Session 17

AGGREGATE SUPPLY: WAGES, PRICES,

INFLATION AND UNEMPLOYMENT

1
 What is inflation?

Intensity of inflation
Low inflation
Galloping inflation
Hyper inflation

Source of inflation
Demand-pull inflation
Cost-push inflation
Inertial inflation
2
 The economic impacts of inflation
“Lenin is said to have declared that the best way to destroy the capitalist
system was to debauch the currency. By a continuing process of inflation,
governments can confiscate, secretly and unobserved, an important part of the
wealth of their citizens. By this method, they not only confiscate, but they
confiscate arbitrarily; and, while the process impoverishes many, it actually
enriches some. The sight of this arbitrary arrangement of riches strikes not
only at security, but at confidence in the equity of the existing distribution of
wealth” J.M. Keynes

During inflation all prices and wages do not move at the same rate. The
diverging relative prices leads to

 A redistribution of income and wealth among different groups (lenders vs

borrowers, fixed vs variable income earners, etc.)

 Distortions in the relative prices and outputs of different goods

3
 What is the optimal rate of inflation?

A predictable and gently rising price level provides the

best climate for healthy economic growth

Galloping inflation or hyperinflation can cause serious

harm to productivity and to individuals through the
redistribution of income and wealth

If it goes beyond tolerable level, central bank will curb

it by slowing output growth and raising unemployment

4
 Inflation and Business

• Inflation and interest rate

Fisher effect: Nominal interest rate = real required rate of

return + an inflation premium

• Inflation and exchange rate

Purchasing power parity: Exchange rate reflects the ratio

of domestic prices (Pd) to foreign price (Pf),

S=Pd/Pf
5
 Inflation Control: A Policy Dilemma
The Phillips Curve

• In 1958 A.W. Phillips published a study of wage behavior in the U.K. between 1861 and 1957
• The main findings are summarized in figure below.
 There is an inverse relationship between the rate of unemployment and the rate of
increase in money wages.
 From a policymaker’s perspective, there is a tradeoff between wage inflation and
unemployment.

Price
Annual
inflation
wage rise
(P/P)
(W/W)

Phillips curve

Unemployment rate 6
 The Phillips Curve
• The PC shows the rate of growth of wage inflation decreases with increases in
unemployment
– If Wt = wage this period
Wt+1 = wage next period Wt 1  Wt
gw = rate of wage inflation, then gw 
Wt
• If * represents the natural rate of unemployment, the simple PC is defined as:

gw   (   ) *

where  measures the responsiveness of wages to unemployment.

– Wages are falling when  > * and rising when  < *

– ( - *) is called the unemployment gap.

• For wages to rise above their previous level, unemployment must fall below the
natural rate.
Wt+1 = Wt [1 -  ( – *)]

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 The Phillips Curve
• Suppose the economy is in equilibrium with prices stable and
unemployment at the natural rate
– If money supply increases by 10%, wages and prices both must increase by 10%
for the economy to return to equilibrium
– PC shows:
 If wages increase by 10%, unemployment will have to fall
 If wages increase, price will increase and the economy will return to the full
employment level of output and unemployment

• To see why this is so, Wt 1  Wt

  (    * )
Wt
Wt 1  Wt  Wt (  (    * ))
Wt 1  Wt (  (    * ))  Wt
Wt 1  Wt [1   (    * )]

• For wages to rise above previous levels,  must fall below the natural rate (*).

8
 The Policy Tradeoff

• PC quickly became a cornerstone of macroeconomic policy analysis since

it suggests that policy makers could choose different combinations of  and
 (inflation rates)
– Can choose low  if willing to accept high 
– Can maintain low  by having high  (early 1960’s).

• In reality the tradeoff between  and  is a short run phenomenon

– Tradeoff disappears as AS becomes vertical.

• After 1960, the original PC relationship broke down.

9
 Phillips curve: Implications

• A stable non-linear relationship between unemployment rates and

wage rate growth.

• Wage rates rise even during periods of substantial unemployment.

• Higher the level of unemployment, lower the growth in wages.

• Policy makers choose different combinations of unemployment and

inflation rate.

10
 Why wages are rigid downward?

• Union contracts

• Minimum wage laws

• Money illusion among workers (imperfect information)

11
 The Accelerationist Hypothesis
(Milton Friedman)

Long-run Phillips curve is vertical

“Only by accelerating inflation can the monetary authority

continue to pursue its unrealistic target level of
unemployment”.

In the long-run, there is the lowest sustainable (i.e., minimum)

unemployment rate (non-accelerating inflation rate of
unemployment NAIRU) that is consistent with steady inflation.

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 Monetary Policy in the long run
and the phillips curve
SRPC1 SRPC2 SRPC3

Annual
wage rise 5. cost of
production
(W/W) 4. wage
adjustment
C pushes
output
down

3. Real W
falls
D
B
2. W & P rise,
1. Monetary expansion to push AD
P rises faster than W.
A

NAIRU Unemployment rate

U*
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 Okun’s Law
• An account of the short-run unemployment-output relation

• The gap between an economy’s full-employment output and its actual level
of output increases by 2.0 percentage points for each percentage point the
unemployment rate increases.

Y* Y
*
 2 .0(u  u *
)
Y
Y* - full employment output; u* - natural rate of unemployment

• According to the Law, 1 extra point of unemployment costs 2 % of GDP

i.e., whenever output grows 2% faster than potential GDP, the
unemployment rate declines 1 % point

• If one wants to bring the unemployment rate down, actual GDP must be
growing faster than potential GDP.
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 The sacrifice ratio

• It is the quantitative measurement of the Phillips curve

relationship

• The percentage of output lost from each one point reduction in

the inflation rate.

• The ratio varies depending on the time, place, and methods

used to reduce inflation.

• Reasonable estimates range from 1 to 10% (US: 2.39;

Australia: 1.00; Japan: 0.93)

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 References

• DFS, Macroeconomics, Chapter 6, 7 and 8.

• “Curbing hyperinflation in Bolivia”, handout.
• “Money and prices during hyperinflations”, exercise-
7.
• “The inflation puzzle of the 1990s”, @googledrive.
• “Inflation and unemployment in the US”, Exercise-8.

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