RELATED CONCEPTS:|ACCELATIONIST THEORY | COLD TURKEY AND GRADUALISM |DEMAND-PULL AND COST-PUSH INFLATION |EXPECTED RATE OF INFLATION |LONG-RUN PHILLIPS CURVE |NATURAL RATE OF UNEMPLOYMENT |PHILLIPS CURVE |TAX-BASED INCOME POLICY (TIP) |
Use the following Phillips Curve schedule and answer the following questions.
Unemployment Rate : 3 4 5 6 7 8
a. If natural rate of unemployment is 6%, what is the expected rate of inflation?
b. If inflation falls from 8% to 7%, what will happen to unemployment (if expectations about inflation don’t change).
a. 8%.
b. Unemployment will rise to 7%.
Workers expect inflation to be 20% and the economy is fully employed. Then the Fed acts to reduce the inflation rate to 10%. What will happen in the short run? In the long run?
- Workers will contract for 20% higher wages, but when prices only go up 10%, employers will find they are paying higher real wage and so will cut back employment. The economy will go into a recession (as AD shifts left). In the long run, both unemployment and lower prices will cause workers to adjust their wages down, so the economy will return to full employment (shifting the AS curve right).
What phase of the business cycle (the demand push or the cost pull phase of an
expansion or recession0 is economy in when these statements are made?
a. “Unions have negotiated for lower wages so as to retain their jobs.”
b. “Unemployment has fallen dramatically as inflation has accelerated.”
c. “Firms have been forced by recent wage hikes to raise their prices and produce less.”
b. Demand-pull phase of an expansion.
c. Cost-push phase of an expansion.
Wage inflation is related to expected inflation by the following equation:
Percent change in Wages = Expected rate of Inflation + Percent change in Productivity
If expected inflation is 10% and productivity increases by 2%, how much will wages change?
- Wages will go up 12%.
“Changes in employment and output are caused by how wages and prices change relative to each other.” Explain.
- When wages (W) rise more quickly than prices (P), real wages (W/P) are increasing and employment will fall (holding technology) and capital constant). When wages rise more slowly than prices, real wages are decreasing, and employment will rise.
Suppose you own International Widget Works. How could you evade wage and price controls before and after they are enacted?
- The trick is to increase your widget price before controls are imposed (since you would not be permitted to increase them after) but also to not lose customers because of your higher price. So you raise your price but offer “special” discounts to your customers (such as coupons, special credit terms, and special volume discounts). Once controls are imposed you can raise your effective price by cutting back on these discounts. If this is not enough, have your customers pay for some of your costs by picking up the product themselves. Have very strict credit terms or even demand cash in advance for widgets. Have many grades of quality, each with its own price, so you can push up your effective price by reducing the quality in each grade. If your product is in high demand, insist that your customers buy something else from you (at an inflated price) before they can get widget.
How could wage and price controls appear to be holding down inflation when in fact they are not?
- If many firms employ the tactics described in the above question, reported prices will not rise. But the effective price of goods will. So inflation will not be stopped. Note that by evading wage and price controls, firms are actually serving the customers, for otherwise there would be shortages of goods and less output.
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