INFLATION, UNEMPLOYMENT AND MONETARY POLICY

Introduction
We discussed how the use of fiscal policy can mitigate fluctuations in aggregate demand.
This fiscal policy includes automatic stabilizers (government spending or tax changes)
GDP fluctuations also have other consequences like price changes

Inflation
Introduction
Inflation (𝝅) is an increase in the general price level
Inflation is typically measured by the change in price index

There are three important connected concepts

• Zero inflation: constant price level from year to year [𝜋𝑡 = 0]
• Deflation: decrease in general price level [𝜋𝑡 < 0]
• Desinflation: decrease in the rate of inflation from a previos period [𝜋𝑡 < 𝜋 𝑡 − 1]
o Prices are still increasing but at a slower rate

Inflation allows us to distinguish between nominal and real variables:

• Real interest rate = nominal interest rate – inflation rate (fisher equation)
• Real wage growth = nominal wage growth – inflation rate

How much inflation is good?

Consequences of inflation
For a constant nominal income (pensions, wages, rents, etc.), inflation reduces purchasing power: you can
buy less goods with the same nominal wage

Inflation affects the real value of debt:

• Debt repayment is done at a nominal level: if you borro 1000€ today, you pay 1000€ in a year
• If there is inflation, real valie of the debt decreases – good for borrowers, bad for creditors

High rates of inflation makes the economy work less well:

• High inflation is often volatile, unpredictability increases uncertainty
• It is harder for producers to distinguish between changes in relative prices and inflation
o Relative prices are important to decide cost-effective input combinations (amount of
labour/capital)
• Menu costs as firm have to update prices more frequently

Deflation may be even more problematic:

If prices are falling households postpone consumption expecting future price drops:
• This induces to a negative shock in aggregate demand which may lead to even lower prices
• Firms will reduce production and likely employment
Deflation increases the real debt burden:
• A rise in the real debt burden will incentive consumers to save more to attain their target wealth
• Poorer households will face higher credit constraints
• Overall, this is likely to lead to lower consumption and induce a drop in aggregate demand,
depressing prices further
• This vicious circle can to deflationary spirals
For all this, economist generally agree some inflation (=2%) is good, as long as it remains stable

Causes of inflation
Workers, consumers and firms
Prices are determined by interactions between firms, consumers and workers
Changes in price levels can be motivated by several factors which can be summarized in two categories:
• Increases in bargaining power of firms over consumers:
o Lower competition allows firms to
charge higher prices
o Increases in prices leads to
decline in price-setting curve and
reduction of real wages [long-
run]
• Increases in the bargaining power of
workers over firms:
o Higher labour union power or
employment levels
o Vertical shift of wage setting
curve: higher real wage required
for the same employment level
[long run]
o Movement along the curve [short run]

The Philips curve

Introduction
Higher unemployment may result in inflation:

Since there is a positive relation between employment and inflation:

• An upswing in the business cycles is often associated with rising inflation
• Real wages may remain unchanged but nominal wages and prices keep increasing – inflation spiral
The positive relation between employment and inflation is known as the Phillips curve:
This relation suggest that there is an employment level
that guarantees no inflation (price stability)
An that fluctuations of employment are associated to
inflation or deflation
You cannot have, at the same time, high employment and
low inflation. To attain a lower inflation is necessary to
reduce employment
 (un)Employment and inflation
Labour market is in equilibrium if with the given output market
conditions, real wages are exactly those necessary to ensure
desired worker’s effort
In this scenario employment, unemployment and prices are
stable
This ensures inflation of zero

Business cycles affect unemployment

If unemployment is:
• Below equilibrium value: claims of real wages/profits above total productivity – upward pressure on
wages/prices
• Above equilibrium value: claims of real wages/profits below total productivity – downward pressure
on wages/prices

(un)Employment and inflation: Bargaining gap

Bargaining gap is the difference between real wage required to incentivize effort and real wage that firms
enough profits to stay in business
If we denote (U*,E*) as the equilibrium levels of unemployment and employment, we can distinguish
between 3 cases:
• U<U*, E>E* then the bargaining gap >0 so prices are increasing (inflation)
• U=U*, E=E* then bargaining gap =0 so prices are stable
• U>U*, E<E* then bargaining gap <0 so prices are decreasing (deflation)
We can illustrate the relation between business cycles’ booms and busts and inflation using three tools:
aggregate labour market model, (AD) multiplier model and Philips curve.

Suppose the economy is in equilibrium at point A, with an unemployment of 6% and that:

• AD increases, leading to a boom and a decrease in unemployment to 3% (point B)
• AD decreases, leading to a bust and an increase in unemployment to 9% (point C)

Choosing inflation rates: preferences

When deciding target inflation rate, policymakers weight the trade-offs between inflation and
unemployment
Theory suggests that the economy is better off with a low, but positive, level of inflation
• High inflation has important costs, but inflation around 0% could easily evolve into deflation in a
mild recession.
• Generally agreed “good” level of inflation: 2%
From the perspective of the policy maker, (high) inflation/deflation and low employment are undesirable:
• Indifference curves (IC) are concave
o Inflation and employment are high: IC is flatter [point B]
o 2% inflation and low employment: IC is vertical [point A].
• Best possible outcome is 𝑈, 𝜋 = 0%, 2% , so:
o IC further away from this represent worse outcomes.

Choosing inflation rates: equilibrium inflation

The optimal inflation rate can be obtained by combining:
• The preferences of policymakers regarding inflation and
unemployment
• The feasible combinations of inflation and unemployment
[derived from the Phillips curve]
Equilibrium is obtained where Philips curve is tangent to the IC
closest to F:
• Phillips curve determines feasible combinations of
inflation and unemployment (MRT)
• Indifference curves show preferred combinations of
inflation and unemployment for the policymaker (MRS)
Optimal inflation rate, 𝜋∗, where MRS = MRT
𝜋∗ is associated to an optimal unemployment, 𝑼∗ [point C]

Over time changes

The trade-off between inflation and unemployment is not stable – phillips curve shifts over time
For example:
• In the US, in some periods, like the 70s relation is very steep:
o Small change in unemployment required to change
inflation
• In others, like the late 90s, 00s, 10s, relation is very flat:
o Large change in unemployment required to change
inflation.

So there is no permanent trade-off:

• Phillips curve is not a “traditional” feasible set
• There is only one unemployment rate at which inflation is stable,
but this changes overtime.

If a government tries to keep unemployment ‘too low’ the result will be

not just higher inflation, but rising inflation as well.

The role of expectations

Expectations of future prices can lead to changes in the Phillips curve:
• Suppose expected inflation is 𝜋 𝑒 = 3%:
o If labour market is in equilibrium, bargaining gap is zero:
𝜋 = 𝜋 𝑒 = 3% [pointA]
o If positive demand shock creates (unexpected) 2%
bargaining gap:
▪ 𝜋 = 𝜋 𝑒 + bargaining gap = 3% + 2% = 5% [point
B]
▪ Negative surprise: people expected 3% inflation
got 5%
 As a result, in the next period, expected inflation increases, leading to shift in Phillips
Curve. If 𝜋 𝑒 = 5% and bargaining gap = 2%:
▪ 𝜋 = 𝜋 𝑒 + bargaining gap = 5% + 2% = 7% [point C]

As long as there is a positive bargaining gap, there will always be

surprise inflation leading to revision of expectations for the next
year, and pushing inflation even higher.
Imagine 𝑼 = 𝟑% which is below labour market equilibrium, 𝑈∗ = 6%,
creating a positive bargaining gap.
As long this is the case the inflation will keep increasing
Inflation-stabilizing rate is the unemployment rate which keeps
inflation constant.

Supply shocks
Another cause of high (and rising) inflation is a supply shock:
• Supply shock is any unexpected change on the supply-side of the economy. E.g. oil price shock,
war.
Supply shocks shift the Phillips curve by affecting labour market
equilibrium.
If demand remains constant, a decrease in the supply of oil leads to:
1. Increases in prices
2. Downward shift of price-setting curve
3. Real wage falls
4. Positive bargaining gap opens
5. Persistently higher inflation

Constraints in the supply of goods may have more important

consequences, particularly if they affect energy costs
Oil/gas prices affect the economy:
• Directly: higher prices for consumers
• Indirectly: through the increase in transportation and other
industrial costs
In 1970s, two oil shocks led to:
• Increases in (oil and other) prices
• Decline in GDP growth
• Spikes in unemployment

Monetary policy
Introduction
Central banks are typically responsible for setting monetary policy. They have broadly two dimensions
they can control:
• Policy interest rate
• Money supply

Depending on the exchange rate regime in place, they can also directly manipulate the exchange rate.
Two extreme cases:
• Flexible exchange rate: Currency is allowed to float. Its price is determined by the market. Central
bank should not intervene directly to influence the value of the currency. E.g. Euro, US Dollar or
British pound have flexible exchange rates.
 • Fixed exchange rate: Value of the currency is somehow fixed (or associated) to another currency.
E.g. Danish Krone, some African currencies to the Euro; Caribbean/Middle eastern currencies to
the US Dollar.
Still, even if the exchange rate is not the direct target, changes in monetary policy can induce changes in
the exchange rate

Policy interest rate and monetary policy transmission mechanisms

How policy interest rate may affect the economy?
There are essentially 4 transmission channels:
• Market interest rates
• Asset Prices
• Expectations/confidence
• Exchange rate
Together, they influence:
• The domestic aggregate demand
• Net exports
• Import prices.
Which, in turn, conditions the average price level in the economy.

Interest rate and market interest rates

The market interest rates are one of the most important transmission channels as they affect savings and
borrowing, hence consumption and investment, in the economy

Policy interest rate conditions market interest rates in at least two ways:
• Some loans’ interest rate is directly anchored to money market rates – e.g. house mortgages and
Euribor
• Policy rate influences the cost of money market funds for commercial banks, and thus their
capacity to lend money.

In reality, policy rate is sort of defined backwards, Central banks:

1. Determine the desired level of aggregate demand, based on labour market equilibrium and Philips
curve;
2. Estimate real interest rate, which will produce this level of aggregate demand (using the multiplier
model)
3. Calculate nominal policy rate that will produce the appropriate market interest rate.

Policy interest rate, asset prices and profit expectations

Changes in the policy rate have a ripple effect on market interest rates (lending, mortgage rates), but
also on the interest rates of government bonds.
As a result, they affect prices of assets:
• When interest rate goes down, prices of financial assets (bonds, shares, etc) go up
o This is mainly the result of a substitution effect between savings and other investments
• At the same time, households who own assets become wealthier and are likely to increase
consumption.

Policy interest rates also affect expectations and confidence

• Profit expectations and business confidence are key to determine investment decisions of firms
o If firms expect low interest rates, demand likely increases and so might investment
• Household confidence is also an important determinant of consumption.
Policy consistency and confidence is critical for Central Banks: in its absence, desired outcomes may not
materialize.
Policy interest rate and exchange rate
Exchange rate is the number of units of home currency that can be exchanged for one unit of foreign
currency
The exchange rate between the Australian dollar (AUD) and the US dollar (USD) can be determined as:
Exchange rate AUD = number of AUD / one USD
If the exchange rate is 1.07, this means you need 1.07 AUD to buy 1 USD. Thus, a t-shirt that costs 20
AUD can be bought with 18.69 USD (20/1.07)

The exchange rate typically fluctuates overtime. If exchange rate was 1.07 yesterday and today:
• It is 1.00 – there was an exchange rate appreciation (AUD is worth more than today, compared to
USD)
o 20 AUD t-shirt can now be bought with 20 USD
• It is 1.25 – there was an exchange rate depreciation (AUD is worth less than today, compared to
USD)
o 20 AUD t-shirt can now be bought with 16 USD

Interest rates affect demand for home currency in the foreign exchange market, leading to changes in the
value of the currency, which in turn affect in net exports (changes in international competitiveness):

Depreciation of AUD vis-à-vis USD makes:

• Exports to the US relatively less expensive – this induces an increase in 𝑿
• Imports form the US relatively more expensive – this induces a decrease in 𝑴

And the multiplier model

Suppose economy is initially in equilibrium [point A] and then:
• Autonomous consumption declines [c0 > c’0]:
o This shifts AD downwards
o And leads to a new equilibrium with lower output
[point B]

To stabilize the economy, the central bank can:

• Decrease the real interest rate (𝑟 > 𝑟′)
• This increases investment [𝐼 𝑟 < 𝐼 𝑟’]
• And shifts AD upward: new equilibrium at point A

This suggests monetary policy can be used to stabilize economy, instead of (or as a complement to)
changing in fiscal policy.

Limitations
So, monetary policy could be used to stabilize the economy, this seems particularly appealing because it
does not come with direct budgetary costs.
However, monetary policy has important limitations:
• Discretionary monetary policy changes can erode Central Bank credibility
o If interest rate is high today and suddenly drops tomorrow, investors in the future may
refrain from investing
 • The short-term nominal interest rate (policy rate) cannot go below zero – “zero-lower bound” to
monetary policy:
o When the economy is in a bust, nominal interest rate of zero may not be low enough to
stabilize it
o An alternative is quantitative easing, where central bank purchases financial assets to
reduce yields and boost investment.
• Some countries have no monetary policy autonomy: E.g.: In the Eurozone, the Central Bank of
Spain cannot decide to lower interest rate to face a domestic crisis.

Demand shocks
Policy mixes to stabilize the economy
In the event of a crisis, governments with monetary and budgetary
policy autonomy can use them jointly to stabilize the economy.
Demand shock is an unexpected change in aggregate demand
In response to a drop in autonomous consumption AD will drop, and:
• Point D has lower output, employment and inflation than point
C.
Governments could simultaneously:
• Decrease the nominal interest rate [Monetary policy]
• Cut taxes/increase government spending [Fiscal Policy]
The joint use of these policies can reduce stabilization cost:
• Interest rate does not have to be cut so much
• Budget deficit does not to rise as much.

The effect of a monetary and fiscal policy mix to stabilize the economy can be summarized as follows:

Discretionary policies vs Inflation targeting

Central bank credibility
One important limitation of discretionary monetary policy is that it may reduce the credibility of the
Central Bank
An alternative is to define a rule and stick to it:
• Inflation targeting is a monetary policy regime
where the central bank uses policy instruments to
keep the economy close to an inflation target.
Under inflation targeting, the Central Bank becomes
independent of the Government:
• This makes inflation targets more credible
• And can prevent inflation spirals
o This rule anchors expectations about
inflation and prevents Phillips curve shifts.
Central Bank independence has been progressively implemented in
developed economies since 1990s:
• Main target of CB: keep inflation around 2%
Earlier evidence suggests less-independent central banks delivered
higher inflation rates

Inflation and low unemployment

Another reason for the trade-off
So far we have justified the trade-off between (un)employment and inflation as follows:
• When employment is high, costs of job loss is lower, employers must offer higher wages and
increase prices to keep profits constant.

In reality, there is another reason for low unemployment and high inflation – high capacity utilization
• When capacity utilization is high: all resources (human and physical) are being used for production:
o In the long-run, firms respond to rising capacity utilization by increasing investment (e.g.
increase size of factory)
o In the short-run, firms are capacity constrained: they cannot meet excess demand for
output. As a result, they raise prices.
§ If all the firms respond in the same way, this creates a wage-price spiral that leads to inflation.