Chapter 8 Flashcards
(17 cards)
What happens with the natural rate of unemployment in practice?
The natural rate of unemployment (and the corresponding natural level of output) are affected by m, z and α, therefore you expect:
Differences across countries: National labor market institutions, corporate laws, degrees of market competitiveness, etc should lead to different natural rates across countries.
Differences over time: The above factors may vary over time. Natural rates are medium-run concepts, therefore you don’t expect them to change from one year to another, but they might evolve over decades.
What is wage indexation?
It’s one specific labor market institution.
Wage indexation means that wages are set such that they are automatically adjusted to inflation. This is important when wages are set for a longer period of time, or when inflation is very volatile.
–> the contractual feature that brings wages to increase with inflation
Wage indexation increases the effect of unemployment on inflation.
Suppose there’s absence of wage indexation. What happens?
Nominal wages are set for, let’s say, 5 years. When unemployment is low, below the natural rate, production is high, and inflation increases. Because of the absence of wage indexation, nominal wages do not react immediately. No increase in the costs for firms, no further increase in prices.
Suppose all wages are indexed on inflation. What happens?
When unemployment is low, below the natural rate, production is high, and inflation increases. Because nominal wages react immediately to inflation, they will increase. This increase in the costs for firms will bring them to increase prices further. Inflation will increase even more.
Do you expect a country where wage indexation is a common wage policy to have a Phillips curve that is steeper or flatter than a country where wage indexation is rare?
When inflation is very sensitive to changes in unemployment, i.e., when the effect of unemployment on inflation is high, the Phillips curve is steeper, and vice versa.
What happens when expected price level is increased?
An increase in expected price level leads to an increase in nominal wages, which in turn lead firms to increase their prices and thus leads to an increase in the price level.
What happens when unemployment rate increases?
It leads to a decrease in nominal wages which in turn leads to lower prices and a decrease in price level.
Why does an increase in expected inflation lead to an increase in inflation?
Because an increase in expected price level leads to an increase in price level: if wage setters expect higher price level, the set a higher nominal wage, which in turn leads to an increase in the price level.
Given last period’s price level, this period implies a higher rate of increase in the price level from last period to this period = higher inflation.
What is “the egg”?
A parameter of the effect of last year’s inflation rate on this years expected inflation.
What happens with inflation rate when ut>un?
Inflation rate decreases.
What happens with inflation rate when ut
Inflation rate increases.
What happens with inflation rate when ut=un?
Inflation rate is stable. At non-accelerating inflation rate of unemployment.
Why do workers and firms become more reluctant to enter labor contracts that set the nominal wages for a long period of time when the inflation rate is high?
Because then inflation tends to be more variable.
- If inflation turns out to be higher than expected, real wages plunge and workers will suffer a large cut in their living standard.
- If inflation turns out to be lower than expected, real wages may sharply increase. Firms may not be able to pay their workers.
What is the deflation trap?
When the natural real rate is lower than zero and inflation at zero or below, the central bank cannot achieve the natural rate
Graph: initially, the economy is at A. The central bank wants to achieve rn < 0 but can only achieve r = 0. At this rate, output Y ′ is obtained, which is below the natural level.
This means that inflation keeps decreasing (A’)
In consequence, r increases, leading to an ever lower demand and output
This is a spiral that will move the economy further and further away from the medium-run equilibrium
A negative output gap translates into higher unemployment
How does a contractionary fiscal policy affect the economy in the short and medium-run?
Short-run:
Taxes go up, or government spending goes down, or both.
This policy decreases demand, and, through the multiplier, decreases output. In other words, it creates a recession. The IS curve shifts to the left.
Inflation starts to decrease. We move from A to A’. (slide 31, topic 7)
Medium run:
After the monetary policy intervention, output returns to its initial (medium-run) level, but the composition (i.e. the shares of investment, private and government consumption) has changed.
Investment went down in the short-run (from A to A’), but in the medium-run, in A”, investment is larger than initially in A (output is the same but the real interest rate is lower).
What about consumption?
-It depends on the type of fiscal policy that was implemented: if G ↓: then consumption in A” is the same as consumption in
A (same level of output, same level of taxes). ∆G = −∆I .
if T ↑: then consumption in A” is lower than consumption in A (same level of output but higher taxes). ∆C = −∆I .
The result looks like great news for policy makers: Fiscal consolidation can thus take place without a decrease in output
How does an expansionary monetary policy affect the economy in the short and medium-run?
Short-run:
The central bank decreases the policy rate and therefore the real interest rate decreases. This boosts investment, demand, and, through the multiplier, output. In other words, it creates an expansion.
The LM curve shifts downwards, we move along the IS and the Phillips curves to the right.
In the short-run, both investment and consumption go up. The inflation rate starts increasing
Medium-run:
The central bank will react to increasing inflation by increasing the policy rate.
The policy rate will increase the real interest rate, a policy that will lower investment, demand, and output.
We move back along the IS and the Phillips curves to the left. The economy goes back to the initial state. The composition of output is unchanged.
Only difference: if πe = π(−1), then inflation will be higher than initially.
How does an increase in the price of oil affect the economy in the medium-run?
The increase in the price of oil will lead to:
a change in the price setting relation and therefore a downward shift of the PS curve
an increase in the natural rate of unemployment (because the real wage that firms are willing to pay decreases)
a decrease in the natural level of output (more unemployment → less employment → less production)
a shift of the Phillips curve to the left (because, for a given Y, a decrease of Yn leads to an increase in π − π(−1)
IS- and LM-curve stay the same in the short-run (assuming that firms don’t react by decreasing investment)
Medium-run:
At the initial level of output, the economy is now above potential (above the new natural level of output). Inflation increases. We go from A to A’.
The central bank will react by increasing the policy rate. The policy rate will increase the real interest rate, which will lower investment, demand, and output.
We move along the IS and the new Phillips curves to the left (A’ to A”). The economy converges to the new medium-run equilibrium.
Output, consumption, and investment are permanently lower.
Medium-run:
If πe = π(−1), then inflation will be larger in A” than in A. While moving from A’ to A”, the economy experienced:
an increase in inflation (we are above the 0-line)
a decrease in output
the combination of these two events is called a stagflation.
