Markup matters: monetary policy works through aspirations

Tim
Willems
and
Rick
van
der
Ploeg

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Since
the
post-Covid
rise
in
inflation
has
been
accompanied
by
strong
wage
growth,
interactions
between
wage
and
price-setters,
each
wishing
to
attain
a
certain
markup,
have
regained
prominence.
In
our
recently
published
Staff
Working
Paper,
we
ask
how
monetary
policy
should
be
conducted
amid,
what
has
been
referred
to
as,
a
‘battle
of
the
markups’.
We
find
that
countercyclicality
in
aspired
price
markups
(‘sellers’
inflation’)
calls
for
more
dovish
monetary
policy.
Empirically,
we
however
find
markups
to
be
procyclical
for
most
countries,
in
which
case
tighter
monetary
policy
is
the
appropriate
response
to
above-target
inflation.

In
a
simplified
setup
where
wages
are
firms’
only
input
cost,
while
consumers
only
buy
domestically
produced
goods,
the
‘battle
of
the
markups’
takes
an
intuitive
form
(Rowthorn
(1977)):

By
itself,
there
is
nothing
guaranteeing
that
real-wage
aspirations
held
by
workers
and
firms
are
mutually
consistent
in
this
framework
–
ie,
there
is
nothing
to
ensure
that
${\mu_{w}}$ =
$1/{\mu_{p}}$ (Blanchard
(1986);

Lorenzoni
and
Werning
(2023)).
Every
time
that
workers
get
to
reset
their
wage,
they
may
consider
the
prevailing
real
wage
too
low,
upping
the
nominal
wage.
When
firms
next
get
to
reset
prices,
they
may
consider
the
current
real
wage
too
high,
upping
prices.
This
could
give
rise
to
unstable
wage-price
dynamics.

Unemployment
as
an
equilibrating
device

Layard
and
Nickell
(1986)
argued
that
the
moderating
effect
from
the
presence
of
unemployment
acts
like
a
clearing
mechanism.
They
posed
that
aspired
markups
${\mu_{p}}$ and
${\mu_{w}}$ are
likely
cyclically
sensitive.
Workers
might
feel
that
they
have
less
bargaining
power
when
unemployment
‘ $u$ ’
is
higher,
making
them
settle
for
a
lower
wage
markup.
Unemployment
can
thus
act
to
tame
unrealistic
aspirations.
Formally,
this
can
be
captured
by
modelling
the
aspired
wage
markup
${\mu_{w}}$
as
consisting
of
a
structural
component
(‘ $\overline{\mu_{w}}$ ’)
alongside
a
cyclically
sensitive
one
(‘ $-k_{w}\cdot u$ ’):

$\mu_{w}(u)=\overline{\mu_{w}}-k_{w}\cdot u$
(1)

Here,
the
structural
component
‘ $\overline{\mu_{w}}$ ’
captures
workers’
aspirations
based
on
‘exogenous’
factors,
eg
what
they
have
gotten
used
to
given
their
past
consumption
patterns.
If
0″ class=”latex”>
,
the
cyclical
term
‘ $-k_{w}\cdot u$ ’
captures
the
notion
that
workers’
aspired
markups
are
procyclical,
so
that
workers
are
likely
to
‘settle
for
less’
when
the
threat
of
unemployment
is
greater.

Similarly,
price
markups
aspired
by
firms
also
consist
of
a
structural
component
alongside
a
cyclically
sensitive
one:

$\mu_{p}(u)=\overline{\mu_{p}}-k_{p}\cdot u$
(2)

When
it
comes
to
the
cyclicality
of
price
markups,
it
is
debated
whether
they
are
pro
or
countercyclical.
On
the
one
hand,
a
slowdown
makes
firms
afraid
of
having
to
carry
large
inventories
or
suffer
from
capacity
underutilisation.
This
would
imply
that
aspired
price
markups
are
procyclical
( 0″ class=”latex”>).
On
the
other
hand,
other
theories
imply
that
firms’
aspired
markups
move
countercyclically
(<img decoding="async" src="https://www.easyfxfund.com/wp-content/uploads/2024/03/markup-matters-monetary-policy-works-through-aspirations-10.png" alt="k_{p} ).
For
example,
by
pushing
some
firms
out
of
business,
a
recession
may
increase
the
market
power
of
surviving
firms
–
implying
that
firms’
aspired
markups
rise
in
downturns.

In
general,
and
irrespective
of
the
sign
of
$k_{p}$
,
it
is
possible
to
find
an
equilibrium
rate
of
unemployment,
ensuring
consistency
between
the
real
wage
aspired
by
workers
and
that
aspired
by
firms.
At
this
point
the
wage-price
cycle
is
put
to
rest
–
enabling
inflation
to
land
at
target.

It
can
be
shown
that
the
equilibrium
level
of
unemployment
increases
in
structural
aspirations
held
by
workers
and
firms
( $\overline{\mu_{p}}+\overline{\mu_{w}}$ ):
when
workers
and/or
firms
aspire
to
obtain
a
greater
size
of
the
pie,
without
the
pie
having
grown
in
size,
something
will
have
to
give.
Here,
that
is
unemployment
which
has
the
effect
of
moderating
the
elevated
aspirations,
to
re-establish
consistency.
If
unemployment
does
not
rise
to
tame
aspirations,
there
will
be
pressure
on
inflation
in
the
short
run.
This
is
what
has
been
called
conflict
inflation.

The
role
of
the
central
bank

The
story
so
far
assumes
that,
somehow,
the
unemployment
rate
‘agrees’
to
clear
any
conflict
between
firms
and
workers.
In
reality,
it
won’t
automatically.
There
are
many
reasons
for
unemployment
to
exist,
eg
search
frictions
(Pissarides
(2000))
or
providing
incentives
to
limit
shirking
(Shapiro
and
Stiglitz
(1984)).
This
implies
that
the
level
of
unemployment
is
not
‘free’
to
clear
any
conflict
and
further
action
is
required.

This
is
where
the
central
bank
comes
in.
Through
its
mandate,
the
central
bank
is
tasked
with
setting
policy
to
keep
inflation
at
target.
In
our
framework,
this
implies
that
the
central
bank
will
attempt
to
set
its
policy
to
ensure
that
cyclical
conditions
are
such
that
markup
aspirations
are
consistent
with
the
size
of
national
income.
And
if
aspired
markups
are
cyclically
sensitive,
there
is
an
‘aspirational
channel’
of
monetary
policy
transmission.

If
aspired
markups
of
both
firms
and
workers
are
procyclical
( 0″ class=”latex”>),
the
policy
prescription
for
the
central
bank
is
conventional:
it
should
tighten
in
response
to
inflationary
pressures,
as
doing
so
will
lower
aggregate
markup
aspirations
–
eventually
re-establishing
consistency,
which
brings
inflation
back
to
target.

There
is
however
debate
over
the
sign
of
$k_{p}$
,
with
many
studies
arguing
that
firms’
aspired
markups
are,
in
fact,
countercyclical
(<img decoding="async" src="https://www.easyfxfund.com/wp-content/uploads/2024/03/markup-matters-monetary-policy-works-through-aspirations-15.png" alt="k_{p}),
for
example
because
more
bankruptcies
in
recessions
increase
market
power
of
surviving
firms.
Any
resulting
price
increases
can
then
be
seen
as
a
form
of
‘sellers’
inflation’
(Weber
and
Wasner
(2023)).
In
that
case,
policy
prescriptions
are
less
clear:
even
if
a
monetary
tightening
reduces
workers’
aspired
markups,
it
may
not
be
successful
in
lowering
inflation
if
the
ensuing
recession
ends
up
increasing
markups
aspired
by
firms.
On
balance,
inflation
might
thus
increase
following
tighter
monetary
policy,
and
a
more
‘dovish’
monetary
policy
would
be
called
for
–
particularly
if
the
channel
via
the
Phillips
curve
(a
monetary
tightening
lowering
firms’
marginal
costs)
is
weak.

Consequently,
it
is
important
for
central
banks
to
know
whether
firms’
aspired
markups
are
pro
or
countercyclical.
We
have
estimated
the
cyclicality
of
the
price
markup
( $k_{p}$ )
for
61
countries
(details
are
in
our

Staff
Working
Paper),
and
find
that
price
markups
are
procyclical
in
most,
including
the
UK
and
the
US,
but
countercyclical
in
various
other
countries
(see
Chart
1).

Chart
1:
Estimated
degree
of
cyclicality
in
price
markups
( $k_{p}$ )
in
various
countries

Paying
for
imports

Recent
UK
experiences
have
been
more
involved
than
the
stylised
situation
described
thus
far.
Next
to
domestic
workers
and
firms,
foreign
exporters
also
lay
a
claim
on
UK
output
–
as
output
is
partly
produced
with
imports,
like
energy.
As
energy
prices
rose
around
Russia’s
2022
invasion
of
Ukraine,
the
UK’s
terms-of-trade
worsened
and
the
share
of
national
income
flowing
abroad
suddenly
went
up
–
leaving
less
pie
to
be
distributed
domestically.

Absent
any
reduction
in
the
structural
components
of
markups
aspired
by
firms
and
workers
( $\overline{\mu_{p}}$
and
$\overline{\mu_{w}}$
),
a
larger
share
of
national
income
flowing
abroad
implies
distributional
conflict
domestically
–
pushing
inflation
away
from
target.
Since
price
markups
are
estimated
to
be
procyclical
in
the
UK
(Chart
1),
while
the
same
is
thought
to
apply
to
workers’
aspired
wage
markups,
a
rise
in
inflation
may
require
the
central
bank
to
tighten.
This
is
needed
to
moderate
markup
aspirations,
ultimately
clearing
any
conflict,
enabling
inflation
to
return
to
target.

Indeed,
central
bankers
appear
to
have
an
‘aspirational’
transmission
mechanism
in
mind
as
can
be
seen
from

Christine
Lagarde
(2023):

We
need
to
ensure
that
firms
absorb
rising
labour
costs
in
margins
(…)
The
economy
can
achieve
disinflation
overall
while
real
wages
recover
some
of
their
losses.
But
this
hinges
on
our
policy
dampening
demand
for
some
time

so
that
firms
cannot
continue
to
display
the
pricing
behaviour
we
have
recently
seen
(emphasis
added).

Conclusions
and
policy
implications

A
monetary
tightening
is
not
the
only
way
via
which
markup
aspirations
could
be
moderated.
Faced
with
an
adverse
terms-of-trade
shock,
it
is
also
possible
that
workers
and/or
firms
internalise
the
implications
(that
there
is
less
income
to
be
divided
domestically),
inducing
them
to
lower
the
structural
components
of
their
aspired
markups
( $\overline{\mu_{p}}$
and
$\overline{\mu_{w}}$
).
In
this
regard,
it
would
be
interesting
to
obtain
a
better
understanding
as
to
whether
communication
(by
central
banks
or
governments)
can
‘endogenise’
aspirations
of
workers
and
firms
(making
them
directly
sensitive
to
the
terms-of-trade),
as
it
is
ultimately
costly
for
a
central
bank
to
have
to
step
in
and
tame
aspired
markups
by
affecting
the
business
cycle.

Absent
such
a
co-ordinated
response,
bringing
inflation
back
to
target
following
an
adverse
terms-of-trade
shock
may
require
a
cyclical
slowdown
to
moderate
markups
aspired
by
workers
and
firms.
An
important
caveat
is
that
this
strategy
might
not
work
if
firms’
aspired
price
markups
are
countercyclical,
but
we
find
no
evidence
for
this
in
the
UK.
As
a
result,
the
monetary
tightening
implemented
in
recent
years
is
likely
to
aid
the
disinflation
process
via
our
‘aspirational
channel’
(not
present
in
most
standard
models,
featuring
acyclical
desired
markups),
which
facilitates
inflation
returning
to
target.

Tim
Willems works
in
the
Bank’s
Structural
Economics
Division
and
Rick
van
der
Ploeg
is
a
Professor
at
the
University
of
Oxford.

If
you
want
to
get
in
touch,
please
email
us
at [email protected] or
leave
a
comment
below.

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–
prevailing
policy
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Markup matters: monetary policy works through aspirations

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