Question

You are watching the evening news on television. The news anchor reports that union wage demands are much higher this year because the workers anticipate an increase in the rate inflation. Your roommate says, "Inflation is a self- fulfilling prophecy. If workers think there are going to be higher prices, they demand higher wages. This increases the cost of production and firms raises their prices. Expecting higher prices simply causes higher prices"

Q. If policy makers do nothing and allow the economy to adjust to the natural rate of output on its own, does expecting higher prices cause higher prices in the long run? Explain.

Answer 1

The answer is No

In the long run, rising unemployment will result in salaries and price expectations falling back to their previous levels

High unemployment at low production rate would put pressure on the wage to return to its initial value moving short-run aggregate supply back to its original position.

If we use wage inflation, or the rate of salary change, as a proxy for economic inflation, when unemployment is high, the amount of individuals seeking job far exceeds the amount of employment available. In other words, labor supply is higher than demand for it.

With so many staff available, employers have little need to "bid" for employee services by paying greater salaries to them. Typically, salaries stay stagnant in moments of elevated unemployment and wage inflation

The demand for labor (by employers) exceeds the supply in moments of low unemployment. Employers typically have to pay greater salaries in such a narrow labor market in order to attract staff, eventually leading to increased wage inflation.

Economists have researched over the years the connection between unemployment and wage inflation and the general rate of inflation.