Unit 15

INFLATION, UNEMPLOYMENT, AND MONETARY

POLICY
OUTLINE
A. Introduction
B. Inflation
C. The Phillips Curve
D. Monetary Policy
A. Introduction
 The Context for This Unit
Governments can use fiscal policy e.g. spending, taxation to
stabilize the economy during recessions.
(Unit 14)
Besides unemployment, fluctuations in 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?
• Does the inflation rate capture the real inflation experience
for all?
• 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

• 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
 Objectives of the Unit
• Assess the costs imposed on an economy by deflation and by high and variable inflation

• Be able to critique the inflation rate with reference to some issues related to its calculation

• Calculate the inflation rate based on a basket of goods and different prices over time

• Connect changes in the price level and in inflation to the way wages and prices are set in the economy, allowing
you to derive the Phillips curve graphically from the WS/PS model

• Represent the objectives of the policy maker in the form of loss ellipses in the same space as the Phillips curve
and interpret in terms of a constrained optimisation problem

• Place the original Phillips curve and the expectations augmented Phillips curve in historical context, recognising
the contributions of Bill Phillips and Milton Friedman
Is there a cost-of-living crisis in the South Africa?
Let’s look deeper
What drives inflation in South Africa?

• What is headline inflation?

• Standard quoted inflation rate is
called headline inflation rate.
• Core Inflation rate removes some
volatile components from the month-
to-month calculation.

• What trends do we see over time?

• Which component is growing
since 2020?
• Which is shrinking?
Current state of the basket
What’s in?
• E-cigs & snuff
• Gas in cylinders (impact of
loadshedding)
• More modern appliances like
air fryers
• E-hailing services and vehicle
maintenance
• Streaming services
• After school centres

What’s out?
• Digital cameras, CDs, and
Magazines
• Teddy bears and TV licences

What would happen if these

things were not added or
removed?
Current state of the basket

• This is the composition of the latest CPI basket

updated in Jan 2025.
• In total, there are 391 products in the CPI basket –
down from 396 in recent years.
• Note: StatsSA assumes this applies to the average
household in the country. Do we think this is
reasonable?

• Last updated in 2022 using expenditure patterns

from 2019.
How do the baskets of goods differ across the
income/expenditure distribution?
How do the baskets of goods differ across the
income/expenditure distribution?
How do the baskets of goods differ across the
income/expenditure distribution?
B. Inflation
 Inflation: Key Concepts
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

Real interest rate = Nominal interest rate – Inflation rate

[The Fisher equation]
 Revision from 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
• 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
• GDP deflator differs from cost-of-living measures using CPI in that the deflator includes non-
consumer goods and services while the inflation rate uses only consumer goods.
• GDP deflator only includes domestically produced goods while inflation rate based on the CPI
includes all money spent by households regardless of origin.

18
Measurement of inflation
• Consumer price index (CPI) : the index which shows the price of a representative
basket of goods and inflation as the percentage change in CPI.

• Inflation can be measured through the :

• month-on-month method (commonly used in South Africa).
• the annual average on annual average.
 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)

𝑪𝑷𝑰 𝒊𝒏 𝒕𝒉𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒑𝒆𝒓𝒊𝒐𝒅 – 𝑪𝑷𝑰 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒑𝒆𝒓𝒊𝒐𝒅

Inflation = 𝑿 𝟏𝟎𝟎
𝑪𝑷𝑰 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒑𝒆𝒓𝒊𝒐𝒅

20
 Calculating the inflation rate

• Use the information below to calculate:

1. The yearly inflation rates (annual average on annual average) since
2018.
2. Month-on-month from Dec 2021 and Jan 2022.

21
Solution 1
Year Yearly Average
Inflation =
𝑪𝑷𝑰 𝒊𝒏 𝒕𝒉𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒑𝒆𝒓𝒊𝒐𝒅 – 𝑪𝑷𝑰 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒑𝒆𝒓𝒊𝒐𝒅
𝑿 𝟏𝟎𝟎
𝑪𝑷𝑰 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒑𝒆𝒓𝒊𝒐𝒅

2018 86,8 -

2019 90,3 𝟗𝟎,𝟑–𝟖𝟔,𝟖

= 𝑿 𝟏𝟎𝟎
𝟖𝟔,𝟖
=
2020 93,3 𝟗𝟑,𝟑–𝟗𝟎,𝟑
= 𝑿 𝟏𝟎𝟎
𝟗𝟎,𝟑
=

2021 97,5 𝟗𝟕,𝟓−𝟗𝟑,𝟑

= 𝟗𝟑,𝟑
𝑿 𝟏𝟎𝟎
=
Solution 2
• Remember inflation rate can be calculated year-on-year or month-on-
month
• % Δ in CPI from Dec 2021 to Jan 2022

• Dec 2021 to Jan 2022 month-on-month rate=

𝐶𝑃𝐼 𝐽𝑎𝑛 2022– 𝐶𝑃𝐼 𝐷𝑒𝑐 2021

= 𝑋 100
𝐶𝑃𝐼 𝐷𝑒𝑐 2021

100,2–100
= 𝑋 100
100,0
=
 Calculating Inflation: An example – Year 1
Year Theatre Admission Popcorn Pizza Coke
1 5 2 12 1.25
2 6 2.5 12.50 1.40
3 6.5 3 13 1.50

• Let’s assume that going to movies entails buying two tickets, a box of popcorn, one pizza
• What is the value of the market base? In other words, what does it cost to buy this bundle of goods in the
base period? This is the sum of expenditure at base-period prices at the base-period quantities.

𝐵𝑎𝑠𝑒 = 𝟐 ∗ 𝑅5 + 1 ∗ 𝑅2 + 𝑅1 ∗ 12 + 1 ∗ 𝑅1.25 = 𝑅25.25

Year Basket Cost CPI Inflation

1 R25.25 100 -
2
3
 Calculating Inflation: Year 2
Year Theatre Admission Popcorn Pizza Coke
1 5 2 12 1.25
2 6 2.5 12.50 1.40
3 6.5 3 13 1.50

𝑌𝑒𝑎𝑟 2 = 𝟐 ∗ 𝑅6 + 1 ∗ 𝑅2.50 + 𝑅1 ∗ 12.50 + 1 ∗ 𝑅1.40 = 𝑅28.40

28.40 − 25.25
Growth in basket price = ≈ 12.5%
25.25

𝐶𝑃𝐼2 = 100 + 12.15 = 112.5

112.5 − 100
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 2 = ∗ 100 = 12.5%
100
Year Basket Cost CPI Inflation
1 R25.25 100 -
2 R28.40 112.50 12.5%
3
 Calculating Inflation: Year 2
Year Theatre Admission Popcorn Pizza Coke
1 5 2 12 1.25
2 6 2.5 12.50 1.40
3 6.5 3 13 1.50

𝑀𝑎𝑘𝑒 𝑠𝑢𝑟𝑒 𝑦𝑜𝑢 𝑐𝑎𝑛 𝑓𝑖𝑙𝑙 𝑖𝑛 𝑡ℎ𝑒 𝑟𝑒𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑡𝑎𝑏𝑙𝑒

Year Basket Cost CPI Inflation

1 R25.25 100 -
2 R28.40 112.50 12.5%
3 R30.50 120.8 7.4%
 Some issues with the inflation rate…
• It is subject to some biases that have an impact on its accuracy
• Substitution bias - changing composition of the basket
• Quality bias – maybe we are paying more for better products?
• New product bias – measuring the price of an iPhone just after release versus 6 months
later.
• Outlet bias – Maybe people shop at Makro instead of Woolies.
• Formula bias – The actual formula introduces bias as it often reflect the expenditure
patterns of the rich.
• Exclusion bias – Core inflation versus standard inflation
• Aggregation bias – when constructing the price index (or the basket of goods), prices
are aggregated. This is an issue when prices differ geographically.
• These biases mean that the inflation rate can be an overestimation of the
inflation experience in the country.
 15.1: What’s wrong with inflation?
• High rate of inflation makes the economy work less well:
• high inflation is often volatile → uncertainty
• it is harder for producers to distinguish between changes in relative
prices and inflation
• menu costs as firms must update their prices more frequently
• The inflation experience is not always even across the income
distribution. When the price of Starbucks goes up, the rich can
substitute out of those products. When the price of maize goes up, the
poor cannot make inflation-avoiding substitutions.
 Consequences of Inflation: The distributive nature of
inflation
• Who wins?
• Borrowers and flexible-income recipients could be helped by the presence of inflation.
• Borrowers pay back money with less purchasing power after some time.
• Flexible income earners who experience lower personal inflation rates compared to the national level,
may see real income increases when their salaries are adjusted for inflation.
• Which products contribute significantly to inflation year on year? If you don’t but those products, you
are shielded from inflation to a certain extent. Think alcohol, electricity and/or cigarettes.
• Those who rent out homes they own could win. If rental income grows with inflation but the cost of the
mortgage is tied to the interest rate, then these individuals could win.
• I am sure there are other examples you could think of…
• Why can the government be a winner? Fiscal dividend or bracket creep?
• VAT
• If prices go up, VAT collected goes up.
• Income Tax – Bracket creep or fiscal dividend
• Inflating the debt away over time
• Asset owners – People who own assets and rent these assets out. These rental agreement
are often adjusted according to inflation rates, but the underlying cost of ownership could be
independent of inflation.
 Consequences of Inflation: The distributive nature of
inflation

• Who loses?
• Creditors lose as they may receive money back from debtors that has less
purchasing power due to inflation.
• Fixed-income recipients – If you have a private pension, this is not adjusted
for inflation each year. When you are 65, you may have enough per month to
afford your basket of goods, but as time goes by, your mean purchasing
power gradually decreases.
• Savers – This is linked to the previous point. If the rate of return from your
investments is less than the annual inflation rate, each year you lose money.
• People whose income growth is less than their true inflation experience.
 What’s wrong with deflation?
• Deflation could have even more dramatic consequences 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.
Practice
questions from
Core
• Now that you’ve worked
through the slides, try to
out the following
questions from CORE on
your own:

32
15.2: Causes of inflation
15.3 Inflation, The business cycle, and the Phillips curve in the
short run
• Recall how wages and prices are determined.
• HR sets the nominal wages
• Marketing sets the price immediately after wages.
• Employees care about the level of the real wages they will receive.
• Real wages= nominal wage relative to the price-level.
𝑊
w=
𝑃

• When there is growth in the numerator and the denominator, the real
effect is zero.
• Therefore, when there is additional employment due to business cycle
fluctuations, we move sideways on the price-setting curve.
Figure 9.11: Equilibrium in the Some labour market revision

All parties are doing the best they can,

given what everyone else is doing
labour market

9
 The labour market equilibrium
All parties are doing the best they can, given what everyone else is doing:

• The firms are offering a wage that ensures workers’ effort, at the lowest possible cost
• Employment is the highest it can be, given the wage offered
• Those who have jobs cannot improve their situation by asking for higher pay or working
less hard
• Those who do not have jobs would like to work, but cannot persuade firms to hire them
by accepting lower wage (labour discipline concerns)

• At this point, there is no reason for the wage and price level to change, so there is no
inflation pressure being exerted on the economy. Inflation will be zero in this scenario.

10
Distribution of output per worker at supply-side equilibrium

• At this equilibrium, there is no

incentive for any party to change
their behaviour.
• The real wage on the WS curve is
equal to

• The real profit per worker is equal to

• These sum quite nicely to lambda

and there is no conflict.

• What if we are not at the supply-

side equilibrium? What happens
when the unemployment rate is
below the structural unemployment
rate?
 An Intro into the causes of inflation
• Inflation may result from:
1. An increase in the bargaining power of firms over their consumers: This
is caused by a reduction in competition, which allows firms to charge a
higher markup. It is a downward shift of the price-setting curve.
2. An increase in the bargaining power of workers over firms: This allows
them to get a higher wage in return for working hard. In the labour
market equilibrium diagram this can show as :
a) A shift upward of the wage-setting curve: The wage they would receive is higher at
every level of employment.
b) An increase in the level of employment causing an upward movement along the
wage-setting curve: the position of the wage-setting curve is unchanged.
 Causes of inflation – Differing time periods
• Note that in the first two
scenarios, the level of
unemployment has not changed.
This set unemployment rate we
call the structural unemployment
rate. This occurs in the medium
term.

• In the third scenario, it stems from

a power change as a result of the
level of unemployment changing.
This is a short-run fluctuation tied
to the business cycle.
• This causes inflation because
of the conflict of interest
between workers and owners
about the share of output per
worker. Figure 15.2 Three causes of inflation: changes in bargaining
39
power.
 Conflict as a cause of inflation
• To the right of A, the wage on the
WS curve is higher than the wage
on the PS curve.
• At this lower unemployment rate,
if workers were to receive the
wage associated with the WS
curve, profit margins would be
squeezes below the desired level
of the owners.
• At this lower unemployment level,
nominal wages are forced to rise,
and firms respond to by passing
this increased cost onto the
consumer (they maintain their
markup rate).

40
Where does this movement to right of A come
from?
• When output rises because of a rise in demand and a rise in the level
of output in the economy.
• Given the functional form of our production function in which each
worker is equally productive, more output requires more
employment.
• Therefore, when demand rises above some natural level,
unemployment falls below the structural level of unemployment.
C. The Phillips Curve
 The Phillips Curve
Higher employment may result in inflation.

• It increases workers’ bargaining position →

higher wages → higher cost of production →
higher prices
• Two versions of the Phillips curve. Original
curve did not include expectations while the
revised curve incorporated expectations.
• Suggests there is tradeoff between inflation
and the level of unemployment. When the
economy is “boomy” and there is low
unemployment, there may be higher
inflation.
• Any deviation from the labour market equilibrium is
going to have an impact on the level of employment.
How?

1. When there is excess demand, unemployment is

low. Since unemployment is low, the HR
department needs to set higher wages (+2% as an
example) to recruit more workers.
2. Higher wages mean higher costs for firms: Firms
costs rise by 2%, all else equal.
3. To cover the higher wage costs, the marketing
department will raise prices by 2% as the profit
share is kept constant.
4. Since both wages and prices have changed by the
same amount, there is no change in the real wage.
5. There is a gap between the real wage workers GET
(PS Curve) and what they EXPECT (WS Curve)

The economy experienced wage and price inflation

 The bargaining gap
Bargaining gap = The difference between the real wage
required to incentivize effort, and the real wage that gives
firms enough profits to stay in business. Think wage-
setting real wage minus price-setting real wage.

• Unemployment is below equilibrium: a positive

bargaining gap and inflation.
• Unemployment is above equilibrium: a negative
bargaining gap and deflation.
• Labour market equilibrium: the bargaining gap is zero
and the price level is constant.
 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)
Yellow line shows what workers
need to exert enough effort

Blue arrow shows the real profit

per worker. Shows the real wage
that gives the owners the
maximum profit.
Real wage per worker

Any difference between these real

wages introduces a bargaining gap.

Employment, N

Employment at labour
46
market equilibrium
 15.3 Inflation, The business cycle, and the Phillips curve in the
short run
An upswing in business cycle is often associated with rising inflation.
𝑊
• The economy experiences price and wage inflation, but the real wage ( ) has not
𝑃
increased.
• Constant real wage means that employment stays high, but employees are unhappy with
their real wages and demand more pay. This results in another round of nominal wage and
price increases.
• This increase in nominal wage and prices is called a wage-price spiral, which continues if
unemployment is below the labor market equilibrium unemployment level.
• The only way to stop this cycle is for the unemployment level to decrease to the level
associated with the labour market equilibrium.
Stable price level in labour
market equilibrium

• Prices are stable (inflation is 0%) when

the labour market is in (Nash) equilibrium.
• Any output level beyond that at A is
associated with changes in the
employment level and therefore changes
in the inflation rate.
• Note there is a tradeoff between extra
output and inflation.
• We call this unemployment rate the
inflation-stabilizing unemployment rate.

48
 Disequilibrium in summary
Unemployment below equilibrium:
workers’ claims to real wages + firms’ claims to real profits >
total productivity. In other words, the real wage workers feel they need + the
real wage paid to maximise profits is greater than the actual pie being split.
→ upward pressure on wages and prices

Unemployment above equilibrium:

workers’ claims to real wages + firms’ claims to real profits <
total productivity
→ downward pressure on wages and prices

49
The Phillips Curve and the business cycle
• A positive bargaining gap in boom
→ inflation
• A negative bargaining gap in recession
→ deflation

• Note: Each level of aggregate demand costs

a certain level of unemployment.

• As a nation, how do we decide how a

worthwhile a boomy economy is? We need
to think about the preferences of the
economy. For this, we need indifference
curves which map to the preferences.
Let’s test our knowledge
 Question 1 – Some guiding questions
• What happens to the AD function?
• What happens to effort levels in the labour market?
• Do firms need to pay the same wage compared to before the shift in
the AD function?
Question 1 – Some guiding questions
Let’s test our knowledge
Let’s test our
knowledge-
answer
15.4 – Inflation and unemployment: Preferences
Phillips Curve determines the feasible trade-offs between inflation and
unemployment. (MRT is the slope of these PC)

Indifference curves show policymaker’s preferred tradeoffs between

inflation and unemployment. (MRS is the slope of these ICs )

• Phillips curve represents a feasible set of combination of inflation and

employment levels from which the state can choose depending on
the preferences for inflation and employment.
• The policymaker prefers low unemployment along with low inflation
but must choose as there are tradeoffs.
• Above the target rate, the ICs are positively sloped. This means
that getting closer to full employment costs some additional
inflation.
• Below the target rate, indifference curves are negatively sloped
as getting employment closer to full employment is worth the
introduction of inflation below the target.

Optimal inflation rate where: MRS = MRT

Choosing Inflation Rates
Making sense of this diagram
• This diagram starts with the idea that the goal of this state is
to have an inflation rate of 2% per annum.
• At 2% per annum there would ideally be no
unemployment. This is shown by point F where the
economy is at the inflation target with zero
unemployment.
• At this inflation target of 2%, there are many ICs to the left of
point F that show increasing unemployment rates. Starting
at 2% inflation, we see there are tradeoffs. From 2%, you will
only accept higher or lower inflation if it comes with higher
employment.
• Note: If the starting preference of this state was at 3%, the
most leftward part of the semi-circle would be at the height
of 3%.
• The optimization problem is to find the best indifference
curve subject to being bound by the Phillips curve.
 • Making sense of this diagram

• Note: More inflation is less and less tolerable for an increase in employment.
Choosing Inflation • Close to 2%, the government is happy to accept relatively large growth in the inflation rate for
smaller gains in employment.
Rates • Once we have moved further away from the inflation rate of 2% (consider the third panel), the
government is less tolerant of further increases in inflation to gain additional employment. In this
case, the government will only tolerate very small increasing in inflation to gain increases in
unemployment.
 Figure 15.5. The Phillips curve and the policymaker’s preferences.

Inflation (%)
Phillips Labour
curve supply
Policymaker’s
indifference
• The policymakers’ preferences and the Phillips curves
curve trade off.
• Policymaker prefers 5% inflation with 3% U to 5% C
6% U with stable prices. F
2%
• There is some IC which goes through U=6%
and I=0%, but this is not preferable because all 0
points on the IC going through C are preferred. (U=3%)
(U=6%)

59
Where’s Wally (but also the Phillips curve)?
 15.5 The Phillips Curve Over Time
• Once we start grouping data for various time periods, we
start seeing some trends.

• The 1960s – Economy seemingly in a good state with

relatively low combination of inflation and unemployment
(blue).
• 1970s – Phillips curve has shifted up with levels of
unemployment now associated with higher inflation rates
(Orange). Further shifts up in the late 1970s (Green).
• Further shifts upwards in the 1980s (Pink) with even
higher inflation rates associated with various
unemployment rates.
• Late 1990s and 2000, Phillips curve is nice and low and
quite flat.

• These tradeoffs between inflation and unemployment are

not permanent as suggested by our original Phillips curve.
 15.5 The Phillips Curve Over Time
• Trade-off between inflation and unemployment is not stable:

Phillips Curve shifts over time

• Keeping unemployment “too low” leads to higher prices but also

rising inflation.
• Keeping unemployment too low can lead to accelerating inflation
over time as the Phillips curve gradually shifts upwards.

• Why is this?
• People are forward-looking. They take actions now in
anticipation of things they expect to happen
• Expected inflation is key in this case! If I THINK inflation will
be 5% next year, I will ask for a raise of at least 5% for next
year.
 15.6 – Expectations and the Phillips Curve
Expectations of future prices can cause the Phillips
curve to shift.

Inflation = expected inflation + bargaining gap

• The inflation-stabilizing rate is the unemployment rate

which keeps inflation constant.
• If wage and price-setters expect inflation to be 3% and the
level of AD is normal, then unemployment is stable at 6%
at the labour market equilibrium. In this state, inflation will
remain at 3% and the real wage will be stable at A.
• But what if AD is not normal? What if there is a boom?
• What if an increase in AD moves employment to point B?
 15.6 - The role of expectations and the Phillips
curve
Inflation = expected inflation + bargaining gap

• At point, B what will happen to the inflation rate?

• At point B, employment is higher, meaning a higher real wage is
required for workers to exert enough effort. Therefore, at point B,
workers need 3% due to their inflation expectation, and an
additional 2% due to the movement along the wage-setting curve.
• This additional 2% is our positive bargaining gap.
• This 3%+2% increase in wages means that firms need to increase
prices by 5% leading to inflation above the expected rate.

• In future time periods, this current period inflation rate will become
the new expectation of future inflation.
 15.6 – What happens in the next time period?
Are all parties happy one period later?

• Workers received a 5% increase in the nominal wage and the price

level rose by 5%. No real wage improvements as promised by the
WS curve
• The issue lies in the fact that workers expected a real increase in
wages due to the movement along the wage-setting curve. This did
not materialise.
• Both parties are in conflict as the real wage according to the W/S is
not the same as the real wage according to the P/S.
• Next year, the expected inflation rate is this year’s inflation rate
which is 5%.
• In addition, if output has not decreased and unemployment has not
increased, the bargaining gap remains.
• If the bargaining gap remains, workers will again want to see the
higher real wage
 • What changes the inflation expectation?

The role of • A persistent bargaining app increases expected inflation and shifts up
expectations the Phillips curve.
• As long as the bargaining gap exists (due to lower unemployment),
inflation will accelerate as per the next slide.
 The shifting Phillips curve over time
• In the current time period, inflation is the
sum of expectations and the bargaining
gap. This leaves the economy at point B at
the reduced unemployment level.
• In the next time period, that 5% inflation
rate is associated with 6% unemployment
rate. PC has shifted upwards.
• If the unemployment rate is again too low,
we move to point C on the higher PC at 7%
inflation.
 As long as the bargaining gap
Expected inflation and the bargaining gap remains unchanged, inflation rises
each year
D. Monetary Policy- 15.8
 Monetary Policy
• We have discussed how government used government
spending and taxation to intervene in an economy to
stabilize prices and unemployment.
• Next, we discuss what the reserve bank can do during
booms and troughs to achieve stability
• What can the reserve bank change?
• Through which channels do these changes filter?
• What are the effects?
• What are the tools of the SARB?
 Monetary Policy Tools
1. Repo and Interest Rates (We focus on this for the rest of the unit)
• This involves the increasing (contractionary) and decreasing
(expansionary) of the repo rate to make borrowing more or less
expensive.
2. Reserve ratio
• During economic downturns, the reserve bank can reduce the
reserve requirement such that more loans can be created in the
monetary sector.
3. Open market operations
• The buying and selling of government bonds to increase or
decrease money in circulation
 Transmission mechanisms for monetary policy
when the interest rate changes
• The Central Bank sets an inflation
target (usually 2%). 3% - 6% in South
Africa
• This diagram shows how government
stimulates the economy through the
adjustment of the interest rate in an
economy. Text suggests four main
pathways.
1. Market interest rate (prime lending
rate)
2. Asset prices
3. Expectations/Confidence
4. Exchange rate
 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).
• RER = NER – Inflation

3. Calculate the nominal policy rate (REPO) that will produce the appropriate
market interest rate (Prime lending rate).
 Market interest rates

• Think about how a fall in the interest rate affects the decision to
buy a new house.
• The cost of taking out a loan is now lower, so investors are more
likely going to undertake this purchase.
• This applies to household and firm investment.
• Houses and factories more likely at lower interest rates.
• We worked through this in unit 14 when we spoke about the
determinants of investment spending.
 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 financial assets goes up. Think
about the net present value of future economic inflows. Inverse relationship
between the interest rate and price of an asset paying money in the future.

Households who own assets will be wealthier, which will increase their
consumption.
Think of the relationship between the price of bonds and the interest rate. A
drop in the interest rate increases the net-present value of future income
flows.
 Profit expectations and confidence
Consistent policymaking and good communication with the public builds
confidence in the Central Bank.

This can lead firms to expect higher demand and therefore increase investment.

Households may be confident that they will not lose their jobs, and they may
increase their consumption. If the public sector sees odd decisions from the SARB,
that will cause suspicion and the loss of confidence. Even though it may be
frustrating to see interest rates remaining very high for 16 months (2022 until Sept
2024), if rates were slashed while inflation was high this would be concerning.

Confidence in the reserve bank and their decisions increases overall sentiment
around the RB.
 Exchange rate
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, so affects
the exchange rate (appreciation/depreciation).

The exchange rate affects relative demand for home-produced goods, so affects net
exports.
Therefore, interest rates affect aggregate demand through the market for financial assets.

Remember: In the unit dealing with foreign sector, we looked at the impact of local
interest rates relative to international interest rates and the impact of this differential on
the demand for the currency. If the local interest rate is low relative to other countries,
there is less demand for the local currency and the currency will depreciate, cp.
 Exchange rate as transmission mechanism
Suppose we see a fall in investment due to some exogenous factor

If they don’t want

Lower interest our bonds, there is
rate increases the no need to convert
price of Aus forex into AUD
bonds
 Monetary policy in the multiplier model with
investment spending changing
• This is what an expansionary
monetary policy looks like in the
Keynesian cross model. Here, the
drop in consumption spending is
counteracted by a reduction in
the real interest rate, leading to
an increase in investment across
the economy.

• To stabilize the economy, the

central bank stimulates
investment by lowering the real
interest rate. This shifts the
aggregate demand curve upward
• Note: in this case, monetary
policy moved through
investment. Could also have been
exports etc.
Demand shocks and how countries respond to them

Demand shock = An unexpected change in

aggregate demand

Governments can use both fiscal and

monetary policy to stabilize the economy:
• Monetary policy – decreasing the
nominal interest rate
• Fiscal policy – tax cuts and increased
government spending
 Demand shocks and how countries respond to them

• Demand shock = An unexpected change in

aggregate demand

• In this case, the government is responding

to the bursting of the tech bubble in the US.
• Note: Interest rate is decreased from 2000
and there is growth in the housing market and
moderate improvements in non-residential
investment.
• We also see increase government spending
over the period following the bursting of the
bubble.
Monetary and fiscal reponse to an exogenous
demand shock
• Here we see the response from the
state and the reserve bank.
• An investment slump drops AD to point
D which is undesirable for the economy.

• The economy can be stimulated via

monetary and fiscal policy to move
things back to C.
• Economy needs an expansionary
monetary and fiscal policy to end
back at C.
 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 stabilize the economy by changing the policy

rate
• 4 channels of monetary transmission mechanism: interest
rate, asset prices, profit expectations, exchange rates