Chapter 6 — Inflation, Purchasing Power, and Labour Markets
Chapter 6 — Inflation, Purchasing Power, and Labour Markets
Core question
Do changes in prices and employment indicate stronger demand, constrained supply, changing expectations, or a measurement effect?
Learning outcomes
You will be able to:
- calculate and interpret an inflation rate;
- convert nominal changes into approximate and exact real changes;
- calculate unemployment and participation rates;
- distinguish price, wage, demand, supply, and labour-matching mechanisms.
1. Price level and inflation are different
An index compares the cost of a defined basket with a reference period.
If CPI rises from 120 to 126, inflation is 5%.
| Term | Meaning |
|---|---|
| inflation | price level rises |
| disinflation | price level still rises, but more slowly |
| deflation | price level falls |
Inflation falling from 8% to 3% does not mean prices returned to their earlier level.
2. A price index is an estimate
A consumer index must decide:
- which households and purchases are represented;
- basket weights and update frequency;
- how substitution is handled;
- how quality change and new products are priced;
- treatment of housing and regional variation.
Your personal inflation can differ from the headline rate if your expenditure weights differ. That does not make either calculation fraudulent; it means they answer different aggregation questions.
3. Nominal and real values
Approximation:
Exact calculation:
A nominal wage rises 5% while prices rise 8%:
The same distinction applies to interest:
where expected inflation matters when a contract is signed. Unexpected inflation redistributes between fixed-rate borrowers and lenders.
4. Inflation is an outcome, not a diagnosis
Possible mechanisms include:
| Mechanism | Initial change | Typical evidence |
|---|---|---|
| demand pressure | spending outruns capacity | broad demand, vacancies, output gap |
| supply shock | energy/input/capacity cost rises | relative-price spike, output weakness |
| expectation propagation | wages/prices adjust to expected inflation | contracts, surveys, persistence |
| exchange-rate pass-through | imported goods become dearer | depreciation and import prices |
| administered/tax change | regulated price or indirect tax changes | timing and affected categories |
One CPI number cannot identify the mechanism. Chapter 9 places these shocks in AD–AS.
5. Labour-market definitions
where labour force L equals employed E plus unemployed U who are without work, available, and actively searching under the statistical definition.
Suppose:
employed = 90 million
unemployed and searching = 10 million
not in labour force = 50 million
Then u = 10% and participation is 100/150 = 66.7%.
If two million stop searching, measured unemployment falls to 8/98 = 8.2%. That fall does not represent more employment.
6. Unemployment has different mechanisms
| Type | Mechanism | Relevant response |
|---|---|---|
| frictional | search and matching take time | information and matching efficiency |
| structural | skills/location/industry mismatch | retraining, mobility, adjustment |
| cyclical | economy-wide demand is weak | stabilisation, if inflation permits |
Also inspect hours, involuntary part-time work, earnings, job security, vacancies, participation, and duration. A single unemployment rate cannot describe job quality.
7. Phillips and Beveridge relationships
The short-run Phillips curve links labour-market slack to wage or price pressure conditional on expectations and shocks. It is not a permanent menu from which policymakers choose any inflation–unemployment pair.
The Beveridge curve compares vacancies and unemployment. High vacancies with high unemployment can indicate inefficient matching; movement along the curve can reflect the business cycle.
Always ask whether a relationship shifted before reading movement along it.
8. Evidence case: pandemic-era inflation
Bernanke and Blanchard estimated a dynamic model of U.S. prices, wages, expectations, and labour-market tightness. They concluded that much of the initial 2021–22 inflation surge came from commodity and sectoral price shocks linked to supply constraints and the shift from services to goods. Tight labour markets were not the initial dominant source, but their effects on wages and inflation were more persistent (2023 paper and replication link).
The teaching lesson is diagnostic:
same inflation rate ≠ same cause ≠ same optimal response
It is one model and one economy, not a universal decomposition for every country.
Practice: indicator brief
An economy has inflation of 6%, nominal wage growth of 4%, falling unemployment, falling participation, and record vacancies.
- Approximate real wage growth.
- Explain why lower unemployment may overstate improvement.
- Give one demand and one matching interpretation of vacancies.
- Name two series needed to distinguish an energy shock from broad demand pressure.
- Write a 120-word brief with one conclusion and two uncertainties.
Quick check
- Inflation is a rate of change, not the price level.
- Headline inflation and personal cost change use different weights.
- Real values adjust nominal values for prices.
- Unemployment excludes people not actively searching.
- Correlations such as Phillips or Beveridge curves can shift.
Next: move from short-run indicators to long-run productivity and growth.
Chapter 5 — GDP, Income, Wealth, and Welfare
National-accounting boundaries, value added, expenditure, nominal and real GDP, stocks, flows, distribution, and welfare.
Chapter 7 — Productivity, Technology, and Economic Growth
Growth per person, productivity, capital, skills, ideas, institutions, distribution, sustainability, and AI evidence.