Inflation, Aggregate Supply And The Labour Market

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There is a trade-off between

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inflation and unemployment due to the inverse relationship between the two

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The greater the rate of growth of AD:

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the greater the resulting inflation and GDP and the lower the unemployment level

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The slower the rate of growth of AD,

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the lower the resulting inflation and GDP and the higher the unemployment level

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Fiscal and monetary policies act on

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AD and not on the labour market imbalances and market power

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Two complications that face policymakers are

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The reversibility problem (ratchet effect) and the shiftability of the AS curve

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The phillips curve plots

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inflation on the Y and unemployment on the X

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The simultaneous occurence of unemployment and inflation is known as

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stagflation

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Staglation and the Phillips curve

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conflict in their relationships between unemployment and inflation

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Causes of stagflation include

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Aggregate supply shocks such as severe increases in fuel costs or the devaluation of the AUD

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Two other Causes of stagflation are

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Productivity decline and inflationary expectations and wages

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These causes shift

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the AS curve left

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The natural rate hypothesis suggests

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that there is a unique level of unemployment around which observed unemployment will fluctuate

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Long run stability in the NR hypothesis corresponds with

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the full employment rate of unemployment

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The two variants of the natural rate hypothesis are

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the theory of adaptive expectations and the rational expectations theory

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The theory of adaptive expectations suggests that

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people form their expectation of future inflation based on previous and current rates of inflation and that there is a short run tradeoff between unemployment and inflation but in the long run there is none

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The adaptive expectations theory suggests what kind of phillips curves?

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linear downward sloping short run phillips curves and a vertical long run phillips curve

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The rational expectations theory suggests that

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increases in money wages lag behind increases in the price level, giving rise to temporary increases in profits and employment.

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The rational expectations theory argues that government measures to increase employment

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will only result in accelerating rates of inflation

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New classical policy implications suggest

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price levels may upset short run but the LR is stabke and long run occurs very quickly (instantaneously) so government intervention is not endorsed

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Modern Keynesian policy implications suggest

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markets are not highly competitive, wage adjustments are slow and stabilization policies are required to reduce the severe costs of unemployment or inflation

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Demand pull inflation occurs when

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An increase in AD pulls up the price level

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During demand pull inflation in the short run

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there are increased prices and real output

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In the long run considering demand pull inflation:

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the economy has moved along the vertical aggregate supply curve

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Cost push inflation occurs when there is

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a decrease (left shift) in the short run aggregate supply curve

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In the short run during cost push inflation there are

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increased prices and decreased real output and more unemployment

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In the long run when considering cost push inflation the government may

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intervene or not intervene

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If the government intervenes during cost push inflation by increasing AD

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This solves unemployment/output problems but causes an inflationary spiral

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If the government doesn't intervene during cost push inflation

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Severe recession will result however in the long run AS will return and shift to the right

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Two categories of non-demand policies to address cost push inflation are

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Market policies and wage-price (income) policies

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Labour Market Policies

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Aim to better match workers to jobs thus reducing labour market imbalances or bottle necks

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Three employment programs include

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Vocational training, job information and non discrimination policy

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Wage price policies are

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government policies in the labour and product markets that are designed to constrain both nominal incomes and prices paid in order to influence real income, can be controls or guideposts

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Wage guideposts or controls

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manage wages so as to shift AS

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Price guideposts or controls

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manage prices so as to shift AS