FEDERAL RESERVE OF SAN FRANCISCO ECONOMIC REVIEW

CPI WPI M1 M2 M S

ALTERNATE STRATEGIES TOWARD ,--,...... 197 Michael Bazdarich*

Inflation is currently judged to be the Ameri­ push or -pricing factors. Also, despite can 's number-one problem by Presi­ mixed evidence, we find some signs of effects of dent Carter, Chairman Volcker, and most other 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 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 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 balances into inflation. This is the aim ofthe present paper. We shopping more often, stockpiling , and will evaluate the available theoretical and empir­ making speculative -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 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 inflation- money 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 . Still, it is doubtful only to the extent that they can explain systemat­ that alternative or additional policy actions can ic increases in the . 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 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 *, 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 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 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 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 . However, the aggregates as the primary inciting and sustaining pressures~political or otherwise~which cause factor in . 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 or , 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 -run, before prices have further below. adjusted fully, a higher money supply will induce 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 with fiat mon­ in order to promote economic efficiency. Some ies, the supply ofcurrency and deposits is largely prices will rise and others will fall, but prices on under the government's control, so a complete average need not change at all. Under inflation, monetary theory of inflation must explain why however, the dominant characteristic is an in­ the government would, in effect, chooseto inflict crease in virtually all money prices, with resource inflation on an economy by expanding the mon­ shifts either non-existent or primarily due to ey supply. factors unrelated to the inflation itself. Thus, One obvious explanation is the political press­ there is a fundamental conceptual difference ure to maintain high-employment and output between factors which lead primarily to relative conditions. Since prices and resources are not price changes and those which lead primarily to perfectly flexible in the real world, central absolute price-level changes, or inflation.4 are constantly under pressure to insure that their There is also a distinction between factors domestic money supply grows at least as fast as which cause continuing inflation and those money demand. (Otherwise, there would be which cause only one-time movements in the general downward pressure on prices, which price level. Thus, some factors can have a broad could lead to depressed business conditions ifthe enough impact to raise the general price level economy did not react immediately.) In such a once-and-for-all, but cannot cause continuing case, the money supply inevitably would grow price increases. Therefore, these factors cannot faster than money demand, and thus impart an seriously be considered as causes of sustained inflationary bias to the economy. inflation such as the and other Also, the lags from monetary expansion to countries have experienced. inflation are longer than those from has been linked to increases in the expansion to increases in output. This naturally money supply at least since the writings ofDavid causes conflict between those with short-term Hume some two hundred years ago. 5 The reason time horizons, who are concerned with output is that increases in and deposit holdings and employment here and now, and those with by the public serve to increase demand~andso longer horizons, who are more worried about money prices-for all goods rather than to shift -term problems such as inflation and stable demand from one good to another. Moreover, gro\vth. When short··term problems are especial­ an increase in the money supply serves tojn~ ly pressing, or when those short-run concerns crease nominal demand for goods butdoes not gain superior political force, monetary expan­ change underlying real supply conditions (i.e., sion will accelerate, thus leading to accelerated technology and factor supplies). Such. an in­ inflation later on. crease ultimately affects only prices, without Another oft-cited explanation of inflationary necessarily inducing resource shifts from one monetary expansion is the tendency for higher industry to another. government expenditures to be financed by

8 rather than by higher or All the phenomena discussed in this context sales to the public. The higher spending are primarily sources of relative price change. By therefore leads to faster money-supply growth, themselves, they represent, at most, temporary which then eventually leads to accelerated infla­ or one-time pressures on the price level. The tion. It is important to realize that the same level typical problem for these theories is to explain of government spending would be much less how such one-time, industry-specific factors can inflationary when financed fully by taxes or induce a continuing, general inflation without bond issues to the public. Higher taxes would in disrupting equilibrium levels of output and em­ effect shift demand from the general public to the ployment. government, so that the higher spending could be Consider, for example, an increase in wages in accomplished with a small one-time increase in an industry due to union demands. If all other the price level. Public bond issues would either wages and prices in the economy then increase by shift demand from to the government, like amounts in order to maintain real incomes, or would tend to increase rates in real wealth will decline due to the lower purcha­ markets, in either case mitigating price rises. 7 sing power of and other with fixed However, when money creation govern­ money values. Therefore, demand would be ment spending, this serves to augment rather insufficient to maintain full-employment output, than offset the higher government demand for so that either the price level would fall towards its goods. What's more, the money supply will tend previous level or the economy would go into to continue growing as long as spending remains recession. In other words, if all prices rise, but at a high level, so that a continuing inflation can conditions remain un­ occur. changed, the new set of prices could not be an equilibrium and so could not be sustained. In summary, increases in the monetary aggre­ Thus, for cost-push types ofdisturbances to be gates can be seen to lead to the general type of a source of continuing inflation-but not of price increases which we have defined as infla­ continuing unemployment-there must be an tion. Monetary theories also cite various politi­ accompanying stimulus to aggregate demand, as cal factors which can lead to the initial excessive would be provided by an increasing money monetary expansion. supply. Accommodative monetary policy in such Income-share theories attribute inflation to a situation might occur if policymakers increased the struggles of business firms, labor unions, and the money supply in order to avoid even the other groups to increase their share of the eco­ temporary losses in output and employment nomic pie. Initially, these groups attempt to resulting from inflexible prices and inputs. exploit their perceived monopoly power to raise Equilibrium output levels could then be main­ the prices oftheir goods orservices. When higher tained, because the increased money supply wages raise costs and prices in an industry would serve to increase the equilibrium price and/ or when higher commodity prices raise the level up to the level of actual prices, and thus to costs ofproducing other goods and of maintain­ validate the higher prices. ing living standards, other firms and unions This type of accommodating increase in the attempt to keep pace by raising their own prices, money supply must occur to sustain any inflation which can then cause a wage-price spiral to triggered initially by cost-push influences. An emerge. Various versions of this approach in­ income-share struggle or supply would clude cost-push, wage-push and sellers' inflation provide the initial spark, and the increasing theories, as described in the writings of John money supply would provide the fuel to support Kenneth Galbraith, Abba Lerner, Edward Bern­ the continuing inflation. Though analyses ofthis stein, and others. Similar theories cite shocks to type emphasize various conflicts and shocks, and particular industries-such as the OPEC oil hardly even mention the money supply, an ac­ price hike of 1973 or various crop failures-as commodative monetary policy nevertheless the first causes which raise costs and so generate plays an essential role in sustaining such wage­ continuing inflationary spirals.8 price spirals.

9 The debate between monetary and income­ increases merely symptoms of a general infla­ share theories of inflation can therefore be tionary situation-or are wage and price in­ couched in terms of which is more effective in creases typically autonomous forces, with faster explaining the actual expansion ofthe monetary money growth validating higher prices in order aggregates. That is, does the money supply to prevent business slumps?9 An analysis of the typically increase because of fiscal-and empirical evidence can provide some evidence on monetary-policy decisions, with wage and price this issue.

II. Inflation in Fact Since 1964, consumer-price inflation in the price level has moved inexorably upward United States has averaged 5.75 percent per year, throughout the period, during booms and seri­ and has tended to accelerate, and manufacturing ous , and during and sur­ wage rates have shown much the same behavior pluses for important commodities like food, (Chart 1). Relative price changes have indeed steel, and oil. In other words, we have experi­ occurred over this period, but, as documented in enced a classic inflation, with actual price behav­ Fama and Schwert (1977), they apparently have ior generally characterized by accelerating rates not been systematically related to observed infla­ of increase of all prices rather than by periodic tion. 1O Nor have business slumps and unemploy­ changes in a few dominant commodity prices. ment followed every wave of price increases, or Again, relative price changes and inter-industry worsened as inflation continued. Rather, the shocks have occurred, but have not represented a

Chart 1

Changes in Money Supply and Federal Change (%) 18 17 c- Year· to· year change 16~

15

14

13

12

11

10

9

8

7

10 dominant characteristic of the continuing U.S. the more traditional evidence used to support inflation. income-share inflation hypotheses. Over the last Over this same period, the monetary few decades, several articles have documented a aggregates-'such as M I and Mz -have also relation between various factors (such as wage grown at an accelerating rate (Chart 2), as has increases and changes in industrial concentra­ virtually every nominal variable that one could tion) and inflation rates, both secularly and at name. This concomitant increase in money and various points in the cycle. IZ As Levy (1979) prices is consistent with our argument that the points out, however, all these studies have two money supply must increase for inflation to serious defects: their results are not shown to be continue. What is more impressive is the massive inconsistent with a monetary theory ofinflation, amount of statistical evidence which documents and the phenomena they cite are not shown to be a systematic link between various money-supply sources of autonomous shocks rather than reac­ measures and price levels over a wide range of tions to already existing inflationary forces. In economic experiences. For example, a recent any inflation, as we have seen, all nominal study found that fluctuations in the MI measure variables inevitably rise together. Therefore, were able to explain over 60% of quarterly merely documenting a statistical correlation fluctuations in U.S. consumer prices over lfhe between, say, wages and prices, does not rule out 1959-78 period. 11 Thanks to such results, econo­ the possibility that both are being driven by a mists nearly unanimously acknowledge the im­ third factor, such as the money supply. In the portance of money-supply growth in sustaining jargon of statistics, tests of the cost-push theory inflation. have been of very low power, with little or no As discussed earlier, however, these results do ability to rule out competing hypotheses. not explain what factors lead to the initial mone­ A meaningful way to test between monetary tary expansion, and so do not necessarily rule and income-share theories would be to acknow­ out cost-push-cum-accommodation theories. ledge the long-run monetary nature of inflation, Still, some studies have directly addressed these and then to analyze the factors which cause issues. monetary expansion, and so serve to generate or But first, it may be useful to consider some of perpetuate inflation, as the case may be. If Chart 2

Changes in Manufacturing Wages and Consumer Prices Change (%) 13 Year-to-year change 12

11 10

9

8

7

6 5

4 ~ Consumer prices 3

2

11 income-share or cost-push factors have typically example, a statement that monetary policy react­ been the initial causes of inflation, then there ed to wage pressures, say in 1964, is not testable should be a systematic effect of these factors On at all, since we have only one observation-and monetary policy-and so on the money supply__ that was in fact already used to formulate the if the process is to continue. On the other hand, if hypothesis! Futhermore, even if we could prove ambitious political programs-operating this assertion, it tells us little about what caused through increased government deficits orexpan­ inflation in 1978, or what will cause inflation in sionary monetary policies-have typically been 1981. In other words, a theory must be general the source of money-supply growth and infla­ and have predictive power if it is to have any tion, this link too should be identifiable. practical applicability, and the tests of various These issues have been addressed in independ­ versions of cost-push inflation have revealed ent work by Gordon and Bazdarich, with much little evidence of these qualities. the same results. Gordon (1977) tested for causal As for the effects ofgovernment spending and effects from various cost-push or supply-shock deficits, Gordon (1977) found evidence that variables to the money supply, using data from Vietnam War financing in the U. S. could ex­ seven major industrialized countries over the last plain some of the money-price phenomena in the two decades. Only for the United States did he U.S. and abroad in the late 1960's. Bazdarich find any systematic evidence ofmonetary accom­ (1979) also found evidence of systematic effects modation, and even this evidence was extremely of both government spending and government 13 weak. Over a similar period, Bazdarich tested deficits on M I and M 1 as suggested by Chart 2, for monetary accommodation of wages and although these results had some unsatisfactory prices in the Pacific Basin (1978), and for mone­ features. IS In unrelated attempts to measure tary accommodation of a range of cost-push or money-supply "reaction functions," Barro supply-shock variables in the United States (1976) and others have found effects of fiscal­ (1979). He found no significant evidence that the policy measures and monetary-policy goal vari­ narrow money supply (MI) orthe ables on various money-supply measures. systematically reacted to any of these factors. These studies identify systematic effects trans­ The wider money-supply measure (M1) reacted mitted from various measures of fiscal and systematically only to a few highly cyclical vari­ monetary policy to money-supply growth, and ables, such as steel prices, which may have thence to inflation. Yet on the same terms, they tracked the cyclical nature of M 1 due to disin­ generally fail to find such effects for cost-push termediation and similar effects. For an over­ variables such as wages, unit labor costs, and whelming majority of the variables, the typical various commodity prices. Obviously, result was strong effects from the various mone­ monetary-oriented theories cannot explain every tary aggregates to the "cost-push" measure, but wiggle in money supplies and prices, but over virtually no reverse effects. extended periods oftime-over all phases ofthe In other work on the U.S. economy, Gordon -they appear to have significantly (1978) concluded that only the acceleration of greater explanatory power for inflation than inflation in 1974 could be attributed to non­ cost-push or income-share th·~ories. monetary factors-in this case to food and oil­ Still, the question may arise whether there price shocks. Still, Bazdarich (1979) found that really is a basic distinction between the two even this period could be reasonably well ex­ theories. While income-share theories cite busi­ plained by 1971 ~75 money-supply growth and by ness and labor pressures on the as the 1972-73 removal of wage-price controls. 14 creating expansionary policies, monetary the­ One might argue that the twenty~year data ories cite political pursuit of economic goals as periods used in these studies are too long to pick leading to monetary expansion. Given the simi­ up the possibly temporary effects ofvarious cost­ lar political undertones, does it make much push factors. Yet it is also true that such effects difference which description is most accurate? If lose reliability and applicability if they' do not nothing else, the way in which we have contrast­ hold up over extended periods of time. For ed these theories helps to illuminate the impor- 12 tance of the money supply and monetary policy and the political process in which they operate in the inflation process. Moreover, the evidence have served to generate as well as perpetuate suggests that Congress and the Federal Reserve much ofour recent inflation, which is an import­ have been more than merely passive agents swept ant consideration in our later discussion ofanti­ along on a wave of inflation. These institutions inflation policy.

III. Economic Costs of Inflation Economists are often criticized, and rightly so, cal analyses of inflation. Still, wealth redistribu­ for underestimating the costs of inflation. This tions due to inflation represent returns based on reflects the fact that most of the "costs" of chance rather than effort. These therefore distort inflation recognized by the public either repres­ the public's psychological incentive to prosper ent redistributions of wealth among different from thrift and hard work, rather than from groups, with little cost to society, or arise speculative ventures. Similarly, the "losses" in from popular misconceptions. For example, if purchasing power are real enough to families an increased money supply leads to higher prices, with expectations of future prosperity. These people on fixed nominal incomes, holders of costs are very real to the voting public, and cash, and creditors will lose. On the other hand, cannot be as easily dismissed by policymakers as debtors will gain, as will also the beneficiaries of they are by economists. government activities financed by the money Furthermore, there are very real economic creation. Similarly, if inflation were caused by a costs imposed by inflation, some of which show wage-push-cum-accommodation set of events, up even in theoretical analyses, and some of those negotiating the higher settlement would which are endemic to real-world economies with gain, while creditors and those on fixed incomes laws and contracts written in nominal terms. For would suffer. These direct gains and losses in example, inflation causes individuals; to econo­ wealth due to inflation roughly offset each other, mize on cash holdings, and thus to substitute leading to a redistribution of income, but not more time shopping and bartering for the conve­ necessarily to a decline in national income. nience of using cash or financial instruments. Similarly, the public tends to perceive infla­ The faster that prices rise, the faster money loses tion as causing a decline in living standards as its , and so the more costly it is to hold. This incomes apparently fail to keep up causes individuals to utilize inefficient means of with rising prices. Again, however, real incomes transaction in order to hold as little money as do not typically decline during inflations, and so possible.1 6 These phenomena have been deemed no loss in real purchasing power occurs for the "shoe leather costs of inflation", as the public economy as a whole. Rather, perceived losses spends more time (wearing out shoes) in stores, typically occur because consumers believe. their between stores, or waiting in line, rather than nominal incomes are rising because of their own holding more cash and spadngshopping trips merit, and not because of any general inflation­ farther apart. aryphenomena. Thus, they believetheir $2Q,OQO Similarly, busmesses typicallY attempt to incomes would have accrued to them even if avoid taxes on inflation-expanded profits by prices had not risen, so that they see a 108S in hiring extra accountants and tax consultants to purchasing power compared to what they would devise (say) exotic depreciation or tax-shelter have had with $20,000 incomes but lower prices. schemes. Furthermore, as inflation rises, the This naturally leads them to feel that they have public experiences greater losses from not antic­ been cheated, despite the inconsistencies oftheir ipating it correctly, and thus devotes morere­ underlying reasoning. sources to research and information on inflation Economists often neglect the redistributions prospects and less to the production of tangible of wealth and increased misperceptions that are goods. The growth of T-bill futures, GNMA inherent in any real-world inflation, because futures, and the gold , and the growth of these phenomena are not important in theoreti- various forecasting services, are testimony tothe 13 vigor of attempts to learn abotlt and ods. Gorham's (1979) findings were mixed on the against inflation. These efforts largely stem from relation between commodity prices and infla­ the increased variability of the inflation rate, tion. However, they showed a strong negative more than from an increased level of inflation, effect ofinflation on prices, a.nd no reliable but typically, higher inflation is accompanied by sign of a positive effect of inflation on invest­ a higher variability of inflation as well. 17 These ment. Moreover, a casual look at the numbers phenomena may not lower measuredGNP,bpt suggests that the decade-long acceleration of they reduce living standards by drawing valuable inflation has coincided with slower growth in resources (viz., leisure and financial expertise) to output and productivity. socially less efficient uses. All these costs occur even in simple theoretical How important are these costs? Rose (1979) analyses of inflation, but many more costs of cites estimates that every one-percentage"point inflation occur due to the nominal-value orienta­ rise in the inflation rate costs between $1 to $3 tion of the U.S. legal system. A prominent billion in current dollars per year in extra trans­ example is the progressive income tax, where action costs, or between 0.1 to 0.2 percent ofreal marginal tax rates are calibrated by dollar incre­ GNP per year. Moreover, these costs continue to ments of income. If a worker's salary rises to accrue with continuing inflation. Ifwe discount a "keep up" with inflation, the higher salary pushes permanent flow of such costs at a 2-percent real him into a higher tax bracket, so that a larger rate,IS the present value of the costs of each fraction of his pre-tax income goes to taxes. permanent percentage-point increase in the in­ Thus, he is left with a lower after-tax real income flation rate would approximate $100 billion, or 5 despite the "cost of living" adjustment. Since percent of GNP. These are very rough estimates actual tax rates are not indexed regularly, infla­ of the real costs involved. Still, these costs can tion therefore can reduce after-tax real income clearly be enormous-probably on the same for extended periods of time. Similarly, if the order of magnitude as the temporary losses in nominal value of productive capital rises due to employment and output caused by an anti­ inflation, the nominal rise will be treated as a real inflationary monetary policy. capital gain by the tax system and taxed accor­ Perhaps the most controversial question dingly. Therefore, inflation systematically low­ about the costs of inflation concerns its effect on ers the after-tax real rate of return on capita1,2° . Some economists have con­ Since the government receives these extra tax cluded that inflation speeds growth by reducing revenues, there is no immediate social loss. money holdings and so encouraging and However, the tax system together with inflation . Such results have typically been lowers the effective returns to labor and capital obtained in models where all unconsumed out­ investment-so that this lowers the incentives to put necessarily went to productive investment. work and invest, lowers the supplies oflaborand However, in the real world, when inflation capital to the economy, and so puts a drag onthe causes consumers to decrease cash balances and growth of domestic outpUt. 21 consumption, they often substitute inventories Similar effects can occur because ofdeposit of storeable commodities or precious meta.ls interest-rate ceilings (Regulation Q). When infla­ rather than productive investment. Thus,· the tion pushes up nominal interest rates on other growth process might be unaffected ·oreven investments, interest-rate ceilings ondeposits cut impeded by inflation. 19 off funds for deposit institutions. This serves to The behavior of stock prices and comrnodity restrict financing to sectors, such as housing, prices provide some evidence on this issue. If which depend on a steady flow of funds to higher inflation increas.es thedernand for capita.l deposit institutions. The interaction ofra.te ceil­ investment, we would expect strong prices in ings and inflation thus impedes the efficient periods of accelerating inflation. However,· if functioning of these sectors. higher inflation merely encourages commodity To summarize, even in an ideal econorny with , we would expect weak stockpI"ices full information and perfect flexibility, inflation and volatile commodity prices duringstlch peri- imposes significant costs by discouraging the use 14 of money in financing transactions and other­ resources. These costs, together with the psycho­ wise encouraging socially inefficient use of re­ logical strains caused by inflation, make infla­ sources. In addition, real-world impediments­ tion a very expensive experience for the national such as laws written in nominal terms-combine economy. with inflation to further distort the allocation of

IV. The Inflation-Unemployment -off Numerous and diverse costs are incurred by an Friedman asserted that a fully anticipated economy during inflation. On the other hand, inflation will not cause unemployment to drop the costs of stopping inflation can be charaCter­ below normal levels, so that there is no trade-off ized mainly by the losses in output and employ­ between anticipated inflation and unemploy­ ment which anti-inflation policies are likely to ment, and no sustainable trade-off between impose. These costs can be discussed in terms of actual inflation and unemployment. These in­ the current economic wisdom on the Phillips sights explained not only the Phillips curve curve-the supposed inverse relationship be­ trade-off, but also the deterioration in the trade­ tween unemployment and inflation. off over time. Furthermore, the subsequent Samuelson and Solow (1960) first proposed acceleration in U.S. inflation concurrent with the Phillips curve as an instrument of policy, rising unemployment insured the existence of a partly in the belief that higher rates of inflation receptive audience for his ideas. would allow the economy to achieve permanent Following ten years of research on this reductions in unemployment.22 This belief "natural-rate hypothesis," the economics profes­ stemmed from the then-observed empirical sta­ sion has largely agreed on the importance of bility ofthe Phillips relation, despite the fact that inflation expectations incorrectly specifying the economic theory had never achieved a satisfacto­ Phillips curve relation.23 Economists also widely ry explanation of why such a trade-off should acknowledge that no permanent inflation­ exist. However, once policymakers started to unemployment trade-off exists. The remaining exploit this relationship, its stability began to debate centers on three issues affe~ting the na­ disappear. High inflation rates failed to prevent ture ofthe short-run Phillips trade-off: first, how higher and higher unemployment rates from quickly expectations adjust to new phenomena, occurring. specifically to changes to policy; second, how Friedman (1968) argued that no permanent quickly unemployment returns to its natural rate trade-off actually exists between inflation and once expectations have adjusted; and third, how unemployment. Rather, he asserted that higher much the natural rate varies in response to inflation temporarily leads to higher output and exogenous shocks.24 lower unemployment solely because, during any The first two issues are clearly concerned with inflation, prices initially rise faster than people the extent of short-run gains or losses in output expectthemto. Thiscausesthepublicto confuse and employment that would accrue from a shift the general inflation process with a higher de­ in monetary and fiscal policy. The third issue is mand. and higher relative prices for the·goods also related, since higher (or lower) unemploy­ they produce, so that they respond by increasing ment levels may persist for long periods of time output and hiring moreworkers. Once the public foilowing policy shifts if the unemployment has adjusted to the higher rates ·of inflation, changes represent shifts in the natural rate as unemployment will return to its "natural rate", well. Therefore, estimations ofadjustment lags or perhaps even to a higher natural rate due to which do not allow for shifts in the natural rate the distortions discussed above. At that point, an could conceivably be biased upward. even higher level of inflation will be required to Unfortunately, because expectations cannot again confuse the public and thence reduce un­ be observed directly, we cannot easily distinguish employment. among the three types ofadjustment lags consid-

15 ered here. Most studies merely attetnptto esti.. points. For one thing, his estimates ofthe length mate the lag from changes in prices to changes in of the adjustment period following. policy output or employment. Pigott (1979) and McEl­ changes are longer than those in many monetary hattan (1979), in evaluating these studies, both analyses, although his lags are similar to those conclude that the empirical evidence roughly found in other studies.27 A more vulnerable supports the long-run natural-rate hypothesis conclusion is his argument that incomes policies (i.e., that there is no long-run trade-off between can mitigate the output effects of tighter policy. unemployment and inflation), but they also find Presumably, the wage-price rigidities causing substantial lags from changes ill policy-to Perry's long lags could result from monopolistic changes in inflation. 25 behavior by firms and unions. Yet incomes Pigott, however, also presents a somewhat policies would not directly attack these monopo­ conflicting analysis of recent international expe­ ly powers. For example, a union might exert rience. Germany and 's slow growth during monopoly power by controlling the supply of the 1970's has commonly been attributed to their skilled labor that a manufacturer needs, or by anti-inflationary policies, whereas the U.S.' persuading (contractually) a manufacturer to faster-than-normal growth has been attributed eschew non-union sources. An to a weaker anti-inflation policy. YetPigottfinds might moderate the explicit wage that the union output actually high in the German and Japanese could charge the manufacturer, but it would not economies, when compared to that in the U.K., prevent the union from exploiting its monopoly Sweden, Canada, and Italy, even though these power by demanding a myriad of non·wage other industrialized countries have made little or benefits, including better health and pension no inroads into inflation. In other words, a plans, longer vacations, stricter seniority rules, comparison of Germany and Japan with the etc. These would serve to increase unit labor U. S. alone suggests that large output costs are costs as much as equivalent wage increases, and associated with slowing inflation. However, a so would have much the same effects on output comparison with a number of other industrial­ and employment under an anti-inflation mone­ ized countries leads to a less forthright conclu­ tary policy. sion. Persistent slow growth abroad may have Therefore, justas price controls do not prevent been due to anti-inflation policies, or perhaps queuing and other implicit costs from equilibrat­ more likely, to some common occurrence such as ing , incomes policies need the rising relative price of energy. not prevent firms or unions from exercising their Still, studies involving U. S. data have typical­ monopoly power in other ways. Thus, they may ly found that a contractionary monetary and not help-and may even hurt-the adjustment fiscal policy will reduce output and raise unem­ process to slow inflation.28 Advocates ofincome ployment over a subsequent three-to-five< year policies virtually ignore these issues, but they can period. Perry (1978) concludes that a contrac­ present a damaging argument against the effica­ tionary policy which increased unemployment cy of such policies. by one percentage point will require three years The evidence on balance suggests that a sub­ to shave one percentage point offtheinflation stantial period of slow growth will follow any rate. 26 Perry attributes these long lags torigidi­ serious attempt to slow the rate of inflation. ties in nominal wages and prices, slowness in the Furthermore, it is not clear whether incomes adjustment of expectations, and the existence of policies or the like can shorten this period. While cost-push factors prolonging inflation.• Conse­ the seriousness ofthese output costs varies across quently, he suggests the need for sotnesortof different studies, it would be hopelesslyoptimis­ incomes policies to retard thecost-pushptocess tic to believe that inflation could· be slowed and so ameliorate the output costs of slowing without some temporary losses in production inflation. and jobs. Perry's analysis can be questioned on several

16 V. Stopping Inflation-Odysseus at·the Helm Our conclusions can be used to discuss three the costs and benefits of slowing inflation. Ne­ basic policy issues: I) Should inflation be re­ vertheless, they cast substantial doubt on the duced; 2) what instruments should be used in an argument that inflation is best left alone-that anti-inflation policy; and 3) how quickly should the "cure is worse than the disease." Moreover, we attempt to slow inflation. given our earlierconclusion that Federal govern­ With respect to the desirability of reducing ment and Federal Reserveaetions have been inflation, a rough cost-benefit calculation can be responsible for much of the problem, and given devised. The costs of slowing inflation include the public's increasing distaste for inflation, it the temporary declines in output and employ­ would seem incumbent on policymakers to face ment discussed in Section IV. The benefits in­ up to the task of slowing the price spiral. clude the removal of the recurrent costs of If, then, we conclude that a serious attempt inflation discussed in Section III. should be made to slow inflation, what instru­ Perry's (1978) analysis suggests that one ments should be directed to the task? Our earlier percentage-point higher unemployment for three analysis clearly implied that slower growth in the years would be needed to slow inflation by one monetary aggregates is a necessary part of any percentage point. Even if we assumed that each anti-inflation strategy. This is true whatever unit of labor contributes a constant share to inflation theory one holds, since no type of GNP, these losses in present-value terms amount inflation can continue without a sustaining to less than a 3-percent reduction in GNP to slow monetary expansion. Deregulation of various inflation by one percentage point. Yet the losses industries, liberalization of tax laws, or even from the continuing inefficient allocation of lower government spending financed by lower resources ("shoe leather costs," etc.) due to taxes (leaving money growth unchanged) would inflation were estimated at 5 percent of GNP for allow one-time declines in the pricelevel, but by one percentage point of inflation, in present­ themselves could not permanently overcome value terms. persistent inflation such as the nation has recent­ Consider also the likely sources of error in ly experienced. these calculations. Again, Perry's lags from tight The evidence does not indicate which mone­ policy to lower inflation are longer-and so his tary aggregate the Federal Reserve should focus implied output losses from slowing inflation are on. M i , M2 and the monetary base all display higher-than those in monetary analyses of similar statistical effects on prices. What would inflation. Moreover, it may be incorrect to as­ seem more important is that the Federal Reserve sume that each percentage-point change in un­ concentrate on a particular aggregate of its employment means a constant one percentage­ choice and not switch among aggregates when point effect on GNP. This assumption abstracts they give conflicting signals.30 Otherwise, the from the productive input of capital and other Fed might be tempted to choose whichever factors in GNP, and also ignores the lower aggregate was displaying the most" convenient productivity of marginally employed labor, signal at a given time. which would be the first to become unemployed. Actions to reduce government regulations, to Thus, the output costs of slowing inflation are liberalize (or ) tax laws, to reduce protec­ probably overstated. Itcould be argued in rebut­ tive tarriffs, and other such moves could help tal that the costs of inflation are also overstated. mitigate the. contractionary effects of slower However, our calculations included. only effi­ money growth, and could also provide a quick ciency losses and ignored other costs ofinflation. (albeit temporary) reduction in inflation.Thes.e Also, a 5-percent after-tax real rate ofreturnwas steps thus could serve a useful role in augmenting used to obtain our 2-percent discount rate, which or complementingan anti-inflationary monetary is absurdly high, and so further understates the policy. But since these are supplementary ac­ costs of inflation.29 tions, the basic question about them is whether To be sure, these are very rough estimates of they would be intrinsically good for the econo-

17 my, rather than how much of a temporary before. reduction in inflation they could effect. This apparently is what happened in 1974-76. A more vital supplementary policy. would With inflation at 12 percent in 1974 (see charts), involve lower government spending and deficits. the decline in M2 growth to 7 percent signified As we have seen, federal spending and deficit very restrictive policy. This shift, together with increases historically have apparently helped the oil-price hike, plunged the economy into a stimulate monetary expansion through the deep recession in 1975. But shortly thereafter, monetization of federal debt. A slower money­ following public consternation over high unem­ growth rate unaccompanied by lower deficits ployment, M2 growth began to accelerate would eventually depress the whole economy, again-and it has since been the prime factor in but would initially affect housing and sirnilar causing the currently high rate of U.S. inflation. sectors most heavily because oftheir vulnerabili­ In sum, the temporary costs of slowing infla­ ty to high interest rates. Lowering the deficit tion, and the temptation to avoid these costs along with money growth would reduce the through expansionary means, provide strong strain on credit markets, and would probably enticements to abandon anti-inflationary allow a smoother approach to lower inflation policies-even when these are seriously installed. rates. Like the Sirens of the Odyssey, the short-run trade-offs facing policymakers with short-term A case could be made for incomes policies if horizons have a call that requires more than one could show that cost-push factors have good intentions to resist. 32 played a major role in generating inflation, but It would seem that the surest way to reduce there is little compelling evidence on that score. inflation on a permanent basis is to avoid the Moreover, there is no evidence that incomes large cyclical swings in policy that create swings policies could successfully counter true monopo­ in public opinion as well. Thus, the rate of ly power wherever such occurs. Finally, history growth in the FOMC's chosen aggregate should suggests that incomes policies, when employed, be lowered slowly, say by 1 to I Y2 percentage have tended to license renewed growth in the points per year, over a four-to-six year period. 33 money supply.3! The proponents ofsuch policies Though increases in unemployment would stiB usually emphasize that they are intended as a occur, these would be smaller than under a more complement to slower money growth. Neverthe­ drastic policy, and so would be less unpopular. less, as a practical matter, policymakers typically Of course, the gains in inflation would also become tempted to expand monetary policy come more slowly. Also, even during a mild when incomes policies can be relied upon to hold slowdown, policymakers might be tempted to down prices temporarily. For these reasons, expand policy and so accelerate output growth. incomes policies apparently can do little good These pressures are not easy to abide, but they but much harm, and so probably should i>e left are nevertheless inevitable under any serious unused in formulating plans to slow inflation. attempt to slow inflation. Like Odysseus, the Finally, how fast should we try to reduce policymaker will have to "tie his hands to the inflation? Recent history suggests thata policy of mast" until the progress of his policy takes him rapid reduction in money growth and inflation safely away from the "Siren's calL" Reductions cannot be maintained for very long. A drastic in inflation come slowly under such a policy, but reduction in money growth can cause a quick they will not come at all unless the policy is and deep recession. Once the resulting llnern­ maintained steadfastly for an extended period of ployment becomes severe, politicalse~titllent time. Perhaps the pressuresto"reflate" can be shifts from concern about inflation toworry over mitigated by introduction of supplementary unemployment. In that situation,policYtnakers measures such as those discussed above, which may to short-run pressures and expand the would likely reduce the output costs of slowing money supply anew. After a brief decline, infla­ inflation. tion would then accelerate once more a.nd the In a sense, such a policy would involve some of situation would become as bad as (or worse than) the worst of both worlds. It will not achieve the 18 rapid declines in inflation which are politically but steadily maintained attempt to slow inflation desirable, and unfortunately it will create some runs the middle ground, and should elicit grow­ losses injobs and production which are political­ ing support as the public perceives that it is being ly painful. Yet as we have seen, a "quick fix" to followed. Although not a happy alternative, it inflation is unlikely to be maintained, while a appears to present the best choice available to the "do-nothing" policy leaves inflation at levels that Federal Reserve, the Congress, and the Execu­ increase with each cyclical expansion. A gradual tive Branch.

FOOTNOTES

1. We say "permanently" here, because temporary does not intrinsically affect real factors like tastes, attempts to reduce inflation that are rescinded by industrial capacity, or demographics, and that a equi­ subsequent policy changes would periodically subject proportional change in the magnitudes of all nominal the economy to slow growth and lost jobs every time a assets and prices would leave real conditions un­ tight policy is imposed. changed. Therefore, in the long run, the level of the money supply should have no effect on real magni­ 2. See Schultz (1959), as well as the reference to this tudes, but only on prices. designation in Levy (1979). 7. Theory specifies that in a full-employment economy, 3. We say "perceived" monopoly power, because in equal increases in government spending and taxes many studies it appears to make little difference wheth­ would raise prices, mainly because the lower after-tax er the monopoly power actually exists or not. Given a level of private wealth would lower money demand. slow reaction of demand to higher prices, as well as This higher price level would be consistent with the fact downward. price rigidity elsewhere in the economy, a that, because of higher government spending, less price increase even in a competitive industry could goods would be left over for private consumption. generate the type of inflation spiral propounded by What's more, this is a once-and-for-all increase in the cost-push theorists. equilibrium price level, rather than a continuing infla­ 4. As shown in Section II, real-world inflations have tion. typically been characterized by such general absolute Barro (1974), reflecting , also asserts price increases. that bond finance of a deficit is merely a substitution of 5. In fact, inflation traditionally has been defined as an future taxes for present taxes, since future taxes will increase in the money supply, and only recently have need to be higher in order to the government rising prices been associated with the word. Thus, debt. Therefore, bond financing of spending should Webster's New International Dictionary, 2nd Edition, have identical effects as tax financing. Bailey (1971, p. 1936, defines inflation as a: 60 ff) and Buchanan (1976) also discuss these issues. While most economists do not accept this extreme Disproportionate and relatively sharp and sud­ specification, it's reasonable to believe that bond issues den increase in the quantity of money and do raise expectations of future taxes somewhat, in credit, or both, relative to the amount of ex­ which case they would still be less inflationary than change business. Such increase may come as a monetization of . result of unexpected additions to the supply of precious metals, as in the period following the 8. For further documentation and discussion of these Spanish conquests in Central and South Ameri­ analyses, see Levy (1979) or Bronfenbrenner and Holz­ ca or the period following the opening up of man (1963). Gordon (1977) also discusses the possible large new gold deposits; or it may come in times effects of 1973 oil-price increases and crop failures on of business activity by expansion of credit prices. through the banks; or it may come in times of 9. It may appear that income-share conflicts and politi­ financial difficulty by governmental issues of cal pressures for higher growth and employment are paper money without adequate metallic re­ only slightly different manifestations of the same socio­ serves and without provisions for conversion logical forces, and that the various theories are there­ into standard metallic money on demand. In fore little different. Nevertheless, the different ap­ accordance with the law of the quantity theory proaches to inflation do make a difference, as is of money, inflation always produces a rise in discussed toward the end of the next section. the price level. 10. They found a predominantly uniform effect of inflation on prices in various commodity groups. That Whatever the quality of economic analysis in this is, movements in the consumer price index hadsyste­ definition, it is interesting to note that it describes matic effects on prices in individual commodity classes inflation as causing an increasing price level. The that were generally not significantly different from definitional association of inflation with rising prices, as unity. Therefore, CPI movements do not appear to be documented in newer editions of Webster's dictionary, related systematically to relative price changes. The has apparently arisen in English usage primarily exceptions to this result were in the Categories of rent, through historical experience. homeownership, and prices. These exceptions 6. This assertion embodies the concept of "neutrality of were found by the authors to be due to special factors, money." The idea is that the nominal supply of currency such as measurement problems (rent), as well as non- 19 market pricing of property taxes (homeownership) and sign of tight monetary policy over this period (e.g., of government-regulated (utilities prices). Heller 1977 and Ackley 1979). Yet over such a long period of time, with the large price-level increases 11. This quantitative result is from Bazdarich (1979). As experienced, it seems more realistic to regard this for the traditional work on money and prices, two phenomenon as largely induced by the demand for real hallmark works are the empirical studies by various balances. Thus, in a period where real GNP. grew 20 authors in Friedman (1956) and the study by Friedman percent, which by itself would suggest a rise in real­ and Schwartz (1963). Important work can also be found balance demand, the acceleration in inflation and in in Meiselman (1970) and in a ser.ies of articles by Karl inflation expectations apparently led to a much larger Brunner and Allan Meltzer, as well as many other drop in real-balance demand than would have occurred monetary studies. Our emphasis on recent monetary otherwise. Using regression analysis, Gorham also work is not meant to downplay the importance of earlier finds systematic evidence that inflation has lowered analyses by , Lloyd Mints, and many real balances (demanded) in the U.S. economy. others, but to concentrate on the more sophisticated statistical analyses of the last twenty years. 17. If an acceleration in inflation meant that the average rate of inflation increased, but that the variability of 12. Early empirical research was done by Means (1935), inflation around that average stayed much the same, among others. More recent studies are found in Means then inflation would not imply an increase in uncertain­ (1972), the Cabinet Committee on Price Stability ty. In fact, however, the historical incidence of inflation (1969), Wachtel and Adelsheim (1976), Eckstein and is as described in the text. Sjaastad (1975) presents a Brinner (1972), and Perry (1978). Levy (1979) surveys theoretical explanation of this coincidence in the mean most of these results. and variability of inflation. 13. Gordon's technique used a Granger causality-test 18. Rose obtains the 2-percent discount rate in the which measured the effects of wages on money-supply following manner: He assumes a 5-percent after-tax growth at lags of one to four quarters. Only at the third real rate of return (clearly a very high estimate) and then lag was the estimated effect significant for the U.S. subtracts an assumed 3-percent annual rise in "shoe Taken as a whole, these results did not show a signifi­ leather" costs, reflecting a 3-percent expected annual cant effect. The one significant lag would be reliable rise in real GNP. Thus, present costs should be dis­ evidence only if Gordon were testing the hypothesis counted at a 2-percent (5-3) rate. A lower real rate of that wages affect money at the third lag and at no other. return would result in a lower discount rate, which The weaker hypothesis, that wages have some effect on would result in even higher present values of these money, however, is not supported by these results; that shoe-leather costs for each percentage point of infla­ is, its alternative hypothesis that wages have no general tion. effect is not refuted by this evidence. 19. Tobin (1965) analyzed the general effects of infla­ 14. While it's true that world crop failures occurred in tion on growth. Using a consumption function that 1973 and that oil prices jumped astronomically in 1974, depended on the rate of inflation, rather than prices, he it's also true that monetary expansion accelerated in reached a presumption that inflation speeds growth. 1971-72 in the U.S. and elsewhere. Also, in the U.S., Sidrauski (1967), using maximization to derive price controls in 1971-73 served to suppress much of consumption behavior, found no such effect. These the inflationary pressure of this fast money growth, and other studies are summarized in Dornbusch and postponing it until after the controls were lifted in mid­ Frenkel (1973). 1973. Bazdarich (1979) estimates that most of the 20. Suppose a unit of capital yields a real rate of return r inflation postponed by the controls should have oc­ based on productivity, depreciation, etc. With an infla­ curred by late 1975. Consequently, he estimates the tion rate 11', the price of the good that the unit of capital consumer price level for late 1975 using only money­ produces wil rise, as will the nominal value of the capital supply data through 1975. This estimate differed from itself. Abstracting from relative price changes, then, the the actual price level by only three percentage points, combination of real returns and inflation premia sum to suggesting that money-supply behavior could explain a total pre-tax nominal rate of return of r+rr, so that the much of the total movements in prices over that four­ pre-tax real rate of return (r+rr-rr = r) is unchanged by year period. inflation. However, the inflation premia and the real 15. Though government spending had significant ef­ return are both treated as income and so taxed by the fects on money-supply growth, the effects did not government. With a tax rate t, then, the after-tax nomi­ become positive until the fifth-quarter lag. Yef()ne nal rate of return is (l-tHr+rrl. If we then subtraCt the rate would expect spending financed by money creation to of inflation, the after-tax real rate--or the effective have a much quicker effect on the money supply. rate-of return of capital is (l-t)r-rrt, which declines as Similarly, for statistical reasons (the use of seasonally inflation rises (or 11' increasesl. Thus, because of the tax adjusted data), the results for the effects of the govern­ on inflationary capital gains, effective returns to capital ment deficit on the money supply, though ostensibly will fall as inflation rises, thus discouraging investment. significant, may not be reliable. See Bazdarich (1979) Of course, the can postpone payment of these for details. inflationary capital gains, but he must eventually pay 16. As evidence of the empirical importance of these them. phenomena, Gorham (1979) points to a 7-percentde­ 21. The Council of Economic Advisors (1979) itself has cline in real balances (i.e., the M1 moneysupplydeflat­ recognized a slowdown in the U.S. sustainable rate of ed by prices) in the U.S. over the period 1973-78. growth. The Council cites as contributing factors the Keynesian economists have generally taken this as a declines in productivity growth and in research and

20 development, both of which clearly could be reactions slower money supply growth will affect inflation with a to unfavorable changes in after-tax returns due to lag of generally two years. higher inflation. 28. Incomes polices could hurt the adjustment process 22. Discussion of these and other points in this section because the fringe benefits or tie-in schemes unions can be found in McElhattan (1979) and in Pigott (1979). and firms might pursue are generally inefficient means of exploiting market power, compared to explicit wage 23. See Phelps et al. (1970) for seminal work on the or price increases. Thus, by fostering inefficient, expectations explanation of the Phillips curve. second-best types of arragements, the effects of mo­ 24. In this respect, the existence of long-term contracts nopoly power could be even worse under incomes and other fixed commitments could allow unemploy­ policies. ment to differ from the natural rate for a while even after expectations adjust. See Poole (1974) as well as McEI­ 29. See footnote 18 for details. hattan (1979). By the same token, however, these 30. The question arises as to whether current Federal factors could also be seen as sources of changes in the Reserve operating procedures should be relied upon to natural rate. effect this slower growth in the FOMC's chosen aggre­ gate, and/or what alternative operating procedures 25. Also, see Gordon (1976) for a detailed survey of the would be suitable. These questions are addressed in theory and evidence on the Phillips Curve. Judd and Scadding's article in this issue of the Review. 26. This estimate is provided by William Poole, in the 31. In the United States, money-supply growth actually discussion following Perry (1978): "If Perry's estimates declined in 1970 and early 1971, but then accelerated are taken at face value, a monetary policy that kept the shortly after the imposition of price controls in August unemployment rate 1 percentage point above the natu­ 1971. At the present time, also, it would be hard to argue ral rate would be consistent with a decline in the that the Administration's wage-price guidelines have inflation rate by 0.3 percentage point each year." induced any significant slowing in the growth of M1 or 27. In Perry's analysis, the lag from unemployment to M2. inflation is based on a "mainline" structural model involving aggregate demand, supply, etc. Policy vari­ 32. In Homer's Odyssey, Odysseus and his men prepare ables affect inflation and unemployment in this model to pass through the straits of the Sirens, whose call no only through their effect on aggregate demand and man can resist. He ties rags around his men's ears so supply. This framework is unquestionably correct in that they won't be able to hear. Since someone must be theory, but such an indirect method of estimation available to signal to his men when it is safe, he leaves conceivably could bias the estimated reduced-form his own ears unbound, but has his arms tied tightly to effects of the money supply on inflation and unemploy­ the ship's mast, where he has to endure the agony of ment. That is, if Perry's hypothesized reduction in being unable to answer the Siren's call. unemployment is to be effected through slower money 33. At present, underlying rates of change appear to be growth, it's likely that a direct, reduced-form estimation about 7 percent for M1 and 9 percent for M2 , although of the effects of money on inflation and unemployment historically M2 has tended to grow about 3 percentage would produce shorter estimates of the lags than are points faster than M1 . Also, available existing money­ contained in Perry's analysis. This is because the price evidence suggests that growth rates of zero for M1 reduced-form effects are combinations of a number of and 3 percent for M2 are roughly consistent with the 3­ structural effects. By estimating each structural effect percent per year inflation suggested by the Humphrey­ individually, Perry may be introducing extra sources of Hawkins bill. Therefore, if we take this level as a goal, error in estimating the reduced form than if he had and reduce M1 and/or M2 growth by 1 to 1%percentage estimated it directly. Thus, Bazdarich (1979), for exam­ points a year, zero M1 growth and 3-percent M2 growth ple, finds much shorter lags from money to inflation and would be achieved in four to six years, with 3 percent unemployment. The latter are more consistent than CPI inflation achieved in about six to eight years. Perry's with the common "monetarist" dictum that

REFERENCES

Ackley, Gardner. "Two Views of the Federal Budget." vey of Inflation Theory," American Economic Re­ The AEI Economist. February, 1979. view. September, 1963, pp. 592-661 Bailey, Martin J. Nationai Income and the Price level, Buchanan, James M. "Barro on the Ricardian Equival­ 2nd Edition. McGraw-Hili Books. 1971. ence Theorem." Journal of . Barro, Robert J. "Are Government Bonds Net Wealth?" April; 1976; pp. 337-342 Journal of Political Economy., November, 1974. pp. Cabinet Committee on Price Stability. Staff Study, U.S. 1095-1117. Government Printing Office, 1969. Bazdarich, Michael J. "Inflation and Monetary Accom­ Dornbusch, Rudiger and J. Frenkel. "Inflation and modation in the Pacific Basin." Federal Reserve Growth," Journal of Money, Credit and Banking. Bank of San Francisco, Economic Review. Sum­ February, 1973, pp. 141-156. mer, 1978. pp. 23-36. Eckstein, Otto and R. Brinner. "The Inflation Process in _____. "Current Theoretical and Empirical Per­ the U.S.," A Study Prepared forthe Joint Economic spectives on the Relation Between the Money Committee, 92nd Congress, 1972. Supply and Inflation." FRBSF Staff paper, 1979. Fama, Eugene and G. William Schwert. "The Behavior Bronfenbrenner, Martin and Holzman, Franklyn. "Sur- of Relative and Money Prices of Consumption

21 Goods." Manuscript, University of Chicago, 1977. Perry, George L. "Slowing the Wage-Price Spiral: The Friedman, Milton. "The Role of Monetary Policy." Am­ Macroeconomic View." Brookings Paper on Econ­ erican Economic Review. March, 1968, pp. 1-17. omic Activity, 1978, pp. 259-299. ____. (ed.) Studies In the Quantity Theory of Phelps, Edmund, et. al. Microeconomic Foundations of Money. University of Chicago Press, 1956. Employment and Inflation Theory. Norton, 1970. Friedman, Milton, and Anna Schwartz., A Monetary Pigott, Charles, "Inflation-Unemployment Tradeoffs: History of the United States 1867-1960. Princeton Some International Evidence." FRBSF Staff Paper, University Press, 1963. 1978. Gordon, Robert J. "Recent Developments in the Theory Poole, William. " in the Macro of Inflation and Unemployment." Journal of Mone­ Model." Brookings Papers on Economic Activity 2, tary Economics 2, 1976, pp. 185-219. 1976, pp. 463-514. ____. "World Inflation and Monetary Accommo­ Rose, Sanford. "Commentary-The High Costs of Shoe dation in Eight Countries." Brookings Paper on Leather." Money Manager, May 7, 1979, p. 2. Economic Activity, 1977, pp. 185-219. Samuelson, Paul A. and Solow, Robert. "The Problem ____. . Boston: Little, Brown, of Achieving and Maintaining a Stable Price Level: and Co, 1978. Analytical Aspects of Anti-Inflation Policy." Ameri­ Gorham, Michael. "The Cost of Inflation: A Review." can Economic Review. May, 1960, pp. 177-194. FRBSF Staff Paper, 1979. Schultz, Charles. "Recent Inflation in the United Heller, Walter W. "Monetary Policy at the Crossroads." States," Joint Economic Committee Study of Em­ Wall Street Journal. October 14, 1977, p. 18. ployment, Growth, and Price Levels. 86th Con­ Judd, John and Scadding, John. "Conducting Effective gress, September, 1959. Monetary Policy: The Role of Operating Instru­ Sidrauski, Miguel. "Inflation and Economic Growth." ments." FRBSF Staff Paper, 1979. Journal of Political Economy. May, 1967, pp. 796­ Levy, Yvonne. "A Critique ofthe Cost-Push Explanation 810. of Inflation." FRBSF Staff Paper, 1979. Sjaastad, Larry A. "Why Stable Inflations FaiL" In J.M. McElhattan, Rose. "Where We Stand on the Parkin and A. Zis (ed's.), Inflation in the World Unemployment-Inflation Tradeoff." FRBSF Staff Economy. Manchester University Press, 1975. Paper, 1979. Tobin, James. "Money and Economic Growth." Econo­ Means, Gardiner. "Industrial Prices and Their Relative metrica. October, 1965, pp. 671-684. Inflexibility." A Report to the Secretary of Agricul­ Wachtel, Howard M., and P.O. Adelsheim. "The Infla­ ture. Senate Document #13, 74th Congress, 1935. tionary Impact of Unemployment: Price MarkUps ____. "The Administered Price Thesis Recon­ during Postwar Recessions, 1947-70."Study Paper firmed." American Economic Review, June, 1972, #1, Achieving the Goals of the Employment Act of pp. 292-306. 1946-Thirtieth Anniversary Review. A Study Pre­ Meiselman, David (ed). Varieties of Monetary Experi­ pared for the Joint Economic Committee, 94th ence. University of Chicago Press, 1970. Congress. U.S. Government Printing Office, 1976.

22