Unit 4 Inflation and unemployment

4.8 The business cycle model: Demand and supply shocks, and inflation expectations

demand shock

An unexpected or exogenous change in demand. In macroconomics a demand shock means a change in aggregate demand, such as a rise or fall in autonomous consumption, investment, or exports. In microeconomics it refers to an exogenous shift in the demand curve for a particular good. See also: supply shock, exogenous shock.

supply shock, supply-side shock

An unexpected or exogenous change in supply. In macroeconomics a supply shock means a change on the supply side of the economy, such as a rise or fall in oil prices or an improvement in technology. In microeconomics it refers to an exogenous shift in the supply curve for a particular good. See also: demand shock, exogenous shock.

In this section, we first analyse aggregate demand shocks and then supply-side shocks to understand their implications for inflation. To go beyond the snapshot of the first stage of a business cycle, we introduce inflation expectations and shifts in the Phillips curve.

Aggregate demand shocks

Our attention now is on the implications for inflation and unemployment of a negative shock to aggregate demand (often shortened to ‘demand shock’). We therefore hold other things constant: in particular, everything that determines the WS and PS curves, and therefore the supply-side equilibrium.

Fall in planned investment spending: Downward shift of AD curve

Consider the impact of a fall in investment due to a broad-based fall in business confidence about the growth of markets, and therefore about future expected profits. This is typical of business cycle downturns and was the case in the great recession that followed the global financial crisis of 2007–2009 (discussed in more detail in Unit 8).

As shown in Figure 4.17, this can be modelled in the multiplier diagram by the AD curve shifting down. This reduces the level of employment below the supply-side equilibrium and causes cyclical unemployment. We now assume that low demand persists, which is modelled by keeping the AD curve at the ‘low’ level.

Let us assume that the economy was at supply-side equilibrium before the recession occurred. The diagram indicates that an economy at equilibrium would be observed with wage and price inflation of 3% per annum year after year. In the recession caused by the fall in investment, employment has fallen and there is now cyclical unemployment. At the next wage-setting round, HR departments are aware of the greater slack in the labour market. They can employ the smaller required workforce at a lower real wage: this is captured by the negative bargaining gap (as in Figure 4.17c, where the gap is −1%).

Since workers expect prices to rise by 3% as they had done the previous year, and there is a negative bargaining gap of −1%, HR departments are able to settle for a 2% nominal wage increase. This implies a 1% fall in the real wage. Turning to price setting, there has been no change in the competitive conditions faced by firms so, to maximize profits, marketing departments will increase prices by less than the expected inflation rate. If they were to increase prices by a greater amount, the loss of market share to their competitors would outweigh the extra revenue on units sold.

To summarize, the negative shock to investment increases unemployment and lowers both wage and price inflation—in the example, inflation falls from 3% to 2%. This is a movement along the Phillips curve from A to C in Figure 4.19, where only the Phillips curve and multiplier diagrams are shown.

If the investment shock is expected to have a sustained impact on aggregate demand, workers, who are also consumers, will adjust their expectations about how prices will evolve according to their recent experience. Rolling time forward, they will expect prices to rise by 2%. The Phillips curve will shift down and inflation will fall from 2% to 1%. As long as demand remains depressed, the model predicts the presence of cyclical unemployment and falling inflation, with inflation falling from C to D to E (and so on), as the Phillips curve shifts down period by period. The equation introduced in Section 4.7 illustrates this process:

\[\pi_t = \pi_{t-1} + \text{gap}_t\]

At a lower level of aggregate demand (a recession), there is higher unemployment, a negative bargaining gap, and inflation is lower. The model predicts falling inflation (that is, disinflation) for as long as a negative bargaining gap persists and expected inflation falls, shifting the Phillips curve down. And in the opposite case of a boom, we predict rising inflation period by period for as long as a positive bargaining gap persists and expected inflation rises. The unpopularity of rising inflation and of falling inflation when it threatens to turn into deflation leads policy makers to intervene. We discuss how they do so in Unit 5.

Supply-side shocks

In our next experiment, we hold the demand side of the economy constant. The AD curve in the multiplier diagram remains unchanged and since output and employment are entirely determined by the demand side, they do not change either. At this level of output and employment, we analyse what happens to inflation when there is a change on the supply side.

Increased market power of firms: Downward shift of PS curve

This is an inflationary shock.

protectionist policy

Measures taken by a government to limit trade; in particular, to reduce the amount of imports in the economy. These are designed to protect local industries from external competition. They can take different forms, such as taxes on imported goods or import quotas.

The new scenario is that the government adopts protectionist policies, which make it more difficult for foreign firms to enter its markets. Competition is therefore less intense in domestic markets, which means firms can charge higher markups on their costs. From Unit 1, we know that this shifts the PS curve downward, and using the term we introduced in this unit, it opens up a positive bargaining gap at the pre-existing level of employment. Another way of putting this, which is also shown in Figure 4.20a, is that while employment remains unchanged, the supply-side equilibrium (SSE) has shifted from point A to point C at lower employment, \(N′_\text{SSE}\).

Figure 4.20b combines the supply-side and the multiplier diagrams to highlight the situation following the shock. The economy is at point A in both panels and we assume that aggregate demand continues to remain unchanged as the implications for inflation unfold. From the multiplier model, the level of aggregate demand determines the level of output at \(Y_0\) and this fixes employment at \(N_0\) throughout.

The next step is to introduce inflation and the Phillips curve. Since aggregate demand and employment are fixed, we drop the multiplier panel and replace it with the Phillips curve diagram.

The new supply-side equilibrium (at C in the upper panel) has a different and higher Phillips curve. In the example, the reduction in competition facing firms enables them to increase their prices by 2% on top of the 3% that covers the rise in wages. So at each level of employment, inflation is 2% higher than before. The Phillips curve shifts up by 2%. The economy moves from its initial position at point A with employment of \(N_0\) and inflation of 3% to point D with inflation of 5%. Expected inflation is still 3%. The new Phillips curve is labelled (new SSE, expected inflation = 3%); on this curve, inflation equals expected inflation at point C, the new supply-side equilibrium.

Behind the shift in the Phillips curve is the behaviour of wage and price setters. Prices increased by 5% while workers were expecting a 3% rise (point B). This reduces the real wage by 2%: the real wage on the new PS curve is below the wage on the WS curve at the level of employment \(N_0\). While the owners are happy with the higher price that the marketing department can now charge, workers are unhappy with the fall in the real wage.

At the next wage round, expected inflation is 5% and the Phillips curve shifts again, to the one labelled (new SSE, expected inflation = 5%). To encourage workers to put in the required effort, the HR department will raise the nominal wage by another 2% (to 7%).

Will it end there? No. The nominal wage increase has raised the cost of production to firms by 7% and they will use this as the basis of their markup pricing, leading to a further increase in prices (by 7%) and a fall in the real wage, which the HR department will have to correct the following year by again raising the nominal wage (by \(7 + 2 = 9\%\)). Each year, there will be another rise in inflation of 2%.

In the absence of policy intervention, the economy is characterized by an inflationary wage–price spiral initiated by the weaker conditions for competition in the market for goods and services.

Increased union bargaining power: Upward shift of WS curve

This is a second type of inflationary supply shock.

Still holding the demand side of the economy and employment fixed, we next analyse what happens to inflation when there is an upward shift of the WS curve, because unions become stronger, or withdraw bargaining restraint as described in Unit 2. When the WS curve shifts up, there is a new supply-side equilibrium at lower employment and higher unemployment as shown in Figure 4.21: there is now a bargaining gap at the pre-existing level of employment, \(N_0\).

In this example, the increase in union bargaining power means that HR departments must pay an additional 2% in wage increases on top of the 3% rise in wages required to cover expected inflation. This takes the economy from its initial position at point A with employment of \(N_0\) and inflation of 3% to point B with inflation of 5%. Given that their costs have risen by 5%, the marketing departments in firms across the economy raise prices by 5%. With 5% inflation, the Phillips curve shifts up as shown.

Following the logic in the previous example, inflation expectations will be updated each year, and the Phillips curve will shift upwards. Each year there will be another rise in inflation of 2%. In the absence of policy intervention, the economy is characterized by a wage–price spiral initiated in this case by increased union power.

An upward shift in the WS curve could come about for other reasons, such as improved generosity of unemployment benefits. Although the initial cause is different, this also has the effect of strengthening the position of workers in the labour market, and the effect on wages and prices would be the same.

These two examples show that inflation may result from:

• An increase in the market power of firms over their consumers: This is caused by a reduction in competition, which allows firms to charge a higher markup. It is a downward shift of the price-setting curve.
• An improvement in the position of workers in the labour market: This allows them to get a higher wage offer in return for working hard. It is an upward shift of the wage-setting curve.

Starting at this inflation-stabilizing rate of unemployment, increased inflation can occur for two reasons:

• An inflationary demand shock increases employment above the supply-side equilibrium, and therefore introduces a bargaining gap which raises inflation.
• An inflationary supply shock changes the supply-side equilibrium—either because the PS curve shifts down, lowering the real wage, or because the WS curve shifts up, increasing the real wage workers want (but do not get). As a result, a bargaining gap opens up even if employment remains unchanged.