EDWARD M. GRAMLICH The Universityof Michigan Macro Policy Responses to Price Shocks IN RECENT YEARS the standardview of the inflationprocess has become complicatedby the realizationthat inflationarybursts can emanatefrom supp'yas well as fromdemand disturbances. Supply-side disturbances, re- flectedmainly in risingfood and oil prices, generatedsharp increases in generalprice levels in most countriesof the world duringthe 1973-75 period. The impact in the United States was magnifiedby wage-price catch-upsafter the endingof controls,the productivityslowdown, the de- cline in the dollar,and a numberof legislativemeasures resulting in higher costs and prices.More recently,the decline of oil productionin Iran and risingfarm prices are kindling fears of new supply-shockinflation. Price shocks from the supply side differfrom traditionaldemand-pull disturbancesbecause they can occur even at low levels of aggregatede- mand. Indeed,both theoryand data suggestthat supplyshocks are more likely to be associatedwith recessionsthan with booms. Because this is so, standardremedies for dealing with supply-sideinflation are not readily apparent.Most economistsnow more or less agreethat aggregatedemand policy shouldnot permitunemployment to fall below its natural,or non- accelerating-inflation,rate for any lengthof time. But whetherunemploy- ment shouldbe allowedto rise above its naturalrate in the presenceof a NOTE: I have benefited from the insightful comments of several BPEA partici- pants, especially from discussions with William Fellner, and comments on a draft by University of Michigan colleagues GardnerAckley, Robert S. Holbrook, Saul H. Hymans, George E. Johnson, and William S. Krasker. I would also like to thank Susan Albert, Gregory Dow, and Judith Pregulman for their highly competent re- search assistance. 0007-2303/79/0001-0125$00.25/0 ? Brookings Institution 126 Brookings Papers on Economic Activity, 1:1979 price shockfrom the supplyside-and by how much and for how long- is a much more difficultquestion. At one extreme, macro policy could "accommodate"the shock, using eithermonetary or fiscal policy to shift the aggregatedemand schedule in an expansionarydirection, maintain un- employmentat its initial rate, and acceptwhatever inflation might ensue in the process.At the other extreme,monetary and fiscal policy could be used in an attemptto engineera recessionsufficiently deep to extinguish the shock-inducedinflation promptly. Somewhere in the middlewould be a class of macro policies aimed at a constant or adjustedgrowth path for nominal income. Under these compromisepolicies the higher price levels inducedby the shock (when spendingdemands are inelastic) will imply a temporaryperiod of both unemploymentand inflation,lasting until the higher unemploymentsufficiently reduces wage and price levels throughoutthe economy to permit a returnto the preshockunemploy- ment rate. The choice between policies depends on whetherthe social costs of the greaterinflation generated or permittedby the accommodating macropolicy outweighthe social costs of the greaterinflation and unem- ployment generatedby any of the nonaccommodatingstrategies. Ironi- cally, this raisesthe old questionof how to choose betweenmore inflation and more unemployment,even in a view of the inflationprocess that may allowno long-termtrade-off between the two. In this paperI analyzeand comparethese policy choices.The aimis to summarizeand pinpoint the implicationsof various models of supply shocks and the inflationaryprocess, without advancing a particularpoint of view. The paperbegins with a reviewof two recentmodels of supply- shockprice increases, one developedby Gordonand one by Phelps.lThese models deal primarilywith the impact of supply shocks on employment and price levels and give only partialattention to inflationrates and the feedbackprocess. So I extend the models to include what Perry calls a "mainlinemodel" of the inflationprocess, featuring a pricemarkup equa- tion and a wage-adjustmentPhillips curve with both a price-wageand a wage-wage feedback mechanism.2The model is solved to determine the conditionsunder which accommodatingand nonaccommodatingre- 1. Robert J. Gordon, "Alternative Responses of Policy to External Supply Shocks," BPEA, 1:1975, pp. 183-204; and Edmund S. Phelps, "Commodity-Supply Shock and Full-Employment Monetary Policy," Journal of Money, Credit and Banking,vol. 10 (May 1978), pp. 206-21. 2. George L. Perry, "Slowing the Wage-Price Spiral: The Macroeconomic View," BPEA, 2:1978, pp. 259-91. EdwardM. Gramlich 127 sponseswould be appropriate.It is then fitted empiricallyand simulated in the traditionalway to measurethe degree of inflationand unemploy- ment generatedby variousmacro strategiesin responseto a price shock. Becausethe desirabilityof these outcomesdepends on the relativesocial costs of inflationand unemployment,I then try to value these relative costs. Some attemptsto estimatethem based on the work of others are comparedwith the normativeimplications of my own model, and with inferencesbased on surveydata. Sensitivity tests are also madeto see how the desirabilityof variousstrategies is alteredwhen the parametersof the model changeand when differentconceptions of the social costs of infla- tion andunemployment are adopted. Up to this point the modelused to analyzeprice shocks and the simula- tion of this model are based on relativelystandard techniques. To round out the story, I also investigate the question of how supply shocks mightbe analyzedin some of the newerexpectations-oriented theories of the inflation process-the game-of-strategyview of Fellner and the rational-expectationsviews of Lucas, Sargentand Wallace, Barro, and others.3 As a finalprefatory comment, I note thatthe entirepaper deals with the macroresponse to price shocks, with no discussionof how shocksmight be preventedfrom occurring.One conclusionof the paperis that whether shocksgenerate lingering future inflation or currentand future unemploy- ment,they can havelarge social costs. Therewould then be greatpotential gainsin any microeconomicsupply-management measures that could be designedto preventshocks, or tax adjustmentsintended to neutralizetheir initialimpact on overallprice levels. But the detailsof how thesemeasures shouldbe constructedraise issues that are much more industry-specific than are the issues discussedhere. Despite theirimportance, I simplywill not addressthose questionsin this paper.4 3. William Fellner, Towards a Reconstruction of Macroeconomics: Problems of Theory and Policy (American Enterprise Institute, 1976); Robert E. Lucas, Jr., "Expectationsand the Neutrality of Money," Journal of Economic Theory, vol. 4 (April 1972), pp. 103-24; Thomas J. Sargent and Neil Wallace, "'Rational' Expec- tations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, vol. 83 (April 1975), pp. 241-54; and Robert J. Barro, "UnanticipatedMoney Growth and Unemployment in the United States," AmericanEconomic Review, vol. 67 (March 1977), pp. 101-15. 4. This judgment also partly reflects my view that a good survey of those mea- sures already exists in Robert W. Crandall, "Federal Government Initiatives to Reduce the Price Level," BPEA, 2:1978, pp. 401-40. 128 BrookingsPapers on Economic Activity, 1:1979 The Theoryof SupplyShocks, Price Levels, and Inflation Rates Two papersmodel the relationshipbetween supply shocks and overall output,price, and employmentlevels. The Gordonmodel is a two-sector one in which outputis exogenousin one sector called the "farm"sector; pricesin it are set to equilibratedemand and supply;and overallprice and output levels are then determinedby the degree of accommodationim- plicit in the macro policy response.5Phelps' model containsone sector, withthe exogenoussupply of rawmaterials as one componentof an aggre- gate productionfunction that has the usual propertiesof concavityand linearhomogeneity.6 Gordon considers one case in whichprices and wages are perfectlyflexible and one in which they are completelyinflexible, but the standardcase for both models allowsfor some upwardadjustment in aggregateprice levels as outputand employmentincrease. Hence the solu- tion,of the price and wage sectors of the model (given by the aggregate supplyline, AS, in the diagrambelow) is upwardsloping. Under Gordon's assumptions,at anylevel of real aggregateemployment, the exogenousde- cline in farm suppliesraises farm and overallprices, hence shiftingup the aggregatesupply schedule to AS'; underPhelps' assumptions, the scarcity of materialslowers labor's marginalproduct and, with a fixed money wage, shifts up marginalcosts and prices to AS'. The aggregatedemand schedule for both models representsthe solution of the IS andLM equationsand is shownas the downwardsloping AD line in the diagram.The standardrationale for this slope is that the nominal quantityof money, M, is fixed along the schedule and will support a higherlevel of aggregatedemand for labor when prices,P, are lower and the real money stock is greater.This rationaleworks only when the IS curve is downwardsloping and the LM upwardsloping. The argument could be madeslightly more general and much more realistic by specifying in additionthat all governmentexpenditures are indexed but thatprogres- sive incometax schedulesare written in nominalterms, so thatwhen prices fall, real taxes fall and aggregatedemand for labor againincreases. The impact on output and employmentof a supply shock in either model is found by shiftingthe aggregatesupply curve as