Why does accelerating inflation only occur below the NAIRU? (1 Viewer)

[swagmeister]

Why does accelerating inflation only occur below the NAIRU? Or, in other words, why does a NAIRU exist in the first place because accelerating inflation can occur anywhere...



The logic here:

a) Lowering unemployment below NAIRU → accelerating inflation (correct)
If macro policy increases demand and pushes unemployment below the natural rate, firms will compete for existing workers instead of employing the unemployed (as their skills don't match job vacancies). Furthermore you have the effect of inflationary expectations. This means that AD has shifted from AD1 to AD2 but SRAS has decreased from SRAS1 to SRAS2, meaning that the equilibrium price level has increased while equilibrium national income remains the same. On the Phillips curve, the shift has been from A to C. (LRAS mirrors LRPC, SRAS mirrors SRPC, while how far up the curve is determined by AD).

b) Lowering unemployment even if it is still above the NAIRU → accelerating inflation (incorrect, but I don't know why)
Unemployment is significantly above the natural rate, when macro policy is used to lower unemployment, workers will anticipate that macro policy, as causing an increase in demand, will increase prices and thus demand higher wages due to inflationary expectations. This will result in a similar shift of AD and SRAS, leading to a higher price level and the same level of output, while unemployment remains the same.

Why is my logic wrong in b)?

In both cases you have inflationary expectations accelerating inflation when you attempt to reduce unemployment (although you also have the increased demand for the same workers with a)

 

[Ekman]

b) Lowering unemployment even if it is still above the NAIRU → accelerating inflation (incorrect, but I don't know why)
Unemployment is significantly above the natural rate, when macro policy is used to lower unemployment, workers will anticipate that macro policy, as causing an increase in demand, will increase prices and thus demand higher wages due to inflationary expectations. This will result in a similar shift of AD and SRAS, leading to a higher price level and the same level of output, while unemployment remains the same.

Why is my logic wrong in b)?

In both cases you have inflationary expectations accelerating inflation when you attempt to reduce unemployment (although you also have the increased demand for the same workers with a)

This sounds like a chain link you are making if demand-pull inflation was to occur. Remember demand-pull inflation only occurs when AD increases, and the economy is maxed out to its productive capacity (i.e. all of its resources being employed). If there is some unemployment above NAIRU, then an increase in AD will cause that unemployment to decrease, but not increase inflation. However if the economy reaches NAIRU (i.e. max capacity of employment) then demand-pull inflation comes into play.

 

[swagmeister]

This sounds like a chain link you are making if demand-pull inflation was to occur. Remember demand-pull inflation only occurs when AD increases, and the economy is maxed out to its productive capacity (i.e. all of its resources being employed). If there is some unemployment above NAIRU, then an increase in AD will cause that unemployment to decrease, but not increase inflation. However if the economy reaches NAIRU (i.e. max capacity of employment) then demand-pull inflation comes into play.

Demand pull inflation can happen before the LRAS is met, increases in demand will push up the overall price level either way. For example, say the economy is not at its maximum productive capacity but a certain amount of people want to buy stuff, when the amount of people that wants to buy stuff increases they still still have to compete for it and this pushes the price up.

I guess this is just based on the 45 degree models though, in reality the slope would be different because if there is increased demand then producers would just supply more and it would still be at the same price. This means my notes by someone that got 98 external are wrong haha.


This graph sounds better, only when we are getting close to maximum supply does the elasticity of supply change as we really start to maximise how resources are used.

Ugh, this is where in some cases textbook simplification can be a burden.

 

[Ekman]

Demand pull inflation can happen before the LRAS is met, increases in demand will push up the overall price level either way. For example, say the economy is not at its maximum productive capacity but a certain amount of people want to buy stuff, when the amount of people that wants to buy stuff increases they still still have to compete for it and this pushes the price up.

I guess this is just based on the 45 degree models though, in reality the slope would be different because if there is increased demand then producers would just supply more and it would still be at the same price. This means my notes by someone that got 98 external are wrong haha.

View attachment 32205
This graph sounds better, only when we are getting close to maximum supply does the elasticity of supply change as we really start to maximise how resources are used.

Ugh, this is where in some cases textbook simplification can be a burden.

I don't completely agree with this because when people demand more, they don't straight away increase the price up. Instead they try supplying as much as they can (i.e. their productive capacity), even if it means to employ more labour. Then if they don't have anymore labour to employ to make more of a certain good (i.e. achieving NAIRU), they begin to increase the price. Refer to Dixon in regards to the definition of Demand-Pull inflation because it states that it is achieved if the economy is at it's peak in its productive capacity.

 

[swagmeister]

I don't completely agree with this because when people demand more, they don't straight away increase the price up. Instead they try supplying as much as they can (i.e. their productive capacity), even if it means to employ more labour. Then if they don't have anymore labour to employ to make more of a certain good (i.e. achieving NAIRU), they begin to increase the price. Refer to Dixon in regards to the definition of Demand-Pull inflation because it states that it is achieved if the economy is at it's peak in its productive capacity.

Yeah I agree, kind of realised this myself as I wrote that last post - just I mean in terms of the diagrams in reality they are not linear and looking at it in a linear way can lead you to false conclusions

 

[Ekman]

Yeah I agree, kind of realised this myself as I wrote that last post - just I mean in terms of the diagrams in reality they are not linear and looking at it in a linear way can lead you to false conclusions

I guess the linear diagrams want you to assume that the economy is at maximum capacity.