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Federal Reserve Bank of San Francisco Economic Review FEDERAL RESERVE BANK OF SAN FRANCISCO ECONOMIC REVIEW CPI WPI M1 M2 M S ALTERNATE STRATEGIES TOWARD INFLATION ,--,............ 197 Michael Bazdarich* Inflation is currently judged to be the Ameri­ push or monopoly-pricing factors. Also, despite can economy's number-one problem by Presi­ mixed evidence, we find some signs of effects of dent Carter, Chairman Volcker, and most other government spending and federal deficits on the prominent government officials, not to mention monetary aggregates. These results suggest that the American public. And reducing inflation, of U.S. fiscal and monetary policies have had a course, is a primary goal of Federal Reserve substantial role in initiating and sustaining infla­ policy. Clearly, then, the development of an tion over the last two decades. effective anti-inflation policy is a crucial issue. In Section III, we discuss the economic costs In order to address this issue, one must first of inflation. Besides increasing uncertainty and analyze the nature of the inflation process itself, redistributing wealth, inflation also causes peo­ as well as the underlying economic causes of ple to shift out of holding money balances into inflation. This is the aim ofthe present paper. We shopping more often, stockpiling goods, and will evaluate the available theoretical and empir­ making speculative investments-all of which ical evidence on the causes and costs of inflation lead to inefficient allocations of resources. Also, as well as on the costs ofanti-inflation policy. We because ofgovernment tax regulations written in will then use the results of this analysis to deter­ terms of nominal amounts, inflation distorts mine which anti-inflation policy has the most private decisionmaking. We conclude, then, that reasonable chance of sustained success. the costs of inflation are indeed significant. To this end, in Section I we employ a simple The rest of our analysis concerns the costs of macroeconomic analysis to present comparable anti-inflation policy and the choice of the best statements of both monetary and cost-push (or policy to achieve that end. In Section IV, we income-share) theories ofinflation. On the basis discuss the output-employment costs of anti­ of that analysis, we conclude that all these inflation policy by considering current evidence theories require an accompanying increase in the on the Phillips curve inflation-unemployment money supply in order for them to provide a tradeoff. The available evidence suggests that consistent account of continuing inflation. It significant amounts of output and unemploy­ follows that the various theories can explain ment would be lost under any anti-inflationary sustained inflation, such as we have experienced, fiscal and monetary policy. Still, it is doubtful only to the extent that they can explain systemat­ that alternative or additional policy actions can ic increases in the money supply. avoid such costs while still slowing inflation. In Section II, we use these points to discuss In Section V we consider the implications of what a meaningful test ofthe competing theories this analysis for the formulation of an effective of inflation should show, and evaluate the empir­ anti-inflation policy. Here we attempt to answer ical evidence on these terms. We see ample three questions facing the policymaker: 1) evidence there of a strong positive effect of the Should inflation in fact be slowed? 2)What monetary aggregates on the price level, but find policy instruments should be used ifwe decide to very little evidence that U.S. monetary policy has slow inflation? and 3) How rapid a reduction in systematically reacted to accommodate cost- inflation should policymakers try to attain? The answer to the first question might seem to *Economist, Federal Reserve Bank of San Francisco be a foregone conclusion, yet it's useful to con- 6 sider the pros and cons formally. We argue that push forces, and partly because such policies the costs of inflation are considerable and recur­ have historically tended to substitute for rather ring, whereas the output costs ofstopping infla­ than complement monetary restraint. tion, while considerable, are temporary, and Finally, with respect to the third question, the would be almost wholly absorbed by the econo­ crucial issue in deciding how quickly to stop my within a three-to-five year period following a inflation is how the costs of stopping inflation sustained effort to reduce the rate of inflation.' can be least painfully imposed. Though political In this light, the costs ofstopping inflation do not forces may push for a "quick fix", the lags from appear to outweigh the costs of inflation itself. monetary policy to inflation make it impossible Also, given the substantial responsibility offiscal to achieve an immediate reduction in the infla­ and monetary policymakers for originally caus­ tion rate. Moreover, attempts to eliminate infla­ inginflation, it can be argued that they should tion quickly would make a deep recession inevi­ direct their efforts toward reducing the inflation table, which would tend to shift political problem today. sentiment from fighting inflation to reducing With respect to the second question, the im­ unemployment, and thus could lead to stimula­ portance ofmonetary factors in initiating and/ or tive policies and another inflationary cycle. This sustaining inflation implies that an effective anti­ strongly suggests that restrictive policies should inflation policy must include a sustained reduc­ be implemented slowly enough to avoid a deep tion in the growth rates of the monetary aggre­ recession, but resolutely enough to have some gates. This is true even if one holds to a strict lasting effect on inflation. That is, policymakers cost-push view of inflation. At the same time, we must avoid expansionary temptations once their argue that tighter fiscal policy and the removal or policies begin to work in slowing inflation. easing of governmental regulatory burdens may Naturally, such a passive policy course could be successfully augment monetary policy by miti­ politically unpopular, and thus hard to maintain. gating its contractionary effects on various sec­ Nevertheless, it may be the only course of action tors of the economy. However, we see no useful that can generate a sustainable reduction in role for incomes policies in our anti-inflation inflation without severely distorting or disrup­ strategy, partly because there is no clear evidence ting the workings of the American economy, that wage and price restraints can mitigate cost- I. Inflation in Macroeconomic Theory For our purposes, theories of inflation can be As stated here, both types of inflation theories divided into two major groupings: monetary provide only partial explanations ofthe inflation theories and cost-push~ormore precisely, what process. Monetary approaches provide a reason­ Charles Schultze has called "income share"~ ably complete description of how the money theories of inflation) Monetary theories cite supply operates through demand and supply to accelerations in the growth ofvarious monetary effect an increase in the price level. However, the aggregates as the primary inciting and sustaining pressures~political or otherwise~which cause factor in inflations. Cost-push or income-share policymakers to allow the money supply to theories, on the other hand, stress the impor­ increase in thefirst place often are notdescribed tance of supply factors, such as autonomous or documented as fully as are the effects of increases in important wages or prices, in gene­ money on prices. On the other hand, income­ rating continuing wage-price spirals. Usually, share theories generally provide descriptions of such autonomous increases are. said to occur the economic and sociological forces leadingto when firms or labor unions exercise their per­ cost-push behavior. However, most of these ceived monopoly power in an attempt to increase discussions do not provide a cogent enough their profits or wage· incomes, respectively.3 analysis ofhow the momentum ofcost-generated Their actions subsequently lead to price and wage-price spirals can continue without severe wage increases throughout the entire economy. disruptions of output and employment. These 7 respective analytical problems are discussed Of course, in the short-run, before prices have further below. adjusted fully, a higher money supply will induce Economists typically define inflation as a higher output and employment, and other real sustained increase in the average price level, and effects. However, these will disappear once the thus in the money price of virtually all goods. economy has adjusted fully to the higher money However, industry-specific phenomena-such supply.6 Furthermore, continuing increases in as bankruptcies, mergers, technological develop­ the money supply will exert continuing upward ment, and changes in consumer tastes or supply pressure on nominal demand, and so can cause conditions-typically change prices in one in­ continuing inflation. dustry relative to another, but do not have much In the days of the gold standard, monetary effect on the price level in general. Rather, such analyses explained secular increases in the sup­ relative price changes serve as signals to the ply of specie (gold)-and thus inflation-largely economy to shift resources among industries­ through expropriations or discoveries of gold and to shift consumption habits among goods­ and silver. In modern economies with fiat mon­ in order to promote economic efficiency. Some ies,
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