ECON 102 Tutorial: Week 24
Ayesha Ali
www.lancaster.ac.uk/postgrad/alia10/econ102.html
a.ali11@lancaster.ac.uk
office hours: 8:00AM – 8:50AM tuesdays LUMS C85
Today’s Outline
 Week 24 worksheet – Money & Inflation
Question 1
The Phillips inflation-unemployment relationship is
better described as “L-shaped” rather than a curve.
Explain.
Phillips’s explanation: ‘When the
ΔW/
demand for labour is high we should W
expect employers to bid wage rates up
quite rapidly. On the other hand it
appears that workers are reluctant to
offer their services at less than
prevailing rates when the demand for
labour is low’
% unemployment
rate
Question 2
In the 1960s, ‘the Keynes-Phillips orthodoxy was sailing on smooth waters, the
object of much congratulation, rather like the liner Titanic prior to its collision with
the fateful iceberg’ (Edmund Phelps).
What is the nature of ‘the Keynes-Phillips orthodoxy’ and why was a collision
inevitable?
The Keynes-Phillips orthodoxy argues that inflation cannot occur with
large-scale unemployment.
‘ … an increase in the quantity of money will have no effect whatever on prices,
so long as there is any unemployment …’ (TGT: 295)
‘ … the general level of prices will not rise very much as output increases, so long
as there are available efficient unemployed resources of every type.’ (TGT: 300)
Why is a problem unavoidable?
As subsequent analysis (the Friedman-Phelps expectations-augmented
Phillips curve) predicts, the co-existence of high inflation and high
unemployed is likely when monetary growth is excessive.
In other words: if ΔMS/MS > ΔMD/MD, we get demand-pull inflation.
Question 3(a)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Identify each of the variables:
ΔW/W proportionate increase in wages
prices
P
percentage unemployment rate
U
(ΔP/P)e expected proportionate increase in prices
Question 3(b)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What sign respectively would be expected for the
coefficients f and φ. Explain.
f
negative.
There is an inverse relationship between unemployment and Δmoney
wages. This is the same as in the original Phillips curve.
φ
positive
When workers accept employment contracts, they choose wages that
reflect anticipated price changes. This is expectations-augmented
part.
Question 3(c)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Which description is usually given for φ < 1. Explain.
money illusion
If the rate of increase in wages < the rate of increase in
prices, then, workers are being paid less in real terms.
The workers would be mistaken to accept this, but they
might due to money illusion.
Money illusion is the idea that if you’re paid more you
must be wealthier. You’re only wealthier if you’re paid
more relative to the price levels.
Question 3(d)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the ‘reservation wage’ in the analysis of job
search?
the minimum level of acceptable wage offer
Question 3(e)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the likely impact upon the reservation wage
as the duration of unemployment increases?
reservation wage falls
Question 3(f)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
What is the likely impact upon unemployment if
unemployment benefits increase?
unemployment is likely to rise as job search is
extended
Question 3(g)
With the expectations-augmented Phillips curve represented
conventionally as:
ΔW/W = f(U) + φ(ΔP/P)e
Explain the likely impact upon unemployment of (ΔP/P) >
(ΔP/P)e.
So, we are asking, if the proportionate change in prices is
greater than the expected proportionate change in prices,
what will be the impact on unemployment. (Note, this is
another way of saying if inflation > expected inflation, or if we
underestimate the inflation rate)
The period of job search is likely to be curtailed (cut short), if
the inflation rate is underestimated.
Question 3(h)
With the expectations-augmented Phillips curve
represented conventionally as
ΔW/W = f(U) + φ(ΔP/P)e
Explain the likely impact upon unemployment of
(ΔP/P) = (ΔP/P)e.
unemployment finds its ‘natural rate’
Question 4
With prices rising at 4.0 percent annually, and wages rising at 3.5 percent per
annually, what would be the percentage reduction in real wages over a five year
period?
To answer this question, we need to the difference between future real wages and
the current period real wages.
To find the future period real wages, we have to calculate three things here:
real wages, and wages in a future period, and prices in a future period.
Here are the three equations we’ll need:
Real Wages = nominal wage ÷ prices
Wagefuture period = Wagecurrent period * (1 + growth ratewages)ΔT
Pricefuture period = Pricecurrent period * (1 + growth rateprices)ΔT
We can put it all together into the following equation:
Real Wagesfuture period =
Wagecurrent period*(1 + growth ratewages)ΔT ÷ Pricecurrent period*(1 + growth rateprices)ΔT
Question 4 ctd.
With prices rising at 4.0 percent annually, and
earnings rising at 3.5 percent per annually, what
would be the percentage reduction in real wages
over a five year period?
First, find Real Wages (R) in Year 5:
W5 W1 1.035 5
R5 =
=
= 0.9762 R1
5
P5 P1 (1.04)
Next, find the percentage change from Year 1 to 5:
(0.9762)R1
R5
Percentage Change = -1 =
-1 = -2.4%
R1
R1
Note: Some students used another method and got 2.5% as an answer – I am showing Gerry’s
method here, and would recommend that you learn this for the exam.
Question 5(a): MV ≡ PQ.
If M were to rise by 6 percent, Q by 4 percent while V is
unchanged, by what percentage would P increase?
First, we can normalize everything to 1 so that:
M = V = P = Q = 1 at the beginning.
Then we can re-write the problem: If M = 1.06, Q = 1.04, V = 1,
then solve for the % increase in P.
MV = PQ
(1.06)(1) = P(1.04)
P=
1.06
1.04
= 1.01923
So, P has changed by approximately 1.9%.
Question 5(b): MV ≡ PQ.
If the V remains constant, as M grows at a constant annual compound
rate of 12.2 per cent, and Q grows at a constant annual compound rate
of 10 per cent, in how many years would the price level (P) double?
Again, for simplicity, let’s say M = V = P = Q = 1 initially.
We want to solve for the number of years in which P is doubled. So,
we want to solve for n:
We start with P = MV/Q
(1.122)n(1)n
Plugging in: P =
(1.10)n
1.122 𝑛
1.10
P=
P = 1.02𝑛
ln P = 𝑛 ln 1.02
ln P
𝑛=
ln 1.02
We’ve got n, so now we want to know what is n when P is doubled in
value. We’ll look at that on the next slide.
Question 5(b): MV ≡ PQ.
From the previous slide, we have:
ln P
𝑛=
ln 1.02
Because we want to know when P doubles, and
we’ve normalized all variables to 1 initially, we can
put 2 in for P and solve for n.
ln 2
𝑛=
ln 1.02
𝑛 = 35
So, it takes 35 years for P to double.
Question 5(c): MV ≡ PQ.
If V remains constant as Q grows by 2.5 per cent, and as
M grows by 10 percent, by what annual percentage
would prices rise?
This is just like Question 2(a).
First normalize everything to 1, then let’s use MV = PQ
to solve.
P = MV/Q
P = (1.10)(1)/(1.025)
P = 1.07317
So, P grows by approximately 7.3% annually.
Question 5(d): MV ≡ PQ.
Use the structure MV ≡ PQ to explain demand pull inflation.
My answer:
(Gerry’s answer on next slide)
Initial equilibrium: MS0 ≡ MD0≡ (P0Q0/V0)
Final equilibrium: MSF ≡ MDF≡ (PFQF/VF)
The Monetarist view is that demand-pull inflation is caused by an increase in
money supply.
So that means: MSF > MS0
As a result:
MDF > MD0 and
PFQF/VF > P0Q0/V0
So at least one of the following are true:
Case 1: QF > Q0
Case 2: VF < V0
Case 3: PF > P0
The expectations-augmented Phillips Curve suggests that in the long run, increase
in inflation is unable to increase output, so QF = Q0
Our model doesn’t have any motivation for a change in money velocity, so VF = V0
Thus Case 3 must be true, PF > P0. This is Demand-pull inflation: an increase in
Money Supply leads to an increase in Prices.
Question 5(d): MV ≡ PQ.
Use the structure MV ≡ PQ to explain demand pull
inflation.
Gerry’s answer is:
In equilibrium: MS ≡ MD ≡ (PQ/V)
If there is a disequilibrium because of excess MS:
MS↑ ≡ (PQ/V) > MD
An excess supply of money (Ms) implies an increased
demand for goods and services which pulls up their
prices (P): MS↑ ≡ (P↑Q/V) > MD
which increases the transactions demand for money,
thereby restoring equilibrium at a higher general level of
prices:
MS↑ ≡ (P↑Q/V) ≡ MD↑
Question 6
Using the identity MV ≡ PQ, given an explanation the following
statement:
‘.. it was clear that the liberalisation of the financial system ... the
increased competition between financial institutions would lead to a
steady increase in the ratio of broad money to GDP. This indeed has
been a consistent feature of the 1980s. There is every sign that the
people are holding the increased amounts of broad money quite
willingly. And so long as this is so its growth is not inflationary’
(Nigel Lawson - UK Chancellor of the Exchequer 1983-89)
Nigel is either saying while M↑, P will not ↑, completely ignoring
MV=PQ. Or he might be saying that if M↑ then he expects to see
V↓, therefore eliminating the need for P↑.
Gerry’s answer:
We know this is in equilibrium:
This is what Nigel is saying:
MS
≡ MD ≡ (PQ/V)
MS↑ ≡ (PQ/V) ≡ MD↑
Question 6 ctd.
Lawson made that speech in 1986, when Inflation was falling and
GDP was increasing.
Lawson’s idea was that Money Supply can be increased without
worrying about inflation. We can see some of the results of his policy,
in the late 1980’s:
Monetary Policy
today places much
more emphasis on
controlling inflation.
Questions 7 & 8
These questions are about definitions. Gerry
wants to make the point that deflation of
economic activity, or deflation of GDP, is not the
same as deflation in the value of currency.
I’ll put his answers in the next slides.
Question 7 – Gerry’s answer
Explain the apparent paradox: that a rise in the world price of oil has a
deflationary impact upon economic activity, and causes a rise in price
indices.
Words can have a different meaning in lay conversation than as economics
jargon. For example, ‘inflation’ is generally taken to mean (in lay
conversation) an increase in some price index (say, the RPI). However, if the
RPI rises when commodities in widespread use have become (for whatever
reason) more scarce, this would not constitute (by the jargon of
economics) ‘inflation’. In economics, ‘inflation’ - or, rather, ‘price inflation’ is the persistent tendency of prices to rise in consequence of monetary
profligacy (currency debasement). The impact of monetary expansion is
first to increase and then to reduce (as prices rise) demand. A rise in the
world oil price is neither inflationary nor deflationary per se; though
adjustment would be different within an oil-rich economy (e.g., Saudi
Arabia) as compared to one with no fossil fuel reserves (e.g., Eire).
In general, there are difficulties in matching theoretical concepts (inflation,
unemployment, economic growth, money supply, etc.) and statistical time
series.
Question 8 – Gerry’s answer
If (the definition of) inflation is more complex than a rise
in price indices, how might it be defined?
A definition always requires a context. Even Keynes
accepts the context of the Quantity Theory of Money,
‘as soon as full employment is reached’ (TGT, p. 295)!
The Quantity Theory draws from the most general of
economic propositions: namely, that (unless demand
increases pro rata) the more there is of something, the
less valued it becomes. Thus, whenever the amount of
money held in circulation exceeds the demand to hold
money individuals are likely to increase their
expenditure thereby (with that increased the demand
for goods/services) causing prices to rise
Question 9
With the yield on savings at 3 percent, price inflation at 4
percent and unearned income taxed at 40 percent,
calculate the real rate of return on savings net of taxation.
This question involves putting together 4 concepts:
Effect of interest rate:
savings + savings income = savings * (1 + % yield)
Effect of tax:
income after tax = income * (1 - tax)
Effect of inflation:
real value of income = value / (1 + inflation)
Rate of return:
(final value/initial value) - 1
Effect of tax:
Question 9
income after tax = income * (1 - tax)
Effect of inflation:
real value of income = value / (1 + inflation)
Effect of interest rate:
savings + savings income = savings * (1 + % yield)
Rate of return:
(final value/initial value) - 1
We combine the above 4 equations to make the following equation to find
total real rate of return, net of taxes:
1 + ( % yield ∗ ( 1 – tax ))
−1
( 1 + inflation )
1 + (0.03 ∗ ( 1 – 0.40 ))
−1
( 1 + 0.04 )
1.018
−1
1.04
0.9788 − 1 = − 0.0212
So in this case, we’re actually losing 2% on our investment!
Note: In Gerry’s solution,
he leaves out the -1
when calculating the rate
of return. So, he gets an
answer of 0.9788.
Obviously if the interest
rate is 3%, the real rate
of return net of taxes
should be lower than 3%.
Question 10
Businesses that raise their prices to excess go bust. Workers
who demand excessive wages lose their jobs. So, what on
earth is cost-push inflation?
Gerry’s Answer:
‘Cost-push inflation’ is …? A rise in unit costs produces a oneoff increase in prices.
If some particular raw material approaches depletion, its everrising price chokes of demand as consumers switch to cheaper
substitutes.
If trade unions insist on ever-higher wages, expect ever-higher
levels of unemployment … unless there is monetary
accommodation, in which case, expect demand-pull inflation
as the excessive supply of money has its corollary; that is, an
excess demand for goods and services.
 Exam on Friday
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

Next Class
Check your Timetable for exam time & location.
Bring your Student ID Number, Pencil, Eraser.
Good luck!
 Week 25 is the last tutorial!
 I’ll plan on reviewing the Week 24 Exam 4 in class.