ECON 102 Tutorial: Week 24

Ayesha Aliwww.lancaster.ac.uk/postgrad/alia10/econ102.html

a.ali11@lancaster.ac.ukoffice hours: 8:00AM – 8:50AM tuesdays LUMS C85

Today’s Outline

Week 24 worksheet – Money & Inflation

Question 1The Phillips inflation-unemployment relationship is better described as “L-shaped” rather than a curve. Explain. Phillips’s explanation: ‘When the demand for labour is high we should expect employers to bid wage rates up quite rapidly. On the other hand it appears that workers are reluctant to offer their services at less than prevailing rates when the demand for labour is low’

ΔW/W

% unemployment

rate

Question 2In the 1960s, ‘the Keynes-Phillips orthodoxy was sailing on smooth waters, the object of much congratulation, rather like the liner Titanic prior to its collision with the fateful iceberg’ (Edmund Phelps). What is the nature of ‘the Keynes-Phillips orthodoxy’ and why was a collision inevitable?

The Keynes-Phillips orthodoxy argues that inflation cannot occur with large-scale unemployment.

‘ … an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment …’ (TGT: 295) ‘ … the general level of prices will not rise very much as output increases, so long as there are available efficient unemployed resources of every type.’ (TGT: 300)

Why is a problem unavoidable?As subsequent analysis (the Friedman-Phelps expectations-augmented Phillips curve) predicts, the co-existence of high inflation and high unemployed is likely when monetary growth is excessive. In other words: if ΔMS/MS > ΔMD/MD, we get demand-pull inflation.

Question 3(a)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)e

Identify each of the variables:ΔW/WP U(ΔP/P)e

proportionate increase in wagespricespercentage unemployment rateexpected proportionate increase in prices

Question 3(b)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)e

What sign respectively would be expected for the coefficients f and φ. Explain.

fnegative. There is an inverse relationship between unemployment and Δmoney wages. This is the same as in the original Phillips curve.

φpositive When workers accept employment contracts, they choose wages that reflect anticipated price changes. This is expectations-augmented part.

Question 3(c)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)e

Which description is usually given for φ < 1. Explain. money illusion

If the rate of increase in wages < the rate of increase in prices, then, workers are being paid less in real terms. The workers would be mistaken to accept this, but they might due to money illusion. Money illusion is the idea that if you’re paid more you must be wealthier. You’re only wealthier if you’re paid more relative to the price levels.

Question 3(d)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)e

What is the ‘reservation wage’ in the analysis of job search? the minimum level of acceptable wage offer

Question 3(e)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)e

What is the likely impact upon the reservation wage as the duration of unemployment increases?

reservation wage falls

Question 3(f)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)e

What is the likely impact upon unemployment if unemployment benefits increase?

unemployment is likely to rise as job search is extended

Question 3(g)With the expectations-augmented Phillips curve represented conventionally as:

ΔW/W = f(U) + φ(ΔP/P)e

Explain the likely impact upon unemployment of (ΔP/P) > (ΔP/P)e.

So, we are asking, if the proportionate change in prices is greater than the expected proportionate change in prices, what will be the impact on unemployment. (Note, this is another way of saying if inflation > expected inflation, or if we underestimate the inflation rate)

The period of job search is likely to be curtailed (cut short), if the inflation rate is underestimated.

Question 3(h)With the expectations-augmented Phillips curve represented conventionally as

ΔW/W = f(U) + φ(ΔP/P)eExplain the likely impact upon unemployment of (ΔP/P) = (ΔP/P)e.

unemployment finds its ‘natural rate’

Question 4With prices rising at 4.0 percent annually, and wages rising at 3.5 percent per annually, what would be the percentage reduction in real wages over a five year period? To answer this question, we need to the difference between future real wages and the current period real wages.

To find the future period real wages, we have to calculate three things here: real wages, and wages in a future period, and prices in a future period.

Here are the three equations we’ll need: Real Wages = nominal wage ÷ pricesWagefuture period = Wagecurrent period * (1 + growth ratewages)ΔT

Pricefuture period = Pricecurrent period * (1 + growth rateprices)ΔT

We can put it all together into the following equation:Real Wagesfuture period =

Wagecurrent period*(1 + growth ratewages)ΔT ÷ Pricecurrent period*(1 + growth rateprices)ΔT

Question 4 ctd.

With prices rising at 4.0 percent annually, and earnings rising at 3.5 percent per annually, what would be the percentage reduction in real wages over a five year period? First, find Real Wages (R) in Year 5:

R5 = = =

Next, find the percentage change from Year 1 to 5:Percentage Change = -1 = -1 = -2.4%

Note: Some students used another method and got 2.5% as an answer – I am showing Gerry’s method here, and would recommend that you learn this for the exam.

Question 5(a): MV ≡ PQ.If M were to rise by 6 percent, Q by 4 percent while V is unchanged, by what percentage would P increase?

First, we can normalize everything to 1 so that:M = V = P = Q = 1 at the beginning.

Then we can re-write the problem: If M = 1.06, Q = 1.04, V = 1, then solve for the % increase in P.

MV = PQ (1.06)(1) = P(1.04)

P = = 1.01923

So, P has changed by approximately 1.9%.

Question 5(b): MV ≡ PQ.If the V remains constant, as M grows at a constant annual compound rate of 12.2 per cent, and Q grows at a constant annual compound rate of 10 per cent, in how many years would the price level (P) double?

Again, for simplicity, let’s say M = V = P = Q = 1 initially.We want to solve for the number of years in which P is doubled. So, we want to solve for n:We start with P = MV/Q Plugging in: P =

P = P = 1.02

= 1.02 = We’ve got n, so now we want to know what is n when P is doubled in value. We’ll look at that on the next slide.

Question 5(b): MV ≡ PQ.From the previous slide, we have:

= Because we want to know when P doubles, and we’ve normalized all variables to 1 initially, we can put 2 in for P and solve for n.

= = 35

So, it takes 35 years for P to double.

Question 5(c): MV ≡ PQ.If V remains constant as Q grows by 2.5 per cent, and as M grows by 10 percent, by what annual percentage would prices rise?

This is just like Question 2(a).First normalize everything to 1, then let’s use MV = PQ to solve.

P = MV/QP = (1.10)(1)/(1.025)P = 1.07317

So, P grows by approximately 7.3% annually.

Question 5(d): MV ≡ PQ.Use the structure MV ≡ PQ to explain demand pull inflation.My answer: (Gerry’s answer on next slide)Initial equilibrium: MS

0 ≡ MD0≡ (P0Q0/V0)

Final equilibrium: MSF ≡ MD

F≡ (PFQF/VF)

The Monetarist view is that demand-pull inflation is caused by an increase in money supply. So that means: MS

F > MS0

As a result:MDF > MD

0 and PFQF/VF > P0Q0/V0

So at least one of the following are true:Case 1: QF > Q0

Case 2: VF < V0

Case 3: PF > P0

The expectations-augmented Phillips Curve suggests that in the long run, increase in inflation is unable to increase output, so QF = Q0

Our model doesn’t have any motivation for a change in money velocity, so VF = V0

Thus Case 3 must be true, PF > P0. This is Demand-pull inflation: an increase in Money Supply leads to an increase in Prices.

Question 5(d): MV ≡ PQ.

Use the structure MV ≡ PQ to explain demand pull inflation.

Gerry’s answer is: In equilibrium: MS ≡ MD ≡ (PQ/V)

If there is a disequilibrium because of excess MS:

MS↑ ≡ (PQ/V) > MD

An excess supply of money (Ms) implies an increased demand for goods and services which pulls up their prices (P): MS↑ ≡ (P↑Q/V) > MD

which increases the transactions demand for money, thereby restoring equilibrium at a higher general level of prices:

MS↑ ≡ (P↑Q/V) ≡ MD↑

Question 6Using the identity MV ≡ PQ, given an explanation the following statement:‘.. it was clear that the liberalisation of the financial system ... the increased competition between financial institutions would lead to a steady increase in the ratio of broad money to GDP. This indeed has been a consistent feature of the 1980s. There is every sign that the people are holding the increased amounts of broad money quite willingly. And so long as this is so its growth is not inflationary’ (Nigel Lawson - UK Chancellor of the Exchequer 1983-89)

Nigel is either saying while M↑, P will not ↑, completely ignoring MV=PQ. Or he might be saying that if M↑ then he expects to see V↓, therefore eliminating the need for P↑.

Gerry’s answer:We know this is in equilibrium: MS ≡ MD ≡ (PQ/V)

This is what Nigel is saying: MS↑ ≡ (PQ/V) ≡ MD↑

Lawson made that speech in 1986, when Inflation was falling and GDP was increasing.Lawson’s idea was that Money Supply can be increased without worrying about inflation. We can see some of the results of his policy, in the late 1980’s:

Question 6 ctd.

Monetary Policy today places much more emphasis on controlling inflation.

Questions 7 & 8

These questions are about definitions. Gerry wants to make the point that deflation of economic activity, or deflation of GDP, is not the same as deflation in the value of currency.

I’ll put his answers in the next slides.

Question 7 – Gerry’s answerExplain the apparent paradox: that a rise in the world price of oil has a deflationary impact upon economic activity, and causes a rise in price indices.Words can have a different meaning in lay conversation than as economics jargon. For example, ‘inflation’ is generally taken to mean (in lay conversation) an increase in some price index (say, the RPI). However, if the RPI rises when commodities in widespread use have become (for whatever reason) more scarce, this would not constitute (by the jargon of economics) ‘inflation’. In economics, ‘inflation’ - or, rather, ‘price inflation’ - is the persistent tendency of prices to rise in consequence of monetary profligacy (currency debasement). The impact of monetary expansion is first to increase and then to reduce (as prices rise) demand. A rise in the world oil price is neither inflationary nor deflationary per se; though adjustment would be different within an oil-rich economy (e.g., Saudi Arabia) as compared to one with no fossil fuel reserves (e.g., Eire). In general, there are difficulties in matching theoretical concepts (inflation, unemployment, economic growth, money supply, etc.) and statistical time series.

Question 8 – Gerry’s answerIf (the definition of) inflation is more complex than a rise in price indices, how might it be defined?A definition always requires a context. Even Keynes accepts the context of the Quantity Theory of Money, ‘as soon as full employment is reached’ (TGT, p. 295)! The Quantity Theory draws from the most general of economic propositions: namely, that (unless demand increases pro rata) the more there is of something, the less valued it becomes. Thus, whenever the amount of money held in circulation exceeds the demand to hold money individuals are likely to increase their expenditure thereby (with that increased the demand for goods/services) causing prices to rise

Question 9

With the yield on savings at 3 percent, price inflation at 4 percent and unearned income taxed at 40 percent, calculate the real rate of return on savings net of taxation.This question involves putting together 4 concepts:Effect of interest rate:

savings + savings income = savings * (1 + % yield)Effect of tax:

income after tax = income * (1 - tax)Effect of inflation:

real value of income = value / (1 + inflation)Rate of return:

(final value/initial value) - 1

Question 9Effect of tax:

income after tax = income * (1 - tax)Effect of inflation:

real value of income = value / (1 + inflation)Effect of interest rate:

savings + savings income = savings * (1 + % yield)Rate of return:

(final value/initial value) - 1We combine the above 4 equations to make the following equation to findtotal real rate of return, net of taxes:

1

0.9788 1 = 0.0212 So in this case, we’re actually losing 2% on our investment!

Note: In Gerry’s solution, he leaves out the -1 when calculating the rate of return. So, he gets an answer of 0.9788. Obviously if the interest rate is 3%, the real rate of return net of taxes should be lower than 3%.

Question 10

Businesses that raise their prices to excess go bust. Workers who demand excessive wages lose their jobs. So, what on earth is cost-push inflation? Gerry’s Answer:‘Cost-push inflation’ is …? A rise in unit costs produces a one-off increase in prices. If some particular raw material approaches depletion, its ever-rising price chokes of demand as consumers switch to cheaper substitutes. If trade unions insist on ever-higher wages, expect ever-higher levels of unemployment … unless there is monetary accommodation, in which case, expect demand-pull inflation as the excessive supply of money has its corollary; that is, an excess demand for goods and services.

Next Class

Exam on Friday Check your Timetable for exam time & location. Bring your Student ID Number, Pencil, Eraser. Good luck!

Week 25 is the last tutorial! I’ll plan on reviewing the Week 24 Exam 4 in class.