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THE ECONOMIC OUTLOOK: CAUSE FOR OPTIMISM? Aubrey N. Snellings” The economy is just entering the second year of recovery from the most severe recession this country has experienced since the 1930’s. Over the course of the past year opinion as to the strength and durability of the recovery has undergone a number of changes. In the early months business cycles as Arthur Burns and Wesley Mitchell always emphasized that each cycle is unique, so we shouldn’t expect developments in this period to be exactly like those in any other recovery we have known. Nevertheless, all of the other postwar expansions have shown a number of common characteristics. This one differs from these others in a number of respects. The most important difference is in the timing of the beginning of recovery in the various major sectors of the economy. Over the past year the process of expansion has developed in something of a slow-motion fashion, with revival in some major sectors of the economy delayed much longer than in the typical postwar upturn. The result has been an attenuation of the recovery process, with some sectors still failing to contribute significantly to the upswing. of the upswing widespread concern was expressed as to its durability; more recently, opinion generally has become rather bullish, with some forecasters talking of a possible economic boom. This brief article attempts to put our present economic situation in perspective and to assess the prospects for continued economic expansion. We might begin by noting that the economy has shown considerable improvement over the last twelve months. Real GNP in the first quarter of 1976 was up some 7.1 percent since the first quarter of last year, and industrial production is 11% percent higher than it was last April. The rise in output is reflected in increased utilization of plant and equipment and a great deal of improvement in labor markets. Employment has risen by 3.6 million since last spring, the average factory workweek has lengthened, and the unemployment rate is at 7.3 percent, down from 8.9 percent last May. At the same time, there has been considerable progress in the effort to get a grip on the problem of inflation. In spite of these heartening developments, this would have to be rated as one of the slower recoveries in the period since World War II. The 7.1 percent rise in real GNP between first quarter 1975 and first quarter 1976 compares with an average gain of 8% percent in the comparable periods of the five other postwar revivals. (See chart, page 5.) The 4.5 percent growth in real final sales over the last year was the smallest of any postwar recovery. In addition, we still have some 7 million workers unemployed and about one-fourth of our manufacturing capacity idle, so the recovery process is still far from complete. Not only is this economic upturn one of the slowest of the postwar period, it also differs in some other important respects from most oi these other recoveries. Of course, such students of Typically, the consumer sector accounted for much of the growth in final sales in the early months of the revival. But even so, the increase in total consumer spending since last spring has been smaller than in the comparable periods of most postwar recoveries. Business fixed investment spending, on the other hand, showed virtually no increase (in real terms) from the trough of the recession to the first quarter of 1976. Business fixed investment is something of a lagging series, of course, but in the five earlier recoveries since World War II this type of outlay increased an average of 10 percent over the first year of economic rebound. The swing in inventory policy last summer, when businesses stopped liquidating inventories, provided a bi g boost to production and employment. But unlike other recent recovery periods, businesses did not begin immediately to rebuild inventories when recovery began. As a matter of fact, real inventories declined slightly in each of the last two quarters of 1975, although businesses did begin to add to stocks at a rather substantial pace last quarter. * Vice PreGlent and Economist, Federal Reserve Bank of Richmond. This article is adapted from a speech before the Automotive Market Research Council, Hilton Head, South Carolina, April 21. 1976. FEDERAL RESERVE BANK OF RICHMOND 3 The situation in housing has been different this In recent years, the housing sector time, too. has tended to lead the overall economy, with outlays on residential construction beginning to fall spending, and it seems that prospects in the consumer area are fairly good, although not as bright as they appeared a few months ago. In the early months of this year, the improved employment long before outlook, the reduced inflation rate, rising real improvepersonal income, and the tremendous ment in stock prices all contributed to a major improvement in consumer confidence. The Conference Board survey of consumer attitudes the economy turned down and then leading the upturn by one or two quarters. In the most recent period, the housing sector did not lead the recovery at all, and as a result it provided less stimulus in the early stages of the Outlays on resiupturn than it usually does. dential construction did pick up in the second half of 1975, however, and the increase over the first four quarters of recovery the average gain in the other postwar upturns. was about in line with comparable periods of Nevertheless, because the recovery started from a very low level, a great deal of unused capacity exists in the housing industry. Perhaps one should not make too much of the differences between this recovery and what might be called the typical postwar recovery. It seems possible, however, that the unusually attenuated process of recovery over the past year has set the stage for a much more prolonged expansion than has been typical in the postwar period. It also could turn out to be one of the strongest recoveries, if things go right. One might envision the following scenario: Consumer spending, which has provided much of the strength in final sales thus far, will continue to show moderately strong growth over the months ahead. Inventory accumulation, which until last quarter contributed almost nothing to the upturn, should continue to show a good deal of strength throughout the remainder of this year. This would provide substantial boosts to production, employment, and income over the remainder of this year; and the improvement in income would sustain and strengthen consumption. Residential construction, which is improving, could continue to add strength over the next Finally, by the end of the year, rising year. output, improved capacity utilization rates, and a healthy profit picture could set in motion a burst of capital spendin g that might sustain the expansion through 1977 and perhaps beyond. Now, admittedly, the development of this scenario depends on the achievement of the best possible outcome in each of the major sectors of the economy. There are a lot of points where things could go wrong, but the scenario seems entirely attainable. The most important prerequisite to the realization of this projected chain of events is continued strength in consumer 4 ECONOMIC showed a sharp rise in consumer tween last October and February, level plans since October also improved 1973. sharply, confidence beto the highest Consumers’ buying with the percentage of respondents planning to purchase a car in the next six months setting a record high in the of Michigan history of the series. The University survey conducted at about the same time showed similar results. More recently, however, the Conference Board index of consumer confidence declined enough to more than offset the JanuaryFebruary gain, and other indexes of consumer sentiment evidenced some weakness. The reasons for this apparent weakening of consumer confidence are not entirely clear, but many respondents mentioned the fear of a new outburst of inflation. The recent hesitation in the stock market also may have been a factor. Consumer activity since last fall tends to confirm the increased willingness to spend, although in recent weeks the growth in consumer outlays has tapered off. But total consumer expenditures in the GNP accounts rose at an annual rate of about 11 percent in the first quarter (73A percent in real terms), and retail sales, after pausing briefly last fall, rose at an annual rate of 14 percent between November and April. Moreover, price increases have been quite moderate over the past six months, so much of this increase represents a gain in real sales volume. This strength of consumer demand has led businessmen to reassess their inventory positions. Inventory-sales ratios fell sharply in 1975, and at the retail level they are near the lowest point in a number of years. Businessmen learned some very tough lessons on inventory management in 1974 and 1975, and they would be expected to follow very cautious policies for some time to come. But there is some evidence that vendors halve been losing sales because of an inability to m’eet demands from existing stocks, especially at the retail level, and delivery times are getting longer. As retail sales continue to rise, businessmen may increase orders and production at a pace faster than the increase in sales in order to rebuild in- REVIEW, JULY/AUGUST 1976 ventories to a level they consider consistent with the improved level of consumer spending. Gross National Product data show that inventories were accumulated at a substantial rate in the first quarter, and further needed accumulation may provide significant strength to the recovery throughout this year. Prospects for residential construction appear to have improved, although the housing industry is still faced with a number of large problems. Housing starts are up substantially from last year’s low, but the industry is by no means out of the woods. provement are Important barriers to rapid imthe extensive overbuilding that occurred in the 1972-73 boom, the extraordinary rise in home prices in recent years, and the conditions that have prevailed in mortgage markets. In February, for example, the average price for a new single-family house was $42,300, about llyz percent higher than a year earlier. When the high cost of mortgage money is added to the price of the average house today, the result is a very large monthly mortgage payment, and it is easy to see why it is said that many families in this country have been priced out of the housing market. Still, things are looking better in the housing sector, especially in the market for single-family homes. Sales of houses improved in the second half of 1975, and the backlog of unsold units declined. Rental vacancy rates have declined. Wage increases in the construction industry have been comparatively small this year, and there have been reports that construction workers in some parts of the country have agreed to wage reductions, developments that suggest some slowing in the rise of home prices. Housing starts declined slightly in March and April, but this followed a very large jump in February. Seasonal adjustment problems for this particular series are especially difficult for the winter months, of course, and there is general agreement that the February figure overstated the improvement in housing. Still, an average of the February-April figures indicates a substantial improvement in the housing picture, and building permits issued in the first four months of 1976 were some 55 percent higher than in the comparable period of 1975. All in all, there seems a fairly good chance that the housing industry will provide additional stimulus to the economy throughout 1976. The determining factor may be the continued availability of mortgage money. Savings have been flowing into thrift institutions in large amounts and, until recently, there was some easing in mortgage rates. tinued availability of mortgage financing Conmay depend on what happens to the inflation rate, the strength of loan demand, and the rate of growth of the money supply. Business outlays on plant and equipment have picked up much more slowly in this expansion As noted than in other postwar recoveries. earlier, in real terms plant and equipment expenditures were about the same last quarter as in the first quarter of 1975, although there was a nice increase from the fourth quarter 1975 to first quarter 1976. But it seems that a number of conditions favorable to a resumption of capital forCapital appropriations mation have developed. of large manufacturers rose substantially in the fourth quarter of 1975, and the output of business equipment has risen in recent months. Capacity utilization rates are rising, corporate profits have been moving up strongly, and cash flows are immensely improved. Finally, like consumers, businessmen have regained their confidence, while financial markets are substantially better than they were a year ago. For example, a number of non-blue chip corporations that were excluded from bond markets last year are now able to float security issues, and the rate spread between issues of varying quality is reduced. Evidence of these changes is provided in the recently completed McGraw-Hill survey of business spending intentions. In this survey, estimates of expected outlays on plant and equipment in 1976 were revised upward to 13 percent from last fall’s 9 percent figure, with a sharp surge of expenditures indicated for the second half of this year. Because of all these considerations, there may well be a significant rebound in business investment in the second half of this year or in early 1977. Indeed, first quarter figures indicate it may already be under way. But the timing and strength of this development will depend primarily on the strength of consumer demand and the inventory policies of businesses, If the rebound in plant and equipment spending does begin to gather strength toward year’s end, it would go a long way toward extending the recovery through 1977 and perhaps beyond. The scenario outlined above paints a rather optimistic picture of the economic outlook over the next eighteen months, but it is one that can be achieved. The future is never certain, however, and there are several developments that 6 ECONOMIC could jeopardize the achievement One is a strong resurgence sharp rise in interest of this scenario. of inflation, rates. These another two things a are not unrelated, of course. But a renewed burst of inflation would erode the gains in real income that have been realized in recent months and destroy the improvement in consumer confidence that is vital to continued growth in retail activity. Business confidence also would be impaired, and in the face of weakening consumer outlays, both inventory accumulation and plant and equipment expenditures would be adversely affected. Finally, an acceleration of price increases would damage the much-improved but highly sensitive financial markets interest and contribute to a run-up in rates. The inflation picture has improved greatly over the last year or so, of course, in spite of the recent uptick in both wholesale and consumer prices. But much of the improvement in 1975 came from a working out of the extraordinary price increases associated with worldwide crop failures, OPEC, the lifting of price controls, and other special factors in 1973 and 1974. In more recent months, temporary declines in food and fuel prices have moderated the rate of inflation, but these already have been reversed. Gasoline prices are moving up again, and farm prices jumped sharply in April. In addition, price increases for a number of metals have been announced recently. Given the large cushion of unemployed resources, demand-pull inflation is not likely to be a factor this year, although a strong surge in economic activity might run up against capacity limits in some industries. But the most important single factor influencing prices in the months ahead will be the rise in labor of important this year, of economic been agreed to this industry recovery some increase omy will be considerably year increases tracts. year won’t A number be so large. REVIEW, JULY/AUGUST 1976 rate. the strike. than in these In addition, But the firs,tnew con- not expiring this this year nonunion this year because Finally, rubber for the econ- so the increase may be smaller inflation smaller for of contracts were front-loaded, increases lower provided and costs have settlements in a lengthy in labor but the There sizable of course, is still involved the average negotiations of inflation as well. rather year, A number of these not only the rate already costs. come up for renewal and the outcome will affect rate wage contracts we should wage of the keep in mind that a strong would produce would reduce labor costs. recovery substantial the impact in economic productivity of higher activity wages on unit A sharp rise in interest rates also might be bad news for the continuation of the recovery. The most immediate impact, of course, would be on the housing sector. A run-up in rates would dry up the flow of savings into thrift institutions, and mortgage money would become very scarce and very costly. Other financial markets would be adversely affected and the recent improvement in consumer confidence endangered. Finally, the expected resurgence in business Some gains that investment could be aborted. Interest rates have performed rather well thus far in the recovery. After moving up fairly sharply last summer, they drifted downward for about six months and, until recently, most of them were at about the level they were a year earlier. In late April, however, rates began to move back up. As the economy continues to expand, further upward pressure on interest rates should be expected. Government is borrowing huge amounts of the funds flowing into the capital markets and, if private demands increase with the recovery, total demand in the market may exceed the supply at current rate levels. well-informed ing out” of private observers borrowers fear that the “crowd- was so much talked about last year. The prospect of “crowding out” appears somewhat more plausible this year than last simply because the position of businessmen has been reversed. Throughout 1975 businesses were reducing demands for funds by cutting back on inventories and scaling back capital outlays; in the year ahead they may be doing just the opposite. Continued economic recovery, however, would reduce Government demands for funds. If things should develop this way, with interest rates rising rapidly and private borrowers being crowded out of financial markets, it could create some thorny problems for the Federal Reserve System. A sharp rise in rates would not be welcome because of the adverse effects on continued expansion at a time of relatively high unemployment. But an attempt to prevent a rise in interest rates, under these conditions, could bring a very rapid growth in the money supply that would almost surely bring on renewed inflation. It may be possible, of course, to strike some happy medium between these extremes and to achieve a moderate growth in money without a sharp runup in interest rates. Such a development would bode well for the continuation of the recovery. FEDERAL RESERVE BANK OF RICHMOND 7 SOME CURRENT CONTROVERSIES IN THE THEORY OF INFLATION Thomas M. Humphrey The settled sodes theory of inflation state. Largely of prices stagflation rose concensus off view debated. and control A careful and a clarification tinctive features joblessness and relating of competing trade inflation has to the causes, 1. claims schools issues and dis- of thought The purpose of this article is threefold. First, classificatory framework it develops a general within which particular issues can be organized and examined. Second, it uses this framework to survey some of the main debates that are current in contemporary discussions of the problem of inflation. Third, it identifies four distinct theories that emerge from these debates, specifies their distinguishing characteristics, and comments on the plausibility and relevance of each theory. The basic The Four-Equation Framework framework employed in this article consists of four relationships of the type that appear in many aggregative models of the inflationary process. These relationships are derived from the underlying market demand and supply equations that constitute fairly complete general equilibrium models of the economy. The relationships include (1) a wage equation explaining how the rate of increase of nominal wages is determined ; (2) a price equation specifyin, 0‘ how the rate of price inflation is determined ; (3) a price-expectations equation explaining how people formulate their expectations about the future rate of inflation; and (4) a demand-pressure equation that describes how the level of excess aggregate demand -measured in terms of either output (relative to normal capacity) or unemployment-is determined. ECONOMIC REVIEW, WAGE w 2. 3. W[PL, = peL, XL, ZLI * EQUATION: P[WL, peL, XL, ZLI * PRICE-EXPECTATIONS p’ 4. = EQUATION: PRICE P are being may prove useful. S In its most general form, the basic classificatory framework can be written as follows. explanations. of these rival and curve of inflation sorting-out of the epi- once-dominant Phillips of competing of issues in an un- by recent the unemployment a variety transmission, which of a stable way to a host Today in simultaneously, between given is currently discredited = pe[pL, = x[(m-p>L, : ZLI. DEMAND-PRESSURE x EQUATION EQUATION : fL, ZL]. Here w is the percentage rate of change of nominal wages; p is the percentage rate of change of prices, i.e., the inflation rate; pe is the expected future rate of change of prices, i.e., the anticipated rate of inflation; and x is the level of excess demand, no distinction being made between labor and product markets .l The variables m and m-p are the percentage rates of change of the nominal and real (price-deflated) money stocks, respectively, and f is the fiscal policy variable represented by the size of the government’s budgetary deficit. The variable z is the vector of cost-push forces including such factors as trade-union militancy, monopoly power, and the political commitment to the goal of full employment and the consequent removal of the fear of unemployment as a factor constraining wage demands. The subscript L represents time lags denoting that the dependent variables may be influenced by lagged as well as contemporaneous values of the independent variables. In the above framework, the wage equation states that the rate of money wage increase is determined by the actual and anticipated rates of rise of the cost of living, the excess demand for labor, and cost-push forces. The price equation ‘It is not necessary to specify separate excess demand variables for the product and labor markets since the two measures are assumed to be linearly related. Excess demand in the product market is measured by the gap between actual and potential (i.e.. normal or standard) output. Excess demand in the labor market is measured by the difference between the actual and natural rates of unemployment, where the latter is the rate that, given the inevitable frictions, rigidities, and market imperfections existing in the economy, is just consistent with demand-suppIy equiIibrium in the Iabor market. The linear relationship between the two measures permits them to be used interchangeably. JULY/AUGUST 1976 relates the rate at which businessmen increase their product prices to the rate of rise of wages, to the rate at which prices in general are expected to rise, to excess demand in the product market, and to cost-push forces. The price-expectations equation states that the anticipated future rate of inflation is generated from experienced actual rates of price inflation and perhaps other Finally, the demand-pressure influences also. equation expresses the level of excess aggregate demand as a function of the rate of growth of the real stock of money, the strength of fiscal policy, and the vector of cost-push forces. Taken together, these relations form a simple four-equation system which, given the values of the independent and predetermined (lagged) variables, can be solved for the values of the dependent variables w, p, pe, and x. These latter variables, being determined within the system, are said to constitute the dependent or endogenozts variables of the model. By contrast, the fiscal policy, money growth, and cost-push variables are considered exogenous, i.e., determined outside the system. The exogenous variables are treated as the proximate causes or sources of inflation. They correspond to three leading explanations of how inflation gets started, namely, the fiscalist, the The first monetarist, and the cost-push views. two views constitute alternative versions of the so-called demand-pull theory of inflation. Whereas the fiscalist version concentrates on overexpansionary government fiscal policy as the primary source of demand inflation, the monetarist version focuses on the causal role of money growth, arguing that fiscal policy at best exerts only a transitory impact on the rate of inflation. Monetarist theories also tend to omit the costpush variable as a cause of inflation, although they do acknowledge that cost increases are a vital intermediate link in the transmission mechanism through which inflationary pressures are propagated through the economy. By contrast, cost-push theories stress the inflation-initiatingas distinct from the mere inflation-transmittingrole of the cost-push variable, asserting that it enters the inflationary process both directly to determine wage- and price-setting behavior and indirectly to influence the rate of monetary growth, which is allowed to adjust passively so as to validate the cost inflation generated by unions and firms, The latter point raises the question of the type of policy regime assumed in the general framework. As formulated above, it assumes an exog- enous policy regime, i.e., one in which the authorities conduct their policies to insure that the main line of causation flows from the policy variables directly to the dependent excess demand variable rather than vice versa. As discussed later in the article, however, the framework can be modified to accommodate the reverse-causation assumption of an endogenous policy regime in which the authorities allow the policy variables at least partially to respond to and be determined by changes in excess demand. Thus, with suitable adjustment, the model is capable of handling both types of policy regimes. Finally, it should be noted that the model contains no equations representing the bond and/or equity markets. Thus it is incapable of explaining the transmission of inflationary pressures through the financial sector of the economy. Instead, it concentrates on the transmission of inflation through the money, labor, and product markets. This shortcoming notwithstanding, the framework is still sufficiently general to accommodate important components of many theories of inflation. Specific theories-or at least parts of specific theories-emerge from the general framework when one suppresses certain variables, emphasizes others, and perhaps drops one or more of the equations. In any case, the four equations may be taken as a basis for outlining the main controversies among current expositors of the phenomenon of inflation. The Wage Equation The chief controversy relating to the wage equation concerns the determinants of wage-setting behavior. At least four views can be distinguished, namely, (1) the naive Phillips curve hypothesis, (2) the expectationsaugmented/excess-demand hypothesis, (3) the pure cost-push hypothesis, and (4) the eclectic view. The Phillips curve hypothesis states that the rate of money wage increase depends on the excess demand for labor (i.e., w = w(x) where x is measured or proxied by the inverse of the unemployment rate). This theory is incapable of explaining how rapid wage inflation could persist in the face of slack labor markets in which excess demand is zero or negative. The expectations -augmented/excess-demand hypothesis introduces the price-expectations variable into the Phillips curve and states that the rate of wage increase is determined by excess demand in the labor market and by workers’ and employers’ anticipations of future price inflation FEDERAL RESERVE BANK OF RlCliMOND 9 (i.e., w = w(x, p”)). The logic underlying this formulation is straightforward. Demand pressure The greater the pressure the x pushes up wages. faster will wages rise. Even if demand pressure were absent or negative, however, wages would still exhibit a tendency to rise because workers are primarily concerned with real wages-i.e., with the purchasing power of money wages-and therefore bargain for money wage increases sufficient to protect real wages from anticipated future increases in the cost of living (represented in the equation by p’, or price expectations). Similarly, employers interested in maintaining their relative position in the labor market must offer wage increases sufficient to match those increases that rival employers are expected to offer. Otherwise they will lose employees, and their relative market share will fall. Thus even in a situation of zero excess demand, employers on the average will be raising wages by the amount they expect Nominal wages and prices in general to rise. wages will rise, but each employer’s real wage offer relative to the market average wage will remain unchanged. Opposed to the expectations/excess-demand hypothesis is the pure cost-push view. More influential in the United Kingdom than in the United States, this theory holds that the rate of wage increase is initiated and determined by the vector of cost-push forces independently of price expectations and the state of excess demand (i.e., Cost-push pressures include such w = w(z)). forces as (1) monopoly market power, (2) tradeunion militancy, and (3) wage earners’ frustration arising from unfulfilled expectations regarding growth of real income and relative income Labor unrest, frustration, and militancy shares. are seen as causes and not-as in the monetarist theory-as consequences of inflation. The cost-push ories that whether wielded theories assert to enlarge heading The cized tarists First, ment 10 to monopoly power, These large the market wages is in the class of the- by unions or corporations. that inflation their relative come, utilize to push hypothesis attribute and and causing organizations, shares seeking in the national in- power in their possession prices upward, new rounds thus spear- of inflation. monopoly power hypothesis has been critipredominantly, but not solely, by moneon both theoretical and empirical grounds. critics state that the market power arguis at odds with the orthodox theory of moECONOMIC nopoly behavior. view, a monopolist According sets to the a relative orthodox price for his product that maximizes profits in real terms and maintains that real price by adjusting his nominal price to allow for inflation. The logical implication is that, given the degree of monopoly power, monopolists would have no incentive to raise prices other than to catch up or keep pace with general inflation. 2 With real prices already established at profit maximizing levels, any further upward adjustment would only reduce profits. On the other hand, if prices are currently being raised to exploit hitherto unexploited monopoly poten- tial, the question naturally arises as to why those gains were foregone or sacrificed in the past. In either case, monetarists argue, rising real prices imply non-rational (i.e., non-profit maximizing) behavior, contrary to the basic axiom of conven-, tional economic theory. True, rising real prices’ would be consistent with profit maximizing behavior if the degree of monopoly power were increasing.” But there is little empirical evidence that monopoly power is on the rise. Responding to this criticism, cost-push theorists state that the monopoly power of labor i.c rising, as evidenced by the spread of unionization to groups not previously organized, e.g., public (government) employees. Also cited are factors such as liberal fare payments unemployment to hold out in long strikes. question cost-push tional of rational advocates analysis benefits that have raised With maximizing maintain cannot capacity regard to the behavior, that be applied cause the latter, unlike ditional do not necessarily theory, and wel- workers’ the business the some conven to unions firms be,- of tra- maximize in- come. To the critics, however, this last point is totally irrelevant. Trade unions, they argue, do not have to be income maximizers for the conventional 2 1x1 support of this contention, critics of cost-push cite empirical studies showing that when big firms do raise their prices they are usually trying to catch up with general inflation. Such catch-up price increases should not be interpreted as inflation-generating Similarly, when unions raise wages, they are price increases.. often just trying to catch up with past price increases or protect wages from expected future price increases. They are not necessarily trying to increase their relative income share, which is probably already at its maximum. given the degree of their market POWfZ. 3 The point here is that the mere existence of monopoly power is not enough to produce inflation. The monopoly power must be steadily increasing. Monopoly power results in resource misallocation, thus reducing real income and raising the price level relative to what it would be if perfect competition prevailed. But this is an argument for high, not rising, prices. To produce inflation, i.e., a condition of continually rising prices, monopoly power must be ever-increasing. An existing degree of monopoly power cannot venerate a sustained inflation. REVIEW, JULY/AUGUST 1976 analysis to apply. It still holds as long as union leaders attempt to maximize sowe variable-e.g., downwardly inflexible, particular price increases can cause generalized inflation, i.e., in this case absolute prices are not independent of relative prices. In a world of sticky prices, inflation could occur for two reasons. First, the general price index, constituting an average of all prices, will necessarily rise purely as a matter of arithmetic when a rise in one of its components is not offset by a fall in the others. Second and more important, rising relative prices may induce addi- union membership, hourly wage rates, or the wage bill of a select portion of the union membership. That is, it still holds as long as union behavior results in a determinate equilibrium real wage. What is relevant, the critics assert, is the distinction between relative prices and absolute prices, i.e., the general price level. Cost-push theory is alleged to display a fundamental confusion involving the use of relative price concepts to explain the behavior of the absolute price level. According power to the is not a legitimate inflation. Monopoly change. prices product than price it would level due to resource level stantially of prices would unchanged. in except by price of a morelative specific monopolistic with Again, however, nopoly power affects other this conclusion follows. reduces When level. a monopolist inputs, thereby output and lower prices will be than level of wages of raises resources elsewhere via the policymakers’ impact level of aggregate on employment. but rather society’s thorities the policies level. when Thus directly and employment, while analysts his price he debate between critics continues. to increase econ- omy. Similarly, when a monopolistic labor union raises its wage, it causes a diminution of employment in its sector, thereby releasing labor to other sectors where the increased labor supply acts to lower wage rates. In either case, the rise in monopoly prices (or wages) is offset by a compensating reduction in competitive prices (or wages), leaving the average level unchanged. Monopoly power determines relative prices (and hence quantities sold or employed), not absolute prices as claimed by the cost-push hypothesis. Cost-push theorists rebut this latter criticism by challenging the validity of its underlying assumptions of perfect resource mobility and perfect They correctly point out that if price flexibility. resources are relatively immobile and prices cost infla- accept the extremes demand views According up by excess of un- deplored, have never- as valid, form this eclectic and their that lies between and excess- elements view, wages pushed in response an eclectic cost-push and incorporates demand, and the theorists behavior third But many is, however, of the pure by levels for long periods. There actual falsified high the cost-push and rise cost of living, that the explanation to this has been dis- it has been much view of wage-setting forces, into generalized shows been tolerated as in the by may enter by which particular that which goes of factor its target imposed employment this explanation on grounds experience, theless below pressures. In some quarters missed falls are transformed au- expansionary constraints into the process increases the but to accommodate with employment to high prices Given objectives, increases the political the commitment tionary not in other employment price will gener- employment. may have no choice specific and downwardly reductions and to a constant price increases in output high reaction With expenditure particular ate compensating mo- The logic behind and inflation their rigid prices, were com- and his employment releasing subwage wages overall is straightforward his output or gen- In both cases, the structure prices but not their general rise remain unions the need not be affected. industry specific would be the case if all labor markets petitive. to other the overall probably wages relative or its rate of Likewise comparison of general for a slight misallocation, obtained higher be if the But market determines will be higher competitive. rates explanation To be sure, the particular nopolized were of cost-push, power not the general prices, eral critics tional of both. are pulled up by cost-push to increases and anticipated. in the In equation view can be expressed as w = w(p, p”, x, z>. The Price Equation Regarding the price equation, four issues have dominated recent discussion. The first concerns the proper specification of the independent variables in the equation. What are the dominant determinants of pricesetting behavior? There is unanimous agreement that the rate of wage inflation affects the rate of price increase. But there is much less agreement FEDERAL RESERVE BANK OF RICHMOND 11 about whether excess demand plays a direct role Both the Phillips curve in price determination. and expectations-augmented/excess-demand theories contend that it does, while the cost-push hypothesis claims it does not. This latter cost-push direct point, theorists controls incidentally, advocate demand but rather through wages by cost-push and profit will be immune and to use controls and price Aside theory cess a direct poliforces constrain rates states prices are of markups costs at (standard) to ex- role by unit is applying production levels the markups on equity. main denies This theory determined percentage with that hypothesis. fixed normal view, the other price-determining normal-cost utilization, incomes cost-push behavior the so-called .rates of return In such of capacity set to yield This hypothesis target focuses on the rate of wage increase that constitutes the dominant component of changes in unit costs upon which ever, that price the compatible changes with can influence markets. where pressure the channel that demand, indirectly equation as p = the time-lag for demand through price either Note, hypothesis the notion prices The expressed depend. normal-cost with a lag, to excess is not inrespond, that variable through the labor in this case can be p(w) L represents or p = p(xt) the time it takes to influence of factor prices since how- product prices costs. The second issue is whether a long-run inflation-output (or inflation-unemployment) trade off exists, thereby permitting the authorities to peg the unemployment rate at any desired Ieve without risking persistent acceleration of the rate of inflation. The standard Phillips curve hypothesis implied the affirmative. But the notion of a permanent trade off was severely challenged by the so-called accelerationist school. Using an expectations-augmented/excess-demand version of the Phillips curve price equation, this school demonstrated that the trade off is only temporary, 12 pated. ers, An unexpected who product are deflated) expand ECONOMIC rising costs becomes can be fully the accelerationist anticipated. This by presses the numerical between the variables where of the equation. that the trade real excess inflation when p - A separate activity. the Some existence the equation unanticipated (as represented x) and that it vanishes but closely to provide off and adjusted by when for, i.e., zero.s even an indefinitely cient pe to a ex- of the trade So written, is fully anticipated p” = p = ax + off is between p’ and output demand conclusion rearranging coefficient magnitude states p - the stimu- on the left- and right-hand sides inflation the to when the infla- symbolically ax, their (price- expected, But disappear price equation p’ = real than and employment. expressed produc- to find and their slower eventually tion induces surprised faster rising output lative effects inflation pleasantly prices read p - from the cost-push that it fol- increase. of price-setting demand then to traditional to employ to directly if operating policies. the underlying and For not by excess markups, cases it may be necessary wage policies forces demand-management cies to influence why weapons. is determined lows that inflation restrictive incomes as anti-inflation the rate of inflation explains that it depends upon people being fooled by unanticipated inflation (i.e., the difference between actual and expected inflation p - p’), and that it vanishes in the long run when price expectations fully adjust to price experience and are completely incorporated in wage- and price-setting behavior. Accelerationists argued that inflation stimulates economic activity only if it is unantici- related issue is whether accelerating inflation is suffi- a permanent stimulus to accelerationist of a long-run models trade off that real deny between output and the rate of inflation itself nevertheless imply that, if price expectations are formed in a certain way, there will be a stable trade off between output and the rate of acceleration of the inflation rate (Ap). In other words, while expectations would eventually adapt completely to any stable rate of inflation, thereby negating the trade off, those expectations would consistently lag behind a constantly accelerating rate. A policy of inflatin g the price level at a faster and faster pace can thus permanently fool all the people all the time and peg the economy at any ’ The no-trade-off view implies that the price-expectations variable enters the price equation with a coefficient of unity. To show this let the price equation be p = ax + +p’ where + is the coefficient attached to P’. Long-run equilibrium is characterized by equality between actual and anticipated rates of inflation, reflecting the tendency of price expectations to be correctly formed in the long run. Setting p’ = p in the equation as required for long-run equilibrium and solving for p yields the expression p = [a/ (I- a) lx. If the coefficient + is a fraction, adjustment to fully-anticipated inflation is incomplete, and a stable long-run trade off exists between p and x. But if the coefficient Cpis unity, implying complete adjustment to anticipated inflation, the bracketed term is undefined and the trade off vanishes. REVIEW, JULY/AUGUST 1976 desired level of output and employment.5 As other economists have pointed out, however, it is unlikely that such a policy could fool the people forever. Eventually they would anticipate the rate of acceleration itself and adapt to it. The policymakers would then have to go to still higher derivatives or orders of rates of price change (A2p, A3p, . . . A”p) to stimulate the economy, and these higher derivatives, too, wouId eventually come to be anticipated. It should be stressed, however, that many analysts remain skeptical of arguments denying the existence of permanent trade offs involving inflation and its derivatives. These skeptics point to the stringent assumptions underlying the notrade-off view. Not only must price expectations be correct and unanimously held, but those anticipations must be completely incorporated in all contracts to preserve the equilibrium structure of relative prices and real incomes. Skeptics argue that even if the first condition were satisfied-a heroic assumption-the second probably would be violated. For one thing, certain passive income groups-e.g., rentiers and pensionersmay be powerless to act on their price forecasts. Other groups that possess the power to adjust their nominal incomes for fully anticipated inflation may choose not to do so. An example would be where workers are more concerned about their relative (comparative) wages vis-a-vis each other than about the absolute level of real wages. These workers would be willing to accept inflation-induced reductions in real wages as long as other wages were similarly affected and relative wage relationships remained unaltered. Whether such hypothetical situations of incomplete adjustment under conditions of rational behavior do in fact actually occur, however, is an open question, and the controversy over the existence of long-run trade offs remains unresolved. A fourth issue is concerned with the causes of price rigidity or, more precisely, with explaining why prices tend to respond so slowly to shifts in demand. Interest in this topic has been greatly a An example will demonstrate. Let the price equation be p = ax + pe where the unit coefficient attached to p’ implies the absence of a longrun trade off between p and x. From this equation it follows that the relationship among the rates of change of the variables p, x, and p* is given by the expression p = ax + 9 where the dots indmate rates of change (time derivatives) of the variables. Now assume that people are continuously revising their price expectations by some fraction b of the forecasting error between actual and predicted rates of inflation P - P’. This expectations-generating mechanism is written as 6’ = b(p-p’) where 9 is the rate of change of price expectations. Substituting this latter equation into the one immediately preceding it and simplifying yields i, = a? + abx. Finally, if excess demand is unchanging so that % = zero-as would be the case if the authorities were pegging x at some desired level-this last equation reduces to fi = abx, showing a trade-off relation between the rate of change of the rate of inflation P and excess demand x. stimulated by the recent experience with inflationary recession or stagflation in which prices continued to rise long after excess demand had disappeared. The traditional or classical model of price dynamics is of no help in explaining why inflation persists despite slack markets and high unemployment. According to the traditional model, prices adjust swiftly in response to excess demand or supply so as to clear the market. Nor is the Phillips curve model that expresses the rate of price change as a function of excess demand useful in interpreting stagflation. This model predicts that the rate of price change is zero when excess demand is eliminated and that price deflation accompanies excess supply. Neither model is consistent with experience showing that positive rates of price change can coexist with zero or negative excess demand for protracted periods of time. Apparently, many markets lack the shortrun excess-demand price-adjustment mechanisms postulated by the classical and Phillips curve theories. What accounts for the actual slow-working price mechanism and for the consequent persistence of inflation even in the face of slack demand and high unemployment? At least three explanations have been offered. In the expectations-augmented/excess-demand model, prices can continue to rise even when excess demand is zero or negative as long as inflationary expectations are sufficiently strong. Stagflation is explained in terms of sticky price anticipations. Specifically, the model states that price expectations are based on past price experience. And if that experience has been one of inflation, price anticipations can continue to mount, putting upward pressure on prices even when aggregate demand is falling. With price anticipations still adapting to the inflationary past, the response of actual inflation to a reduction in aggregate demand will be agonizingly slow. A second explanation attributes sluggish price adjustment to the prevalence of long-term contractual arrangements that fix prices for substantial intervals of time. Such contractual rigidities are said to distinguish so-called customer markets from spot-auction markets where flexible prices operate to keep the market continuously cleared. In customer markets, high search costs (time, effort, inconvenience, etc.) of comparison shopping give buyers an incentive to continue trading with customary sellers whose offers have proven satisfactory in the past. The customers of course FEDERAL RESERVE BANK OF RICHMOND 13 must believe that the terms of the offers will remain unchanged, otherwise it might pay them to The Price-Expectations Equation The preceding sections have concentrated on alternative views desert sellers of wage- and price-setting behavior. As previously noted, many of these explanations stress the role of expectations of future price inflation as regular suppliers and shop elsewhere. The themselves have an incentive to maintain stable prices in order to retain their established clientele. Since higher prices would encourage customers to shop elsewhere, sellers avoid or deto short-run lay changing p rices in response shifts in demand. In effect, their sellers price promises offers of continued remains implicit of negotiating written parties dard of fair basis to accept shifts play of long-run all unwritten contracts to certain in price unit increases costs. Sellers work if of fair play. prices Buyers induced formal the typical setting costs. costs agreements, only rules markets involves unit legal out an explicit Like assent implicit The agreement implicit In the case of customer to maintain buyers’ of the high and spelling these agree for patronage. because contract. however, both implicitly in return stanon the are willing by permanent in turn agree to absorb temporary cost increases just as they agree to ignore short-run shifts in demand when Thus prices remain unresetting their prices. sponsive to short-run shifts in demand and costs. a key determinant of rates of actual wage and price increase. In view of the central importance attached to price expectations, it is not surprising that much recent attention has focused on the mechanism by which those expectations are generated and revised. Concerning expectations, at least three the formation of hypotheses. have emerged. The first sees price expectations as determined by essentially unexplainable psychological forces. This view interprets the anticipated rate of inflation as a volatile, unstable variable subject to sudden and frequent shifts due to changes in subjective non-economic factors that cannot be systematically explained within the framework of a macroeconomic model. The second hypothesis, in sharp contrast with the first, states that price expectations are systematically determined by objective economic data, namely, actual rates of inflation experienced in the past. Known as the adaptive-expectations or error-learning hypothesis, this theory postulates that A third explanation of sluggish price adjustment stresses producer interdependence and the This view states need for price coordination. that in many industries there is much uncertainty concerning the market-clearing price. Given this uncertainty, firms endeavor to avoid the market disruption, confusion, and perhaps even outright price warfare that could result if each sought individually to determine the equilibrium price. In order to prevent such confusion from developing, firms seek ways to coordinate price changes. individuals form expectations of future rates of inflation from a geometrically weighted average of experienced past rates of inflation and then periodically revise those expectations if actual inflation turns out to be different than expected. In econometric studies of the inflationary process the adaptive-expectations model constitutes the most prevalent explanation of how price expectations are generated. Despite its widespread use, many economists are dissatisfied with the adaptive-expectations hypothesis. They think it is an unrealistic and Such coordination, if successful, will assure that firms raise prices in unison and that price changes will not occur when demand shifts are thought to be temporary and reversible. The preferred method of facilitating coordination is to base price changes on changes in standard unit labor and material costs, which tend to be the same for all firms in the industry. This cost-based pricing behavior assures that prices will respond only to costs, not to demand-although demand pressure may of course affect prices indirectly through the factor markets. It also assures that price changes will be uniform throughout the industry thereby minimizing the risk of competitive price undercutting. inaccurate description of how price anticipations are formed. Expectations, they claim, are as likely to be generated from direct forecasts of the future as from mere projections of the past. Moreover, people probably base their anticipations at least as much on current information about a variety of developments - e.g., money stock growth rates, imminent changes in political administration-as on data pertaining solely to past price changes. In short, one would expect rational individuals to utilize all the relevant information to improve the accuracy of their price forecasts. Yet the adaptive-expectations hypothesis holds that people look at only a small subset of the relevant information-namely, past price 14 ECONOMIC REVIEW, JULY/AUGUST 1976 changes--’ m forming expectations. This does not appear to be consistent with rational forecasting Monetarist behavior. model has stimulated explanation a search search has culminated in the formu- lation of the so-called rational-expectations sis, which constitutes formation since impact information about the inflationary process when making their price forecasts. If true, this means that forecasting errors ultimately could arise only from random (unforeseen) shocks occurring to the economy. At first, of course, forecasting errors could also arise because individuals initially possess limited or incomplete information about the inflationary mechanism. But it is unlikely that this latter condition would persist. For if the public is truly rational, it will quickly learn from these inflationary surprises and incorporate the new information into its forecasting procedures, i.e., the sources of forecasting mistakes will be swiftly perceived and systematically eradicated. As knowledge of the inflationary process improves, forecasting models will be continually revised to produce more accurate predictions. Eventually all systematic (predictable) elements influencing the rate of inflation will become known and fully understood, and individuals’ price expectations will constitute the most accurate (unbiased) forecast consistent with that knowledge.6 As incorporated in monetarist models, the rational-expectations hypothesis implies that thereafter, except for unavoidable surprises due to purely random shocks, price expectations will always be correct and the economy will always be at its long-run steady-state equilibrium.7 be 7 In deterministic non-stochastic models of the type employed in this article, random shocks are ruled out. Therefore. in terms of the model, the rational-expectations hypothesis implies that the economy is perpetually in steady-state equilibrium. able to actual and expected the monetarist variables control rules-can- already create have antici- inflation. This view that inflation without change predictable that behavior moves. actions Stable are of course policy response and incorporated by forecasters. authorities Then, agents can to on the basis wages and prices. actions on the predict future of these predicbefore- adjustments to all Consequently, when do occur, on real variables into Rational for the policies correct by makin g appropriate impact an idenThis used the rate of policy policy future is, can use past observations of stabilization The au- if the public can predict can be estimated information nominal real rate. policy actions. functions tions, from causing expected Systematic actions. policy follows influences the actual simultaneously in the may be impossible agents, between only when it is unanticipated. inflation hand To have an the authorities a divergence must be able to alter the actions- even in the short run, would thorities tical Specif- policy on output and employment they will have no since they will have been discounted and neutralized in advance. The only conceivable way that policy can have even a short-run influence on real variables is for it to be completely unexpected, i.e., the policymakers must act in an unpredictable random fashion. But random behavior hardly seems a proper basis for public policy. Monetarist proponents use reasoning similar effectiveness But argue of that unwarranted. such They ingly powerful actions run have effects rarely FEDERAL RESERVE BANK pronounced on real at or even equilibrium tremely According path, hazardous OF RICHMOND not are the strict ra- its seem- stand up well to this group, policy and variables, near policy. conclusions despite does logic, the discretionary out that hypothesis, the facts. to deny stabilization extreme point expectations above countercyclical tional-expectations against of rational to the of discretionary advocates policy 6 Specifically, the rational expectations hypothesis states that when expectations are formed rationally, the anticipated rate of inflation formed at the end of the preceding period p’-% is an unbiased predictor of the actual rate of inflation p, given all the information I-, available at the end of the preceding period. That is! the expected value of p. given the information I-,, is p”-]. In equation form, p’-r = E(plI-,) where E is the expectations operator. This latter formulation implies that the actual rate of inflation can differ from the expected rate only by a random forecasting error e, i.e., ~--p’-~ = p-E(plL1) = P. The forecasting error E is of course statistically independent of all information known as of the end of the preceding period, since all statistical correlations between l and I already would have been incorporated into the latter variable. agents must above. According to the rational-expectations hypothesis, individuals will tend to exploit a21 the pertinent on feedback rationalsome rad- policy. systematic real variables rational strict pated and acted upon those policies. hypothe- the third view of expectations as mentioned that based not influence mech- the that it carries for stabilization it implies e.g., those for an alternative of the expectations-generating This ically with the adaptive-expectations of view argue ical implications Disenchantment anism. advocates expectations protracted the its long-run forecasting is steady-state remains and surprise-ridden short- economy an ex- business, 15 and the rate restrictive of inflation To Something policy. with the strict responds this view flaws. First, the rational-expectations in common plies that transitory In actual two all main monetarist im- can only arise i.e., discrepancies rates non-stochastic of price world never occur since expectations Second, wrong hypothesis effects errors, and expected a rational from with output expectational be the rational-expectations be- change. such are always plies perfect price flexibility. the view that actual prices to view. suffers models, tween must rational-expectations critics, from sluggishly errors correct. hypothesis This never im- follows deviate from from expected prices, i.e., the current rate of inflation always adjusts completely and instantaneously to changes in the expected rate, so that steady-state equilibrium always prevails. Both implications, critics hold, strain Far from being perfectly flexible, ally slowly-as sticky and respond the persistence the of stubborn loneb price-adjustment sponding effects protracted observed solely in terms setters purely and the associated from contractual prevent Critics even indicated lags the and employment cannot be explained surprises. effects Price can only arise agents it from is rigidities into account, the strict that adjusting correctly to in- anticipated. argue that once such contractual are taken corre- and and institutional when by take that long to react to errors. Long price delays quantity economic flation are actuMoreover, of expectational just do not expectational prices inflation. output in practice credulity. rigidities version of the wage and price equations to determine the rate Debates pertaining to the demandof inflation. pressure equation center on two issues. The first issue involves the question of the relative importance of the three main independent variables in the equation : the rate of money stock growth, fiscal policy, and cost-push forces. Of these three variables, which exercises the major influence on demand pressure? Not surprisingly, the answer often depends upon whether the analyst is a nonmonetarist, a monetarist, or an advocate of the cost-push view. Moreover, within the monetarist camp the answer may differ depending upon whether one is an adaptive-expectations monetarist or a rational-expectations monetarist. Many nonmonetarists and monetary portance. policy Other that monetary theless clusively fiscal policy fiscal would almost variable have a temporary would be ex- and treat negligible could they never- concentrate grudgingly would im- agreeing Monetarists, as having But fiscal policy. might effects vanishing while they demand. fiscal that are of equal is important, would variable policy excess any hand, True, fiscal variables on the money growth tance. state nonmonetarists, rank it behind on the other the would impor- admit that impact emphasize short-lived on that before altogether. Although phasizing monetarists the are unanimous impact of fiscal to differ on the question tary growth on excess adaptive-expectations in the rate of monetary demand. branch growth Members believe tend of moneof the that changes can generate such cases may well be one that approximates adaptive-expectations model.8 monetarists of the rational-expectations branch growth can influence real deny that monetary excess demand even temporarily. If expectations are formed rationally, the economy is alwaysexcept for random disturbancesat its steadystate equilibrium. And if steady-state equilibrium always prevails, it follows that shifts in the rate of monetary growth influence only nominal variables (e.g., the rate of inflation) but not real variables like excess demand. With expectations adjusting completely and instantaneously to actual outcomes, inflationary surprises are absent, and rational agents are never fooled into producing excess (i.e., greater than equilibrium) output. The Demand-Pressure pressure flationary proximate variable equation Equation completes process. demand- It does so by specifying determinants that interacts The the model of the in- of the with other excess variables the demand in the *The strict rational-expectations hypothesis departs from reality in still another way. It assumes that all relevant information is freely available so that forecasting accuracy can be perfected at zero marginal cost. In actuality. however, the cost of acquiring and processing additional information may be quite high relative to benefits-think of the cost of computer time. Confronted with high information costs, economically rational agents might well forego the pure rational-expectations approach in favor of cruder but less costly forecasting techniques. e.g., the adaptive-expectations model. 1G ECONOMIC REVIEW, JULY/AUGUST 1976 are unfulfilled. demand tem- porary expectations in real excess they rational-expectations hypothesis ceases to hold. Instead, the forecasting procedure best suited to the changes policy, of the influence in deem- as long as On the other hand, While monetarists fluence may disagree of monetary growth on real mand, they do agree that cost-push not enter the demand-pressure point they theorists, are in direct about the in- excess factors equation. opposition de- should play a major role in the determination of excess demand. latter not only does the cost- argues push variable equation affects stant, excess demand With real excess and unemployment but indirectly to fall. growth, causes sign, pressure that on prices will thereby assuming operation demand the rate held of to become con- act to causing constant cost-push negative to rise. It is evident from the preceding discussion that cost-push theorists also believe that the monetary growth variable plays an important role in the determination of excess demand. In fact, this belief constitutes the basis for their advocacy of accommodative monetary policy. Passive monetary growth is necessary to offset or counteract the contractionary influence of cost-push forces. On the other hand, an activist anti-inflationary monetary policy is definitely harmful. Not only is it incapable of controlling cost inflation, but it also intensifies the unemployment problem generated by cost-push forces. Cost inflation should be restrained by direct controls, not by demandmanagement policies. A second debate concerns the process by which two of the determinants of excess demandnamely the monetary and fiscal variables-themselves are determined. On this latter question two issues are especially relevant. First, should the policy instruments be viewed as determined outside or inside the system? Second, are the policy instruments independent of each other? Regarding the former issue, there are two views. One asserts that the policy instruments should be treated as exogenous variables whose magnitudes are fixed outside the model of the inflationary process. Advocates of this view believe that the main line of causation or channel of influence runs from the policy instruments to excess demand and prices rather than vice versa. The policy instruments can be treated not as dependent or accommodative variables respond- conditions. as running Advocates of this view see at least partially from ag- gregate demand and inflation to the policy variables. They argue that models of the inflationary process should contain additional equations-socalled policy reaction functions-describing how the authorities change the settings of the monetary and fiscal instruments in response to fluctuations in aggregate demand and the rate of inflation. An example of such a policy response function would be where the authorities pursue a target level of excess demand, seeking monetary growth and budgetary deficits consistent with the attainment of the target. In this case the target level of excess demand would enter the system as a datum to determine the values of the monetary and fiscal instruments, and the policy regime would be described by the equations m = m(x) and f = f(x). it also through growth power, Thus, the economic causation The the demand-pressure monetary purchasing spending monetary forces enter a negative cost-push reduce real directly with of inflation. that that the policy instruments should be treated as endogenous variables determined within the system by the policymakers’ responses to changes in On this to cost-push who hold that such forces group ing to prior changes in demand but rather as the active independent variables that precede and cause shifts in demand. The alternative view is In addition to the exogeneity-endogeneity issue, there is also the question of the independence of the policy instruments. Are the monetary and fiscal variables truly independent of each other or do they move together ? This question is central to the debate over the causes of inflation. For if the instruments are in fact interrelated so that fiscal deficits are accompanied by accelerating monetary growth, it is virtually impossible to identify which is the unique source of inflation. Monetarists and nonmonetarists can cite the same evidence to support their respective views. Many analysts believe that the policy instruments are not independent but instead are interrelated through the so-called government budget This constraint states the matheconstraint. matical identity between the government’s budget deficit and the means of financing it. Specifically, the budget constraint states that the deficit G T-i.e., the gap between government expenditures G and taxes T-must be financed by an increase in government debt AD and/or by an increase in the monetary base AB consisting of currency and bank reserves created by the central bank. In short, a fiscal deficit G - T must be financed by debt issuance AD and money creation AB as expressed by the budget constraint identity G - T = AD + AB. FEDERAL RESERVE BANK OF RICHMOND 17 In principle, financed budget entirely vided interest rates ciently high levels. with the potentially by deficits new G - debt T could issues AD, be pro- were allowed to rise to suffiIn practice, however, concern disrupting effects of sharply rising interest rates insures that this drastic route is rarely taken. Instead, fiscal deficits are usually accommodated growth. Thus, at least partially by money stock the variables G - T and AB tend to move together, making it difficult to identify which, if either, is the unique cause of inflation. Summary and Conclusions This article has ex- amined within a simple aggregative framework some of the major current controversies in the On the basis of alternative theory of inflation. positions taken in these debates, at least four distinct theories can be identified. They are summarized as follows. 1. ADAPTIVE-EXPECTATIONS MONETARISM. This theory states that inflation is determined by excess aggregate demand and price expectations ; that expectations are generated by past price history and hence by previous excess demand; that excess demand results from excessive monetary growth; and therefore that excessive monetary growth, past and present, is the root cause of Only monetary growth matters; costinflation. push factors are totally ignored, and fiscal stimuli are largely dismissed on the grounds that they have no lasting impact on inflation. Inflation-unemployment trade offs are seen as existing in the shortbut not the long-run. That is, changes in monetary growth, by causing divergences between actual and expected rates of inflation, can generate large and protracted transitory changes in excess demand. In the long run, and associated real variables. however, expectations will be fulfilled, excess demand will be zero, and monetary growth will influence only the rate of inflation. Monetary growth cannot affect real variables in steady-state equilibrium. 2. RATIONAL-EXPECTATIONS MONETARISM. This version of monetarism predicts that, in the absence of unpredictable random disturbances, steady-state equilibrium always prevails. Monetary changes produce no surprises, no disappointed expectations, no transitory impacts on real variables. Trade offs are impossible even in the short run. This theory is hard to square with such phenomena as stagflation, the apparent intractability of the inflation rate, and the short-run nonneutrality of money. 3. PURE COST-PUSH THEORY. More popular in Britain than in the U.S., this theory postulates that wage and price increases are determined solely by non-economic, socio-political cost-push 1s ECONOMIC forces independent of general economic conditions. Inflation is explained by the introduction of the cost-push variable in the wage and price equations. All other determinants are dispensed with. Thus monetary growth is denied a direct inflation-determining role, its only function being to passively accommodate push-induced cost increases in order to maintain output and employment at high levels. 4. ORTHODOX NONMONETARISM. Included in this category are a variety of models that may differ with regard to such features as long-run inflation-unemployment trade-off properties, relative weight given to monetary vs. fiscal influences, and the like. Whatever their individual differences, however, nonmonetarist models as a class have the following distinguishing characteristic. They permit all three exogenous variables -monetary growth, fiscal policy, push factors-to influence excess demand and the rate of inflation. Moreover, orthodox nonmonetarism shares with adaptiveexpectations monetarism the view that policy actions will affect output and employment first and prices only later, often with very long lags. But whereas monetarists attribute these phenomena solely to price surprises (disappointed expectations) and lags in the revision of expectations, nonmonetarists believe that institutional and contractual rigidities are also to blame. Of these four theories, two appear untenable when judged against the criteria of plausibility, realism, and relevance. These two, of course, are rational-expectations monetarism and the pure cost-push view. The former, as previously stated, conflicts with the observed tendency for quantities to bear the burden of adjustment to monetary changes, while prices respond very slowly and with long lags. The cost-push theory, on the other hand, ,implies a degree of trade-union market power and full-employment-at-any-cost policy that has never existed in the United States. This tarism leaves only adaptive-expectations moneand orthodox nonmonetarism as serious contenders for the distinction of constituting the most plausible theory of inflation. Both are capable of accounting for the phenomenon of stagflation, for the intractability or resistance of inflation to anti-inflationary demand-management policies, and for the tendency of quantities rather than prices to adjust to shifts in demand. Of the two, the nonmonetarist view seems to be the more convincing since it explains sluggish price adjustment in terms of contractual and institutional, as well as expectational, rigidities. In any case, if and when a new consensus view of inflation finally emerges, it will probably contain elements of both the monetarist and nonmonetarist explanations. REVIEW, JULY/AUGUST 1976 References The concepts and issues discussed in the text are more fully developed in the following sources. Cagan, Phillip. The Hydra-Headed Monster: The Problem of Inflation in the United States, Washington, D. C.: American Enterprise Institute for Public Policy Research, 1974. Perhaps the best and most judicious survey of the present state of knowledge regarding inflation. Stresses the need-for-coordination explanation of sluggish price adjustment and shows hat cost-oriented price-setting “practices are not inconsistent with demand-pull theories of inflation. Friedman, Milton. “Comments.” Guidelines, Informal Controls and the Market Place. Edited by G. P. Schultz and R. Z. Aliber. Chicago: University of Chicago Press, 1966, pp. 55-61. A leading monetarist’s critique of monopoly power theories of inflation. Argues that such theories imply irrational non-profit maximizing behavior. Gordon, Robert J. “Recent Developments in the Theory of Inflation and Unemployment,,’ Northwestern University Center for Mathematical Studies in Economics and Management Science Discussion Paper No. 199, December 1975. (Mimeographed.) Contains a critical evaluation of the rational-expectations hypothesis and its application to economic policy. Also discusses markup pricing models and contractual-rigidity theories of sluggish price behavior. Gray, Malcolm and Michael Parkin. “Discriminating Between Alternative Explanations of Inflation.” University of Manchester- Inflation Workshop Discussion Paper No. 7414, December 1974. (Mimeographed.) The source of the four-equation classificatory framework used in the text. Gray and Parkin employ the four-equation schema to distinguish among monetarist, Keynesian, and cost-push models of inflation. They also show how alternative theories of inflation can be treated as particular special cases of the general framework. Haberler, Gottfried. "Thoughts on Inflation : The Basic Business Economics, 10 (January 1975), 12-18. Comments on the monetarist critique of costpush theories. Argues that the monopoly power of trade unions has been increasing, thereby putting upward pressure on wages and prices. Humphrey, Thomas M. “The Persistence of Inflation.” 1975 Annual Report. Richmond: Federal Reserve Bank of Richmond. Discusses factors contributing to sluggish price adjustment and describes the adaptive-expectations or- error-learning mechanism used to explain the generation of inflationary anticipations. Institute of Economic Affairs. Inflation: Causes, Consequences, Cures; Discourses on the debate between the monetary and trade union interpretations. London: The Institute of Economic Affairs. 1975. Entertaining and instructive debate between proponents and opponents of monopoly power theories of inflation. Peter Jay attempts to defend the monopoly power theory against the attacks of monetarists David Laidler and Milton Friedman. In the course of the debate all the relevant points, pro and con, are raised. Johnson, Harry G. Inflation and the Monetarist ConAmsterdam : North-Holland Publishing troversy. Company, 1972. Chapters 1 and 2 contain a relentless monetarist critique of cost-push theories. On page 12 Johnson argues that monopoly power explanations of inflation conflict with the conventional economic theory of profit maximizing behavior. Laidler. David and Michael Parkin. “Inflation : A Survey.,, Economic Journal, 85 (December 1975)) 741-809. An exhaustive survey of the literature on wage- and price-setting behavior, the formation of price expectations, and the determinants of excess aggregate demand. Presents a general model similar to the classificatory framework used in the text and then develops a simple monetarist model as a particular special case of the general model. Okun, Arthur M. “Inflation: Its Mechanics and Welfare Costs.,’ Brookings Papers on Economic Activity, 6 (1975, No. 2)) 351-90. The most complete version of the contractual-rigidity explanation of sticky wages and prices. Parkin, Michael. “The Causes of Inflation: Recent Contributions and Current Controversies.,’ Current Economic Problems. Edited by M. Parkin and A. R. Cambridge : Cambridge University Press, 1975. Surveys the main debates regarding wageand price-setting behavior. the generation of inflationary expectations, and the determinants of excess demand. Reports on empirical as well as theoretical findings. Sargent, Thomas J. and Neil Wallace. “Rational Expectations and the Theory of Economic Policy.” Studies in Monetary Economics, No. 2. Minneapolis: Federal Reserve Bank of Minneapolis, June 1975. A clear and concise nontechnical exposition of the rational-expectations hypothesis by two of its chief adherents. Tobin, James. “The Wage-Price Mechanism : Overview of the Conference.” The Econometrics of Price Determination. Conference sponsored by Board of Governors of the Federal Reserve System and Social Science Research Council. Washington, D. C., October 30-31, 1970. Presents a general inflation model similar to the classificatory framework used in the text. Shows how alternative theories can be treated as particular special cases of the general model. Describes the logic of the accelerationist approach and summarizes some controversies associated with the wage, price, and price-expectations equations. Trevithick, James A. and Charles Mulvey. The Economics of Inflation. New York: John Wiley and Sons, 1975. An excellent textbook survey of the theory of inflation. The expectations-augmented / excess-demand hypothesis is explained with great clarity in Chapter 7. See also Chapter 5, which describes alternative versions of the wage and price equations and Chapter 6, which deals with the role of trade unions and collective bargaining in the inflationary process. FEDERAL RESERVE RANK OF RICHMOND 19
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