Macroeconomy (Lecture 8) Monetary Policy and Inflation ( (• Inflation is…
Macroeconomy (Lecture 8) Monetary Policy and Inflation
Inflation and unemployment
The Phillips Curve
Over the business cycle, there is a positive correlation between inflation and employment (or output).
.When output is growing fast and employment is high, inflationary pressures are strong
Conversely when the economy is in recession and employment is low, inflationary pressures are low.
This positive relationship between inflation and employment
is called the Phillips Curve and has a key role in the conduct of monetary policy.
The Phillips Curve implies a negative relationship between inflation and unemployment.
Why the Phillips Curve?
• Suppose the economy has high aggregate demand and is in expansion.
• Unemployment falls and workers have less chances to loose their job. They ask for higher wages.
• What do firms do? Higher costs of labor reduce their profits.They set higher prices to restore profits.
• Inflation is the outcome of this bargaining process between workers and firms.
• High aggregate demand and low unemployment leads to higher prices and inflation --- the opposite in a period of recession.
The wage-price spiral
The only cost of a firm is wages (w). Producing one unit costs wages (w)
The firm has monopoly power and can set prices
Price = mark up of m% over its cost wages
p = w x(1 +m) or Real wage w/p = 1/(1 +m )
If workers ask higher wages w, firms will set higher prices p, to restore their profit margin m
This exactly what happens when unemployment is low-- below its natural rate.
Prices (and wages) stable only when unemployment is at its natural rate.
Natural rate U* = intersection of wage curve and profit curve in the long-run.
If aggregate demand is high and unemployment low
(Ulow <U*), workers ask higher wages. Firms increase the prices to restore their profits.