Inflation stability only at the natural rate of unemployment

• The natural rate of unemployment is the usual unemployment rate in which the actual unemployment rate changes. The actual unemployment rate is effected by
  • Changes in Labor Force Characteristics
  • Changes in Labor Market Institutions
  • Changes in Government Policies
  • Changes in Productivity
• Inflation will occur when unemployment is below the natural rate
• Deflation will occur when unemployment is above the natural rate.

Firms set prices to equal the prices of other firms to stay competitive. This is termed the real price. Unity refers to the price at the natural rate of unemployment

• The price is affected by the wages of the employees because it contributes to the total cost of production.
  • When demand is increased, wages are increased, real prices are in excess of unity, resulting in inflation
    • Forces unemployment below the natural rate of unemployment
      • The employee’s opportunity costs increases i.e. finding alternative jobs
      • The firm’s desires increase.
        • Look to Figure 15-8 on page 384 of the class textbook to conceptualize how this leads to inflation and a decrease in unemployment
  • When demand decreases, wages are decreased, and real prices are less than unity, resulting in deflation
    • Forces unemployment above the natural rate of unemployment
      • The employee’s opportunity cost decreases
      • The firm’s desire’s decreases

Inflationary/Deflationary Spiral

• Inflationary Spiral occurs when firms set prices above other firms it will cause inflation to be greater than expected. The inflationary expectations will actually cause inflation to increase with respect to it. Expected inflation will keep increasing, causing inflation to keep increasing. However, if unemployment remains at the natural rate of unemployment inflation will match expectations and remain constant. Deflationary Spiral occurs when unemployment is below the natural rate.
• Look to Figure 15-11 on page 387 of the class textbook to conceptualize how there can be inflation stability at the natural rate of unemployement

However, spirals did not occur during the 12 great depressions. Ackerlof explains that the behavioral expectations with respect to norms cause “wage stickiness.”

Wage Stickiness

• Employers have norms about what wages should be which affect inflation and unemployment
  • Truman Bewley Study
    • When unemployment was high, employers did not decrease wages because of moral and the fear of their employees quitting
• Employees have norms about what wages should be which affect inflation and unemployment
  • Employees typically believe they should not have to take a decrease in pay
  • Employees have norms regarding the rate of increase of their pay
    • Shafir, Diamond and Tversky
      • Conducted a survey that asked which woman would be better off
        • a woman getting a 5% raise with inflation
        • a woman receiving a two percent raise without any inflation
      • 79% responded that the second was better off. However, 64% responded that the first would be happier.
      • Suggesting that employees hold “real returns” at a higher value
  • Robert Shiller
    • Conducted a study that showed that people expect wage increases

Therefore according to Ackerlof, at higher levels of inflation workers do not get disappointed when they receive lower nominal wage increases. Therefore, real wages will be lower, prices will decrease, and unemployment will decrease. Hence there is inflation. At lower levels of inflation people will not be happy unless wages exceed inflation.

Regardless, both the spirals and the latter effect inflation or deflation on the bases of expectations which are behavioral.

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