Unit 15:

INFLATION,
UNEMPLOYMENT, AND
MONETARY POLICY
OUTCOMES
Students should be able to:
• describe the measurement and process of inflation and deflation
• Calculate the inflation rate and other relevant rates
• understand and interpret the two versions of the Phillips curve
• evaluate how inflation may affect unemployment (given constraints and preferences)
• identify supply shocks and explain their effect on inflation
• inspect the relevance of monetary policy to curb uncontrolled inflation
• provide an overview of the interest rate channel of the monetary transmission mechanism
• provide an overview of the exchange rate channel of the monetary transmission mechanism
• understand the effect of the exchange rate channel on inflation and the importance of this channel
in an open economy
• categorise demand shocks and explain demand side policies
• draw the AD model (from Unit 14) as it relates to changes in inflation (see Figure 15.5)
OUTLINE
A. Introduction
B. Inflation: Units 15.1 & 15.2
C. Additional material on inflation calculations
D. The Phillips Curve: Units 15.3 - 15.7
E. Monetary Policy: Units 15.8 - 15.11
A. Introduction
 The Context for this unit
Governments can use fiscal policy, e.g. spending and taxation,
to stabilise the economy during recessions. (Unit 14)

Besides unemployment, fluctuations in real GDP also affect

prices.
• What factors affect the price level in an economy?
• What is the ideal level of inflation and how do central
banks achieve it?
• How do central banks respond differently to supply-side
and demand-side shocks?
 This Unit
• Inflation: causes and effects on the economy

• The trade-off between inflation and unemployment

(opportunity cost)

• How central banks can use monetary policy to respond to

shocks in the economy

• The importance of expectations and how central banks

can manage them
 B. Inflation
Unit 15.1 & 15.2 (and 13.8)
 Inflation: Key Concepts
(refer back to unit 13.8)

Inflation = an increase in the general price level

Zero inflation = A constant price level from year-to-year
Deflation = A decrease in the general price level
Disinflation = A decrease in the rate of inflation

See textbook: analogy of driving car

Inflation = an increase in the general price level
Zero inflation = inflation rate is 0%
Deflation = inflation rate is negative
Disinflation = inflation rate is positive but lower than before
Inflation rates: Japan

Disinflation

Zero
inflation

Deflation
 Refer to Unit 13.8:
Inflation, GDP, and Unemployment

Inflation = an increase in the

general price level in the
economy.

Inflation tends to be lower

during recessions (high
unemployment)

Figure 13.20a UK GDP Growth (1875-2020)

Refer to Unit 13.8:
Inflation, GDP, and
Refer to Unit 13.8:
Unemployment

Figure 13.20a UK GDP

Growth (1875-2020)

Figure 13.20b UK
unemployment rate
(1875-2020)
 Refer to Unit 13.8:
Measuring inflation
The Consumer Price Index (CPI) measures the general level of prices that
consumers have to pay for goods and services, including consumption
taxes (e.g., VAT).
• Based on a representative bundle of consumer goods – “cost of living”
• Common measure of inflation = change in CPI

GDP deflator = A measure of the level of prices for domestically produced

output (ratio of nominal to real GDP)
• Tracks prices of components of GDP (C, I, G, NX)
• Allows GDP to be compared across countries and over time

Nominal GDP
deflator =
Real GDP
 Inflation rates: Selected countries
30

25

20
Percentage

15

10

European Union - 27 countries (from 01/02/2020)

-5
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
Japan United States United Kingdom European Union ** South Africa China
 Average consumer inflation for
Inflation South Africa 2020 was the lowest since 2004
and the second lowest since 1969
Global inflation surge - 2022
Inflation in USA - 2022
Inflation in South Africa - 2023
 What’s wrong with inflation?
1. For people on fixed nominal income (e.g. pensioners), higher
inflation means lower real value of income.

2. Inflation reduces the real value of debt – good for borrowers,

bad for lenders (creditors) (think about Julia and Marco from
Unit 10).
• Effect of inflation on borrowing and lending?
• Real interest rate= Nominal interest rate – Inflation rate
[The Fisher equation] rt = it - πt
3. A high inflation rate reduces the performance of the
economy:
• high inflation is often volatile → uncertainty
• it is harder for producers to distinguish between changes
in relative prices (signal about scarcity) and inflation
• menu costs as firms have to update their prices more
frequently (discussion point: how has technology
reduced these costs?)
 What’s wrong with deflation?
Deflation can cause even more damage than high inflation.

When prices are falling, households will postpone consumption

(particularly of durables) because they expect goods will be
cheaper in the future. This is similar to a negative shock to
aggregate demand.

Deflation increases the real debt burden, which may lead

households to cut consumption to return to their target wealth.
 Japan’s lost decade

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2593714
 Consequences of prolonged deflation as
seen in Japan
• impeded monetary policy efficacy,

• hampered financial market activities,

• squeezed corporate profitability,

• raised the real burden of private and public debt.

Japan 2022 – inflation, finally.
 Current deflation in China
(the world’s second largest economy):
 Question 15.2
The following table shows the nominal interest rate and the annual inflation rate (the
GDP deflator) of Japan in the period 1996–2015 (Source: World Bank).
1996–2000 2001–2005 2006–2010 2011–2015
Interest rate 1,5% 1,4% 1,3% 1,2%
Inflation rate –1,9% –0,9% –0,5% 1,6%

Based on this information, which of the following statements are correct?

a) The real interest rate in 1996–2000 was –0,4%.

b) Japan’s real interest rate has been rising consistently over this period.
c) Japan’s real interest rate turned from being positive to negative during the
period.
d) The real interest rate has been falling faster than the nominal interest rate.
 Causes of inflation (figure 15.3)
Recall: Wages and prices are
determined by interactions between
firms, consumers, and workers.

Inflation may be due to:

• Increases in bargaining power of firms
over their consumers
e.g. reduction in competition This third (bottom) panel is what has been referred
• Increases in the bargaining power of to as the Phillips Curve (lecture 3)

workers over firms, due to (1) higher

bargaining power or (2) higher
employment
 Inflation calculations
(compulsory material not in CORE textbook, use
the slides as primary study material)
The Consumer Price Index (CPI)

Table E – Consumer price indices for all urban areas

• How the CPI is calculated:
• Take the prices of all goods/services in the basket,
multiply it with the weight
• See Statistics South Africa (StatSA) table on the right (CPI
weights as at May 2019)

• How does Statistics South Africa determine the

content of the CPI market basket and the weight of
each component in the basket?
• Use the Living Conditions Survey from 2014/2015,
implemented in 2017
 The base period
• The CPI is an index, so it is calculated by considering prices relative to
the BASE PERIOD
What is the value of the CPI in the base period? Explain your answer. What does it
mean if the CPI in the following periods is higher than in the base period?
 Calculating the inflation rate
• Recall that inflation is the continued increase in the general price level
• So, if the CPI continually increases, it indicates inflation
• Inflation rate = growth rate of a price index (% Δ in CPI)

• What were the yearly inflation rates since 2019?

What were the yearly inflation rates since 2019?

• To calculate:

• Inflation rate in 2020

• Inflation rate in 2021
• Inflation rate in 2022

CPI Inflation rate

(% Δ in CPI)

2019 90,3 --- Historic low

during the COVID
2020 93,3 3,3% pandemic
2021 97,5 4,5%
2022 104,2 6,9%
 More inflation concepts
• Year-on-year vs month-on-month rate
• do not confuse with annualised rate, which is something different
• % Δ in CPI from April 2019 to May 2019 ? month-on-month rate:

• % Δ in CPI from May 2019 to May 2020? year-on-year rate:

 Real vs nominal values
• We have already discussed the impact of inflation on people’s
standard of living in the previous section
• To be able to compare income from one period to another, we need
real income
Suppose you earned an annual salary of R200 000 in Year 1 and at the end of Year 1 you were
informed that you will earn an annual salary of R212 000 in Year 2. In Year 1 the CPI was 97,8 and
in Year 2 the CPI was 103,4. Would you have been satisfied with this salary increase, i.e. were you
better off in real terms in Year 2?

CPI Nominal income Real income

Year 1 97,8 R200 000
Year 2 103,4 R205 029,01

Therefore, in Year 2 you were slightly better off than in Year 1

 Purchasing power
• Purchasing power of income – what one can afford to buy with the money
earned
• Real income is used to determine whether the purchasing power of
income:
1. keeps up with inflation
• real income constant

2. doesn’t keep up with inflation

• real income falls

3. more than keeps up with inflation

• real income rises
 Converting prices between years

E.g.: what is the

current (2019) $ price
of a $5,10 Beatles Price in 2019=
ticket from 1965, if
CPI in 1965 was 13,16
and the CPI in 2019
was 108,54
C. The Phillips Curve
Unit 15.3 - 15.7

A.W (“Bill”) Phillips

(1914-1975)
 Inflation and employment
As discussed in the previous session, higher employment may result in inflation.

How? Higher employment increases workers’ bargaining position → higher wages → higher
cost of production → higher prices

Figure 15.3 Phillips’s original curve: Wage inflation and unemployment in Britain (1861–1913).
 Inflation and aggregate demand
An upswing in the business cycle is often associated with rising
price level.
• higher aggregate demand → higher employment → HR dept sets higher
wages → higher cost of production → marketing dept sets higher prices
• the economy experiences price and wage inflation, but the real wage
has not increased

Real wage?

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑤𝑎𝑔𝑒
𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 =
𝐶𝑃𝐼

• constant real wage means that employment stays high

• …and the wage-price spiral continues
 Stable price level in labour market
equilibrium
Prices are stable (inflation is 0) when the labour market is in
(Nash) equilibrium.
Figure 15.4(a):
 What happens if labour market NOT in
equilibrium?
Employment level higher than at labour market equilibrium
∴Unemployment below equilibrium:
workers’ claims to real wages + firms’ claims to real profits >
total productivity
→ upward pressure on wages and prices

Employment level lower than at labour market equilibrium

∴Unemployment above equilibrium:
workers’ claims to real wages + firms’ claims to real profits <
total productivity
→ downward pressure on wages and prices

See figure 15.4(b), next slide

Figure 15.4b. Inflation and conflict over the pie at low and high unemployment.

Wage-setting
curve

Labour productivity

Real profit per worker

Real wage

Price-setting curve
(high unemployment) C A B (low unemployment)

Real wage per worker

Employment, N

Employment at labour
market equilibrium
 The bargaining gap
Bargaining gap = The difference between the real wage
required to incentivise effort, and the real wage that gives
firms enough profits to stay in business.

• Unemployment is below labour market equilibrium: a

positive bargaining gap and inflation.
• Unemployment is above labour market equilibrium: a
negative bargaining gap and deflation.
• Labour market equilibrium: the bargaining gap is zero
and the price level is constant.
The Phillips Curve and the business cycle

A positive bargaining gap in boom

→ inflation

A negative bargaining gap in

recession → deflation

Figure 15.4d. The short-and medium-run models: Aggregate demand, employment, and inflation
The Phillips Curve and the business cycle (more detail I)
Real wage
Wage-setting curve

1% = Bargaining gap (%), positive

Price-setting curve
Bargaining gap,
negative(-0.5%)

Employment, N
Inflation
Rate, π Phillips curve

1% Inflation (%) = bargaining gap (%)

0 Employment, N
Deflation
-0.5%
Employment at labour
market equilibrium, no
bargaining gap
Figure 15.4c. Bargaining gaps, inflation, and the Phillips curve.
The Phillips Curve and the business cycle (more detail II)

Supply side
(medium run)

Aggregate AD(high)
B
demand, AD AD(medium)
A
AD(low)
Demand side C
(short run)

45°
Recession Normal Boom Output, Y Figure 15.4d.
(U=9%) (U=6%) (U=3%)
Question 15.5: Which one of the following options is
correct?

A. There is no inflation when the unemployment rate is

zero.

B. In the boom shown, the upward shift in the aggregate

demand curve reduces the unemployment rate, which
in turn creates a bargaining gap of 1%.

C. In the recession shown, the downward shift in the

aggregate demand curve increases the unemployment
rate, which in turn creates a bargaining gap of 0.5%.

D. The resulting Phillips curve shows a positive

correlation between the unemployment rate and
inflation rate.
Unit 15.4 and Unit 15.5
 Choosing Inflation Rates
Phillips’ Original Curve acts as
feasible set: determining the
feasible trade-offs between
inflation and unemployment.

Indifference curves show

policymaker’s preferred tradeoffs
between inflation and
Figure 15.5. The Phillips curve and the policymaker’s preferences. unemployment.
Figure 15.5. The Phillips curve and the policymaker’s preferences.

Policymaker’s
Inflation indifference Inflation (%)
(%) , π curves Labour
Phillips Labour
supply
curve supply
Worse Policymaker’s
outcomes indifference
curves

5% C
F F
2% 2%
0 0
Employment, N
(U=6%) (U=3%)
Best
outcome

a. The policymakers’ preferences b. The policymakers’ preferences

and the Phillips curve trade-off
 What happened to the Phillips Curve?
Figure 15.6: The Phillips Curve in
the US (1960-2014)
• Trade-off between inflation and
unemployment is not stable:
No discernable Phillips Curve in the
long run

• Milton Friedman in late 1960’s:

“There is always a temporary trade-off
between inflation and unemployment;
there is no permanent trade-off”
 The Phillips Curve Over Time
• Since no permanent trade-off, the Phillips curve not a feasible
set in the true sense of the word

• Milton Friedman: Keeping unemployment “too low” leads to

higher prices but also rising inflation

• This means Phillips curve would keep on shifting upward

• There is only one unemployment rate at which inflation is

stable; the Nash equilibrium in the labour market
Unit 15.6 and Unit 15.7
 The role of expectations
• Recap: Milton Friedman: at low levels of unemployment,
inflation keeps rising

• 2 building blocks:
• People are forward looking (expectations matter)
• Prices are signals of what will happen

• Expected inflation: The opinion that wage- and price- setters

form about the level of inflation in the next period
 Figure 15.7. Bargaining gaps, expected inflation, and the Phillips curve.

Real wage Wage-setting curve

2% = Bargaining gap
In a boom (i.e. low unemployment),
Price-setting curve
with inflation > 0%, workers will
expect prices to rise, and will
demand a nominal wage increase
Employment, N
equal to the inflation rate plus the
bargaining gap
Inflation Phillips curve
rate, π
Therefore, Inflation = expected 5% B Inflation (%) =
inflation + bargaining gap A
bargaining gap (2%)
Inflation (%) =
3% expected inflation
= 3% +
expected inflation (3%)
0
U=3% Employment, N
Employment at labour market equilibrium,
no bargaining gap (U=6%)
 Expectations and the Phillips Curve
• Expectations of future prices can cause the Phillips curve to
shift.

• How? In a situation where low levels of unemployment

continue, workers will continue to demand wage increases
equal to expected inflation + the bargaining gap
• Expected inflation informed by last period’s inflation (which in turn
was equal to the expected inflation of that period + the bargaining
gap), and so on

• See figures 15.8 and 15.9

 Figure 15.8. Unstable Phillips curves: Expected inflation and the bargaining gap

The inflation-stabilising rate is the unemployment rate

which keeps inflation constant. This occurs at labour
market equilibrium
Figure 15.9. Inflation expectations and Phillips curves.

Real wage Wage-setting curve

2% = Bargaining gap
Price-setting curve

Employment, N

Inflation Phillips curves

rate, π
7% C Inflation (%) =
bargaining gap (2%)

5% B
Inflation (%) =
bargaining gap (2%)
A +
3%
+ expected inflation (5%)
expected inflation (3%)

0
U=3% Employment, N
Employment at labour market equilibrium,
no bargaining gap (U=6%)
 Expected inflation and the bargaining gap

Figure 15.10. Inflation, expected inflation, and the bargaining gap

As long as the bargaining gap remains unchanged, inflation rises each year
 Supply shocks
Another cause of high and rising
inflation are supply shocks =
unexpected change(s) on the
supply-side of the economy
e.g. oil price shock.

Supply shocks:
- shift the Phillips curve by
affecting the labour market
equilibrium. Figure 15.11. An oil shock and the price-setting curve.
 Oil price shocks and inflation
Increase in the price of oil

→ downward shift of price-setting

curve
→ prices rise
→ real wages fall
→ positive bargaining gap
→ persistently higher inflation,
and Phillips curve shifts up year
by year Figure 15.11. An oil shock and the price-setting curve.
 Oil price shocks in 1970s

Figure 15.12. UK GDP growth and real oil prices (1950-2020).

Unexpected increases in oil prices in 1970s caused simultaneous increase in

unemployment and prices.
 D. Monetary Policy
Units 15.8-15.11
(only focus on material mentioned in the
slides)
 Central Banks and inflation
• NB distinction: Monetary Policy implemented by central banks (in
SA: Reserve Bank); fiscal policy implemented by national
government (SA: national treasury)

• Many central banks target low levels of inflation (say around 2%)

• As set out in Unit 10:

• these central banks use monetary policy to adjust aggregate demand
and employment to steer economy towards targeted inflation
• policy instrument is the interest rate
 Transmission mechanisms
Policy interest rate:
Interest rate set by
Central Bank

Market interest rate

(also Bank Lending
Rate – see unit 10):
Average interest rate
charged by
commercial banks to
firms & households
(typically above
policy interest rate,
includes mark-up)
Figure 15.14. Monetary policy transmission mechanisms.

The Central Bank sets an inflation target

 Market interest rates
To set the policy rate, the central bank will work backwards:

1. Choose the desired level of aggregate demand, based on the

labour market equilibrium and the Phillips curve

2. Estimate the real interest rate, which will produce this level of
aggregate demand (using the multiplier model)

3. Calculate the nominal policy rate that will produce the

appropriate market interest rate.
Interest rate cuts during Covid-19 crisis
 Asset prices
A change in the policy rate has a ripple effect through all the
interest rates in the economy.

When the interest rate goes down, the price of assets goes up.

Households who own assets will be wealthier, which will increase

their consumption.
Refer back to the pathway of precautionary savings and target
wealth in unit 14.3
 Profit expectations

Consistent policymaking and good communication with the

public build confidence in the Central Bank.

This can lead firms to expect higher demand and therefore to

increase their investment. (refer back to unit 14.4)

Households may be confident that they will not lose their jobs,
and they may increase their consumption.
 Exchange rate
(Note: Read through unit 15.9, but only study what is on the slides.)

• Exchange rate = number of units of home currency that can be

exchanged for one unit of foreign currency.

• Interest rates affect demand for home currency in the foreign

exchange market, thus affecting the exchange rate
(appreciation/depreciation).

• Therefore, interest rates affect aggregate demand through the market

for financial assets.
• Why important?
➢Net exports: The exchange rate affects relative demand for home-
produced goods, thus affecting net exports.
➢Financial (capital) flows
 Exchange rate: direct and indirect quotation
The demand for SA demand for European Demand for Euros (in Supply of Rands (to get
currency is a goods order to buy those goods) Euros)
DERIVED demand
(similar to the European demand for SA Demand for Rands (in Supply of Euros (to get
goods
demand for labour) order to buy those goods) Rands)
Market for rands (ZAR) Market for euros (€)
€/ZAR

S S

ZAR/€
𝟏
11
𝟏𝟏

D D

Qrands Qeuros

Example: South Africans pay R11 for one euro. The graph on the left graphically represents the
87
market for rand (indirect quote) and the graph on the right shows the market for euros (direct quote).
 Exchange rate: Changes in real interest rates
The South African real interest rate increases.
▪ Higher demand for South African financial assets.
▪ The rand appreciates against the euro and the euro depreciates against the
rand.
€/ZAR

ZAR/€
S1 S1 S2

𝟏 11
𝟏𝟏
9
D2
D1 D

Qrands Qeuros 88
Exchange rate as transmission mechanism
(CORE section 15.9)
 Monetary policy in the multiplier model

Figure 15.15. The use of monetary

policy to stablise the economy in a
recession.

To stabilise the economy, the central bank stimulates investment by

lowering the real interest rate. This shifts the aggregate demand
curve upward.
 Monetary Policy: Limitations
1. The short-term nominal interest rate (policy rate) cannot go
below zero (“zero lower bound”)
• when the economy is in a slump, a nominal interest rate of
zero may not be low enough to stabilise the economy
• Quantitative easing (“QE”) = Central bank purchases of
financial assets aimed at increasing investment by
reducing yields.

2. A country without its own currency does not have its own
monetary policy (E.g. Namibia linked to South African Rand)
 Demand shocks

Demand shock = An unexpected positive or negative change in

aggregate demand

Governments can use both fiscal and monetary policy to stabilise

the economy:
• Monetary policy – changing the nominal interest rate
• Fiscal policy – changing taxes and/or government expenditure
 Demand shocks

A decrease in the policy interest

rate is expected to increase the
inflation and employment rate
and a higher level of output.

Figure 15.18 A policy intervention to restore employment

and output after a fall in investment.
 Inflation targeting
• Inflation targeting = monetary policy regime where the central
bank uses policy instruments to keep the economy close to an
inflation target
• Inflation targeting dominant policy outcome prior to global
financial crisis
• Making the central bank independent from the government gives
inflation targets credibility and prevents an inflation spiral by
setting expectations.
 Inflation targeting

Figure 15.21 The economy’s inflation-stabilizing unemployment rate.

Inflation and central bank independence

Figure 15.20 Inflation and Central Bank independence: OECD countries.

The South African Reserve Bank (SARB)
• Follows an inflation targeting regime since 2000. (3% - 6%)

• Has been relatively successful in achieving low and stable

inflation

• Policy tool is the Repo rate

SARB independence from the government
• Since mid-2019, there have been discussions within the
ANC to nationalise the SARB. Both the governor of the
SARB (Lesetja Kganyago) and the former minister of finance
(Tito Mboweni, and since Aug 2021 Enoch Godongwana),
have opposed such suggestions
• Kganyago has also repeatedly confirmed the SARB’s
commitment to inflation targeting as policy outcome (as
opposed to QE or a broadening of the mandate), even in
the midst of the Covid-19 pandemic
 SARB independence in the news

https://www.businesslive.co.za/bd/economy/2020-08-10-lesetja-kganyago-stands-by-reserve-banks-covid-19-response/
https://www.moneyweb.co.za/news/south-africa/inflation-targeting-is-here-to-stay-kganyago/
https://ewn.co.za/2019/08/08/sarb-governor-says-will-go-to-war-to-protect-independence
 Summary
1. Inflation is caused by bargaining gaps and capacity constraints
• Phillips Curve: tradeoff between inflation and unemployment
• Positive bargaining gap leads to persistently high inflation
• The trade-off isn't stable: expectations matter

2. Central banks can stabilise the economy by changing the policy

rate
• 4 channels of monetary transmission mechanism: interest
rate, asset prices, profit expectations, exchange rates
• Zero lower bound puts a limitation on monetary policy
 Coming up next (Unit 16):
• The long-term effects of economic policies, institutions,
and technological progress on living standards and
unemployment

• Factors that determine the economic performance of a

country, and why policies might fail