What’s wrong with inflation

15.1 : What’s wrong with inflation?
What is the difference between inflation, deflation, and disinflation?
• Zero inflation: A constant price level from year to year means that inflation is zero. This is like a stationary
car: the car’s location is constant and the distance travelled per hour is zero.
• Inflation: Now, consider a rate of inflation, such as 2% per year. This means that the price level goes up by
2% each year. This is the case of a car travelling at a constant speed: a car travelling at 20 km per hour means
that the distance from the initial location increases by 20 km each hour. After two hours, the car is 40 km
away from its initial location; after another hour, it is 60 km away, and so on.
• Deflation: Deflation is when the price level falls. This is equivalent to the car travelling backward at 20 km
per hour. After an hour, the car is 20 km behind its initial location, and so on.
• Rising inflation: If the rate of inflation is increasing, the price level is increasing at an increasing rate.
Suppose now that the rate of inflation increases from 2% to 4% to 6% in successive years, so the economy
experiences rising inflation. This is the case of a car accelerating: the distance travelled from the starting
point is increasing at an increasing rate, for example from 20 km per hour in the first hour to 40 km per hour
in the second hour, and so on. After two hours, the car is 60 km away from its initial location.
• Falling inflation: This is called disinflation and is equivalent to a car reducing its speed, for example from
60 km per hour to 40 km per hour to 20 km per hour. Once the speed reaches zero, the car’s location does
not change. The equivalent in the economy is that when inflation falls to zero, the price level does not
Why do people dislike inflation?
For some people in the economy, such as some pensioners, incomes are fixed in nominal terms, meaning that they
receive a fixed number of yuan or dollars or euros. If prices rise during the year, these households can buy fewer
goods and services at the end of the year than they could at the beginning. They are worse of and will tend to vote
against a party they believe will permit higher inflation.
Whether one loses or benefits from inflation also depends on which side of the credit market one is on.
inflation means that:
• Borrowers with nominal debt will benefit: Those with mortgages on fixed nominal interest rate
• Lenders with nominal assets will lose: Banks or others who have loaned money at fixed nominal interest
rates will lose, because when the sum is repaid it will be worth less in terms of the goods or services it can
buy. Very high inflation will wipe out the value of nominal assets
To take account of inflation when analysing borrowing and lending, we use what is termed the real interest rate,
which is defined as follows and is also known as the Fisher equation
Fisher equation :The relation that gives the real interest rate as the difference between the nominal interest rate and
expected inflation: real interest rate = nominal interest rate – expected inflation.
The real interest rate
measures the buying
power of the
repayment of a loan at the prices that exist when the loan is repaid. To see what this means, let’s suppose Julia were
to borrow $50 from Marco with a repayment of $55 next year. The nominal interest rate is 10%. But if next year’s
prices were 6% higher than this year’s (6% inflation rate), then what Marco could buy with the repayment is not 10%
more than he could have bought with the sum he loaned to Julia, but instead only 4%. The real interest rate is 4%.
While there is no evidence that moderate inflation is bad for the economy, when inflation is high it is often also
volatile and therefore hard to predict. Large price changes create uncertainty, and make it more difficult for
individuals and firms to make decisions based on prices.
Negatives of high and volatile inflation:
• it is hard to separate the signal about the scarcity of resources (sent by relative prices) from the noise
of erratically rising prices.
• Firms might find it harder to know which sector to invest in
• Individuals would find it harder to find out if products are more expensive or not, and which are
• Firms have to keep updating their prices, this requires time and resources, referred to as menu costs.
Negative of deflation:
• Same reasons as inflation but could be even more dramatic
• When prices fall, households will postpone their consumption because they expect goods to
become cheaper
• Deflation also increases the debt burden of borrowers
• This fall in consumption will lead to lower AD, leading to further price drops and a spiral effect
(This happened in Japan)
Economists generally think low and stable inflation is good.
15.2 : Inflation results from conflicting and inconsistent claims on output:
Imagine firms set their wages and prices consistent with the maximising profit rate, then there will be no reason for
prices or wages to change, at this unemployment rate the price level is constant. This is the labour market nash
equilibrium from unit 9.
Suppose now the government adopts protectionist policies, which make it difficult for foreign firms to enter its
markets. Then markets facing the firm become less competitive, so firms can charge higher mark-up. This results in
increasing price levels which lower the real wage of workers. So, workers lack motivation to work, so HR
departments raise nominal wage. Both prices and wages rise and the economy experiences inflation.
The nominal wage increase leads to raised cost of production, so mark-up increases, and prices rise. So real wage
falls, and HR then raises nominal wages again, this will continue as long as:
• Firms are powerful enough to charge the higher mark-up
• Workers at given unemployment rate have enough bargaining power to require the initial real wage in
order to motivate them to work
Inflation can rise also when the degree of competition remains constant but level of employment rises. At a new
lower level of unemployment firms would want to pay workers a higher real wage to keep them. This induces prices
to rise, to maintain mark-up, leading again to inflation.
To summarise, inflation may result from:
• An increase in the bargaining power of firms over their consumers: This is caused by a reduction in
competition, which allows firms to charge a higher mark-up. It is a downward shift of the price-setting
• An increase in the bargaining power of workers over firms: This allows them to get a higher wage in
return for working hard.
Bargaining power of workers can increase in 2 ways:
• A shift upward of the wage-setting curve: The wage they would receive is higher at every level
of employment.
• An increase in the level of employment, moving along the wage-setting curve: In this case, the
wage-setting curve is unchanged.
• 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.
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
If there is a recession instead of a boom, the wage-price spiral operates in reverse, and the price level falls year after
Prices are constant year after year before the boom because the labour market was in equilibrium.
• A is where real wage on WS curve coincides with real wage on PS curve, the labour market here is at
Nash equilibrium.
• Workers and owners at this point are doing the best they can given the action of the other.
• At A inflation will be 0
• At B unemployment decreases, so real wage
required increases
• At C unemployment increases, workers are in a weaker bargaining position. Real wage decreases.
• 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 2 curves.
• If unemployment is lower than at the equilibrium: There is a positive bargaining gap and there is inflation.
• If unemployment is higher than at the equilibrium: There is a negative bargaining gap and there is deflation.
• If there is labour market equilibrium: The bargaining gap is zero and the price level is constant.
The bargaining gap and the Phillips curve:
Summary of chain effects from bargaining gap to inflation:
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:
inflation (%)
≡increase in prices (%)
=increase in costs per unit of output (%)
=increase in wages (%) (if wages are the only costs)
=bargaining gap (%)
inflation (%)≡increase in prices (%) =increase in costs per unit of output (%)=increase in wages (%) (if wages are the
only costs) =bargaining gap (%).
Bargaining gap: The difference between the real wage that firms wish to ofer 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).
• At low unemployment, bargaining gap is positive
• The high unemployment bargaining gap is negative.

To complete the picture now include the multiplier
This highlights:
• 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.
• At a higher level of AD (in a boom), there is a
positive bargaining gap and inflation is positive.
• At lower level of AD (in a recession), there is a
negative bargaining gap and deflation
15.4: Inflation and unemployment:
Constraints and preferences:
Phillips’ curve suggests there is a lasting trade-off between
inflation and unemployment. If the government wants zero
inflation, then it needs to keep AD at normal level (unemp at
6%). This suggests the Phillips curve is a feasible set.
Policymakers prefer low inflation and high employment, and
these preferences can be represented in the form of
indifference curves.
Notes when drawing ICs. A choice further from the origin is
preferred since more of what is on each axis is
• Policymakers best outcome is F, with
inflation at target and full
• Policymaker is likely to prefer low
inflation to 0, so ICs become vertical
at 2%
• Above target inflation the ICs are
positively sloped, as getting
employment closer to full is worth
accepting higher inflation.
• Below target ICs are negatively sloped, as
getting employment closer to full is worth accepting lower inflation.
• We assume diminishing marginal returns to the 2 targets so: when outcome is further from inflation and
close to FE, then IC becomes flatter as policy makers place more value on getting closer to the inflation
target. Conversely, when the outcome is further from full employment but closer to the inflation target,
the indifference curve is steeper because the policymaker places more value on getting closer to full
• Policymaker chooses from the feasible set on the Phillips curve, This is C
15.5: What happened to the Phillips curve?
Phillips’ curve changed through history. Milton Friedman said that since 1966 unemployment has been steadying,
but inflation has increased (US). He said the only way unemployment could be kept as low as 3% was by allowing
inflation to keep increasing: ‘There is always a temporary trade-of between inflation and unemployment; there is no
permanent trade-of,’ he claimed.
If there is no permanent trade-off, then the Phillips curve is not a feasible 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.
Inflation means rising prices. Rising inflation means prices increasing at an ever-faster rate. This means that the
Phillips curve would keep shifting upward.
15.6 : Expected inflation and the Phillips curve:
Now we explain why the Phillips curve shifts and why inflation keeps rising when the government tries to keep
unemployment low. Need to consider:
• People are forward-looking: 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: 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.
Introducing expected inflation:
• At labour market equilibrium A, inflation is 3%
• At lower unemployment, bargaining gap is 2%
• At B, inflation is equal to EXPECTED INFLATION
+ bargaining gap
• In the boom, workers expect prices to rise by 3% and will
require a nominal wage increase of 3% just to keep real
wages unchanged. But they require a further 2% rise to
give them an expected real wage rise on the WS curve, so
wage increase is 5%. With costs rising by 5%, prices rise by
5% so on.
When inflation is not zero, we can summarize the causal chain
from expected inflation and the bargaining gap to inflation like
To work out the inflation rate:
inflation (%)
≡increase in prices (%)
=increase in costs per unit of output (%)
=increase in wages (%) (if wages are the only costs)
=expected inflation (%) + bargaining gap (%)
inflation (%)≡increase in prices (%)=increase in costs per unit of output (%)=increase in wages (%) (if wages are the only
costs)=expected inflation (%) + bargaining gap (%)
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
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
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.
15.7 : Supply shocks and inflation:
• Inflation is 3%
• At lower unemployment, bargaining gap is 2%. Inflation
= expected inflation +bargaining gap
• Next period with unemployment still low,
inflation is = expected inflation + bargaining gap.
Phillips curve has shifted up as expected inflation
increased pop
Friedman was correct that expected inflation shifts Phillips curve, but other factors include PS and WS curve shifting.
Shocks that move the Phillips curve by changing the labour market equilibrium are called supply shocks, as labour
market represents supply in the economy.
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. The labour market model and the Phillips curve can explain why a one-of increase in the world oil
price can lead to a combination of:
• a one-of increase in the price level (inflation) at the time of the shock, and
• rising inflation over time
We show a rise in oil price by shifting PS curve down, leading to a positive bargaining gap and inflation. Shift
Phillips curve up, due to expected inflation rising.
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. (But firms charge higher
prices as costs have increased). This creates a bargaining gap.
Although owners are happy, workers aren’t, and many become
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 bargaining 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.
15.8 : Monetary policy:
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 spending. 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.
The transmission of monetary policy:
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 (aka bank lending rate). 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:
• It will estimate a target for the
total aggregate demand, Y, to stabilize the economy, based on the labour market equilibrium and the Phillips
• 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.
• Finally it calculates the nominal policy rate, i, that will produce the appropriate market interest rate.
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 economy, from
mortgage rates to the interest rates on 20-year government bonds. As we saw in 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 expected to feed through to
spending, because households who own the assets will feel wealthier.
Profit expectations and confidence:
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 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:
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.
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.
shows how monetary policy can be employed to stabilize the economy following a downturn caused by a drop in
• Economy starts at A
• Consumption then falls, which shifts AD
down and economy enter recession
• Central banks stimulate investment by
lowering the real interest rate from r to r’.
This shifts AD up.
A warning!!:
Using simple diagrams like above give the impression
that CB is able to stabilise economy by precise
intervention. However this is unlikely, these are just
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
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.- Why monetary policy? Fiscal
policy is complicated to adjust and inflexible. Whereas CB can adjust interest rates month-by-month.
There are 2 limitations to usefulness of monetary policy:
• 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.
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.
During the financial crisis 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
• This boosts spending: Particularly on housing and consumer durables, because both the cost of
borrowing and return to holding financial assets has gone down.
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.
15.9 : The exchange rate channel of monetary policy:
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.
The exchange rate is defined as the number of units of home currency for one unit of foreign currency, in other
e.g. exchange rate of AUS dollar= number of AUD/one USD
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.
Figure 15.16 is a rough summary of the chain of events in Australia.
15.10 : Demand shocks and demand-side policies:
The recession and the policy response: (2000 to 2003)
● Monetary policy: 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.
● Fiscal policy: To compensate for the stagnation in firms’ private investment, 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.
● The recession and the model:
Note that now, the best outcome for the policymaker is not full
employment. Rather, it is the level of employment (and
unemployment) that maintains labour market equilibrium, to
avoid consistently rising or falling inflation.
● Economy starts at C
● Investment decreases > AD shifts down, economy moves to D
● Decrease in interest rate and fiscal stimulus via tax cuts and increased
spending shifts AD back
● Increase in output reduces unemployment and raises inflation, moving back to
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. Despite a major oil shock in the 2000s, the British economy and many other
economies continued to experience steady growth, low inflation and low unemployment.
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. By 2012, 28 countries had adopted inflation targeting, usually with a band (range) of what
was judged an acceptable level of inflation.
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
Figure 15.21 shows the Phillips curve and
indifference curves for an economy 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 equilibrium, and
hence the inflation-stabilizing rate of
unemployment, will be different in different
15.12: Another reason for rising inflation at low unemployment:
Why is there a trade-of in the economy between
unemployment and inflation? So far, the answer is that
when unemployment is high in the economy, 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 unemployment and high inflation.
Diagram shows 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. 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 of a wage-price spiral.

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