The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
THE PURCHASING POWER PARITY DOCTRINE Thomas M. Humphrey Prominent among the many competing explanations that have been advanced to account for foreign exchange rate movements in the post-Bretton Woods era of floating exchange rates is the so-called purchasing power parity (PPP) theory. One of the most popular, simple, and durable explanations of exchange rate behavior, the purchasing power parity doctrine holds that currencies are valued for what they will buy. Therefore the relative external value of two currencies, i.e., the exchange rate between them, is determined by their relative internal purchasing powers as measured by the ratio of the general price levels in the two countries concerned. From this it follows that changes in relative national price levels determine changes in the exchange rate. In particular, the theory predicts that the percentage rate of change of the exchange rate will tend to equal the differential between the relative rates of price inflation at home and abroad. Thus if the domestic rate of inflation in the U. S. is, say, five percentage points higher than the comparable rate of inflation in Switzerland, the theory maintains that the dollar will tend to depreciate on the foreign exchanges at a rate of five percent relative to the Swiss franc. It follows from the theory that the way to strengthen a currency’s external value is to strengthen its internal value by reducing the domestic rate of inflation. In terms of the preceding example, the way to arrest the fall of the dollar relative to the Swiss franc is to bring the U. S. rate of inflation down into equality with the lower Swiss rate. With both currencies experiencing the same rate of inflation (or fall in internal purchasing power), their relative purchasing power will remain unchanged and the exchange rate will stabilize. The foregoing view is scarcely new. Rather it is the product of at least 175 years of past theorizing about the connection between money, prices, and exchange rates. It is no exaggeration to say that the PPP doctrine has attracted the attention of some of the leading monetary theorists of all time, including Thornton, Wheatley, Ricardo, Marshall, Cassel, von Mises, Keynes, and Viner. As proponents or critics, these economists helped formulate, develop, modify, and refine the central analytical propositions of the PPP doctrine. The purpose of this article is to identify and explain these propositions, to trace their development in the history of economic thought, and to indicate the extent of their survival in modern versions of the theory. What is the PPP Doctrine? In essence, the PPP doctrine is a theory of the determination of the nominal exchange rate and its movements in long-run equilibrium when the trade balance is zero and the real barter terms of trade and its underlying real determinants are presumed to be constant. Given these conditions and assuming that all goods are exportables, the equilibrium exchange rate can be expressed as the product of the terms of trade and relative general price levels, respectively. In symbols, (1) E=TP/P* where E is the exchange rate (defined as the domestic currency price of a unit of foreign currency), T the terms of trade (defined as the real export cost per unit of imports, i.e., the quantity of exports given up to obtain a unit of imports), P the home country price level, and P* the foreign price level.1 Via an appropriate choice of units, the terms-oftrade variable can be normalized and set equal to unity. This step permits the PPP theory to be stated conventionally in its so-called absolute and relative versions. The absolute version of the doctrine states that the equilibrium exchange rate will equal the ratio of domestic to foreign general price levels, i.e., (2) E = P/P*. 1 The derivation of Equation 1 is particularly simple in the case where each country produces only one good, part of which it exports to the other. Trade balance Equilibrium requires that the total value of each country’s exports must exactly equal the total value of its imports measured in terms of the same money. For the home country, this condition can be expressed as QP = Q*P*E, where Q is the quantity of physical exports of the home country, Q* the physical quantity of its imports (i.e., the quantity of the foreign country’s exports), P the home currency price of home country product, P* the foreign currency price of foreign country product, and E the exchange rate defined as the home currency price of a unit of foreign currency. This expression says that the values (quantity times price) of exports and imports are the same measured in terms of the home country’s money. Solving this expression for the exchange rate yields E = (Q/Q*)(P/P*), where the first term on the right hand side is the real terms of trade, i.e., the quantity of exports given up to obtain a unit of imports. Denoting the terms of trade variable as T, the foregoing expression reduces to E = T P/P*, which is Equation 1 of the text. FEDERAL RESERVE BANK OF RICHMOND 3 Original formulators of the doctrine stated it this way, arguing that since currencies are valued for what they will buy, the exchange rate between them must equal their relative internal purchasing powers measured by relative general price levels. The relative version of the doctrine states that changes in the equilibrium exchange rate will equal changes in the ratio of general price levels, or, more generally, that the percentage rate of change of the exchange rate will equal the differential between the percentage rates of price inflation at home and abroad. In symbols, the relative version is (3) e = p-p* where the lower-case letters denote percentage rates of change of the variables in Equation 2. The foregoing brief statement of the doctrine, however, is hardly sufficient. More than just the bare conclusion that the exchange rate and its movements tend to equal relative national price levels and their movements, the doctrine also consists of a number of interrelated propositions that support that conclusion. The most important of these propositions refer to (1) the international equalization of price levels measured in terms of a common currency, (2) the corresponding international equalization of the value of money, (3) the stability of PPP equilibrium, (4) the neutrality of equilibrium exchange rate changes, and (5) the causal role of money. Taken together these propositions constitute the central analytical core of the PPP doctrine. Price Level Equalization The first proposition states that the equilibrium floating exchange rate must equalize foreign and home country general price levels measured in terms of a common currency unit General prices must be at the rate of exchange. equalized across countries because if they were not, goods would be a bargain in one country compared to the other. Everybody would want to buy in the low-price country and sell in the high-price one. The resulting excess demand for the currency of the former and the corresponding excess supply of the currency of the latter would force the exchange rate into PPP equilibrium thereby eliminating the price disparity. That the condition of price equalization is implied by PPP can be seen by rearranging Equation 2 to read P = EP*, which says that home and foreign price levels are the same when expressed in terms of home currency units at the equilibrium rate of exchange. Likewise, price levels are also the same when expressed in foreign currency units as can be seen by arranging the equation to read P/E = P*. In short, 4 the PPP doctrine implies that a representative bundle of goods will cost the same everywhere measured in terms of either money. Neither country will enjoy a price advantage over the other at the PPP exchange rate. Nor will residents of either country be able to purchase goods more cheaply at home with local currency than abroad after converting local into foreign currency. Neglecting transport costs, Londoners will find goods to be as cheap in New York as in London and vice versa for New Yorkers. Equalization of the Value of Money A second PPP proposition refers to the international equalization of the value (purchasing power) of money. According to the PPP doctrine, the equilibrium value of money must be everywhere the same. For if it were not, people would demand more of the high- and less of the low-purchasing power money on the market for foreign exchange. The resulting excess demand for the former money and the corresponding excess supply of the latter would cause the exchange rate between the two moneys to adjust until purchasing power was equalized and both money stocks were willingly held, Equalization of the value of money across countries is therefore a necessary prerequisite of international monetary equilibrium. For only if such equalization prevails would there be no inducement to switch from one currency to the other. Only then will both money stocks be willingly held and the markets for money balances in both countries be cleared simultaneously. Note that equalization of the value of money is the exact counterpart of price level equalization. By definition, the value of money is nothing other than And since the its purchasing power over goods. purchasing power of money in terms of a representative market basket of goods is simply the inverse of the general price level l/P, it follows that equalization of price levels automatically implies equalization of the value of money. That is, when PPP prevails, any currency tends to command roughly the same amount of goods and services whether spent at home or converted into foreign currency at the equilibrium rate of exchange and then spent abroad. Thus a dollar will purchase no more in the U. S. than it will buy in the U. K. after conversion into pounds sterling at the equilibrium rate of exchange and vice versa for sterling. A third proposition Stability of Equilibrium refers to the stability of PPP equilibrium. Regarding stability, the PPP doctrine contends that when the actual rate of exchange deviates from the PPP equilibrium, automatic responses tend to eliminate ECONOMIC REVIEW, MAY/JUNE 1979 the deviation and restore the exchange rate to parity. With respect to disturbances to equilibrium, the PPP theory readily admits a host of factors-real shocks, expectations, speculation, capital flows and the likethat may cause the exchange rate to deviate temporarily from PPP. But it also describes strong stabilizing pressures that work to correct such deviations and push the exchange rate back toward equilibrium. More specifically, the doctrine postulates an automatic self-correcting mechanism that keeps the actual exchange rate hovering close to its equilibrium level. This mechanism relies on the corrective influence of price-induced shifts in international trade and the associated shifts in the demand for and supply of foreign exchange. For example, suppose the dollar price of the pound falls below its PPP equilibrium. On the market for foreign exchange, the pound is now undervalued and the dollar overvalued relative The to their actual internal purchasing powers. undervalued pound makes British goods seem underpriced to Americans whose eagerness to purchase them deluges the foreign exchanges with dollars seeking to buy pounds. Conversely, the overvalued dollar makes American goods appear overpriced to Britons whose reluctance to buy them dries up the supply of pounds seeking to buy dollars. The resulting surplus of dollars and the corresponding shortage of pounds would quickly bid the exchange rate back to PPP where the external and internal values of the currencies correspond. Via this self-adjusting mechanism the actual exchange rate would tend toward its equilibrium value, i.e., the exchange rate would tend to hover about the PPP. Neutrality of Exchange Rate Changes A fourth tenet of the PPP doctrine is that equilibrium exchange rate movements that merely reflect differential inflation rates have no effect on real variables such as exports, imports, the trade balance, or the terms of trade. These real variables are determined by real (exchange rate-adjusted) relative prices. According to Equation 2, however, the real relative price term P/EP* is a fixed constant equal to one. This means that movements in the equilibrium exchange rate exactly offset changes in the nominal price ratio P/P*, thereby preserving the real terms of trade between foreign and domestic goods. For example, Equation 2 says that a doubling of domestic prices relative to foreign prices will be accompanied by a corresponding doubling of the exchange rate leaving real (exchange rate-deflated) relative prices unaltered. Since the real relative price of domestic goods compared with foreign goods is the same after inflation as before, the general rise in domestic prices will not affect imports or exports. The physical quantities of those variables will be the same as originally and only the monetary units in which they are measured will have changed. In short, the PPP doctrine holds that exchange rate movements serve the purpose of offsetting differential rates of inflation and thus leave real relative prices and all real variables undisturbed. Provided the exchange rate corresponds to PPP, its changes will not affect real economic magnitudes. Being perfectly synchronized with price movements, such exchange rate changes are entirely neutral in their impact on the real economy. Causal Role of Money The fifth proposition refers to the direction of causality between price levels and the equilibrium exchange rate. Although strictly speaking the PPP price-exchange rate an equilibrium condition between two equality is endogenous variables, it is often interpreted as a cause and effect relationship. Causation is typically viewed as running from price levels to the exchange rate rather than vice versa. In particular, many PPP theorists argue that, in the long run when the determinants of the demand for money have stabilized at their steady-state equilibrium values, national money stacks determine national price levels which in turn determine the equilibrium exchange rate. If true, this means that the ultimate determinant of the equilibrium exchange rate is relative national money stacks and that the exchange rate moves over time as the differential in the growth rates of the money stocks. It also means that depreciation of the equilibrium exchange rate is a consequence rather than a cause of domestic inflation. Henry Thornton and the Origin of the PPP Doctrine The foregoing propositions are hardly new. They were enunciated early in the 19th century to explain the behavior of the floating paper pound following Britain’s suspension of the gold convertibility of its currency in 1797. Henry Thornton (1760-1515) was the first economist to clearly explain the operation of the self-adjusting mechanism that keeps the exchange rate close to its purchasing power par. In his classic The Paper Credit of Great Britain (1802) he argued that a rise in the price level in a country with an excess stack of paper money would automatically produce a roughly equivalent rise in the exchange rate. He explained how a rise in British prices relative to foreign prices would, at the preexisting exchange rate, make foreign goods seem relatively cheap to the British whose desire to acquire them would increase the supply of FEDERAL RESERVE BANK OF RICHMOND 5 pounds seeking to buy foreign exchange. At the same time, British goods would become relatively expensive to foreigners whose unwillingness to purchase them would reduce the supply of foreign currency seeking to buy pounds. The resulting excess supply of pounds and the corresponding excess demand for foreign money would immediately bid the exchange rate up to the new PPP equilibrium consistent with the higher level of British prices. [11, pp. 198-9] Thornton was also the first to advance the notion of the neutrality of equilibrium exchange rate changes. He noted that the rise in British prices would not act as an obstacle to British exports because the corresponding change in the equilibrium exchange rate would “obviate the dearness of our articles” and “serve as a compensation to the foreigner” for the higher price of British goods. In this manner, he said, the offsetting rise in the exchange rate would “prevent the high price of goods in Great Britain from producing that unfavourable balance of trade, which, for the sake of illustrating the subject [11, p. 199] Here is the was supposed to exist.” origin of the proposition that PPP exchange rate changes cannot affect real variables like the balance of trade since they merely offset divergent nominal inflation rates and thus leave real (exchange rateadjusted) relative prices unaltered. John Wheatley Thornton’s discussion of PPP took the foreign money stock and price level as given constants. On this basis he concluded that the equilibrium exchange rate moves with the domestic price level alone. His contemporary John Wheatley (1772 1830), however, extended his analysis by considering variations in money and prices abroad as well as domestically. Wheatley concluded that the relative quantity of money operating through genera1 prices is the sole determinant of the exchange rate so that the latter varies in strict proportion to relative money stocks. He reached this conclusion via the following route. First, he asserted that “the course of exchange is exclusively governed by the relative state of prices, or the relative value of money, in the different countries between whom it is negotiated.” [13, p. 85] This, of course, is the absolute version of the PPP theory stating that the equilibrium exchange rate equals the ratio of domestic to foreign price levels according to the relationship (4) E = P/P*. Second, he argued that under purely paper monetary standards the level of prices in each country 6 varies in strict proportion to the quantity of money. This, of course, is the rigid version of the quantity theory of money which may be expressed as (5) P = kM and P* = k*M* where M is the money stock, k is a constant coefficient equal to the ratio of the circulation velocity of money to real output (both variables treated as fixed constants by Wheatley), and the asterisks denote foreign country variables. Third, he substituted Equation 5 into Equation 4. This gave him the result that the exchange rate varies in strict proportion with relative money supplies, i.e., (6) E = kM/k*M* = K(M/M*) where K is the ratio of the constants k and k*. He stated this result when he declared that “the course of exchange is the exclusive criterion of how far the currency of one country is increased beyond the cur [14, p. 207] rency of another.” Wheatley commented at length on the key propositions of the PPP doctrine. Regarding the directic of causation between price levels and exchange rate he asserts that “variation in the state of the exchange . . . is the effect, not the cause” of variation in price levels. [13, p. 88] With respect to equalization of price levels and the value of money he asserted that “prices are everywhere the same” and that money serves “as a uniform measure of value over the whole world.” [13, p. 59] Two things, he said, operate to ensure price equalization across countries. The first is exchange rate adjustment, which equalizes the common currency value of any given local currency price levels. The second is commodity arbitrage, which equalizes the common currency prices of internationally traded goods at any given exchange rate. Regarding the equalization of prices by commodity arbitrage, he contended that the openness of modern national economies rendered the law of one price applicable to general price levels as well as to the specific prices of internationally traded goods. As he put it, The facility with which the reciprocal communications of nations is carried on has a necessary influence on the markets of all, and approximates the price of their produce to a general level. [13, p. 45] Nevertheless, he insisted that the essence of the PPP concept consists of more than just the law of one price. Specifically, he interpreted PPP as a condition of international monetary equilibrium in which the value of money is equalized across countries and exchange rate variations are the means by which this result is achieved. That this is indeed his view is ECONOMIC REVIEW, MAY/JUNE 1979 evident from his statement that “the course of exchange constitutes the practical means, by which money is enabled to discharge its functions over the whole world as a uniform measure of value.” [13, p. 25] To Wheatley the central role of the exchange rate is to clear all markets for money balances by equalizing the internal purchasing power of various currencies. It therefore follows that fluctuations in the exchange exclusively arise from the efforts of the different individuals of different countries to reduce their respective currencies to the same relative amount for the purpose of maintaining the general equivalency [of purchasing power]. [13, p. 25] Wheatley also discussed the stability of PPP equilibrium and the neutrality of equilibrium exchange rate changes. His treatment of these issues is among the more rigid and uncompromising in the literature. Regarding temporary deviations from PPP, he flatly denied they could occur. In his view, the exchange rate is always at its equilibrium level and thus it is impossible for currencies to be temporarily over- or undervalued on the market for foreign exchange. In other words, the self-equilibrating mechanism works perfectly and instantaneously to maintain the exchange rate at its PPP equilibrium. Here is a supreme example of Wheatley’s tendency to apply the PPP theory of long-run equilibrium to the short run as well. This tendency is also manifest in his treatment of the neutrality issue. Regarding neutrality, he argues that, because the exchange rate is always in equilibrium, its fluctuations will not affect trade in the slightest. To summarize, Wheatley’s version of the PPP doctrine is among the more extreme in the history of monetary analysis. Not only did he argue that the exchange rate is determined solely by relative money supplies operating through relative price levels, he also emphatically denied that real shocks could ever affect the exchange rate. His position was that such shocks, by affecting real national incomes, would immediately alter each country’s demand for the other’s product sufficient to maintain equilibrium in the trade balance and the exchange rate. For example, he argued that a domestic crop failure requiring increased food imports would, by reducing British real income and capacity to purchase, tend to force a compensating contraction of nonfood imports leaving the trade balance undisturbed. Conversely, if imports were not curtailed the resulting rise in British purchases from abroad would itself increase the income of foreign exporters and so their demand for British goods. Exports would rise to match imports thus leaving the trade balance and the exchange rate unEither way, adjustment would occur disturbed. frictionlessly through income changes without affecting the exchange rate.2 By ruling out real disturbances, Wheatley was able to assert that the exchange rate never deviates even momentarily from PPP and that causation runs in a strict unidirectional channel from money to prices to the exchange rate. In his view, exchange rate movements are always and everywhere solely a monetary phenomenon. Others adhering to this extreme monetarist version of the PPP doctrine were David Ricardo (17721823) and Walter Boyd (17641837). They too denied that real shocks could affect the exchange Such shocks they regarded rate even temporarily. as automatically and instantaneously self-correcting having no impact on the exchange rate. That is, they simply assumed that the slightest real pressure on the exchange rate would, by making British goods cheaper to foreigners, result in an immediate expansion of exports sufficient to eliminate the pressure.3 In their view the exchange rate is always at the PPP equilibrium determined by relative money stocks, and rises in the exchange rate are solely and completely the result of an overissue of currency. Consequently they regarded exchange rate depreciation, together with the premium on gold bullion, as constituting both proof and measure of excessive money creation. In other words, if the exchange rate is 5 percent above its old gold standard par, then this is prima facie evidence that the money stock is also 5 percent in excess of its nonflationary level and should be contracted. The PPP doctrine also appears in the famous Bullion Report (1810) where it is expressed in the following words. In the event of the prices of commodities being raised in one country by an augmentation of its circulating medium, while no similar augmentation in the circulating medium of a neighboring country has led to a similar rise in prices, the currencies of the two countries will no longer continue to bear the same relative value to each other as before. The exchange will be computed between these two countries to the disadvantage of the former. [6, quoted in 1, p. 91] Like Ricardo and Boyd, the Bullion Report concludes that exchange rate movements, together with the premium on gold bullion, “form the best general criterion from which any inference can be drawn as to the sufficiency or excess of paper currency in circulation.” [6, quoted in 1, p. 91] 2 Regarding Wheatley’s notion of the frictionless income adjustment mechanism see Fetter [4, p. 47], Metzler [8, p. 217], O’Brien [10, p. 149], and Viner [12, pp. 138-9, 295-7]. 3 On this point see Fetter [4, p. 47], Metzler [8, p. 217], and O’Brien [10, p. 149]. FEDERAL RESERVE BANK OF RICHMOND 7 Gustav Cassel The preceding has specified the key propositions of the PPP theory and has traced their origin to Thornton and Wheatley in the early 1800’s. For the classic statement of these propositions, however, it is necessary to turn to the writings of the Swedish economist Gustav Cassel during and immediately following World War I. It was Cassel who introduced the phrase “purchasing power parity” into the literature. He did so when he resurrected the theory to explain the behavior of the dislocated European exchanges during the war and afterward in the hyperinflation episodes in the early 1920’s. His forceful and systematic exposition of the theory was largely responsible for the popularity it enjoyed in the 1920’s. His contributions to the doctrine include the following. First, as previously mentioned, he christened the theory with the name it bears today. Second, he clarified the concept of the PPP exchange rate, defining it in its absolute version as “the quotient between the general levels of prices in the two countries” and in its relative version as “the old rate multiplied by the quotient of the degree of inflation” in both countries. [2, p. 62; 3, p. 140] Third, he redefined the somewhat vague notion of equalization of the value of money to mean that “a certain representative quantity of commodities must cost the same in both countries, if the exchange rate . . . stands at its equilibrium.” [3, p. 175] He points out, however, that this statement is strictly true only if the representative market basket of commodities is identical for both countries. Fourth, he reformulated and refined the neutrality proposition in the following words. the purchasing power parity represents an indifferent equilibrium of the exchanges in the sense that it does not affect international trade either way. Thus a country’s export is not checked by low rates of exchange? provided only these rates correspond to a high price level abroad, or a low level at home; nor . . . is export particularly stimulated by high foreign exchange rates, so long as they only correspond to the relative purchasing power of the different currencies. Similarly, low prices of foreign currencies do not mean the encouragement of import from abroad or keener competition for the home producers, so long as these rates are merely a true expression for the purchasing power parity of the foreign currencies. On the same hypothesis high prices of foreign currencies do not in any way act as a check on import. [3, p. 157] Here is the classic statement of the proposition that PPP exchange rate changes leave the real (inflationadjusted) exchange rate unaltered and so do not affect real exports and imports. From this Cassel drew the practical policy conclusion that no country could increase its competitiveness in foreign markets simply by deflating its price level. The deflation, he 8 said, will be matched by an identical fall in the equilibrium exchange rate, leaving the real exchange rate and hence real exports unchanged. [3, p. 143] Cassel’s fifth contribution was his identification of the sources of temporary deviations from PPP and his description of the self-correcting mechanism that operates to eliminate such deviations. Regarding causes of temporary deviations from PPP, he specified (1) expectations of future depreciation of the currency owing to anticipations of future inflationary money growth, (2) speculation against the currency, (3) forced sales of a country’s currency abroad at arbitrarily low prices, (4) failure of export prices to move equiproportionally with general prices in response to monetary shocks, and (5) random real disturbances to the balance of payments. For all these reasons, he notes, a country’s currency may be temporarily undervalued on the foreign exchanges. Regarding the operation of the self-correcting mechanism in such cases, he writes that as soon as a country’s currency is undervalued compared with its purchasing power parity, it will be of peculiar advantage to buy this currency, and to employ the money thus obtained in procuring commodities from that country. This stimulus thus applied to demand will necessarily very soon raise the price of the currency to the level of the purchasing power parity. [3, p. 149] Conversely, the corresponding overvaluation of the currency of the other country will, by making its goods seem overpriced on international markets, reduce the demand for its exports and thus for its currency. If country A’s currency is overvalued and B’s currency undervalued, then the export from A to B must be largely checked . . . . At the same time the import from B to A would be artificially stimulated by such a valuation. Indeed, both these influences would tend to raise the value of B’s currency in A, and to restore it to the purchasing power parity, which shows that this parity is the true equilibrium of the exchanges. [3, p. 158] In short, deviations from PPP affect trade flows in a direction that counteracts the deviation and represents a corrective to it. Finally, Cassel elaborated on the issue of priceLike exchange rate causality and its implications. Wheatley, he repeatedly states that causation runs from price levels to the equilibrium exchange rate, i.e., that the latter variable is “determined by” or [3, “dependent upon” the ratio of the price levels. pp. 141, 185, 186] More precisely, he invokes the quantity theory of money to assert that money determines prices which in turn determine the exchange rate. In short, he argues that the exchange rate is determined by relative national money stocks operating through relative price levels. This means that ECONOMIC REVIEW, MAY/JUNE 1979 relative national money stocks are the ultimate determinant of exchange rates. In his words, the exchange rate between two countries “must vary as the quotient between the quantities of their respective circulating media.” [2, p. 62] From the foregoing he drew two implications. The first is that in a regime of floating exchange rates, inflation is entirely homemade and cannot be imported from abroad. “An important consequence of the . . . dependence of the exchange on the purchasing power parity,” he said, “is . . . that a rise in prices in a foreign country can never cause a rise in prices at home.” [3, p. 145] For, assuming the exchange rate is at PPP, a rise in prices in a foreign country should have no other effect than that of the country’s currency being quoted so much lower that the prices on goods imported therefrom remain unaltered. If the influence of the rise in foreign prices is carried further, it is a sign that it has found support in an independent domestic inflation. [3, p. 167] In sum, a rise in foreign prices will be offset by a corresponding drop in the equilibrium exchange rate leaving the price of imports, and so the domestic price level, unchanged. If the domestic price level does indeed rise, it is because of domestic monetary expansion and not the rise of foreign prices. The second implication is that exchange rate depreciation itself cannot cause domestic inflation. A rise in the equilibrium exchange rate, he said, is the result, not the cause, of domestic inflation. He did acknowledge that a rise in the exchange rate above the PPP could produce import price increases. But he denied that these import price increases could be transmitted to general prices provided the money stock and total spending were held constant. He maintained that, given a fixed money stock, the rise in the particular prices of imported commodities would be offset by compensating reductions in other prices leaving the general price level unchanged. As he put it Only if the B currency were quoted above the PPP could the high price of this currency have any influence to raise the prices in country A. But even this influence would not be able to raise the general price level unless it had the support of a more plentiful supply of means of payment . . . . [3, p. 168] Ludwig van Mises Rivaling Cassel as the principal proponent of the PPP doctrine in the 1920’s was the famous Austrian economist Ludwig von Mises. It is not necessary to give a lengthy summary of his writings on the subject. Three quotations will suffice. The first refers to equalization of the value of money, the second to the stability of equilibrium, and the third to the causal role of money- all key propositions of the PPP doctrine. Regarding zation of the value of money, he states that equali- exchange rates must eventually be established at a height at which it makes no difference whether one uses a piece of money directly to buy a commodity, or whether one first exchanges this money for units of a foreign currency and then spends that foreign currency for the desired commodity. [9 p. 30] The operation of the self-equilibrating mechanism is described by von Mises in the following words. Should the rate deviate from that determined by the purchasing power parity . . . an opportunity would emerge for undertaking profit-making ventures. It would then be profitable to buy commodities with the money which is legally undervalued on the exchange, as compared with its purchasing power parity, and to sell those commodities for that money which is legally overvalued on the exchange, as compared with its actual purchasing Whenever such opportunities for profit power. exist, buyers would appear on the foreign exchange market with a demand for the undervalued money. This demand drives the exchange up until it reaches its “final rate” [i.e., the PPP]. [9, pp. 30-1] Finally, with respect to the causal role of money in the determination of the equilibrium exchange rate, he states the “exchange rates rise because the quantity of the domestic money has increased and commodity prices have risen.” [9, p. 31] Criticisms of the PPP Doctrine Even at the height of its popularity in the 1920’s the PPP doctrine was the target of severe criticism. Critics such as Frank Taussig, J. M. Keynes, A. C. Pigou, and Jacob Viner contended that the theory suffered from certain crippling defects. For one thing, it overlooks factors other than relative price levels that determine exchange rates. Consisting of the terms of trade, obstacles to trade (tariffs, transport costs and the like), and the structure of prices in both countries, these factors may produce a permanent disparity between the equilibrium exchange rate and the calcuMoreover, their movements lated absolute PPP. over time tend to generate a persistent discrepancy between exchange rate movements and those of the PPP thus invalidating the relative version of the doctrine. For example, changes in the terms of trade caused by shifts in international demand would produce permanent changes in the equilibrium exchange rate even if PPP remained unchanged. Likewise changes in tariffs and transport costs as well as alterations in the relationship between export prices and general prices in either country would prevent the equilibrium exchange rate from adhering to the path dictated by PPP. Discrepancies may also stem from the existence of nontraded (purely domestic) goods whose prices have no close connection with the ex- FEDERAL RESERVE BANK OF RICHMOND 9 change rate although they do enter the general price levels used to compute the PPP. For these reasons the critics argued that the doctrine is incorrect when applied to general price levels. They held that it was valid only when restricted to the prices of internationally traded goods in which case, to use Keynes’s expression, it becomes a “truism, and as nearly as possible jejune.” [7, p. 75] Bresciani-Turroni’s Critique The foregoing criticisms were themselves evaluated in a famous 1934 paper by the Italian economist Costantino BrescianiTurroni. In what is perhaps the most rigorous and systematic analysis of the PPP doctrine to be found in the economic literature, Bresciani-Turroni concluded (1) that the absolute version of the doctrine is indeed generally incorrect, (2) that the relative version, however, is theoretically correct in the case of monetary but not real shocks, and (3) that, as an empirical matter, the relative version may be approximately correct even in the latter case. In so doing he provided a masterful defense of the relative version of the theory. The foregoing conclusions were derived by Bresciani-Turroni on the basis of a simple analytical model which he constructed via the following steps. First, he assumed that tariffs, transport costs, and other obstacles to trade tend to raise the supply price of each country’s exports by a certain fraction. Thus if Px and are the domestic prices of a unit of home and foreign country exportables, respectively, and t and t* represent the fraction by which those prices are raised by obstacles to trade, then the total supply prices to buyers of the countries’ exports will be Px(l+t) and (1+t*), respectively. These expressions state that the price of goods in the buying market must exceed the price in the selling market by the cost of transport and tariffs. Second, he argued that long-run equilibrium requires that the total value of each country’s exports be exactly equal to the total value of its imports measured in terms of a common currency. For the home country, this zero trade balance equilibrium condition can be expressed as (7) QPx(l+t) = Q*Px*(l+t*)E where Q is the quantity of physical exports of the home country, Q* the physical quantity of its imports (i.e., the quantity of the foreign country’s exports), PX(l+t) the home currency supply price (including transport costs) of home country exports, (1+t*) the foreign currency supply price of foreign country exports, and E the exchange rate 10 defined as the home currency price of a unit of foreign currency. Third, he assumed that the domestic price of each country’s exportables can be linked to general price levels P and P* via the following relationships (8) Px = RP and = R*P* where R and R* denote the equilibrium ratio of export prices to general prices in each country, as can be seen by expressing the equations in the form R = Px/P and R* = /P*. Representing the equilibrium relative prices of exportables in terms of general price levels at home and abroad, these equations summarize the equilibrium structure of prices in the two countries concerned. Finally, he substituted Equation 8 into Equation 7 and solved for the equilibrium exchange rate thereby obtaining the expression which says that the equilibrium exchange rate is the product of four determinants, namely the unobstructed barter terms of trade, relative transport and tariff costs, relative price structures, and the PPP, respectively. Regarding these determinants, note that the terms of trade variable shows the quantity of exports the home country must give up in the absence of tariff and transport costs to obtain a unit of imports (the other country’s exports) and thus represents the real cost of obtaining the latter in terms of the amount of the export good sacrificed. Determined by real factors such as tastes, technology, and resource endowments, the terms of trade variable captures nonmonetary influences affecting the exchange rate. The relative tariff and transport cost variable shows the impact on the exchange rate of natural and artificial obstacles to trade. Note that when these obstacles are identical both for exports and imports such that t=t*, the ratio reduces to one and thus cannot distort the exchange rate from the PPP. Only if trade barriers are more severe in one direction than another, i.e., exports and imports are hampered unequally, would such distortion exist. The remaining determinants can be summarized briefly. The price structure variable compares the relationship between export prices and general price levels at home and abroad. Unless both countries possess identical price structures, this determinant will cause a persistent discrepancy between the equilibrium exchange rate and the PPP. Note also that the price structure variable is determined not by monetary but by real factors (e.g., tastes, technology, ECONOMIC REVIEW, MAY/JUNE 1979 resource supplies), which means that it is largely invariant to monetary changes. By contrast, the PPP variable is, in Bresciani-Turroni’s own words, determined by “the monetary conditions particular to each country” and thus varies with changes in relative money stocks. [1, p. 93] On the basis of Equation 9, Bresciani-Turroni reached the following conclusions regarding the validity of the PPP theory. First, the absolute version of the theory is generally incorrect. Evidently the equilibrium condition is not “exchange rate equals PPP” but rather “exchange rate equals PPP multiplied by the terms of trade, relative obstacles to trade, and relative internal price structures.” These other things may cause the equilibrium exchange rate to deviate permanently from the PPP. Second, the relative version of the doctrine remains valid if these other factors are constant. That is, other things remaining the same, the exchange rate varies equiproportionally with relative price levels as predicted by the theory. This can be demonstrated by holding the other factors constant in Equation 9 and letting the PPP double or quadruple. The changes in the PPP will be matched by a corresponding doubling or quadrupling of the exchange rate. Third, whether other things remain the same depends upon whether disturbances emanate from the Purely monetary or real sectors of the economy. monetary disturbances will not affect the long-run equilibrium values of the non-PPP determinants of the exchange rate. These determinants are real variables. As such they are largely invariant to monetary shocks. In long-run equilibrium the latter affect only price levels and the PPP. It therefore follows that the relative version of the theory holds in the case of monetary changes. Fourth, in sharp contrast to purely monetary disturbances, real disturbances will indeed alter the non-PPP determinants of the exchange rate, thus producing systematic divergences between exchange rate variations and those of the PPP. This means that the relative version will not hold exactly in the case of real changes. Nevertheless, it may hold at least approximately if the real effects are small. And, according to Bresciani-Turroni, that is exactly what one would expect to find. He maintained that there are limits to how far away from the PPP real disturbances can distort the exchange rate. These limits are set by the price sensitivity (elasticity) of international demands. If this sensitivity is high, then even slight deviations from PPP will invoke large price-induced shifts in trade sufficient to check further deviations. It follows, he said, that “when international demands are very elastic, which happens in the case of modern industrial countries with a considerable resourcefulness of supply,” the influence of real changes on exchange rates is “likely to be confined within narrow limits.” If so, “there will be for exchange rate indexes a tendency to settle at a level approximately equal to the ratio of . . . price indexes.” [1, p. 122] In short, provided international demand elasticities are high, the relative version of the doctrine remains approximately valid even in the case of real economic changes. Finally, mention should be made of BrescianiTurroni’s rejection of the so-called commodity arbitrage interpretation of PPP. This interpretation sees PPP as an extension of the law of one price, according to which the operation of goods arbitrage equalizes the common currency price of internationallytraded goods across countries. Since this reasoning only applies to internationally traded goods, its proponents advocate restricting the PPP concept solely to the prices of traded goods. Bresciani-Turroni, however, emphatically rejected this interpretation as a trivial truism devoid of economic content. He argued that because internationally-traded goods have a single world price, their common currency prices by definition must everywhere be the same (transport costs aside). In other words, the ratio of their prices in domestic currencies must, shipping costs aside, move with exchange rates purely as a matter of arithmetic. Moreover, since arbitrage by definition equalizes prices of traded goods at any given exchange rate, it fails to explain how a unique equilibrium exchange rate is determined. He, of course, took it for granted that arbitrage would occur, but he insisted that the essence of the PPP doctrine was not the law of one price but rather the notion that exchange rates accurately reflect the monetary conditions in the countries concerned. And if the purpose of PPP is to indicate relative monetary conditions, then one should compare not the prices of traded goods alone but rather general price levels that measure the value of money. Friedman and Schwartz The principal contribution to the PPP doctrine since Bresciani-Turroni’s analysis has been Milton Friedman’s and Anna Schwartz’s 1963 generalization of the price-induced PPP self-equilibratin g mechanism to apply to all items in the balance of payments. This was a new development. Prior to Friedman and Schwartz, stabilizing price pressures were viewed as operating solely or primarily through the trade accounts alone. Cassel, for example, argued that the exchange rate would be brought into conformity with PPP via price-induced changes in commodity trade. In his FEDERAL RESERVE BANK OF RICHMOND 11 account, a doubling of U. S. prices relative to foreign prices at the existing exchange rate would, by making U. S. goods twice as expensive to foreigners and foreign goods half as expensive to Americans, discourage U. S. exports and encourage U. S. imports thereby resulting in an increased supply of dollars seeking to buy a reduced supply of foreign currency on the market for foreign exchange. The resulting excess demand for foreign currency and the corresponding excess supply of dollars would bid the exchange rate to double its original level. In this way changes in exports and imports and the corresponding shifts in the supply and demand for foreign exchange would raise the exchange rate to the level Thus, in the traditional view, dictated by PPP. price-induced changes in commodity trade constitute the primary means by which the exchange rate is restored to the PPP equilibrium.4 excess supply of dollars would help bid the exchange rate up toward its PPP equilibrium. In this manner the self-equilibrating mechanism operates through the capital account as well as the current account of the balance of payments. More generally, since all items in the balance of payments are critically dependent on relative national price levels, all contribute to the stability of PPP equilibrium. On the market for foreign exchange, this reluctance to invest in the U. S. would be reflected in a reduced supply of pounds seeking to buy dollars. Likewise, the corresponding increased desire of Americans to invest in Britain would be manifested in an increased supply of dollars seeking to buy pounds. The resulting excess demand for pounds and the corresponding Concluding Comments This article has traced the evolution of the PPP theory of exchange rates from its initial formulation by Thornton and Wheatley in the early 1800’s to its definitive critique and restatement by Bresciani-Turroni in the mid-1930’s. It is now time to summarize the views of current proponents of the doctrine. With the exception of Friedman and Schwartz, modern proponents have added little beyond Bresciani-Turroni’s analysis. Like him they hold that the long-run behavior of the equilibrium exchange rate is chiefly, but not solely, determined by the behavior of relative money stocks operating through relative price levels.” Like him they readily acknowledge that a variety of factors-tariff changes, output disturbances, shifts in demand, capital movements and the like-impinge on the equilibrium rate and force it to deviate from the path dictated by the PPP. And like him they argue that price parities operate to limit these deviations and hold them in check. In particular, they contend that divergences from PPP will trigger the restraining force of price-induced trade and capital flows that arrest further deviations. For example, they argue that real factors that push the external value of a currency below its PPP will inevitably generate price incentives tending to spur exports and check imports. The resulting trade balance improvement and the associated strengthening of demand for the currency on the foreign exchanges will halt further deviations from price parity. In this manner, the PPP mechanism tends to constrain systematic distortions between the equilibrium rate and price parity. The same mechanism, proponents note, also works to correct random rate variations and to keep the actual rate tending toward the equilibrium rate whether or not the latter differs from PPP. That is, suppose the equilibrium rate is permanently distorted from price parity as indicated by the expression E = K (P/P*) where K is the divergence between the two variables. Notwithstanding this distortion, the self-corrective mechanism will eliminate all devi- 4 Recall, however, that in Wheatley’s ments also play a role. 5 What follows 214-23]. Friedman and Schwartz, however, argued that such adjustment is not restricted to the trade accounts alone. In particular, price-induced changes in unilateral transfers and capital movements also play a role. Regarding unilateral transfers, they contended that a doubling of wages and prices in the U. S. relative to those abroad would mean that a given number of dollars transferred by immigrants, for example, to their families abroad would constitute only half as large a fraction of the immigrants’ wages and so would tend to increase the amount sent. [5, p. 61] On the market for foreign exchange, this increased desire to make unilateral transfers would translate into an increased supply of dollars seeking to buy foreign currencies, thereby putting upward pressure on the exchange rate. The same holds true for capital flows. Regarding such flows, Friedman and Schwartz state that, given the U. K. price level and the dollar/pound exchange rate, a doubling of U. S. prices would mean that a given number of pounds sterling intended for capital investment in the United States would buy only half as much physical capital while still commanding an unchanged amount at home and so would discourage capital investment in the U. S. [5, p. 61] 12 view income adjust- ECONOMIC REVIEW, MAY/JUNE 1979 draws heavily from Yeager [15, pp. 210, ations from PPP up to the factor K and the. equilibrium exchange rate will remain powerfully related to the PPP. Finally, proponents note that the PPP theory completely explains equilibrium exchange rate movements stemming from purely monetary changes. Moreover, they contend that it applies, albeit approximately, when monetary changes dominate real changes. They point out that a money-induced rise in the PPP tends to be reflected to its full extent, without modification, in the exchange rate. By contrast, a real shock operating through the balance of payments provokes compensations that limit its effect on the exchange rate. In the long run, therefore, exchange rate movements will largely reflect changes in relative money stocks as predicted by the theory. For these reasons proponents hold that the PPP theory remains a valid and useful concept. References 1. Bresciani-Turroni, C. “The ‘Purchasing Power Parity' Doctrine.” L’Egypte Contemporaine, 25 (May 1934), 433-64. Reprinted in his Saggi di Economia. Milan: Giuffre, 1961. Friedman, M., and Schwartz, A. J. A Monetary History of the United States, 1867-1960. Princeton, New Jersey: Princeton University Press for the NBER, 1963. Papers, (Commons), 6. Great Britain, Parlimentary “Report from the Select Committee on the High Price of Gold Bullion” (no. 349) III, 1810. A Tract on Monetary Reform 7. Keynes, J. M. Reprinted in the Collected Writings of (1923). John Maynard Keynes. London : Macmillan for the Royal Economic Society, 1971. 8. Metzler, L. A. “The Theory of International Trade.” A Survey of Contemporary Economics. Edited by Howard S. Ellis. Philadelphia: Blakiston, 1948. 9. Mises, L. V. Stabilization of the Monetary Unit from the Viewpoint of Theory (1923). In On the Manipulation of Money and Credit. Translated by Bettina Bien Greaves and edited by Percy L. Greaves, Jr. Dobbs Ferry, New York: Free Market Books, 1978. 10. O’Brien, D. P. The Classical Economists. Oxford University Press, 1975. London: 11. Thornton, H. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802). Edited with an introduction by F. A. v. Hayek. New York: Rinehart, 1939. 12. Viner, J. Studies in the Theory of International Trade. New York: Augustus Kelley, 1965. 2. Cassel, G. “The Present Situation of the Foreign Exchanges.” Economic Journal, 26 (March 1916), 62-65. 13. Wheatley, J. An Essay on the Theory of Money and Principles of Commerce. Vol 1. London: Cadell and Davies, 1807. 3. After 14. Remarks on Currency London : Burton, 1803. 4. Fetter, F. W. Development of British Monetary Orthodoxy 1797-1875. Cambridge, Mass. : Harvard University Press, 1965. 15. Yeager, L. International Monetary Theory, History, and Policy. 2nd ed. Harper and Row, 1976. 1914. Money and Foreign Exchange New York: Macmillan, 1922. FEDERAL RESERVE BANK OF RICHMOND and Commerce. Relations: New York: 13 WAGE-PRICE RESTRAINT AND MACROECONOMIC DISEQUILIBRIUM Roy H. Webb During the past forty years the United States government has made numerous attempts to restrain wage and price increases. Initially these were associated with comprehensive wartime economic controls, as in World War II and, to a lesser extent, the Korean War. Several varieties of wage-price restraint were even attempted during the Viet Nam era. President Kennedy introduced “guideposts” in 1962 which were to “provide standards . . . not replace the normal processes of free private decisions.” [3] Throughout President Johnson’s tenure, wage-price restraint escalated as more detailed rules were estabAlthough the Nixon Administration first lished. eschewed any type of wage-price restraint, it imposed a comprehensive wage-price freeze in August 1971. Controls of varying severity were maintained through April 1974. Recently, even without the excuse of war, attempts to restrain individual wages and prices have remained remarkably durable. President Ford announced a “Whip Inflation Now” program in October 1974 which included a token mention of wage-price restraint. President Carter has announced several versions of wage-price restraint, the last of which was put forward in October 1978.l Other modern industrial nations with market economies have also made numerous attempts at wage-price restraint. And throughout history wage-price restraint has been repeatedly attempted in preindustrial societies. Based on its frequency of use, one might conclude that wage-price restraint is a panacea. Yet on eco- 1 The latest program involves quasi-voluntary wage and price standards. Violators are explicitly threatened with bad publicity and loss of government contracts. Implicitly, possible violators must be aware of potential retaliation by regulatory agencies not formally incorporated in the wage-price control program. For example, the Carter Administration has recently hinted [11] that the amount of future trucking industry deregulation (by the Interstate Commerce Commission or by act of Congress) will depend on the outcome of Teamster wage negotiations. Due to the magnitude of discretionary authority possessed by the Internal Revenue Service, Environmental Protection Agency, Federal Trade Commission, Occupational Safety and Health Administration, etc., a large potential for retaliation confronts any business. 14 nomic and other grounds, such restraint has been charged with creating many severe difficulties while This article delineates the failing to curb inflation. persistent puzzle, continued advocacy of wage-price restraint by those who are well aware of its many drawbacks. Accordingly, some of the more obvious shortcomings of wage-price restraint are first reviewed. Second, a theoretical case for such restraint, shortcomings notwithstanding, is explained. In short, this article will present both the modern theory behind wage-price restraint as well as some severe, predictable pitfalls common to all control programs. PRELIMINARY TOPICS Effectiveness In subsequent parts of the article it will be assumed, for purposes of discussion, that wage-price restraint programs can be effective. However, this assumption may not be valid, since wage-price restraint conflicts with a basic human characteristic, the desire of individuals to improve their own welfare through trade. If each party involved in a transaction agrees to the price, or terms of trade, then clearly they believe the transaction to be mutually beneficial. Thus controllers seeking to prohibit such transactions, on the grounds that the terms of trade conflict with policy objectives, should not be surprised that the traders are willing to circumvent price regulations. For example, although the sticker price of a new car might be frozen by law, a dealer can always vary the trade-in allowance, warranty terms, credit terms, predelivery preparation, etc. Similarly, automobile manufacturers can vary the options included or excluded on the same model, or introduce a new model that is only superficially different from the old. Since prices of new products, or new models of old products, are difficult to regulate, exchange may actually occur at the same quality adjusted price that would prevail in the absence of a price freeze. Wage controls can also be circumvented. For one thing, employers may upgrade workers’ jobs in name only, a difficult practice to detect. As an ECONOMIC REVIEW, MAY/JUNE 1979 illustration, consider the opening of a new factory. While it would probably first attempt to hire skilled workers at prevailing wages, it might not receive a sufficient response, in which case it might choose to raise its wage offers. If confronted with wage controls, the newcomer might label its machinists “assistant mechanical engineers” and offer a higher wage. Price controllers may not realize that the jobs are the same, albeit with different titles. If not, existing firms, who continue to pay the controlled wage rate, must find some way of making their jobs more rewarding if they are to retain their employees. In principle, given enough information, vigorous enforcement, and a legal staff large enough to either write clear regulations or litigate ambiguous ones, evasions could be controlled. In practice, however, the quantity of information required to evaluate product quality and to classify employee functions is enormous. Moreover, much of the data is rapidly changing. But if this information is not timely and acquired in useful form, evasion is both possible and profitable. At the very least, therefore, any discussion of wage-price restraint should consider the high cost of obtaining and evaluating information, as well as the cost of specifying clear regulations. particularly dramatic example was the televised drowning of baby chickens when the Nixon program of wage-price restraint froze the price of chickens while simultaneously exempting the price of grain included in chicken feed. Consequently it became less costly to kill a baby chicken than to pay high feed prices and sell the grown animal at the low controlled price. Distortions created by price controls are exacerbated in an open economy. When a commodity is freely traded on the world market, the domestic price can diverge from the world price only by the cost of transportation. If the domestic price is kept artificially below the world price, there is no incentive for foreign producers to sell in the country with the controlled price. Moreover, it is more profitable for domestic producers to export rather than sell at the controlled price. However, if prices of traded goods are not controlled, a price control program would be limited to non-traded commodities such as haircuts and local telephone calls. It should not be assumed that an ineffective attempt to control wages and prices indicates lack of will by controllers, since even the most draconian control measures have not always been successful. For example, the Roman emperor Diocletian initiated a program of wage-price restraint under which violators received the death penalty. One account reports that the law effected “much blood shed upon very slight and trifling accounts; and the people brought provisions no more to market.” [6] The program “in shambles” was abandoned after thirteen years. These difficulties notwithstanding, the remainder of this article will assume, for purposes of discussion, that wage-price restraint is able to hold wages, and prices received by sellers, below market levels. This assumption facilitates the discussion of some predictable consequences of effective wage and price restraint. Single Market Effects A basic proposition of economics is that if a price is set below the marketclearing level, then actions by both buyers and sellers will be distorted. At an artificially low price, buyers wish to buy more than sellers wish to supply, and a shortage results in that market, as illustrated in Figure 1. Effective price control programs provide ample illustrations of such distorted behavior. A FEDERAL RESERVE BANK OF RICHMOND 15 Another perverse effect is that even if the price a seller receives is below the market-clearing level, it does not follow that the buyer pays a below market price. If shortages occur and buyers as a whole cannot obtain all they wish at the controlled price, individual buyers may well spend valuable time and money attempting to buy the scarce good. The expense of waiting in lengthened queues, as well as additional search for a scarce item, are both included in the total cost of an item to a buyer. A recent example occurred in early 1974, when the ceiling price of gasoline was set at an artificially low level. When predictable shortages occurred in several metropolitan areas, long lines appeared at open gas stations. Waits of well over an hour were common. Some dealers made it possible for buyers to avoid the lines by selling gasoline only to buyers of overpriced repair services. Additionally, middlemen may be able to buy at the low, controlled price and sell at the higher price buyers are willing to pay. “FEA millionaires” were recently enriched by such reselling of domestic crude oil. In short, when a price is restrained below the market-clearing level, the low price received by producers discourages production. And final buyers confront reduced supply, even though the item’s total cost to an individual buyer may well be no lower than in an uncontrolled market. GENERAL EFFECTS OF WAGE-PRICE RESTRAINT Wage-Price Restraint as a Substitute for Monetary and Fiscal Restraint While economists generally agree that monetary and fiscal restraint will eventually lower inflation, such restraint will also temporarily lower real economic growth, possibly causing a severe recession. As the director of the Council on Wage and Price Stability, Barry Bosworth, put it, “In the last three recessions, on average you had to throw 1 million people out of work in order to get 1 percentage point off the rate of inflation. You have to do it for at least 2 years and each year you lose about $75 billion worth of GNP.” [12] In light of this high cost, policymakers often refuse to lower inflation by lowering aggregate demand through monetary or fiscal restraint. Rather, wageprice restraint is advocated in place of lowered aggreThe view that wage-price restraint gate demand. and monetary-fiscal restraint are substitutes is exemplified by Sherman J. Maisel, a former governor 16 of the Federal Reserve Board, “Stable prices result primarily from either severe depressions or pricewage controls.” Moreover, the record of American policymakers also indicates that wage-price restraint is used as a substitute for monetary and fiscal restraint. During Phases I and II of the Nixon wage and price controls, the money supply (Ml) grew at an annual rate of 7.5 percent and the high employment deficit averaged 1.2 percent of GNP ; during the tenure of the Nixon administration before Phase I, the money supply grew at an annual rate of 5.2 percent and the high employment surplus averaged 0.2 percent of GNP. Thus, both monetary and fiscal policies were less restrictive after controls were imposed.2 Other American experiences with wage-price restraint were generally accompanied by expansionary monetary and fiscal policies. When wage-price restraint is imposed as a substitute for monetary and fiscal restraint, it unfortunately shifts attention from monetary and fiscal policy to individual prices or wages. For example, shortly after President Carter announced the October 1978 wage-price restraint program, the mass media directed considerable attention to a relatively trivial matter, the rising price of Hershey chocolate bars. The monthly report on policy action released by the Federal Open Market Committee received almost no coverage. However, had the President, in his televised address, substituted a discussion of monetary policy for his lengthy discussion of single prices and wages, reporters might have paid more attention to the FOMC. At worst, this distracted attention can degenerate into a search for scapegoats while monetary and fiscal expansion remain unchecked. A General Output Effect There is another, often overlooked effect of wage-price restraint when used as a substitute for monetary and fiscal restraint. Whenever a price level which cannot freely adjust is inconsistent with the existing level of aggregate demand and high output, the economy can encounter macroeconomic disequilibrium. Robert Barro and Herschel Grossman have provided an incisive analysis of such disequilibrium. Both the informal discussion of this section and an 2 A myopic measure of monetary policy, looking no earlier than May 1971. nor later than June 1972, would show the opposite. However, most economists believe that a few months is too short to establish a policy, since unrelated influences can cause abnormal figures in short period data. Thus. May-August 1971 would not be taken as indicative of precontrol policy. ECONOMIC REVIEW, MAY/JUNE 1979 Appendix giving a more elaborate disequilibrium analysis rely heavily on the Barro-Grossman presentation.3 While this method of analysis generally confirms conclusions of orthodox macroeconomics, its use helps divert attention from minor issues which have often obscured more important topics. One very important topic highlighted by Barro-Grossman is the macroeconomic importance of wage and price levels. A conclusion of this analysis is that when inflexible price and wage levels are too low (as would happen when wage-price restraint is effective) the result is macroeconomic disequilibrium, in this case labeled general excess demand. Consequences of general excess demand include involuntary unemployment and reduced production, exactly as would be expected from a recession. When general excess demand exists, economic recovery can occur only if (1) prices and wages rise, or (2) aggregate demand is lowered by monetary-fiscal restraint. To understand these results, consider the essentials of a very simple disequilibrium model, containing (1) a household sector, whose members supply labor and purchase commodities, (2) firms which purchase labor and supply commodities, (3) a government which can create or destroy money, levy taxes, and buy commodities, and (4) price and wage levels which are realized as the outcome of all private and governmental decisions. When the economy functions normally, price and wage levels adjust so that output and employment are at high levels. For example, if the money supply4 were to rise in an economy with full employment, thereby raising aggregate demand, prices and wages normally would increase. However, if aggregate demand is greater than the economy can supply at current price and wage levels, but prices and wages are legally frozen, then something else has to give. And an output-employment fall is the only “give” left in the system. Moreover, the fall is more severe than might be expected from looking only at single markets. Dislocations in one market can aggravate problems in another market and vice versa. If prices are too low 3 But any shortcomings in this article responsibility of the author. naturally are the 4 An increase in the money supply is used as an example of a change which affects aggregate demand. This category also includes changes in government spending, taxes, household preferences for current relative to future consumption, and in more complex models, changes in investment decisions of firms and net exports. Since the origin of an aggregate demand change is of secondary importance in discussing its qualitative effects, for ease of exposition the example of a money supply change will continue to be used as an example of a change affecting aggregate demand. to equilibrate demand with available supply, households will not be able to buy all the commodities they wish, and they will thus tend to substitute current leisure for unavailable current consumption. Since more current leisure means less current work, firms will be unable to obtain the amount of labor they seek. However, a reduced amount of labor employed limits the amount of commodities firms can produce. In this manner an initial disturbance can cause selfreinforcing output-employment declines throughout the economy. In short, output and employment fall when there is inconsistency among (1) high output and employment levels, (2) fixed price and wage levels, and (3) the prevailing level of aggregate demand. If either of the latter two elements were able to change, Starting then output and employment could rise. from an economy experiencing general excess demand, recovery could thus involve allowing prices and wages to rise. Alternatively, lowering aggregate demand, possibly by cutting the money supply, could also initiate recovery. Fortunately, general excess demand has not been a problem in industrialized, market economies. Especially in the U. S. experience with wage-price restraint, it is hard to see any sign of general excess demand, which suggests that controls may have been more symbolic than real. An alternative explanation might be that single market distortions were promptly ameliorated by relaxing controls at the first sign of trouble. Consequently, the price level could rise and there would not be enough time for spillovers among markets to generate disequilibrium and a general output effects.5 Additionally, a real economy has, for a short time, more flexibility than the simple economy described above. Lower inventories, higher unfilled orders, and more employee overtime could be immediate responses to an aggregate demand increase. But there is a limit to the flexibility such measures can provide. Inventories cannot fall lower than zero, and employees will not accept whatever amount of overtime firms propose. Therefore, while an economy has many responses which can delay the onset of general excess demand, the delay is only temporary. Events in post-World War II Germany can be interpreted as indicating general excess demand, al5 Eastern European economies might be studied for general excess demand effects, due to their rigid prices and expansive aggregate demand policies. However, necessary data on output, prices, and government policies are difficult to obtain in a form suitable for analysis. However, see Howard. FEDERAL RESERVE BANK OF RICHMOND 17 though there are other plausible explanations.6 In 1936 the Nazi government imposed a comprehensive price freeze, which combined with wages frozen at 1932 levels to yield a wage-price restraint policy which outlasted the Nazi government. In 1945 the Allied Control Authority maintained German price laws as well as local price control agencies. While it may not be surprising that a totalitarian police state was able to implement effective restraint, even under the Allies “price control during the first three years of occupation was surprisingly effective . . . the bulk of the goods changed hand at legal or nearly legal prices . . . legal wages prevailed throughout the economy.” [9] On June 20, 1948, actions were taken which ultimately cut the money Simultaneously much wagesupply by 93 percent. price restraint was abandoned. As the economy recovered industrial production rose at an annual rate of 97 percent between June and November 1948. The German recovery is thus similar to recovery from general excess demand as modeled in this article. In both, cutting the money supply and relaxing wage-price restraint result in higher output and employment. To summarize, users of the disequilibrium model are in the position of predicting the danger of general excess demand on the basis of theory unconfirmed by strong empirical evidence.7 If the analysis presented above is relevant, then to ignore the possibility of general excess demand would seem to imply that necessary conditions to create it are not met. That is, either wage-price restraint is believed to be ineffective or, as discussed below, it is expected to be used 6 Any discussion of the postwar German experience should mention what many economists would refer to The identification as a severe identification problem. problem arises because any economic result at the time can be plausibly attributed at first glance to numerous exceptional causes. One explanation of low output might note Allied bombing lowering the stock of business fixed capital. High output growth-rates could be a catch-up to more normal levels or a result of Allied aid, notably the Surprisingly, Germany had substantial Marshall Plan. industrial capacity at the end of the war. Wallich noted that after all allowingfor in-slant repairs, more capacity was added during the war than was destroyed. He also noted that while Germany received $4.5 billion in Allied aid, the Allies simultaneously imposed burdens on Germany including reparations, occupation costs, etc. that could offset some, or all, of the stimulating effects of aid payments. Also, the data available are distorted by the pervasive black markets. hoarding. and bilateral barter of the period. For example, it is hard to interpret early industrial production figures due to hoarding by manufacturers (anticipating the relaxation of price controls) and sales in the black markets. 7 But the same approach applied to another problem, the business cycle characterized by periods of general excess supply, has better empirical support. 18 as a complement to, rather monetary and fiscal restraint. than a substitute for, Wage-Price Restraint as a Complement to Monetary-Fiscal Restraint As discussed above, general excess demand can develop if prices are too low. But general excess demand is not the only possible form of disequilibrium. If rigid prices and wages are too high, then general excess supply is possible. For example, suppose that the economy is initially producing high levels of output and employment. Then suppose that the money supply is suddenly reduced, with prices and wages not immediately changing.8 The fall in real money holdings would result in a fall in the household sector’s desired level of consumption, and an increase in their desired amount of employment (to restore some of their lost money holdings). Firms, however, would offer less employment, since their sales are down. But if firms cut the amount of employment, households would buy even less, leading to further drops in sales, jobs, income, and consumption. The final outcome of the resulting general excess supply is lower output and employment. The reasoning behind this conclusion is analogous to the reasoning that general excess demand causes lower Both general excess supply output and employment. and general excess demand occur when inflexible wages and prices are inconsistent with government’s monetary and fiscal policies, households’ consumption and labor supply choices, firms’ production and employment choices, and high output and employTo restore equilibrium, one of two ment levels. things must happen: either prices and wages must adjust to appropriate levels, or the government’s monetary and fiscal policies must adjust aggregate demand appropriately. The contention that monetary-fiscal restraint is a costly way to lower inflation has a firm foundation, namely the premise that such restraint would entail a period of genera1 excess supply. That is, for some time after restraint is imposed on an inflationary economy, prices and wages would be too high and disequilibrium would develop. Were the government able to establish equilibrium levels of prices and wages at the initiation of monetary and fiscal restraint, disequilibrium could be avoided. This is a major reason why some economists continue to advo8 The Achilles Heel of this section is the failure to show why prices and wages would not adjust immediately and completely. An earlier discussion relied on the assumpOne approach, tion of effective wage-price restraint. taken by Okun, notes that in an uncertain world buyers and sellers can benefit from formal and informal long term contracts which limit price and wage flexibility. ECONOMIC REVIEW, MAY/JUNE 1979 cate wage-price restraint despite its past performance.9 An observant reader might question the implicit contention that the government will have better information on appropriate price and wage levels than do households and firms. After all, the only information possessed exclusively by the government is the course of monetary and fiscal policy. Thus, it would appear that simply announcing policy changes before they went into effect would allow the private sector to adjust smoothly to the policy change. Unfortunately, this simple solution is probably too good to be true. Government policy has historically been so erratic that current announcements have little credibility. Moreover, formal and informal contracts would limit immediate price or wage adjustment in response to even a credible announcement. Consequently, if one believes the government to possess better knowledge than the private sector on appropriate levels of wages and prices, and if one believes the government to be capable of promptly employing this knowledge in wage-price control, then one could logically support temporary wage-price restraint, concurrent with monetary-fiscal restraint. 9 Another economic argument for wage-price restraint rests on the concept of administered prices. While often stated as a simplistic conspiracy theory with little economic content, it can also be given a more sophisticated form. Imagine an economy with most prices determined by firms that can arbitrarily move price within a zone of control, and most wages set by unions with similar economic power. Now imagine one or both of these groups attempting to grab a larger portion of national income by using its economic power to push up prices or wages. That group could be successful, at least temporarily, if the government concurrently expanded aggregate demand enough so that sales and employment were not reduced. The result of this expanded aggregate demand,. however, is inflation. Wage-price restraint, it is argued, is the best way to curb this “administrative inflation.” Means has given a classic statement of this doctrine. Even in its most sophisticated form, however, many economists do not find the argument persuasive. First, there may be better ways to limit price increases in concentrated industries. For example, proponents of the administrative inflation doctrine often point to the steel industry. But the steel industry has been able to raise prices only because the government has limited imports of low cost foreign steel. Thus, removal of import tariffs and quotas would allow American manufacturers to purchase low cost steel without wage-price restraint. Also, if big business and big labor have enough political clout to induce the government to expand aggregate demand in the first place, they probably have enough clout to influence a wage-price restraint program in their favor. Moreover, it is not clear what fraction of prices and wages are administered, how large are the zones of price control, and to what extent members of a group like big business would cooperate rather than compete. Yet these are all crucial elements of the theory. For example, an oligopolist might not be able to raise its price since that would create sufficient profit opportunities to attract new competitors. And not being-able to raise price makes the theory inapplicable. Therefore, unless these questions can be satisfactorily answered, it is possible to accept the abstract theory without seeing any relevance to the American economy. Present rhetoric acknowledges the latter part of this conclusion. For example, President Carter’s chief inflation fighter Alfred Kahn has stated “it has been recognized that wage and price controls would be futile if they were not accompanied by really quite stringent budgetary restraint and monetary restraint.” It should be noted, however, that political rhetoric has often endorsed demand restraint while simultaneous actions produced monetary-fiscal expansion. CONCLUSION Economic activity consists of the production and exchange of goods and services. A person may exchange productive labor for money wages, and at a different time trade the money for any of numerous commodities. Trades are made whenever each party concerned believes the transaction will improve his own well-being. Wage-price controls, however, seek to prohibit certain of these mutually beneficial transactions. In so doing, controls conflict with a very powerful human motivation, the desire to improve one’s own well-being. Therefore it is not clear that controls will actually succeed in prohibiting transactions. Even if the central authority does successfully limit the transactions people can make, it does not follow that the effects will be desirable. Since governments are limited in the amount of information they can acquire and process, and make decisions slowly, if at all, single market distortions are inevitable when controls are effective. Dogged controllers, undeterred by such distortions, could cause general excess demand unless they were to follow the unusual procedure of concurrently restricting aggregate demand by monetary or fiscal policy. And even if aggregate demand restraint is concurrently employed, and if single market effects are not severe, wage-price controls still may not have a desirable impact on the economy. The theoretical argument that controls will allow the economy to avoid general excess supply requires not only that the government be better able to identify appropriate price and wage levels than the market process, but also to be able to act expeditiously upon that knowledge. Both requirements are stringent, and demand a higher level of governmental competence than is actually observed. Therefore, employing wage-price restraint to battle inflation might well prove to be the Viet Nam of economic policy. That is, the battle is likely to be protracted, with no light at the end of the tunnel, and with burdens on the population mounting as the battle FEDERAL RESERVE BANK OF RICHMOND 19 continues. Perhaps a paraphrase of Senator Aiken’s Viet Nam strategy is appropriate for wage and price controls. That is, declare victory over inflation if necessary, but end the controls program immediately. APPENDIX This appendix uses a simplified model economy to examine macroeconomic disequilibrium. After the basic features of the economy are presented, suppressed inflation is studied in Part I. A more traditional recession is analyzed in Part II, as a first step towards explaining a rationale sometimes given for wage-price restraint. The disequilibrium model presented is quite flexible, and can be applied to a wide range of macroeconomic problems. I. GENERAL EXCESS DEMAND The Basic Model Imagine an economy with three markets: output (Y), labor (L), and money (M); three types of decision makers : firms, households, and a government; and two prices : the price of commodity output (P) and the price of labor (W). Households and firms engage in economic activity in their own self-interest, and no attempt is made to explain why the government engages in economic activity. Households make two economic decisions: how much output to buy and how much labor to sell. It is assumed that the higher the real wage (W/P) or the higher their real money balances (M/P), the more output households wish to consume (Cd). While a higher real wage is assumed to induce households to supply more labor (Ls), it is assumed that households who are wealthier because of higher real money balances enjoy their additional wealth by consuming both additional output and additional leisure. Since more leisure means less work, increasing real money balances will lower the labor supply schedule (that is, the amounts of labor potentially offered at each possible wage rate). Firms decide how much output they produce (Ys); their labor demand (Ld) is the quantity of labor needed to produce Ys.10 An increase in the real wage rate lowers the demand for labor and thus, with less labor employed, a smaller amount of output is produced. Government obtains funds to purchase output (G) by taxing households or printing money. Ag10 More precisely, there is an aggregate production func- tion F such that Y = F(L); moveover, it is also assumed that the quantity produced is equal to the quantity sold. 20 gregate commodity demand (Yd) is the sum of demands by households and the government. For the commodity market to be in equilibrium, it is necessary that Ys = Cd + G; for labor market equilibrium, Ls = Ld. If these two markets are in equilibrium, so must the money market11 and the model economy consequently exhibits general equilibrium. If Ld > Ls and Cd + G > Ys, the situation will. be labeled general excess demand (although general here refers to only the “real” sectors as opposed to the monetary sector). Persistent Excess Demand Assume that there is initially a general equilibrium, with LO hours of labor and YO units of output exchanged at wage WO and price PO. Now imagine that the government prints additional money (M rises from MO to M1) and distributes it to households. A first analysis might simply note (as described above) that the increase in real money holdings would increase household demand for output but decrease household labor supply (by increasing the demand for leisure). If the wage and price levels did not change, there would be excess demand in each market, as shown in Figure 2. However, a sufficient increase in the price 1evel could lower Ml/P to MO/PO; along with the same percentage increase in the wage level, commodity demand and labor supply of households would return to their original values. Now suppose that wage-price restraint is imposed at the same time the money supply is increased. If wages and prices do not adjust then there are new questions to answer. First, what quantities are exchanged in each market? When quantity demanded is equal to quantity supplied, the answer is easy. But now quantity demanded is greater than quantity The answer uses the assumption that supplied. households and firms engage in economic activity in their own self-interest, and are not forced to make any transactions; accordingly, the quantity supplied is the quantity exchanged. Suppliers do not wish to supply more and are not forced to. While a naive analysis might stop here, there is another problem. Firms cannot buy as much labor by paying WO as they could before; is it reasonable to assume an unchanged supply of output? In this simple world, cutting back labor input directly lowers the level of commodity output. As shown in Figure 3, Ys’ is the effective commodity supply given the labor market constraint on the amount of labor firms 11 This follows from direct application of Walras' Law. Crouch presents an unusually clear exposition of Walras’ Law. ECONOMIC REVIEW, MAY/JUNE 1979 FEDERAL RESERVE BANK OF RICHMOND can purchase. Moreover, there is another spillover: households supply labor in order to receive wages with which they buy output; if they cannot buy all the output they wish, then they can at least reduce their labor supply and have more leisure time to enjoy. Thus the labor supply can be represented as in Figure 3 by Ls’, the effective supply of labor given the commodity market constraint on the amount of output households can purchase. The analysis presented above can be summarized with the aid of a graph, such as the one in Figure 4, which includes effective supply curves for labor and real output, Ls’ and Ys’. Demand curves are omitted since when there is excess demand, exchange is limited to the amount supplied. At point A both markets are in equilibrium. While the wage and price levels are restrained at WO and PO the quantity of money is increased from MO to M1. As a result there are excess demands in the labor and output markets. Households thus face a supply constraint on consumption and firms face a supply constraint In response, households reduce on labor purchases. effective labor supply and firms reduce effective out- put supply. The final outcome yields levels of employment and output, point B, significantly below initial levels. Recovery The economy can recover and move back to point A in one of two ways. If restraints are removed and the price level rises enough so that M/P returns to its old level, and there is an equal percentage increase in the wage level, then the economy can move from B to A. If wages and prices continue to be restrained, a cut in the money supply12 can still result in movement from B to A. In either case, after adjustment W/P = WO/PO and M/P = MO/PO; therefore Yd = YS = YO and Ld = Ls = LO. This analysis can give meaning to the phrases “too high” or “too low” a price and/or wage level. At point B both the price level and the wage level are too low, since increasing both would increase employment and output. One of the hardest tasks in learning economics is unlearning oft-repeated fallacies; one such fallacy is that high prices are bad but low prices are good. As has been seen, if low prices and wages result in general excess demand, then the whole economy suffers. It is interesting to contrast this general approach with the partial analysis of viewing equilibrium in only one market, as in Figure 2. Imagine, as before, that the money supply increases and, consequently, households’ planned purchases rise. In the market for output it would appear that lowering the real wage, by lowering W with P unchanged, would effect a new equilibrium at an output level higher than YO. A general analysis, as summarized in Figure 3, would show the error of ignoring the labor market. The initial shock causes a movement from A to B. If W were forced down with P unchanged, then Ls’ would shift to the left, resulting in even lower output and employment than at B. II. GENERAL EXCESS SUPPLY Without Continuing Inflation The basic model of Part I will be used to examine a typical recession, in which the problem is general excess supply rather than general excess demand. Assume that initially there is a general equilibrium, with LO hours of labor and YO units of output exchanged at wage WO and price PO. Now suppose that the money supply is suddenly reduced from MO to M2. A first analysis might simply note that the decrease in real money holdings would decrease household demand for outThus if wages and prices did not put and leisure. 12 More generally, any action which decreases aggregate demand can be substituted for a cut in the money supply. 22 ECONOMIC REVIEW, MAY/JUNE 1979 change there would be excess supply in both the commodity and labor markets. However, a sufficient decrease in the price level could raise M2/P to MO/PO; along with the same percentage decrease in the wage level, Cd and Ls would return to their original values. Now suppose that wages and prices cannot fall as much as described above. Consequently there is still excess supply in each market. As before, when quantities supplied and demanded are not equal, the lesser of the two is the quantity traded. Thus, the quantity demanded is the quantity exchanged. Also, there are spillovers between the two markets. Firms cannot sell as many commodities as in equilibrium; therefore they have a smaller labor requirement. Households cannot sell all the labor they wish; this fall in income lowers their planned commodity purchases. Thus the initial shock is exacerbated by these reinforcing spillovers. In other words, the initial aggregate demand shock has a multiplier effect. The resulting situation is illustrated in Figure 5 with effective demand curves for labor and commodities. Note that disequilibrium does not result from too high or too low a real wage ; on the labor market side, the real wage rate can vary substantially without affecting the quantity of labor employed. Effective FEDERAL RESERVE BANK OF RICHMOND 23 demand curves are also drawn in Figure 6. Supply curves are omitted, since under excess supply, exchange is limited to quantity demanded. The initial demand shock is a reduction in the quantity of money from MO to M2 with the wage and price levels stuck at WO and PO. Consequently there is general excess supply. The final outcome entails levels of output and employment, point D, significantly below initial levels. Recovery occurs in an analogous manner to the case of general excess demand. Either the wage and price levels must fall, or the money supply must rise, so that W/P = WO/PO and M/P = MO/PO. The symmetry of general excess supply and general excess demand is illustrated in Figure 7. It is assumed that the real wage is WO/PO and that wage and price levels are frozen. Then there is one quantity of money at which output is at its maximum level, YO. A lower money supply results in general excess supply while a higher money supply results in general excess demand. One can also observe the potential importance of a flexible price level, which could change M/P and thus raise output from low disequilibrium levels. Similar diagrams can be used to illustrate effects of other variables, such as government spending or taxes. Recession ‘with Inflation The preceding section presents a disequilibrium model of a recession in an economy without continuing inflation. In this section an ad hoc addition is made to the basic model so that continuing inflation is included. The purpose is to show how monetary-fiscal restraint can trigger general excess supply, and how this might be avoided by perfectly administered wage-price restraint. Suppose that in every month for the past 10 years, the money supply has increased by 1 percent, although the monetary authority announced at various times its intention of slowing money growth. In. the simple economy described above, general equilibrium could be maintained by price and wage levels rising 1 percent per month. Furthermore, imagine the monetary authority again announcing its intention of slowing money growth and actually stopping growth completely. Using anticipations (which with perfect hindsight can be seen to be incorrect) based on the previous 10 years, firms and households might well ignore the monetary authority’s announcement and agree to wages and prices 1 percent higher. If the higher wage and price levels stuck, there would be general excess supply, as described above. Real money holdings would fall as the price level rose and the money supply did not change ; consequently, households would cut purchase plans. As a result, firms would demand less labor. But if households could not sell their desired amount of labor at the going wage, they would lower planned purchases. Thus monetary restraint would cause an initial fall in output and employment. If monetary restraint were maintained, then for recovery to occur it would be necessary for households and firms to correctly comprehend the monetary action, and for prices and wages to adjust accordingly. However, an effective freeze of prices and wages at the same time the money supply was first held constant would avoid the general excess supply scenario. Quantities exchanged in the commodity and labor markets would not fall when the money supply is lower than expected. This happy result is due to artificially low price and wage levels being consistent with the unexpectedly low money supply and general equilibrium. Even in this simple world, there are quite strong restraint to necessary conditions for wage-price achieve the potential output-employment gains mentioned above. First, prices and wages must not automatically fall when monetary restraint is imposed (otherwise, monetary restraint would not cause general excess supply). Next, the wage-price controllers must have better knowledge of the extent of monetary restraint than the public (otherwise, the public 21 ECONOMIC REVIEW, MAY/JUNE 1979 could adjust prices and wages to appropriate levels without intervention). Finally, wage-price restraint must be effective. “Suppressed Infla1. Barro, R., and H. Grossman. tion and the Supply Multiplier.” Review of Economic Studies, 41 (January 1974), 87-104. 3. York: Money, Employment and Inflation. New Cambridge University Press, 1976, ch. 2. Council of Economic Advisors. 1963 Annual ReWashington : Government Printing Office, port. 1964. New York: 4. Crouch, R. Macroeconomics. Brace Jovanovich, pp. 144-147. 5. Kahn, A. Interview December 18, 1978. the Dollar. 8. Means, G. The Corporate Revolution Crowell Collier Press, 1962. New York: in America. 9. Mendershausen, H. “Prices, Money, and the Distribution of Goods in Postwar Germany.” American Economic Review, 39 (June 1949), 651-672. References 2. Managing 7. Maisel, S. Norton, 1973, p. 282. reprinted in American Harcourt Banker, 6. Lactantius, quoted in J. Collins, “Price Controls: 40 Centuries of Failure.” Business Week, December 18, 1978, p. 13. 10. Okun, A.- “Inflation: Its Mechanics and Welfare Costs" Brookings Papers on Economic Activity, (2: 1975). 11. Slevin, J. “Inside the Economy.” American Banker, February 26, 1979. 12. U. S. Congress. House. Committee on Banking, Finance and Urban Affairs. The Administration’s Anti-Inflation Program. Statement by Barry P. Bosworth at the Hearings before the Subcommittee on Economic Stabilization, House of Representatives, 95th Cong., 2nd sess., June 21, 1978, p. 28. 13. Wallich, H. Mainsprings Binghampton, New York: of the German Revival. Vail-Ballou Press, 1955. Model in a Con14. Howard, D. “The Disequilibrium trolled Economy.” American Economic Review, 66 (December 1976), 871-79. The ECONOMIC REVIEWis produced by the Research Department of the Federal Reserve Bank of Richmond. Subscriptions are available to the public without charge. Address inquiries to Bank and Public Relations, Federal Reserve Bank of Richmond, P. O. Box 27622, Richmond, Virginia 23261. Articles may be reproduced if source is given. Please provide the Bank’s Research Department with a copy of any publication in which an article is used. Also note that microfilm copies of the ECONOMICREVIEWare available for purchase from University Microfilms, Ann Arbor, Michigan 48106. The identification number is 5080. FEDERAL RESERVE BANK OF RICHMOND 25
@FedFRASER