Variable Markups and the Inflation-Unemployment Tradeoff
In an economy where firms' ability to set prices at a higher markup over their costs increases as the level of employment rises, explain the complete mechanism that determines the inflation response to a fall in unemployment. Does this characteristic of firms' pricing behavior make inflation more or less sensitive to changes in the unemployment rate? Justify your reasoning.
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Consider two economies that are identical except for how firms set prices. In Economy A, firms maintain a constant price markup over their costs, regardless of how busy the economy is. In Economy B, firms find they can increase their price markups when demand is high and employment is strong. How would the short-run relationship between a change in unemployment and the resulting change in inflation likely differ between these two economies?
Firms' Pricing Power and Inflation Sensitivity
In an economy where businesses can charge significantly higher price markups when the labor market is tight (low unemployment), a given decrease in the unemployment rate will lead to a relatively small and manageable increase in the inflation rate.
Variable Markups and the Inflation-Unemployment Tradeoff
Figure 4.26: Profit-Push Inflation Due to Capacity Constraints