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A Lecture Presentation
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to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Copyright © 2002 by Thomson Learning, Inc.
Chapter 25
Issues in Macroeconomic
Theory and Policy
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve

Periods of high unemployment still
occur despite legislation committing the
federal government to the goal of full
employment and the development of
macroeconomic theory purporting to
show that full employment can be
achieved by manipulating aggregate
demand.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve


Similarly, price stability, which had been
achieved for long periods before the
1930s, has not been consistently
observed since that time.
In every year in the lifetimes of most
students enrolled in this course, the
general level of prices has risen.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve


We usually think of inflation as an evil.
But some economists believe that
inflation could actually help eliminate
unemployment in the short run.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve



If output prices rise but money wages
do not go up as quickly or as much, real
wages fall.
At the lower real wage, unemployment
is less because the lower wage makes it
profitable to hire more, now cheaper,
employees than before.
Hence, with increased inflation, one
might expect lower unemployment in
the short run.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve


An inverse relationship between the rate
of unemployment and the changing
level of prices has been observed in
many periods and places in history.
Credit for identifying this relationship
generally goes to British economist A.H.
Phillips

In the late 1950s he published a paper
setting forth what has since been called the
Phillips curve.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve

Phillips, and many others since, have
suggested that



at higher rates of inflation, the rate of
unemployment is lower,
while during periods of relatively or falling
stable prices, there is substantial
unemployment.
The cost of lower unemployment
appears to be greater inflation, and the
cost of greater price stability appears to
be higher unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve


The actual inflation-unemployment
relationship for the United States for the
1960s is shown in the next slide.
U.S. Phillips curve


The curved line is the smooth line that best
“fits” the data points.
It shows an inverse relationship between
the rate of unemployment and the rate of
inflation.

The Phillips curve is steeper at higher rates of
inflation and lower levels of unemployment.
Copyright © 2002 by Thomson Learning, Inc.
The Phillips Curve Relationship,
United States, 1960s
Inflation Rate
(percent per year)
6
69
5
68
4
67
66
3
2
65
1
0
1
Copyright © 2002 by Thomson Learning, Inc.
64 60
63 61
62
2
3
4
5
6
Unemployment Rate
(percent per year)
7
25.1 The Phillips Curve


This suggests that once the economy
has relatively low unemployment rates,
further reductions in the unemployment
rate can occur only by accepting larger
increases in the inflation rate.
Once unemployment is low, it takes
larger and larger doses of inflation to
eliminate a given quantity of
unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve

Presumably, at lower unemployment
rates, an increased part of the economy
is already operating at or near full
capacity, and further fiscal or monetary
stimulus primarily triggers


inflationary pressures in sectors already at
capacity,
while eliminating decreasing amounts of
unemployment in those sectors where
some excess capacity and unemployment
still exist.
Copyright © 2002 by Thomson Learning, Inc.
25.1 The Phillips Curve

The relationship between AS and AD analysis
and the Phillips curve


Increased annual inflation lowering unemployment
is a move up along the Phillips curve.
We can see the same relationship in AD/AS
model, as a result of an AD shift.


Increasing AD, moving up along an upward-sloping,
short-run AS curve, increases the price level and real
output.
To increase real output, firms employ more
workers, so employment increases and
unemployment falls.
Copyright © 2002 by Thomson Learning, Inc.
The Phillips Curve and the AD/AS Curves
AS
B
4
Phillips
curve
3
A
2
Price Level
Inflation Rate
5
B
PL1
PL0
1
0 1
AD1
A
AD0
2
3
4
5
Unemployment Rate
0
RGDP0
(5 percent
unemployment)
RGDP1
(4 percent
unemployment)
RGDP (trillions of dollars)
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

In the 1960s it became widely accepted
that policy makers merely had to decide
on the combination of unemployment
and inflation they wanted from the
Phillips curve and then simply pursue
the appropriate economic policies.
Copyright © 2002 by Thomson Learning, Inc.
The Phillips Curve, United States,
1960–2000
14
PC3 1974–82
80
13
12
79
74
(percent per year)
Inflation Rate
11
81
10
75
9
8
PC2 1983–1993
PC1
7
1960–69;
6 1994-2000
5
4
3
2
1
1
Copyright © 2002 by Thomson Learning, Inc.
78
77
73
70 90
76
69
8971
91
84
68
88
72
87 85
67 00
95 93
92
66
97
99
96 94
65 64 60 86
63
98 62 61
82
83
2 3 4 5 6
7 8 9 10
Unemployment Rate (percent per year)
25.2 The Phillips Curve Over Time


A reduction in the rate of unemployment
came at a cost (more inflation) as did a
reduction in the amount of inflation
(more unemployment).
Nonetheless, policy makers believed
they could influence economic activity in
a manner in which some goal could be
met, though with a trade-off in terms of
other macroeconomic goals.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

At first the empirical evidence on prices
and unemployment fit the Phillips curve
approach so beautifully that it is not
surprising that it was embraced so
rapidly and completely.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

Economists like Milton Friedman and
Edmund Phelps, who questioned the
long-term validity of the Phillips curve,
were largely ignored in the 1960s.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


These economists believed there might
be a short-term trade-off between
unemployment and inflation, but not a
permanent trade-off.
According to Friedman, the short-run
trade-off comes from unanticipated
inflation.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


In the 1970s (and 1980s and 1990s),
economists recognized that
macroeconomic decision making was
not as simple as picking a point on the
Phillips curve.
The data from the 1970s showed the
Phillips curve started to break down.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

From 1970 to 1996, every data point
was to the right of the 1960s Phillips
curve, meaning a worsening trade-off
between inflation and unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


The 1970s experienced more of both
inflation and unemployment than
existed in the 1960s.
However, in the 1980s, the Fed followed
a very tight monetary policy to combat
high inflation rates.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


People altered their expectations of
inflation downward.
In the mid-1990s, when lower inflation
was achieved and expected, the Phillips
curve shifted inward, back to the level of
the 1960s.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time



The long-run Phillips curve shows the
relationship between the inflation rate
and the unemployment rate when the
actual and expected inflation rates are
the same.
The long-run Phillips curve is vertical at
the natural rate of unemployment.
This is equivalent to the vertical longrun AS curve.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


Along the long-run Phillips curve we see
that the natural rate of unemployment
can occur at any rate of inflation.
That is, regardless of fiscal and
monetary stimulus, output and
employment will be at their natural rate
in the long run.
Copyright © 2002 by Thomson Learning, Inc.
The Long-Run Phillips Curve
Inflation Rate
LRPC
B
A
0
Natural Rate
of Employment
Unemployment Rate
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

Starting from the natural rate of
unemployment, suppose that the growth
rate of the money supply increases.


If it is unanticipated, it will stimulate
aggregate demand.
In the short-run, the increase in aggregate
demand will increase output and decrease
unemployment below the natural rate as
the economy moves up along the short-run
Phillips curve, increasing the actual
inflation rate.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


However, over time, people adjust to the
new inflation rate and the short-run Phillips
curve shifts to the right.
If the higher inflation rate continues, the
adjustment of expectations will move the
economy to where the expected and actual
inflation rates are equal at the natural level
of output and the natural rate of
unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


This reveals that there is no trade-off
between the inflation rate and the
unemployment rate in the long run.
The policy implication is that the use of
fiscal or monetary policy to alter real output
from the natural level of real output or
unemployment from the natural rate of
unemployment is ineffective in the long run.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

Say there was a decrease in the rate of
growth in the money supply.


If unanticipated, it would reduce aggregate
demand.
In the short-run, the decrease in aggregate
demand moves the economy down along
the short-run Phillips curve, where the
actual inflation rate has decreased and the
unemployment rate has risen above the
natural rate.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time



The decrease in aggregate demand has
led to lower production and to a fall in
employment.
When people recognize that prices are not
rising as rapidly as before, they adjust their
expectations to reflect that fact, and the
short-run Phillips curve shifts downward.
The inflation rate is now lower and
unemployment and output have returned to
their natural rates.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time

In this scenario, the economy’s road to
lower inflation rates has come at the
expense of higher unemployment in the
short run, until people’s expectations adapt
to the new lower inflation rate in the long
run.
Copyright © 2002 by Thomson Learning, Inc.
The Short-Run and Long-Run Phillips Curve
b. reduction in the growth of
the money supply
a. increase in the growth of
the money supply
6
LRPC
C
B
SRPC´
(High inflation of 6%)
A
3
SRPC
(Low inflation of 3%)
0
3
5
Natural Rate
of Unemployment
Unemployment Rate
Copyright © 2002 by Thomson Learning, Inc.
Inflation Rate
Inflation Rate
LRPC
C
6
3
D
E
SRPC
(High inflation of 6%)
SRPC´ (Low inflation of 3%)
0
5
7
Natural Rate
of Unemployment
Unemployment Rate
25.2 The Phillips Curve Over Time




Changes in the expected inflation rate
can shift the short-run Phillips curve.
So can supply shocks.
An adverse supply shock, such as
higher energy prices, causes a leftward
shift in the SRAS curve, with a higher
price level and lower RGDP stagflation.
But the higher inflation rate and higher
unemployment rate that result shift the
short-run Phillips curve to the right.
Copyright © 2002 by Thomson Learning, Inc.
Adverse Supply Shock
PL1
SRAS0
B
A
PL0
AD
0
Price Level
Price Level
SRAS1
B
A
SRAS1
0
SRAS0
RGDP1 RGDP0
RGDP
Copyright © 2002 by Thomson Learning, Inc.
Unemployment Rate
25.2 The Phillips Curve Over Time

A favorable supply shock, causes a
rightward shift in the SRAS curve with a
lower price level and higher RGDP.


example: lower energy prices
But the lower inflation rate and lower
unemployment rate that result shift the
short-run Phillips curve to the left.
Copyright © 2002 by Thomson Learning, Inc.
Favorable Supply Shock
PL0
SRAS1
A
B
PL1
AD
0
A
Price Level
Price Level
SRAS0
B
SRAS0
SRAS1
0
RGDP0 RGDP1
RGDP
Copyright © 2002 by Thomson Learning, Inc.
Unemployment Rate
25.2 The Phillips Curve Over Time



The impact of adverse or favorable
shocks depend on expectations.
If people expect the changes to be
permanent, then the shifted Phillips
curve will stay in the new position until
something else happens.
If the shock is expected to be
temporary, the Phillips curve will soon
shift back to its original position.
Copyright © 2002 by Thomson Learning, Inc.
25.2 The Phillips Curve Over Time


If economic fluctuations are expected to
be permanent and are caused primarily
by supply-side shifts, then there may be
a positive relationship between the
inflation rate and the unemployment
rate—a shifting Phillips curve.
Higher rates of inflation will be coupled
with higher rates of unemployment and
lower rates of inflation will be coupled
with lower rates of unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Is it possible that people can anticipate
the plans of policy makers and alter
their behavior quickly, to neutralize the
intended impact of government action?

For example, if workers see that the
government is allowing the money supply
to expand rapidly, they may quickly
demand higher money wages in order to
offset the anticipated inflation.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


In the extreme form, if people could
instantly recognize and respond to
government policy changes, it might be
impossible to alter real output or
unemployment levels through policy
actions unless they can surprise
consumers and businesses.
An increasing number of economists
believe that there is at least some truth
to this point of view.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

At a minimum, most economists accept
the notion that real output and the
unemployment rate cannot be altered
with the ease that was earlier believed;
some believe that the unemployment
rate can seldom be influenced by fiscal
and monetary policies.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

The relatively new extension of
economic theory that leads to this rather
pessimistic conclusion regarding
macroeconomic policy’s ability to
achieve our economic goals is called
the theory of rational expectations.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


The notion that expectations or
anticipations of future events are
relevant to economic theory is not new;
for decades economists have
incorporated expectations into models
analyzing many forms of economic
behavior.
Only in the recent past, however, has a
theory evolved that tries to incorporate
expectations as a central factor in the
analysis of the entire economy.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Rational expectation economists believe
that wages and prices are flexible, and
that workers and consumers incorporate
the likely consequences of government
policy changes quickly into their
expectations.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

In addition, rational expectation
economists believe that the economy is
inherently stable after macroeconomic
shocks, and that tinkering with fiscal
and monetary policy cannot have the
desired effect unless consumers and
workers are caught off-guard (and
catching them off-guard gets harder the
more you try to do it).
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


Rational expectations theory suggests
that government economic policies
designed to alter aggregate demand to
meet macroeconomic goals are of very
limited effectiveness.
When policy targets become public, it is
argued, people will alter their own
behavior from what it would otherwise
have been, and, in so doing, they
largely negate the intended impact of
policy changes.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

If government policy seems tilted
towards permitting more inflation in
order to try to reduce unemployment,
people start spending their money faster
than before, become more adamant in
their wage and other input price
demands, and so on.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

In the process of quickly altering their
behavior to reflect the likely
consequences of policy changes, they
make it more difficult (costly) for
government authorities to meet their
macroeconomic objectives.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


Rather than fooling people into
changing real wages, and therefore
unemployment, with inflation
“surprises,” changes in inflation are
quickly reflected into expectations with
little or no effect on unemployment or
real output even in the short run.
As a consequence, policies intended to
reduce unemployment through
stimulating aggregate demand will often
fail to have the intended effect.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Fiscal and monetary policy, according to
this view, will work only if the people are
caught off-guard or fooled by policies so
that they do not modify their behavior in
a way that reduces policy effectiveness.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


In the case of an expansionary
monetary policy, AD will shift to the
right.
As a result of anticipating the
predictable inflationary consequences of
that expansionary policy, the price level
will immediately adjust to a new higher
price level.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Consumers, producers, workers, and
lenders who have anticipated the effects
of the expansionary policy simply built
the higher inflation rates into their
product prices, wages, and interest
rates because they realize that
expansionary monetary policy can
cause inflation if the economy is
working close to capacity.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Consequently, in an effort to protect
themselves from the higher anticipated
inflation, workers ask for higher wages,
suppliers increase input prices, and
producers raise their product prices.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


Because wages, prices, and interest
rates are assumed to be flexible, the
adjustments take place immediately.
This increase in input costs for wages,
interest, and raw materials causes the
aggregate supply curve to also shift up
or leftward.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

So the desired policy effect of greater
real output and reduced unemployment
from a shift in the aggregate demand
curve is offset by an upward or leftward
shift in the aggregate supply curve
caused by an increase in input costs.
Copyright © 2002 by Thomson Learning, Inc.
Rational Expectations and the AD/AS Model
LRAS
AS1
AS0
PL1
AD1
PL0
AD0
0
Copyright © 2002 by Thomson Learning, Inc.
RGDPNR
RGDP
25.3 Rational Expectations



An unanticipated increase in AD as a
result of an expansionary monetary
policy stimulates output and
employment in the short run.
The output is beyond the full
employment level, and so is not
sustainable in the long run.
The price level ends up higher than
workers and other input owners
expected.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

However, when they eventually realize
that the price level has changed, they
will require higher input prices, shifting
SRAS left to a new long-run equilibrium
at full employment and a higher price
level.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

In the short run, the policy expands
output and employment, but only
increases the price level inflation in the
long run.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


A correctly anticipated increase in AD
from expansionary monetary or fiscal
policy will not change real output or
unemployment even in the short run.
The only effect is an immediate change
in the price level.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

The only way that monetary or fiscal
policy can change output in the rational
expectations model is with a surprise—
an unanticipated change.
Copyright © 2002 by Thomson Learning, Inc.
An Expansionary Policy That Is
Unanticipated
Price Level
LRAS
SRAS1
SRAS0
PL2
C
B
PL1
PL0
A
AD1
(Unanticipated)
AD0
RGDPNR RGDP1
RGDP
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


In the rational expectations model,
when people expect a larger increase in
AD than actually results from a policy
change (say, from a smaller increase in
the money supply than expected), it
leads to a higher price level and a lower
level of RGDP—a recession.
A policy designed to increase output
may actually reduce output if prices and
wages are flexible and the expansionary
effect is less than people anticipated.
Copyright © 2002 by Thomson Learning, Inc.
An Actual Expansionary Policy That Is Less
Than the Anticipated Policy
Price Level
LRAS
SRAS1
SRAS0
C
PL2
PL1
B
A
PL0
AD2 (Anticipated)
AD1 (Actual)
AD0
RGDP1 RGDPNR
RGDP
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Rational expectations theory does have
its critics.

Critics want to know if consumers and
producers are completely informed about
the impact that say, an increase in money
supply will have on the economy.

In general, not all citizens will be completely
informed, but key players like corporations,
financial institutions, and labor organizations
may well be informed about the impact of these
policy changes.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations

Are wages and other input prices really
that flexible?

Even if decision makers could anticipate the
eventual effect of policy changes on prices,
prices may still be slow to adapt (e.g., what if
you had just signed a three-year labor or supply
contract when the new policy is implemented?).
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


Many economists reject the extreme
rational expectations model of complete
wage and price flexibility.
Most still believe there is a short-run
trade-off between inflation and
unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.3 Rational Expectations


The reason is that some input prices are
slow to adjust to changes in the price
level.
In the long run, the expected inflation
rate adjusts to changes in the actual
inflation rate at the natural rate of
unemployment.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing


If monetary and fiscal policy are
ineffective or counterproductive, what
policies are left to control inflation?
It is possible that the federal
government could set up a
comprehensive program over wages
and prices—often called incomes policy.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

We have imposed such controls three
times in modern American history,



during World War II,
during the Korean War, and
in 1971 near the end of the Vietnam War.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

Wage and price controls involve either



a complete freeze on wages and prices at
pre-control levels or
some rigid limits as to the increases in
wages and prices that will be permitted.
One or more government agencies are
created to monitor the program.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

Sometimes voluntary guidelines or
guideposts are established to avoid
forcing companies and unions to limit
their price and wage levels.



This approach avoids the expense and
political acrimony associated with
establishing a control bureaucracy.
Sometimes the “jawboning” gets pretty
intense.
Such guidelines can come close to being
mandatory controls.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

There are two justifications given for
wage and price controls.


By limiting price increases by law, the
government directly reduces the rate of
inflation legally allowed.
Especially with respect to wage controls, it
is argued that wage and price controls
lower the inflationary expectations of
workers and their unions, reducing the
“inflation psychology” that contributes to
cost-push inflation.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

Wage and price controls have several
major disadvantages, which are very
likely to be viewed as greater than the
advantages, except possibly during
wartime situations when aggregate
demand is growing very rapidly.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing



There is the problem of enforcing the
controls.
Black markets (illegal sales) often
develop.
These problems are often very hard to
solve.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing


Another, even more fundamental
problem with wage and price controls is
that they lead to shortages of goods,
services, and workers
Inflationary pressures are not
eradicated but rather disguised,
manifesting themselves not in price
increases but in the lack of desired
goods or human resources.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing


Severe and prolonged controls can lead
to a very serious misallocation of
resources, as a result.
Straightforward supply and demand
analysis indicates the misallocation of
resources due to wage and price
controls. At the legal price ceiling, the
quantity demanded exceeds the
quantity supplied and shortages arise.
Copyright © 2002 by Thomson Learning, Inc.
Price of Refrigerators
The Impact of Price Controls
S
P1
PCEILING
P0
PCEILING
Shortage
D0
D1
0
Quantity of Refrigerators
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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Problems with price controls are
illustrated by the 1973 Arab oil boycott,
when the federal government imposed
price ceilings on gasoline that prevented
gas prices from rising as they normally
would have in response to reduced
supply.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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At the ceiling price, quantity demanded
exceeded quantity supplied; gas
stations ran out of gas, were often
closed, or placed a limit on the amount
of gas they would sell.
When drivers were able to buy gas, they
often not only filled their tanks but also
several containers they carried along to
reduce the risk of being unable to buy
gas when they needed it.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

In the former Soviet Union, where pricecontrol-related shortages were
commonplace, citizens typically carried
briefcases or even suitcases and large
quantities of cash, in case they were
able to purchase a normally unavailable
good.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

Rather than just buy the product for
themselves, they would buy several
items for their friends and relatives as
well, to keep them from having to stand
in line for hours, often in vain, trying to
buy it.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

In the case of prolonged wage controls,
shortages of personnel can occur.
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Wages serve as market signals.
Rising wages in an occupation increases
an occupation's attractiveness, leading to
new entrants of workers.
If the government decrees that salaries in
that field could not rise enough, the
increase in the quantity of new workers
supplied will not occur and a shortage will
arise.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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Whether the gains from wage and price
controls in the form of reduced inflation
outweigh the costs in the form of
shortages and inefficient resource
allocation is debatable.
This is a normative issue where honest,
informed people can differ in their
perceptions of costs and benefits.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

An example was the debate over the
removal of price controls on natural gas.
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One side argued that controls should be
removed to end shortages and enhance
long-term supply.
The other side argued that removing
controls would lead to inflated prices for
gas and inflated profits for gas producers,
while causing hardships to lower income
users of gas.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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The attempt to control prices politically
can take another form.
The presence of monopolistic elements
in an industry can lead to higher prices
for that industry’s products than would
be the case for a more competitive
industry.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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By stimulating price competition among
private firms, the government may be
able to help in reducing inflationary
pressures.
However, there has been relatively little
actual use of antitrust laws to try to
reduce inflation pressures. Moreover,
monopoly power can also be artificially
created by government regulations.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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Another approach to some of the
problems posed by inflation is indexing.
Inflation poses substantial equity and
distributional problems only when it is
unanticipated or unexpected.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

One means of protecting parties against
unanticipated price increases is to write
contracts that automatically change
prices of goods or services whenever
the overall price level changes,
effectively rewriting agreements in
terms of dollars of constant purchasing
power.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

By making as many contracts as
possible payable in dollars of constant
purchasing power, those involved can
protect themselves against
unanticipated changes in inflation.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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Indexing seems to eliminate most of the
wealth transfers associated with
unexpected inflation. Why then is it not
more commonly used?
One main argument against indexing is
that it could worsen inflation.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

As prices go up, wages and certain
other contractual obligations would also
automatically increase.
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e.g., rents
This immediate and comprehensive
reaction to price increases will lead to
greater inflationary pressures.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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If inflation gets bad enough, it may
become almost impossible
administratively to maintain the indexing
scheme.
There are other inefficiencies, as well.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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During the German hyperinflation of the
early 1920s, prices at one point rose so
rapidly that workers demanded to be
paid twice a day, at noon and at the end
of work.
During their lunch hour, workers would
rush money home to their wives, who
would then run out and buy real goods
before price increases further eroded
purchasing power.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing

Indexing also reduces the ability for
relative price changes to allocate
resources where they are more
valuable.
Copyright © 2002 by Thomson Learning, Inc.
25.4 Wage and Price Controls and
Indexing
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Not everything can be indexed, so
indexing would cause wealth
redistribution plus the cost of
negotiating cost of living (COLA)
clauses.
Excessive inflation leads to great
inefficiency, as well as a loss of
confidence in the issuer of money,
namely the government.
Copyright © 2002 by Thomson Learning, Inc.