[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

labor markets. Conversely, wages will rise more slowly when cyclical unemployment
rises. For most firms, labor costs are their primary costs of production. If wage hikes
outpace increases in workers’ productivity, firms’ labor costs rise. As labor costs go
up, firms will raise their prices; when labor costs fall—as occurs, for instance, if
labor productivity increases faster than wages rise—firms will cut their prices. This
means that for a given rate of increase in labor productivity, prices will rise more
rapidly—that is, inflation will be higher—when wages rise more rapidly; when wages
rise slowly, so will prices, and inflation will be lower. Thus, cyclical unemployment
affects wages, which in turn affect inflation.
This connection between cyclical unemployment and inflation points to a tradeoff
in the economy. When the economy experiences a business cycle expansion and
enjoys lower unemployment, inflation is likely to start to rise. To lower inflation typically
requires a period of high cyclical unemployment. Thus, if inflation is too high,
the cost of lowering it will be temporarily high unemployment. Of course, cyclical
unemployment isn’t the only factor affecting inflation, but it is among the most
important. The short-run trade-off between cyclical unemployment and inflation
can present policymakers with hard choices.
Fundamentals of Fluctuations 3
SHORT-RUN INFLATION–UNEMPLOYMENT
TRADE-OFF
In the short run, policymakers face a trade-off between unemployment and inflation.
This trade-off occurs because attempts to reduce unemployment cause nominal
wages to increase faster than labor productivity, raising firms’ labor costs.
Higher costs, in turn, lead to more rapidly rising prices (i.e., inflation increases).
Attempts to reduce inflation require periods of high cyclical unemployment to reduce
the rate of wage increases.
INFLATION, MONETARY POLICY, AND
SPENDING
We have just set out three of the key concepts we will use as we explore how the
economy behaves in the short run. These will help us begin to understand economic
fluctuations, but they also open up new questions. For example, if firms respond to
shifts in demand by adjusting production and employment, what explains the level
of demand and its shifts? And is spending, like cyclical unemployment, also related
to that other important macro variable, inflation?
The answer to this last question is yes. As inflation starts to rise, governments
are likely to undertake policies designed to bring it back down. Maintaining stable,
low rates of inflation is a primary goal of most countries, and central banks—the
UNDERSTANDING MACROECONOMIC FLUCTUATIONS ∂ 653