inflation and unemployment

Question 1

Define:

Zero inflation

Inflation

Deflation

Disinflation

Answer 1

Zero inflation: Price level constant (0% change).

Inflation: Price level rises (e.g., 2% annually).

Deflation: Price level falls.

Disinflation: Inflation rate declines (e.g., 6% → 4%).

Question 2

Why do voters dislike inflation?

Answer 2

Fixed-income groups (e.g., pensioners) lose purchasing power.

Borrowers benefit (debt shrinks in real terms), lenders lose.

Question 3

How does inflation create conflict between borrowers (Julia) and lenders (Marco)?

Answer 3

Julia (borrower): Repays loan in “cheaper” dollars (real debt ↓).

Marco (lender): Repayment buys fewer goods (real value ↓).

Question 4

What is the Fisher equation, and how is it used?

Answer 4

Real interest rate = Nominal rate − Inflation rate.

Example: 10% nominal − 6% inflation = 4% real interest rate.

Question 5

Why is volatile inflation harmful?

Answer 5

Uncertainty: Hard to predict prices → inefficient investment.

Menu costs: Firms spend resources updating prices.

Question 6

Why is deflation dangerous?

Answer 6

Postponed spending: Consumers wait for lower prices → ↓ demand.

Debt burden ↑: Real value of loans grows → defaults rise.

Deflationary spiral: Falling demand → lower prices → economic stagnation.

Question 7

Compare inflation vs. deflation effects on debt.

Answer 7

Inflation: Helps borrowers (real debt ↓), hurts lenders.

Deflation: Crushes borrowers (real debt ↑), benefits lenders.

Question 8

What are menu costs?

Answer 8

Resources wasted on frequent price adjustments (e.g., printing new menus).

Reduces firm efficiency.

Question 9

How can deflation trigger a vicious cycle?

Answer 9

Prices fall → consumers delay spending.

↓ Demand → firms cut production → unemployment ↑.

Economic slump → further price drops.

Question 10

What causes inflation in the conflicting claims model?

Answer 10

Inconsistent claims: Firms (via markup pricing) and workers (via wage demands) make mutually incompatible claims on output.

Bargaining power shifts:

Firms: ↑ Market power → ↑ markups → inflation.

Workers: ↑ Bargaining power → ↑ wages → inflation.

Question 11

How does reduced competition trigger inflation?

Answer 11

Firms ↑ markups (price-setting curve shifts down).

Real wages fall → workers demand ↑ nominal wages.

Firms pass wage costs to prices → wage-price spiral.

Question 12

What inflation is there at the Nash equilibrium unemployment rate?

Answer 12

Zero inflation: Wages/prices are consistent with profit maximization (wage- and price-setting curves intersect)

Question 13

How does higher employment cause inflation?

Answer 13

Moves along wage-setting curve: Workers demand ↑ real wages.

Firms ↑ prices to maintain markup → inflationary spiral.

Question 14

What are the two effects of worker bargaining power increases?

Answer 14

Wage-setting curve shifts up (e.g., higher unemployment benefits).

Employment rises (movement along existing curve).

Question 15

What is the Phillips curve relationship?

Answer 15

Negative correlation: Low unemployment ↔ High inflation (and vice versa).

Question 16

If worker bargaining power rises (e.g., via ↑ benefits), what happens?

Answer 16

Wage-setting curve shifts up (initial wage hike).

Firms raise prices → real wages fall back.

No curve shift: Inflation continues until claims reconcile.

Question 17

Why does inflation persist in conflicting claims?

Answer 17

Feedback loop:

Wages ↑ → costs ↑ → prices ↑.

Prices ↑ → real wages ↓ → workers demand ↑ wages.

Continues until bargaining power or policy intervenes.

Question 18

How do protectionist policies affect inflation?

Answer 18

↓ Competition → ↑ firm markup power → price-setting curve shifts down.

Triggers wage-price spiral (workers resist real wage cuts).

Question 19

What triggers the wage-price spiral?

Answer 19

Low unemployment → workers demand higher nominal wages (cost of job loss ↓).

Firms raise prices to maintain markups → inflation.

Workers demand further wage hikes (real wages unchanged) → cycle continues.

Question 20

Define the bargaining gap and its link to inflation.

Answer 20

Gap = Wage-setting curve wage − Price-setting curve wage.

Positive gap (low unemployment): Inflation (claims > productivity).

Negative gap (high unemployment): Deflation.

Zero gap (equilibrium): Stable prices.

Question 21

How does the Phillips curve relate unemployment and inflation?

Answer 21

Negative short-run relationship: Low unemployment ↔ High inflation (and vice versa).

Shifts over time: No permanent trade-off

Question 22

What happens in a boom (low unemployment)?

Answer 22

Positive bargaining gap → wage-price spiral → rising inflation.

Claims of workers + firms > labor productivity.

Question 23

What happens in a recession (high unemployment)?

Answer 23

Negative bargaining gap → falling wages/prices → deflation.

Claims of workers + firms < labor productivity.

Question 24

Why is there no permanent inflation-unemployment trade-off?

Answer 24

Attempts to keep unemployment below equilibrium cause accelerating inflation (Phillips curve shifts up).

Question 25

How do central banks use interest rates to control inflation?

Answer 25

Raise rates → ↓ AD → ↑ cyclical unemployment → ↓ wage pressure → inflation ↓. Lower rates → opposite effects.

Question 26

What causes the Phillips curve to shift over time?

Answer 26

Inflation expectations: Workers/firms anticipate future inflation → demand higher wages/prices. Supply shocks: E.g., oil price hikes shift curve upward (1970s stagflation).

Question 27

Compare inflation vs. rising inflation.

Answer 27

Inflation: Prices increase at a constant rate (e.g., 2% yearly). Rising inflation: Inflation rate accelerates (e.g., 2% → 4% → 6%).

Question 28

What is the key policy lesson from the Phillips curve?

Answer 28

Short-run: Trade-off exists (can reduce unemployment with higher inflation). Long-run: No trade-off; unemployment returns to equilibrium, inflation adjusts

Question 29

What is the inflation-stabilizing unemployment rate?

Answer 29

The Nash equilibrium unemployment rate where inflation remains constant (no bargaining gap). Example: 6% unemployment with 3% stable inflation (Point A).

Question 30

How does expected inflation affect wage/price setting?

Answer 30

Workers demand nominal wages = expected inflation + desired real wage increase. Firms set prices = expected inflation + markup → fuels inflation spiral.

Question 31

What is the inflation equation with expected inflation?

Answer 31

Inflation (%) = Expected inflation (%) + Bargaining gap (%) Example (Point B): 5% = 3% (expected) + 2% (gap).

Question 32

Why does the Phillips curve shift upward over time?

Answer 32

Low unemployment → persistent bargaining gap → workers raise inflation expectations → next year’s inflation = last year’s + gap. Example: 3% → 5% → 7% inflation at 3% unemployment (Points B → C).

Question 33

What happens if unemployment stays below equilibrium?

Answer 33

Rising inflation: Each year, inflation = previous inflation + bargaining gap. Real wage unchanged: Stays on price-setting curve despite nominal hikes.

Question 34

Compare stable vs. accelerating inflation:

Answer 34

Stable (Point A): 6% unemployment, 3% inflation (expected = actual). Accelerating (Points B/C): 3% unemployment, inflation rises yearly (5% → 7%)

Question 35

Why can’t policymakers permanently reduce unemployment via inflation?

Answer 35

Short-run: Trade-off exists (lower unemployment → higher inflation). Long-run: Workers adjust expectations → Phillips curve shifts up → rising inflation for same unemployment.

Question 36

What is the key takeaway from shifting Phillips curves?

Answer 36

Only one stable unemployment rate (Nash equilibrium). Attempts to keep unemployment below equilibrium cause ever-rising inflation.

Question 37

What is a supply shock?

Answer 37

A disturbance (e.g., oil price hike) that shifts the price-setting curve down, reducing real wages and creating a bargaining gap. Example: 1970s oil crisis → stagflation (↑ inflation + ↑ unemployment).

Question 38

How does an oil price shock trigger inflation?

Answer 38

Firms’ costs ↑ → price-setting curve shifts down. Real wages fall → workers demand ↑ nominal wages (bargaining gap). Wage-price spiral: Firms raise prices → inflation rises (e.g., 3% → 5% → 7%).

Question 39

Why do supply shocks shift the Phillips curve up?

Answer 39

Higher expected inflation: Workers/firms anticipate continued price hikes. Persistent bargaining gap: Low unemployment or high import costs sustain pressure.

Question 40

What is stagflation?

Answer 40

Rising inflation + rising unemployment (e.g., due to oil shocks). Occurs when AD policy keeps employment at pre-shock level despite ↓ price-setting curve.

Question 41

How can inflation be stabilized after a shock?

Answer 41

↑ Unemployment: Must exceed new equilibrium (negative bargaining gap). ↓ Expected inflation: As actual inflation falls, expectations adjust. Cost: Prolonged high unemployment ("disinflation").

Question 42

What role do capacity constraints play in inflation?

Answer 42

Low unemployment → high capacity utilization → firms: Raise markups (less competition). Invest less (short-term profit focus). Trigger wage-price spirals.

Question 43

Compare demand vs. supply shocks:

Answer 43

Demand shock (e.g., ↓ investment): ↑ Unemployment + ↓ inflation. Supply shock (e.g., oil crisis): ↑ Unemployment + ↑ inflation (stagflation).

Question 44

Why do firms raise markups during booms?

Answer 44

Capacity constraints: Fewer idle resources → steeper demand curves (less elastic). Reduced competition: Firms exploit pricing power.

Question 45

What is the policy dilemma of supply shocks?

Answer 45

Option 1: Tolerate stagflation (high inflation + unemployment). Option 2: Raise rates → deep recession to curb inflation.