE IN PRICE
LEVEL
• Inflation: The price level is rising
• Deflation: The price level is
falling
• Disinflation: The inflation rate is
falling
nominal interest rate The interest
rate uncorrected for inflation. It is
the interest rate quoted by high-
street banks. See also: real interest
rate, interest rate.
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.
See also: nominal interest rate,
interest rate.
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 equivalent in the economy is that when inflation falls to zero, the
price level does not change.
We have seen why voters dislike unemployment. But why do voters 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. Julia the borrower and Marco the lender (in
Unit 10) have a conflict about the interest rate at which Julia borrows. They
also have differing interests about inflation, because if prices rise before
Julia repays her loan, Marco will find that he can buy less with the
repayment than would have been the case if there were zero inflation.
More generally, using the same logic as we used when discussing the
government’s debt in the previous unit, inflation means that:
• Borrowers with nominal debt will benefit: Those with mortgages on fixed
nominal interest rate loans, for example, 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.
Very high inflation will wipe out the value of nominal assets, which
happened in Zimbabwe in 2008–2009.
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. 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%.
In addition to redistributing income from creditors (those with assets)
and those on nominally fixed incomes (like pensioners) to debtors, in some
cases inflation can also make the economy work less well. 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.
‘In Dollars They Trust’
(https://tinyco.re/3392021). The
Economist. Updated 27 April 2013.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
644
relative price The price of one
good or service compared to
another (usually expressed as a
ratio).
menu costs The resources used in
setting and changing prices.
In an environment of high and volatile inflation, 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, 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. Moreover, in
an inflationary environment, firms have to update their prices more
frequently than they would prefer. This requires time and resources,
referred to as menu costs.
Would households and firms be better off with falling prices? No. A
sustained fall in the price level is undesirable for many of the same reasons
that inflation is undesirable, and could have even more dramatic economic
consequences. When prices are falling, households will postpone consump-
tion (particularly of expensive items such as fridges, televisions, and cars)
because they expect goods will be cheaper in the future. Similarly, deflation
increases the debt burden of borrowers, for the same reason that inflation
reduces it.
As we have seen in Unit 14, a rise in the debt burden depresses con-
sumption because some affected households save to restore their target
wealth and others find themselves credit-constrained. The fall in consump-
tion will induce a drop in aggregate demand and economic activity. Weaker
aggregate spending will tend to depress prices further and can trigger a
vicious circle of falling prices and economic stagnation.
This happened in Japan. The Japanese economy was one of the great
success stories of the period after the Second World War. The upward slope
of its hockey stick was remarkably steep, as you saw in Unit 1. Living
standards, as measured by GDP per capita, went from less than one-fifth of
the level in the US in 1950 to more than 70% by 1980. But in the past 25
years, Japan has faced low growth and rising unemployment. For the first
time for an advanced economy in the postwar period, there has been
persistent deflation: deflation was observed in 12 years out of 21 between
1995 and 2015.
Many economists think that a little bit of inflation is a good thing, as
long as it remains stable. In the next unit we will see one reason why this is
the case. 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. With rising prices, a fall in
real income among the losers may be masked by the fact that nominal
incomes are rising, or at least not falling. For example, many people will not
even notice a slight fall in their real wage due to modest inflation, but
nobody would fail to notice a reduction in his or her nominal wage. With
some low inflation, the adjustment of workers and resources between dif-
ferent firms and industries in response to changes in relative wages can take
place without losers experiencing falling nominal wages. Inflation greases
the wheels of the labour market.
Another important reason to prefer a bit of inflation to none is that it
gives monetary policy more room to manoeuvre. As we will see later, posit-
ive inflation allows the real interest rate to go lower in order to offset a
major recession than if inflation is zero.
15.1 WHAT’S WRONG WITH INFLATION?
645
QUESTION 15.1 CHOOSE THE CORRECT ANSWER(S)
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):
2010 2011 2012 2013
Japan −1.9% −1.7% −0.8% −0.3%
UK 1.6% 2.0% 1.6% 1.9%
China 6.9% 8.2% 2.4% 2.2%
Nauru −18.2% 18.1% 24.1% −21.7%
Based on this information, which of the following statements is
correct?
Japan experienced a persistent period of disinflation between 2010
and 2013.
In the UK the price of goods and services remained stable between
2010 and 2013.
China has been experiencing deflationary pressure between 2011
and 2013.
Nauru’s price level at the end of 2013 is lower than it was at the
start of 2010.
QUESTION 15.2 CHOOSE THE CORRECT ANSWER(S)
The following table shows the nominal interest rate and the annual
inflation rate (the GDP deflator) of Japan in the period 1996–2015
(Source: World Bank).
1996–2000 2001–2005 2006–2010 2011–2015
Interest rate 1.5% 1.4% 1.3% 1.2%
Inflation rate –1.9% –0.9% –0.5% 1.6%
Based on this information, which of the following statements are
correct?
The real interest rate in 1996–2000 was –0.4%.
Japan’s real interest rate has been rising consistently over this
period.
Japan’s real interest rate turned from being positive to negative
during the period.
The real interest rate has been falling faster than the nominal
interest rate.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
646
protectionist policy Measures
taken by a government to limit
trade; in particular, to reduce the
amount of imports in the economy.
These are designed to protect local
industries from external competi-
tion. They can take different forms,
such as taxes on imported goods or
import quotas.
15.2 INFLATION RESULTS FROM CONFLICTING AND
INCONSISTENT CLAIMS ON OUTPUT
Inflation arises from conflicts among economic actors, when they are
powerful enough that their claims on goods and services are inconsistent.
To see how this works, think of an economy composed of many firms
(each of which is owned by a single individual) and their employees, who
are also the consumers of the various goods produced by the firms. To keep
track of what is happening in the firms, we assume that prices are set by the
marketing department and wages by the human resources (HR) department.
Initially the marketing department in each firm is setting prices based on
the markup that maximizes its profits, given the degree of competition in
the markets in which it sells (as we saw in Units 7 and 9). And the HR
department is also setting the real wage for its workers (which is the
nominal wage in the firm, divided by the price level in the economy) as the
lowest wage consistent with workers actually working, given the level of
unemployment in the economy (as we saw in Units 6 and 9).
If, once all firms have set their wages and prices, the wage rate and the
price level are consistent with the firms maximizing their profits, then there
will be no reason for either prices or wages to be changed. At this
unemployment rate, the price level is constant (inflation is zero). This is the
level of unemployment where the wage-setting and price-setting curves
intersect, that is, the labour market Nash equilibrium that we saw in Unit 9.
Suppose now that the government adopts protectionist policies, which
make it difficult for foreign firms to enter its markets. Then the markets
facing the firm become less competitive, so that the firm can charge a
higher markup on its costs. If this is the case across the economy, the
resulting increase in the price level will lower the real wage of the workers.
But while the owner of an individual firm is happy with the higher price
that the marketing department can now charge, the workers are unhappy
with the fall in the real wage. The result is that workers now lack the
motivation to work. So the HR department of the firm will raise its
nominal wage, and all other firms will do the same. Both prices and wages
have risen and the economy experiences inflation.
Will it end there? No. The nominal wage increase has raised the cost of
production to firms and they will use this as the basis of their markup
pricing, leading to a further increase in prices and a fall in the real wage,
which the HR department will correct by again raising the nominal wage.
The process of rising wages and prices will continue as long as:
• firms are powerful enough to charge the higher markup
• workers at the given unemployment rate have enough bargaining power
to require the initial real wage in order to motivate them to work
In the example given, inflation rose while unemployment did not change,
following a change in the competitive conditions facing firms that allowed
them to raise their markup, increasing the owners’ profits. But there are
other ways that the process could have begun from the same starting point.
Suppose the degree of competition in product markets remains the same,
but the level of employment rises. At the new lower level of unemployment
the firms would want to pay workers a higher real wage to keep them
working. This induces the marketing departments of firms to raise their
prices, so as to maintain the markup that competitive conditions allowed.
And the inflationary process would begin.
15.2 INFLATION RESULTS FROM CONFLICTING AND INCONSISTENT CLAIMS
647
wage inflation An increase in the
nominal wage. Usually measured
over a year. See also: nominal
wage.
To summarize, 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 markup. 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.
There are two ways that the increase in the bargaining power of workers
could take place:
• 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.
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.
The movement along the wage-setting curve, rather than a shift in the
curve, is what we will analyse next.
Figure 15.2 summarizes three causes of inflation. In Section 15.3, we
explain how the changes in bargaining power illustrated in Figure 15.2
translate into inflation. The third cause—higher employment may result in
inflation—came to light when William (Bill) Phillips, the economist,
published a scatter plot of annual wage inflation and unemployment in the
British economy. This is shown in Figure 15.3.
Re
al
w
ag
e Price-setting curve
shifts down
Wage-setting curve
Price-setting curve
Re
al
w
ag
e Wage-setting curve
shifts up
Wage-setting curve
Price-setting curve
Re
al
w
ag
e
Employment, N
Unemployment falls
Wage-setting curve
Price-setting curve
1. Owners’ power rises relative to
consumers’ (e.g. lower competition) –
medium to long run
2. Employees’ power rises relative to
owners’ (e.g. stronger unions) –
medium to long run
3. Employees’ power rises relative to
owners’ in a business cycle upswing –
short to medium run
Figure 15.2 Three causes of inflation: changes in bargaining power.
1. Owners’ power rises relative to
consumers’
For example, due to lower competition
(medium- to long-run effect).
2. Employees’ power rises relative to
owners’
For example, due to stronger unions
(medium- to long-run effect).
3. Employees’ power rises relative to
owners’
For example, due to a business cycle
upswing (short- to medium-run effect).
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
648
−4
−2
0
2
4
6
8
24681012
Unemployment rate (%)
In
fla
tio
n
(%
)
Figure 15.3 Phillips’s original curve: Wage inflation and unemployment
(1861–1913).
See more https://tinyco.re/2934011
Ryland Thomas and Nicholas Dimsdale.
(2017). ‘A Millennium of UK Data’
(https://tinyco.re/0223548). Bank of
England OBRA dataset.
A. W. Phillips. 1958. ‘The Relation
Between Unemployment and the
Rate of Change of Money Wage
Rates in the United Kingdom,
1861–1957’ (https://tinyco.re/
5934214). Economica 25 (100):
p. 283.
GREAT ECONOMISTS
Bill Phillips
A. W. (‘Bill’) Phillips (1914–1975)
was an unusually colourful
character for a world-renowned
economist. Raised in New
Zealand, Phillips spent time as a
crocodile hunter, a movie director,
and a prisoner of war in Indonesia
during the Second World War,
before finally becoming a
professor at the London School of
Economics.
Phillips had engineering know-
how, and while studying sociology
in London in 1949, he built a hydraulic machine to model the British
economy. The Monetary National Income Analogue Computer
(https://tinyco.re/0194162) (MONIAC) used transparent pipes and
coloured water to bring economists’ equations to life. It was like the
hydraulic economy model produced by Irving Fisher half a century
earlier (mentioned in Unit 2), but much more elaborate. MONIAC had
tanks for each of the components of domestic GDP, such as investment,
consumption, and government expenditures. Imports and exports were
shown by water being added or drained from the model. The machine
could be used to model the effect on the economy of shocks to different
variables, such as tax rates and government spending, which would set
in motion flows between the tanks. Working versions of the machine
15.2 INFLATION RESULTS FROM CONFLICTING AND INCONSISTENT CLAIMS
649
Phillips curve An inverse relation-
ship between the rate of inflation
and the rate of unemployment.
QUESTION 15.3 CHOOSE THE CORRECT ANSWER(S)
The following diagram depicts the model of the labour market:
Workers (millions)
Employed Unemployed
Wage-setting curve
Re
al
w
ag
e
Labour supply
Labour productivity
Price-setting curve
A
5 9 10
Suppose now that the government adopts policies that make it difficult
for foreign firms to enter its markets. Assume that the level of employ-
ment and the labour supply remain constant. Which of the following
statements regarding mechanisms by which inflation is created are
correct?
With reduced competition, firms can now charge a higher markup
on their costs, raising the price-setting curve.
With the labour market not in equilibrium at the lower real wage,
the workers now lack the motivation to work at the given
unemployment rate. Therefore the wage is increased, described by
an upward shift in the wage-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.
can still be found in the London Science Museum and universities
around the world.
In a 1958 paper, Phillips made another major contribution to the
study of economics. By drawing a scatterplot of the data for the rates of
unemployment and inflation in the British economy between 1861 and
1913, he found that low rates of unemployment were associated with
high rates of inflation, and high unemployment with low inflation. The
relationship has since been referred to as the Phillips curve.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
650
QUESTION 15.4 CHOOSE THE CORRECT ANSWER(S)
The following diagram depicts the model of the labour market:
Workers (millions)
Employed Unemployed
Wage-setting curve
Re
al
w
ag
e
Labour supply
Labour productivity
Price-setting curve
A
5 9 10
Suppose there is an increase in workers’ bargaining power that causes
inflation. Which of the following statements are correct?
Workers’ bargaining power can increase due to an increase in
unemployment benefits, resulting in a rise in the wage-setting
curve.
Workers’ bargaining power can increase due to an increase in the
unemployment level along a given wage-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.
After the initial increase in the workers’ bargaining power, the firms
adjust the wages and prices, creating inflation. Neither the wage
nor the price-setting curve shifts.
15.3 INFLATION, THE BUSINESS CYCLE, AND THE
PHILLIPS CURVE
When central banks report their interest rate decision to the public, they
normally justify a rise in the interest rate by saying that forecast inflation is
up. They are raising the interest rate to dampen aggregate demand, raise
cyclical unemployment, and as a result, bring inflation back toward target.
Conversely, if they are announcing a lower interest rate, they explain
that this is because there is a danger of inflation falling too low (possibly
into deflation). Just as a reduction in aggregate demand and employment
will bring inflation down, a rise in aggregate demand and employment will
increase inflation.
To model inflation, we assume that the HR departments of firms set
nominal wages (for example, in dollars, pounds, or euros) once a year, and
that the marketing departments set prices immediately after wages. The real
15.3 INFLATION, THE BUSINESS CYCLE, AND THE PHILLIPS CURVE
651
real wage The nominal wage,
adjusted to take account of
changes in prices between different
time periods. It measures the
amount of goods and services the
worker can buy. See also: nominal
wage.
wage-price spiral This occurs if an
initial increase in wages in the eco-
nomy is followed by an increase in
the price level, which is followed by
an increase in wages and so on. It
can also begin with an initial
increase in the price level.
wage that employees care about is their nominal wage relative to the eco-
nomy-wide level of prices, and is defined as:
It is the real wage on the vertical axis in the labour market diagram in
Question 15.4.
To see how inflation comes about in a business cycle upswing, we begin
with the economy at the labour market equilibrium and with constant
prices, and consider a rise in aggregate demand, which reduces unemploy-
ment below the equilibrium.
• 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.
What happens next? We assume that aggregate demand remains high
enough to keep unemployment below the labour market equilibrium. At the
next annual round of wage-setting, the HR department is in the same
position as the previous year: with continuing low unemployment, workers
are disappointed with their real wage. It must raise nominal wages. When
costs go up, the marketing department raises prices once more. This is
called the wage-price spiral. It explains why, at low unemployment, the
price level rises, not just in the year that unemployment fell, but year after
year.
If there is a recession instead of a boom, the wage-price spiral operates
in reverse, and the price level falls year after year.
We now ask why prices would have been constant year after year before
the boom in aggregate demand reduced unemployment. We will see that
when the labour market is in equilibrium (the normal phase of the business
cycle), there is no pressure for wages and prices to change. From Unit 9 we
know that labour market equilibrium is where the wage-setting curve and
the price-setting curve intersect. But why is this unemployment rate so
special for the rate of inflation?
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. As we saw in Unit 9, at this
point both workers and firms are doing the best that they can, given the
actions of the other. 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). 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. The real
wage will remain constant and no one will be disappointed.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
652
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 markup that maximizes profits
given the degree of competition.
In an economy at the unemployment rate at labour market equilibrium
(point A), wages and prices will be stable and inflation will be zero.
We now use the labour market diagram to show what happens in a
boom, when unemployment is lower than at A. Figure 15.4b shows how
workers’ claims to real wages and firms’ claims to real profits sum to more
than total productivity when unemployment is below equilibrium, and sum
to less than total productivity when unemployment is above equilibrium.
When unemployment is below equilibrium this leads to upwards pressure
on wages and prices, or a rising wage-price spiral. When unemployment is
above equilibrium it leads to downwards pressure on wages and prices, or a
declining wage-price spiral.
If we sketch the relationship between inflation and unemployment from
the three phases of the business cycle, we get something similar to the one
Phillips discovered in the data: when unemployment is lower, inflation is
higher and vice versa.
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. When the real wage given by the
wage-setting curve and that given by the price-setting curve are not equal,
we say there is a bargaining gap equal to the vertical distance between the
two curves.
• If unemployment is lower than at the equilibrium: There is a positive bar-
gaining gap and there is inflation.
• If unemployment is higher than at the equilibrium: There is a negative bar-
gaining gap and there is deflation.
• If there is labour market equilibrium: The bargaining gap is zero and the
price level is constant.
For example, if the wage on the price-setting curve is 100 and on the wage-
setting curve it is 101, the bargaining gap is 1%.
Employment, N
Unemployed at labour
market equilibrium
Real profit per worker
Real wage per worker
Output per worker
Re
al
w
ag
e
Labour supply
Labour productivity
Price-setting curve
A
Wage-setting curve
Figure 15.4a Inflation and conflict over the pie: Stable price level at labour market
equilibrium.
15.3 INFLATION, THE BUSINESS CYCLE, AND THE PHILLIPS CURVE
653
Bargaining
gap (%)
Increase in
wages (%)
Increase in unit
costs (%)
Increase in
prices (%) =
inflation (%)
The bargaining gap and the Phillips curve
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. So, to work out the inflation rate, we use the
following:
Employment, N
Employment at
labour market
equilibrium
Real profit per worker
Real wage per worker
Wage-setting curve
(High unemployment) (Low unemployment)
Re
al
w
ag
e
Labour productivity
Price-setting curve
AC B
Figure 15.4b Inflation and conflict over the pie at low and high unemployment.
1. Labour market equilibrium at A
At A, the economy is at labour market
equilibrium. The real wage on the
wage-setting curve is equal to that on
the price-setting curve, so firms’ claims
to real profit per worker plus the
workers’ claims to real wages sum to
labour productivity.
2. Low unemployment at B
At low unemployment, the real wage
required so that workers will work hard
increases so the claims of workers for
wages and owners for profits are
inconsistent: they sum to more than
labour productivity.
3. High unemployment at C
At high unemployment, workers are in
a weaker bargaining position. The
claims of workers and owners sum to
less than labour productivity.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
654
BARGAINING GAP
The difference between the real wage that firms wish to offer
in order to provide workers with incentives to work (the wage-
setting curve), and the real wage that allows firms the markup
on costs required to motivate them to continue in business (the
price-setting curve).
• When the bargaining gap is positive, the real wage on the
wage-setting curve is above the price-setting curve, and the
claims of employers and owners to output per worker are
inconsistent.
• The percentage bargaining gap is equal to the wage on the
wage-setting curve, minus the wage on the price-setting
curve, divided by the wage on the price-setting curve.
In Figure 15.4c, we draw a new diagram beneath
the wage-setting curve and price-setting curve.
This is the Phillips curve diagram, with inflation
on the vertical axis and employment on the hori-
zontal axis. If we begin with employment at the
labour market equilibrium, and inflation of zero,
we note that the economy can remain here: there
is no pressure for the price level to rise or fall.
This gives a point on the Phillips curve. Now con-
sider a higher level of employment due to stronger
aggregate demand. A positive bargaining gap
opens up and wages and prices will rise. Firms
increase wages in response to the fall in
unemployment. The price level rises as firms put
up their prices in response to the rise in their
labour costs. If the bargaining gap is 1%, prices
and wages will rise by 1%. This gives a second point on the Phillips curve.
As long as employment remains above the labour market equilibrium,
employees will be disappointed at the end of the year. Their real wage will
not have risen by 1% as they had anticipated, so they will bargain for
Employment, N
Wage-setting curve
Re
al
w
ag
e
Price-setting curve
1% = Bargaining gap (%), positive
Bargaining gap,
negative (–0,5%)
Employment at labour
market equilibrium, no
bargaining gap
Phillips curve
0
Inflation (%) = bargaining gap (%)
Deflation
–0.5
In
fla
tio
n
ra
te
, π
(%
)
1
Employment, N
Figure 15.4c Bargaining gaps, inflation, and the Phillips curve.
1. Labour market equilibrium
The bargaining gap is zero and
inflation is zero.
2. Low unemployment
The bargaining gap is positive and
inflation is positive.
3. High unemployment
The bargaining gap is negative and
inflation is negative.
15.3 INFLATION, THE BUSINESS CYCLE, AND THE PHILLIPS CURVE
655
another 1% rise. The result: wages and prices will rise by 1% the following
year as well: firms will put up wages by 1% to take the real wage up to the
wage-setting curve, and they will put up prices by 1% in response to that
cost increase. We will observe lower unemployment and higher inflation as
in Phillips’ original empirical scatter plot.
To complete the picture, we include the multiplier model beneath the
labour market and Phillips diagrams to bring the short- and medium-run
models together. This highlights that:
• At a higher level of aggregate demand (a boom) inflation is positive:
Unemployment is lower, which means there is a positive bargaining gap,
so wages and prices are rising continuously.
• At a lower level of aggregate demand (a recession), there is deflation:
Unemployment is higher, which means there is a negative bargaining
gap.
EXERCISE 15.1 THE BARGAINING GAP IN A RECESSION
Suppose the economy is initially at labour market equilibrium with stable
prices (inflation is zero). At the beginning of year 1, investment declines
and the economy moves into recession with high unemployment.
1. Explain why a negative bargaining gap arises.
2. Assume the negative bargaining gap is 1%. Draw a diagram with years
on the horizontal axis and the price level on the vertical axis. 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%.
3. Who are the winners and losers in this economy?
EXERCISE 15.2 POSITIVE AND NEGATIVE SHOCKS
Draw a labour market diagram where the economy is at labour market
equilibrium with stable prices. Now consider:
• A positive shock to aggregate demand that reduces the unemployment
rate by 2 percentage points.
• A negative shock that increases it by 2 percentage points.
1. What happens to the bargaining gap in each case?
2. What would you expect to happen to the price level in each case?
Explain your answers.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
656
Employment, N
Employment, N
Wage-setting curve
Re
al
w
ag
e
Price-setting curve
1% = Bargaining gap (%), positive
Bargaining gap,
negative (–0,5%)
Employment at labour
market equilibrium, no
bargaining gap
Phillips curve
0
Ag
gr
eg
at
e
de
m
an
d,
A
D
Su
pp
ly
s
id
e
(m
ed
iu
m
ru
n)
Inflation (%) = bargaining gap (%)
Deflation
–0.5
Output, Y
D
em
an
d
si
de
(s
ho
rt
ru
n)
45º
A
B
C
Recession
U = 9%
Normal
U = 6%
Boom
U = 3%
AD (low)
AD (medium)
AD (high)
In
fla
tio
n
ra
te
, π
(%
)
1
Figure 15.4d The short- and medium-run models: Aggregate demand, employment,
and inflation.
1. Labour market equilibrium
When the level of aggregate demand
produces employment at labour
market equilibrium (a normal level of
activity), the price level is stable
(inflation is zero).
2. A boom
At a higher level of aggregate demand
(a boom), there is a positive bargaining
gap and inflation is positive.
3. A recession
At a lower level of aggregate demand
(a recession), there is a negative bar-
gaining gap and deflation.
15.3 INFLATION, THE BUSINESS CYCLE, AND THE PHILLIPS CURVE
657
feasible set All of the combinations
of the things under consideration
that a decision-maker could choose
given the economic, physical or
other constraints that he faces. See
also: feasible frontier.
QUESTION 15.5 CHOOSE THE CORRECT ANSWER(S)
See Figure 15.4d (page 657) for diagrams of the labour market model,
the Phillips curve, and the multiplier model of aggregate demand. The
unemployment rates and the bargaining gaps at different states of the
economy are shown.
Based on this information, which of the following statements is
correct?
There is no inflation when the unemployment rate is zero.
In the boom shown, the upward shift in the aggregate demand
curve reduces the unemployment rate, which in turn creates a bar-
gaining 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%.
The resulting Phillips curve shows a positive correlation between
the unemployment rate and inflation rate.
•15.4 INFLATION AND UNEMPLOYMENT: CONSTRAINTS
AND PREFERENCES
Phillips’ original curve, and the model in Figure 15.4d, suggest that there is
a lasting trade-off between inflation and unemployment. For example, with
the Phillips curve in the figure, if the government is happy to have inflation
of 1% each year, then it can support a boom level of aggregate demand with
an unemployment rate of 3% year after year.
If it prefers stable prices (zero inflation), then it needs to keep aggregate
demand at the normal level, with unemployment of 6%. This suggests that
the Phillips curve is a feasible set from which the policymaker can select
the desired combination of unemployment and inflation. The policymaker
prefers low inflation and high employment, and those preferences can be
represented in the usual way in the form of indifference curves.
Work through the steps of the analysis in Figure 15.5 to see how the
policymaker’s preferences are described by indifference curves.
Note first some important features of the diagram. Typically when
drawing indifference curves, a choice further from the origin is preferred
since more of what is on each axis is preferred. In this case, the
policymaker’s best outcome is shown by point F, with inflation at the target
and full employment. As we saw at the end of Section 15.1, the policymaker
is likely to prefer low (stable) inflation to zero. This means the indifference
curves become vertical at, say, 2% inflation. Above target inflation, the
indifference curves are positively sloped, as getting employment closer to
full employment is worth accepting higher (above target) inflation. Below
the target, the indifference curves are negatively sloped, as getting employ-
ment closer to full employment is worth accepting lower (below target)
inflation.
We assume that there are diminishing marginal returns to the two
targets of high employment and low inflation. 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. Conversely, when the outcome is
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
658
further from full employment but closer to the inflation target, the indiffer-
ence curve is steeper because the policymaker places more value on getting
closer to full employment.
In the right-hand panel of the figure, the indifference curves and the
Phillips curve are shown. The policymaker sees the Phillips curve as the
feasible set and will try to use monetary or fiscal policy to choose the level
of aggregate demand so that employment is at C. This is the indifference
curve closest to the best outcome of F, which is consistent with the Phillips
curve trade-off.
In this example, the policymaker prefers a combination of unemploy-
ment of 3% and inflation of 5% to another feasible combination of
unemployment of 6% and a stable price level (zero inflation).
Employment, N Employment, N
Phillips curve
0
2
Best outcome
F
Worse outcomes
Labour supply
The policymakers’ preferences
In
fla
tio
n
(%
)
0
2
5
U = 6% U = 3%
Labour
supply
Policymaker’s
indifference curves
FC
Policymaker’s
indifference curves
In
fla
tio
n
(%
)
Feasible set
The policymakers’ preferences
and the Phillips curve trade-off
Figure 15.5 The Phillips curve and the policymaker’s preferences.
1. The policymaker’s preferences
The figure shows the policymaker’s
indifference curves.
2. High employment and inflation
When employment and inflation are
very high, the indifference curve is flat.
3. Lower employment and inflation
When inflation and employment are
lower, the indifference curve is steeper.
4. Inflation at 2%
The indifference curve is vertical when
inflation is at 2%.
5. Full employment
The indifference curve is horizontal
when employment = labour supply.
6. The policymaker’s preferred
outcome
F marks the policymaker’s preferred
combination of inflation and
unemployment.
7. The feasible set
The policymaker chooses from the
feasible set on the Phillips curve.
8. The preferred feasible outcome
This is on the Phillips curve at point C.
15.4 INFLATION AND UNEMPLOYMENT: CONSTRAINTS AND PREFERENCES
659
EXERCISE 15.3 THE PHILLIPS CURVE AND THE POLICYMAKER’S
PREFERENCES
The following questions refer to Figure 15.5 (page 659).
1. What would the policymaker’s indifference curves look like if the
policymaker cared only about low unemployment?
2. Which point on the Phillips curve would that policymaker choose?
3. What would the policymaker’s indifference curves look like if the
policymaker cared only about low inflation?
4. Which point on the Phillips curve would this policymaker choose?
5. What would the indifference curves look like if, to be re-elected, the
policymaker needed the support of pensioners more than that of
working-age people?
••15.5 WHAT HAPPENED TO THE PHILLIPS CURVE?
The model in Figure 15.5 suggests that a policymaker who is able to adjust
the level of aggregate demand can pick any combination of inflation and
unemployment along the Phillips curve. But the data in Figure 15.6 suggests
that the trade-off between inflation and unemployment is not a stable one.
There is a mass of data points and no discernible, positively sloped Phillips
curve.
Figure 15.6 shows the inflation and unemployment combinations for the
US for each year between 1960 and 2020. Note that on the horizontal axis,
the scale for the unemployment rate declines as we move to the right in the
figure. A Phillips curve sketched through the observations in the 1960s
gives a reasonably good picture of the inflation-unemployment trade-off in
that decade. But that curve clearly does not fit in other periods. The figure
shows how the Phillips curve changed over time.
In his presidential address to the American Economic Association in
December 1967, Milton Friedman provided an explanation for why the
Phillips curve is not stable. He referred to the recent experience in the US.
Since 1966 unemployment had been steady, averaging 3.7%, but inflation
had decreased from 3.0% to 1.2%. He said that the only way unemployment
could be kept as low as 3% was by allowing inflation to keep increasing:
‘There is always a temporary trade-off between inflation and unemploy-
ment; there is no permanent trade-off,’ he claimed. This is what Helmut
Schmidt knew, but did not want to admit to the voters, in 1972.
If there is no permanent trade-off, then the Phillips curve is not a feas-
ible 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. By contrast, Friedman, supported by evidence from many countries
from the late 1960s, showed that if a government tries to keep unemploy-
ment ‘too low’ the result will be not just higher inflation, but rising inflation
as well.
Inflation means rising prices. Rising inflation means prices increasing at
an ever-faster rate. This means that the Phillips curve would keep shifting
upward.
Milton Friedman. 1968. ‘The Role
of Monetary Policy’. American Eco-
nomic Review 58 (1): pp. 1–17.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
660
24681012
PC (1960s)
PC (early 1970s)
1975 PC (late 1970s)
1980
1981
1982
1983
PC (late 1990s–2000s)
PC (late 2000s/2010s)
−2
0
2
4
6
8
10
12
14
Unemployment rate (%)
In
fla
tio
n
(%
)
1960s
Early 1970s
Late 1970s
Early 1980s
Mid-1980s/early 1990s
Early/mid-1990s
Late 1990s/early 2000s
Late 2000s/2010s
Figure 15.6 Phillips curves in the US (1960–2020).
See more https://tinyco.re/4412065
Federal Reserve Bank of St. Louis. 2021.
FRED (https://tinyco.re/3965569).
1. Where is the Phillips curve?
The figure shows the inflation and
unemployment combinations for the
US for each year between 1960 and
2020.
2. A shifting curve
We can use the figure to show how the
Phillips curve shifted over time.
3. The 1960s
The Phillips curve (PC) for the 1960s
shows the economy was in a good
state. The US could achieve combina-
tions of relatively low inflation and
unemployment.
4. The 1970s
In the early 1970s, the Phillips curve
appears to have shifted up.
5. The 1970s
The curve shifts up again in the late
1970s.
6. The 1980s
And up again in the early 1980s, further
worsening the trade-off between
unemployment and inflation.
7. The 1990s
Both in the late 1990s–2000s and in the
late 2000s to present, the Phillips curve
is low and flat.
15.5 WHAT HAPPENED TO THE PHILLIPS CURVE?
661
expected inflation The opinion that
wage- and price-setters form about
the level of inflation in the next
period. See also: inflation.
Expected
inflation (%) +
bargaining
gap (%)
Increase in
wages (%)
Increase in unit
costs (%)
Increase in
prices (%) =
inflation (%)
15.6 EXPECTED INFLATION AND THE PHILLIPS CURVE
We now explain why the Phillips curve shifts: why does inflation keep
rising when governments try to keep unemployment too low? We will show
that there is only one unemployment rate at which inflation is stable, and
that this is the labour market Nash equilibrium.
We need to go back to two familiar points:
• People are forward-looking: We explained this in Units 6, 9, 10 and 13.
They take actions now in anticipation of things they expect to happen.
To stress this, economists say that ‘expectations matter’.
• People treat prices as messages: Friedrich Hayek taught us this (see Unit
11). Therefore people also treat changes in prices as messages about
what will happen in the future, just as people treat a build-up of clouds
as a prediction of rain.
With these two building blocks, we can see why Friedman was right. As
well as the battle for the pie between workers and the owners of firms that
is the fundamental cause of rising prices, Friedman showed that, at low
unemployment, inflation keeps increasing. This is because of the way that
wage- and price-setters form their views about what will happen to
inflation, which is called expected inflation. The behaviour of inflation
will reflect both elements.
Introducing expected inflation
We introduce the role of expected inflation by returning to the Phillips
curve.
Look at Figure 15.7. You will notice that at the labour market equilib-
rium with an unemployment rate of 6%, the inflation rate is 3% and not
zero as in Figure 15.4d.
If wage- and price-setters expect prices to rise by 3% per annum, and the
level of aggregate demand is ‘normal’ and keeps unemployment at 6%, then
the economy can remain at the labour market equilibrium with inflation
remaining constant at 3% per annum. Every year, wages and prices will rise
by 3% and the real wage will remain at the intersection of the wage- and
price-setting curves. This is point A.
Now consider a boom, which takes the economy to lower unemployment
at point B. What will happen to inflation? Workers expect prices to rise by 3%
and will require a nominal wage increase of 3% just to keep their real wage un-
changed. 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%. With their costs
rising by 5%, firms will increase prices by 5%. In the boom, inflation will be 5%.
This gives a Phillips curve like the one we have seen before. The only differ-
ence is that inflation at labour market equilibrium is 3% rather than zero.
When inflation is not zero, we can summarize the causal chain from
expected inflation and the bargaining gap to inflation like this:
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
662
To work out the inflation rate:
But Friedman pointed out that with low unemployment, inflation would
not remain at 5% at point B. To see why, we ask what happens next.
The shifting Phillips curve
With low unemployment continuing, workers will be disappointed with the
outcome, since they did not achieve their expected real wage. Why not?
Workers expected a 2% real wage increase at B from their nominal pay rise
of 5% (to give the real wage on the wage-setting curve), but they did not get
this because firms raised their prices by 5%.
But the story does not end there. 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. Now, we assume that workers expect
Employment, N
Employment, N
Wage-setting curve
Re
al
w
ag
e
Price-setting curve
2% = Bargaining gap
Employment at labour
market equilibrium, no
bargaining gap (U = 6%)
U = 3%
A
Phillips curve
0
In
fla
tio
n
ra
te
, π
(%
)
Bargaining gap (2%)
Expected inflation (3%)
5
3
B
Figure 15.7 Bargaining gaps, expected inflation, and the Phillips curve.
1. Labour market equilibrium
At labour market equilibrium, inflation
is 3% as expected.
2. A boom
At lower unemployment, the bargain-
ing gap is 2%.
3. The new rate of inflation, 5%
At B, inflation is equal to expected
inflation plus the bargaining gap.
15.6 EXPECTED INFLATION AND THE PHILLIPS CURVE
663
Last period’s
inflation (%)
= expected
inflation (%)
Expected
inflation (%)
+ bargaining
gap (%)
Increase in
wages (%)
Increase in
unit costs (%)
Increase in
prices (%) =
inflation this
period (%)
inflation next year to be equal to inflation last year. So at the next wage-
setting round, the human resources department has to take into account the
fact that their employees expect prices to rise by 5%. Another interpretation
is that HR includes inflation over the past year in the wage settlement, to
make up for the shortfall in the real wage that workers experienced because
inflation turned out to be higher than expected. So in order to achieve
another real wage increase of 2%, the HR department sets a wage increase
of 7%. The process continues with the rate of inflation increasing over time.
The table in Figure 15.8 summarizes the situation. We compare the situ-
ation over a three-year period with unemployment at two levels: 6% and 3%.
The first column of Figure 15.8 reflects forward-looking behaviour.
Expected inflation over the year ahead is based on the previous year’s
inflation. The second column shows the unemployment rate. The third
column shows the bargaining gap. The fourth column is the inflation out-
come, which reflects expectations and the bargaining gap.
We can summarize the causal chain from the last period’s inflation rate
to this period’s inflation rate like this:
To work out the inflation rate:
We can show the data in the table in Figure 15.8 and in the Phillips curve
and labour market diagrams in Figure 15.9. The stable inflation case is at
point A with unemployment of 6% and inflation of 3%, year after year. At
low unemployment (3%), the Phillips curve shifts up from the one
Year Expected
inflation
(previous year's
inflation)
Unemployment Bargaining
gap
Inflation outcome:
expectations plus
bargaining gap
1 3% 6% 0% 3%
2 3% 6% 0% 3%
Stable
inflation
3 3% 6% 0% 3%
1 3% 3% 2% 5%
2 5% 3% 2% 7%
Rising
inflation
3 7% 3% 2% 9%
Figure 15.8 Unstable Phillips curves: Expected inflation and the bargaining gap.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
664
inflation-stabilizing rate of
unemployment The unemploy-
ment rate (at labour market
equilibrium) at which inflation is
constant. Originally known as the
‘natural rate’ of unemployment.
Also known as: non-accelerating
rate of unemployment, stable
inflation rate of unemployment.
See also: equilibrium unemploy-
ment.
through point B to the one through point C when expected inflation
rises from 3% to 5%.
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. In this example, the bargaining gap opens up in year 1 because of
the move to low unemployment. The assumption that unemployment
remains below the inflation-stabilizing rate is reflected in the persistence
of the bargaining gap. Inflation rises in every period because the previous
period’s inflation feeds into expected inflation and therefore into wage and
price inflation. Note that the real wage does not change, but remains on the
price-setting curve.
Employment, N
Employment, N
Wage-setting curve
Re
al
w
ag
e
Price-setting curve
2% = Bargaining gap
Employment at labour
market equilibrium, no
bargaining gap (U = 6%)
U = 3%
A
Phillips curves
0
In
fla
tio
n
ra
te
, π
(%
)
Inflation (%) =
bargaining gap (%)
+
expected inflation (3%)
Inflation (%) =
bargaining gap (%)
+
expected inflation (5%)
5
7
3
B
C
In
fla
tio
n
ra
te
, π
(%
)
Figure 15.9 Inflation expectations and Phillips curves.
1. Labour market equilibrium at A
Inflation is 3% as expected.
2. A boom: First period at B
At lower unemployment, the bargain-
ing gap is 2%. Inflation is equal to
expected inflation plus the bargaining
gap.
3. A boom: Next period at C
Next period, with unemployment still
low at 3%, inflation is equal to expec-
ted inflation plus the bargaining gap.
The Phillips curve has shifted up
because expected inflation increased.
15.6 EXPECTED INFLATION AND THE PHILLIPS CURVE
665
EXERCISE 15.4 A NEGATIVE AGGREGATE DEMAND SHOCK WITH HIGH
UNEMPLOYMENT
Copy Figure 15.9 (page 665), making sure you leave plenty of space to the
left of the 6% unemployment marker. Assume that from an initial position
at A, there is a negative shock to private sector demand such as depressed
private investment, which raises unemployment to 9%.
1. Show the inflation, expected inflation, and the bargaining gap at the
new level of unemployment on your diagram.
2. What do you predict will happen to inflation over the following two
years, assuming there is no further change in unemployment?
3. Draw the Phillips curves and write a brief explanation of your findings.
Inflation
Expected inflation = last year’s inflation
Bargaining gap
In
fla
tio
n
ra
te
, π
(%
)
7
8
9
10
6
5
4
3
2
1
0
1
11
2 3 4 5 6
Years
Figure 15.10 Inflation, expected inflation, and the bargaining gap.
1. A zero bargaining gap
Inflation is as expected: 3%.
2. Year 1
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 bar-
gaining gap (2%) plus expected
inflation (3%).
3. Year 2
At the start of year 2, with no change in
the bargaining gap, inflation goes up to
7%, equal to the bargaining gap plus
expected inflation.
4. … and each year afterwards
As long as the bargaining gap remains
unchanged, inflation rises each year.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
666
EXERCISE 15.5 INFLATION, EXPECTED INFLATION, AND THE BARGAINING
GAP
Use the same axes as in Figure 15.10 (page 666) to plot inflation, expected
inflation, and the bargaining gap in a single diagram. Assume that the
price level is constant in period zero. The economy is hit by a recession at
the beginning of period 1 and unemployment remains at a constant high
level until the beginning of period 6.
1. Plot the path of the bargaining gap.
2. Plot the path of inflation and expected inflation.
3. Give a brief explanation of why the bargaining gap might have
disappeared and state any other assumptions you are making.
Summarize your findings.
QUESTION 15.6 CHOOSE THE CORRECT ANSWER(S)
Figure 15.6 (page 661) is a scatter plot of the inflation rate and the
unemployment rate for the US for each year between 1960 and 2020.
Based on this information, which of the following statements is
correct?
The Phillips curve is stable over the years.
The Phillips curve shifted higher over the period.
In the 1960s, the Phillips curve suggests a trade-off of a 2% fall in
the unemployment rate and a 2–3% rise in the inflation rate.
In the most recent period, the US economy has been able to lower
its inflation rate with little effect on the unemployment rate.
QUESTION 15.7 CHOOSE THE CORRECT ANSWER(S)
Figure 15.9 (page 665) depicts the diagrams of the labour market
model and the Phillips curve that incorporates inflation expectations.
Based on this information, which of the following statements is
correct?
The labour market equilibrium occurs at zero inflation and 6%
unemployment rate.
With the fall in the unemployment rate to 3%, the Phillips curve
shifts up immediately.
The bargaining gap returns to zero after the first round of wage-
and price-setting.
Upward shifts of the Phillips curve represent a rising inflation rate
for a given unemployment rate.
15.6 EXPECTED INFLATION AND THE PHILLIPS CURVE
667
supply shock An unexpected
change on the supply side of the
economy, such as a rise or fall in oil
prices or an improvement in tech-
nology. See also: wage-setting
curve, price-setting curve, Phillips
curve.
demand shock An unexpected
change in aggregate demand, such
as a rise or fall in autonomous con-
sumption, investment, or exports.
See also: supply shock.
•••15.7 SUPPLY SHOCKS AND INFLATION
Friedman was correct in two ways:
• Expected inflation shifts the Phillips curve.
• Policymakers were wrong to think of the Phillips curve as a feasible set
from which they could simply select the most electorally popular com-
bination of inflation and unemployment.
But there are other causes of high and rising inflation. The Phillips curve
will shift up if the price-setting curve shifts down or the wage-setting curve
shifts up. Recall Figure 15.2: if the power of owners of firms relative to con-
sumers increases, the marketing department raises prices and kicks off a
wage-price spiral. In that example, owners of firms in the home economy
became more powerful because the government adopted policies that made
it more difficult for foreign firms to enter the economy. Similarly, a wage-
price spiral can begin if the power of employees increases relative to
owners—as would be the case if trade unions become more powerful and
exercise that power to achieve higher wage increases from the HR
department.
Shocks that move the Phillips curve by changing the labour market equi-
librium are described as supply shocks, because the labour market
represents production or supply in the economy. They are different from
demand shocks, like a change in investment or in consumption, which
work via their effect on aggregate demand. While a negative demand shock
will increase unemployment and reduce inflation, a negative supply shock
can lead to increased unemployment and inflation at the same time.
Changes in the global economy can also cause supply shocks that trigger
inflation. A particularly important change for understanding the shifts in
Phillips curves, such as those for the US economy shown in Figure 15.6, is a
change in the world oil price (we look at other possible causes in Units 16
and 17). 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:
• a one-off increase in the price level (inflation) at the time of the shock,
and
• rising inflation over time
To do this, we show that a rise in the oil price:
• Shifts the price-setting curve down: This leads to a positive bargaining gap
and inflation.
• Shifts the Phillips curve up: It will continue to shift up as expected
inflation rises.
An increase in the oil price pushes down the price-setting curve. A typical
firm uses imported oil in the production process. With increased costs for
oil, the firm’s profits can only remain unchanged if real wages fall. 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.
We show in the Einstein at the end of this section how to modify the
price-setting curve once firms in the economy use imported materials in
production.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
668
A rise in the oil price creates a bargaining gap and triggers a wage-price
spiral through its effect on the price level. Firms raise their prices to protect
their profit margins when the cost of imported oil rises. Firms across the
economy will behave this way so the price level will rise. This reduces the
real wage of employees, so the price-setting curve shifts down (to see how
firms set their prices following an oil price rise, see the Einstein at the end
of this section). At the initial employment level this opens up a bargaining
gap between the real wage on the price-setting curve and the real wage on
the wage-setting curve. That is, the rise in prices satisfies firms, but the
corresponding fall in real wages does not satisfy workers.
In Figure 15.11, the price-setting curve shifts down following the oil
shock. In this example, a bargaining gap of 2% opens up between the wage-
setting curve and the post-shock price-setting curve. This fits the scenario
in Figure 15.10, where a bargaining gap of 2% appears at the beginning of
year 1. This increases inflation from its pre-existing level of 3% to 5% and
as expected inflation adjusts, inflation rises thereafter every year. The
Phillips curve shifts up year by year.
As long as employment remains at its pre-oil-shock level, inflation will
increase every period, as illustrated in Figure 15.10. The new labour market
equilibrium and post-shock inflation-stabilizing employment level is
shown in Figure 15.11. Unemployment is higher at the new labour market
Employment, N
Wage-setting curve
Re
al
w
ag
e
Price-setting curve
2% = Bargaining gapIncrease in oil price
A
B
Pre-oil-shock labour market equilibrium
Price-setting curve
(post-oil-shock)
Post-oil-shock labour market equilibrium
(inflation-stabilizing employment level)
Figure 15.11 An oil shock and the price-setting curve.
1. Labour market equilibrium
The economy is initially at point A.
2. An oil shock
The oil price increases and shifts the
price-setting curve down.
3. The bargaining gap
If aggregate demand is maintained to
keep the economy at A, there is a posit-
ive bargaining gap. Inflation will
increase year by year.
4. A new equilibrium
There is a new labour market equilib-
rium at B with higher unemployment.
15.7 SUPPLY SHOCKS AND INFLATION
669
equilibrium where the post-shock price-setting curve intersects the wage-
setting curve.
Shocks to the world oil price are a major source of macroeconomic
disturbance.
Following the early 1970s oil shock, for example, US inflation jumped
from 6.2% in 1973 to 9.1% in 1975 and unemployment went from 4.9% to
8.5% at the same time.
This pattern was common across the developed world. For example, in
the same period, inflation in Spain rose from 11.4% to 17% and unemploy-
ment increased from 2.7% to 4.7%.
We can see from Figure 15.12 that there were two big recessions in the
UK in the 1970s. They were due to the oil shocks of 1973–74 and 1979–80,
which were associated with a rise in both unemployment and inflation to
their highest levels since the Second World War (you can see the effect on
inflation in Figure 13.19a and Figure 13.19b).
High inflation in the 1970s and early 1980s was associated with high
unemployment in many countries. Unemployment in the UK peaked at
nearly 12% in the mid-1980s.
The model helps us to understand why the rise in the oil price led to
rising inflation and high unemployment. But it also helps to explain the role
that high unemployment played in bringing inflation down.
In the model, the only ways that high inflation can be brought down are:
• a reduction in the bargaining gap
• a fall in expected inflation
If unemployment is sufficiently high, then there will be a negative bargain-
ing gap and inflation will fall. Remember that for the bargaining gap to be
negative, unemployment has to rise above the new higher inflation-
stabilizing unemployment rate. Once inflation begins to fall, it will
continue to fall as the Phillips curve shifts downwards and the economy
follows the path shown in Figure 15.10 in reverse.
Figure 15.13 shows a scatterplot of unemployment and inflation for the
British economy from 1950 to 2020. Instead of fitting Phillips curves to the
1973
First oil shock
1979 Second oil shock 2002–2008 Third oil shock
−10
−5
0
5
10
15
0.1
1
10
100
19
50
19
54
19
58
19
62
19
66
19
70
19
74
19
78
19
82
19
86
19
90
19
94
19
98
20
02
20
06
20
10
20
14
20
18
Year
G
D
P
gr
ow
th
(%
)
Ra
tio
sc
al
e:
re
al
oi
lp
ri
ce
s
(U
K,
19
50
=
1)
GDP growth (%)
Real oil prices (ratio scale)
Figure 15.12 UK GDP growth and real oil prices (1950–2020).
UK Office for National Statistics
(https://tinyco.re/9188818); Ryland
Thomas and Nicholas Dimsdale. (2017).
‘A Millennium of UK Data’
(https://tinyco.re/0223548). Bank of
England OBRA dataset.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
670
observations, as in Figure 15.6, the points are joined and dated. This helps
us to follow the path taken by the economy. Notice the large increase in
unemployment in the 1980s associated with bringing inflation down. This
is sometimes referred to as the cost of disinflation.
But there’s a puzzle here: why did the third oil shock from 2002–08 not
lead to increased inflation, just like the earlier ones? This section should
have provided you with some starting points to investigate this, and a
speech given in 2006 by David Walton, an economist, will help you. If you
read both carefully, you might ask the following questions:
• Was the unit cost increase smaller due to less energy-intensive production?
This would have made the increase in the materials cost per unit of
output smaller and reduced the size of the initial downward shift in the
price-setting curve.
• Did the wage-setting curve shift downwards at the same time as the third oil
price shock? This also would have reduced or perhaps even eliminated the
bargaining gap opened up by the oil price shock.
• Did a wage-price spiral fail to develop because expected inflation did not
adjust upward, as in the past oil shocks?
What could stop expected inflation rising? In the next section, we examine
the role of monetary policy.
EXERCISE 15.6 AN OIL SHOCK
Think about the three questions related to oil shocks that we listed above.
In each case:
1. Explain the mechanism linking the oil shock to inflation using a diagram.
2. Identify some evidence (for example, data or commentary in the eco-
nomics press) that is consistent with the hypothesis proposed.
David Walton. 2006. ‘Has Oil Lost
the Capacity to Shock?’
(https://tinyco.re/
8182920). Oxonomics 1 (1):
pp. 9–12.
1950
1973
1974
1975
1979
1980
1981
1986
1991
2002
2008
20140
5
10
15
20
25
30
0 2 4 6 8 10 12 14
Unemployment rate (%)
In
fla
tio
n,
π
(%
)
Figure 15.13 UK inflation and unemployment rate (1950–2020).
View this data at OWiD https://tinyco.re/
0273434
UK Office for National Statistics
(https://tinyco.re/9188818); Ryland
Thomas and Nicholas Dimsdale. (2017).
‘A Millennium of UK Data’
(https://tinyco.re/0223548). Bank of
England OBRA dataset.
15.7 SUPPLY SHOCKS AND INFLATION
671
EINSTEIN
The price-setting curve with imported materials
In the Einstein in Unit 9, we explained how the price-setting curve for
the economy as a whole results from the decisions of individual firms.
Here we take a shortcut and go straight to the economy as a whole.
Firms in the economy use both the products of other firms in the eco-
nomy and imported products as inputs. The cost of these inputs will be
affected by wage costs and costs of imported materials. Once we put
together all the firms in an economy, we have only two types of cost:
labour and imported materials. (Here we are setting aside the opportun-
ity cost of the capital goods used in production that are the property of
the firm owners and the basis of their profits.)
In Unit 9, we assumed that other than the firm’s own capital goods,
there were no inputs other than labour and hence no costs other than
wages. In this case, the value of a firm’s output was the same as the firm’s
value added. Expressed on a per worker basis this was divided into wage
and profits:
Here, there are imported materials such as oil that are necessary to
produce the output. As a result, the firm’s costs include not only wages
but also the costs of purchasing these imported materials.
This makes it clear that unlike in Unit 9 where there were just two
claimants on the value of the output (wages and profits), we now have
three: labour costs, imported materials costs, and profits. This affects the
price-setting curve, as we shall see.
In the Unit 9 Einstein, λ represented value added per worker, or
labour productivity. Now, where we have inputs other than labour, we
define q as the units of output per worker, which is not the same thing as
labour productivity because output now exceeds value added by the
value of imported inputs.
Since output per worker is q and the nominal wage is W, the firm’s
unit labour cost (ulc) is:
Now the firm’s cost per unit is its unit labour cost (ulc) plus its unit
imported materials cost (umc).
So unit costs (uc) are:
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
672
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. For example, suppose the price per unit is $5, imported
materials cost $1 per unit and labour costs $2.50 per unit. Then
imported materials comprise 20% of the cost, wages another 50%, and
the share of profit, or the markup, is:
which is 30%.
Substituting ulc = W/q gives us:
Multiplying each side by q and rearranging, and remembering that P is
both the price of the individual firm’s output and the general price level
in the economy, we get the price-setting curve:
This shows that the real wage per worker is equal to output per worker,
q, minus a share μ that goes as profits to the owner, minus a share umc/P
that goes to foreign producers who supply the imported materials. Any
increase in unit materials costs such as a rise in the price of oil will shift
the price-setting curve down.
In the absence of imported materials, q = λ and umc = 0, and we get
the familiar expression for the price-setting curve from Unit 9:
An equivalent but alternative version of the markup equation is
provided in the next section.
The markup price-setting equation for the firm
As we saw in the Einstein in Unit 9, the price set by a profit maximizing
firm is a markup on its costs, where the markup μ is the share of the
price that was the firm’s profits, and is lower the more competition there
is in the product market.
When explaining the process of inflation, economists often simplify
by setting aside changes in the degree of competition so as to focus on
the ways that increasing costs contribute to price increases. For this it is
useful to have an equation describing how firms will set different prices
15.7 SUPPLY SHOCKS AND INFLATION
673
as their costs change, assuming that the degree of competition in
product markets (and therefore μ) is unchanged.
For this purpose economists use the following equation:
where the percentage markup on costs is m, umc is the unit cost of
materials, and ulc is the unit cost of labour.
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. So the extra $0.30
charged above unit costs is equal to 10% of those costs. If we want to
know μ in this case, we ask what the extra $0.30 is as a share of the total
price, rather than as a share of the cost. Then μ = $0.30/$3.30 = 0.09 or
9%.
One advantage of using m is that it makes it easy to see that if the
markup is fixed, then a rise in unit costs must imply a proportionate
price rise (for example, an increase in unit costs of 5% must imply a price
rise of 5%). This follows directly from the markup price-setting equation
above.
We can also ask what happens to P when just one part of the costs
rise, such as the imported materials cost. Assuming m remains constant,
the percentage change in the price is equal to the percentage change in
total unit costs:
We now divide both the numerator and the denominator of the first
term on the right hand side by umc, and the second term by ulc:
This is equivalent to:
In words, the percentage change in P is equal to the percentage change in
umc times umc’s share of unit costs, plus the percentage change in ulc
times ulc’s share of unit costs. For example, suppose the markup is 60%
and unit cost is $5, of which $4 is labour cost and $1 is imported
materials, so the price is P = 1.6 × $5 = $8. Wages are 80% of the cost, so
if wages go up 10% then the price will rise by 80% × 10% = 8%. In this
example, unit costs rise to $4.4 + $1 = $5.4 and the price rises to
P = 1.6 × $5.4 = $8.64 (a rise of 8%). Equally, if the price of imports, such
as oil, were to rise by 10% then the price would rise by 20% × 10% = 2%.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
674
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. Also known as: base rate,
official rate. See also: real interest rate, nominal interest rate.
lending rate (bank) The average interest rate charged by
commercial banks to firms and households. This rate will
typically be above the policy interest rate: the difference is the
markup or spread on commercial lending. Also known as:
market interest rate. See also: interest rate, policy rate.
••15.8 MONETARY POLICY
We use the Phillips curve and the policymaker’s indifference curves to look
at shocks and policy responses. Before doing so, we need to recall how
monetary policy affects the economy.
As we saw, we can explain why people might dislike rising or volatile
inflation, but most people have no reason to object to a (slowly) rising price
level. In fact, many central banks around the world have policies to target
an inflation rate of 2%. They either set this objective for themselves, or the
government sets the objective for them. It means they are doing best if
prices rise each year by a rate close to 2%.
When central banks target an inflation rate of 2%, the best answer to the
question ‘why does the price level rise at 2%?’ becomes ‘because the central
bank makes it happen’.
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.
When they can, central banks use changes in the policy interest rate as
their monetary policy instrument to stabilize the economy. Monetary
policy relies on the central bank being able to control interest rates, and on
changes in interest rates influencing aggregate demand. For example,
higher interest rates make it more expensive to borrow money to spend. It
is important to remember that it is the real interest rate that affects spend-
ing. But when the central bank sets the policy rate, it sets it in nominal
terms. So by setting a particular nominal rate it is aiming for a specific real
interest rate, and it therefore takes account of the effect of expected
inflation (see our Einstein at the end of this section for more about the
Fisher equation).
The transmission of monetary policy
Figure 15.14 shows how the Bank of England views the transmission of
monetary policy from its interest rate decision to aggregate demand and
inflation in ‘normal’ situations—that is, when the interest rate is its policy
instrument.
Look at the boxes in the first column of Figure 15.14.
Market interest rates
In Unit 10 we explained that, although the central
bank sets the policy interest rate, commercial
banks set the market interest rate (also referred
to as the bank lending rate) that households and
firms pay when they take out loans. When the
central bank cuts the policy rate to stimulate
spending, the market interest rate typically falls by
approximately the same amount. To set the policy
rate, the central bank will therefore work
backwards, starting with its desired level of
aggregate demand:
15.8 MONETARY POLICY
675
1. It will estimate a target for the total aggregate demand, Y, to stabilize the
economy, based on the labour market equilibrium and the Phillips curve.
2. It will then estimate the real interest rate, r, which will produce this
level of aggregate demand, based on shifting the aggregate demand line
into the desired position in the multiplier diagram.
3. Finally it calculates the nominal policy rate, i, that will produce the
appropriate market interest rate.
Think about how a fall in the market interest rate affects the decision to
build a new house. The cost of taking out a loan to finance the construction
of the house will fall, so as the interest rate falls, investors will consider
more new housing projects to be financially viable. Through this channel, a
lower policy rate will raise investment by businesses and households, and a
higher policy rate will lower it (see Figure 14.9).
Asset prices
This refers to financial assets in the economy such as government bonds
and shares issued by companies. When the central bank changes the
interest rate, this has a ripple effect through all the interest rates in the eco-
nomy, from mortgage rates to the interest rates on 20-year government
bonds. As we saw in the Einstein in Unit 10, when the interest rate goes
down, the price of the asset goes up. So a fall in interest rates will be expec-
ted to feed through to spending, because households who own the assets
will feel wealthier.
Profit expectations and confidence
In Units 13 and 14 we stressed the importance of profit expectations and
confidence for the investment decisions of firms. When setting the interest
rate, the central bank tries to build confidence through consistent
policymaking and good communication with the public. If it lowers the
policy rate and explains its reasoning, this can lead firms to expect higher
Policy
interest
rate
Asset
prices
Net
exports Inflation
Aggregate
demand
Expectations/
confidence
Exchange
rate
Market
interest
rates
Domestic
inflationary
pressure
Import
prices
Domestic
aggregate
demand
Figure 15.14 Monetary policy transmission mechanisms.
The Bank of England.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
676
demand, who will therefore increase investment. Similarly, if it increases
the confidence of households that they will not lose their jobs, then they
may also increase their spending.
Exchange rate
We return in the next section to the way monetary policy affects aggregate
demand through the exchange rate channel: this will shift the aggregate
demand line by changing net exports, (X − M).
In the multiplier model of aggregate demand, the transmission channels
from the policy rate to domestic aggregate demand are reflected in the
investment function (including new housing), which shifts when the real
interest rate changes. We write this function I(r). The expectations and asset
price effects will shift the investment function as we saw in Figure 14.5, and
the consumption function, by changing c0 (Figure 14.11a).
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. If the central bank is trying to boost the economy in a
business cycle downturn, it cuts the interest rate. 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.
Figure 15.15 shows how monetary policy can be employed to stabilize
the economy following a downturn caused by a drop in consumption (for
example, as a result of a fall in consumer confidence). Follow the steps in
the analysis in Figure 15.15 to see how a cut in the real interest rate brings
the economy out of recession. In this example, we assume that the decline
in the interest rate to r′ only increases investment and not autonomous con-
sumption, which remains at c0′.
A warning
Using simple diagrams like Figure 15.15 may give the impression that the
central bank is able to stabilize the economy by accurate diagnosis of a
shock and precise intervention with a change in the interest rate. This is far
from the case! The economy emits all kinds of noisy signals and it is
difficult to decide, for example, whether a downturn is a temporary blip or
signifies a long-term weakness. The models we use help us to organize our
thinking about the causal links in the economy and what policies might be
warranted. They do not give a complete recipe for effective stabilization.
Figure 15.15 shows how the central bank could attempt to counteract a
recession. But how should the central bank react to a consumption boom?
It needs the opposite policy. A boom will shift the aggregate demand line
upwards, so the central bank must pursue policies that dampen demand and
return the aggregate demand line back to its starting point. The central
bank can do this by raising the interest rate.
But why would it want to curtail a boom? From the Phillips curve, we
know that a boom leads to higher inflation, and, if expectations adjust to
past inflation, to rising inflation. High and rising inflation imposes costs on
the economy.
We have shown how monetary policy can be used by the central bank to
stabilize the economy in a recession. The government could also have
played this role by cutting taxes, or by boosting spending.
15.8 MONETARY POLICY
677
Why monetary policy, and what are its limits? Fiscal policy is
complicated to adjust and inflexible. Instead, to keep aggregate demand
close to the level it desires, the central bank can adjust the interest rate up
and down by small amounts month-by-month.
There are two important limitations, however, to the usefulness of
monetary policy in stabilization:
• The short-term nominal interest rate cannot go below zero: But this is the
central bank’s policy instrument.
• A country without its own currency does not have its own monetary policy.
The zero lower bound
If the policy interest rate were negative, people would simply hold cash
rather than put it in the bank, because they would have to pay the bank for
holding their money (that’s what a negative interest rate means). This is the
zero lower bound on the nominal interest rate. It matters because when
the economy is in a slump, a nominal interest rate of zero may not be low
enough to achieve a sufficiently low real interest rate to drive up interest-
sensitive spending and get the economy going again. Remember that the
real interest rate is equal to the nominal interest rate minus inflation. So the
zero lower bound on the nominal interest rate means that the lower bound
on the real interest rate is equal to minus the inflation rate. Policy interest
‘Controlling Interest’
(https://tinyco.re/7889919). The
Economist. Updated 21 September
2013.
Output (income), Y
c0 + I(r) + G + X
c0′ + I(r) + G + X
c0′ + I(r′) + G + X
Ag
gr
eg
at
e
de
m
an
d,
A
D
AD
45º
A
AD (lower level of
consumption, c0′)
AD (lower consumption, c0′,
and higher investment due
to lower interest rate, r)
B
Y = AD on 45-degree line
Note: AD = c0 + c1(1 – t)Y+ I(r) + G + X – mY
Figure 15.15 The use of monetary policy to stabilize the economy in a recession.
1. Goods market equilibrium
The economy starts in goods market
equilibrium at point A.
2. 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.
3. 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 eco-
nomy out of recession and back to its
starting point.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
678
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. See also: quantitative
easing.
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. See also:
zero lower bound.
common currency area A group of
countries that use the same
currency. This means there is just
one monetary policy for the group.
Also known as: currency union.
rates were reduced close to zero in many economies after the global finan-
cial crisis, but this was not enough to restore aggregate demand to the
labour market equilibrium. For this reason, some economists argue that
countries with inflation targets of 2% should raise them to 4% in order to
allow real interest rates to become more negative in a slump.
This is also why economies that were badly hit by the global financial
crisis introduced a new kind of monetary policy called quantitative easing
(QE). The aim of QE is to increase aggregate demand by buying assets, even
when the policy interest rate is zero.
How is QE supposed to work?
• 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, as
explained in the Einstein in 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.
So, even when the interest rate the central bank directly controls is stuck at
zero, it can use QE to try to reduce the interest rate on a variety of other
financial assets. The empirical evidence suggests that the effects of QE in
boosting aggregate demand are positive but small.
No national monetary policy
Monetary policy may not be available to a country. Members of the
Eurozone gave up their own monetary policy when they joined the
currency union. The Eurozone is called a common currency area (or
currency union) because all the members use the euro. This means there is
just one monetary policy for the whole of the Eurozone. 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. This interest
rate may be more appropriate for some members than for others. In
particular, after the financial crisis, unemployment was low and falling in
Germany but in the southern Eurozone countries such as Spain and Greece,
it was high and rising fast. There were many complaints that the ECB’s
monetary policy remained too restrictive for too long for the needs of the
latter countries.
EXERCISE 15.7 FISCAL OR MONETARY POLICY?
Think back to the discussion of the government finances in Unit 14.
1. In the event of a financial crisis, would it be preferable for the govern-
ment to stabilize the economy using fiscal or monetary policy?
2. What are the dangers of using fiscal policy?
3. When might the government have no choice but to use fiscal policy?
15.8 MONETARY POLICY
679
QUESTION 15.8 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct regarding monetary
policy?
When interest rates go down, asset prices go up.
The zero lower bound refers to the central bank’s inability to set the
real interest rate to below zero.
Quantitative easing involves the central bank lowering its official
interest rate.
Interest rates cannot be set in a currency union.
EINSTEIN
The real interest rate and the Fisher equation
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. If you are a lender, it tells you how
many dollars you will receive in the future by giving up the use of $1
today.
The interest rates that you see quoted in bank windows or bank
websites are nominal interest rates. That is to say, they do not take
inflation into account. If you are a lender, what you really want to know
is how many goods you will get in the future in exchange for the goods
you don’t consume now. If you are a borrower, what matters is how
many goods you will have to give up in the future to pay the interest,
rather than the total interest measured in dollars. The opportunity cost
of the loan is the goods you have to give up, not the money you have to
give up. To make this distinction, you need to take account of inflation.
Households and firms make decisions based on real interest rates.
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 equation for the real interest rate is known as the Fisher
equation, named after Irving Fisher, whose physical model of the eco-
nomy we saw in Unit 2. The Fisher equation states that the real interest
rate (per cent per annum) equals the nominal interest rate (per cent per
annum) minus the inflation expected over the year ahead:
When evaluating an investment project, the expected inflation rate
needs to be taken into account. For a given nominal interest rate, higher
inflation reduces the real interest rate, reducing the real cost of borrow-
ing. We can also see that when prices are expected to fall over the year
ahead—that is, expected inflation is negative, or deflation is expected—it
raises the real interest rate above the nominal interest rate. At the higher
real interest rate, some investment projects that would have been
undertaken in the absence of forecast deflation are ruled out.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
680
exchange rate The number of units
of home currency that can be
exchanged for one unit of foreign
currency. For example, the number
of Australian dollars (AUD) needed
to buy one US dollar (USD) is
defined as number of AUD per USD.
An increase in this rate is a
depreciation of the AUD and a
decrease is an appreciation of the
AUD.
••15.9 THE EXCHANGE RATE CHANNEL OF MONETARY
POLICY
Monetary policy in the US works mainly through the effect of changes in
the interest rate on investment, particularly on new housing and consumer
durables. But in many other economies, especially smaller ones, an import-
ant channel for monetary policy is through the effect of interest rate
changes on the exchange rate and the economy’s competitiveness in inter-
national markets, and hence on net exports.
Why does the interest rate affect the exchange rate? Much of the demand
for different countries’ currencies comes from international investors who
want to hold and trade financial assets from around the world. These
investors prefer to earn a higher return, so they prefer assets with a high
yield, or interest rate. For this reason, if a country’s central bank lowers the
interest rate, demand for that country’s bonds declines: international
investors are less attracted to their financial assets. With the demand for
bonds lower, the demand for the currency to buy those bonds declines. The
decline in demand for the currency will lead to depreciation, that is, a
decline in its price in terms of other currencies.
Take the case of a slowdown in the Australian economy caused by a
decline in investment demand. The Reserve Bank of Australia responds to
this by cutting the interest rate. This lowers the yield on Australian finan-
cial assets, making them less attractive to international investors. 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. If the demand for Australian financial assets like government bonds
goes down, then the demand for the Australian dollars needed to buy them
also goes down.
Because of this, the cut in the interest rate leads to a depreciation of the
Australian dollar, which means that it will buy a smaller number of US
dollars, Chinese yuan, euros, or any other currency. Depreciation makes
Australian exports and home-produced goods more competitive, boosting
aggregate demand and stabilizing the economy. Both higher export demand
for home-built products (X) and lower demand from Australians for goods
and services produced abroad (M) raise aggregate demand in the home eco-
nomy.
The foreign exchange market is a market in which currencies are traded
against each other, such as the Australian dollar (AUD) and the US dollar
(USD). The exchange rate is defined as the number of units of home
currency for one unit of foreign currency, in other words:
When one USD buys more AUD, the AUD is said to have depreciated.
When one AUD buys more USD, the AUD is said to have appreciated.
A depreciation of the home country’s exchange rate makes their exports
cheaper, and imports from abroad more expensive. 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. Equivalently, a T-shirt sold for 18.69 USD
in the US would cost 20 AUD in Australia. If the exchange rate of the
Australian dollar then depreciates to 1.25, what happens to the price of
15.9 THE EXCHANGE RATE CHANNEL OF MONETARY POLICY
681
Fall in investment (I) Fall in AD Fall in
forecast inflation
Australia’s
central
bank cuts
interest
rate
Fall in
demand
for
Australian
bonds
Fall in
demand
for AUD
Depreciation
of AUD
Exports
become
relatively
cheaper
and
imports
more
expensive
Increase
in (X – M)
Increase
in AD
Figure 15.16 A cut in Australia’s interest rate.
exports and imports of T-shirts in Australia? Exports of Australian T-shirts
become cheaper; a 20 AUD T-shirt now costs only 16 USD in the US rather
than 18.69 USD. In contrast, imports of US T-shirts into Australia become
more expensive—a 18.69 USD T-shirt now costs 23.36 AUD rather than
20 AUD.
Figure 15.16 is a rough summary of the chain of events in Australia.
EXERCISE 15.8 WHY BONDS?
Explain why a change in the central bank’s policy interest rate affects the
exchange rate through the market for financial assets (such as govern-
ment bonds).
QUESTION 15.9 CHOOSE THE CORRECT ANSWER(S)
The following is a table of the British pound (GBP) exchange rate
against the dollar (USD) and euro (Source: Bank of England):
24 Nov 2014 23 Nov 2015
USD/GBP 1.5698 1.5131
euro/GBP 1.2622 1.4256
In this table, the exchange rates are defined as the number of USD or
euro per GBP. Based on this information, which of the following state-
ments are correct?
USD appreciated against GBP over the year.
GBP depreciated against euro over the year.
Exports of British goods were cheaper in the US in November 2015
than a year before.
Imports from Europe were more expensive in Britain in November
2015 than a year before.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
682
••15.10 DEMAND SHOCKS AND DEMAND-SIDE POLICIES
To see how policymakers respond to demand shocks in practice, think
about the recession in the US after the bursting of the tech bubble. The
table in Figure 15.17 illustrates the fiscal and monetary policy mix used
during the US recession in 2001 when after a decade of expansion, the
growth rate of the US economy slowed.
The top row shows that the annual growth rate of real GDP decreased
from 4.1% to 0.9%. 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 end of the boom of the late
1990s, during which firms had been over-optimistic about the profits to be
made on investment in new technology and had overestimated the need for
new capacity in ICT-producing industries, triggered the slowdown (see Unit
11 for more about the tech bubble and Figure 14.5 for the model of invest-
ment with supply and demand effects shifting the investment function).
The recession and the policy response
The figure shows that the contribution of non-residential investment to the
percentage change in GDP was much larger than either residential invest-
ment or government expenditure in 2000. It fell in 2001, pulling the
economy into recession.
The recession could have been much worse in the absence of the strong
response from monetary and fiscal policy.
In 2001, the Federal Reserve started rapidly decreasing the nominal
interest rate, from a high of 6.2% on average in 2000, to 3.9% in 2001, and a
low of 1.1% in 2003.
• Monetary policy: We can see from Figure 15.17 that this large drop in
nominal interest rates helped boost residential investment in 2001 and
2002. Its contribution to growth became much larger than before. It also
helped non-residential investment to recover, but the adjustment was
slower: the contribution of non-residential investment to growth
became positive only in 2003.
2000 2001 2002 2003
Real gross gomestic product (annual % change) 4.1 0.9 1.8 2.8
Change in non-residential investment 1.15 −1.2 −0.66 0.69
Change in residential investment −0.07 0.09 0.39 0.66
Change in government expenditure 0.10 0.88 0.74 0.36
Contribution to % change in GDP
Change in other contributions 2.92 1.13 1.33 1.09
Federal Reserve nominal interest rate (annual average, %) 6.24 3.89 1.67 1.13
Unemployment rate (%) 4 4.47 5.8 6
Inflation rate (%) 3.4 2.8 1.6 2.3
Figure 15.17 The policy mix: Fiscal and monetary policy in the US following the
collapse of the tech bubble.
Federal Reserve Bank of St. Louis. 2015. FRED (https://tinyco.re/3965569).
15.10 DEMAND SHOCKS AND DEMAND-SIDE POLICIES
683
• Fiscal policy: To compensate for the stagnation in firms’ private invest-
ment, the government used expansionary fiscal policy. It introduced large
tax cuts and increased spending in 2001 and 2002. The multiplier model
helps explain the logic of the government’s policy, and the large increase
in the contribution of public expenditure to growth in 2001 and 2002.
We can see from Figure 15.17 that the swift action of the government and
central bank helped to stabilize the economy. Inflation and GDP growth
bounced back rapidly from the recession. Unemployment was slower to
react, however, continuing to creep up in 2003. In fact, the US unemploy-
ment rate did not drop all the way down to its 2000 level, perhaps
suggesting that the US economy was operating above capacity in the run-
up to the tech bubble.
The recession and the model
We can apply the model we have developed to the case of a slump in invest-
ment spending in the US economy in Figure 15.18. From the multiplier
diagram in the lower panel, we know that a fall in investment spending
shifts the aggregate demand line down, and leads to a new goods market
equilibrium in the economy with lower output and higher unemployment.
Figure 15.17 showed that this is what happened in the US after the tech
bubble ended. Unemployment increased from 4% in 2000 to 6% in 2003,
and inflation fell from 3.4% in 2000 to 1.6% in 2002.
Following the logic of the Phillips curve, inflation will fall in response to
a rise in unemployment. Work through the steps of the analysis in Figure
15.18 to see the consequences of the shock, and the government’s response
of a fiscal stimulus and the Federal Reserve’s response of looser monetary
policy.
Note that now, the best outcome for the policymaker is not full employ-
ment. Rather, it is the level of employment (and unemployment) that
maintains labour market equilibrium, to avoid consistently rising or falling
inflation. In Figure 15.18, point X is the policymaker’s best outcome.
Inflation is at target and employment is consistent with constant inflation.
It is clear from the indifference curves that the recession reduces wellbeing
in the economy.
EXERCISE 15.9 A CONSTRUCTION BOOM
1. What happens when there is a positive shock to aggregate demand
from a boom in the construction of new housing? Explain using the
multiplier diagram and the Phillips curve diagram.
2. What would you expect the central bank to do?
‘Bush’s Push’ (https://tinyco.re/
1194788). The Economist. Updated
6 January 2003.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
684
Employment, N
0
2 Best outcome
Phillips curve
Labour supply
4
C
X
D
D
AD (investment slump)
AD (monetary and fiscal stimulus)
AD (before the downturn)
C
Ag
gr
eg
at
e
de
m
an
d
45º
In
fla
tio
n,
π
(%
)
Output (income)
Figure 15.18 A policy intervention to restore employment and output after a fall in
investment.
1. Before the downturn
The economy is at point C.
2. The investment slump
This shifts aggregate demand down.
The economy moves to a situation with
higher unemployment and lower
inflation (from point C to point D).
3. Both the central bank and the
government respond
A cut in the interest rate and fiscal
stimulus via tax cuts and increased gov-
ernment spending shifts the aggregate
demand line back to its starting
position.
4. The effect of intervention
The increase in output from higher
aggregate spending reduces unemploy-
ment and raises inflation. The economy
moves back along the Phillips curve to
point C.
15.10 DEMAND SHOCKS AND DEMAND-SIDE POLICIES
685
great moderation Period of low
volatility in aggregate output in
advanced economies between the
1980s and the 2008 financial crisis.
The name was suggested by James
Stock and Mark Watson, the eco-
nomists, and popularized by Ben
Bernanke, then chairman of the
Federal Reserve.
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.
•••15.11 MACROECONOMIC POLICY BEFORE THE GLOBAL
FINANCIAL CRISIS: INFLATION-TARGETING POLICY
The 25 years before the global financial crisis in 2008 came to be known as
the great moderation. A look back at Figure 15.12 tells us why. Despite a
major oil shock in the 2000s, the British economy and many other eco-
nomies continued to experience steady growth, low inflation and low
unemployment. This is a remarkable contrast with the high inflation and
high unemployment of the 1970s.
There were two important features of the 1990s and 2000s prior to the
crisis:
• Central banks were made independent of government control: Monetary
policy was placed in the hands of these independent central banks in
most advanced and many developing countries.
• Inflation targeting: These banks used their policy instruments to keep
the economy close to a target rate of inflation. As shown in Figure 15.19,
by 2012, 28 countries had adopted inflation targeting, usually with a
band (range) of what was judged an acceptable level of inflation.
Why make central banks independent and give them inflation targets? The
lessons of Figure 15.6 about the instability of Phillips curves, and the high
costs of unemployment incurred by countries in the 1980s as they brought
inflation down, created the impetus. Policymakers globally believed there
would be an inflation-stabilizing unemployment rate.
Beginning in the 1990s, governments increasingly took the view that
central banks should be given responsibility for keeping the economy close
to a target rate of inflation. This is typically around 2% in developed eco-
nomies, but higher in some developing economies, as the table in Figure
15.19 shows. Since many voters will prefer lower unemployment even if it
comes with higher inflation, as we saw in Section 15.1, how can central
banks credibly commit not to deviate from their announced inflation
target?
To tackle this concern, many countries increased the independence of
the central bank. Politicians, like the West German superminister Helmut
Schmidt, may want to promise lower unemployment now—even if this
leads to rising inflation later—to be re-elected. Making the central bank
independent, with an explicit inflation target, makes it easier for the central
bank to resist political pressure. This prevents a wage-price spiral. The
central bank is committed to act to keep inflation close to the target and
this, in turn, is expected to help keep the inflation rate expected by workers
and firms close to target.
Figure 15.20 illustrates the relationship between the degree of central
bank independence in the mid-1980s, and average inflation between 1962
and 1990, across OECD countries. There is a strong negative correlation
between the two variables. Countries with little central bank independence
in the mid-1980s were those where inflation was, on average, higher over
the 30-year period.
We can’t conclude from this correlation how, or even if, central bank
independence limited inflation, but many suspected that central bank
independence would make it easier to control inflation. As a result, the
high-inflation countries granted much more independence to their central
bank, with a low inflation target embedded in official statutes.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
686
New Zealand, which had high inflation in 1989, pioneered inflation
targeting. Inflation fell and remained low. Other high-inflation countries
soon followed, in particular Mediterranean countries like Portugal, Greece,
Spain, Italy, and France.
This evidence suggests that 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 favourable
Country Inflation targeting
adoption date
Inflation rate at adoption
date (%)
2010 end-of-year
inflation (%)
Target inflation
rate (%)
New Zealand 1990 3.30 4.03 1–3
Canada 1991 6.90 2.23 2 ± 1
UK 1992 4.00 3.39 2
Australia 1993 2.00 2.65 2–3
Sweden 1993 1.80 2.10 2
Czech Republic 1997 6.80 2.00 3 ± 1
Israel 1997 8.10 2.62 2 ± 1
Poland 1998 10.60 3.10 2.5 ± 1
Brazil 1999 3.30 5.91 4.5 ± 1
Chile 1999 3.20 2.97 3 ± 1
Colombia 1999 9.30 3.17 2–4
South Africa 2000 2.60 3.50 3–6
Thailand 2000 0.80 3.05 0.5–3
Hungary 2001 10.80 4.20 3 ± 1
Mexico 2001 9.00 4.40 3 ± 1
Iceland 2001 4.10 2.37 2.5 ± 1.5
Korea, Republic of (South
Korea)
2001 2.90 3.51 3 ± 1
Norway 2001 3.60 2.76 2.5 ± 1
Peru 2002 −0.10 2.08 2 ± 1
Phillipines 2002 4.50 3.00 4 ± 1
Guatemala 2005 9.20 5.39 5 ± 1
Indonesia 2005 7.40 6.96 5 ± 1
Romania 2005 9.30 8.00 3 ± 1
Serbia 2006 10.80 10.29 4–8
Turkey 2006 7.70 6.40 5.5 ± 2
Armenia 2006 5.20 9.35 4.5 ± 1.5
Ghana 2007 10.50 8.58 8.5 ± 2
Albania 2009 3.70 3.40 3 ± 1
Figure 15.19 Countries who had inflation-targeting central banks by 2012.
Sarwat Jahan. 2012. ‘Inflation Targeting: Holding the Line’ (https://tinyco.re/5875915). Interna-
tional Monetary Fund Finance & Development.
15.11 MACROECONOMIC POLICY BEFORE THE GLOBAL FINANCIAL CRISIS
687
indifference curve), the central bank would raise the interest rate and
dampen aggregate demand. Similarly, 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. We described the actions of
the Federal Reserve in these terms in Figure 15.17.
Figure 15.21 shows the Phillips curve and indifference curves for an eco-
nomy 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 labour market equilibrium is 6%. Labour market equilib-
rium, and hence the inflation-stabilizing rate of unemployment, will be
different in different countries. For example, during the 2000s, it was
estimated at 5.9% in the UK, and 7.7% in Germany.
If an aggregate demand shock reduces unemployment below 6%,
inflation rises along the Phillips curve. In response, the central bank would
Line of best fit
Portugal
New Zealand
Greece
Spain
Italy
UK
Japan
France
Belgium
Australia
Austria Netherlands
Canada
Switzerland
US
Germany
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
Central bank independence index, mid-1980s
Av
er
ag
e
in
fla
tio
n
ra
te
,1
96
2–
19
90
(%
)
Figure 15.20 Inflation and central bank independence: OECD countries.
View this data at OWiD https://tinyco.re/
3742287
CPI inflation: OECD. 2015. OECD
Statistics (https://tinyco.re/9377362).
Independence of central bank: Vittorio
Grilli, Donato Masciandaro, Guido
Tabellini, Edmond Malinvaud, and
Marco Pagano. 1991. ‘Political and
Monetary Institutions and Public Finan-
cial Policies in the Industrial Countries’
(https://tinyco.re/7432619). Economic
Policy 6 (13): pp. 341–392.
Employment, N
In
fla
tio
n,
π
(%
)
0
Phillips curvesCentral bank’s
indifference curves
Labour supply
2
X
Inflation
target
U = 6%
Employment at labour market equilibrium,
inflation-stabilizing unemployment rate
Inflation-targeting central bank’s
best outcome: target inflation and
the inflation-stabilizing
unemployment rate
Figure 15.21 The economy’s inflation-stabilizing unemployment rate.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
688
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.
The commitment of central banks to an inflation target helps explain
why the third oil shock in the 2000s did not provoke a return to the high
inflation of the 1970s. The commitment meant that even if the inflation
rate rose temporarily, no one expected it to last because the central bank
was committed to preventing it. With stable inflation expectations, there
was no reason for a wage-price spiral to begin.
QUESTION 15.10 CHOOSE THE CORRECT ANSWER(S)
Figure 15.21 (page 688) depicts the Phillips curve and the indifference
curves of an economy. This economy has an independent central bank
with an inflation target of 2%.
Based on this information, which of the following statements is
correct?
The central bank will try to achieve zero unemployment while
keeping the inflation at 2%.
The shape of the indifference curves indicates that the central bank
is willing to trade higher inflation for lower unemployment at all
times.
Consider an aggregate demand shock that increases unemploy-
ment. Without monetary or fiscal policy to counter the negative
bargaining gap, the Phillips curve would shift down.
Consider an aggregate demand shock that increases unemploy-
ment. The central bank would raise the interest rate to put
downward pressure on inflation, in order to bring it back to the
target rate.
15.12 ANOTHER REASON FOR RISING INFLATION AT
LOW UNEMPLOYMENT
Why is there a trade-off in the economy between unemployment and
inflation? So far, the answer is that when unemployment is high in the eco-
nomy, 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.
But there is a second reason for the relationship between low unemploy-
ment and high inflation. In Figure 15.22, the horizontal axis shows the
degree of capacity utilization in the economy. 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. In Unit 14 we explained the usual response
of firms to rising capacity utilization: that they increase investment to
expand their ability to meet orders.
15.12 ANOTHER REASON FOR RISING INFLATION AT LOW UNEMPLOYMENT
689
Pr
ic
e
m
ar
k-
up
Capacity utilization
Less competition
Price mark-up curve
Figure 15.22 Price responses to rising employment and capacity utilization.
capacity-constrained A situation in
which a firm has more orders for its
output than it can fill. See also: low
capacity utilization.
However, building new plants and installing new equipment takes time.
Meanwhile, at current prices, firms have more orders than they can fill.
Economists say they are capacity-constrained. They lose nothing by
raising prices in these conditions. Moreover, their competitors—firms
producing similar products—are capacity-constrained too, so these firms
face less competition, meaning that their demand curves are now steeper
(less price-elastic). So all firms will tend to respond to higher capacity
utilization by raising the markup of prices above costs, and this will kick off
a wage-price spiral.
15.13 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.
Central banks are believed to be more likely to consider the future
impact of their actions than politicians, who respond to short-term demo-
cratic pressures. For this reason, 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.
UNIT 15 INFLATION, UNEMPLOYMENT, AND MONETARY POLICY
690
Concepts introduced in Unit 15
Before you move on, review these definitions:
• Disinflation, expected inflation
• Real interest rate
• Conflicting claims on output
• Phillips curve, shifting Phillips curve
• Bargaining gap
• Policymaker’s preferences
• Monetary policy transmission, exchange rate channel
• Exchange rate
• Quantitative easing
• Supply shocks, demand shocks
• Central bank independence
• Inflation target
• Capacity-constrained firms
15.14 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Carlin, Wendy and David Soskice. 2015. Macroeconomics: Institutions,
Instability, and the Financial System. Oxford: Oxford University Press.
Chapters 3, 4, 9–13.
Friedman, Milton. 1968. ‘The Role of Monetary Policy’ (https://tinyco.re/
8348372). The American Economic Review 58 (1): pp. 1–17.
Phillips, A W. 1958. ‘The Relation Between Unemployment and the Rate of
Change of Money Wage Rates in the United Kingdom, 1861–1957’
(https://tinyco.re/5934214). Economica 25 (100): p. 283.
The Economist. 2003. ‘Bush’s Push’ (https://tinyco.re/1194788). Updated
6 January 2003.
The Economist. 2013. ‘Controlling Interest’ (https://tinyco.re/7889919).
Updated 21 September 2013.
The Economist. 2013. ‘In Dollars They Trust’ (https://tinyco.re/3392021).
Updated 27 April 2013.
Walton, David. 2006. ‘Has Oil Lost the Capacity to Shock?’
(https://tinyco.re/8182920). Oxonomics 1 (1): pp. 9–12.
15.14 REFERENCES
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