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Transcript
28 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 Web Site Suggestions: http://www.gpoaccess. gov/indicators/ browse.html 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. PART 6 The Financial System and the Macroeconomy 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 CHAPTER 28 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. PART 6 The Financial System and the Macroeconomy 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 660 PART 6 The Financial System and the Macroeconomy 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. 662 PART 6 The Financial System and the Macroeconomy 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. CHAPTER 28 Inflation: Causes and Consequences 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. 664 PART 6 The Financial System and the Macroeconomy 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 Inflation: Causes and Consequences 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 PART 6 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. CHAPTER 28 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 2π = 10% P0 E0 AD 1πe = 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.