Unit 4 Inflation and unemployment

4.10 A review of causes of inflation

Explanations of inflation in the media frequently refer to ‘demand pull’, ‘cost push’, and ‘expectations’ as drivers of inflation in a particular episode. These terms can be a useful shorthand. By digging deeper into the conflicts of interest that lie behind wage setting and price setting, the model developed in this unit takes us further. We have derived the Phillips curve and learned about a wage–price spiral by combining the supply-side WS–PS model, the multiplier model of aggregate demand, and a model of expectations formation.

‘Cost-push’ inflation

So-called cost-push inflation could be the result of a rise in the price of imported oil, or an improvement in the labour market position of workers because of a rise in unemployment benefits or stronger legislation protecting the right to strike, for example. The model helps us to understand the underlying cause of the ‘cost push’ and the mechanism linking it to a shift of the Phillips curve. Whereas the oil price shock shifts the PS curve down, a rise in union bargaining power shifts the WS curve up. Either way, equilibrium unemployment rises and the Phillips curve shifts upward. How inflation expectations are formed dictates whether there is just a one-off rise in inflation as in Bill Phillips’ original curve, or whether a wage–price spiral will ensue. Figures 4.20c, 4.21, and 4.24 illustrate cost-push inflation.

‘Demand-pull’ inflation

Demand-pull inflation refers to a movement along a Phillips curve to a higher inflation rate because of a rise in aggregate demand, which we model with a shift in the AD curve in the multiplier model. Once again, the inflation expectations process will determine whether the one-off increase in inflation becomes a wage–price spiral. Figure 4.15 illustrates demand-pull inflation and Figure 4.19 shows the opposite, that is, a downward wage–price spiral caused by a fall in aggregate demand taking employment below the supply-side equilibrium.

‘Expectations-driven’ inflation

‘Expectations-driven’ inflation refers to a rise in inflation because of a shift of the Phillips curve due to a change in peoples’ expectations about inflation. If people expect prices to rise by say, 4%, then according to the model, wages will have to rise this year by 4% plus the bargaining gap. One model of expected inflation is that whatever inflation was last year, it gets built into this year’s expected inflation and feeds through into this year’s inflation. This is represented by the upward shift in the Phillips curve. The effect of introducing inflation expectations to the analysis of the Phillips curve is found in the comparison between Figure 4.15 and the earlier Figure 4.9.

It is important to remember that the updating of inflation expectations does not always occur. Bill Phillips’ original curve covered five decades when this did not happen in the UK. As we shall discuss in Unit 5, policymakers place great importance on trying to prevent a process of updating inflation expectations (and the upward shifts in the Phillips curves) from taking hold: they want expectations of inflation to be anchored on a low inflation target like 2%. As explained in Unit 5, one reason is that this reduces the cost in terms of higher unemployment that an economy has to pay to bring inflation down.

Profit-push (or sellers’) inflation

Our model suggests a fourth type of inflation, which we call ‘profit-push’ inflation (it is also called ‘sellers’ inflation’). We have already studied one example of this in Figure 4.20c: when weaker competition in markets for goods and services increases the markup, the PS curve shifts down, opening up a bargaining gap. This triggers rising inflation.

There is another mechanism through which profit-push inflation occurs. To set the scene, recall that when unemployment is low in the economy, employees face a shorter expected duration of unemployment searching for a job. This produces a smaller cost of job loss, and employers will only be able to recruit and motivate workers at a higher wage than would be the case when unemployment is higher. This lies behind the convex WS curve and the Phillips curve of the same shape, capturing a trade-off in the economy between unemployment and inflation.

But there is a second reason for the relationship between low unemployment and high inflation. In Figure 4.25, the horizontal axis shows the degree of capacity utilization in the economy. When capacity utilization rises as we move to the right along the horizontal axis, fewer machines are idle, there are fewer empty tables in restaurants, and other indicators (for example, more people working overtime shifts) show a reduction of spare capacity in factories and shops. Firms usually increase investment to expand their ability to meet orders when there is rising capacity utilization.

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-10-review-causes-inflation.html#figure-4-25

Figure 4.25 Price responses to rising employment and capacity utilization.

capacity constrained

A situation in which a firm has more orders for its output than it can fill. See also: low capacity utilization.

But building new plants and installing new equipment takes time and confidence that the increased demand will be sustained. Meanwhile, at current prices, firms have more orders than they can fill. Economists say they are capacity constrained. They lose nothing by raising prices in these conditions. Moreover, their competitors—firms producing similar products—are capacity constrained too, so these firms face less competition, meaning that they can earn a higher margin. So all firms will tend to respond to higher capacity utilization by raising the markup of prices above costs, and because this widens the bargaining gap, it will kick off a wage–price spiral.

Figure 4.26 illustrates the implications of the ability of firms to widen their markup when capacity utilization rises. In this case, the markup increases with the level of output and employment, so the PS curve is downward-sloping. As the diagram shows, when firms can raise their markup as they become capacity constrained, the bargaining gap widens for two reasons: the tightness of the labour market and the capacity constraints encountered by firms. This results in a steeper Phillips curve because of the combined effect of the upward-sloping WS curve and the downward-sloping PS curve.

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-10-review-causes-inflation.html#figure-4-26

Figure 4.26 Profit-push inflation due to capacity constraints.

Intensive research was undertaken in universities and central banks in 2022–2023 to ascertain whether firms had taken advantage of the circumstances post-pandemic and associated with the Russia–Ukraine war to increase their markups.

Detailed analysis of input–output relationships tracing the effect of higher input costs through the production structure indicates that in the US, there has been some ‘sellers’ inflation’.¹

Watch this video of Isabella Weber, one of the authors of the research study, explain the causes and consequences of ‘sellers’ inflation’.

Isabella Weber, University of Massachusetts Amherst

The authors argue that the decades-long increase in market power of firms (read Section 2.9 for data on markups) interacted with the supply shocks of COVID-19 (increased input costs because of supply chain disruption) to provide the opportunity for firms not only to pass on cost increases but also to widen their profit margins confident that their competitors would do the same.

Central banks began highlighting the problem in 2022: Lael Brainard, vice chair of the US central bank, the Federal Reserve, pointed out that ‘reductions in markups could make an important contribution to reduced pricing pressure’. Isabel Schnabel, a member of the European Central Bank’s executive board, said in May 2022 that ‘profits have recently been a key contributor to total domestic inflation’. And the governor of the Bank of England, Andrew Bailey, said, ‘I would say to the people who are setting prices, please understand that if we get inflation embedded, interest rates will have to go up further.’² Research is ongoing using different methodologies and the extent of sellers’ inflation appears to differ across sectors and across countries. Two examples are research at the European Central Bank³ and at the IMF⁴.