Question

1. Suppose that from 2020 to 2025, the price level rises at a rate of 3% per year.
   1. [1] In 2025, real GDP is equal to potential, so there is no output gap. Workers and employers are bargaining the wage for the next year.

If they are backward-looking, are wages likely to increase? If so, by how much?

2. [1] Given your answer in a, will there also be an increase in the price level next year (inflation)? If so, by how much?

3. [1.5] Suppose that in 2026, an inflationary output gap opens. Workers and employers once again bargain the wage increase for the next year.

Compared to the past year (in part b), do you think that inflation will be higher or lower than in 2025?

4. [1.5] In 2027, there is still an output gap. The price of energy—an important input—increases.

Will this affect inflation? If so, will the inflation rate be higher or lower than in 2026?

Answer 1

a.

• If actual GDP = Potential GDP, then it means there is no excess demand. Further there is a constant inflation rate of 3% every year. The increase in prices are a direct result of increase in nominal wages of workers. In backward looking expectations, price level increases gradually with increase in wages. So nominal wages will increase by 3 % as well.
• Next year, workers have adapted wages with inflation rate.They will bargain for 3% raise due to price increase. So price level will continue to rise at 3%.
• Since there is an inflationary gap in 2026 it means that actual GDP > potential GDP. So there exists excess demand. Also workers anticipate based on their past experience that prices will rise by 3 % so they bargain for increase in nominal wages to keep their real purchasing power intact. So inflation in 2026 will be higher than in 2025 because actual inflation is caused by excess demand and inflationary expectations.

This is summarized as -

Actual inflation in 2026 = Demand pull inflation (due to inflationary gap) + Expected inflation(by workers)

• Now in 2027, apart from inflationary gap, there is nominal wage bargaining and increase in input prices( energy price rise). So the above equation becomes -

Actual inflation in 2027 =

Demand pull inflation (due to inflationary gap) + Expected inflation(by workers) + Supply shock( energy price rise)

Note: If Excess demand gets balanced by supply shock, then price level will be not change than that of 2026 but output or GDP will be lower.However if Excess demand is > supply shock then prices will spiral up and inflation rate will further increase in 2027.