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CHAPTER
Inflation: Causes and
Consequences
Inflation—the scourge of the U.S. economy in the late 1970s and early 1980s—fell during the late 1980s and 1990s, virtually vanishing by some measures by the beginning
of the twenty-first century. This change brought praise for the Federal Reserve and Fed
Chairmen Paul Volcker and Alan Greenspan. At the same time, inflation fell around the
world, in industrial and emerging economies alike—in part because central bankers
and the public became more acutely aware of the high costs of inflation in the 1970s.
By the early 2000s, many economists and policymakers worried about deflation—a
falling general price level. Deflation had set in in Japan in the mid-1990s and Europe
and the United States encountered deflationary pressures in the early 2000s.
To understand why the Fed and other central banks are at center stage in the
debate over inflation, we need to connect changes in the money supply to inflation.
Nobel Laureate Milton Friedman once remarked that “inflation is always and everywhere a monetary phenomenon.” In the first section of this chapter, we show why this
is true. A number of factors can lead to changes in the price level, but sustained
increases in the price level—inflation—can be traced to sustained monetary expansion.
To explain the widespread opposition to inflation, we then investigate the costs of inflation to households and businesses. Even with opposition to inflation, inflationary
episodes occur; we analyze pressures on policymakers to permit inflation. Finally, we
describe and estimate costs of reducing inflation and discuss the link between the credibility of monetary policy and those costs. The Federal Reserve’s efforts since the 1980s
to put forth a credible low-inflation policy make the Fed wary of allowing increases in
inflation. These efforts have been mirrored in the actions of many central banks around
the world.
Explaining Price Level Changes
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Presents information
on prices reported by
the Council of Economic Advisers.
The federal government tracks the price level and reports its value. When official statistics report that inflation is 3%, it means that a measure of the general price level has
risen by 3% over some period. Three commonly used measures of changes in the price
level are the consumer price index (CPI), the producer price index (PPI), and the
implicit price deflator for the gross domestic product. To get the most up-to-date information on them, you can consult U.S. government publications such as the Bureau of
Labor Statistics’ Monthly Labor Review or the Council of Economic Advisers’ Economic Indicators.
Figure 28.1 shows that consumer prices rose by more than 950% from 1939 through
2002. In other words, at the end of 2002, you would have needed $1.00 to make a purchase that would have cost less than $0.10 in 1939. Since World War II, increases in the
price level have been ever present but uneven. The price level increased rapidly in the
1960s and 1970s and more slowly in the 1980s and 1990s. A steady rise in the price level
isn’t normal by historical standards. Indeed, throughout U.S. history, prices have fallen in
655
FIGURE 28.1
Consumer Price Level in the
United States, 1939–2002
Throughout U.S. history, the price
level has increased and decreased
at various times. During the past
several decades, the price level
has increased, although at an
uneven rate. The graphed data
represent the consumer price
index for all urban consumers.
Source: Council of Economic Advisers,
Economic Report of the President, various
issues.
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Price level, P (1982–1984 = 100)
656
180
165
150
135
120
105
90
Consumer price level
75
60
45
30
15
0
1940 1945 1950 1955 1960 1965
1970 1975 1980 1985 1990 1995 2000 2002
Year
more years than they have risen. In this section, we extend the aggregate demand–aggregate supply model of the financial system and the economy that we developed in Chapter 25 to study the causes of changes in the price level and inflation.
Causes of Price Level Changes
To identify the reasons the price level changes, we return to the equation of exchange that
we presented in Chapter 23. This equation expresses the relationship among the nominal
money supply, M, the price level, P, and output, Y:
MV PY.
V is the velocity of money. Recall that V is defined as PY/M because the equation of
exchange is an identity.
To move from price level changes to inflation, we have to change the equation of
exchange somewhat. We are interested in the rate of change in prices rather than the
price level itself. Therefore we change the equation to percentage change form. The percentage change in the nominal money supply, m , the percentage change in velocity, v,
the percentage change in the price level, p, and the percentage change in output, y, can
be expressed as
m v y
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Inflation: Causes and Consequences
657
Rearranging terms to isolate determinants of price level changes gives
m v y.
(28.1)
When prices are rising, p represents inflation. Equation (28.1) shows us that inflation, p, equals the rate of growth of the nominal money supply, m , plus the rate of
growth of velocity, v, less the rate of growth of real output, y. To link the variables in
this equation with the AD-AS model, we can use y to represent the growth rate of
aggregate supply (the economy’s growth in output), and we can use m v to represent
the growth rate of nominal aggregate demand. We use these relationships in the following graphs to observe what happens when there is a one-time change in the price
level and more sustained changes in the price level.
Causes of Price Level Fluctuations
To assess potential causes of short-term inflation, we must determine whether the
growth rate of nominal aggregate demand can exceed the growth rate of aggregate supply over short periods of time. Equation (28.1) identifies three causes of short-term
inflation: (1) Nominal aggregate demand could rise in response to an increase in the
nominal money supply. (2) Nominal aggregate demand could rise because of short-run
increases in velocity owing to increases in government spending, consumer spending,
or investment spending. (3) Even if nominal aggregate demand does not change, the
growth rate of aggregate supply could fall.
Response to monetary policy. A one-time increase in the money supply ultimately
leads to an increase in the price level, all else being equal. To see this, recall that new classical and new Keynesian economists believe that the aggregate supply curve slopes
upward in the short run, as Fig. 28.2 shows. In the new classical view, unexpected
changes in the price level may cause producers to change their output. Hence the actual
level of output can be less than or greater than the level that is consistent with long-run
full employment. In the long run, the aggregate supply curve is vertical at the full employment level of output.
What is the effect of an unexpected increase in the money supply on the price level?
An unexpected increase in the money supply shifts the AD curve to the right, from AD0
to AD1 in Fig. 28.2. As a result, the economy moves from initial equilibrium at E 0 to
a new short-run equilibrium at E1′ , representing both a higher price level and increased
output. In other words, new classical economists predict that the short-run reaction to
an unexpected increase in aggregate demand is an increase in both output and the price
level.
In the long run, however, the gap between the full employment and actual levels of
output puts upward pressure on the price level, shifting the SRAS curve to the left from
SRAS0 to SRAS1. Because firms recognize the true price level over time, the economy’s
long-run equilibrium lies at the intersection of the AD1 and LRAS curves at E1. Money
is neutral in the long run; only the price level, not the level of output, is affected.
Although some prices are sticky in the short run in the new Keynesian view, the
process of price adjustment to an output change is similar to that predicted by new classical economists. However, the adjustment is slower. From a full employment equilibrium at E 0 , an unexpected increase in the nominal money supply shifts the AD curve
to the right from AD0 to AD1. In the short run, output increases to Y1′ at E1′ . However, the higher aggregate demand puts upward pressure on wages and prices, shifting
FIGURE 28.2
Price Level Increase
Resulting from an Increase
in the Money Supply
1. In both the new classical and
new Keynesian views, an unexpected increase in the nominal
money supply shifts the AD curve
from AD0 to AD1, moving the
equilibrium from E0 to E1′.
2. In the short run, actual output,
Y1′, exceeds full employment output, Y*. As a result, upward pressure on prices pushes the SRAS
curve from SRAS0 to SRAS1 to
intersect the AD1 curve at E1. A
one-time increase in the money
supply causes the price level to
rise from P0 to P1′. In the long
run, only the price level is
affected, rising to P1.
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Price level, P
658
LRAS
2. Price
level rises.
SRAS1
SRAS0
E1
P1
E1'
P1'
1. Money
supply rises.
P0
E0
AD1
AD0
Y*
Y1'
Current output, Y
the SRAS curve gradually upward from SRAS 0 to SRAS1. The economy returns to full
employment equilibrium at E1, with output Y* and a higher price level P1 P0. Hence,
in the new Keynesian explanation of price level changes, as in the new classical view,
an unexpected increase in aggregate demand causes the price level and output to
increase in the short run.
The aggregate demand
curve represents the combinations of the price level and output at which the goods and
asset markets are in equilibrium. How do changes in government spending, consumer
spending, or investment spending affect the price level?
Let’s consider a one-time increase in government spending on roads and bridges, for
example. (Shifts in consumer or investment spending have similar effects.) As was the case
for a one-time increase in the money supply, in the short run, the AD curve shifts to the
right, as it did in Fig. 28.2. This shift increases both output and the price level. New classical and new Keynesian economists predict that the price level rises in the short run and
that the excess of actual output over full employment output puts upward pressure only
on prices in the long run. Hence increases in government spending (and consumer spending or investment spending) raise output and the price level in the short run. Such changes
increase only the price level in the long run, leaving output unchanged.
Response to other changes in aggregate demand.
Shifts in the short-run aggregate supply curve due
to supply shocks, such as changes in raw materials’ prices or workers’ wage demands,
can cause changes in the price level. As Fig. 28.3 shows, an adverse supply shock, such
as a one-time increase in the price of oil, raises input prices and shifts the short-run
aggregate supply curve from SRAS0 to SRAS1. If the money supply and government
taxes and spending don’t change, the aggregate demand curve remains at AD0. As a
result, the economy’s equilibrium shifts from E0 to E1. The price level has risen from
P0 to P1, resulting in an increase in the price level in the short run.
At E1, however, output Y1 is below the full employment level of output, Y*. Over
time, prices fall, and the SRAS curve shifts back down from SRAS1 to SRAS 0. The
Response to supply shocks.
FIGURE 28.3
Price Level Increase from an
Oil Price Increase
1. An increase in the price of oil
shifts the short-run aggregate
supply curve from SRAS0 to
SRAS1.
2. The price level rises from P0 to
P1, causing inflation in the
short run.
Inflation: Causes and Consequences
Price level, P
CHAPTER 28
659
1. Oil
price rises.
SRAS1
2. Price
level rises.
SRAS0
P1
E1
E0
P0
AD
Y1
Y*
Current output, Y
economy eventually returns to equilibrium at E 0. Thus supply shocks can affect the
price level in the short run, but they do not cause sustained changes in the price level—
inflation.
Sustained Changes in the Price Level: Inflation
One-time increases in the money supply, other short-run increases in nominal aggregate
demand, or supply shocks can increase the price level. Sustained rates of change in the
price level constitute inflation. We can use Eq. (28.1) to determine sources of inflation.
Inflation arises whenever the growth rate of nominal aggregate demand exceeds the
growth rate of aggregate supply over sustained periods of time.
One-time changes in government spending or taxes cannot by themselves produce
inflation, as just defined. This is because such inflation would have to result from persistent increases in government spending or decreases in taxes. Government spending
and the size of government are limited by both the obvious consideration that government spending cannot exceed the economy’s total production (GDP) and limitations on
spending imposed by the political process. These same constraints apply to tax changes.
If the money supply is unchanged, expansionary fiscal policy alone cannot produce
inflation for a long period of time. Similarly, while one-time adverse supply shocks can
increase the price level in the short run, a one-time supply shock alone can’t lead to prolonged inflation.
Returning to Milton Friedman’s prediction from the chapter introduction, economists attribute persistent inflation to sustained growth in the nominal money supply at
a rate faster than the growth rate of velocity and the growth rate of output. Figure 28.4
illustrates how money supply growth could cause inflation. Suppose that households
and businesses expect the growth rates of velocity and output to be 0% and the money
supply to increase steadily by 5% each year.
Let’s begin with the new classical explanation for inflation. From initial equilibrium at E 0, the AD curve shifts to the right from AD0 to AD1 as the nominal money
supply increases. The money supply growth leads individuals and firms to change their
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Persistent Money Supply
Growth and Inflation
Money is neutral in the long run.
Persistent growth of the money
supply leads to inflation with no
long-term increase in real output.
1. Increases in the nominal
money supply shift the aggregate
demand curve from AD 0 to AD1
and then from AD1 to AD2.
2. Increases in the expected price
level as a result of the increase in
the money supply shift the SRAS
curve upward. In both the new
classical and new Keynesian
views, the shift is from SRAS 0 to
SRAS 1 (as the expected price
level increases from P0 to P1) and
then from SRAS 1 to SRAS 2
(as the expected price level
increases from P1 to P2).
Price level, P
FIGURE 28.4
LRAS
SRAS 2
SRAS 1
E2
P2
P2'
E2'
2. Price
level rises.
SRAS 0
E1
P1
P1'
E1'
E0
P0
AD 1
AD0
Y*
AD 2
1. Money
supply rises.
Y'
Current output, Y
expectations of the price level from P0 to P1. (Recall that anticipated changes in the
money supply lead households and businesses to expect a higher price level.) The SRAS
curve shifts upward from SRAS0 to SRAS1 (quickly, in the new classical approach), and
the economy’s equilibrium shifts from E0 to E1. As the nominal money supply increases
again, the AD curve shifts to the right from AD1 to AD2. The process then repeats as
the SRAS curve shifts upward from SRAS1 to SRAS2 to reflect the rise in the expected
price level. At the economy’s new equilibrium, E2, the price level has risen to P2. Thus
sustained increases in the price level over the long run can be traced to persistent
increases in the nominal money supply.
In the new Keynesian explanation of inflation, sustained increases in the nominal
money supply also shift the aggregate demand curve to the right from AD0 to AD1. The
SRAS curve shifts upward gradually from SRAS0 to SRAS1. Output initially rises from
Y* to Y′ and the price level rises from P0 to P1′ as at E1′ until the SRAS curve is at
SRAS1, as households and businesses change their expectations of the price level. At the
new equilibrium E1, the price level has risen to P1, but output remains at its initial level,
Y*. As the money supply increases again, the AD curve shifts farther to the right, from
AD1 to AD2. Before prices adjust, output rises from Y* to Y′ and the price level rises
from P1 to P2′ as at E2′. As the expected price level rises from P1 to P2, the SRAS curve
shifts upward from SRAS1 to SRAS2. At the new equilibrium E2, output is Y* and the
price level is P2.
Hence, in both the new classical and new Keynesian views, sustained growth in the
money supply doesn’t affect real output in the long run but does lead to inflation. As
Fig. 28.1 shows, the U.S. economy has experienced long-term inflation since World War
II. The reason is that, as our analysis of inflation over the long term reveals, the rate of
growth of the nominal money supply has been “too fast” relative to the rates of growth
of velocity and output. The observation that long-term inflation is principally a monetary phenomenon also is consistent with evidence from other countries. During the
1980s, countries with high average rates of inflation (such as Argentina and Israel)
CHAPTER 28
Inflation: Causes and Consequences
661
experienced rapid average rates of growth of the nominal money supply. Countries
with low average rates of inflation experienced slow average rates of growth of the
nominal money supply.
C H E C K P O I N T
Do government budget deficits cause inflation? In the short run, government budget deficits can raise aggregate demand and thus [according to Eq. (28.1)] lead to
short-term inflation. For government budget deficits to be inflationary in the long run,
the Fed must be expanding the monetary base to acquire government bonds. More
rapid growth of the monetary base raises the growth rate of nominal money supply,
leading to inflation if nothing else changes. ♦
Costs of Inflation
Since the early 1980s, Fed policymakers and many other central bankers have made
low inflation a major goal to avoid the rapid and sustained price increases that
occurred during the 1970s. They reacted to complaints by households and businesses
that such inflation placed undue burdens on them. In this section, we examine what
those costs are. We divide our analysis into an investigation of (1) expected inflation,
which households and businesses take into account when conducting financial transactions, and (2) unexpected inflation, which causes households and businesses to redistribute funds.
Expected Inflation
Expected inflation can affect the allocation of the economy’s resources. First, inflation
causes money to lose value. Specifically, it places a tax on real money balances when
those balances pay less than the market rate of interest. This tax is a loss in purchasing
power. For example, if you held $100 in currency in 1996 when the rate of inflation
was about 3%, you lost $3.00 of purchasing power over the year. By imposing a tax
on real money balances, inflation reduces the public’s demand for real money balances.
One cost of this tax, known as shoe leather costs, is the cost to consumers and businesses of making more trips to the bank to avoid holding significant amounts of currency or of shifting funds from interest-bearing assets into money. When the public’s
shoe leather costs exceed the government’s revenue gain from the inflation tax, inflation generates an excess burden, or social loss. Stanley Fischer of the World Bank has
estimated that the annual excess burden in the United States of a modest inflation rate
of 5% is approximately 0.3% of GDP, or about $32 billion in 2003 dollars.✝
Inflation distorts the taxes that individuals and firms pay on their income. Income
tax rates usually apply to nominal income, and income tax rates are progressive. Under
a progressive tax system, tax rates increase as income increases. If tax brackets are not
indexed for inflation, as income rises with inflation, individuals are subject to higher
tax rates, even though they might not gain purchasing power from the increase in
✝ See
Stanley Fischer, “Towards an Understanding of the Costs of Inflation: II,” in K. Brunner and A. Meltzer,
eds., Carnegie Rochester Conference Series on Public Policy, 15, 1981.
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income. This problem, called bracket creep, was particularly severe in the 1970s, when
income brackets were not indexed and the individual income tax was more progressive
than it was in the early 2000s. The tax code also fails to adjust values of inventories
and the value of depreciation allowances for inflation, raising the corporate tax burden
and depressing business investment during periods of high inflation.
Expected inflation also can distort financial decisions because lenders pay taxes on
nominal rather than real returns. Suppose that expected inflation is 4% and that an
individual faces a tax rate of 30%. On an investment with a nominal interest rate of
8%, an individual realizes a real after-tax return of (1 − 0.30)(8%) − 4% = 1.6%. Suppose that the expected inflation rate rises to 8% and that the nominal interest rate rises
by the same amount to 12%. The investor’s real after-tax return falls to (1 − 0.30)(12%)
− 8% = 0.4%. Hence nominal interest rates would have to increase by more than the
change in inflation (8% – 4%) to maintain the real return of 1.6%. But there are winners as well as losers during a period of high inflation. Borrowers such as corporations
and individual home buyers benefit from expected inflation, because borrowers deduct
nominal interest payments (not real interest payments) in calculating their income tax
liabilities. Changes in expected inflation can change the real after-tax cost of borrowing. For example, with high expected inflation, corporations find debt financing more
attractive, because nominal interest payments are deductible. Households find housing
investment more attractive relative to stocks, because home mortgage interest is
deductible for tax purposes.
Another cost of expected inflation according to the new Keynesians arises from socalled menu costs, or costs to firms of changing prices (reprinting price lists, informing
customers, and so on). Faced with different menu costs, not all firms change prices at
the same time; that is, price changes that are brought on by inflation are not synchronized throughout the economy. Even so, expected inflation can change relative prices
in the short run and make the allocation of the economy’s resources less efficient.
Unexpected Inflation
Many labor contracts that arise from collective bargaining agreements specify wage
payments in nominal amounts for an agreed-upon time period. Similarly, prices in contracts for goods and financial assets are sometimes set in nominal amounts and are
valid for a specific number of months or years. Although many of these contracts have
provisions for expected inflation, unexpected inflation, or the difference between actual
and expected inflation, redistributes wealth. For example, suppose that a borrower and
a lender expect no inflation and agree to a one-year, $1000 loan at 4% interest.
Regardless of the inflation rate for the year, the lender receives ($1000)(1.04) = $1040
from the borrower at the end of the year. If the actual rate of inflation is 7%,
the lender’s real return (the return in terms of purchasing power) is −3%. Conversely,
the borrower’s real interest rate is −3%. The unexpected inflation of 7% (7% − 0%)
effectively transferred $70 of real purchasing power from the lender to the borrower.
Another example of this redistribution occurs when unexpected inflation reduces real
wages for employees who have nominal wage contracts.
The effects of unexpected inflation are more difficult to gauge than those of
expected inflation for the macroeconomy. Losses to some parties are matched by gains
to others. Nonetheless, that redistribution of resources can generate costs. For example, amounts that businesses or households spend on forecasting inflation to protect
themselves against unfavorable redistributions represent a cost of unexpected inflation.
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663
C H E C K P O I N T
Consider the actions of four people: Ms. A borrowed money at a fixed nominal
interest rate; Mr. B lent money at a fixed nominal interest rate; Ms. C borrowed
money at a variable interest rate (indexed for inflation); and Mr. D lent money at
a variable interest rate. If inflation rises, who loses the most in real terms? Who
gains the most? Lenders and borrowers incorporate expected inflation into the
agreed-upon interest rate. When the interest rate is fixed, additional (unexpected)
inflation redistributes purchasing power from lenders to borrowers: Mr. B loses the
most, and Ms. A gains the most. ♦
Inflation Uncertainty
Uncertainty about the rate of inflation causes the most serious cost of inflation: distortion of information provided by prices. In a market economy, households and businesses
view prices of goods and assets as signals for resource allocation. For example, an
increase in the price of beef relative to the price of chicken encourages farmers to produce
more beef and individuals to consume more chicken. An increase in stock market prices
relative to the general level of prices is a signal that businesses’ prospects are good and
that there are opportunities for profitable investment. Relative prices, not individual
prices, provide these signals. When inflation fluctuates significantly, relative prices may
change in response to general price-level changes, distorting the valuable signals provided
by prices. Variations of relative prices because of uncertain inflation cause households
and businesses to waste resources investigating price differences.
An extreme case of uncertain inflation occurs in a hyperinflation, in which the rate
of inflation is hundreds or thousands or more percentage points per year for a significant period of time. The costs of hyperinflation are extremely high. Households and
businesses must minimize currency holdings, and firms must pay employees frequently.
Employees must spend money quickly or convert it to more stable foreign currencies
before prices increase further.
A classic example of hyperinflation occurred in Germany after World War I. A
burst of money creation by the government ignited inflation, increasing the price level
by a factor of more than 10 billion between August 1922 and November 1923.✝ For
example, if a candy bar cost the equivalent of 5 cents in August 1922, this increase in
the price level would have raised its cost to more than $500,000,000 by November
1923. Our analysis of money demand tells us that in such an extreme case, the demand
for real money balances should plummet. In Germany, that proved to be the case: By
October 1923, real money balances had shrunk to only about 3% of their August 1922
value. The German hyperinflation ended suddenly in late 1923, with a strong government commitment to stop the money printing presses. With a significant decline in
growth of the money supply, hyperinflation ended.
Confusing signals from prices are particularly problematic during hyperinflation.
With overall prices rising very rapidly, merchants change prices as often as possible.
✝This
historical German experience is not the outer bound. By 2003, Argentina’s price level had increased
100 trillion times since 1970, Brazil’s a quadrillion times, and the Democratic Republic of the Congo almost
10 quadrillion times.
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Prices therefore quickly fail to indicate value or direct resource allocation. The government’s tax-collecting ability diminishes significantly during hyperinflation. Because tax
bills typically are fixed in nominal terms, households and businesses have a major
incentive to delay their payments to reduce their real tax burdens.
Inflation and Monetary Policy
Although inflation imposes economic costs, governments sometimes pursue inflationary monetary policies to achieve other goals, particularly full employment of the economy’s resources. Low inflation may be desirable, but it may bring hardship in terms of
lost output and jobs when the economy isn’t operating at or near capacity. Angry voters pressure elected officials to do something when recessions idle factories and swell
unemployment. In fact, movements in current output can greatly influence the outcome
of elections, creating a temptation to increase aggregate demand in the short run and
to increase inflation. Ray Fair of Yale University has noted that significant GDP growth
and a falling unemployment rate increased the reelection chances of the incumbent
President and other candidates of the same party.
The Full Employment Act of 1946 and the Humphrey-Hawkins Act of 1978 committed the federal government to promoting full employment and a stable price level.
Particularly during the 1960s and 1970s, U.S. policymakers often pressed for full
employment even at the expense of inflation. Two types of inflationary pressures
resulted: cost-push inflation, which results from workers’ pressure for higher wages,
and demand-pull inflation, which results from policymakers’ attempts to increase
aggregate demand for current output above the full employment level.
Cost-Push Inflation
Cost-push inflationary pressures begin when workers push for higher wages either to
raise their real wages (wages adjusted for changes in purchasing power) or to “catch
up” to current or expected future inflation. As Fig. 28.5 shows, when the economy
starts at full employment at E 0 , an increase in wages raises production costs and the
expected price level, shifting the SR AS curve upward from SRAS0 to SRAS 1. With no
change in monetary policy, short-run equilibrium occurs at the intersection of the AD0
and SRAS1 curves, at E1′ , with a drop in output from Y* to Y ′ (and more unemployment) and a rise in the price level from P0 to P1′ . Without any other government action
over time, wages and prices would fall in response to the slack economy, and the economy’s equilibrium would return to E 0.
However, if policymakers were committed to maintaining the full employment level
of output even in the short run, expansionary policy would follow wage increases. This
effect would be to push the aggregate demand curve to the right from AD0 to AD1, with
the short-run equilibrium at E1 and a higher price level at P1 rather than at P1′. If this
process continues (that is, if workers again push for higher wages and policymakers
increase the money supply), inflation can occur. Hence, if a second wage push shifts the
SRAS curve to the left from SRAS1 to SRAS2 and policymakers’ actions shift the AD
curve from AD1 to AD2, the price level eventually rises from P1 to P2 (which is higher
than P2′ at E2′) although output remains at Y*. At each point, higher wages lead to lost
output and jobs; policymakers then pursue an accommodating policy, stimulating aggregate demand to restore output and jobs but at the cost of greater inflation. A sustained
cost-push inflation is a monetary phenomenon. Without inflationary responses via
CHAPTER 28
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665
Price level, P
FIGURE 28.5
Cost-Push Inflation
If policymakers expand the money
supply to accommodate workers’
demands for higher wages for a
significant period of time, costpush inflation will result.
1. Cost-push inflation can occur
in the short run if workers push
for higher wages so that the
SRAS curve shifts from SRAS 0 to
SRAS 1. In the short run, output
falls from Y* to Y ′.
2. In the long run, cost-push
inflation can occur only if the Fed
pursues an inflationary policy
(shifting the aggregate demand
curve to the right from AD 0 to
AD1) to avoid output and job
losses. These effects occur in
both the new classical and new
Keynesian views.
LRAS
SRAS2
E2
P2
SRAS1
P2'
E2'
AD2
E1
2. Money
supply increases.
P1
AD1
P1'
E1'
E0
1. Wages demands
shift SRAS.
SRAS0
P0
AD0
Y'
Y*
Current output, Y
expansionary monetary policy actions, cost-push inflation could not persist in the
long run.
Demand-Pull Inflation
Another type of inflation results from policymakers’ attempts to keep the economy
operating at a level greater than its long-run full employment level.✝ In this instance,
employment is above the full employment level. Full employment does not mean that
there is 0% unemployment. Even at the full employment level of output, some people
who want jobs might not have them. Unemployment may exist because there is a mismatch between the skills or location of workers and job requirements (structural
unemployment) or because workers who have quit jobs, have been laid off, or are new
to the workforce are searching for suitable jobs (frictional unemployment). The natural rate of unemployment is simply the level that exists when the economy produces the
full employment level of output.✝✝ Let’s see what happens when policymakers try to
reduce the unemployment rate below the natural rate of unemployment for a sustained
period of time.
Suppose, as in Fig. 28.6, that the economy starts at full employment equilibrium,
E 0. To increase output above the full employment level to Y′, policymakers unexpectedly expand the money supply to shift the aggregate demand curve to the right from
AD0 to AD1. As a result, as both the new classical and new Keynesian economists predict, output rises in the short run, and the economy’s equilibrium shifts from E 0 to E1′.
As prices adjust, however, the SRAS curve shifts upward from SRAS0 to SRAS1, and
✝ The
appendix to this chapter extends the analysis to consider a possible policy trade-off between inflation
and the unemployment rate.
✝ ✝ The natural rate can change over time, rising when productivity growth slows and falling when productivity growth increases. See Laurence Ball and N. Gregory Mankiw, “The NAIRV in Theory and Practice,”
Journal of Economic Perspectives 16 (Fall 2002): 115–136.
666
PART 6
Price level, P
FIGURE 28.6
The Financial System and the Macroeconomy
Demand-Pull Inflation
If policymakers attempt to
increase current output above the
full employment level Y* for a
significant period of time,
demand-pull inflation will result.
1. When expansionary monetary
policy shifts the aggregate
demand curve from AD 0 to AD1,
output is temporarily above the
full employment level at Y ′.
2. The higher expected price level
shifts the SRAS curve upward so
that in the long run, only the price
level—and not the output level—is
affected. The longer policymakers
attempt to increase output above the
full employment level (or, equivalently, to reduce the unemployment rate below the natural rate),
the greater the cumulative
inflation.
LRAS
SRAS2
E2
SRAS1
P2
E2' 2. Price
level rises.
SRAS0
E1
P1
E1'
E0
P0
1. Money
supply rises.
AD1
AD0
Y*
AD2
Y'
Current output, Y
output returns to the full employment level, Y*, with the price level increasing from P0
to P1. The new equilibrium occurs at the intersection of the AD1 and SRAS1 curves, at
E1. The expansion of output above the full employment level lasts longer according to
the new Keynesian economists than to new classical economists because the price
adjustment is gradual.
If the process continues, the AD curve shifts to the right from AD1 to AD 2, raising
output to Y ′ in the short run (at E 2′). Over time, the SRAS curve shifts upward from
SRAS1 to SRAS 2, placing the economy at full employment equilibrium E2, with a
higher price level at P 2. Because the long-run aggregate supply curve is vertical, policymakers cannot permanently maintain the unemployment rate below the natural rate
or, equivalently, permanently maintain a level of output greater than the full employment level.
Both cost-push inflation and demand-pull inflation cause sustained increases in
the price level. In cost-push inflation, there are periodic episodes in which unemployment is higher than the natural rate (caused by attempts to keep real wages “too
high”). In demand-pull inflation, there are attempts to keep the unemployment rate
below the natural rate. Recognizing these differences in the real world can nonetheless be difficult. Economists do not agree on how to measure the natural rate of
unemployment. In addition, cost-push inflation can occur as a catch-up response to
demand-pull inflation.
Costs of Reducing Inflation
When policymakers pursue high levels of output and employment growth at the
expense of maintaining a low inflation rate, they may exert an inflationary bias on
monetary policy.✝ Eventually, households, businesses, and policymakers become less
possibility (not considered here) is that the Fed may incorrectly estimate the growth rate of velocity over long periods of time, allowing an inflationary money supply growth.
✝ Another
CHAPTER 28
Inflation: Causes and Consequences
667
willing to bear high inflation than to maintain high levels of output and employment
growth. One such shift in opinion occurred in the late 1970s, when President Carter
appointed Paul Volcker as chairman of the Federal Reserve. What options do policymakers and the Fed have in reducing inflation? In this section, we describe disinflation,
a decline in long-run inflation. The predictions and recommendations of the new classical economists differ from those of the new Keynesians, and we describe each view of
the disinflation process.
New Classical Disinflation: Reducing Inflation
Cold Turkey
A hallmark of the new classical view of the macroeconomy is that wages and prices
adjust quickly to changes in expectations. Hence the new classical recommendation,
illustrated in Fig. 28.7, for reducing the rate of inflation is to lower expectations about
future money growth and inflation cold turkey—that is, all at once.
For example, suppose that because of long-term inflation, the public expects Fed
actions to shift the AD curve from AD0 to AD1. As the expected price level increases,
the short-run aggregate supply curve shifts from SRAS 0 to SRAS1. Hence, with a builtin expected rate of inflation, the economy’s equilibrium moves from E 0 to E1.
Figure 28.7 shows that in cold turkey disinflation, when the Fed announces that it
will reduce the rate of money supply growth to eliminate inflation, the SRAS curve does
not shift from SRAS0 to SRAS 1. Because money supply growth doesn’t continue, the
AD curve shifts back to AD 0. Hence, because the policy shift is expected, the economy’s equilibrium lies at E 0. Wages and prices adjust rapidly in the new classical view,
so inflation falls with little or no loss in output. Accordingly, the costs of cold turkey
disinflation in terms of lost output and jobs are small.
Thomas Sargent of Stanford University has stressed the importance of changing
expectations to reduce inflation while keeping costs low in terms of lost output and
New Classical Suggestion:
Cold Turkey Disinflation
When the public expects inflation,
the economy’s equilibrium moves
from E0 to E1.
1. In a cold turkey disinflation, the
Fed announces that it will reduce
the rate of money growth to eliminate inflation; the AD curve does
not shift from AD 0 to AD 1.
2. The price level adjusts rapidly
to this policy change, so that the
SRAS curve does not shift from
SRAS 0 to SRAS 1. Equilibrium
remains at E 0 , and disinflation
occurs with no loss in output.
Price level, P
FIGURE 28.7
LRAS
2. Monetary authority’s
reduction in rate of
money growth prevents
SRAS from shifting.
SRAS1
SRAS0
E1
P1
1. Public expects
shift by monetary
authority, but
it does not occur.
P0
E0
AD1
AD0
Y*
Current output, Y
668
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The Financial System and the Macroeconomy
jobs.✝ He studied hyperinflation in four European countries during the period between
World War I and World War II, including Germany, which we discussed earlier. Financing rising government budget deficits with money creation ignited rapid inflation. In
each case, announcements of budget reforms and cessation of inflationary increases in
the domestic money supply reduced inflation dramatically. In those cases, output losses
were small, lending support to the new classical view that the costs of disinflation will
be significantly less for expected reductions in money growth than for unexpected
reductions.
New Keynesian Disinflation: Reducing Inflation Gradually
The cold turkey disinflation that the new classical economists recommend works best
for countries that are experiencing hyperinflation because contracts in those economies
tend to be indexed to changes in the price level. But can the gains of cold turkey disinflation be applied to reducing inflation in economies that have moderate inflation rates,
such as the United States, Japan, and the European nations? The new Keynesians do
not think so. They believe that there is always some nominal price stickiness. New Keynesian economists argue that long-term nominal contracts and the costs of changing
prices slow the adjustment of the price level to changes in expectations. Even when
households and businesses have rational expectations, not all prices adjust immediately
to changes in expectations about future inflation.
The new Keynesians propose a different process for disinflation. Let’s reconsider
cold turkey disinflation in the new Keynesian view. Suppose that the economy is at full
employment, with the inflation rate and growth rate of the nominal money supply at
10%. In Fig. 28.8, from initial equilibrium at E 0 , the aggregate demand curve is
expected to shift from AD 0 to AD1 , with the SRAS curve shifting from SRAS0 to
SRAS1. Hence the public expects the new equilibrium to lie at E1 , with output Y* and
a higher price level P1. Now suppose that the Fed decides that the rate of inflation is
Price level, P
FIGURE 28.8
New Keynesian Suggestion:
Gradual Disinflation
With a built-in expected rate of
inflation, the economy’s equilibrium will shift from E0 to E1.
1. In cold turkey disinflation, the
Fed announces that the growth
rate of the nominal money supply
will be reduced to lower inflation;
the AD curve does not shift from
AD 0 to AD 1.
2. The price level falls gradually
in the short run from SRAS 1 to
SRAS 1′.
3. Instead of shifting to E1 , the
economy shifts to E1′ , with a significant output loss. Only gradually will the economy return to full
employment at E 0 with a lower
rate of inflation.
2. Price level
falls gradually.
LRAS
1. Money supply
expected to grow
but monetary authority
does not allow growth.
SRAS1
SRAS 1'
E1
P1
SRAS0
P1'
3. Over time, economy
returns to full
employment with
lower inflation.
E1'
P0
E0
AD0
Y1'
✝ Thomas
Y*
AD1
Current output, Y
J. Sargent, “The Ends of Four Big Inflations,” in R. E. Hall, ed., Inflation: Causes and Effects.
Chicago: University of Chicago Press, 1981.
CHAPTER 28
Inflation: Causes and Consequences
669
too high and announces that it will reduce money growth to zero to reduce the longrun inflation rate to zero. (For simplicity, we assume that long-run rates of output and
velocity growth are zero.) As a result, instead of the aggregate demand curve shifting
to AD1 , consistent with expected money growth of 10% per year, it remains at AD 0.
In the short run, the SRAS curve shifts to SRAS1′ because in the new Keynesian view,
not all prices can change instantly. As a result, at E1′ , output falls to Y1′ . Disinflation
(the price level is P1′ , lower than P1 ) is accompanied by a loss of current output and
jobs. Only over time does the economy return to full employment equilibrium at E 0.
Because of these costs, new Keynesian economists support a policy of gradualism, or
slowly and steadily reducing the rate of growth of the money supply so that the inflation
rate can adjust slowly, with smaller losses of output and jobs. These economists concede
that gradual disinflation is slower than the cold turkey disinflation but maintain that
overall costs to the economy are smaller.
Central Bank Credibility
We have shown that to achieve disinflation at a low cost, the public’s expectation of
the inflation rate must be reduced. This will shift the SRAS curve down so that lower
inflation is not “paid for” by lost output and jobs. However, merely announcing a disinflationary policy might not be enough to change the public’s expectations. An additional, crucial factor is central bank credibility: For households and businesses to
respond to an announced commitment to reducing inflation, the public must believe
that the central bank will, in fact, carry out its disinflationary promises. The public
might not believe the central bank because disinflation entails economic costs—lost
output and jobs—that are likely to be politically unpopular. If the public believes that
policymakers will back off from the stated objective to reduce inflation, inflationary
expectations will change very slowly until the central bank convinces the public of its
credibility.
Strategies for Building Credibility
In this section, we demonstrate why a central bank that follows a credible policy can
pursue a less costly strategy in reducing inflation than can a central bank that does not
back up its inflation-fighting goals. We compare the actions of the Fed and the public
to determine which behavior gives them the greatest possible benefits, and we consider
how the Fed and the public respond to each other’s actions.
We use Fig. 28.9 and assume that the economy is at full employment equilibrium at
E 0, that the growth rate of real output is 0%, and that the nominal money supply and the
price level are both growing at 5% each year. Accordingly, the AD curve shifts from AD0
to AD1 and the SRAS curve shifts from SRAS0 to SRAS1; the public expects the economy’s
equilibrium to be at E1 next year.
The Federal Reserve Board chairman wants a 0% inflation rate but doesn’t want
output to fall. Accordingly, in an interview with The Wall Street Journal, the chairman
offers a bargain to firms, the gist of which is “You business executives don’t like inflation, and the Fed doesn’t either. If you don’t raise prices this year, the Fed won’t increase
the money supply.” This proposition offers some attractive benefits: If neither the nominal money supply, M, nor the price level, P, shifts, the aggregate demand curve won’t
shift. By announcing the proposed agreement in The Wall Street Journal, the Fed hopes
that the short-run aggregate supply curve will not shift either. The economy will remain
670
OTHER
PART 6
TIMES,
The Financial System and the Macroeconomy
OTHER
PLACES
...
Central Bank Credibility in without cost, however. In response to by the central bank to reduce the rate of
the contractionary monetary policy that growth of the nominal money supply will
the United States
was initiated in late 1979, output and reduce inflation. The importance of credand Japan
Since World War II, the U.S. Federal
Reserve System has frequently stated
an anti-inflation policy. During the second half of the 1970s, when inflation
rose steadily, the credibility of the Fed’s
promise to fight inflation eroded. In
October 1979, the Fed announced that
it would focus on targets for the growth
rates of monetary aggregates and that
target ranges would be reduced significantly to reduce inflation.
employment declined and real interest
rates increased. The economy experienced a severe recession in 1981 and
1982.
Because Japan relied wholly on
imported oil, the oil shocks of 1973
and 1974 led to wholesale price inflation of more than 30% by 1974. In
1975, the Bank of Japan (the Japanese central bank) announced that it
would target the growth rate of the
Japanese M2 to reduce inflation. The
The Fed experienced difficulty in achiev- consistency with which the Bank of
ing its targets, owing in part to deregu- Japan fulfilled its promises quickly
lation and the wave of financial bolstered its credibility. The central
innovation in the early 1980s. The Fed’s bank did indeed succeed in reducing
announced intention to combat inflation inflation in the 1980s and did so
indeed succeeded over time. Inflation without large losses in output and
fell from double-digit levels in 1979 to employment.
about 4% per year by 1982 and has
What do these episodes tell us? The
remained relatively low since then. In
experiences of the United States and
part because of the Fed’s lack of crediJapan illustrate that a prolonged effort
bility at that time, disinflation was not
ibility in determining the costs of disinflation is striking. On the one hand, the
U.S. Federal Reserve System, with low
initial credibility and a poor performance
in hitting its announced money growth
targets, achieved disinflation only after a
recession and significant unemployment.
On the other hand, the highly credible
Bank of Japan managed to reduce inflation with little direct output loss. Alan
Blinder of Princeton University found in
a survey of economists and central
bankers that credibility is believed to be
the key factor in a central bank’s success
in achieving its goals.
By the late 1990s and early 2000s, the
Federal Reserve’s anti-inflation credibility gave it flexibility to react to shortterm economic disturbances. The Bank
of Japan lost credibility in its price stability objectives, as it allowed deflation
to persist in Japan.
in equilibrium at E 0, and the Fed and businesses will avoid inflation with no loss of
output.
To obtain cooperation from firms, the Fed chairman adds a threat to the offer: “If
your firms increase prices anyway, the Fed will stick by its promise of no money supply growth.” That would be unattractive to the public. If the nominal money supply
didn’t increase but prices did, the economy would come to equilibrium at E2, making
everyone worse off. Inflation would result, firms would lose output and profits, and
workers would lose jobs. The public doesn’t like inflation, and firms don’t like output
losses. Although the Fed’s anti-inflation stance is clear, political pressures may be
exerted on the Fed if its actions are perceived to have caused a recession.
Let’s examine the payoffs for the economy from alternative actions of the Fed and
firms. For simplicity, each side has two strategies: Firms can raise prices or not raise
prices; the Fed can increase the nominal money supply or not increase the nominal money
supply. Figure 28.10(a) represents the payoffs for the economy in each case (the equilibrium points refer to those in Fig. 28.9). The top left square represents the initial situation,
with the economy at full employment and the nominal money supply and the price level
expected to grow at a rate of 5% per year. If the Fed and firms accept the bargain not to
raise the money supply and prices (bottom right square), the economy remains at full
employment and inflation falls to zero. If firms increase prices and the Fed follows
through on its threat to leave the nominal money supply unchanged (bottom left square),
inflation (though less than 5%) results, but the economy enters a recession. If firms keep
FIGURE 28.9
Strategies for Changing the
Economy’s Equilibrium
From initial full employment equilibrium at E0 , the public expects
that money supply growth and the
resulting increase in inflation will
lead to a new equilibrium at E1. If
the Fed agrees to hold the nominal money supply constant and
firms agree not to raise prices, the
economy can remain at E0 , with
full employment and no additional
inflation. If the Fed doesn’t
increase the money supply but
firms raise prices, output falls, as
at E2. If the Fed unexpectedly
increases the nominal money
supply and firms do not raise
prices, output rises, as at E3.
Inflation: Causes and Consequences
Price level, P
CHAPTER 28
671
Public’s expectation
of inflation
SRAS1
SRAS0
E1
E2
Fed increases
money supply,
firms do not
raise prices
E3
E0
AD1
Fed does not
increase money
supply, firms
raise prices
Fed holds money
supply constant,
firms don’t raise
prices
Y*
AD0
Current output, Y
their promise not to raise prices but the Fed increases the money supply anyway (top right
square), short-term expansion results.
These four outcomes are the potential payoffs for the economy, but recall our
assumption that the Fed and firms pursue the strategy that will give each the greatest
payoff. Therefore we must consider the payoffs presented in Fig. 28.10(b). The top left
square represents the status quo at which current output is at full employment.
Let’s first consider the Fed’s view, as indicated in the left-hand portion of each
square. Because the Fed dislikes inflation, it wants firms to keep their promise not to
raise prices; the “Don’t raise prices” squares at the top and bottom right represent an
improvement over the status quo from the Fed’s perspective. Both result in full or
greater than full employment and inflation that is lower than 5%. If political pressures
associated with rising unemployment prevail, the top right-hand square (short-term
expansion) is a good outcome from the Fed’s point of view; the bottom left-hand square
(a recession) is a situation to be avoided.
Now let’s consider firms’ decisions. Suppose that they believe that the Fed is more
likely to favor a strategy to minimize the chance of a recession (even though it says that
it is firmly committed to reducing inflation). In this case, firms believe that the Fed will
increase the money supply. Firms then will raise prices (their best move for the Fed’s
expected action). As Fig. 28.10(a) shows, the result is an inflationary equilibrium.
To achieve disinflation without the costs depicted in the lower right-hand corner,
the Fed’s promise must be credible. If firms believe that the Fed will not increase the
money supply, they will not raise prices. Central bank credibility is essential to achieving disinflation at low cost to the economy.
New classical economists believe that cold turkey disinflation not only works, but
enhances the central bank’s credibility. When the public observes that money growth
has been sharply reduced, inflationary expectations fall quickly. However, new Keynesian economists question the credibility of the cold turkey disinflation in the real world.
Whereas a cold turkey reduction in money growth will make headlines, it also will
reduce output and employment substantially in the short run. As a result, political
672
PART 6
FIGURE 28.10
The Financial System and the Macroeconomy
Payoffs from Alternative Actions
(The equilibrium points refer to those in Fig. 28.9.)
a. The Fed and firms would like the economy to achieve equilibrium at E0.
b. Payoffs for the economy are the greatest at E0. Economic equilibrium can remain at E0 (the status quo) if firms believe that the Fed’s concern with unemployment is much greater than its concern with inflation.
Firms
Firms
Raise prices
Don’t raise prices
Y = Y * (E1)
Y > Y * (E3)
Raise prices
Don’t raise prices
E1
E3
Fed
Firms
Fed
Firms
Status
Status
Better than Worse than
quo
quo
status quo status quo
Increase the
Increase the
money supply
money supply
Inflation = 5%
Inflation < 5%
Fed
Fed
E2
Y < Y * (E2)
Y = Y * (E0)
Fed
Don’t
Don’t
increase the
increase the
money supply
money supply
Inflation < 5%
Inflation = 0%
(a) Payoffs for the Economy
E0
Firms
Fed
Firms
Worse than Worse than Better than Better than
status quo status quo status quo status quo
(b) Payoffs to Players
objections could force the central bank to back off. New Keynesian economists stress
that a gradualist policy, by being more feasible politically, may be a more credible way
to reduce inflation than the cold turkey reduction.
Appointing a “tough” central banker, then, is likely to increase the public’s willingness to believe anti-inflation statements by the central bank.✝ A tough central banker
openly dislikes inflation and is believed to be willing to tolerate higher unemployment if
necessary to bring inflation down. An example is Paul Volcker, who was appointed by
President Jimmy Carter in 1979. President Carter wanted to convince the public about
his anti-inflation resolve by appointing Volcker. While the Volcker Fed’s policies indeed
reduced inflation, the economy experienced significant losses in output and employment. Hence his appointment alone did not completely relieve credibility suspicions.
Rules versus Discretion
Many economists and policymakers believe that the key to central bank credibility is
the adoption of and adherence to rules. A rules strategy for monetary policy suggests
that the central bank follow specific and publicly announced guidelines for policy.
When the central bank chooses a rule, this strategy requires that it follow the rule,
whatever the state of the economy. One example of a monetary policy rule is a commitment by the Fed to expand the monetary base by 5% each year, regardless of disturbances in money and financial markets or the economy. The main criterion for
formulating rules, advocates suggest, is that rules should apply to variables that are
✝ The idea that a tough central banker may enhance central bank credibility was put forth by Kenneth
Rogoff, “The Optimal Degree of Commitment to an Intermediate Monetary Target,” Quarterly Journal of
Economics 99:1169–1189, November 1985.
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CONSIDER
THIS
Inflation: Causes and Consequences
673
...
changes such as those caused by German reunification in the early 1990s.
In 1999, analysts awaited news of
Achieving credibility in the conduct of whether the new European Central
monetary policy brings benefits in Bank would achieve the same crediterms of future flexibility. Once a cen- bility as the Bundesbank in pursuing
tral bank establishes a credible repu- low inflation.
tation for carrying out its promises,
inflexible rules may no longer be A case in which a central bank’s lack
required. The successful track record of credibility led to economic probof the Bundesbank, the German cen- lems is the Reserve Bank of New
tral bank, in fighting inflation con- Zealand’s announcement in 1989 of a
vinced participants in international policy to reduce inflation nearly to
financial markets that price stability is zero by 1993. To provide an incentive
the Bundesbank’s dominant goal. This for success, the salary of the governor
credibility has given the bank some of the central bank was actually tied
flexibility in responding to short-term to the central bank’s success in reduc-
Can Credibility Enhance
Central Bank Flexibility?
ing inflation. However, the Reserve
Bank of New Zealand lacked credibility because of its past behavior.
Although the central bank exceeded
its targets in 1991 and 1992 in bringing down inflation, the early lack of
credibility gave the central bank little
room to react to the decline in economic activity that began in 1990. In
fact, the Reserve Bank had to pursue
a contractionary monetary policy
(worsening the recession) to convince
the public of its commitment to lower
inflation. Many economists argue that
an inflation target per se is not a good
substitute for central bank flexibility.
significantly controllable by the Fed. An instruction to “maintain the growth rate of
real GDP at 4%” is not a useful rule because the Fed has no direct control over GDP.
Economists and policymakers who oppose the rules approach support a discretion
strategy for monetary policy, which means that the central bank should adjust monetary policy as it sees fit to achieve goals for economic growth, inflation, and other economic and financial variables. This approach differs from the rules strategy in that it
allows the Fed to change its policy to adjust to changes in the economy.
Proponents of the rules strategy argue that the central bank must commit to rules
that limit its ability to adjust monetary policy to achieve short-term objectives. However, inflexible rules may be needlessly rigid and have unforeseen consequences. For
example, if a rule specifying a constant rate of growth of M1 had been in effect in the
early 1980s (when deregulation and financial innovation increased the demand for
money), monetary policy would have led to more contraction than the Fed intended.
Many economists believe that a middle course is desirable. They argue that rules
can allow policymakers to make adjustments in policy as long as those adjustments are
stated as part of the rules. For example, the Fed could decide to maintain the growth
of M2, not at a constant rate but at a rate that would be adjusted in a predetermined
manner for movements in inflation. The problem with this strategy is that it limits a
central bank’s discretion over monetary policy. If rules are not binding and central
banks can modify their policies, the rules will not be successful. The central bank will
be tempted to abandon the announced policy in favor of short-term objectives. Hence
establishing a credible commitment to a rule is more important than stating a precise
form of the rule (such as a specified growth rate for M2).
Even a modified rule isn’t foolproof. The same lack of flexibility that can make a
rule credible can limit the central bank’s ability to respond during a financial crisis.
Both new classical and new Keynesian economists agree that if the central bank avoids
the temptation to intervene regularly to fine-tune the economy, its ability to respond
effectively during a crisis will be enhanced. Most economists believe that the best way
to achieve commitment to rules is to remove political pressures on the central bank.
The idea is that when the central bank is free of political pressures, the public is more
674
PART 6
The Financial System and the Macroeconomy
likely to believe the central bank’s announcements. By the early 2000s, many economists also suggested that the Federal Reserve should be more transparent about its
objectives for inflation.
Price Controls and Credibility
Political constraints may limit the central bank’s willingness to follow a disinflationary
policy, raising an interesting question: Wouldn’t price controls, or official government
restrictions on price changes, stop inflation?
Binding and enforced price controls can reduce increases in the price level but
might not stop inflation, for two reasons. First, the mechanics of demand and supply
tell us that if the price of a product is prevented from rising to equate the quantity
demanded and the quantity supplied, shortages and long lines will develop. Second,
and more important, if the public expects the price controls to be removed sometime
in the future, inflation is suppressed, only to burst forth when controls are lifted. Price
controls combined with a credible disinflationary monetary policy are more likely to
reduce inflationary expectations than are price controls alone.
The U.S. experience with price controls in the early 1970s during the Nixon administration (August 1971–April 1974) bears out this conclusion. The Nixon administration and the Fed (under Chairman Arthur Burns) pursued expansionary policies during
the period in which price controls were in effect. As a result, the controls reduced inflation only during that period. Robert J. Gordon of Northwestern University found that
the burst of inflation between April 1974 and mid-1975 was so great that the price
level was even higher than it probably would have been without the controls.✝
✝ See
Robert J. Gordon, “The Impact of Aggregate Demand on Prices,” Brookings Papers on Economic
Activity, 3:613–685, 1975.
KEY TERMS AND CONCEPTS
Cost-push inflation
Price controls
Appendix
Demand-pull inflation
Hyperinflation
Okun’s law
Discretion strategy
Inflation
Phillips curve
Disinflation
Menu costs
Central bank credibility
Natural rate of unemployment
Expectations-augmented Phillips
curve
Cold turkey
Rules strategy
Simple Phillips curve
Gradualism
Shoe leather costs
SUMMARY
1. Price level changes result from the interaction of shifts
in aggregate demand and aggregate supply. Increases
in the price level can be explained by factors that shift
the AD curve or the SRAS curve. In particular,
increases in the money supply, other increases in
nominal aggregate demand, or supply shocks may
lead to an increase in the price level.
2. Inflation is a sustained rate of increase in the price
level. Inflation is primarily a monetary phenomenon:
In both the new classical and new Keynesian views,
sustained increases in the nominal money supply
cause sustained inflation.
3. Both expected and unexpected inflation have economic
costs. By imposing a tax on money holdings, expected
CHAPTER 28
Inflation: Causes and Consequences
inflation reduces the public’s demand for real money
balances. Costs of expected inflation include shoe
leather costs and distortions to saving and investment
that arise because the U.S. tax system is defined in nominal terms. Unexpected inflation redistributes economic
resources, forcing households and businesses to spend
resources on forecasting inflation. It also distorts the
relative price signals for resource allocation that markets provide.
4. Monetary policy can have an inflationary bias (despite
the costs of inflation) if policymakers perceive that
growth in output and jobs can be achieved with higher
inflation. In the long run, policymakers cannot maintain output above the full employment level without
high and rising inflation.
5. Disinflation is a decrease in the economy’s long-run
rate of inflation. In the new classical view, disinflation
can be achieved with only small losses in output if
money growth is cut drastically and immediately—
675
cold turkey disinflation. New Keynesian economists
argue that prices adjust only gradually in response
even to expected changes in money growth. Accordingly, they suggest a strategy of gradualism for disinflation: By reducing the rate of growth of the money
supply gradually, the price level can adjust slowly,
with smaller losses of output and jobs.
6. Another factor influencing the costs of disinflation is
the credibility of the central bank. If the public
believes that policymakers will not carry through on
their disinflationary promises, inflationary expectations will change very slowly—until the central bank
convinces the public of its credibility. New classical
economists believe that cold turkey disinflation
enhances the central bank’s credibility. New Keynesian economists believe that a gradualist policy is a
more credible way than the cold turkey approach to
reduce inflation.
REVIEW QUESTIONS
QUIZ
1. How does inflation hurt people? Who gets hurt?
2. The president proposes spending an additional $100
billion on a large telescope to look for life in other
galaxies. Opponents of the plan argue that this spending would be inflationary. As a presidential adviser,
what would you tell the president about this argument?
3. What is the principal cause of long-term inflation?
4. According to the new classical approach, what will be
the effect on the economy of an increase in the money
supply that people fully anticipate?
5. What does “inflation is a tax on money balances”
mean?
6. According to the new classical view, what is different
about each short-run aggregate supply curve?
7. Why would you never expect the unemployment rate
to be zero?
8. What are people likely to do (financially) in a hyperinflation?
9. Why did the price level increase by a factor of more
than 10 billion in Germany between August 1922
and November 1923? What happened to the demand
for real money balances? What brought the hyperinflation to an end?
10. How does the tax system distort financial decisions in
its interaction with inflation?
11. According to the new classical view, what actions
should policymakers take to reduce inflation?
12. How might menu costs affect the allocation of
resources in the economy when there is inflation? For
what types of firms might menu costs be important?
13. Why don’t new Keynesians believe in cold turkey disinflation? What do they suggest instead?
14. Why don’t economists find price controls an attractive way to reduce inflation?
15. Evaluate: Inflation isn’t necessarily a monetary phenomenon. Workers can push up wages in cost-push
inflation. Increases in government spending can lead
to demand-pull inflation.
16. Evaluate: An announced monetary contraction can
reduce inflation with no loss in output in the new
classical approach.
17. Why is it important to policymakers that people
believe them when they say that they are going to
reduce the inflation rate?
676
PART 6
MOVING
The Financial System and the Macroeconomy
FROM
THEORY
TO
PRACTICE
THE WALL STREET JOURNAL
...
MAY 7, 2003
Pray for Inflation?
The Federal Reserve left
interest rates unchanged.
But in a profound shift from
half a century of preoccupation with fighting inflation,
the central bank signaled
that it may cut interest rates
later to ward off even the
possibility of deflation.
Over the next few
quarters, the Fed said in a
statement, “the probability
of an unwelcome substantial fall in inflation, though
minor, exceeds that of a
pickup in inflation from its
already low level.” . . .
The central bank kept
its target for the federalfunds rate, charged on
overnight loans between
banks, at 1.25%, as widely
expected.
The Fed’s statement
marks a significant change
in the Fed’s concern about
prices—away from inflation and toward deflation,
or falling prices, which
would weaken economic
growth. Since the end of
World War II, Fed officials’
primary goal has always
been avoiding inflation or
a reining it in since inflation
interferes with the smooth
working of the economy
and undermines confidence
in the government.
Even in the 1950s,
when inflation was gener-
ally lower than it is today,
policy makers worried that
it would shoot up. “When
you become a central
banker you are inoculated
with anti-inflation serum,”
said Carnegie Mellon University economist Allan
Meltzer, who has written a
history of the Fed. Most of
the terms of Fed Chairman
Alan Greenspan and of his
predecessor, Paul Volcker,
were devoted to dragging
the U.S. back to “price stability,” a zone where inflation is imperceptible. . . .
When inflation is close
to zero, an unexpected
shock or prolonged period
b of economic weakness
could push the economy
into outright deflation,
that is, generally declining
prices. Deflation weakens
the Fed’s ability to boost
spending because interest
rates can’t go below zero.
Deflation also makes it
harder for businesses and
individuals to repay debts
because their incomes fall
while their debts are fixed.
Most Fed officials think
deflation is highly unlikely,
but they have been sensitized to its dangers by
Japan’s battle with deflation, which has crippled its
economy and weakened its
banking system. Federal
Reserve Bank of San Francisco President Robert
Parry, for years an antiinflation “hawk,” said last
fall that in part because of
Japan’s experience, his
views had changed and now
he felt “the zero inflation
objective is not desirable for
the U.S. economy.”
Though the Fed has no
explicit inflation target,
officials broadly agree that
measured inflation ought
to be kept above zero to
maintain a buffer against
deflation. Fed governor
Ben Bernanke, an advocate
of adopting an explicit
inflation target, told a German newspaper last week
that a range of about 1%
to 2.5% would be appropriate.
Many officials, including Mr. Greenspan, have
previously said they see no
risk of inflation heading
higher. But yesterday for the
first time the central bank
took the added step of saying that there is a risk, however small, of it going too
low.
Even if the Fed doesn’t
cut rates soon, analysts
said it is unlikely to raise
them for a long time—
probably until well into
next year.
CHAPTER 28
ANALYZING
THE
NEWS
As Alan Greenspan served his fourth
term as chairman of the Federal
Reserve Board in the United States, he
was praised by many economists for
the Fed’s successful battle to reduce
inflation. The Fed has stood vigilant
against increases in expected inflation,
so as to avoid the unpleasant choice
between accommodating inflation on
the one hand and aborting the economy’s expansion on the other.
In 2001, the U.S. economy experienced a recession, and in 2001 and
2002, the Federal Reserve employed
an expansionary policy to combat economic weakness. At the same time, the
central bank’s concerns shifted toward
deflation. Just as an inflationary spiral
is costly for the economy, the Fed
feared that economic costs could be
high if it allowed deflationary expectations to take root.
a Traditional Fed concerns balance
the trade-off between growth
and inflation. Suppose the Fed
believes that the economy is roughly at
full employment. Consider the AD-AS
diagram, in which the economy starts
at a full employment equilibrium at
Price level, P
Inflation: Causes and Consequences
LRAS
677
...
E0 , the intersection of the AD0 , SRAS0 ,
and LRAS curves. Now a boom in
demand shifts the economy’s aggregate demand curve to the right from
AD0 to AD1 , leading to a short-run
increase in output from Y* to Y1′ and
upward pressure on prices. The economy’s long-run equilibrium lies at E1 ,
with output, Y*, and a higher price
level, P1. In that sense, the overheating
economy can be a warning of inflation
to come.
b In contrast to the inflationary spi-
ral described in (a), the Fed
began to worry about a deflationary
spiral in the United States. Favorable
productivity growth trends in the
United States put downward pressure
on the price level. At the same time,
the Fed worried that lingering weakness in aggregate demand as the economy recovered from the 2001
recession would put additional downward pressure on the price level and
inflation. Were deflation to emerge,
balance sheets of household and business borrowers would deteriorate with
rising real debt burdens, further curtailing consumer and business spending. By maintaining modest positive
inflation, Fed officials hoped to balance the costs of inflation with the
potentially severe costs should persistent deflation emerge. Fed officials
began speaking of the central bank’s
interest in price stability as “symmetric”—that is, the central bank would
take steps to combat deflation as well
as inflation.
Once an inflationary spiral has begun,
fairly drastic action by the Fed may be
required to regain credibility with the
public and financial markets. In the
context of the AD-AS diagram, once
the Fed finds itself at E1′ , it may have
to pursue a contractionary monetary
policy that shifts the aggregate
demand curve from AD1 to AD0. If
inflationary expectations lead to the
SRAS curve’s remaining at SRAS1
instead of SRAS0 following the contraction, the economy winds up at E1″ ,
and output, Y1″ , is less than Y*. Only
gradually, as inflation subsides, does
the economy return to the full employ- For further thought . . .
ment equilibrium E0.
Why might the Fed be unwilling to
accommodate incipient inflation even if
the SRAS curve is relatively flat (so
SRAS1
that some short-run gain in output is
possible)?
SRAS
0
E1
2. Inflationary
pressure
P1
E1''
E1'
P0
1. Economy
booms
E0
AD 1
AD 0
Y1''
Y*
Y1'
Current output, Y
Source: Excerpted from Greg Ip, “In a Shift, Fed Signals Concern
Over Deflation,” The Wall Street Journal, May 7, 2003. Copyright
© 2003, Dow Jones. Reprinted by permission.
678
PART 6
The Financial System and the Macroeconomy
ANALYTICAL PROBLEMS
QUIZ
18. In a 1998 publication of the Federal Reserve Bank of
St. Louis, William Dewald argued that M2 velocity had
settled down to a value of about 2. He observed that
the trend growth rate of output had been about 2.5%
and inflation was currently about 1.5%. He concluded: “[I]f M2 growth continues to range from 5 to
7 percent and M2 velocity [stays around 2], the inflation trend would accelerate by 1 to 3 percentage
points. . . . It is such arithmetic that has some economists worried about inflation rising again.” Explain
the author’s arithmetic. Be as specific as possible in
explaining why he believes inflation may accelerate by
1 to 3 percentage points.
19. Some economic historians have argued that one
source of discontent among farmers in the United
States during the late nineteenth century was that
they were debtors at a time of falling prices. Other
economic historians have argued that deflation
should not have been a problem for farmers, because
it went on for several decades. Evaluate these views,
being sure to discuss under what circumstances
debtors are hurt by deflation.
20. Describe what happens in both the short and long run
in the new Keynesian view when the Fed reduces the
money supply unexpectedly.
21. If the Fed wanted to reduce the inflation rate, why
might a coordinated fiscal policy move to reduce the
federal budget deficit help to reduce the costs of disinflation? How would the credibility of such a move
be aided by such coordination between fiscal and
monetary policies?
22. Suppose that the economy initially is in equilibrium
at full employment. Then the government unexpectedly increases income taxes. What are the effects on
output and the price level in the short and long run,
according to the new classical view?
23. Suppose that the economy initially is at a point at
which output exceeds the full employment level of output. In the new Keynesian view, what could the Fed do
to restore equilibrium at the full employment level of
output? (Use the aggregate demand–aggregate supply
diagram.) What would happen in the long run if the
Fed didn’t do anything?
24. Suppose that Ms. A is in the 50% tax bracket. When
inflation is zero, she earns a nominal return (before
taxes) of 4%. Suppose that inflation rises to 10% and
that the nominal return (before taxes) rises to 14%.
What is Ms. A’s after-tax real return when inflation is
zero? When inflation is 10%?
25. In the new classical view, can optimism among consumers be self-fulfilling? Use the aggregate
demand–aggregate supply model to show why or why
not.
26. Suppose that monetary policymakers take actions
that shift the AD curve so that it intersects both the
SRAS curve and the LRAS curve to maintain full
employment. What would happen to the economy if
the true LRAS curve were to the left of where the policymakers perceived it to be?
27. What should money growth be if real output grows
3% per year, velocity grows 2% per year, and the Fed
wants inflation to be 4% per year? What should it be
if the Fed targets zero inflation?
28. Would it be a good idea to pass a law that requires
the Fed to keep money supply growth below 5% each
year? Why or why not?
29. Suppose that the nominal interest rate is 8% and that
expected inflation is 5%. What is the expected real rate
of return? Calculate the actual real rate of return for
each of the following cases, and state whether lenders
or borrowers are better off than they expected to be.
a. Actual inflation is 10%.
b. Actual inflation is 0%.
c. Actual inflation is 5%.
30. The Federal Reserve Board chairman announces a policy
of keeping short-term interest rates low. The financial
press criticizes the policy as inflationary. Why?
31. Is it possible for policymakers to trade off more inflation for higher output in the short run? In the long
run? In your answer, explain the differences in the
new classical and new Keynesian views.
32. At a meeting with his cabinet, the President decides that
the country’s inflation rate of 15% is too high. The central bank is independent of the administration and
announces that it will maintain the rate of money
growth at current levels. The President imposes price
controls, outlawing all increases in wages or prices.
a. Using the new Keynesian view, illustrate the effects
of the price controls on output and the price level.
CHAPTER 28
Inflation: Causes and Consequences
679
(Assume that firms have a maximum capacity for
production; that is, output can’t exceed production
capacity.)
the new classical and new Keynesian views if the Fed
continuously attempted to keep output above its full
employment level.
b. Having kept inflation at bay for two years, the
President hands out “Inflation: Rest in Peace” buttons and removes the controls. Use the aggregate
demand–aggregate supply analysis to illustrate the
effects on the economy. Do these effects necessarily
accompany the removal of price controls? Why or
why not?
35. Suppose that the Fed believes that the new classical
view is correct and tries cold turkey disinflation to
reduce inflation from 10% to 0%. What happens to
the economy (output, unemployment rate, and inflation rate) if, in fact, the new Keynesian view is the
correct one?
33. Suppose that the Fed gets new information suggesting
that the aggregate demand curve has shifted to the left
but that the public doesn’t have this information. Using
the new classical view, what will happen to output and
inflation if the Fed does nothing? What will happen to
the price level if it uses expansionary policy to offset the
shock and stabilize output?
34. Milton Friedman argued in 1968 that there was no
permanent trade-off between unemployment and
inflation. Demonstrate what would happen in both
36. Germany experienced a hyperinflation during the
early 1920s. In early 1971 under the Bretton Woods
system West Germany was committed to maintaining
a fixed exchange rate between the mark and the dollar. Many speculators believed that this exchange rate
left the mark undervalued versus the dollar and they
believed that Germany’s inflation history made it
unlikely that the West German central bank would be
willing to defend the fixed exchange rate indefinitely.
Explain the reasoning of these speculators.
DATA QUESTIONS
37. In the latest Economic Report of the President, look
up data on the consumer price index for the past 11
years. Calculate the inflation rate for the past 10
years from the index levels. Has the inflation rate
been declining or rising? What do you think have
been the major factors causing this movement in the
inflation rate?
38. Look in the latest Economic Report of the President
for data on the percentage change in the consumer
price index and producer price index from December
of any one year to December of the following year,
and compare these two measures of the inflation rate.
Could you use one to predict the other? Why or why
not?
39. The U.S. Department of Labor’s Bureau of Labor Statistics collects information on the U.S. price level
(among other statistics that affect the labor force). At
its data web site (http://www.bls.gov/data/home.htm)
locate the reported inflation rates for all urban consumers (“U.S. All Items”). With the information pro-
vided, construct the average inflation rate for the past
ten years. In terms of purchasing power, how much
more money would you have to be paid to remain
equivalent with a college graduate who graduated ten
years ago and began work with a starting salary of
$30,000? Assume that during this time many firms
decided to implement costly changes in operation in
response to the new concern about terrorism. Explain
how policies like this could have affected the inflation
rate during this time period in terms of the AD-AS
model.
40. The U.S. Department of Labor’s Bureau of Labor Statistics maintains a monthly consumer price index
table from 1913 to the present at ftp://ftp.bls.gov/pub/
special.requests/cpi/cpiai.txt. Basing your answers on
the month of January, how much did the inflation
rate increase in the three-year period following the
end of World War II in 1945? Why do you suppose
this inflation occurred? Explain your answer in terms
of both price controls and credibility.
680
PART 6
The Financial System and the Macroeconomy
APPENDIX
Inflation versus Unemployment: The Phillips Curve
If there are costs to inflation, why is it tolerated? Virtually everyone feels the pinch of
rising prices, so policymakers have reason to worry about inflation: It is a real economic problem, and it angers voters. However, another issue concerns voters: unemployment. Workers fear losing a job and the income that it represents. News stories
sometimes cite the misery index, the sum of the inflation rate and the unemployment
rate, as a measure of economic distress.
Inflation and Unemployment
Why should we think about inflation and unemployment together? In an influential
article, A. W. Phillips analyzed data on British inflation and unemployment rates from
1861 to 1957 and reported a statistical regularity, which quickly was dubbed the
Phillips curve. The unemployment rate tended to be high when the inflation rate was
low, and vice versa.✝ This finding raised a tantalizing possibility: Could a policymaker
choose between inflation and unemployment (depending on the relative social concern
over the two problems), tolerating a higher value of one to obtain a lower value of the
other? Exploiting this trade-off, U.S. economic policy in the 1960s favored a steadily
declining unemployment rate accompanied by a gradually increasing inflation rate.
Events of the 1970s and since fundamentally changed this relationship.
To analyze whether there is a trade-off between inflation and unemployment, we
need to examine the relationships between (1) output changes and the unemployment
rate and (2) price adjustment and output changes. As we consider these relationships,
note that analysis of an inflation-unemployment trade-off follows closely the development of the aggregate demand–aggregate supply model.
Output Changes and the Unemployment Rate
How responsive is the unemployment rate to changes in output? Okun’s law, a statistical relationship between changes in output,Y, and the unemployment rate, u, provides
a widely cited answer.
We begin our explanation of Okun’s law by defining the natural rate of unemployment, u*, as the rate of unemployment that exists when the economy produces the
full employment level of output, Y*. This unemployment rate is not zero. (Recall that
even at the full employment output level, unemployment exists because of structural or
frictional unemployment.) The late Arthur Okun, chairman of the Council of Economic Advisers under President Lyndon Johnson, found that the unemployment rate
increased whenever actual output is less than full employment output, or
Y Y* 2.51u u*2.
Y*
In other words, the gap between actual and full employment output rises by 2.5 percentage points for each percentage-point increase in the unemployment rate. Okun’s
✝ A.
W. Phillips, “The Relationship Between Unemployment and the Rate of Change of Money Wage Rates
in the United Kingdom, 1861–1957,” Economica, 283–299, 1958. Phillips’s study focused specifically on
wage inflation.
CHAPTER 28
Inflation: Causes and Consequences
681
law enables us to discuss changes in the unemployment rate in terms of particular
changes in actual output.✝
We can now trace the potential relationship between unemployment and inflation
depicted in Fig. 28A.1. When the unemployment rate equals the natural rate, actual
output and full employment output are equal. When the unemployment rate is above
the natural rate, actual current output is below full employment output. When the
unemployment rate is below the natural rate (the portion of the Phillips curve above
the line for 0% inflation), actual current output exceeds the full employment level.
In this chapter, we showed that output changes and inflation are connected by the
process of price adjustment. When actual and full employment output are equal, there
is no pressure for inflation to change. When actual output exceeds full employment output, the inflation rate increases; and when actual output is less than the full employment level, the inflation rate declines.
Linking Okun’s law and the process of price adjustment yields a negative relationship between inflation, , and the unemployment rate, u:
p h1u u*2,
(28A.1)
where h 0 indicates the extent to which the inflation rate is associated with the deviation of the actual unemployment rate from the natural rate of unemployment. The
relationship in Eq. (28A.1) is known as the simple Phillips curve, where inflation is positive when u u* and negative when u u*, as plotted in Fig. 28A.1.
The well-defined, negatively sloped simple Phillips curve disappeared in the 1970s.
This result had been anticipated in the late 1960s when various economists stressed the
importance of distinguishing between expected and unexpected inflation in assessing a
trade-off between output and inflation. Whether monetary policy can exploit such a
trade-off between inflation and unemployment rates as is suggested by the simple
Phillips curve depends on whether money supply changes are expected or unexpected.
Nobel Laureate Milton Friedman now of Stanford University and Edmund Phelps of
Columbia University argued that only the portion of inflation that is unexpected (and
not the total rate of inflation) could affect output. The essence of the Friedman–Phelps
argument is that there is no long-run trade-off between output and inflation.
We use the new classical view to determine whether there is a trade-off between
output and expected inflation. (Results from the new Keynesian view are qualitatively
similar.) Suppose that the economy is at full employment (with no growth in output)
but with an ongoing expected rate of inflation and money growth of 5% each year; that
is, the aggregate demand curve shifts upward each year, as Fig. 28A.2 shows.
The long-run aggregate supply curve for any year is represented by the full employment level of output. What about the short-run aggregate supply curve? Because households and businesses expect the money supply growth, they expect the price level to
increase each year. Hence the short-run aggregate supply curve shifts to the left and the
economy’s full employment equilibrium shifts from E 0 to E 1 in any year. Output
doesn’t change, but the price level increases in response to the expected increase in the
money supply.
✝ Okun
actually estimated that each percentage-point increase in the unemployment rate raised the output
gap by 3.0 percentage points, but more recent research suggests that the coefficient is closer to 2.5. See
Arthur M. Okun, “Potential GNP: Its Measurement and Significance,” reprinted in Arthur M. Okun, The
Political Economy of Prosperity. Washington, D.C.: The Brookings Institution, 1970, pp. 132–145.
FIGURE 28.A1
The Simple Phillips Curve
The simple Phillips curve shows
the relationship between unemployment and inflation for a
constant natural rate of unemployment. When the unemployment rate equals the natural rate,
u *, the rate of inflation, ,
equals zero.
PART 6
The Financial System and the Macroeconomy
Inflation rate, 682
Actual output full employment output
(unemployment rate falls and inflation rises)
Actual output full employment output
(unemployment rate natural rate and
inflation is zero)
0
Phillips curve
Actual output full employment
output (unemployment rate
rises and inflation falls)
u*
Unemployment rate, u
Now suppose that the rate of the money supply increases unexpectedly. Instead of
growing at 5% per year, the money supply unexpectedly grows by 10%. Because a 5%
rate of money growth and inflation had been expected, the aggregate demand and shortrun aggregate supply curves should have shifted from AD0 and SRAS0 to AD1 and
SRAS1, respectively. In that case, the price level rises from P0 to P1, and the economy is
in equilibrium at E1. However, because money growth was higher than expected, the
economy’s equilibrium lies at the intersection of SRAS1 (conditional on an expected rate
of inflation of 5%) and AD 2 (representing an increase in money growth of 10%), at
point E 1′ . Output is higher than the full employment level (Y1 Y*), and the price level
rises by more than 5% (at P1′) but less than 10% (at P2) in the short run. In the long
run, as producers realize that the equilibrium aggregate price level is higher, prices rise
and the economy’s equilibrium is characterized by full employment output and a higher
price level (reflecting inflation of 10%), at E 2.
Therefore output increases in response only to unexpected inflation. If we connect
output and the unemployment rate through the relationships of Okun’s law, we obtain
a revised relationship between the inflation and unemployment rates:
p pe h1u u*2,
(28A.2)
where pe is the expected rate of inflation. The fundamental contribution of Friedman and
Phelps yields an expectations-augmented Phillips curve, in which the simple Phillips curve
is combined with expected inflation. If the expected rate of inflation were zero, the expectations-augmented Phillips curve and the simple Phillips curve would be identical. (Since
the work of Friedman and Phelps, a number of economists have modeled price-setting
behavior in more depth to construct a “New Keynesian Phillips Curve.”)✝
✝See, for example, Guillermo A. Calvo, “Staggered Prices in a Utility Maximizing Framework,” Journal of
Monetary Economics 12(1983): 383–398; Jordi Gali and Mark Gertler, “Inflation Dynamics: A Structural
Econometric Analysis,” Journal of Monetary Economics 44(1999): 195–222; and N. Gregory Mankin and
Ricardo Reis, “Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips
Curve,” Quarterly Journal of Economics 117(November 2002): 1295–1328.
FIGURE 28.A2
Expected and Unexpected
Inflation and Output Changes
1. At E0, the economy is at full
employment. The public expects
an inflation rate of 5% because it
expects the Fed to increase the
money supply by 5%, thereby
shifting the AD curve from AD0 to
AD1. The increase in the expected
price level shifts the SRAS curve
from SRAS0 to SRAS1. As a
result, the economy is expected to
achieve equilibrium at E1 , at full
employment but at a higher price
level, P1.
2. With unexpected money
growth, the AD curve shifts to
AD2. The SRAS curve remains at
SRAS1 , as expected inflation was
only 5%. As a result, output
increases in the short run; the
short-run equilibrium lies at E1′ .
3. Over time, the price level
increases so that the long-run
equilibrium lies at E2. The unexpected increases in the money supply and inflation have no effect on
output in the long run.
Inflation: Causes and Consequences
Price level, P
CHAPTER 28
LRAS
SRAS 2
3. Over time, price
level slowly
increases.
P2
P1'
E2
P1
E1
683
SRAS 1
SRAS 0
2. Unexpected inflation,
owing to unexpected
growth in M; π = 10%.
E1'
AD 2π = 10%
P0
E0
AD 1πe = 5%
AD 0
Y*
Y1
1. Expected inflation;
π = πe = 5%.
Current output, Y
For any expected rate of inflation, a Phillips curve (a relationship between inflation
and unemployment rates) exists. However, if expected inflation changes over time, as
it did in the 1970s and 1980s, the simple Phillips curve relationship isn’t stable.
The expectations-augmented Phillips curve suggests an important difference
between short-term and long-term trade-offs between inflation and unemployment
rates. The short-run Phillips curve describes the relationship between the inflation and
unemployment rates, as Fig. 28A.3 shows. The short-run Phillips curve suggests a
trade-off only between the unemployment rate and unexpected inflation.
If expected inflation changes, the short-run Phillips curve shifts. An increase in
expected inflation from p1 to p2 shifts the short-run Phillips curve upward. A decrease
in expected inflation from p1 to p3 shifts the short-run Phillips curve downward. Hence
the point that is raised by Friedman and Phelps is that any observed relationship
between the unemployment rate and the actual inflation rate will change over time as
the expected inflation rate changes. As a result, actual inflation can be high even when
the unemployment rate is higher than the natural rate.
The Long-Run Phillips Curve
Both new classical and new Keynesian economists agree that policymakers cannot
maintain an unemployment rate that is below the natural rate without permanently
maintaining a high rate of inflation. Over time, rational expectations of the inflation
rate will equal the actual rate, on average. That is, expected inflation pe equals actual
inflation p. Hence, for the expressions represented by the expectations-augmented
Phillips curve, u must equal u* in the long run. Then, as Fig. 28A.3 shows, the longrun Phillips curve is vertical.
With a vertical long-run Phillips curve, changes in the nominal money supply cannot
affect output or the unemployment rate in the long run. In other words, money is neutral
in the long run, as we demonstrated in the aggregate demand–aggregate supply analysis.
This proposition is common to both the new classical and new Keynesian models.
684
PART 6
The Financial System and the Macroeconomy
Output, Unemployment,
and Inflation in the
Expectations-Augmented
Phillips Curve
For any expected inflation rate,
the short-run expectationsaugmented Phillips curve slopes
downward. An increase in
expected inflation shifts the shortrun Phillips curve upward. A
decrease in expected inflation
shifts the short-run Phillips curve
downward.
Inflation rate, FIGURE 28.A3
Long-run Phillips curve
Expected
inflation rate rises.
2
Short-run Phillips
curve, e 2
1
Short-run Phillips
curve, e 1
3
Short-run Phillips
curve, e 3
Expected
inflation rate falls.
u*
Unemployment rate, u
Trade-off Exploitation in the Short Run
Both new classical and new Keynesian economists stress that the long-run Phillips curve
is vertical: There is no trade-off between inflation and unemployment rates in the long
run. New classical economists also question whether policymakers can exploit a tradeoff between inflation and unemployment rates even in the short run. In the new classical view, households and businesses have rational expectations. They learn over time
about the behavior of the Fed, the President, and Congress—and they will anticipate
changes in policy in reaction to economic events. As long as the public expects changes
in policy, those changes will have no real effects (on output or the unemployment rate).
Expectations of policy shifts will be correct on average, so unexpected inflation will be
zero on average. Because unexpected inflation cannot be created repeatedly, the Phillips
curve doesn’t offer a short-run trade-off for policymakers in the new classical view.
New Keynesian economists agree that rational expectations on the part of the public limit the short-run trade-off offered by the Phillips curve. However, in the new Keynesian view, the expected inflation is the forecast made at the time sticky prices are set.
If actual inflation exceeds expected inflation, inflationary expectations adjust gradually
in the aggregate. As a result, the unemployment rate can exceed the natural rate for a
period of time. Nevertheless, many new Keynesian economists believe that policymakers should limit their attempts to exploit a short-run trade-off between inflation and
unemployment rates to enhance the long-run credibility of policy.
If the new classical and new Keynesian views do not suggest important reductions in
unemployment from unexpected inflation, why might policymakers be tempted to allow
inflation? One possibility in the new Keynesian view is that exploiting a short-run tradeoff can have political payoffs for policymakers, as we discussed in the chapter.