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Chapter 8
Causes and
Cures for Inflation
What Causes Inflation?
• In the long run, inflation is a monetary
phenomenon.
• In the short run, changes in inflation are
closely correlated with changes in unit
labor costs, which are wage rates divided
by productivity.
• Expectations play an important role in both
the short and the long run.
Inflation as a Monetary
Phenomenon
• During periods of actual shortages, monetary ease can
cause inflation in the old-style sense of “too much money
chasing too few goods”.
• However, it is more often the case that inflation rates
soar during periods of economic slack. In fact, in many
cases, the growth rate and the inflation rate are
negatively correlated.
• That often occurs because the monetary authorities are
signaling that labor and business can raise wages and
prices without the penalty of losing jobs or sales.
Individual economic agents believe they can improve
their relative position by raising wages or prices, but in
the aggregate, no one benefits.
How Monetary Policy Can Cause
Inflation
• In a typical case, the government runs a large deficit.
• The central bank monetizes the debt by issuing
additional Treasury securities (sometimes known as
“printing money”)
• Private investors do not want to buy these securities, so
the central bank essentially buys them back.
• Capital flees the country, reducing the value of the
currency and increasing import prices.
• Wages rise rapidly to offset the higher cost of imports,
and domestic prices rise because of higher labor costs.
• The situation spirals indefinitely until the government – or
the International Monetary Fund – reverses the process.
Inflation in the Short Run
• Economists used to believe that inflation would
rise as the economy approached full
employment.
• We now know that is no longer the case. The
unemployment rate in the U.S. economy fell to
4% in the late 1990s, yet the inflation rate did not
rise at all.
• However, during the previous 10 business
cycles, inflation invariably rose as the
unemployment rate fell to its full-employment
level.
Which Determinants of Inflation
Changed?
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Change in expectations
Greater credibility of the monetary authorities
Faster productivity growth
More open economy and greater reliance on
foreign trade
Deregulation
Slower growth in fringe benefit costs
Indexed tax rates
However, NOT because people became more or
less greedy.
What About the Deficit?
• There need not be any correlation between the
budget deficit and the rate of inflation.
• If the budget deficit is large, that will not be
inflationary if the additional Treasury securities
issued are sold to private investors (instead of
being repurchased by the government)
• Inflation was much lower during the large deficits
of the 1980s than during the near-surpluses of
the 1970s.
The Role of Expectations
• Expectations affect wages and prices jointly, not
just prices
• If firms expect they will not be able to pass along
cost increases, they will hold the line much more
firmly on wage gains.
• If workers expect that higher wage rates will
result in a permanent decline in jobs, possibly to
foreign locations, they will settle for smaller
increases.
• If labor and business are jointly convinced that
the monetary authorities will not accommodate
higher inflation, they will settle for smaller gains.
Expectations, Slide (2)
• Most important, workers have some expectation
about where the inflation rate is heading in the
future. If they think it is likely to accelerate, they
will be more anxious to get larger gains than if
they think prices will be stable.
• After 1985, the Federal income tax rate tables
have been indexed, so workers are not
automatically pushed into a higher bracket when
inflation rises. As a result, they are willing to
settle for smaller increases, which in turn
reduces the rate of inflation further.
Determinants of Wage Rates,
Slide 1
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Foreign competition
Domestic competition
Level of Minimum Wage
Government Regulation
Strength of Labor Unions
Stance of Federal government toward
labor. In 1981, Reagan’s decision to fire
the striking airline controllers was a major
factor in reducing inflation.
Determinants of Wage Rates,
Slide 2
• Expected rate of inflation
• Marginal tax rates, especially whether the
tax code is indexed
• Value of the currency. If the dollar is
strong and rising, wage gains are
generally smaller than if it is weak and
falling
Determinants of Wage Rates, Slide
3: Type of Compensation
• Prices are usually closely correlated with
unit labor costs calculated from base wage
rates.
• If the base wage rate remains stable but
total compensation rises because of
bonuses, profit-sharing, or stock options,
inflation is much likely to rise than if
compensation rose the same amount
through an increase in the base wage rate.
Factors Determining Unit Labor
Costs
• Productivity (output per employee-hour)
• Private sector fringe benefits, mainly
retirement and health benefits
• Social security taxes
• When the stock market rises rapidly, firms
can contribute less to pension plans,
which reduces unit labor costs and
inflation.
Cyclical Patterns of Productivity
• Until the late 1990s, productivity growth always
declined near business cycle peaks.
• Many factors accounted for that decline,
including the “bottom of the barrel” effect, and
some employees did not work diligently if they
thought they could find alternative employment
quickly.
• However, in the late 1990s, productivity growth
accelerated even as the unemployment rate
declined to 4%.
Why Did Productivity Accelerate in
the late 1990s?
• Economists are still not sure whether this is a
one-time phenomenon, or will be repeated in
future business cycles
• However, it does seem likely that the increased
pressure from foreign competition removed
many of the factors that would ordinarily cause
productivity to slump at full employment.
• That represents another reason why inflation is
likely to remain constant at future business cycle
peaks.
The Role of “Supply Shocks”
• Supply shocks refer to changes in factors
that affect prices other than wage rates.
• They can be either malign or benign.
• The major example of a malign shock has
been the various spikes in energy prices.
• Benign shocks include an increase in the
rate of technological progress, a stronger
currency, or a decline in commodity prices.
Energy Shocks
• The first energy shock, in 1973, had a major impact on
inflation. In recent years, though, similarly large changes
in the price of energy have had much smaller impacts on
the overall inflation rate.
• Consumers and businesses have adjusted to these
shocks, and energy-intensive users now know how to
hedge against major price fluctuations.
• Expectations have changed, and most people think
spikes in energy prices are temporary.
• The “energy coefficient” has been cut in half since 1973.
• Even when energy prices spike, there have been no
actual shortages since the early 1980s.
Currency Shocks
• Sometimes, a major decline in the value of the
currency boosts inflation substantially; other
times, it has no apparent impact.
• If the currency falls below its equilibrium value,
that will generally boost inflation. But if it is far
above equilibrium and then declines back to
normal, the impact will be minimal.
• Increases in the value of the currency have a
significant impact on reducing inflation, but it is
much smaller than the increases that usually
occur when the currency depreciates below its
equilibrium value.
Lags in Wages and Prices
• If unit labor costs change, prices will usually
adjust very quickly.
• However, wage rates usually adjust to changes
in the inflation rate only with a substantial lag.
Most wage rates are adjusted only annually, and
in some cases, union contracts are negotiated
only once every three years.
• As a result, inflation could still be rising even
after the initial factors that caused an increase
have ended.
Causes and Cures of Hyperinflation
• Hyperinflation is generally caused by a
combination of large budget deficits, excessive
growth in monetary and credit aggregates,
purchase of Treasury securities by the
government, and an outflow of foreign capital.
• During periods of hyperinflation, real growth
generally declines and often turns negative.
• Inflation can be stopped almost immediately with
the imposition of a new regime, a return to a
balanced budget, and renewed investor
confidence. It does not take years to wind down
a hyperinflationary spiral.
Factors Currently Affecting Inflation
• Most economists believe that inflation will remain
low and stable in the indefinite future for the
following reasons.
• Monetary credibility has been restored
• Wage gains are being held in check by vigorous
domestic and foreign competition
• Note that the large budget deficits of the early
2000s are not expected to boost inflation at all.
This can be seen by the unusually low rate of
long-term interest rates.