causes of inflationaRy MonetaRy policy
If everyone agrees that high inflation is bad for an economy, why do we see so much of it? Do governments pursue inflationary monetary policies intentionally? We have seen that monetary authorities can set the inflation rate in the long run, so it must be that in
C h a p t e r 2 3 Monetary Policy Theory 581
trying to achieve other goals, governments end up with overly expansionary monetary policy and high inflation. In this section, we will examine the government policies that are the most common sources of inflation.
high employment targets and inflation
The primary goal of most governments is high employment, and the pursuit of this goal can bring high inflation. The U.S. government is committed by law (the Employment Act of 1946 and the Humphrey-Hawkins Act of 1978) to engage in activist policy to promote high employment. Both laws require a commitment to a high level of employ- ment consistent with stable inflation—yet in practice the U.S. government and the Federal Reserve have often pursued a high employment target with little concern about the inflationary consequences of policies. This tendency was true especially in the mid- 1960s and 1970s, when the government and the Fed began to take an active role in attempting to stabilize unemployment.
Two types of inflation can result from an activist stabilization policy to promote high employment:
1. Cost-push inflation results either from a temporary negative supply shock or a push by workers for wage hikes beyond what productivity gains can justify.
2. Demand-pull inflation results from policymakers pursuing policies that increase aggregate demand.
Y2
Aggregate Output, Y Inflation
Rate,
3
AD3 AD1 AS3
T3 2 T1
Step 2. and inflation rises to the new, higher target.
LRAS
YP
AS1
1 2
Step 1. Autonomous monetary policy easing shifts the AD curve to the right, and over time, the short-run aggregate supply curve shifts upward . . .
Figure 8 a rise in the inflation target
To raise the inflation target to pT3, the central bank undertakes an autonomous monetary policy easing, of lowering the real interest rate at any given inflation rate, thereby shifting the aggregate demand curve right- ward to AD3. The economy would then move to point 2 and the short-run aggregate supply curve would shift up and to the left, eventually stopping at AS3, moving the economy to point 3, with the output gap at zero and inflation at pT3.
582 p a r t 6 Monetary Theory
We will now use aggregate demand and supply analysis to examine the effect of a high employment target on both types of inflation.
Cost-Push Inflation Consider the economy Figure 9, which is initially at point 1, the intersection of the aggregate demand curve AD1 and the short-run aggregate supply curve AS1. Suppose workers succeed in pushing for higher wages, either because they want to increase their real wages (wages in terms of the goods and services they can buy) above what is justified by productivity gains, or because they expect inflation to be high and wish their wages to keep up with it. This cost-push shock, which acts like a temporary negative supply shock, raises the inflation rate and shifts the short-run aggregate supply curve up and to the left to AS2. If the central bank takes no action to change the equilib- rium interest rate and the monetary policy curve remains unchanged, the economy would move to point 2 at the intersection of the new short-run aggregate supply curve AS2 and the aggregate demand curve AD1. Output would decline to Y below potential output and the inflation rate would rise to p2, leading to an increase in unemployment.
In contrast, activist policymakers with a high employment target would implement policies, such as a cut in taxes, an increase in government purchases, or an autonomous easing of monetary policy, to increase aggregate demand. These policies would shift the aggregate demand curve in Figure 9 to AD2 quickly returning the economy to potential
4 3
2' 2 1
Aggregate Output, Y Inflation
Rate,
AS1
Y' YP LRAS
AS2 AS3 AS4
AD4 AD3 AD2 4
3 2 4'
3' 2'
1
AD1
Step 1. A temporary negative supply shock shifts the short-run aggregate supply curve upward . . .
Step 2. causing output to fall
and unemployment to increase. Step 3. Policy makers increase
aggregate demand in response . . . Step 4. leading to a
spiraling rise in inflation.
Figure 9 Cost-push inflation
A cost-push shock (which acts like a temporary negative supply shock) shifts the short-run aggregate sup- ply curve up and to the left to AS2, and the economy moves to point 2´. To keep aggregate output at YP and lower the unemployment rate, policymakers shift the aggregate demand curve to AD2 so that the economy will return quickly to potential output at point 2 and an inflation rate of p2. Further upward and leftward shifts of the short-run aggregate supply curve to AS3 and so on cause the policymakers to keep on increas- ing aggregate demand, leading to a continuing increase in inflation—a cost-push inflation.
C h a p t e r 2 3 Monetary Policy Theory 583 output at point 2 and increasing the inflation rate to p2. The workers fare quite well, earning both higher wages and government protection against excessive unemployment.
The workers’ success might encourage them to seek even higher wages. In addi- tion, other workers might now realize that their wages have fallen relative to their fellow workers, leading them to seek wage increases. As a result, another temporary negative supply shock would occur that would cause the short-run aggregate supply curve in Figure 9 to shift up and to the left again, to AS3. Unemployment develops again when we move to point 3, prompting activist policies once again to shift the aggregate demand curve rightward to AD3 and return the economy to full employ- ment at a higher inflation rate of p3. If this process continues, the result will be a continuing increase in inflation—a cost-push inflation.
Demand-Pull Inflation The goal of high employment can lead to inflationary fiscal and monetary policy in another way. Even at full employment (the natural rate of unemployment), some unemployment is always present because of frictions in the labor market that complicate the matching of unemployed workers with employers. Con- sequently, the unemployment rate when employment is full will be greater than zero.
When policymakers mistakenly underestimate the natural rate of unemployment and so set a target for unemployment that is too low (i.e., less than the natural rate of unem- ployment), they set the stage for expansionary monetary policy that produces inflation.
Figure 10 shows how this scenario can unfold, using an aggregate supply and demand analysis. If policymakers have set a 4% unemployment target that is below the 5% natural rate of unemployment, they will be trying to achieve an output target greater than potential output. We mark this target level of output in Figure 10 as YT. Suppose that we are initially at point 1: The economy is at potential output but below the target level of output YT. To hit the unemployment target of 4%, policymakers must enact policies such as expansionary fiscal policy or an autonomous easing of monetary policy to increase aggregate demand.
The aggregate demand curve in Figure 10 shifts to the right until it reaches AD2 and the economy moves to point 2, where output is at YT and policymakers have achieved the 4%
unemployment rate goal—but there is more to the story. At YT, the 4% unemployment rate is below the natural rate level, and output is above potential, causing wages to rise. The short-run aggregate supply curve will shift up and to the left, eventually to AS2, moving the economy from point 2 to point 2, where it is back at potential output but at a higher infla- tion rate of p2. We could stop there, but because unemployment is again higher than the target level, policymakers would once more shift the aggregate demand curve rightward to AD3 to hit the output target at point 3—and the whole process would continue to drive the economy to point 3 and beyond. The overall result is a steadily rising inflation rate.
Pursuing too low an unemployment rate target or, equivalently, too high an output target, thus leads to inflationary monetary or fiscal policy. Policymakers fail on two counts: They have not achieved their unemployment target and have caused higher inflation. If, however, the target rate of unemployment is below the natural rate, the process we see in Figure 10 will be well under way before they realize their mistake.
Cost-Push Versus Demand-Pull Inflation. When inflation occurs, how do we know whether it is demand-pull inflation or cost-push inflation? We would nor- mally expect to see demand-pull inflation when unemployment is below the natural rate level, and cost-push inflation when unemployment is above the natural rate level.
Unfortunately, economists and policymakers still struggle with measuring the natural rate of unemployment. Complicating matters further, a cost-push inflation can be initi- ated by a demand-pull inflation, blurring the distinction. When a demand-pull inflation
584 p a r t 6 Monetary Theory
produces higher inflation rates, expected inflation will eventually rise and cause workers to demand higher wages (cost-push inflation) so that their real wages do not fall. Finally, expansionary monetary and fiscal policies produce both kinds of inflation, so we cannot distinguish between them on this basis.
In the United States, as we will see in the following application, the primary reason for inflationary policy has been policymakers’ adherence to a high employment target.
As we saw in Chapter 19, high inflation can also occur because of persistent govern- ment budget deficits.
APPLICATION ◆ The Great Inflation
Now that we have examined the roots of inflationary monetary policy, we can investigate the causes of the rise in U.S. inflation from 1965 to 1982, a period dubbed the “Great Inflation.”
Panel (a) of Figure 11 documents the rise in inflation during those years. Just before the Great Inflation started, the inflation rate was below 2% at an annual rate; by the late 1970s, it averaged around 8% and peaked at nearly 14% in 1980 after the oil price shock in 1979. Panel (b) of Figure 11 compares the actual unemployment rate to
4 3 2 1
Aggregate Output, Y Inflation
Rate,
AS1
YT YP LRAS
AS2 AS3 AS4
AD4 AD3 AD2 4
3 2
4'
3' 2' 1
AD1
Step 2. causing AS to shift upward in response to rising wages . . .
Step 1. Policy makers increase aggregate demand to reach a higher output target . . . Step 3. leading to a
spiraling rise in inflation.
Figure 10 Demand-pull inflation
Too low an unemployment target (too high an output target of YT) causes the government to increase ag- gregate demand, shifting the AD curve rightward from AD1 to AD2 to AD3 and so on. Because the unem- ployment rate is below the natural rate level, wages will rise and the short-run aggregate supply curve will shift up and leftward from AS1 to AS2 to AS3 and so on. The result is a continuing rise in inflation known as a demand-pull inflation.
C h a p t e r 2 3 Monetary Policy Theory 585
estimates of the natural rate of unemployment. Notice that the economy experienced unemployment below the natural rate in all but one year between 1960 and 1973, as represented by the shaded areas. This insight suggests that in 1965–1973, the U.S.
economy experienced the demand-pull inflation we described in Figure 10. That is, policymakers pursued a policy of autonomous monetary policy easing that shifted the
14%
6%
2%
0%1960 1965 1970 1975 1980
Year
Inflation (percent) 10%
16%
8%
12%
4%
Step 2. leading to demand-pull inflation.
Step 4. suggesting a cost-push inflation.
Panel (a) Inflation, 1965–1982
6%
2%
0%1960 1965 1970 1975 1980
Year
Unemployment Rate (percent) 10%
12%
8%
4%
Step 1. Unemployment was below the natural rate . . .
Panel (b) Unemployment and the Natural Rate of Unemployment, 1965–1982
Unemployment Rate Natural Rate of Unemployment
Step 3. Unemployment was above the natural rate . . .
Figure 11 inflation and unemployment, 1965–1982
As shown in panel (a), the CPI inflation rate was below 2% at an annual rate in the early 1960s, but by the late 1970s, it was averaging around 8% and peaked at over 14% in 1980 after the oil price shock in 1979.
As shown in panel (b), the economy experienced unemployment below the natural rate in all but one year between 1960 and 1973, suggesting a demand-pull inflation described in Figure 10. After 1975, the unem- ployment rate was regularly above the natural rate of unemployment, suggesting a cost-push inflation as delineated in Figure 9.
Source: economic Report of the president.
586 p a r t 6 Monetary Theory
aggregate demand curve to the right in trying to achieve an output target that was too high, thus increasing inflation. Policymakers, economists, and politicians were commit- ted in the mid-1960s to a target unemployment rate of 4%, a level of unemployment they believed to be consistent with price stability. In hindsight, most economists today agree that the natural rate of unemployment was substantially higher in the 1960s and 1970s, between 5% and 6%, as shown in panel (b) of Figure 11. The inappropriate 4%
unemployment target initiated the most sustained inflationary episode in U.S. history.
After 1975, panel (b) of Figure 11 shows that the unemployment rate lingered above the natural rate of unemployment (see shaded area), yet inflation continued, as per panel (a), indicating the phenomenon of a cost-push inflation we described in Figure 9 (the impetus for which was the earlier demand-pull inflation). The public’s knowledge that government policy was aimed squarely at high employment explains the persistence of inflation. The higher rate of expected inflation from the demand- pull inflation shifted the short-run aggregate supply curve in Figure 9 upward and to the left, causing a rise in unemployment that policymakers tried to eliminate by autonomously easing monetary policy, shifting the aggregate demand curve to the right. The result was a continuing rise in inflation.
Only when the Federal Reserve committed to an anti-inflationary monetary policy under Chairman Paul Volcker, which involved hiking the federal funds rate to the 20%
level, did inflation come down, ending the Great Inflation. ◆
Summary
1. For aggregate demand shocks and permanent supply shocks the price stability and economic activity sta- bility objectives are consistent: Stabilizing inflation stabilizes economic activity even in the short run. For temporary supply shocks, however, there is a tradeoff between stabilizing inflation and stabilizing economic activity in the short run. In the long run, however, no conflict arises between stabilizing inflation and eco- nomic activity.
2. Activists regard the self-correcting mechanism through wage and price adjustment as very slow and hence see the need for the government to pursue active, accom- modating policy to address high unemployment when it develops. Nonactivists, by contrast, believe that the self-correcting mechanism is fast and therefore advocate that the government avoid active policy to eliminate unemployment.
3. Milton Friedman’s view that in the long-run inflation is always and everywhere a monetary phenomenon is borne out by aggregate demand and supply analysis: It shows that monetary policymakers can target any infla- tion rate in the long run they want through autono- mous monetary policy, which adjusts the equilibrium real interest rate using the federal funds rate policy tool to change the level of aggregate demand.
4. Two types of inflation can result from an activist sta- bilization policy to promote high employment: cost- push inflation, which occurs because of negative supply shocks or a push by workers to get higher wages than is justified by productivity gains; and demand-pull inflation, which results when policymakers pursue high output and employment targets through policies that increase aggregate demand. Both demand-pull and cost-push inflation led to the Great Inflation from 1965 to 1982.
Key terms
activists, p. 578
cost-push inflation, p. 581
data lag, p. 579
demand-pull inflation, p. 581
divine coincidence, p. 573 effectiveness lag, p. 579
C h a p t e r 2 3 Monetary Policy Theory 587
Questions
All questions are available in MyEconLab at www.myeconlab.com.
1. What does it mean for the inflation gap to be negative?
2. “If autonomous spending falls, the central bank should lower its inflation target in order to stabilize inflation.”
Is this statement true, false, or uncertain? Explain your answer.
3. For each of the following shocks, describe how mon- etary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a long- run equilibrium.
a. Consumers reduce autonomous consumption.
b. Financial frictions decrease.
c. Government spending increases.
d. Taxes increase.
e. The domestic currency appreciates.
4. During the global financial crisis, how was the Fed able to help offset the sharp increase in financial frictions, without the ability to lower interest rates further? Did it work?
5. Why does the divine coincidence simplify the job of policy making?
6. Why do negative supply shocks pose a dilemma for policymakers?
7. In what way is a permanent negative supply shock worse than a temporary negative supply shock?
8. Suppose three economies are hit with the same nega- tive supply shock. In country A, inflation initially rises and output falls; then inflation rises more and output increases. In country B, inflation initially rises and out- put falls; then both inflation and output fall. In country C, inflation initially rises and output falls; then infla- tion falls and output eventually increases. What type of stabilization approach did each country take?
9. “Policymakers would never respond by stabilizing a temporary positive supply shock.” Is this statement true, false, or uncertain? Explain your answer.
10. The fact that it takes a long time for firms to bring new plant and equipment on line is an illustration of the concept related to what policy problem?
11. If someone told you, “Congress and the Senate couldn’t vote themselves out of a phone booth,” what type of policy lag are they referring to?
12. Is stabilization policy more likely to be conducted with monetary policy or fiscal policy? Why?
13. “If the data and recognition lags could be reduced, activist policy would more likely be beneficial to the economy.” Is this statement true, false, or uncertain?
Explain your answer.
14. Why do activists believe the economy’s self-correcting mechanism is slow?
15. If the economy’s self-correcting mechanism works slowly, should the government necessarily pursue dis- cretionary policy to eliminate unemployment? Why or why not?
16. Suppose one could measure the welfare gains derived from eliminating output (and unemployment) fluc- tuations in the economy. Assuming these gains are relatively small for the average individual, how do you think this conclusion would affect the activist/nonactiv- ist debate?
17. Given a relatively steep and a relatively flat short-run aggregate supply curve, which one supports the case for nonactivist policy? Why?
18. “Because government policymakers do not consider inflation desirable, their policies cannot be the source of inflation.” Is this statement true, false, or uncertain?
Explain your answer.
19. How can monetary authorities target any inflation rate they want to?
20. What will happen if policymakers erroneously believe that the natural rate of unemployment is 7%, when it is actually 5%, and pursue stabilization policy?
21. How can demand-pull inflation lead to cost-push inflation?
implementation lag, p. 579 inflation gap, p. 570 inflation target, p. 570
Keynesians, p. 578 legislative lag, p. 579
nonactivists, p. 578 recognition lag, p. 579
588 p a r t 6 Monetary Theory
All applied problems are available in MyEconLab at www.myeconlab.com.
22. Suppose the current administration decides to decrease government expenditures as a means to cut the existing government budget deficit.
a. Using a graph of aggregate demand and supply, show what the effect would be in the short run.
Describe the effects on inflation and output.
b. What would be the effect on the real interest rate, inflation rate, and output level if the Federal Reserve decides to stabilize the inflation rate?
23. Use a graph of aggregate demand and supply to dem- onstrate how lags in the policy process can result in undesirable fluctuations in output and inflation.
24. As monetary policymakers care more about inflation stabilization, the slope of the aggregate demand curve becomes flatter. How does the resulting change in the slope of the aggregate demand curve help stabilize inflation when the economy is hit with a temporary negative supply shock? How does this affect output?
Use a graph of aggregate demand and supply to demonstrate.
25. Many developing countries suffer from graft and endemic corruption. How does this help explain why these economies have typically high inflation and eco- nomic stagnation? Use a graph of aggregate demand and supply to demonstrate.
applied problems
Web exercises
1. This chapter discusses the Great Inflation from 1965 to 1982. Go to ftp://ftp.bls.gov/pub/special.requests/
cpi/cpiai.txt. Move data into Excel, using the method described at the end of Chapter 1. Delete all but the first and last column (date and annual CPI). Graph these data and compare them to the inflation data in Figure 11.
a. Has inflation increased or decreased since 1982?
b. When was inflation at its highest?
c. When was inflation at its lowest?
d. Have we ever had a period of deflation? If so, when?
e. Have we ever had a period of hyperinflation? If so, when?
2. It can be an interesting exercise to compare the pur- chasing power of the dollar over different periods in history. Go to www.bls.gov/cpi/ and scroll down to the link to the inflation calculator. Use this calculator to compute the following:
a. If a new home cost $125,000 in 2011, what would it have cost in 1950?
b. The average household income in 2011 was about
$40,000. How much would this have been in 1945?
c. An average new car cost about $20,000 in 2011.
What would this have cost in 1945?
d. Using the results you found in Exercises b and c, does a car consume more or less of average house- hold income in 2011 than in 1945?
Web references
www.bls.gov/cpi/
The home page of the Bureau of Labor Statistics, which reports inflation numbers.
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Download historical inflation statistics going back to 1913.
These data can easily be moved into Microsoft Excel, using the procedure discussed at the end of Chapter 1.
http://www.gpoaccess.gov/eop
The Economic Report of the President reports debt levels and gross domestic product, along with many other economic statistics.