Tutorial 6 Memo

1. Based on the Phillips curve theory, label True or False the following statement
and explain your answer.
a) The original Phillips curve is the negative relation between interest rate and
unemployment rate that was first observed in the United Kingdom.
False. This is because A.W. Phillips observed that there is a negative
relationship between the inflation rate and the unemployment rate, not interest
rate.
b) The original Phillips curve has proven to be stable across countries and over
time.
False. In the 1970s, a new relation appeared which was the relationship
between unemployment and the change in the rate of inflation. The curve
shifts and adjusts with inflation over time.
c) Expected inflation always equals actual inflation.
False. This could only be true if the unemployment rate was at its natural rate.
d) Deflation means that the rate of inflation is negative.
False. Deflation is the general decrease in price levels over time.

2. With regards to the original Phillips curve, explain the trade-off that
policymakers faced with?
A country could achieve low unemployment if it were willing to tolerate higher
inflation, or it could achieve price level stability - zero inflation - if it were
willing to tolerate higher unemployment.

3. Policymakers like to smooth fluctuations in unemployment around its natural

rate. Doing so requires that one knows what the natural rate is. Mention the
factors that may affect the unemployment rate.
 The natural rate of unemployment is the unemployment rate at which
the actual price level is equal to the expected price level. Equivalently,
the natural rate of unemployment is the unemployment rate such that
the actual inflation rate is equal to the expected inflation rate. In other
words, the natural rate of unemployment is the rate of unemployment
required to keep the inflation rate constant. The equation for the natural
unemployment is as follows:

(m ; z)
un =
α
 Hence, the higher the mark-up, m, or the higher the factors that affect
wage setting, z , the higher the natural rate of unemployment.

4. Discuss the relationship between inflation, expected inflation and

unemployment

π = π e + (m + z) – au

 An increase in expected inflation, π e , leads to an increase in actual inflation, π .

There is a positive relationship between expected inflation and actual inflation.
 Reason: An increase in the expected price level Pe, leads, one for one, to an
increase in the actual price level, P. If wage setters expect a higher price
level, they set a higher nominal wage, which leads in turn to an increase in the
price level.

 Given expected inflation, π e , a decrease in the unemployment rate, u, leads to

an
increase in actual inflation π . There is a negative relationship between
unemployment and actual inflation.
Reason: Given expected inflation, π e , an increase in the unemployment rate,
u, leads to an increase in inflation, π .

 Given expected inflation, π e, an increase in the mark-up, m, or an increase in

the factors that affect wage determination, z, leads to an increase in actual
inflation, π .
Reason: Given the expected price level, Pe, an increase in either m or z
increases the price level, P.

5. Why did the Phillips curve disappear? Explain.

In the 1970s the relationship between inflation and unemployment started
disappearing. This was because of the oil crisis in the 1970s, which affected
the whole world. There was a large increase in the price of oil, which resulted
into increases in the markup price, leading to high prices of goods and
services. So, since the prices were higher, wage setters had to change the
way the formed their expectations. (Remember a rising price level = inflation).
There was a change in the behaviour of inflation. The rate of inflation became
more persistent. High inflation in one year became more likely to be followed
by high inflation the next year. As a result, people, when forming expectations,
started to consider the persistence of inflation. In turn, this change in
expectation formation changed the nature of the relation between
unemployment and inflation.

6. Based on your understanding of the Phillips curve, explain what happens to

actual inflation (relative to expected inflation) when the actual unemployment
rate is either above or below the natural rate of unemployment.

When the actual unemployment rate is higher than the natural rate of
unemployment, the inflation rate decreases; when the actual unemployment
rate is lower than the natural unemployment rate, the inflation rate increases
7. Explain why workers and firms may be more reluctant to enter labour
contracts that set nominal wages for a long period of time.
When the inflation rate becomes high, inflation also tends to become more
variable. If inflation turns out higher than expected, real wages may plunge,
and workers will suffer a large cut in their living standard. If inflation turns out
lower than expected, real wages may sharply increase. Firms may not be able
to pay their workers and some of these firms may go bankrupt.

8. Discuss how an increase in the proportion of indexed labour contracts will

impact inflation. Begin by defining wage indexation.
Wage indexation, which is a provision that automatically increases wages in
line with inflation. Wage indexation is denoted by, λ. These changes lead in
turn to a stronger response of inflation to unemployment. Wage indexation
increases the effect of unemployment on inflation.
The higher the proportion of contracts that are indexed, the higher λ, the
larger the effect of the unemployment rate has on the inflation rate.
Reason: Without wage indexation, lower unemployment increases wages,
which in turn increases prices. But because wages do not respond to prices
right away, there is no further increase in prices within the year.
With wage indexation, however, an increase in prices leads to a further
increase in wages within the year, which leads to a further increase in prices,
and so on, so that the effect of unemployment on inflation within the year is
higher.

9. What do critics have in mind when they talk about the 'labour-market rigidities'
afflicting (pros and cons) Europe?
They have in mind in particular:

• A generous system of unemployment insurance. The replacement rate,

which is the ratio of unemployment benefits to the after-tax wage is often high
in Europe, and the duration of benefits, the period for which the unemployed
are entitled to receive benefits, often runs in years. Some unemployment
insurance is clearly desirable. But generous benefits are likely to increase
unemployment in at least two ways. (1) They decrease the incentives the
unemployed must search for jobs. (2) They may also increase the wage that
firms must pay. The higher unemployment benefits are, the higher the wages
firms must pay to motivate and keep workers.

• A high degree of employment protection. By employment protection,

economists have in mind the set of rules that increase the cost of layoffs for
firms. These range from high severance payments to the need for firms to
justify layoffs, to the possibility for workers to appeal the decision and have it
reversed. The purpose of employment protection is to decrease layoffs, and
thus to protect workers from the
risk of unemployment. However, it also increases the cost of labour for firms
and thus to reduce hires and make it harder for the unemployed to get jobs.
The flows in and out of unemployment decrease, but the average duration of
 unemployment increases. Such long durations increase the risk that the
unemployed lose skills and morale, decreasing their employability.

• Minimum wages. Most European countries have national minimum wages.

And in some countries, the ratio of the minimum wage to the median wage
can be quite high. High minimum wages clearly run the risk of limiting
employment for the least-skilled workers, thus increasing their unemployment
rate.

• Bargaining rules. In most European countries, labour contracts are subject

to extension agreements. A contract agreed to by a subset of firms and
unions can be automatically extended to all firms in the sector. This
considerably reinforces the bargaining power of unions because it reduces the
scope for competition by nonunionised firms. As we saw in Chapter 7,
stronger bargaining power on the part
of the unions may result in higher unemployment. Higher unemployment is
needed to reconcile the demands of workers with the wages paid by firms.

10. Consider two scenarios. In one, inflation is 4%, and your nominal wage goes
up by 2%. In the other, inflation is 0%, and your nominal wage is cut by 2%.
Which do you dislike most?
You should be indifferent between the two. In both cases, your real wage
goes down by 2%. There is some evidence, however, that most people find
the first scenario less painful, and thus suffer from money illusion.