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World Inflation and Monetary Accommodation in Eight Countries

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World Inflation and Monetary Accommodation in Eight Countries ROBERT J. GORDON Northwestern University World Inlation and Monetary Accommodation in Eight Countries The "monetarist"view of ... the accelerationof inflationsince 1965 [is] that it has been the ultimateconsequence of an increasein the rate of world monetary expansion, an increase attributableprimarily to the excessively expansionary monetary policy pursued by the United States in recent years.-Harry G. Johnson' I find the alternativeexplanation ... which regardsthe basic cause as increased trade-unionmilitancy ... moreplausible.-Nicholas Kaldor2 There is little doubt, then, that the wage-inflationidea does not apply to the inflationaryexperiences we have seen in the real world.... Only when the mac- roeconomic implicationsof the wage-inflationhypothesis are traced through and confronted with the facts does it become apparentthat it cannot be sus- tained.-Arnold C. Harberger3 Note: This research has been supported by the National Science Foundation. I am gratefulto my colleague John Bilson for aiding me in the acquisitionof data from the InternationalMonetary Fund, and to my research assistant James Glassman for an absolutely outstanding job. Also helpful were the suggestions of Victor Argy, Jacques Artus, Jacob Frenkel, Hans Genberg, John Helliwell, Paul Krugman,David Laidler, Michael Parkin, Richard Sweeney, George Zis, and members of the Brook- ings panel. Of special value were a number of discussions with ChristopherSims. 1. Harry G. Johnson, "Inflation: A 'Monetarist' View," in Harry G. Johnson, Further Essays in Monetary Economics (Allen & Unwin, 1972), p. 335. 2. Nicholas Kaldor, "Inflationand Recession in the World Economy," Economic Journal,vol. 86 (December 1976), p. 710. 3. Arnold C. Harberger,"Inflation," in John Van Doren, ed., Symposium on the Emerging World Economy (Great Ideas Today series) (Encyclopaedia Britannica Educational Corporation, 1976), pp. 94-106. 409 410 Brookings Papers on Economic Activity, 2:1977 WHILE"SUPPLY SHOCKS" in oil and food are widely agreed to have ag- gravatedinflation in many countriesin 1973-75, no consensushas yet emergedto explain the accelerationof inflationbetween the mid-1960s and 1970-72 in the majorindustrialized nations outside of North Amer- ica. Instead,two majorschools of thought,the "internationalmonetarist" and the "wage push," have developed alternativeexplanations having radically differentpolicy implications. The first group views inflation within a conventionalmacroeconomic framework as an "international monetaryphenomenon" and identifiesits fundamentalcause as an excess demandfor commoditiesgenerated by governmentactions. Any attempt to bringin other factors, particularlythose of the wage-pushvariety, is dismissed.Adherents of the wage-pushor "sociological"school of thought disagree, pointing to the allegedly spontaneouswage explosions that occurredin a numberof Europeancountries in 1968 and 1970 as evi- dence of the specialnoneconomic character of the recentinflation. Wage claims are viewed as part of a continuingconflict over income shares among competingsocial groups, and the events of the 1968-70 period reflectedlabor's "long-smouldering resentment and dissatisfaction."4 Aims of the Paper The sourcesof inflationin the mainindustrialized nations in the period of fixed exchangerates have not yet been adequatelyestablished. Both the international-monetaristand wage-pusharguments are unsatisfactory and incomplete. The accelerationof wages and pricesin 1969-70 in the majornations outside of the UnitedStates followed a continuingdecelera- tion of their rates of monetarygrowth between 1963 and 1969. For the "world"-the United States plus seven other importantindustrial na- 4. Kaldor, "Inflation and Recession," p. 710. In his more eclectic analysis of wages, George L. Perry considerswage push, closely associated with a dissatisfaction with shares, an important part of the wage explosions of the 1968-70 period, and consequently one of the factors that brought the average rate of wage inflation in the 1970s to a new, higher, plateau. See his "Determinantsof Wage Inflation around the World," BPEA, 2:1975, pp. 403-35. Earlier, William D. Nordhaus had rejected a related explanation labeled "frustrationtheories" in "The Worldwide Wage Ex- plosion,"BPEA, 2:1972, pp. 431-64. RobertJ. Gordon 411 tions5-the 1969-70 accelerationof wage rates preceded by almost a year the 1971 explosionof money and internationalreserves, in apparent conflict with the international-monetaristexplanation. Wage-push pro- ponentshave not made their case either, because autonomouswage in- creasesdo not automaticallypass into the pricelevel. This paperaccepts from the outset the propositionthat world inflation must in the long run be a world monetaryphenomenon. Confirmation of a connectionbetween the rates of growthof world money and prices, as in severalrecent studies, is viewedas only the firststep in the development of a fuller understandingof the inflationprocess, because the sourcesof changes in world money are left unexplained.6A correlationbetween worldprices and money does not rule out wage push as a sourceof world monetarygrowth. Instead of viewing internationalmonetary and wage- push factorsas competitiveexplanations of inflation,a more comprehen- sive theoretical frameworkis presented which incorporatesthese two ingredientsas possible explanationsof the behavior of the monetary authorities,together with fiscal deficits, supply shocks, and a counter- cyclicalmonetary reaction function. Since a time-seriescorrelation between inflation and monetarygrowth is consistentwith several sources of monetarygrowth, a more discrimi- nating empirical methodology is required. An impirical study of the United Statesand seven other majorindustrial nations attempts to deter- mine whetherthe data are consistentwith an effect of any or all of the possible sourcesof monetaryaccommodation. Among the majorquestions to be answeredare the following: If U.S. monetarygrowth is to be blamedfor the accelerationof inflationin other countries,by what channelswas this impulsetransmitted? Did patternsof causationdiffer among countries?Were some countriesbetter able than othersto pursuecountercyclical rather than procyclical monetary policies? Did differencesacross countries in the degreeof accommodationto supply shocks in 1974 correspondwith the degree of accommodationto wage 5. The "Other Seven" countries are Canada, France, West Germany, Italy, Japan, Sweden, and the United Kingdom. 6. See, for instance, David I. Meiselman, "WorldwideInflation: A Monetarist View," in Meiselman and Arthur B. Laffer, eds., The Phenomenon of Worldwide Inflation (American EnterpriseInstitute, 1975), pp. 69-112. See also Hans Genberg and Alexander K. Swoboda, "Causes and Origins of the Current Worldwide Infla- tion," discussion paper (Geneva: Graduate Institute of International Studies, November 1975; processed). 412 Brookings Papers on Economic Activity, 2:1977 push or reserveinflows in the earlierperiod? Do episodesof wage push identifiedby othersappear to have been genuinelyexogenous or were they precededby episodes of monetaryaccommodation? Can the breakdown of the BrettonWoods systembe treatedultimately as anothercasualty of the VietnamWar, or did domesticevents in othercountries play a role? Answersto these questionsare useful not only for an understandingof history, but for future policymaking:Is control of the money supply eithernecessary or sufficientfor a nationto controlits inflationrate? Is it likely that monetaryauthorities will be able in the futureto insulatethe inflationrate from the tendenciesto wage push, or are incomes policies requiredas a cure? Finally,the paperraises a methodologicalquestion of interestto many economistscaught in the middle without any particularallegiance to an international-monetaristor wage-pushview of the world: Can economet- ric techniquesuncover systematic tendencies toward procyclical accom- modationor countercyclicalactivism on the part of centralbanks, or do shiftingtargets and prioritiesdefy statisticalgeneralizations and call in- stead for a moredescriptive and anecdotalapproach to monetaryhistory? International-MonetaristApproach The international-monetaristapproach begins from the proposition that underfixed exchangerates the world inflationrate is determinedpri- marily by previous changes in the rate of growth of the world money supply. This follows from two basic propositionswhich previouslyhad been emphasizedby U.S. monetaristsaddressing issues of a closed econ- omy: the stabilityof the demand-for-moneyfunction, and the lack of any long-run tradeoff between inflation and unemployment.Both of these elements have been tested by international-monetaristeconomists who have estimated structural equations describing the behavior of the demand-for-moneyfunction and the expectationalPhillips curve for the "world"(usually the Group of Ten).7 Further,reduced-form tests have 7. See M. R. Gray, R. Ward, and G. Zis, "The World Demand for Money Func- tion: Some PreliminaryResults," and Nigel Duck and others, "The Determinationof the Rate of Change of Wages and Prices in the Fixed Exchange Rate World Econ- omy, 1956-71," both in Michael Parkin and George Zis, eds., Inflation in the World Economy (Manchester University Press and University of Toronto Press, 1976), pp. 151-78 and 113-43, respectively. RobertJ. Gordon 413 found that changesin the world rate of monetarygrowth have preceded changesin the world inflationrate.8 The behaviorof individualcountries is characterizednot only by stable national
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