Kindle Notes & Highlights
When the demand for labour is high, and there are very few unemployed, we should expect workers to bid up wages quite rapidly, each firm and each industry being continually tempted to offer a little above the prevailing wage rates to attract the most suitable labour from other firms and industries. On the other hand it appears that workers are reluctant to offer their services at less than the prevailing wage rates when the demand for labour is low and unemployment is high so that wage rates fall only very slowly. The relation between unemployment and the rate of change of wage rates is
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when unemployment falls below 2% wages start rising very sharply (wage inflation accelerates) while wage deflation (<0) is limited even at higher unemployment rates (5–10% range).
a process of ‘job hopping’, as firms poach workers from other firms in a tight labour market by paying more, but aggregate URATE does not change.
While the original Phillips curve was the link between money wage inflation and unemployment, the normal Phillips curve, drawn as above for USA, is a link between price inflation and unemployment. In effect there is a labour market Phillips curve and a product market Phillips curve. The difference between wage inflation and price inflation is due to (mainly manufacturing) productivity growth that results from technical progress.
Usually averaging across business cycles phases, price inflation will be lower than wage inflation since productivity growth lowers unit labour costs and hence it lowers prices relative to wages.
p (prices) = π (wages) – producti...
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a policy of trading off a rise in inflation for a fall in unemployment.
a fall in unemployment leads to a large rise in social welfare, while the welfare loss from the ensuing rise in inflation is small. There is no doubt that unemployment has high costs while inflation is a relatively minor nuisance at low inflation rates.4 Hence, within reasonable limits, based on preferences of the public, policy makers should tolerate some more inflation to reduce unemployment.
Macroeconomic Welfare Function (MEW): MEW = 100 – α (URATE) – β (INFLATION), with α much > β, reflecting the much higher cost of unemployment.
Reducing URATE was seen as a crucial plank of this policy, since poverty rates tend to fall when URATE falls.
inflation cannot be traded off for unemployment on a sustained basis. He introduced the concept of the natural rate of unemployment. Based on that, he predicted that macro-economic policy attempts to lower unemployment below the natural rate would be self-defeating, because there is no long run trade-off between inflation and unemployment.
the natural rate of unemployment, according to Friedman, is the rate at which the economy would tend towards on its own without governmental macroeconomic interference. It is the unemployment rate at which inflation will be stable and neither rise nor fall.
The natural rate is not God given. It can (and often should be) reduced by microeconomic policies that reduce the distortions in the labour market, such as minimum wage laws, hiring and firing rules that reduce labour demand, unemployment insurance benefits etc. The natural rate can be reduced by subsidizing the cost of say daily travel to work and thereby increasing labour mobility. However, the natural rate cannot be influenced or lowered by monetary or fiscal policies, which can only affect aggregate demand. Job schemes that push up aggregate demand without adding to aggregate supply cannot
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The original Phillips curve, while valid in a world of zero inflation, was flawed according to Friedman and Phelps, because it does not take into account expected inflation
In Long Run Equilibrium, expected inflation must equal actual inflation.
Workers ultimately care only about what money can buy, i.e., the real wage.
So the aggregate supply curve of labour is vertical with respect to price level.
In the economy with ongoing inflation the same vertical curve logic applies to the inflation rate and the unemployment rate. This phenomenon is defined as the “absence of money illusion”, a very important concept in monetary economics. This absence of money illusion should apply not only to wages but to the prices of other transactions as well.
commodity and oil prices tend to rise when URATE falls (whatever its level) and growth rises, with ensuing temporary impact on inflation. Vice versa, when URATE rises.
the underlying demand-supply gap depends far more on URATE than on its change.
We will assume the level of URATE relative to U* determines inflationary pressures.12 When U is below U*, that implies AD > AS and continues to be so in subsequent periods. Hence in a dynamic economy U being below U* corresponds to a continuing excess of demand relative to supply, and so continuing inflationary pressure in subsequent periods.
the Expectations Augmented Phillips Curve (henceforth EAPC), can be written as: π t = πt (Expected) − q (Ut – U*) + error term, with q > 0 where U is the current unemployment rate, U* is the natural rate (assumed constant here), small t denotes period, and q denotes the response of inflation to the unemployment rate, i.e., the slope of the short-run Phillips curve. By taking expected inflation to the left hand side of the EAPC we get: πt − πt (Expected) = q(U*) − q(Ut) If πt (Expected) = πt–1, i.e., expected inflation is equal to last period’s inflation, then Dπ = q(U*) − q(Ut) = zero.
The long run (vertical) Phillips curve can be defined as the locus of different short run Phillips curves at which expected equals actual inflation and so U = U*,
expectations augmented Phillips Curve (EAPC) represents not just one curve, but a whole process and model. With reference to the diagram on the previous section, it combines: (i) the short-run Phillips curves (points A to B), (ii) the adjustment process as the simple, short run Phillips curve shifts up (points B to C), and (iii) Long Run Equilibrium (LRE) with the vertical Phillips curve (points A, F and G).
Friedman’s explanation for short run movements in unemployment came to be called the confusion or fooling theory of unemployment. Workers are fooled because they underestimate the inflation rate or price level and thus overestimate the real wage they are getting. But they cannot be fooled all the time (to quote Abraham Lincoln). When the real wage turns out to be lower than expected, they demand higher money wages (or a bigger raise) as compensation to ensure they get the real wage they had anticipated or contracted for, setting the whole EAPC process in motion.
Natural Rate Hypothesis (NRH)
The basic EAPC idea—that money wages should adjust fully for expected inflation—follows from logic. Across the world and across time, wages and other contracts get adjusted for changes in the cost of living. It could be more accurately called the Inflation Adjusted Phillips Curve (or IAPC) since the process is often a mechanical adjustment to past inflation, rather than decisions to raise money wages based on expectations about the future.
the proportion of contracts with Cost of Living Adjustment (COLAs) clauses rose since inflation had gone up. Thus inflation adjustment can take place without unions. Conversely, union workers can get premium wages, relative to nonunion workers, even without inflation.
natural rate hypothesis i.e. there is no long run trade-off between inflation and unemployment.
For developing economies, it was believed and still is that some inflation (more than the 2% deflation threshold, discussed in the next chapter) is necessary and desirable for growth: about 5–6% in Indian policy writings.
The higher capacity utilization rate puts pressure on resources and may lead to a one time rise in prices, but not a continuing inflation which requires ongoing wage increases. With surplus labour, continuing wage inflation is unlikely to happen.
Growth in Nominal GDP = Growth in Real GDP + Inflation, or gY = gy + π
phenomenon of weak growth and rising inflation is called stagflation.
since Macroeconomic Welfare (MEW) increases when URATE falls, reduction in interest rates is a major reason for expansions and overheating.
MEW = 100 – a (URATE) – b (INFLATION),
The Macroeconomic Welfare (MEW) Function used in Section 2.7.1 puts a high weight on URATE and a low weight on inflation.
The costs of inflation can be categorised under anticipated and unanticipated inflation respectively. Unanticipated inflation involves huge real costs and/or benefits, arising from discrepancies (informational or contractual) between expected and actual real wages for workers, input costs for firms, and interest rates for debtors and creditors etc.
MEW = 100 – α u – β p.
With regard to the MEW function, the costs of unanticipated inflation to employed workers can be subsumed in the ‘alpha’ term linked to unemployment, i.e., alpha can be thought of as the net gain from the benefit to the newly employed, after subtracting the loss to employed workers due to higher inflation.
The welfare loss ‘beta’ in the MEW can be assumed to be due to the impact of anticipated inflation on various economic agents. These losses occur even when the economy is along the LRPC,
These costs are further categorized into what are called Shoe Leather costs and Menu Costs. Shoe leather costs pertain to the demand for money balances.
Menu costs is a term widely used to denote the costs of anticipated inflation. In the narrow literal sense, the term implies the cost to a restaurant owner of having to print new menus as prices rise. In a broader sense, menu costs are one component of the broader transaction costs in setting prices (often, the distinction may not be made).
The magnitude of menu costs rises with the inflation rate since higher inflation leads to more price revisions.
Menu cost do not affect only consumption, but also production. Having to raise prices frequently just to cope with inflation distorts the production process.
the staggering of prices that naturally occurs, high inflation leads to a higher frequency of price revisions, not just higher magnitude.
“Steady inflation is a mirage.”
Across countries, the mean and variance of inflation are quite highly correlated, i.e., high inflation also tends to be more variable and erratic.
the welfare costs of inflation are higher than the textbook case of steady inflation.
In all economies, lower denomination currency generally circulate more than higher denomination currency
For small transactions, a premium exists for coins and thus, a black market can develop in coins.
