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The Effects of External Inflationary Shocks (Brookings Papers On

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The Effects of External Inflationary Shocks (Brookings Papers On JAMES L. PIERCE Staff, Board of Governors of the Federal Reserve System and JARED J. ENZLER Staff, Board of Governors of the Federal Reserve System The Effects of External Inflationary Shocks THE ECONOMYIS ALWAYSVULNERABLE to a variety of external influences or shocksthat have important impacts on income,employment, and prices. Whilethese externalshocks are unforeseeableand unavoidable,economic policy must somehowdeal with theirconsequences. Lately an alarmingnumber of upwardjolts to priceshave come from sourcesbeyond the normalinteraction of production,wages, and prices. Onewas the relativedecline in the valueof the dollarfollowing the abandon- ment of the systemof fixedexchange rates, which raisedthe pricesof im- portedgoods and contributedto the risein farmprices as exportscompeted with domesticconsumption. A numberof otherevents shook the economy at about the same time. Crop failuresin the Soviet Union resultedin a giganticsale of Americangrain. The Peruviananchovy catch mysteriously Note: The views expressedin this paper are our own and do not necessarilyreflect those of the Federal Reserve Board or its staff. We want to thank members of the Brookings panel for their many constructivecomments on an earlier version of this paper. 13 14 Brookings Papers on Economic Activity, 1:1974 dropped,contributing to a worldwideprotein shortage and higherprices for feedstocks.Then floods in the Midwestdestroyed part of the soybean crop, drivingfeedstock prices still higher.Late in 1973,a cartelof oil pro- ducersgot the upperhand over the buyercartel and forcedfuel pricesdras- tically upward.Finally, the dismantlingof domesticprice controls may undo whateverdownward pressures the programhad on the price level. Becausethese inflationarysurges have substantialeffects on real income and on relativeprices, their implications for economicstabilization policy deserveexamination. The consequencesof the recentupward shocks to priceswill be analyzed underthe assumptionthat they are permanent,even though they may be overshadowedby downwarddisturbances from other sources, or evenpartly reversethemselves (anchovies may reappearoff the coast of Peru and soy- bean fieldsmay yield a bumpercrop, for example).This assumptionper- mits analysisof the longer-runconsequences of externaldisturbances that are not quicklyreversed. Table 1 presentsrecent growth rates of selectedprice deflators from the nationalincome accounts. Farm and importprices have risenat a tremen- dous rate; many of these increaseshave found their way into consumer prices,which have risensubstantially relative to the nonfarmbusiness de- flator.The extentto whichmonetary policy has contributedto the current high ratesof inflationis a subjectof considerablecontroversy. We will not enterinto this debate,but ratherwill deal with the impactof externalinfla- Table1. Changesfrom Preceding Quarter in SelectedPrice Deflators, NationalIncome Accounts Basis, 1972 and 1973 Seasonallyadjusted annual rate of change in percent Gross Consumer Nonfarin Yearand national nondurables business, Farm quarter product and services adjusteda business Imports 1972:1 5.7 3.0 5.0 20.6 3.8 2 1.6 2.9 0.8 19.2 15.4 3 2.7 3.2 1.8 28.7 6.7 4 3.3 4.3 2.8 23.2 7.9 1973:1 6.0 6.9 4.3 50.5 12.1 2 7.2 8.7 5.4 75.8 40.9 3 7.0 7.2 5.0 107.4 20.0 4 8.7 10.0 7.1 4.2 35.6 Source: Official data from the U.S. Bureau of Economic Analysis. a. Nonfarm business price deflator adjusted for federal indirect business taxes. James L. Pierce and Jared J. Enzler 15 tionaryshocks to the economy and with the specialproblems that these disturbancespose for monetarypolicy.' An importantissue for monetarypolicy is the type of responsethat is appropriateto externallyinduced surges in inflation.Some observershave arguedthat monetary policy should respond vigorously to theseprice surges, whileothers believe that policy should "accommodate" them, at leastin the shortrun. This paperargues that the conceptof accommodationis a slip- peryone in this context.Furthermore, the effectsof pricedisturbances may dependin part on the source of the shock, and so, therefore,may the appropriateresponse of monetarypolicy. To examinethese matters, we have used a modifiedversion of the MPS (MIT-Penn-SSRC)quarterly econometric model to obtain quantitative estimatesof the effects on individualsectors and on the economy as a whole of imposingdomestic price controls and of a rise in foreign oil prices.The modelhas been adjustedand modifiedin waysdescribed below to make it a more suitabletool for analyzingthe specialproblems under study. The followingsection attempts to assessthe initialimpact of externalin- flationaryshocks on individualsectors of the economyconsidered in isola- tion. The sectorsmost relevantfor the analysisinclude the moneymarket, consumptionexpenditures, and the interactionof wages and prices. The next section reportsa simulationof the full model to study the effectsof these shockson the economyas a whole, and concludeswith a discussion of the possibleimplications for monetarypolicy. InitialImpacts of Shocks In this section, we start with a general,qualitative, discussion of the initial impactsof the shocks on each sector, and then turn to a more de- taileddiscussion of theseimpacts on the relevantsectors of the MPSmodel. A BRIEF OVERVIEW First we considerthe impact that a sharp increasein the price of an importedcommodity-in this case, oil-has on the demandfor money. 1. While fiscal policy can, and probably should, play an important role in com- bating the effects of externalshocks, this paper will deal only with monetarypolicy. 16 BrookingsPapers on EconomicActivity, 1:1974 In keepingwith accepted doctrine, we shallassume that the public'sdemand for money varies directlywith the volume of transactionsand inversely with marketinterest rates.2 But this discussioncalls attentionto the well- known problemsof an appropriatemeasure of transactions. Gross nationalproduct, which is often used as a proxyfor transactions, ignoressuch potential complications as the level of integrationof the econ- omy and the absolutelevels of importsand exports.Thus, for example,if import prices rise relative to other prices, the GNP deflatorwill re- main unchanged.The rise in the prices of consumptionand investment goods containingimports will be offsetby the correspondingrise in prices of imports themselves.Thus, both nominal and real GNP remain un- changed. However,importers and purchasersof final consumptionand investmentgoods will wish to hold largermoney balances at giveninterest rates and nominalGNP to supportthe largervalue of their transactions. Thus, whenimport prices rise, the correspondingrise in transactions-and hence moneydemand-are missedif GNP is used as the measureof trans- actions. If the pricesof exportsrise relative to otherprices, the GNP deflatorand nominalGNP willboth rise.The demandfor moneyshould rise with GNP, but probablyless than when domesticprices rise; domesticpurchasers of finalinvestment and consumptiongoods feel no need to hold largermoney balancesbecause the valueof theirtransactions has not risen. In analyzingthe increasein oil prices,we will use GNP plus importsas our measureof transactionsdemand, and will provide evidence on the importanceof thisarbitrary adjustment. While this measureprobably over- states the impacton transactionsof an increasein pricesof importedoil, it sets an upperlimit to thateffect. Because we do not considerexport prices, no adjustmentsneed be made to the transactionsvariable for this factor. The initialeffects on the monetarysector of an increasein the pricesof importedoil follow from this discussionof transactionsdemand. Assume that the volumeof real transactionsis unchanged,at least initially,by a rise in importprices (or, more realistically,that any initial drop in real transactionsis small relativeto the price increase).The nominalvalue of transactions(GNP plus imports)increases, as just described,augmenting 2. For an excellentdiscussion of money demandfunctions, see StephenM. Goldfeld, "The Demand for Money Revisited," Brookings Papers on Economic Activity (3:1973), pp. 577-638. Hereafterthis documentwill be referredto as BPEA, followed by the date. JamesL. Pierce and JaredJ. Enzler 17 the demandfor moneyat giveninterest rates and GNP. Thus,other things equal, interestrates will rise if the money stock is fixed. The analysisof the initialimpact of the increasein the priceof imported oil on the real volume of consumptionexpenditures is straightforward. Althoughhigher import prices do not raisethe GNP deflatorthey do raise the pricesof consumptiongoods. This rise reduces the realvalue of dispos- able incomeand of householdnet worth,since the nominalvalues of these variablesare unaffected.Thus, initialiythe priceincrease will reducereal consumptionexpenditures. Nominal consumptionexpenditures are likely to rise at firstbecause consumers wili adjustreal purchasesslowly to their reducedreal incomesand net worth.Thus, nominal saving drops initially. The direction,if not the size, of the initial impacton wages and prices also can be anticipated.The surgein importprices wili make the goods that workersbuy moreexpensive, putting pressure on wages,and in turn tend- ing to raisedomestic prices. The pricesof import-competinggoods shouldalso respond.An increase in the worldprice of an internationallytraded commodity like oil would, in the absenceof regulation,probably spur the sameincrease in the domes- tic price.Prices of energysubstitutes, such as coal, shouldrise as demand shiftsfrom oil. Domesticenergy producers
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