Unit 4 Inflation and unemployment

4.11 Application: The return of inflation after the pandemic

Recall from Figure 4.1 that between the late 1990s and 2020, inflation in the UK economy was low and relatively stable. This was also the case in other EU countries and the US. Governments, central banks, households, and firms had got used to a stable inflation economy (Figure 4.3). And as we explore in Unit 5, following the global financial crisis, central banks were preoccupied with how to avoid deflation. Things changed significantly in 2021 as economies around the world emerged from the COVID-19 pandemic, and again in February 2022 when Russia invaded Ukraine. The former saw shortages in the supply of key commodities because the pandemic disrupted supply chains; the latter triggered significant increases in oil and gas prices.

The cost-of-living crisis reported in Section 4.1 reflected the rapidly rising prices for daily essentials that were squeezing the standard of living for households. Wage increases were not keeping pace with price increases. Because of the assumption in the model that firms are able to defend their profit margins by passing cost increases on in higher prices, a squeeze on real wages is predicted when rising import costs take a larger share of output per worker. In the model, a bargaining gap opens up because the PS curve shifts down.

To determine whether this was the case, we need data. With data, we can begin to test the anecdotes and the predictions of the model against the facts.

The data in the case study below refer to the British economy. All of the charts begin at 2020. Figure 4.27 shows that from the middle of 2021, prices rose faster than wages (the yellow series is steeper than the blue one), which meant a fall in real earnings (the green series falls).

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-11-application-inflation-after-pandemic.html#figure-4-27

Figure 4.27 Indexes of nominal and real earnings and of consumer prices, UK (2020–2024).

Earnings (nominal): Whole economy level (£): Seasonally adjusted total pay excluding arrears (2023). Office for National Statistics. Accessed 27 October 2023. Earnings (real): Whole economy real terms index: Seasonally adjusted total pay (2023) . Office for National Statistics. Accessed 27 October 2023. CPI index 00: All items 2015=100, CPI INDEX 00. Office for National Statistics. 2023 available at. Accessed 27 October 2023.

We investigate indicators of three determinants—according to the WS–PS model—of the real wage workers receive, namely the wage on the PS curve. The PS curve is shifted down by an increase in:

• the net cost of imports, which is represented by the factor \((1+ \tau)\) (Section 2.8),
• the tax share, as explained in Section 2.7, and
• the profit share itself, \(\sigma\).

Note that the other determinant of the real wage, labour productivity, \(λ\), was unchanged in this period. The UK has experienced a long period of stagnant productivity.

Net cost of imports

The global pandemic caused widespread disruption of production and trade around the world. The result was shortages of commodities and components. According to an index of energy prices from the IMF, prices rose from 126 in January 2020 (pre-COVID-19) to a peak of 376 in August 2022.

terms of trade

A country’s terms of trade are measured by the ratio of the export price to the import price. When the price it receives for exports falls relative to the price it pays for imports, we say that its terms of trade have deteriorated.

These developments affected UK import prices, which rose by 16.3% during 2022, when the cost-of-living crisis dominated public debate. Export prices rose by 13.7% over the same period. This means that the UK experienced a terms-of-trade loss: when the prices a country has to pay for its imports rise by more than the prices of the exports it sells, the country as a whole is poorer and some people will be poorer as a result. The question is: who will bear the burden of the deterioration in the terms of trade? As we have discussed in this unit, rising wages and prices are the consequence of the different groups in the economy (workers and the owners of firms) trying to pass on the burden coming from abroad to the other group.

The effect on countries of the shocks that occurred in 2022 varied widely. Figure 4.28 shows that countries like Norway, which are net energy exporters, experienced a gain in national income (a terms-of-trade gain) because the value of their exports increased relative to the cost of their imports. Most European countries, however, were in a position like the UK, and experienced a terms-of-trade loss.

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-11-application-inflation-after-pandemic.html#figure-4-28

Figure 4.28 Gains and losses in the terms of trade in 2022: net energy exporters like Norway experienced terms-of-trade gains.

Organisation for Economic Co-operation and Development (OECD).
Note: Calculated as the four-quarter change in real gross domestic income (which includes imports but not exports) and real GDP (which includes exports but not imports). All international figures are correct as of 9 January 2023.

We can estimate how much of the burden of higher import prices was borne by workers in the form of a lower real wage. To do this, we compare the size of the terms-of-trade loss as a proportion of the UK’s wage and salary bill with the fall in real wages (Figure 4.29, top panel).

The estimate is that higher prices of imports relative to exports was equivalent in the fourth quarter of 2022 to reducing the wage and salary bill by 2.4%. And in the fourth quarter of 2022, real wages were 3.1% below the level at the same time in the previous year. These estimates suggest that real wages bore about three-quarters of the burden of the loss imposed on the British economy by the effect of rising oil, gas, and other import prices on the terms of trade. In the model, this corresponds to a downward shift in the PS curve. We come back to the reversal in the terms-of-trade shock from mid-2022 below.

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-11-application-inflation-after-pandemic.html#figure-4-29

Figure 4.29 Comparison of real wages with the terms-of-trade loss to the UK as a proportion of earnings (top panel); UK taxes as a percentage of the national wage bill (bottom-left panel); share of profits in GDP, where profits are measured by the ‘gross operating surplus’ of private businesses (bottom-right panel).

GDP quarterly national accounts time series. (2023) Office for National Statistics. Accessed 27 October 2023. Public sector current receipts: Appendix D (2023) Office for National Statistics. Accessed 27 October 2023.
Note: The spike in the national wage bill in the first quarter of each year reflects the pattern of revenue collection.

Tax share

As we discuss in Unit 2 (Section 2.7), taxes are another ‘claimant’ on national income. When tax rates rise then, ceteris paribus, the PS curve shifts down. As usual, there are caveats to this result. For example, if higher taxation improves the health, education, and infrastructure of a country, it could raise its productivity, shifting the PS curve up, although these effects are likely to take time to materialize and are not relevant to this case study.

The series in Figure 4.29 (bottom-left panel) shows total taxes as a share of the national wage and salary bill. They increased over this period. And note that government measures to provide some protection for households facing higher energy prices through subsidies in the form of an ‘energy price cap’ did not prevent the decline in real wages documented above.

Profit share

In the WS–PS model, unless competitive conditions change, the profit share is predicted to remain constant. Firms use their ability to set prices to pass on additional costs, including higher imported energy costs and higher taxes. The data in Figure 4.29 (bottom-right panel) show an economy-wide measure of private sector profits as a percentage of GDP. The profit share rose by about 1% of GDP from 2020 to 2023. In the UK data, therefore, it appears that in aggregate, firms were able to pass on their higher costs and somewhat widen their profit margins when setting their prices.

To sum up, the WS–PS and Phillips curve models shed light on the return of high inflation to the UK economy in 2022–2023. The model predicts that the downward shift of the PS curve caused by the increase in energy prices (the terms-of-trade loss) and to a lesser extent by rising taxes opened up a bargaining gap, which in turn caused the Phillips curve to shift up. Wage inflation rose as wage offers included some compensation for the erosion of workers’ living standards. This was passed on in price inflation. Figure 4.29 shows that workers bore the brunt (about three-quarters) of the terms-of-trade impact of the energy price increases.

The model draws attention to three issues in understanding how inflation might evolve in a situation like this:

• Are inflation expectations updated based on last year’s inflation as assumed in the model or are they anchored, for example, to a central bank inflation target?
• Does the central bank raise the interest rate to reduce the level of aggregate demand and the bargaining gap?
• Does the terms-of-trade loss persist or reverse?

We discuss the first two bullets in Unit 5.

Figure 4.29 shows that the terms-of-trade loss reversed from late 2022 and was followed by rising real wages, as nominal wages grew faster than the CPI. The model predicts that this would be followed by a fall in inflation. A slowdown in the rate of inflation is illustrated by the flattening of the series for the CPI index in Figure 4.27 from the second quarter of 2023.

The British economy provides another interesting insight in this period. The wages of public-sector workers were set in advance of the rise in import prices and unlike HR departments in the private sector, those in the public sector were not able to respond to the increased cost of living in annual wage-setting rounds. As discussed in Section 2.5, it would be expected that unions would use the right to strike as a mechanism to exert pressure on public sector employers to raise wages. According to the Office for National Statistics, the industries most affected by strikes in this period were rail and bus networks, postal workers, civil servants, teaching staff, and workers in the National Health Service, including senior doctors.