Unit 15: inflation unemployment and monetary policy. Inflation is one of the most important
macroeconomic variables. It is almost always in the news and especially after the recent pandemic,
economists are discussing the possibility of high inflation rates returning. What is inflation?
ITuttois the rate at which price is changing in the economy. Who changes prices? Firms do,
but why do they change the prices? To understand that, we need to scroll down and go to Unit 15.3:
inflation, the business cycle and the Phillips curve. Let's scroll down.
This conceptual graph captures the process that leads to inflation,
the causal change that generates inflation. We covered each of these topics separately
in some of the units that we have discussed so far. Let me start backward. Inflation happens when
firms decide to increase the price of goods and services. Why do they increase their
price of goods and services? They do so when they encounter an increase in their cost of production.
One of the elements that increases the cost of production is the increase in wages.
What drives the increase in wages is a bargaining gap. A bargaining gap kicks off this whole causal
chain and in order to understand this concept we need to go to our price setting and wage setting
curves model that captures the whole economy at the aggregate level, so let's scroll down.
On the top, you have the wage setting and price setting curves that we covered in Unit 9. This
model captures the whole economy at the aggregate level. Below, you have the Phillips curve,
which will get to later on, but for the moment notice that the shape of the wage setting curve
and the Phillips curve are very similar and, as you will find out later, this is no coincidence.
But how does this model capture the process of inflation? Let's start with the situation
where the economy is at the equilibrium level of employment. At this level of employment neither
the workers nor the firm have an incentive to change their behaviors. The workers don't
have an incentive to demand higher wages and the firms don't have an incentive to change prices,
so at this level of employment the prices are stable, in other words, the inflation
is zero. Let's assume, for whatever reason, you have a positive demand shock in the economy.
Again, everything starts with a positive demand shock: for whatever random reason,
people start to buy more and more goods and services. In reaction,
the firms have to increase their production, and therefore they start to hire more and more
workers. The employment level goes up at this new level of employment, a bargaining gap opens up:
on the one hand the firms need to pay higher nominal wages to their workers
to keep them motivated as before at this new level of employment, so they increase the nominal wages,
but on the other hand this reduces their profits, because they have increased the nominal wage and
the prices have remained the same, so the markups have gone down for firms, while
the overall level of competitiveness in the economy has stayed the same. So,
the profits go down in order to counteract the fact that the firms start to increase their prices
in order to keep the markups the same and maximize their profit. This process creates inflation. So,
let me go through it again. You had a positive demand shock in the economy,
the employment rate goes up at this new level of employment, the firms need to increase the nominal
wages to keep the workers motivated as before but once they increase the nominal wages, they also
increases the prices to keep the mark-ups the same as before, and this creates inflation. Now
the Phillips curve captures all the story that I told you. This curve shows that in
the short to medium term there is a positive relationship between employment and inflation
rate: higher employment goes hand in hand with higher inflation in the economy.
Now we can think about the exact opposite case of a negative demand shock: for whatever reason,
households and firms start to spend less in the economy, firms cut down their production,
therefore the employment rate in the economy goes down. At this new level of employment rate,
the firms reduces the nominal wages because at this lower nominal wage they can keep
the workers as motivated as before, but once they reduce the nominal wages they have to
reduce the prices as well. Why? Because the competitiveness in the economy hasn't changed
and therefore they cannot increase the markups. The mark-ups have to remain the same as before,
so once the wages go down, the prices have to go down, and this creates deflation
in the economy. As you can see we can use the wage setting curve and the price setting curve
to explain the process of inflation and out of the wage setting curve we get the Phillips
curve. Now you understand why the shape of the wage-setting and Phillips curves are the same.
If you go through the story again, you might say to yourself: the workers were fooled.
Remember, for instance, in the case of a positive demand shock at this new level of employment
the firms first started to pay higher nominal wages for their workers to keep them motivated
but at the same time the firms increased their prices by one percent and generated inflation.
So why did the workers not expect this? Why did the workers not expect a one percent inflation to
begin with from the onset? This tells us that we need to augment our Phillips curve with the notion
of expectations: the workers are no fool. If they expect one percent inflation in the future,
a one percent increase in the nominal wages wouldn't motivate them so we need to introduce
the concept of expectations in the Phillips curve and I'm going to do that in a separate
video. But let's go back to this model and as a final step, let's integrate the Phillips curve
with the aggregate demand curve (the Keynesian cross) we learned from the previous unit.
So, basically, these three models/graphs tell the same story but from different perspectives.
So we're talking about the causes of inflation resulting from the demand side. Let's assume
that we got a positive demand shock. The aggregate demand goes up, therefore spending in the economy
goes up. This, according to the Phillips curve, results in a higher level of employment and higher
inflation in the short to medium term. This is the underlying storyL a higher aggregate demand
leads to higher level of employment, higher nominal wages, therefore higher prices. The
exact opposite happens when you got a negative demand shock: the aggregate demand goes down,
the employment levels go down, the prices go down, why? Because you have a negative bargaining gap,
so Bill Phillips very creatively showed all these relationships in a mechanical machine he built,
a mechanical machine that captures the macro economy, what happens when you have a change
in the level of aggregate demand, in the spending, what's going to happen to the level of employment
inflation and the economy as a whole. And you can find this very creative
machine, the Bill Phillips machine in the Science Museum in London today.