Unit 15

Question 1

Inflation
Deflation
Disinflation

Answer 1

Price level is rising
Price level is falling
Inflation rate is falling

Question 2

1 winner and 1 loser from inflation

Answer 2

• borrowers with nominal debt
• lenders with nominal assets.

Question 3

Real interest rate =

Answer 3

Nominal interest rate - inflation rate

Known as fisher equation

Question 4

Volatility

Answer 4

Difficulty for planning and forecasting, menu costs - have to change prices constantly

Question 5

Deflation impact

Answer 5

Delayed consumption, if you see prices falling, will wait out longer to purchase - across economy may lead to a recession

Question 6

Greasing the wheels

Answer 6

Low stable inflation allows for workers to not see nominal wages fall, even if real wages fall

Question 7

Room to manoeuvre for monetary policy

Answer 7

Lot less ability to impact the economy with interest rates if inflation is 0

Question 8

Causes of inflation:

Answer 8

• increase in bargaining power of firms over consumers - less competition = higher markup = downward shift of ps curve
• Increase in bargaining power of workers over firms = higher wage, leads to upward shift of the wage setting curve, increase in level of employment

Question 9

Owners power rises relative to consumers, e.g. lower competition - medium to long run

Answer 9

Price setting curve shifts down, lower wages and employment
- higher markup so u rises, as w/p = k(1-u), price goes up while nominal remains constant - lower real wage

Question 10

Employees power rises relative to owners, e.g. stronger unions - medium to long run

Answer 10

• at each level of employment workers demand higher wages
  therefore wage setting curve shifts up = higher wages = higher prices = more inflation

Question 11

Positive bargaining gap

Answer 11

= increase in wages paid = higher unit costs = firms increase prices to maintain margins = economy wide inflation

Question 12

Increase in employment caused by demand side has lead to bargaining gap

Answer 12

As workers ask for wages that are higher than what firms are willing to pay.

Question 13

Negative bargaining gap

Answer 13

Firms recognise this and decrease wages, leading to deflation

Question 14

Policy maker preferences:

Answer 14

Inflation y axis, employment x axis - Philips curve:
- indifference curves are semi circles with F as central point and cut off at vertical labour supply line - as finite labour
- policy maker is willing to tradeoff some employment for inflation and vice versa
- as you zone in on F higher levels of utility
- meets the feasible set - Philips curve at MRS = MRT

Question 15

People are forward looking

Answer 15

Therefore take actions in anticipation of future - expectations matter

Question 16

There has been a positive demand shock leading to unemployment rate of 3%, bargaining gap of 2% now
- what’s the major assumptions we’re holding?

Answer 16

Now as a worker you expect wages to rise by 3%, but now there is a bg, since unemployment is low we will demand a 5% nominal wage increase. HR dont agree then workers wont put effort - so they pay and then inflation rises as higher costs passed on to higher price to maintain profit margin
- major assumption is level of competition hasn’t changed

Question 17

Now expectations for future inflation rates have increased

Answer 17

so at A, people expect 5% inflation at labour market equilibrium, leading to a new Philips curve. Workers realise their real wages havent really increased, so now ask for a 5+2% increase in nominal wages, firms increase prices - cycle, as seen below
- basically firms will always match wage increases with price increases, which causes inflation which means real wage increase is cancelled out

Question 18

If supply side shock:

Answer 18

• oil prices rise, increasing price level leading to lower real wages, as well as lower employment -> known as stagflation

Question 19

Some limitations of monetary policy

Answer 19

• short term nominal interest rate cant be below 0
• Country without own currency does not have its own monetary policy

Question 20

Quantitative Easing

Answer 20

• central bank buys bonds to create base money
• Raises demand for bonds and other financial assets, increasing price and decreasing interest rate
• Boosts spending

Question 21

Exchange rate channel

Answer 21

fall in investment = fall in AD = fall in forecast inflation, Australia central bank curs interest rate, fall in demand for bonds, fall in demand for AUD, exchange rate weakens - may improve net exports

Question 22

Competition and markup link

Answer 22

As competition falls, markup increases, which translates to inflation

Question 23

How could increase in bargaining power of workers take place

Answer 23

• increase in level of employment, moving along the wage setting curve
• shift outward of wage setting curve

Question 24

Employees power rises relative to owners in a business upswing

Answer 24

Higher employment rate, higher wages so higher prices, so inflation occurs

Question 25

Fall in employment rate

Answer 25

Price setting and wage setting curves remain constant, but lower wage, so now there is a negative bargaining gap for workers

Question 26

Last periods inflation = expected inflation

Answer 26

- expected inflation + bargaining gap = increase in wages = increase in unit costs = increase in prices = inflation this period

Question 27

When capacity utilisation goes up

Answer 27

Linked to higher demand, likely due to lower comp = higher markup on curve

Question 28

Link between interest rate and bond prices and exchange rate

Answer 28

Higher interest rates mean new bonds become more attractive than old ones, so old bonds reduce in prices to match desirability of new bonds. - therefore higher demand for GBP = appreciation

Question 29

One would expect to observe higher but constant inflation at a lower unemployment rate

Answer 29

True - higher constant rate of inflation is associated with lower unemployment in Philips curve.