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Central Banking across the Atlantic:
Another Dimension
Inventory Valuation Adjustments
Greatly Influence Corporate Earnings
A Perspective on Stagflation

FEDERAL RESERVE RAISE of PHILADELPHIA

business reeletc




IN THIS ISSUE . .
Central Banking across the
Atlantic: Another Dimension

. . . Some U. S. officials want the Fed to
imitate its foreign cousins by allocating
credit for “social priorities/' but such a task
may be easier said than done.
Inventory Valuation Adjustments
Greatly Influence Corporate Earnings

. . . The corporate profit share of GNP usually
dips during economic downswings, but not
so this time around, and the contradiction
can be traced to inflation hiking the value of
business inventories.
A Perspective on Stagflation

. . . Expectations of future price increases
provide the key for understanding stagflation
—a simultaneous rise in unemployment and
inflation.

On our cover: Lemon Hill, located in Philadelphia's Fairmount Park, is a notable example
of Federal period architecture. Its chief historical association is with Robert Morris, a signer
of the Declaration of Independence and a financier of the American Revolution, who owned
the original estate of 42 acres and occupied it up to 1799. The present mansion was built by
the purchaser of the estate, Henry Pratt, a Philadelphia merchant and philanthropist. It was
acquired by the city in 1844 and dedicated a public park in 1855, marking the commencement
of Fairmount Park. Lemon Hill is now maintained by the Colonial Dames of America. (Photo­
graph by Sandy Sholder.)
BUSINESS REVIEW is produced in the Department of Research. Editorial assistance is pro­
vided by Robert Ritchie, Associate Editor. Ronald B. Williams is Art Director and Manager,
Graphic Services. The authors will be glad to receive comments on their articles.
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Bank of Philadelphia, Philadelphia, Pennsylvania 19105. Phone: (215) 574-6115.



Central Banking
Across the Atlantic:
Another Dimension
By James M. O'Brien

The Federal Reserve is the only major central
bank in the world which has refused to as­
sume a responsibility for allocating credit to
socially important sectors of the economy. . . .
It is high time we broughtthe Federal Reserve
Board into the 20th century.
— Senator William Proxmire

Scrutinizing the practices of West Euro­
pean central banks does evidence a concern
for credit costs and allocation. Toward this
end, these foreign central bankers have
adopted a variety of tools that are largely out­
side the experience of Uncle Sam's financial
policymakers. But rerouting credit to favored
activities may be easier said than done. The
West European experiences appear to raise
more questions than they answer— espe­
cially those dealing with the costs of credit

Fed watchers are continuously active and
full of proposals. Some want to harness the
System's responsibilities in monetary mat­
ters. Yet, others want it to assume greater
responsibilities. A movement is currently un­
derway in Congress and elsewhere to get
the Fed to imitate some of its foreign coun­
terparts by directing credit flows at low in­
terest costs to "social priorities."1

Banking, Housing and Urban Affairs, Selective Credit
Policies and Wage-Price Stabilization: Hearings on S.
1201 and H. R. 4246, 92d Cong., 1st sess., 31 March, 1 and
7 April 1971, pp. 1-3, 145-49; of Representative Wright
Patman in U.S., Congress, House, Committee on Bank­
ing and Currency, Activities by Various Central Banks to
Promote Economic and Social Welfare Programs: A Staff
Report, 91st Cong., 2d sess., December 1970; and of
Representative Henry S. Reuss in U.S., Congress, House
of Representatives, Congressional Record, 93d Cong.,
2d sess., 1974, 96, H5920.

1See statements of Senator William Proxmire and Pro­
fessor Lester C. Thurow in U.S., Congress, Senate, Sub­
committee on Financial Institutionsof the Committee on




3

MAY 1975

BUSINESS REVIEW

WEST EUROPEAN CENTRAL BANKS:
A CONCERN FOR CREDIT ALLOCATION

tant policy dimension. Favored activities
have generally been those industries be­
lieved important for economic growth and
modernization, including the export indus­
tries and housing.2

Inflation, unemployment, balance of pay­
ments— these are the "traditional" concerns
of central bankers. At the Federal Reserve
they are part and parcel of its policy actions
(see Box for discussion of Fed policy goals
and tools). But for many central banks in
Western Europe attempts to funnel credit
to government-set priorities at relatively low
interest costs represent still another impor­

2
The countries whose central banking practices are
reviewed are the United Kingdom, France, Italy, West
Germany, Sweden, The Netherlands, and Belgium. This
review was prepared using the material from a number
of recently published studies on foreign central banking
which are listed in the Bibliography. Among these, the
most important source of reference is Donald Hodgman,
National Monetary Policies and International Monetary
Cooperation (Boston: Little, Brown, and Company,
1974).

controls, their effectiveness, and their adapt­
ability to the home economy.

A LOOK AT THE FED
At least since the early 1950s, Fed money managers have directed much of their
monetary policy efforts toward the ultimate goals of price stability and full employment
of resources. Fed policymakers have also been mindful of keeping down sharp interestrate fluctuations in the money markets and have traditionally given some weight to bal­
ance of payments considerations. But Fed watchers generally agree that the nation's bal­
ance of payments has taken second place in deference to domestic objectives, partic­
ularly the goal of full employment.
In pursuing its primary goals of an acceptable inflation rate and full employment, the
Fed has relied mainly on those tools that change the outstanding volume of its own
liabilities— cash reserves in the banking system and currency in the hands of the non­
bank public. These consist of open market operations, lending to member banks, and
changing reserve requirements that member banks must observe. The first of these is
the Fed's most important monetary tool. Through open market operations it buys or
sells Government securities in the marketplace. When securities are bought, the
amount of cash in the banks or that held by the nonbank public is increased. This inflates
the nation's money supply and stimulates the economy. The process is reversed when
the Fed sells securities.
Lending cash to banks and setting the terms of the loans, while not insignificant, plays
no more than a supportive role in monetary policy. The same has been true with respect
to changes in reserve requirements of member banks.
Thus, the Fed's main policy tools have not included direct controls either generally on
financial markets or specifically on the banking system. Nor have the Fed's policy goals
generally included the allocation of credit. There have, however, been some excep­
tions: administering the regulation of consumer and mortgage credit during World
War II and the Korean War, controlling down payments on stock purchases, setting in­
terest-rate ceilings on bank deposits, and, in the '60s, using moral suasion to persuade
bankers to curb loans to certain borrowers. But these exceptions remain just that and
have not been an integral part of the Federal Reserve's financial policies.




4

FEDERAL RESERVE BANK OF PHILADELPHIA

Credit allocation constitutes a measurable
part of the policy goals of the central banks in
the United Kingdom, France, Italy, Sweden,
and Belgium. The Bank of England, for exam­
ple, makes some attempt to keep credit flow­
ing to priorities such as shipbuilding, ex­
ports, "productive" investment and, more
generally, to activities undertaken by the
government. Across the Channel, the Banque de France has broadly aimed its financial
policies toward modernization of the French
economy. In doing so, it has sought to re­
route credit flows as mandated by the gov­
ernment's five-year plans.
Italy's monetary authority, the Banca
d'ltalia, also undertakes policies designed to
influence the allocation of credit among dif­
ferent uses. It backs investment projects that
boost economic development and growth —
particularly government or governmentrelated investment. Sweden's Riksbank, too,
has traditionally supported government
financing needs and, especially, homebuilding. Belgium, like France, Italy, and Sweden,
is deeply committed to controlling the use of
credit, and the Banque Nationale de Belgique
plays a sizable role in the government's credit
allocation programs.
Central banks' support for investment in
"social priorities" has not been limited to
direct attempts at rerouting credit flows. En­
deavors to regulate interest rates are also
made. For example, the Bank of England and
the Banca d'ltalia have sought to keep in­
terest rates on government debt lower and
more stable than free markets would permit.
At least in part, this policy is designed to aid
the respective governments in financing rela­
tively large deficits resulting from sizable
government spending programs. Moreover,
these central banks and those in France,
Sweden, and Belgium have attempted to con­
trol market rates on various types of private
credit as well.3

All central banks in Western Europe pursue
some credit allocation policies. However,
those of The Netherlands and West Germany
differ from their West European cousins in
maintaining only a minimal amount of selec­
tive credit policies aimed at resource alloca­
tion. On this point, they are more like the
Federal Reserve System. Both the Nederlandsche Bank and Bundesbank have primar­
ily aimed their policies at inflation and bal­
ance of payments objectives.
TOOLS FOR INFLUENCING CREDIT FLOWS
AND INTEREST RATES
Long-Term Credit Markets. Among the
countries striving to route credit flows, only
Great Britain has refrained from interfering
with the long-term credit markets (and only
since 1959). Countries concerned with the
placement of long-term funds — France, Ita­
ly, Belgium, and Sweden— have relied on
two main devices. One is direct control over
the floating of securities on the capital mar­
ket. Those wishing to issue marketable secu­
rities must get permission for both the issue
and its terms from a capital issues committee.
The committee's job is to provide a favorable
market for securities issued by the govern­
ment or by private firms to finance highpriority investments. In Sweden, for exam­
ple, the business sector has been limited to
about 20 percent of capital-market bond is­
sues since 1960, while housing issues have
accounted for about half the funds raised in
the capital market. Italy goes even further.
Besides controlling issues of capital market
securities, private firms have had to pay a
38-percent tax on the interest cost of bond
issues. Government and government-related
bond issuers are both exempted from the tax
and receive priority access to the capital mar­
ket. Some central banks— for example, the
Riksbank and the Banca d'ltalia— serve as
capital issues committees.
in France, Italy, Sweden, and Belgium,
substantial control over credit institutions
also helps to determine the direction of long­
term credit. Control is exercised in various

beginning in the late 1960s and early 1970s some West
European governments have had to abandon, at least
partly, low-interest rate policies because of mounting
balance-of-payments deficits.




5

MAY 1975

BUSINESS REVIEW

ways. Important in each of these countries
are publicsavings institutions— often includ­
ing the post office. And in France, Italy, and
Belgium there are nationalized savings
banks. Also in France, both public and
private savings banks have had to turn all
funds over to a government institution. In all
of these countries, and especially in Italy,
there exist public or semi-public credit in­
stitutions that obtain funds from the (con­
trolled) capital markets. These specialized
institutions then provide various highpriority industries with medium- and long­
term credit. National commissions, com­
mittees, or "agreements" coordinate the
control of this institutional lending. It's atthis
level that governors of the central banks
often play important roles as supervisors,
chairmen, or executive agents.
Shorter-Term Credit Markets. Monetary
policies of central banks impinge most im­
mediately on short-term credit or money
markets, including commercial bank be­
havior. Because of this, credit allocation
policies of West European central banks have
been mainly directed at the short-term credit
markets and the financial policies of com­
mercial banks. To a large degree, the objec­
tive has been to coordinate the central bank's
stabilization policies with the government's
credit allocation goals.
For instance, at least until most recently,
central bank loans to commercial banks have
been an importanttool for controlling money
supplies in West European countries. In
some of these countries — France, Belgium,
Italy, and even West Germany— loan re­
quests are honored partly on a basis of
whether the commercial banks' intended use
of the funds satisfied a social priority. Bank
lending ceilings have also been a major
stabilization tool for most central banks in
Western Europe (only West Germany has
abstained from this form of policy). The ceil­
ings are invoked during periods when the
central banks try to slow the overall pace of
economic activity. However, except for The
Netherlands, they are imposed in a selective



manner, allowing loans for favored activities
to be either exempted or to exceed the ceil­
ings.
Special "reserve requirements" are an­
other tool for stabilization and allocation
purposes. These requirements specify that
bankers must hold a "reserve" in the form of
certain types of assets. Often expressed as a
percentof the bankers' deposit liabilities, the
requirement has been used in France, Italy,
the U.K., Belgium, and Sweden. The objec­
tive has not only been to restrict deposit and
loan growth generally, but also to spur the
demand for assets which finance investment
in social priorities. For example, government
securities in Great Britain and housing credit
in Italy and Sweden have been assets which
can help satisfy banks' "reserve require­
ments."
An even more direct control on credit is
central bank review of individual loans by
commercial banks. This practice has been
quite important in France. Commercial banks
report to the Banque de France all business
loans and obtain from business clients dos­
siers on their financial status and use of
funds. The Banque then uses this informa­
tion in rationing its loans to commercial
banks.
Attempts to control short-term interest
rates— especially those on government
debt— have been an integral part of these
selective credit policies. Several methods are
important for controlling short-term rates.
Supplying cash reserves to the banking sys­
tem and discount houses in amounts suffi­
cient to provide a strong and steady demand
for government securities is one procedure.
This has been practiced in England, Italy, and
Belgium.4 Another method is the formal or
informal tying of bank loan and deposit rates
to the central bank's discount rate. This has
been used in Great Britain, France, Sweden,
Belgium, and (more informally) in Italy.
“The supplying of reserves or currency is effected
through either central bank discounting or open market
operations.
6

FEDERAL RESERVE BANK OF PHILADELPHIA

Hard evidence concerning an inflationsocial priorities tradeoff is difficult to come
by. However, it has been argued that the
relatively high rates of inflation in France,
England, and Italy can be partly traced to dif­
ficulties in coordinating policies aimed at
supporting high-priority borrowers with
those employed to reduce inflation. For
example, to guarantee ample financing for a
gamut of favored activities, the Banque de
France has at times had difficulty restricting
the growth of its own liabilities to a level
consistent with low inflation. In the U.K. and
Italy, the continual obligation to support
government debt markets is also suggested
to have produced excessive monetary
growth and inflation.6
An even more general criticism leveled at
the West European experiences is the ad­
verse effect of credit controls on the func­
tioning of financial markets. One argument
notes that controls tend to expand. An exam­
ple sometimes cited is that of Great Britain.
Initially, in the early '60s, clearing (commer­
cial) banks were the only institutions subject
to credit controls. As time wore on, the clear­
ing banks began losing business to other un­
controlled and more competitive financial
institutions. Moreover, the banks them­
selves began evading the controls by acquir­
ing other unregulated lenders as sub­
sidiaries. In response to these growing leak­
ages, unregulated lending sources came
under restriction in the late '60s.7

IS THE FED WITH IT?

Because of a concern for domestic credit
allocation and, specifically, the "uneven" in­
cidence of tight-money policies, U.S. law­
makers have been considering the possible
use of selective credit controls.5 Ideally,
these controls would help offset marketdetermined patterns of credit allocation and
result in more funds flowing to governmentset priorities. In attempting to make the Fed
incorporate selective credit policies into its
monetary policy procedures, advocates have
touted their importance in the policy reper­
toires of foreign central banks. However, be­
fore making these foreign experiences the
guiding light, inquiry should go beyond
merely establishing that "everyone (or at
least almost everyone) is doing it." There are
important issues still to be unraveled.
At What Cost? Few things in life are free,
and critics of the West European experiences
have argued that concern for credit alloca­
tion has been at the expense of other objec­
tives. For one thing, it is suggested that credit
allocation goals may have an inflationary
bias. The argument is that efforts by a central
bank to see that favored activities have
"adequate" or low-cost financing could mili­
tate against those policies aimed at com­
bating inflation. Tight-money policies de­
signed to dampen excessive spending will
tend to have "loopholes" in the form of
priority-borrowing classifications. The flow
of funds through these "escape hatches" can
be expected to increase as financing
elsewhere becomes more difficult. The au­
thorities must be willing to tighten up on
nonpriority credit categories, and even allow
for some restriction on priority items when
total spending is excessive. Otherwise, ex­
cessive monetary expansion and more infla­
tion may result.

6For a discussion of the French experience with credit
allocation policies and inflation, see Hodgman, op. cit.,
pp. 27-52; and Jacques Melitz, “Selective Credit Con­
trols: The Lessons from French Experience," Federal
Reserve Bank of Philadelphia, unpublished, 1972. The
reference to the Italian experience with inflation is from
Hodgman, pp. 85-125. With respect to the U. K., see
Hodgman, pp. 117-25; and his “ British Techniques of
Monetary Policy: A Critical R e v ie w Journal of Money,
Credit, and Banking 3 (1972): 760-79; and Brian Griffiths,
"Monetary Policy in the Float," The Banker, July 1972,
pp. 1023-25.

Currently there are two bills in Congress which would
have the Federal Reserve direct some form of selective
credit controls: S.887 sponsored by Senator Richard S.
Schweiker and H. R. 212 sponsored by Representative
Henry S. Reuss.




7See, for example, Hodgman, pp. 158-96 and Paul
Davidson, "Discussion Paper," David R. Croome and
Harry G. Johnson, eds., Money in Britain: 1959-69 (Lon­

7

MAY 1975

BUSINESS REVIEW

signed to end bank credit ceilings and the
Bank of England's responsibility for support­
ing the government securities market. The
reform has also attempted to reduce the re­
strictive practices of clearing banks and, in
the process, give competition a stronger
hand in determining lending rates.9For many
years the West German government had reg­
ulated deposit interest rates for reasons
otherthan credit allocation. During 1965-67,
the Bundesbank experimented with deposit
and loan rate controls as a part of its mone­
tary policy. The objective was to shield bor­
rowers from exorbitant interest costs and
credit institutions from "cutthroat" compe­
tition. However, in 1967 all interest rate con­
trols were revoked with the official explana­
tion that the controls were unworkable,
biased against the smaller wealthholder, and
damagingto the efficient workingof financial
markets.
How Effective Are Credit Policies? A second
issue is the ability of the West European ex­
periments to achieve their goals. How much
resource reallocation toward priorities has
actually been effected through selective
credit policies? Or how low and stable have
interest rates been kept? Up to now, few per­
sons have bothered to ask these questions
seriously. Moreover, a casual look at the
numbers does not obviously indicate that
those countries allocating credit through
controls perform better than other countries
in terms of economic growth, low interest
rates, or inflation (see Table).
More detailed evidence is fragmentary and

However, this growth in the scope and
complexity of regulation cuts down on the
efficiency with which financial markets are
able to channel savings into investment. For
example, it is argued that where comprehen­
sive systems of controls have evolved, lend­
ers have found it difficult to cut the costs of
financing or to attract customers in other
ways. Moreover, the central banks have tradi­
tionally found it advantageous to support
programs designed to minimize bank com­
petition in order to maintain an environment
conducive to credit control. Officially sanc­
tioned banking cartels or cartel-like agree­
ments have, at least until most recently,
characterized the banking systems of Italy,
France, Belgium, Sweden, and the U.K. It is
through these cartel arrangements that the
respective central banks have sought to make
their controls effective.8
In fact, these defects have caused concern
even among users of selective credit policies.
In France, for instance, a high-level govern­
ment commission has recommended sig­
nificantly reducing the government's control
over credit flows in order to make for a more
competitive and efficient financial structure
and to give the Banque de France more con­
trol of the money supply. And, in 1971, Eng­
land embarked on a "credit reform" de­
don: Oxford University Press, 1970), pp. 189-% . For a
review of similar experiences with the few long-term
selective credit and interest controls used in the U. S.,
see James M. O'Brien, "Interest Ban on Demand De­
posits: Victim of the Profit Motive?" Business Review of
the Federal Reserve Bank of Philadelphia, August 1972,
pp. 13-19; and "Federal Regulation of Stock Market
Credit: A Need for Reconsideration," Business Review
of the Federal Reserve Bank of Philadelphia, July-August
1974, pp. 23-33.
8Hodgman, National Monetary Policies and Interna­
tional Monetary Cooperation; Brian Griffiths, "The Wel­
fare Costs of the U. K. Clearing Banks Cartel,"Journal of
Money, Credit, and Banking 4 (1973): 61-77; David A.
Alhadeff, Competition and Controls in Banking: A Study
of the Regulation of Banking in Italy, France, and England
(Berkeley and Los Angeles: University of California
Press, 1968); Activities by Various Central Banks to Pro­
mote Economic and Social Welfare Programs.




’However, in the case of Britain, one reviewer re­
ported that since the credit reform of 1971, the author­
ities have greatly expanded the money supply in the
hope of furthering economic growth. The inflationary
pressures of excess monetary growth and an accom­
panying large deficit which the monetary authorities
were called on to finance has helped to produce a good
measure of dissatisfaction with the new system. It is
suggested that, while the old system of controls may not
be reinstituted, other forms of controls may be deemed
desirable in the future. See Marcus Miller, "Discussion,"
Credit Allocation Techniques and Monetary Policy
(Federal Reserve Bank of Boston, 1973), pp. 173 - 77.
8

FEDERAL RESERVE BANK OF PHILADELPHIA

COUNTRIES ALLOCATING CREDIT THROUGH CONTROLS
DO NOT GENERALLY OUTPERFORM OTHER COUNTRIES
IN TERMS OF ECONOMIC GROWTH, INFLATION, OR
INTEREST RATES (1961-70)
Countries Substantially Using
Credit Controls
For Allocative Purposes
Belgium
France
Italy
Sweden
United Kingdom
Other Countries
The Netherlands
West Germany
United States

Growth
in
Output*
4.9
5.9
5.3
6.3
2.7

Inflation
Rate*
3.2
4.2
4.2
4.1
4.1

Long-Term
Government
Interest Rate**
6.38
5.80
6.71
6.03
6.97

5.3
4.8
4.2

4.5
2.8
2.9

5.57
6.78
4.77

*Federal Reserve Bank of St. Louis, Rates of Change in Economic Data forTen Industrial Countries, October
1974; and Organization for Economic Cooperation and Development,Main Economic Indicators, 1955 -71. Fig­
ures presented are annual average rates of change.
^International Monetary Fund, International Financial Statistics, February 1974.

the mix of real investment appear less clear
(Chart 2). Even over the longer haul, the
proportion of investment devoted to housing
in Sweden appears to be no greater than that
in the U. S. This is despite the much greater
emphasis that Swedish credit allocation
programs are supposed to give to housing
than the freer credit markets in the U. S.1
1

inconclusive. For example, a recent study of
bank lending ceilings in Great Britain con­
cluded that although the ceilings effectively
reduced clearing bank lending, they also
produced continuous adjustments on the
part of borrowers “ involving the sale of mar­
ketable securities, encashment of liquid de­
posits and substitution for bank loans of both
debt and equity instruments."1 Credit con­
0
trols in Sweden, it's been argued, have
shifted the burden of "tight credit" from
housing and government to business (see
Chart 1). But the effects of these controls on

Over the period 1960-70, both countries devoted
about a quarter of real investment to housing. Prior to
1960 the U. S. appears to have invested a somewhat
higher proportion in housing than Sweden. For a de­
scription of housing credit programs in Sweden, see
U.S., Congress, House of Representatives, Committee
on Banking and Currency, Foreign Experience with
Monetary Policies to Promote Economic and Social
Priority Programs: Staff Report, 92d Cong., 2d sess.,
May 1972, pp. 18, 25-37.

,0Alan Pankratz, “ Effects of Direct Lending Controls:
An Empirical Case Study of the United Kingdom," Jour­
nal of Economics and Business 27 (1974): 49-59.




9

BUSINESS REVIEW

MAY 1975

CHART 1

CHART 2

BUSINESS BEARS BURDEN OF TIGHT CREDIT
IN SWEDEN . . .

BUT REAL INVESTMENT EFFECTS ARE LESS
TELLING.

Kronors (Millions)

Percent of Gross National Product

CREDIT EXTENDED TO:
Private Business
--------- — - Government
mmmmmmm Local Authorities
----------------Housing Sector

Private Gross Investment
Excluding Dwellings
Government Gross Investment
Excluding Dwellings
. ................ Dwellings

9000

SOURCE: Assar Linbeck, “Some Fiscal and Mon­
etary Policy Experiments in Sweden,” Credit Allo­
cation Techniques and Monetary Policy (Federal
Reserve Bank of Boston, 1973), p. 191. Numbers
expressed as yearly changes as percent of GNP are
constant (1959) prices.

SOURCE: Lund Lars Jonung, “Swedish Central
Bank Policy in the Postwar Period: Some Com­
ments,” Kredit und Kapital 3 ( 1973): 323-43.




10

FEDERAL RESERVE BANK OF PHILADELPHIA

other financial institutions and the capital
markets.

All of this is not to say that credit control
programs have had no effect on the realloca­
tion of credit toward national priorities and at
relatively low interest costs. Rather, that how
much effect they have had on resource allo­
cation is largely unknown and deserving of
more study.

A SUMMING UP

Unlike the Federal Reserve System, many
central banks of Western Europe try to influ­
ence directly the allocation of credit and its
relative cost, especially bank lending. The
objective has been to support investment in
“ productive" activities and others deemed to
be of high priority by their respective gov­
ernments. Various devices have been em­
ployed such as direct control of bank lending
and interest rates, and special forms of re­
serve requirements. The tools have gener­
ally been used for both credit allocation and
economic stabilization purposes.
Now, some U. S. officials want the Fed to
copy its foreign counterparts and become
actively involved in credit allocation. But
there are important issues still outstanding.
For one thing, the foreign experiences have
not been without costs — particularly the
stunting of competition and the further ex­
pansion of controls. Also, very little is known
concerning the effectiveness of the foreign
credit allocation programs. Finally, experi­
ments with credit controls in the United
States are apt to have even tougher sledding
than have those in Western Europe. Ameri­
can financial markets are currently more
highly developed, less restricted, and more
competitive than their foreign counterparts.
It may be wise to take a more searching look
before we leap.

How Appropriate Are the West European Ex­
periences? Several characteristics of the West
European economic and political systems are
apt to make effective credit controls more
feasible than they would be in the U. S. One
is the concentrated and cartelized banking
structures of Western Europe. Given the cur­
rently more competitive environment of
American banking, the spirit of cooperation
which has existed between West European
bankers and their respective central banks is
not likely to be seen here. American bankers
are likely to be under more competitive pres­
sure to evade the regulations.
Also important is the much greater degree
of government economic planning in West­
ern Europe than in the U. S. The credit alloca­
tion responsibilities of West European cen­
tral banks are as much a part of this story as a
story in themselves. And if the central banks
achieve some degree of success in influenc­
ing the allocation of credit, it could depend
significantly on the existence of these other
controls. Thus, in attempting to shape credit
allocation through controls on the banking
system (as has been proposed for the Federal
Reserve), West European central banks have
generally had the support of controls on




11

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BUSINESS REVIEW

SELECTED BIBLIOGRAPHY
Alhadeff, David A. Competition and Controls in Banking: A Study of the Regulation of
Bank Competition in Italy, France, and England. Berkeley and Los Angeles:
University of California Press, 1968.
Hodgman, Donald R. "Credit Controls in Western Europe: An Evaluative Review." In
Credit Allocation Techniques and Monetary Policy, pp. 137-61. Federal Reserve
Bank of Boston, September 1973.
Hodgman, Donald R. National Monetary Policies and International Monetary Coopera­
tion. Boston: Little, Brown, and Company, 1974.
Holbik, Karel, ed. Monetary Policy in Twelve Industrial Countries. Federal Reserve Bank
of Boston, 1973.
Jonung, Lund Lars. "Swedish Central Bank Policy in the Postwar Period: Some Com­
ments." Kredit und Kapital 3 (1973): 323-43.
U. S., Congress, House, Committee on Banking and Currency. Activities by Various
Central Banks to Promote Economic and Social Welfare Programs: A Staff Report.
91st Cong., 2d sess., December 1970.
U. S., Congress, House, Committee on Banking and Currency. Foreign Experiences with
Monetary Policy to Promote Economic and Social Priority Programs: A Staff Report.
92nd Cong., 2d sess., May 1972.




12

Inventory Valuation Adjustments
Greatly Influence Corporate Earnings




,

By Robert Christian Jr.
CHART

1

HISTORICALLY, THE AFTER-TAX CORPORATE PROFIT SHARE OF
GNP FALLS DURING RECESSIONARY PERIODS. HOWEVER, THE
CURRENT DOWNTURN APPEARS TO BE BUCKING THIS TREND . . .
Percentage Points
2

Change in Ratio of After-Tax Corporate Profits to GNP
1

-2

IV ’48
to
II ’49
SOURCE:

II ’53
to
II ’54

III ’57
to
1 ’58

II ’60
to
1 ’61

U. S. Department of Commerce.

13

IV '69
IV ’73
to
to
IV ’70
IV ’74
Recessions
(Defined by Quarters)

MAY 1975

BUSINESS REVIEW




14




FEDERAL RESERVE BANK OF PHILADELPHIA

15

BUSINESS REVIEW




MAY 1975

16




FEDERAL RESERVE BANK OF PHILADELPHIA

CHART 5
AND AS A SHARE OF GNP, INVENTORY-ADJUSTED CORPORATE
PROFITS HAVE REACTED SIMILARLY IN PERIODS OF ECONOMIC
SLOWDOWN.
Percentage Points
2
Change in Ratio of Corporate Profits to GNP
After Inventory Valuation Adjustment
1

to
II ’49

to
II ’54

to
I ‘58

17

to
I ’61

to
IV ’70

to
IV ’74

BUSINESS REVIEW

MAY 1975

On December 31, 1974, Americans were permitted to buy and sell gold for the first
time in some 40 years. Since then questions have been raised about the once-hallowed,
almighty metal's worth and importance. For example, has its status in the United States
and in the international monetary system changed? If so, in what manner? A pamphlet
recently produced by the Philadelphia Fed's Department of Public Information con­
siders the role of gold— past, present, future.
Copies are available free of charge. Please address all requests to Public Services,
Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105.




A Perspective
O n Stagflation
By John J. Seater

tary and fiscal policies. Hence, its cure must
have the same foundations.

Downgrading economics has become chic.
The profession is in a shambles, many claim,
because the "old-time religion" doesn't work
anymore, and no new Moses is on the hori­
zon to lead us from the economic wilderness.
Conventional economic wisdom holds that
inflation and unemployment aren't supposed
to increase at the same time. We're supposed
to face a tradeoff— more of one and less of
the other. Yet with both unemployment and
inflation rising in 1974, there appeared to be
no tradeoff, only the worst of both worlds.
This phenomenon— dubbed stagflation— is
frustrating everyone. We're stuck with stag­
flation and economists have trouble explain­
ing it, let alone knowing how to cure it.
An increasingly popular school of thought,
however, holds that stagflation is neither in­
explicable nor uncontrollable. This band of
economists argues that stagflation is based
on the old standbys of rational economic
behavior— supply and demand, and mone­



THE TYPES OF UNEMPLOYMENT

Getting to the whys and wherefores of
stagflation requires an understanding of the
three types of unemployment.
Even in the best of times, there are the
voluntarily unemployed — people who have
just entered the labor force or have quit their
jobs to look for something better. These
people, who choose to pass up low-payingor
distasteful jobs in order to search for
higher-paying or more enjoyable jobs, are
said to be frictionally unemployed.
Another group of unemployed consists of
those who have been fired because of struc­
tural changes in the economy. For example,
consumers may decide to buy fewer books
and more TV sets. This means that some
editors will be thrown out of work, and more
19

MAY 1975

BUSINESS REVIEW

with just monetary and fiscal policies. When
this is attempted, unemployment dips tem­
porarily, then bounces back to its natural
rate. The rate of inflation, however, rises to a
new level and stays there.

electrical workers will be hired. Such struc­
tural changes occur continually, and it takes
time for the newly unemployed to find jobs.
These people are the structurally un­
employed.
When the number of frictionally and struc­
turally unemployed equals the number of job
vacancies in the economy, unemployment
can be said to be at its “ natural rate," and the
economy can be said to be at full employ­
ment.1There are enough jobs around for the
unemployed; the unemployed just don't fit
the jobs. By this definition, full employment
does not mean no unemployment; it means
no unemployment in excess of (or below!)
the natural rate.
A third type of unemployment, which we
can call excess unemployment, arises when
the total demand for the economy's goods
and services (aggregate demand) falls below
the sum of everything business wishes to
produce (aggregate supply). For example,
consumers decide to save more and spend
less; in particular, suppose they decide to
buy fewer automobiles. Then automobile
producers, finding their cars unsold, will lay
off workers. Unlike structural unemploy­
ment, excess unemployment is not matched
by increases in vacancies because demand is
not merely shifting from one market to
another; it is decreasing in the total of all
markets. So when aggregate demand falls
below aggregate supply, the number of un­
employed exceeds the number of vacancies.
Government can eliminate excess un­
employment by applying monetary and fiscal
policies that stimulate total demand —
increasing the money supply, increasing
Government spending, and reducing taxes.
As demand increases, producers hire idle
labor. However, once unemployment
reaches its natural rate, the Federal Govern­
ment cannot permanently reduce it further

HISTORICAL PERSPECTIVE

What is the current natural rate of un­
employment for the U. S. economy? No one
knows for sure. Although the data on un­
employment are very good, data on vacan­
cies are not, partly because they have been
collected only for about five years. Meaning­
ful comparisons of unemployment and va­
cancies are thus impossible. Oneway around
the problem, though, is to estimate the
natural rate of unemployment by finding the
average rate of unemployment over a long
period. The idea is that cyclical fluctuations
will cancel out over a long period so that the
average rate will approximate the natural
rate. For the period 1900-29, the average rate
of unemployment is 4.8 percent. Remarka­
bly, the average rate for the period 1948-73 is
also 4.8 percent.2 For the sake of argument,
then, let's assume the natural rate of un­
employment is 4.8 percent.3
In 1970, about when the current criticisms
of economics and talk of stagflation began,
the unemployment rate averaged 4.9 per­
cent, almost equal to the assumed natural

2
The World War I, Great Depression, and World War II
years have been ignored because they were clearly un­
usual periods.
’Although there is currently no consensus on the ac­
tual value of the natural rate of unemployment, most
estimates place it between 4.5 and 5.5 percent. The pre­
sent explanation of stagflation is compatible with any of
these values. Some people who believe that 5 percent
unemployment is too high mightfavora reduction inthe
natural rate of unemployment itself. Economists do not
fully understand how the natural rate is determined, but
many believe that the natural rate cannot be changed by
countercyclical stabilization policies— that is, by
monetary and fiscal policies. Apparently, other kinds of
policies, such as education, retraining, and information
programs, would be needed.

’Full employment often is defined as that state in
which all expectations are realized. The two definitions
seem to be equivalent, however.




20

FEDERAL RESERVE BANK OF PHILADELPHIA

rate, but up from the low 3.5 percent rate of
1969. In 1974 the average unemployment rate
was 5.6 percent. However, since 1913 there
have been nine years outside the Great De­
pression which had unemployment rates
higher than 1974's rate. (These years are listed
in Table 1.)
Inflation last year proceeded at a rate of

TABLE 2

1974's RATE OF INFLATION
HAS BEEN EXCEEDED FOUR
TIMES SINCE 1913
Year
1916
1917
1918
1946
1974

TABLE 1

UNEMPLOYMENT HAS
EXCEEDED 1974's RATE
NINE TIMES SINCE 1913
Year
1914
1915
1921
1922
1949
1958
1961
1963
1971
1974

Annual Average
Rate of Unemployment
8.0%
9.7
11.9
7.6
5.9
6.8
6.7
5.7
5.9
5.6

SOURCE: U.S. Department
Bureau of Labor Statistics.

of

Labor,

TABLE 3

STAGFLATION HAS
OCCURRED BEFORE
Year
1914
1915

Annual
Average Rate of
Unemployment
8.0%
9.7

- 1.9
- 1.1

4.1
4.4

1932
1933

-10.3
0.5

23.6
24.9

1945
1946

2.2
18.1

1.9
3.9

1956
1957

2.9
3.0

4.1
4.3

1962
1963

1.2
1.6

5.5
5.7

1973
1974

12.2 percent. This is unusually high, but it has
been exceeded four times since 1913, as
shown in Table 2. The extraordinary de­
velopment of 1974 was not so much that the
rates of unemployment and inflation were
high, but rather that they rose simultaneous­
ly. Actually, this situation was not unprecendented; it has occurred six times before in
this century. Table 3 lists the pairs of years in
which both the rate of unemployment and of
inflation rose from one year to the next. What
does seem to be unprecedented in 1974,

Annual
Rate of
Inflation
0.9%
2.1

1927
1928

‘ Unemployment comprises roughly those
people not working but looking for a job.
SOURCE: U.S. Department of Labor,
Bureau of Labor Statistics.




Annual
Rate of Inflation
(December to December)
18.7%
20.7
14.6
18.1
12.2

8.8
12.2

4.9
5.6

SOURCE: U.S. Department of Labor, Bureau of
Labor Statistics.

21

MAY 1975

BUSINESS REVIEW

fall but their rate of increase dropped con­
siderably.5
That prices may rise rather than fall during a
recession— as in 1958, 1961, 1971, and
1974— needs explanation. Indeed, these
bouts of stagflation seem to contradict basic
economic theory. Recessions are charac­
terized by too much production relative to
demand, and the textbook response to ex­
cess supply is a drop in prices. So, how can
prices rise during a recession? The answer to
this question seems to lie in people's expec­
tations about future prices.
Expectations. People learn from experi­
ence. If they observe that prices have been
rising at a constant rate for a long time they
will come to believe that prices will continue
to rise at that rate in the future— in other
words, people will anticipate the inflation.
Let's see how this relates to their economic
behavior. Let's suppose that people change
their expectations so that they suddenly an­
ticipate higher inflation in the future. For
example, suppose people were previously
anticipating no inflation but now become
convinced that a 10-percent price rise is more
likely. They then figure their money will be
worth less in the future than it is today. Since
it will buy more today than it will tomorrow,
they are better off spending their money
now. If the economy is near full employment,
this attempt to accelerate buying will jack up
demand and drive up prices today. Changes
in expectations about future prices therefore
affect today's prices. (See Box 1 for a more
detailed discussion of the interaction be­
tween expected and actual price behavior.)
At the outset of inflation, however, people
are unlikely to change their outlook for fu­
ture price increases very rapidly. The reason
is they cannot be sure at first that the price
changes are permanent rather than tempo­
rary. If inflation persists, however, people
will build more and more of it into their
expectations, and in time they will com­

though, are. the magnitudes by which these
rates rose. Only 1946 and perhaps 1915 offer
anything comparable.
AN EXPLANATION OF STAGFLATION
One explanation of stagflation that has
gained favor among economists, though it is
not universally accepted, holds that there
are two parts to the stagflation story— un­
employment and its relation to what busi­
ness wants to produce (or, aggregate supply),
and inflation expectations and their relation
to what people want to buy (or, aggregate
demand).
Unemployment. Let's begin with un­
employment. Unemployment rises above its
natural rate when, because of some shock to
the economy, aggregate supply exceeds
aggregate demand. "Too much" is being
produced or, as economists say, there is "ex­
cess aggregate supply." Whenever produc­
ers face excess aggregate supply, they lay off
workers and curtail production, thereby
tending to eliminate the oversupply of
goods. However, the laid-off workers, sud­
denly finding their incomes reduced, curtail
their spending. These cutbacks in turn re­
duce aggregate demand, so that producers
still find they are producing "too much,"
which sets off another round of layoffs. Even­
tually, because of what economists call the
multiplier (see the Appendix), this process
stops with the economy left in a state of lower
output and higher unemployment.4 Reces­
sion has set in.
During or after a recession, prices eventu­
ally fall, or at least rise more slowly than be­
fore it. For example, in 1929, prices fell by 2.5
percent, in 1930 by 8.8, in 1931 by10.3, and in
1954 by 0.5. In 1958, 1961, and 1971— all
terminal years of recessions — prices did not

“This state will not last forever, according to economic
theory. Eventually, prices and wages will fall. The falling
prices lead to an increase in aggregate demand, and the
falling wages lead to an increase in employment. Ulti­
mately, the economy returns to full employment.




5ln 1971, the drop occurred even before wage-price
controls were instituted.
22

FEDERAL RESERVE BANK OF PHILADELPHIA

pletely adjust to it. At that point, when
people fully anticipate inflation, the rate of
inflation tends to level off. (Again, see Box1.)

Let's see how that can happen by taking a
simple example of Sam Searcher, diligent job
seeker. Sam lives in an environment where
prices have been increasing at about 2 per­
cent a year for sometime, so that everyone
expects that this rate is likely to continue into
the future. The unemployment rate is 4.8
percent (the presumed natural rate), and un­
fortunately Sam is one of the frictionally un­
employed. Suppose that the Government pur­
sues expansionary monetary and fiscal poli­
cies to bring unemployment to 3 percent—
well below the natural rate. Since there is no
"slack" in the economy, the effect of these
stimulative policies must be a general rise in
prices, say, on the order of 10 percent. Most
of the increase in prices will be unanticipated,
because people are expecting a 2-percent in­
flation based on past experience. What effect
will this have on unemployment? Let's see
what Sam Searcher is doing.

A Theory of Stagflation. Stagflation gets un­
derway as people revise their expectations
about inflation and try to take additional
steps to protect themselves from it. One way
they can protect themselves is to try to buy
today what will cost more tomorrow. But with
everybody playing the same game, more buy­
ing pressure is put on the economy and to­
day's prices turn out to be higher than they
otherwise would be.
Unemployment increases for a slightly dif­
ferent and more complicated reason, how­
ever. At first, people are "fooled" by in­
creased inflation and take jobs they wouldn't
ordinarily take in a less inflationary economy.
But after a while, they catch on to their "er­
rors" and revert to their old behavior.

BOX 1

EXPECTATIONS AND ECONOMIC ACTIVITY INTERACT
Suppose the economy has been in the happy state of full employment with no
inflation for a long time. Suddenly, prices begin to rise by 10 percent a year. At first,
people will feel that, because prices have been constant for so long, the current
increases are aquirk and soon will stop. However, if the inflation continues at the rate of
10 percent, eventually people will change their minds about the temporary nature of the
inflation. They will come to believe that 10 percent inflation is here to stay. As people
decide that inflation has become permanent, however, they alter their buying behavior.
They reason that if prices go up tomorrow, their money will be worth less than it is today.
Therefore, better to spend the money today rather than tomorrow when it will buy less.
So in anticipating inflation, people attempt to accelerate their purchases and increase
their demand for goods. Unfortunately, because the economy is at full employment,
more goods cannot be provided to meet the higher demand. Instead, prices must rise by
even more than the 10 percent rate to throttle this extra demand. Consequently, the
expectation of inflation, by raising aggregate demand, has increased inflation itself.
More inflation heightens expectations, spurring yet another round of inflation, and so
on up the spiral.
What stops prices from soaring through the roof? As prices rise faster than expected,
the real (or price-adjusted) value of that part of people's wealth in assets with fixed dollar
values such as cash begins to fall. For example, if someone has a $100 bill in his wallet and




23

MAY 1975

BUSINESS REVIEW

BOX 1 (Continued)
prices suddenly double, the $100 becomes worth only half as much as before— it can
buy only half as many goods. As the value of peoples' wealth falls, they channel less of
their income into consumption and more into saving to restore at least part of their lost
real wealth. So, the reduced value of wealth reduces consumption, which in turn
relieves pressure on prices.
In summary, as inflation proceeds and price expectations rise, people tend to increase
their consumption; however, simultaneously, the inflation eats into peoples' real
wealth and this tends to reduce consumption. Eventually, these two forces come into
balance. Once this happens, inflation stops rising and continues at a constant rate.
There are no further forces to change the actual rate at which prices rise.

On April 1, Sam contacts the XYZ Corpora­
tion and learns of a vacancy at $10 an hour. He
tells them he is unwillingto work for less than
$11 an hour and goes back to searching. On
April 2, inflation begins because of the Gov­
ernment's stimulative policies, and XYZ starts
getting higher prices for its products. On
April 3, XYZ decides to raise the wage as­
sociated with its vacancy to $11 an hour to
attract more workers. They call Sam and tell
him they are now willing to pay $11 an hour.
Delighted, Searcher accepts and becomes
employed. Multiply this situation across the
country, and unemployment falls below its
natural rate. Consequently, it seems that
lower unemployment has been bought by
higher inflation. However, by the time, say,
April Fools' Day 1976 has rolled around, Sam
Searcher and others like him have learned
that inflation has been galloping along at 10
percent and that as a result all wages and
prices, not just their own, have risen. In fact,
they discover that their current wages of $11
an hour are worth no more now than the
$10-an-hour wage was worth on April 1,1975.
Because they were not willing to work at $10
an hour at the old prices, they are not willing
to work at $11 an hour now at the new prices;
for they recognize that relative wages and
prices have not changed. They quit work and
once again become unemployed. Un­
employment returns to its natural rate. How­
ever, inflation continues at the rate of 10 per­
cent.



Stagflation has set in. Inflation has in­
creased from 2 to 10 percent as a result of
overly stimulative policies, whereas after a
temporary decline, unemployment has risen
back to the natural rate. When people per­
ceive that all prices have risen simultaneously
and build this into their expectations, their
behavior is no longer affected by inflation; so
that even though inflation may be higher,
unemployment after a period of economic
adjustment will end up back at its natural
rate. (See Box 2 for a demonstration that an­
ticipated inflation does not affect economic
behavior.)
FROM THEORY TO REALITY
Economists who subscribe to the natural
rate view say that it explains events in the
U. S. economy since the middle '60s. In
1964, inflation was proceeding at the low
rate of 1.2 percent, and unemployment
was 5.2 percent. As the Vietnam War
heated up, inflation rose to 6.1 percent in
1969, and unemployment fell below the
natural rate to 3.5 percent. Subsequently,
however, unemployment began to rise
back toward the natural rate but inflation
remained high, as the natural rate theory
would predict. Unemployment continued to
rise (except during 1973, when it fell some­
what following the highly stimulative mone­
tary policy of 1972) above the assumed natu­
ral rate until in 1975 it reached the 8-9 per­
cent range.
24

FEDERAL RESERVE BANK OF PHILADELPHIA

BOX 2

FULLY ANTICIPATED INFLATION DOES NOT
AFFECT ECONOMIC BEHAVIOR
Let's look closely at the situation where prices are rising at a constant and fully
anticipated rate. How are people behaving? Consumers, expecting higher prices in the
future, demand wage contracts that allow for future wage increases to match the
anticipated price increases. Employers, expecting to sell their goods for higher prices,
are willing to grant such contracts. Everybody is happy, and the inflation affects neither
employment nor output.
Interest rates also reflect the expected rate of inflation. Lenders, expecting prices to
rise, demand that an inflation premium equal to the expected rate of inflation be tacked
onto the interest rate charged for loans. For example, if lenders would charge 5 percent
interest, compounded continuously, on loans when there is no inflation, then if they
come to expect a rate of inflation of 10 percent, they will up their interest rate to 15
percent. Borrowers, in contrast, are willing to pay the inflation premium because they,
expecting a rate of inflation of 10 percent, figure they will be able to earn the extra 10
percent with the borrowed money. Again, everybody is happy, with inflation affecting
neither savings nor investment.
Inflation, then, once fully anticipated, has no effect on the unemployment rate. The
reason for this startling conclusion is that once everyone anticipates inflation fully and
adjusts to this anticipation, the inflation will not affect relative prices. (The real rate of
return on money balances is an exception; it is reduced by an increase in inflation.
However, the effects of this change are small for the moderate rates of inflation
experienced by the U. S. and can be ignored.)
Economic activity depends not on the absolute levels of wages, prices, and assets, but
on their relative values. For example, when the price of, say, butter rises relative to
margarine, people reduce their consumption of the former and buy the latter. However,
when all wages, prices, and asset values rise by the same proportion (and this change is
correctly perceived by the public), there are no changes in anyone's economic be­
havior. Because prices have doubled, people must spend twice as many dollars for every
item they buy. But because wages and asset values also have doubled, people have twice
as many dollars to spend. Their "real income" and "real assets" are unchanged, and
they will continue to buy exactly the same basket of goods as before prices, wages, and
asset values doubled. Therefore, if inflation proceeds at a rate of 10 percent and if
everybody expects it to proceed at this rate, then all wages, prices, and asset values will
rise at a rate of 10 percent. In short, their relative values will not change and economic
activity will be unaffected by the inflation.
The following example may be helpful. Mr. Chubby lives for three days— today,
tomorrow, and the day after tomorrow. He currently has a job at which he works an hour
a day and earns 15 cents an hour. He plans to work today and tomorrow and then retire
the day after tomorrow. He only consumes 10-cent candy bars. Chubby, having




25

MAY 1975

BUSINESS REVIEW

BOX 2 (Continued)

foresight, plans to spend 10 cents today and 10 cents tomorrow, saving 5 cents each day
toward his retirement, when he will spend his savings on one last candy bar. Chubby's
life plan is summarized in the following table:
Day after Tomorrow

Today

Hours Worked
Earnings
Candy Bars Consumed
Expenditure
Stock of Savings at Start of Day
Addition to Stock of Savings

Tomorrow

15<t

154

04
104

54

104
54
54

1

1
104
04

1

1

0

1

104
-104

Suppose that everything goes according to plan today, so that Chubby earns his 15
cents, buys one candy bar, and saves 5 cents. At the end of the day, his assets total 5
cents. Suppose, however, that at the end of today the Government announces it will
double all wages, prices, and asset holdings before tomorrow. Then Chubby can
anticipate an increase in the price of candy bars to 20 cents apiece, and an increase in his
current asset holdings to 10 cents. As we can see from the following table, Chubby can
stick to his plan of working one hour tomorrow, retiring the day after tomorrow, and
consuming one candy bar each day:
Tomorrow

1

Hours Worked
Earnings
Candy Bars Consumed
Expenditure
Stock of Savings at Start of Day
Addition to Stock of Savings

304

1

204

104
104

Day after Tomorrow

0

04

1
204
204
-204

The doubling of all wages, prices, and asset values has no effect on Chubby's economic
behavior.

Why did unemployment rise far beyond
the natural rate even though people were
beginning to anticipate increased rates of
inflation? The answer seems to be that the
Government believed that inflation was
"too" high and had to be reduced. Con­
sequently, restrictive monetary and fiscal
policies were implemented. Total demand
fell below the amount that businesses
wanted to produce. As unwanted inventories
began to pile up, firms cut back production
and layoffs began, touching off a period of



sharp contraction of economic activity. With
the sharp slackening in demand the pace of
inflation has slowed, but because doubledigit inflation remains fresh in the minds of
the people, inflationary expectations still
plague the economy. As a result, prices are
still rising at a fast clip by historical standards.
But as people revise downward their inflation
expectations and curtail further their attempt
to "beat inflation," a further easing of price
pressures is in the cards, according to the
natural rate view.
26

FEDERAL RESERVE BANK OF PHILADELPHIA

depiction of this whole process.) How rapidly
the economy returns to this happy state de­
pends on the policies pursued. The natural
rate approach presents policymakers with a
Hobson's choice— eliminating inflation re­
quires some increase in unemployment. How
much unemployment is chosen determines
how quickly the inflation is eliminated.

In short, the process that brought the
economy to a high rate of inflation is being
reversed. Eventually both the actual and ex­
pected rates of inflation will fall to a more
acceptable level, and unemployment will re­
turn to its natural rate. The economy will end
up back in a state of full employment with
little or no inflation. (See Box3 fora graphical
BOX 3

HOW THE NATURAL RATE PROCESS WORKS
The economy starts at point A, where inflation is 0 and unemployment is at the
natural rate N. As inflation begins to rise, unemployment falls at first because people are
fooled into thinking their wages have risen relative to prices and therefore accept
employment more readily. Unemployment reaches its low point at B. As people begin to
learn of inflation, unemployment begins to rise because people find that their wages in
fact have not increased relative to prices by as much as they had thought, and they
therefore leave employment more readily. Once everybody fully anticipates the infla­
tion, the economy ends up at C, with inflation proceed in gat 10 percent but employment
back at its natural rate. If at this point inflation were to rise to 20 percent, the process
would be repeated and the economy would move from C to D to E.
How can the economy be moved from C back to A? Suppose the economy is at C in
Graph 2, which corresponds to C in Graph 1. The expected rate of inflation equals the
GRAPH 2

GRAPH 1
HOW INCREASING THE RATE OF INFLATION
CAN LOWER THE RATE OF UNEMPLOYMENT
TEMPORARILY BUT NOT PERMANENTLY

HOW TO GET BACK TO A ZERO RATE OF
INFLATION
Rate of Inflation (Percent)

Rate of Inflation (Percent)

10

0
Rate of Unemployment (Percent)




27

Rate of Unemployment (Percent)

BUSINESS REVIEW

MAY 1975

BOX 3 (Continued)

actual rate. Suppose Uncle Sam ends the stimulative policies that brought the economy
from A to C. Then aggregate demand falls below aggregate supply. This takes pressure
off prices and reverses the process that brought the economy from point A to point C.
The economy moves from C back to A via F. At point A, both the expected and actual
rates of inflation are back down to 0 percent, and unemployment is at its natural rate.
The economy is back in a state of full employment with no inflation.
Graph 3 shows the recent path of the U. S. economy.
GRAPH 3
THE RECENT EXPERIENCE OF THE U.S. ECONOMY
Rate of Inflation (Percent)

Rate of Unemployment (Percent)

tradeoff emerges. The faster the economy is
forced to return to price stability and full
employment, the higher is the unemploy­
ment that must be endured in the meantime.
Conversely, the lower the rate of unemploy­
ment is kept, the longer the economy will
take to return to price stability and full
employment.
Why isn't it possible to employ restrictive
policies to fight inflation but keep un­
employment down by starting a program like
the WPA of the 1930s? That's possible, but
here the Government must be careful. The
purpose of Government-sponsored job pro­

POLICY CHOICES: HOW FAST TO GO AND
WHO GETS HURT?

The natural rate approach suggests that the
higher the unemployment rate now, the fas­
ter inflation will be eliminated, and the
sooner the natural rate of unemployment can
be restored. The more restrictive the Gov­
ernment makes its policies, the more demand
declines. Hence, the rate of inflation sub­
sides more rapidly, and people quickly revise
down their expectations about inflation.
However, more restrictive policies also mean
more unemployment. Consequently, a clear



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FEDERAL RESERVE BANK OF PHILADELPHIA

There are, then, two policy tradeoffs. First,
there is a speed tradeoff. The faster society
wants to reduce the rate of inflation, the
greater the unemployment burden it must
bear during the process of price reduction —
but, the sooner it can return to normal condi­
tions. Second, there is a distribution trade­
off. Whatever speed tradeoff society
chooses, it must decide how to distribute the
ensuing burden. It can adopt a "hands-off"
policy, in which the unemployed bears a dis­
proportionate share of the burden of re­
ducing inflation, or it can attempt to alleviate
unemployment through Government assis­
tance, in which case some of the burden of
reducing inflation is shifted to others.

grams is to spread the burden of fighting
inflation more equitably across the popula­
tion. There are two ways to finance a job
program— by increasing deficit spending or
by increasing taxes. Any simple increase in
deficit spending would tend to offset the
original restrictive policy that was insti­
tuted to fight inflation. The anti-inflationary
thrust of the total program would be less.
However, if the Government is going to
employ deficit spending to finance job
programs and still salvage some anti-infla­
tionary benefits from its policies, it must
pay the workers something less than their
original salaries. The less the Government
pays the workers it hires, the more rapidly
inflation will be eliminated, but the largerwill
be the burden of the anti-inflation struggle.
The other possibility is to finance the job
programs by taxes instead of by deficit
spending. Under this scheme, the job pro­
grams themselves would have little, if any,
net effect on aggregate demand, no matter
what their size. Every dollar given to unem­
ployed Paul simply would be taxed away from
employed Peter. This is merely a transfer of
income and has no effect on the total amount
of income there is to be spent. However, it
would spread the burden of the inflation
fight in a way many people consider more
equitable.
Following this logic, the Government can
use WPA-style programs to fight unemploy­
ment while it is fighting inflation. However, if
total policy is to remain anti-inflationary,
someone still must get hurt temporarily.
Either the people rehired by the jobs program
must be paid less than their original salaries,
or the people still employed must pay higher
taxes to finance the jobs program, or both.6

Rx FOR STAGFLATION?

The natural rate view appears to have some
merit in explaining the current predicament
of the U. S. economy. The basic idea is that
stabilization policy has been used in an at­
tempt to keep unemployment below its
natural rate. As unemployment returned to
its natural rate, stagflation resulted. In an at­
tempt to combat the resulting inflation, un­
employment was permitted to rise to its cur­
rently high levels. Relief on the inflation front
has finally begun to appear.
Within this framework of analysis, the
"old-time religion" offers a cure for our ills.
In a nutshell, the cure is to bear a temporary
burden of higher unemployment, lower in­
comes, and/or higher taxes until inflationary
expectations are eliminated. Granted, this
cure is painful. But, unfortunately, if the
natural rate approach is correct, there seems
to be no other remedy. What choices there
are revolve around how fast the economy
should take the inflationary cure and how the
burden should be distributed.

6
Why couldn't the Government apply stimulative
policies to reduce unemployment and institute wageprice controls to prevent inflation? The debate over con­
trols is complex and beyond the scope of this article.
What is pertinent here is that controls do not eliminate
the cause of inflation— excess demand; they merely
force the demand pressures to manifest themselves in




different ways. For example, if prices cannot rise to clear
the market, people may have to spend more time waiting
in lines to make their purchases, which means that al­
though it costs fewer dollars to buy goods, it costs more
time. Controls do not cure the disease of inflation; they
only affect the symptoms.
29

MAY 1975

BUSINESS REVIEW

APPENDIX

THE MULTIPLIER EFFECT
Let's look at a very simple example to see the main points involved. Assume that the only factor
of production is labor and that producers are all philanthropists who pass on all their profits to
workers. Then each worker is paid exactly the value of what he produces. Suppose all workers are
alike and earn $10,000. Suppose all workers always devote four-fifths of their income to consump­
tion and one-fifth to saving.
Imagine that the Federal Government suddenly cuts its purchase of consumption goods by
$10,000. Producers react by cutting production goods by $10,000 and fire one worker. This fired
worker, having lost his income, reduces his consumption. He was earning $10,000, of which he
spent four-fifths, or $8000. For simplicity, suppose that when he is fired, he stops consuming alto­
gether so that total spending drops by another $8000 over and above the Government's original
reduction of $10,000. Producers now must cut production by $8000. They do this by firing fourfifths of a worker, that is, by reducing the number of hours that one worker is employed by fourfifths (for example, if workers normally work an eight-hour day, one of them now would work
8 — 4/5 x 8 = 2.6 hours) and reducing his pay by $8000. He must reduce his consumption by
4/5 x $8000 = $5400. This causes producers to reduce output again and reduce another worker's
pay and so on. The total reduction in pay turns out to be
$10,000 x — 1 = $50,000.
—
1- 4/5
The total number of man-hours eliminated is
g hours
_____ ° worker $10,000 ~ ^ — r = 40,
1- 1
$10,000 worker
—
5
which is equivalent to firing five workers. The fraction
1-4/5
is called “the multiplier." There are two important things to notice in this example. (1) Because of
the multiplier, the decrease in Government spending caused a contraction in the economy that
was larger than the original decrease in spending itself. (2) This contraction did not continue in­
definitely so as to wipe out the entire economy but stopped at a point determined by the mul­
tiplier.
This simple example overstates the multiplier; there are many “ leakages" in the economic
system which reduce the multiplier from the pure, theoretical value used above. Adjustments in
interest rates, the existence of unemployment compensation, and the automatic reduction in tax
receipts that occurs as incomes fall are examples of such leakages. However, for simplicity's sake,
these complications are ignored.




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FEDERAL RESERVE BANK OF PHILADELPHIA

SELECTED BIBLIOGRAPHY
Friedman, Milton. "The Role of Monetary Pol icy. "A me rican Economic Review 58 (1968):
1-17.
Grossman, Herschel I. "Aggregate Demand, Job Search, and Employment, "journal of
Political Economy 81 (1973): 1353-69.
Grossman, Herschel I. "The Cyclical Pattern of Unemployment and Wage Inflation."
Economica 41 (1974): 403-13.
Lucas, Robert E., Jr.; and Rapping, Leonard A. "Real Wages, Employment, and Infla­
tion." In Microeconomic Foundations of Employment and Inflation Theory, edited by
Edmund S. Phelps, pp. 257-305. New York: W. W. Norton and Company, 1970.
Mortensen, Dale T. "A Theory of Wage and Employment Dynamics." In Microeconom­
ic Foundations of Employment and Inflation Theory, edited by Edmund S. Phelps,
pp. 167-211. New York: W. W. Norton and Company, 1970.
Sargent, Thomas J. "Rational Expectations, the Real Rate of Interest, and the Natural Rate
of Unemployment." Brookings Papers on Economic Activity, No. 2, 1973, pp. 429-72.
Tobin, James. "Inflation and Unemployment." American Economic Review 62 (1972):
1-18.
Tobin, James. "The Wage-Price Mechanism: Overview of the Conference." In The
Econometrics of Price Determination: Conference. Washington: Board of Governors
of the Federal Reserve System, June 1972.
S




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FEDERAL RESERVE BANK of PHILADELPHIA
PHILADELPHIA, PE> ASY LVA> IA 19105

business review
FEDERAL RESERVE BANK
OF PHILADELPHIA
PHILADELPHIA, PA. 19105