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INFLATION AND GROWTH:
THE ECONOMIC POLICY DILEMMA

July 1978

CONGRESS OF THE UNITED STATES
Congressional Budget Office
Washington, D.C.

INFLATION AND GROWTH:
THE ECONOMIC POLICY DILEMMA

The Congress of the United States
Congressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402

PREFACE

Inflation and Growth: An Economic Policy Dilemma is one of a
series of reports on the state of the economy issued periodically
by the Congressional Budget Office. In accordance with CBO f s
mandate to provide objective analysis, the report contains no
recommendations. It was prepared by George Iden, Cornelia Motheral, Joan Schneider, Steven Zeller, Nancy Morawetz, Nariman Behravesh, Marvin Phaup, Toni Gibbons, Rebecca Summerville, John Jacobson, and other members of the Fiscal Analysis staff, under the
direction of William Beeman and James Annable. Patricia H. Johnston
and Marion F. Houstoun edited the manuscript. Special recognition
goes to Debra Blagburn, Dorothy J. Kornegay, and Marsha L. Mottesheard for their skill and patience in typing the many drafts.

Alice M. Rivlin
Director

July 1978

111

CONTENTS

PREFACE

•

SUMMARY
CHAPTER I.

iii
.

...

INTRODUCTION
The Current Policy Dilemma*..
The Inflation-Unemployment Tradeoff

CHAPTER II.

1
......

1
2

The Report

THE ECONOMIC OUTLOOK

Recent Trends in Fiscal and
Monetary Policies
Trends in Nonfederal Demand
•
Trends in Employment, Productivity,
and Prices
Projections for 1978 and 1979
CHAPTER III. INFLATION: ITS PERSISTENCE AND
RECENT ACCELERATION
The Record.... *
The Persistence of Inflation in a
Period of Economic Slack.
The Recent Acceleration of Inflation
Summary
CHAPTER IV.

...

7
14
23
26
33
33
33
43
52

POLICY ALTERNATIVES

Restrictive Fiscal Policy Options
An Expansive Fiscal Policy Option
The Composition of Fiscal Policy and
the Monetary-Fiscal Policy Mix
Other (Non-Aggregate) Approaches
Conclusion

54
55

.....

56
62
68

TABLES
Page
TABLE 1.

UNIFIED BUDGET ASSUMPTIONS

TABLE 2.

FEDERAL EXPENDITURES GROWTH, NATIONAL
INCOME ACCOUNTS BASIS
FULL-EMPLOYMENT BUDGET ESTIMATES,
FISCAL YEARS 1972 TO 1979
..
CHANGE IN FINAL SALES AND ITS MAJOR
COMPONENTS
STATE AND LOCAL GOVERNMENT RECEIPTS
AND SPENDING
ECONOMIC PROJECTIONS BASED ON CURRENT

TABLE 3.
TABLE 4.
TABLE 5.
TABLE 6.

7
8
10
14
22

POLICY, CALENDAR YEARS 1978 AND 1979..

TABLE 7.

ECONOMIC PROJECTIONS BASED ON TIGHTER MONEY....

TABLE 8.

ESTIMATED WAGE ADJUSTMENTS DURING THE
1976 BARGAINING YEAR

TABLE 9.

INFLATION AND ECONOMIC SLACK, 1975-1977

TABLE 1 0 .
TABLE 1 1 .

RECENT FOOD PRICE MOVEMENTS
CHANGE IN THE VALUE OF THE DOLLAR AGAINST
OTHER CURRENCIES
MEASURES OF LABOR-MARKET SLACK—UNEMPLOYMENT

RATES FOR SELECTED GROUPS

TABLE 1 3 .

MEASURES OF CAPACITY UTILIZATION

TABLE 1 4 .

ESTIMATED ECONOMIC EFFECTS OF THE
NO TAX CUT OPTION

TABLE 1 2 .

Vll

TABLES (CONTINUED)

TABLE 15. APPROXIMATE EFFECTS OF TWO ILLUSTRATIVE
$10 BILLION TAX REDUCTIONS
TABLE 16. TOTAL AND NONWHITE UNEMPLOYMENT RATES IN
POVERTY AND NONPOVERTY AREAS, 1973 AND
FIRST QUARTER OF 1978

TABLE 17. EMPLOYMENT GROWTH SINCE THE
RECESSION TROUGH

Vlll

FIGURES
Page
FIGURE 1.

INFLATION AND UNEMPLOYMENT

FIGURE 2.

FEDERAL EXPENDITURES BY TYPE, AS A

PERCENT OF TOTAL FEDERAL EXPENDITURES

FIGURE 3.

INTEREST RATES

FIGURE 4.

INTEREST RATES, SAVINGS FLOWS,
AND HOUSING STARTS

FIGURE 5.

INVESTMENT ORDERS AND SPENDING

FIGURE 6.

RATE OF CHANGE IN STRIPPED CONSUMER
PRICE INDEX
RATE OF CHANGE N PHYSICIANS1 FEES AND LAGGED
RATE OF CHANGE IN CONSUMER PRICE INDEX
TEENAGE UNEMPLOYMENT RATES (AGE 16-19),

FIGURE 7.
FIGURE 8.

BY RACE

36
65

31-331 O - 78 - 2

SUMMARY

Consideration of the Second Concurrent Resolution on the
Budget for Fiscal Year 1979 presents the Congress with difficult
choices. Inflation is accelerating, while the economic expansion
is giving indications of running out of steam. Consequently, there
is a troubling policy dilemma: standard anti-inflation measures may
weaken growth and, perhaps, lead to a recession, while policies
designed to sustain the expansion may increase the pressures on
prices.
THE CBO PROJECTION
Any forecast of economic activity depends critically on
how policymakers respond to this dilemma. The CBO projection is
based on the following assumptions about economic policy:
o The fiscal policy is as given in the first concurrent
resolution, including a $15 billion tax cut for fiscal
year 1979 to take effect in January;
o With respect to monetary policy, it is assumed that shortterm interest rates will not rise much further and that
credit conditions will not become so restrictive as to
abort the expansion.
Given these assumptions, CBO projects that constant dollar
gross national product (GNP) will increase by 3.5 to 4.5 percent
during 1978, slowing to 2.7 to 4.2 percent growth during 1979. This
expansion of output is about what has typically been needed to keep
the growth in employment in line with the growth in the labor
force. As a result, the unemployment rate is not expected to
improve much from its mid-1978 level, ranging between 5.2 and 6.0
percent by the end of the projection period. Meanwhile, prices are
expected to continue to rise at a rapid rate, albeit below the
double-digit pace during the first half of this year. The increase
in the Consumer Price Index (CPI) for all of 1978 is forecast
between 6.8 and 7.8 percent. Even in the absence of any unanticipated shocks, inflation is projected to remain very high next year,
although somewhat below the 1978 rate.

SUMMARY OF ECONOMIC PROJECTIONS, CALENDAR YEARS 1978 AND 1979
Rates of Change (percent)
1976:4
to 1977:4
(actual)

1977:4
to 1978:4

11.8

10.1 to 12.2

9.0 to 11.6

GNP (1972 dollars)

5.7

3.5 to 4.5

2.7 to 4.2

Consumer Price Index

6.6

6.8 to 7.8

6.2 to

Economic Variable

GNP (current dollars)

1978:4
to 1979:4

7.2

End of Period (percent)
Unemployment rate

6.6

5.5 to 6.1

5.2 to

6.0

Inflation Outlook
Consumer price inflation accelerated rapidly during the first
half of 1978, rising at about twice the rate recorded in the final
six months of last year. This upsurge was not because of widespread shortages of labor and capital* Rather, about 90 percent of
the acceleration was associated with the simultaneous occurrence of
three events: the jump in food prices resulting from adverse winter
weather and depleted cattle herds, the decline in the foreign
exchange value of the dollar, and the January hikes in payroll
taxes and the minimum wage. While no comparable food and depreciation shocks are forecast for next year, the upward momentum of
prices is projected to moderate only somewhat from the rapid
1978 pace. The principal factor causing this continued high level
of inflation is expected to be rising labor costs—largely reflecting a catch up in wages to the acceleration of consumer prices
earlier this year.
Reasons for the Slowdown
Both the foreign trade and state and local government sectors
are expected to provide somewhat greater stimulus to economic

xii

growth through the forecast period than they did last year.
Consequently, the projected slowdown rests largely on the anticipated behavior of three sectors of the economy: housing, consumption, and business fixed investment,
o Spending on residential construction is expected to slow
from the present high rate because of the tightening of
credit markets that had occurred by midyear; this tightening has already limited the funds available for home
mortgages •
o Consumer spending is likely to be constrained by the
sharp increase in the ratio of personal debt to income and
the reduced opportunity to liquidate equity in real estate
caused by tighter mortgage markets. Moreover, consumer
attitude surveys indicate the surge in retail sales earlier
this year may have been in part to avoid future price
increases; such buy-in-advance behavior "borrows11 consumption from the future.
0

The recent Department of Commerce survey of business
anticipations showed that constant dollar spending on plant
and equipment is likely to continue to rise faster than
overall growth but to increase less rapidly this year than
in 1977.

Reasons for No Recession
Many forecasters believe that the anticipated slowdown in
economic growth will turn into a recession. CBO agrees that the
risks of a recession sometime in the projection period are substantial; however, given CBO*s policy assumptions, CBO does not believe
that, on balance, current economic trends point to a downturn, for
the following reasons:
o The tax cut included in the first concurrent resolution
more than offsets the effects on disposable personal
incomes of rising payroll taxes and of the rising income
tax burden, caused by the combination of inflation and the
progressive tax structure. Thus the tax cut should help
sustain consumer spending. In addition, the tax package
should provide some stimulus to business fixed investment.

Xlll

o The impact of higher interest rates on housing activity may
be softened somewhat by the new regulations permitting
lending institutions to pay market rates on deposits of
$10,000 or more,
o The recent depreciation of the dollar should eventually
help boost net exports,
o There is little evidence of the imbalances between production and final sales that often precede a recession;
indeed, throughout the current expansion, businesses have
pursued a conservative inventory policy, keeping stocks
closely aligned with sales.
These factors, however, do not touch upon the principal
difference between the CBO projection and those that forecast a
near-term recession: the future course of monetary policy, CBO
simply assumes no significant further tightening of credit markets.
By contrast, many forecasters anticipate a recession brought
on by a credit crunch, as the Federal Reserve continues to raise
interest rates in response to the acceleration of inflation and the
rapid increase in the basic money supply.
POLICY OPTIONS
The first concurrent resolution enacted by the Congress last
spring included a sizable tax cut to ensure continued economic
growth. If such a tax cut is adopted, fiscal policy would be about
as expansive in fiscal year 1979 as this year. The Congress now has
an opportunity to review that earlier decision in the light of
changing economic conditions.
Restrictive Fiscal Policy Options
If the Congress feels that the first concurrent resolution
policy provides too much stimulus—particularly in light of the
recent acceleration of inflation—it can take steps to reduce the
fiscal year 1979 deficit:

o One way would be to forego all or part of the $15 billion
tax cut for fiscal year 1979* If the tax cut were dropped,
real output would be about three-fourths of one percentage

xiv

point lower by the end of 1979 and the unemployment rate
about two-tenths higher. The restrictive effect would be
larger at the end of 1980. By that time, prices might be
0.2 percent lower with the impact still incomplete since
inflation reacts to fiscal policies more slowly than
unemployment.
o A significant restrictive economic effect could also be
attained by cutting expenditures. If the Congress could
achieve a cut in spending of $10 to $15 billion beyond the
estimated shortfall, the effect on economic activity would
be roughly similar to that described above for eliminating
the $15 billion tax cut, depending on the composition of
the reductions.
While such a reduction in fiscal stimulus could lessen the
risk of added inflation, real growth appears to be slowing, and
there is a substantial danger that monetary and fiscal policies
will become restrictive simultaneously—a shift that in the past
has generally been followed by recession.
Expansive Fiscal Policy Options
In contrast to these restrictive measures, the Congress has
before it a proposal (H.R. 8333, the Kemp-Roth Tax Reduction Act)
fjor large tax cuts over a period of three years without comparable
deductions in spending. The first-year tax cut—about $6 billion
in fiscal year 1979 than that included in the first concurrent
ssolution—does not appear to be so large as to generate widespread excess demand, but the commitment to large future tax cuts
nvolves a substantial risk. Conventional economic analysis indiites that such a policy could be highly inflationary during the
/second and third years, because it would sharply increase the
budget deficit during a period when the econony might be reaching
full employment. Experience has shown that it is extremely difficult to wring inflation out of the econonjy once it gets started.
In contrast to the conventional analysis, some of the proponents of this policy optical contend that the deficit would not
rise. They argue that large tax cuts increase incentives to work,
save, and invest to such an extent that the cuts would pay for
themselves in the first or second year and, therefore, would not be
inflationary. CBO does not know of any empirical evidence for
the view that the supply-increasing effects of tax cuts are so

large and so quick. The available evidence indicates that the
stimulative effects of most tax cuts occur primarily through
increased aggregate demand and that these effects are not large
enough for the reductions to be self-financing.
Other Policies
The aggregate fiscal actions described above are not the only
tools available to the Congress for reducing inflation and sustaining economic growth. Some others are described briefly here:

o Payroll taxes could be reduced instead of income taxes.
The CBO analysis indicates that, while cuts in payroll
taxes and income taxes have about the same effects on real
output and employment per dollar of tax cut, the effect on
prices is more favorable with payroll taxes. A $10 billion
cut in payroll taxes will reduce the price level by about
0.3 percent after eight quarters, while an equal size cut
in personal income taxes will increase the price level by
about 0.1 percent, according to CBO estimates. Of course,
there are other important considerations that may rule out
reductions in social security taxes, such as the objective
of keeping the financing of the social security system
separate from the rest of the budget.
o Better coordination of macroeconomic policy could be
achieved. In addition to avoiding excessive shifts of
monetary and fiscal policies in the same direction, improved coordination might result in a more desirable mix of
policies. The long-run performance of the economy might be
improved by a tighter fiscal policy and an easier monetary
policy. The result might be smaller federal deficits
combined with lower interest rates—conditions that might
increase investment and ease future inflation by adding
to industrial capacity.
o The Congress might enact additional structural measures to
improve the tradeoff between inflation and unemployment.
Increased skill training as well as public jobs programs
could help reduce the high unemployment rate. At the same
time, a variety of measures could be used to reduce inflation, including the reform of government regulations, the
reduction of the minimum wage for young workers, and the
vigorous promotion of free international trade. Western

xva

industrial economies also have frequently employed incomes
policies to place direct restraint on inflation; in the
United States, tax-based incomes policies have been receiving increasing attention.
CONCLUSION
Past experience indicates that monetary and fiscal policies
have little capability for dealing with high inflation without
incurring substantial costs in terms of output and employment.
This limitation of macroeconomic policies suggests that, in the
present circumstances, it would be useful to investigate closely
other measures, such as policy composition and structural programs,
that could eventually improve the tradeoff between inflation and
unemployment. Such structural improvements, however, are not a
panacea for the current economic ills, and the near-term resolution
of the inflation-unemployment dilemma still will depend on whether
the Congress, the Administration, and the Federal Reserve give
greater emphasis to inflation or to sustaining economic growth.

XYll

31-331 O - 78 - 3

CHAPTER I.

INTRODUCTION

For most of the period since the 1975 recession, monetary and
fiscal policies have been moderately expansive. The excess
capacity in the economy allowed a gradual reduction in unemployment
without adding substantially to inflationary pressures. There is
little doubt that these expansive policies have contributed to the
reduction in unemployment from nearly 9 percent three years ago to
5.7 percent in June. For a time, during 1976, there appeared to be
some reduction in the rate of inflation as well. But this proved
to be temporary, and it is new evident that there has been little
improvement in the underlying rate of inflation since the trough of
the recession. Indeed, the inflation rate accelerated in the last
six months and, although this upsurge did not reflect widespread
shortages, many forecasters expect it to cause a lagged acceleration in wage gains which, in turn, will add to the existing
inflationary momentum.
THE CURRENT POLICY DILEMMA
At the same time that inflation has accelerated, the economic
expansion is showing signs of slowing. Despite the recent drop,
unemployment rates are still high by postwar standards, and most
forecasters project little improvement in the jobless rate in
the months ahead, while some foresee a deterioration. But if
these forecasts prove too pessimistic and the unemployment rate
continues to drop rapidly, the availability of unused productive
capacity that has held down the inflationary effect of expansive
policies so far in the upswing would be eliminated. Moreover,
there is uncertainty about the level of unemployment at which
inflationary pressures begin to mount. Thus, policymakers face a
most difficult dilemma. On the one hand, the standard fiscal and
monetary policy remedies for inflation may weaken economic growth
and, perhaps, trigger a new recession. On the other hand, expansive policies designed to sustain the expansion and reduce unemployment further could worsen inflation.

THE INFLATION-UNEMPLOYMENT TRADEOFF
The traditional view about the relation between inflation
and unemployment was that inflation would subside significantly in
a period of high unemployment and excess capacity. The experience
of the 1970s suggests, however, that high unemployment and excess
capacity have not been effective in reducing inflation.
As shown in Figure 1, the combination of inflation and unemployment has reached very high levels in recent years. Upward
price momentum has proven to be relatively insensitive to economic
slack. The persistence of inflation makes the prospective cost of
reducing it through macroeconomic policies high in terms of lost
production and unemployment; conversely, expansive policies to
reduce unemployment could generate even faster price increases.
Furthermore, as a result of the momentum of inflation once started,
the tradeoff is not symmetrical; unemployment responds much more
quickly to fiscal and monetary policies than do prices. Most
models estimate that unemployment rates would have to remain high
for many years to reduce inflation to the levels experienced in the
1960s. While the benefits of attaining such a reduction in inflation could be significant, they need to be balanced against the
loss of output and employment over a long period of tame.
THE REPORT
In addition to the inflation-unemployment dilemma, the choices
of policymakers are made more difficult by the uncertainty that
exists in the economic outlook. The second chapter of this report
reviews recent economic trends and presents the CBO forecast. The
third chapter examines the problem of inflation. The final chapter
presents several policy options that are available to the Congress
for dealing with the problems of unemployment and inflation.

Figure 1 .

Inflation and Unemployment
Percent
15

10
Percent change in Consumer Price Index,
December from December of previous year)

W
Unemployment Rate
10

15 I
1960

I I I I I I I
1968
1962 1964
1966

I I i I I
1970
1972
1974

Calendar Year

I I I I
1976 1978 a

SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.
NOTES: Inflation rates are plotted above the zero line and unemployment rates below. The increase in the total height of the bar indicates the worsening of the inflation-unemployment tradeoff.
a

1978 data are for first half of year. Inflation data partly estimated by CBO.

CHAPTER II.

THE ECONOMIC OUTLOOK

Based on the assumptions outlined below, CBO expects real
gross national product (GNP) to grow at a 3.5 to 4.5 percent rate
during 1978, slowing to a 2.7 to 4.2 percent rate during 1979. The
unemployment rate will be little changed at a rate between 5.2 and
6.0 percent at the end of 1979. Assuming there are no unanticipated
price shocks, the inflation rate is expected to be between 6.8 and
7.8 percent during 1978, subsiding somewhat to between 6.2 and 7.2
percent during 1979. (See Table 6 on page 27.)
For the purposes of this forecast, CBO made the following
policy assumptions:
o Fiscal policy is as given in the First Concurrent Resolution on the Budget for0 Fiscal Year 1979, with the $15
billion tax cut contained in that resolution.
o For monetary policy, it is assumed that short-term interest
rates will not rise much further and that credit conditions
will not become so restrictive as to abort the expansion.
The expected slowdown in real economic activity in 1979 is
largely the result of the recent acceleration of inflation and of
credit tightening by the Federal Reserve. Many economic forecasters now expect a sharper slowdown—or even a recession—during
the next year or two, arising from further tightening by the
Federal Reserve. The CBO forecast of a moderate rather than
a severe reduction of growth during 1979 depends critically on the
assumption that the monetary authorities will not allow short-term
interest rates to rise much further—certainly not to the point at
which there is a substantial movement of funds from thrift accounts, which finance housing, into higher-yielding short-term
market instruments.
The behavior of the Federal Reserve assumed in the CBO forecast is by no means certain to occur. The recent acceleration of
inflation and the growth of the narrowly defined money stock
(Ml)—currency and checking accounts—above the Federal Reserve's
announced targets places the monetary authorities in a difficult
position. The Federal Reserve does not want to validate inflation

by permitting growth in money aggregates above target ranges. 1/
But, because of the strong momentum of inflation, real economic
activity tends to respond more quickly than inflation to tight
credit conditions. Therefore, if monetary authorities increase
short-term interest rates much beyond current levels, CBO anticipates a sharp slowdown in activity, with rising unemployment—and
perhaps even a recession, depending on the severity of the credit
restraint. Inflation would slow, although this effect would be
relatively small and occur later, with little perceptible effect
during the forecast period.
Aside from a possible credit squeeze, there now appear to be
few other sources of major weakness in the economy. Fiscal policy
is moderately stimulative in the current fiscal year and will
remain so in fiscal year 1979 if the policies of the first concurrent resolution are not altered significantly. The state and local
government sector of the economy is likely to be more stimulative
over the next few years than it has been recently. Underlying
demands by consumers and business generally seem to be sufficient
to maintain growth at moderate rates, and there are few signs of
the excesses in inventories that frequently precede a drop in
production.
The first section of this chapter reviews recent developments in fiscal and monetary policies in more detail. The second
and third describe current trends in major components of nonfederal
demand, and inf output, employment, and prices. The final section
presents CBO s forecast, the policy assumptions on which the
forecast is based, and the major sources of uncertainty associated
with the forecast.

1/ Historical relationships suggest that the Federal Reserve would
be required to violate its Ml targets in order to achieve the
growth rates shown in the CBO forecast. However, a new Federal
Reserve rule that would permit commercial banks to transfer
funds automatically from savings accounts to checking accounts
beginning next November may alter these relationships, at least
temporarily. Unless the Congress or the courts overturn this
rule change, depositors are expected to reduce their checking
accounts and increase savings accounts, which would reduce the
growth rates of Ml but not of M2. The size of the effect is
uncertain and hence Ml growth rates will be difficult to
interpret during this transition period.

RECENT TRENDS IN FISCAL AND MONETARY POLICIES
Fiscal Policy
In the spring of 1977, with the unemployment rate hovering
around 7 percent, the Congress enacted several budget measures to
boost the economy. This stimulus, which mainly involved tax cuts
but also included sane spending measures, helped maintain economic
growth and reduce unemployment during the past year. Largely
because of these measures, the budget deficit is expected to
increase somewhat in the current fiscal year (1978) over fiscal
year 1977, as shown in Table 1.
TABLE 1. UNIFIED BUDGET ASSUMPTIONS: BY FISCAL YEARS, IN BILLIONS OF DOLLARS
1977
(actual)

1978
(CBO estimate)

1979 a/
(CBO estimate)

Outlays

402

451

495

Receipts

357

398

446

Deficit (-)

-45

-53

-49

a/ Based on First Concurrent Resolution for Fiscal Year 1979•
Beginning in 1979, earned income credit payments in excess of
an individuals tax liability are treated as outlays rather
than as income tax refunds in accordance with the convention
adopted by the Budget Committees in the first resolution.
Fiscal Year 1978. Total federal expenditures are projected to
grow about 10.3 percent (on a National Income Accounts [NIA] basis)
in fiscal year 1978, below the 11.6 percent annual average growth
rate of the previous five fiscal years (see Table 2 ) . But purchases of goods and services are expected to rise more rapidly this
fiscal year than the five-year trend increase. In addition, the
stimulus undertaken in the spring of 1977 added funds for grants

31-331 O - 78 - 4

to state and local governments, such as countercyclical revenue
sharing, public works, and public service employment. In contrast,
transfer payments to individuals in this fiscal year will grow more
slowly than the recent trend, as the decline in unemployment and
the expiration of some special unemployment insurance provisions
reduce outlays.
TABLE 2. FEDERAL EXPENDITURES GROWTH, NATIONAL INCOME ACCOUNTS
BASIS: BY FISCAL YEARS, PERCENT CHANGE
Average
Annual
Growth,
1972 to 1977 a/
(actual)

1978
(CBO
estimate)

1979
(CBO
estimate)

11.6

10.3

9.8

6.7

8.9

9.7

Domestic Transfer Payments to Individuals

16.2

7.7

9.5

Grants to State and
Local Governments

14.4

14.1

10.0

9.7

20.7

11.5

Total Expenditures
Purchases of
Goods and Services

Other b/

a/ Adjusted for transition quarter between fiscal years 1976 and
1977.
b/ Transfers to foreigners, net interest paid, subsidies less
current surpluses of government enterprises, and wage accruals
less disbursements*
Federal revenues are expected to be reduced by about $18
billion in fiscal year 1978 as a result of last yearfs tax cuts.
The standard deduction for the personal income tax was increased,
causing lower withholding after mid-1977 and extra refunds in early
1978. Revenue growth is also being held down by the extension

through 1978 of tax reductions that had been enacted previously—
the general personal income tax credit, the 10 percent earned
income credit for low-income families with dependents, and a
decrease in the corporate tax rate for corporate incomes within
certain ranges. Last year's stimulus package also included an
employment tax credit with limited subsidies to firms increasing
employment levels.
The reduction in federal personal income taxes has offset
much of the increase in effective tax rates caused by inflation and
real growth. At the same time, social insurance taxes—payroll
taxes for social security and unemployment insurance—have taken a
slightly higher share of income because of legislated increases in
both tax rates and tax bases.
Fiscal Year 1979* Federal spending in fiscal year 1979 will
increase at about the same rate as in fiscal year 1978, assuming no
change from the first concurrent resolution policies. This resolution includes a $15 billion cut in taxes, beginning in January
1979, that will more than offset the impact in 1979 of the scheduled increases in social security taxes and of the upward drift of
effective tax rates caused by the interaction of inflation and the
progressive income tax structure.
Fiscal policy is expected to be moderately stimulative in
both fiscal years. One measure of the effects of the budget
on the economy is the "full-employment budget"—that is, the budget
as it would be with full employment, which would increase federal
revenues and decrease outlays for programs such as unemployment
insurance. Using the full-employment budget, fiscal stimulus
increased in fiscal year 1978, largely because of the measures
mentioned earlier. In fiscal year 1979, the federal sector would
provide slightly more stimulus if the full tax cut and other
measures of the first resolution were enacted, including extension
of the temporary tax cuts made in 1977. The quarterly pattern
shown in Table 3 indicates a trailing off of stimulus in the second
half of fiscal year 1978, followed by a spurt in early fiscal year
1979, caused by a step up in expenditure growth in the last quarter
of 1978 and the tax cut that takes effect in the first quarter of
calendar year 1979. Thereafter, the budget position remains about
unchanged, with the full-employment deficit fluctuating narrowly
around $20 billion. Without the tax cut, the full-employment
budget would swing to near balance in the second half of the fiscal
year, a significantly less stimulative position.

TABLE 3. FULL-EMPLOYMENT BUDGET ESTIMATES, FISCAL YEARS (FY)
1972 TO 1979: IN BILLIONS OF DOLLARS, ANNUAL RATE

Full-Employment
Expenditures
FY
FY
FY
FY
FY
FY

1972
1973
1974
1975
1976
1977

Full-Employment
Revenues

Full-Employment
Deficit (-) or
Surplus (+)

223.8
243.3
276.6
315.9
349.2
387.0

230.1
255.6
277.5
322.6
360.6
401.5

-6.3
-12.3
-0.9
-6.7
-11.4
-14.5

Fiscal Year 1978
1977:4
1978:1
1978:2
1978:3
FY 78

439.8
446.6
451.5
463.5

409.7
427.8
441.5
450.9

-30.1
-18.8
-10.0
-12.6

450.4

432.5

-17.9

Fiscal Year 1979
(Assuming policy in the First Concurrent
Resolution for FY 1979) a/
1978:4
1979:1
1979:2
1979:3
FY 79

480.2
491.7
500.0
513.9

462.5
468.4
480.8
491.5

-17.7
-23.3
-19.2
-22.4

496.5

475.8

-20.7

a/ The CBO estimate of actual spending in fiscal year 1979 is
$499.2 billion (NIA basis), $4.5 billion less than the amount
in the first concurrent resolution• If a spending shortfall
greater than that forecast by CBO occurs, full-employment
expenditures will be below the levels shown in the table and
the stimulus provided by the federal sector will be reduced
from that shown.

Both the actual and full-employment federal deficits for
fiscal years 1977 and 1978 are seen by many as unusually large for
the second and third years of a cyclical recovery. Even so, these
deficits have not yet produced a high-employment economy such as
occurred in 1968 or 1973 > when full-employment deficits were also
sizable. What is the explanation for this difference?
o First, of course, the size of the economy and the price
level have grown, so that today's deficits are relatively
smaller.
o Second, a changed composition of federal expenditures means
that stimulus per dollar of deficit is less today than
in the 1960s and early 1970s. Many studies indicate that
changes in federal purchases have a larger impact on the
economy per dollar of expenditures than do changes in
transfer payments to individuals or grants to states and
local governments. As shown in Figure 2, federal purchases
have declined sharply as a proportion of total federal
spending since the late 1960s. The rapid growth of transfer payments in recent years partly reflects the automatic
response of such programs as unemployment insurance benefits and social security payments to increases in claims
and the rising cost of living. A number of new grant
programs, such as countercyclical revenue sharing, were
also enacted in recent years to offset the effect of the
recession.
o Finally, the international and state and local government
sectors of the economy were not a drag on the economy in
earlier years, as they have been recently. Large trade
deficits and large surpluses run by state and local governments haVe tended to offset the stimulative effects of
recent federal deficits. (The surpluses accruing to
foreigners and state and local governments also provide
funds to finance the increase in the federal debt.)
Monetary Policy
The growth in the narrowly defined money stock (Ml)—currency
and checking accounts—has been quite high during the last year
because rapid growth in current dollar income, boosted by inflation, pushed up the demand for money for transaction purposes.

Figure 2.

Federal Expenditures by Type, as a Percent
of Total Federal Expenditures
50

Domestic Transfer
Payments

Purchases of Goods
and Services

40
30

Interest, Subsidies,
and Miscellaneous

Grants to State and
Local Governments

•—

——L

10
i

'62 '63 '64 '65 '66 '67 '68 '69 70 71 72 '73 74 75 76 77 78 79
Calendar Years

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis for historical
data. CBO estimates for 1978 and 1979* those for fiscal year 1979 based on
First Concurrent Resolution for Fiscal Year 1979.

The growth in Ml over the last year has been about 8 percent,
well above the Federal Reserve's 4.0 to 6.5 percent target range.
However, the growth of M2 (Ml plus savings deposits) has been
within its target range of 6.5 to 9 percent, as high interest rates
reduced the flow of savings deposits. Although the Federal Reserve
has responded to this situation by periodically raising its interest rate targets on federal funds, it has not been successful in
bringing down the growth of Ml to the target range.
As a result of Federal Reserve policy and rising money demands, interest rates have been moving up steadily for about 18
months. For example, the six-month Treasury bill rate increased
from 4.8 percent to 7.4 percent since the beginning of 1977.
Longer-term interest rates have also risen significantly, as shown
in Figure 3.

Figure 3.

Interest Rates
Percent
14

Moody's AM
Corporate Bonds

1972

1973

1974

1975
Calendar Years

1976

1977

1978

SOURCE: Board of Governors, Federal Reserve System.

Despite the relatively moderate growth in M2, which is more
closely related to current dollar GNP than Ml, some interpret the
recent expansion of money (Ml) above the Federal Reserve target
range as an indication that monetary policy has been expansive.
Treasury bill rates have increased sharply, however, as the Federal
Reserve attempted to reduce the growth of Ml to its target range.
In the short run, such increases in short-term market rates can
reduce net new deposits in savings accounts and thus reduce the
availability of credit for housing. Thus, in terms of credit
conditions and the short-run impact on economic activity, recent
Federal Reserve actions represent a significant tightening.

TRENDS IN NONFEDERAL DEMAND
On balance, macroeconomic policy has supported substantial
growth over the past year. A significant impetus to the growth in
economic activity in 1977 and in the first half of 1978 came from
the stimulative fiscal measures described earlier in this chapter.
Moreover, because of the lags between changes in monetary policy
and their impact on economic activity, the tightening of credit
conditions that had occurred by mid-1978 has as yet had only
limited impact on economic growth.
Recent quarterly changes in real (constant dollar) final
sales—a measure of the strength of demand—are shown in Table 4.
Although final sales in the first quarter of this year were quite
weak, this is a misleading indicator of the strength of the economy
at the turn of the year. A particularly harsh winter and a prolonged coal strike distorted patterns of production, employment,
income, and spending. Available data indicate a sharp rebound of
sales in the second quarter.
TABLE 4. CHANGE IN FINAL SALES AND ITS MAJOR COMPONENTS: PERCENTAGE CHANGE, CONSTANT DOLLARS, SEASONALLY ADJUSTED ANNUAL
RATE, BY QUARTERS OF CALENDAR YEARS
1978

1977

III

3.8

5.1

4.4

6.1

-1.7

5.1

1.8

3.0

9.3

-0.9

14.7
5.4
19.0

16.8
42.6
7.0

2.5
-0.7
3.9

8.1
17.6
4.0

1.5
-3.9
4.1

Government Purchases -1.9
Federal
-0.3
-2.8
State and Local

10.6
18.2
6.3

6.1
8.9
4.4

4.3
3.4
4.9

-3.8
-9.1
-0.4

Total Final Sales
Personal Consumption Expenditures
Fixed Investment
Residential
Nonresidential

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

At mid-year, however, there are gathering signs that the
underlying strength of the expansion may be waning, particularly if
monetary policy becomes increasingly restrictive*
Personal Consumption
Since the beginning of 1977, personal consumption expenditures
have risen about as fast as total final sales. This recent behavior is in marked contrast to the first year and a half of the
recovery when consumer spending provided significant impetus to the
expansion of overall economic activity.
During the second quarter of this year, retail sales rebounded
sharply from the weather-depressed pace of the first quarter,
rising at an 18 percent annual rate in current dollars—a substantial gain even after allowing for large price increases. Besides
making up for purchases that were postponed earlier in the year,
the recent burst in consumer spending was also the result of
at least two other factors. First, employment has been increasing
at an exceptionally rapid pace. Total employment, as measured by
the monthly household survey, rose by nearly 2 million between
January and June, and the consequent addition to consumers1 incomes
contributed to their recent buying surge. Second, inflation
accelerated sharply from its rate during the second half of 1977,
apparently convincing a number of consumers to buy early. Surveys
of consumer attitudes show that a rising proportion of respondents
believe that now is a good time to buy because prices are expected
to go higher in the future.
A buy-in-advance psychology, of course, affects primarily the
purchases of durable goods, and recent data on auto sales suggests
that consumers are acting on their opinions about prices. These
sales were at annual rates of 11.9 million cars in June and
11.4 million cars in the first six months of this year, just about
the same as in the corresponding period last year when purchases
were rebounding after the Ford strike. If this current strength in
consumer spending is indeed based on buy-in-advance sentiment, it
is likely to be temporary.
In addition to the lull after buy-in-advance purchases, a
number of other factors are likely to retard the growth of consumer
spending later this year and in 1979. The recent rapid rate of
employment growth is not expected to continue. Furthermore,
consumer debt considerations suggest that the saving rate may
15

31-331 O - 78 - 5

rise, thereby slowing the growth of consumer spending. The ratio
of consumer debt (excluding home mortgages) to personal income has
been rising and is now above its 1974 high. Other measures of
the debt burden remain below previous peaks but have been increasing; further indication of the rising debt burden can be found in a
recent rise in installment loan delinquency rates. Finally, if
higher interest rates reduce the turnover of existing houses as
well as the construction of new ones, this may reduce the capital
gains that homeowners have been able to realize—and spend—when
selling houses, providing another reason for a rising saving rate
and less impetus from consumption.
The scheduled social security tax rise and continued fiscal
drag associated with personal income taxes (that is, rising tax
rates resulting from a progressive tax structure in a period of
rapid current dollar income growth) would normally also retard the
growth in disposable income and dampen consumer spending. These
effects, however, are offset by the personal income tax cuts
specified in the first concurrent resolution.
Housing
For 1977 as a whole, spending on residential construction was
a significant source of strength for total final demand. Housing
starts were nearly 2 million units last year—well above the 1.5
million recorded in 1976. Although starts were depressed by severe
winter storms in the first two months of this year, they have
rebounded sharply in subsequent months; the 2.1 million unit annual
rate in May was one-fifth greater than the first-quarter average.
As a result, spending for housing provided significant impetus to
the strength of final demand in the second quarter.
After midyear, however, the prospects for the housing sector
become less bright; the probable slowdown will result largely from
the recent rapid increase in interest rates described earlier in
this chapter. In part, rising mortgage rates, along with rising
land and other housing costs, may price some households out of the
market. But more important, sharply higher short-term interest
rates will limit the funds available for financing house purchases.
In the past, when short-term rates (top panel, Figure 4) have risen
significantly above rates paid on savings accounts, net new flows
of funds to savings and loan associations and mutual savings banks,
the main sources of housing finance, have dwindled (middle panel,
Figure 4 ) . In turn, housing starts tend to decline when savings
flows fall, as the bottom panel of Figure 4 shows.

Figure 4.

Interest Rates, Savings Flow, and Housing Starts
Percent

Market Yield on U.S.
Government Three-Month Bills

(A
V

SOURCE: U.S. Department
of the Treasury •

\
Billions of Dollars, Annual Rate

Net Savings Inflow,
All Savings and Loan
Associations (Quarterly)
Latest point shown is average for
April-May 1978.

N
N
/

50
40
30

[

20
SOURCE: Federal Home Loan
Bank Board;seasonally
adjusted by CBO.

v / \

Millions of Units, Annual Rate

2.6

Housing Starts

2.4
12

\J \

2.0

1.6
1.4
SOURCE: U.S. Bureau of the
Census.

I \\

\
\\K
\\

1.8

1.2
1.0
1972

1973

1974

1975

1976

Calendar Years

1977

1978

If past relationships hold, residential construction activity
-is likely to slow markedly by the end of 1978. Signs of creditmarket tightening are already apparent. In the first five months
of 1978, net inflows at savings and loan associations were 29
percent below a year earlier. While these institutions have been
able to reduce their liquidity and borrow from other sources,
mortgage lending has already declined significantly; by May,
comnitments outstanding for future mortgage lending had fallen
for five consecutive months on a seasonally adjusted basis.
Starting June 1, savings associations have been allowed to
offer new saving certificates that bear interest rates competitive
with Treasury bills. First indications are that over half of the
funds for these new instruments came from other savings at the same
institutions. Thus, they may serve to prevent further declines in
inflows but not necessarily provide the upturn in savings flows
necessary to finance a relatively high level of housing starts.
Business Fixed Investment
Although business fixed investment rose faster than total
final sales in the last year and a half, spending on new plant and
equipment continues to fall considerably short of its typical
postwar performance during economic expansions. This moderate
performance will probably persist throughout the remainder of
1978. According to the latest Commerce Department survey, business
intends to increase current dollar spending for fixed investment by
11.2 percent in 1978, up only slightly from the previous survey,
suggesting some slowdown in the real growth from 1977. Contracts
and orders for plant and equipment (see Figure 5) indicate nearterm strength in this spending category but do not guarantee that
it will continue, since this series does not presage long leads on
investment spending.
Continued economic expansion depends importantly on substantial growth in spending for fixed capital expansion; furthermore, a
rising capital stock contributes to the advance in labor productivity and higher living standards. Consequently, the relative
weakness in this sector in the recent recovery is a matter of

Figure 5.

Investment Orders and Spending
Indexes of Constant Dollar Values, 1972 = 100
130

Contracts and Orders for
Plant and Equipment

120

]

Nonresidential Fixed
Investment Spending

1973

1974

1975

_L
1972

1976

1977

1978

Calendar Years

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
NOTE: The index of contracts and orders is a two-quarter moving average placed at
the second quarter. The preliminary figure for the second quarter of 1978
is an average of first quarter 1978 and the April-May average.

special concern. Economists offer several related reasons for the
relatively poor performance of business fixed investment, including
the following:
o

Capacity utilization in manufacturing has increased very
little over the past year, and remains below the rate that
is expected to induce capital expansion.
Furthermore,
there is substantial excess capacity in Europe and Japan,
where the recoveries from the mid-1970s recession have been
relatively weak.

o The rate of return on capital is low, partly because
federal tax law requires depreciation to be charged at
historical cost, which overstates taxable profits during
inflation.
Since the prospective rate of return is
obviously an important factor in deciding to undertake a
capital project, the existing low returns depress investment activity.
o Business firms find it difficult to plan for the future in
an atmosphere of rapidly rising prices and uncertainty as
to the future course of government regulation, energy
prices, and macroeconomic policy.
o Reflecting the previously mentioned factors, the stock
market has been quite depressed. At the same time, the
prices of new construction and equipment have risen rapidly. Together these factors make it more profitable
to buy existing facilities than to invest in new plant and
equipment, thus decreasing spending on fixed capital.
It is not clear why there has been such a shortfall in business fixed investment over the last few years; the answer is
probably some combination of the factors listed above, and perhaps
others as well. As a result of the uncertainty about the cause of
the relative weakness in this sector, it is difficult to assess its
prospects for 1979. It is possible that the second-quarter
strength in output will lead to higher capacity utilization and
higher profits, which could cause businesses to revise their
investment plans upward. On the other hand, tight credit and
higher interest rates would reduce investment spending, though not
so quickly and dramatically as they reduce housing activity.
International Trade
In recent quarters, constant dollar exports have changed
little while imports have risen. The increase in imports was
particularly sharp in early 1978, as cold weather and the coal
strike raised oil demand, and steel imports were accelerated to
make purchases before the new reference price system, which raises
the prices of imported steel, became effective. The current dollar
trade and services balance deteriorated even more sharply, as the
depreciating dollar was reflected in accelerating import prices.

The lagged effects of the earlier depreciation of the dollar
may begin to be felt in expanded real volume of exports and a
slowing volume of imports. With the reference price system in
effect, a reduction in steel imports can also be expected. Ultimately, however, the future course of net exports will depend
heavily on the recoveries of economies abroad and on whether the
United States enacts a program to reduce oil imports (and the
design of such a program).
State and Local Governments
State and local government spending, aided by federal grants
for public service employment and public works, expanded strongly
in real terms in the final three quarters of 1977, but levelled off
in the first quarter of 1978 as unusually bad weather inhibited
construction activity. A strong spending rebound probably occurred
in the second quarter. Federal grants are expected to peak at the
end of calendar year 1978 and provide little stimulus thereafter.
State and local government receipts have continued to outpace
spending, however, and the combined operating surpluses ("other
funds") of these governments have risen sharply since 1976 (see
Table 5 ) , with the net result that this sector too has retarded
growth in the economy. For some time, observers of state and local
fiscal patterns have speculated that the trend of rising operating
surpluses would be reversed. The passage of Proposition 13 in
California's June election suggest that the reduction of these
surpluses may be about to begin and that it may take the form of
reduced taxes rather than increased spending. The impact of
Proposition 13 on national economic activity, however, is likely to
be very small, unless it is the first of a series of similar
measures enacted in numerous states. 2/

2/ The most significant impact of Proposition 13 is on prices.
The national rate of inflation is estimated to be 0.2 percentage points less in 1978 and in 1979 as a result of Proposition
13• For further details, see CBO, Proposition 13: Its Impact
on the Nation's Economy, Federal Revenues, and Federal Expenditures, Background Paper (July 1978).

TABLE 5. STATE AND LOCAL GOVERNMENT RECEIPTS AND SPENDING: BY CALENDAR YEARS, IN BILLIONS OF
CURRENT DOLLARS

III

11.2

281.0

288.1

301.6

307.1

313.8

227.0
67.5

11.4
10.7

219.0
62.0

224.5
63.6

228.9
72.7

235.4
71.7

239.1
74.7

246.2

265.2

7.7

253.7

262.6

268.7

276.0

279.6

Surplus or Deficit, Total

18.4

29.2

58.7

27.3

25.4

32.9

31.1

34.1

Social insurance funds
Other funds

14.5
3.9

15.5
13.7

6.9
251.3

15.4

15.5
10.0

15.5
17.4

15.7
15.4

16.0
18.1

Taxes and social
insurance contributions
Federal grants-in-aid
Expenditures

1977

264.7

294.4

203.7
61.0

1978

1977

Receipts, Total

1976

Percent
Change,
1977
from
1976

11.9

SOURCE: U.S. Department of Conmerce, Bureau of Economic Analysis.

Inventories
Business inventories were kept in fairly close alignment with
sales during 1977 and early 1978, and in real terms the inventory/
sales ratio changed little and remained relatively low. Evidently
anticipating a strong second quarter, businesses maintained production levels and increased employment during the first-quarter
slowdown in sales, rebuilding stocks after a fourth quarter in
which sales gains outstripped additions to inventories. Low ratios
of inventories to sales and to unfilled orders early in the second
quarter were expected to encourage further stockbuilding during the
quarter.
As sales gains slow in succeeding months, the rate of inventory investment will probably subside, if businesses continue to
bring inventories in line with sales as quickly as they have in the
past two years. Hence, inventory stimulus to output should end
around midyear. Recent business caution with respect to inventory
stockbuilding has apparently prevented the widespread imbalances
that have previously contributed to sharp adjustments in production
and employment when total demand weakened. The available evidence
continues to show little indication of a speculative inventory boom
like the one that accentuated the 1973 expansion and the 1974-1975
recession.
TRENDS IN EMPLOYMENT, PRODUCTIVITY, AND PRICES
Employment
Recent output increases have been accompanied by relatively
large employment gains. From the second quarter of 1977 to the
second quarter of 1978, the gain in real gross national product was
about 4.4 percent. Over the same period, employment also rose
4.4 percent, as measured by both the household and establishment
surveys. It is unusual for employment to rise as fast as output.
Part of the explanation was a slight decline in the average workweek, possibly associated with a rise in part-time employment.
Also, there was an expansion in the number of public service jobs,
each of which provides fewer GNP dollars than the average private
job.

31-331 O - 78 - 6

Labor force growth over the past year also continued at a
relatively high rate of 3.1 percent. But as a result of the faster
employment growth, 3/ the unemployment rate declined more than
a full percentage point, from 7.1 percent in the second quarter of
1977 to 5.9 percent in the second quarter of 1978, with the June
rate unexpectedly low at 5.7 percent.
The decline in unemployment was not the same for all groups
in the labor force. From the second quarter of 1977 to the second
quarter of 1978, the white unemployment rate dropped from 6.3 to
5.1 percent, while the rate for nonwhites only fell from 12.8 to
12.0 percent, and the nonwhite/white differential rose to an
unusually high ratio of 2.4:1. For nonwhite teenagers, the unemployment rate of 36.9 percent was little changed over the year,
and, for women who head families, the rate actually rose, from 9.3
percent to 9.4 percent.
While these unemployment rates are evidence of continued
problems for some labor market groups, they should not be interpreted as evidence that disadvantaged groups have failed to share
in employment gains. In fact, employment gains for nonwhites
over the year were 7.3 percent, nearly double the 4.0 percent rate
of gain for whites. The reason the black unemployment rate fell so
little was not a lower rate of job gain but a higher rate of labor
force growth. This reflected both faster population growth and the
return of previously discouraged workers to an active search for
jobs.
Productivity
The growth in output per hour worked (productivity) is the
principal source of rising living standards, and recent performance
here has been disappointing. As noted above, employment growth
over the past year has been nearly as rapid as the gain in output.
The increase in labor productivity for the private nonfarm business
sector was only 1 percent during the year ending in the first
quarter of 1978, well below the 2.8 percent rise recorded during
the previous four quarters. Preliminary indications are that

3/ Labor force measures both those who are employed and those who
are actively looking for jobs.

productivity growth rebounded little in the second quarter, so that
the first half of 1978 may have been characterized by further
deterioration in a rate of productivity growth that was already
weak by postwar standards.
A widely advanced explanation of the 1978 productivity deterioration is that firms have been hiring in anticipation of
future output gains. If this is the case, it can be anticipated
that from now on employment gains will slow and productivity
increase. If, instead, the current low rate of productivity growth
continues, higher rates of increase in unit labor cost will
result, lowering profits and raising prices.
Prices
Consumer prices in the first five months of 1978 increased at
about twice the rate recorded during the previous 6 months. This
acceleration is examined in more detail in Chapter III; in brief,
it can be attributed to higher food prices, government-mandated
cost increases, and the depreciation of the dollar against the
currencies of other major countries. Although the full effect of
these factors on prices has not yet occurred, much of it has.
Consequently, the rate of consumer price inflation is expected to
decelerate in the second half of the year.
But inflation may well pick up speed again next year. Another
round of minimum wage and payroll tax increases is scheduled.
Energy prices may rise more rapidly than this year, especially if
OPEC increases crude oil prices and if domestic action raising
energy prices is taken. Perhaps most important, 1979 is a relatively big collective bargaining year, and the negotiating unions
will be seeking to restore traditional real income growth eroded by
the recent rapid rates of inflation. An analysis of the trend in
real income lost over the past three years by workers in the auto,
rubber, electrical machinery, and trucking industries, despite
cost-of-living escalator clauses, indicates that increases in
life-of-contract (three-year) wage settlements could run 30 percent
or more in 1979. Such wage adjustments would'clearly be well above
probable productivity gains as well as above recent average rates
of wage increase, and hence they would contribute to the continued
momentum of inflation.

PROJECTIONS FOR 1978 AND 1979
Monetary and Fiscal Policy Assumptions
The CBO forecast of the economy through 1979 is based on the
following assumptions:
o Federal outlays on a unified budget basis of $451 billion
in fiscal year 1978 and $495 billion in fiscal year 1979.
These figures represent shortfalls of about $7 billion and
$4 billion, respectively, from the most recent budget
resolutions.
o A tax cut of approximately $15 billion in fiscal year 1979
($20 billion annual rate) beginning next January. Personal
tax cuts comprise roughly two-thirds of this amount with
the balance consisting of reduced corporate taxes and a
retroactive increase in the investment tax credit. The
1977 tax cuts are extended; all other tax legislation is
assumed to be unchanged.
o Little further rise in short-term interest rates.
As emphasized earlier, this course of monetary policy is only an
assumption. The dilemma of the Federal Reserve, with accelerating
inflation on one hand and the prospect of recession on the other,
makes the outlook for monetary policy particularly uncertain. The
probable response of the economy to an alternative, more restrictive, course of action by the Federal Reserve is given at the
end of this chapter.
The Projection
Given the assumptions outlined above, the economy is expected
to show moderate growth through 1978, with real gross national
product in the final quarter of this year 3.5 to 4.5 percent
above the fourth quarter of 1977* The projection is shown in Table
6. During 1979, the advance in real GNP is expected to slow,
averaging between 2.7 and 4.2 percent. As a result, the unemployment rate is expected to be between 5.2 and 6.0 percent by the end
of next year, a range that includes the June 1978 rate of 5.7
percent. Even if price increases moderate in the second half of
1978, the rate of consumer price increase for the year as a whole
is expected to be between 6.8 and 7.8 percent, compared with

TABLE 6.

ECONOMIC PROJECTIONS BASED ON CURRENT POLICY, CALENDAR YEARS 1978 AND 1979
Rates of Change (Percent)

Levels
Economic Variable

1977:4
(actual)

1978:4

1979:4

1976:4
to 1977:4
(actual)

1977:4
to 1978:4

1978:4
to 1979:4

GNP (billions of
current dollars)

1962 a/ 2160 to 2202 a/ 2354 to 2457 a/ 11.8

10.1 to 12.2

9.0 to 11.6

Real GNP (billions of
1972 dollars)

1360 a/ 1408 to 1421 a/ 1446 to 1481 a/ 5.7

3.5 to 4.5

2.7 to 4.2

General Price Index
(GNP Deflator,
1972=100)

144 a/ 153 to 155 a/

163 to 166 a/

5.8

6.4 to 7.4

6.1 to 7.1

Consumer Price Index
(1967=100)

185

198 to 200

210 to 214

6.6

6.8 to 7.8

6.2 to 7.2

Unemployment Rate
(percent)

6.6

5.5 to 6.1

5.2 to 6.0

a/ Estimates do not reflect July 1978 revisions in GNP levels.

the 6.6 percent rate of increase from the fourth quarter of 1976 to
the fourth quarter of 1977 Consumer price inflation is expected to
moderate a little during 1979, rising 6.2 to 7.2 percent, as the
effects of the recent food price run-up and dollar depreciation
wane. V
From a policy perspective, this projection raises two interrelated questions:
o Why is the expansion of economic activity expected to slow
down?
o Why will this slowdown not turn into a recession during the
forecast period?
Each question will be considered in turn.
Factors Contributing to a Slowdown. Even with luck, it will
be difficult to maintain the pace of output expansion recorded
in 1977. Most notably, the credit market tightening that had
occurred by mid-year and the consequent slowing of deposit growth
in thrift accounts is likely to reduce outlays for residential
construction later this year and during 1979, whereas such spending
provided significant impetus to real output growth last year.
Business fixed investment typically provides an increasing
share of the stimulus to economic activity as an expansion proceeds. According to the Commerce Department survey of business
anticipations, however, real outlays for plant and equipment are
likely to increase less rapidly in 1978 than last year, providing
another reason for the slowdown. Moreover, a deceleration in the
pace of economic activity later this year means little additional
increase in capacity utilization rates, thus making it less likely
that businesses will step up their rate of capital expansion next
year.

The critical assumptions upon which the price projection is
based are as follows: wholesale fuel prices rise 4.6 percent
during 1978 and 7.2 percent during 1979; wholesale food
prices rise 10.3 percent during 1978 and 6.4 percent during
1979; and little further depreciation of the dollar occurs.

Finally, consumer spending can be expected to provide little
impetus to an acceleration in the growth of total demand. As
described earlier in the chapter, a variety of factors will probably combine to slow the increase in constant dollar consumption
spending both this year and next. Employment and income will
probably increase less rapidly than they have to date in the
expansion. Consumer installment debt has risen sharply relative to
income. To the extent that the consumer attitude surveys are
correct and the recent surge in retail sales has resulted in
part from an inflation-induced, buy-in-advance psychology, the
recent strength is being borrowed from later this year or from
1979. Finally, the reduced rate of housing turnover that is
expected to result from tightening mortgage market conditions will
reduce opportunities to liquidate equity in real estate, a practice
that has helped sustain the advanced pace of consumer spending
throughout the expansion.
Reasons for No Recession. A recession—frequently defined as
two consecutive quarters of declining real GNP—can result from an
unforeseen economic shock, such as an oil embargo. In the absence
of such shocks and with the policy assumptions outlined above, a
recession does not seem likely during the forecast period. The
rationale for this assessment derives from a number of factors:
o The tax cut included in the first concurrent resolution
more than offsets the effects of rising payroll taxes and
rising effective income tax rates and should help sustain
consumer spending.
o The tax cut should also stimulate additional business fixed
investment; moreover, there are reports that businesses are
under growing pressure to replace aging capital equipment.
o The new regulation permitting banks and nonbank thrift
institutions to pay market interest rates on deposits of
$10,000 or more may limit somewhat the effect of rising
short-term interest rates on the availability of mortgage
funds.
o The recent depreciation of the dollar eventually may
improve the performance of net exports.
o Finally, there is little evidence of the imbalances between
production and final demands that tend to characterize
periods preceding recessions. As noted above, businesses
have apparently held their inventories closely aligned with
sales.

Outlook with Tight Monetary Policy
As emphasized throughout this report, the CBO projection
assumes little further tightening of credit market conditions. No
one knows precisely how much higher short-term rates can go before
the economy is greatly weakened. Historical experience suggests
not much further. In order to illustrate the critical importance of
the monetary assumption in the projection, this section briefly
outlines the probable consequences of a policy in which the Federal
Reserve sharply raises short-term interest rates further. The
three-month Treasury bill rate was assumed to rise to the neighborhood of its previous quarterly peak value of 8.5 percent in either
late 1978 or early 1979, and then fall gradually over the remainder
of the forecast period as the economy weakened. The results are
shown in Table 7. 5/
Real growth would weaken in 1978 and output would probably
decline during 1979, resulting in the seventh recession of the
postwar period, with unemployment likely to rise above 7 percent.
Although inflation would be unaffected in 1978, it would be reduced
by about half a percentage point in 1979, with further reductions
in later years as well.
To achieve this reduction in inflation, the tight money policy
would reduce employment by over 2 million jobs by the end of 1979.
This projected recession, like its predecessors, would reduce
business profits and investment in plant and equipment and postpone
still further advances in labor productivity and improvements in
employment opportunities for the most disadvantaged.
The next
chapter will analyze the sources of the inflation problem in the
U.S. economy and discuss in further detail the implications of
reducing inflation by reductions in aggregate demand.

5/ Although there is considerable uncertainty concerning the
relationship between money growth and interest rates, the above
illustration assumes growth in M2 at or below the mid-point of
the Federal Reserve target range. Because of the institutional
changes described earlier, the associated growth of Ml cannot
be estimated.

TABLE 7. ECONOMIC PROJECTIONS BASED ON TIGHTER MONEY: RATES
OF CHANGE IN PERCENTS

Economic Variable

1977:4
to 1978:4

1978:4
to 1979:4

GNP (billions of
current dollars)

9.4 to 11.5

4.3 to 6.9

Real GNP (billions of
1972 dollars)

2.8 to 3.8

-1.2 to 0.3

General Price Index
(GNP Deflator,
1972=100)

6.4 to 7.4

5.6 to 6.6

Consumer Price Index
(1967=100)

6.8 to 7.8

5.7 to 6.7

Level, End of Period
Unemployment Rate
(percent)

5.8 to 6.4

6.9 to 7.7

CHAPTER III.

INFLATION:

ITS PERSISTENCE AND RECENT ACCELERATION

THE RECORD
At the heart of the current economic policy dilemma is
the high rate of inflation. While the public debate on this
issue has intensified recently, the fundamental problem and the
difficult choices it presents are not new. The price performance
of the U.S. economy has deteriorated badly over the past decade.
The average annual rate of consumer price increase since 1968 has
been 6.4 percent, more than three times as rapid as during the
previous 20 years.
Many economists agree on the factors that initiated this
period of rapid inflation. In the main, they point to continued
government deficits and accelerated money growth during periods of
widespread resource shortages—especially during the late 1960s—as
well as sharply changing conditions in important individual markets, such as food and energy in the 1970s. There is less agreement, however, on why inflation seems to have become even more
intractable recently. Over the three years since the trough of the
1974-75 recession—a period notably without resource shortages—
consumer prices have increased at an annual rate of more than 6
percent.
Furthermore, the concern over inflation has been exacerbated
recently by a sharp acceleration in the rate of price increase.
The Consumer Price Index (CPI) rose at an annual rate of 10 percent
during the first five months of 1978, well above the 6-3/4 percent
rise in the year ending December 1977. This chapter will attempt
to answer two questions:
1.

What caused the recent acceleration of inflation?

What caused the persistence of high rates of inflation
even during periods of economic slack?

THE PERSISTENCE OF INFLATION IN A PERIOD OF ECONOMIC SLACK
Inflation has shown little tendency to decelerate during the
past three years. Figure 6 presents the six-month rate of change

of a "stripped11 CPI—one that eliminates some of the components,
such as food and energy, that are more responsive to conditions of
supply than to demand. According to this measure, prices have
continued to rise at a 6 to 6,5 percent annual rate over the past
three years. With the exception of the 1973-1974 period, this is
the most rapid pace of inflation in 25 years, and it occurred
despite prolonged periods of exceptionally high unemployment and
low capacity utilization. This combination of economic conditions has been called "stagflation."
Figure 6.

Rate of Change in Stripped Consumer Price Index:8
Percent Change from 6 Months Earlier, Annual Rate
Percent

12.5
10.0 -

1974

1975

1976

1977

1978

Calendar Years

SOURCE:

U.S. Department of Labor Bureau of Labor Statistics; calculated and
seasonally adjusted by CBO.
a
Excluding food, energy, used cars, and mortgage interest.

In general, there are three explanations for such persistence
of inflation:
o

First, the on-going price advance results principally from
various interest groups using their economic and political
power to maintain their traditional rates of real income
growth.

Second, it results largely from inappropriate fiscal
and monetary policies.

Third, the continued momentum of inflation during periods
of high unemployment is rooted in self-fulfilling expectations—held by workers, business and consumers—about
future high rates of price increase.

Attempts To Maintain Real Income Growth
When prices are rising rapidly, take-home pay buys less, but
households find it difficult to lower their living standards. They
have assumed obligations and hold expectations about the future;
usually both are based on the anticipation of continued real income
advance. It has become especially difficult for Americans to
maintain their customary income growth since the share of total
national income going to oil-producing countries increased.
In this environment of rapid inflation, households can attempt
to maintain their traditional standards of living in a variety of
ways:
o

Reducing household assets (although the assets of many
households are neither sizable nor liquid);

Increasing household borrowing (reflected recently in
the movement of the ratio of consumer debt to personal
income to a relatively high level); and

Increasing household labor-force participation (reflected
in the continued rapid influx of married women into the
labor force).

Similarly, many groups in the economy try to maintain customary
real income growth in a number of ways, including:
o

Efforts to reduce taxes (today manifested in a growing
taxpayers1 revolt, marked most recently by the passage of
sharp reductions in property taxes in California); and

Linking income to the movement in consumer prices, perhaps
with a customary annual improvement of real income factored in. Such linking, either implicit or explicit, is
called indexing.

This section examines the role that the explicit or implicit
indexing of wages and other incomes to the CPI has played in the
persistence of inflation during the recent period of economic
slack.
If labor markets are tight, then competitive pressure by
firms to fill job vacancies will bid up worker compensation; in

such circumstances, wages and prices increase together* If labor
markets are slack, however, firms are under no competitive pressure
to raise wages. Yet, even during periods of widespread unemployment, the wages paid to a large number of workers can continue
to rise rapidly because they are linked closely to past price
behavior.
Such linking can occur through either contractual or less
formal processes. Informal indexing has been the consequence of a
variety of factors, including the threat of union organization and
the general attempt by firms to maintain the morale and productivity of their workers. Under such circumstances, wage policy
has been affected by considerations of workers1 perceptions of
equity—a concept heavily influenced by the rate of real wage gains
that employees have come to expect as a result of past experience.
In addition, professional organizations have used their market
and political power to help maintain traditional growth in members1
real income. For example, as can be seen in Figure 7, except for
the period of mandated medical cost controls in the early 1970s,
the movement in physicians1 fees corresponds quite closely to the
previous year's change in consumer prices.

Figure 7.

Rate of Change in Physician's Fees and Lagged Rate of Change
in Consumer Price Index
Percent

14
12
Rate of Change
in Physicians' Feesk

8
/
6

/
/

Rate of Change in
Consumer Price Index
in Previous Year

\
>

1969

1970

1971

1972

1973

1974

Calendar Years

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

1975

1976

1977

Another important vehicle of largely implicit indexing has
been the wide variety of government actions taken to alleviate the
impact of inflation on living standards. These actions have
attempted either to increase incomes directly or to reduce competition in order to provide more room for groups to increase incomes
on their own, including:
o

Increased minimum wage;

Increased social security benefits (through a cpst-of
living escalator), which helped lead to higher payroll
taxes;

Increased farm price supports;

The steel price referencing plan; and

Various orderly marketing agreements limiting imports for
products such as television sets. 1/

The effects of some of these programs are difficult to quantify, but certainly the pressure on prices is upward. Overall, most
analysts agree that government cost-raising actions have played an
important role in sustaining the inflationary momentum of the
past three years.

Other government cost-raising activities contributed to the
persistence of measured inflation over the past three years
but were motivated by the desire to correct sane perceived
external diseconomy; efforts here include environmental
standards and worker health and safety regulations. It has
been estimated that these regulations have been adding threequarters of a percentage point to the annual rate of inflation. See Thomas D. Hopkins, flCurrent Inflationary Conditions
and Regulatory Measures of the Council on Wage and Price
Stability,11 Papers and Proceedings of a Symposium on Inflation
(University of Tennessee, March 1978).

Contractual indexing of wages to consumer prices is usually
accomplished by cost-of-living (COL) escalators included in unionmanagement agreements. About 60 percent of all workers covered by
major collective bargaining contracts receive periodic wage adjustments based on the increase in consumer prices. Such escalator
clauses, along with annual improvement increases and first-year
catch-up wage adjustments, are designed to maintain traditional
real wage growth for union members. Furthermore, for many unions,
the desire and ability to maintain customary real growth appears
relatively insensitive to fluctuations in total demand. 2/
The importance of wage catch-up to past inflation was demonstrated clearly in the 1976 bargaining round, the results of which
are summarized in Table 8. There was great heterogeneity in
cost-of-living protection by major unions going into the negotiations in that year. The Rubber Workers had no COL escalator in
their existing contract, while the Teamsters and Electrical Workers
had capped escalators. 3/ The Auto Workers, on the other hand, had
the benefit of an uncapped COL escalator during the previous three
years. The pattern of the first-year settlements reflected the
differing needs of each union to restore real wages eroded by the
rapid 1973-1976 inflation. Since the total wage and benefit
adjustments scheduled in each contract were well above productivity
gains, these settlements placed significant upward pressure on
prices; each has contributed and will continue to contribute to
the momentum of inflation. Furthermore, these large settlements
were made despite weak labor demand in the industries; indeed,
demand for labor was the strongest in the auto industry, which had
the smallest first-year wage adjustment, and weakest in the tire
industry, which had the largest catch-up increase.

The relative insensitivity of current dollar wage change in
high-wage industries to variations in labor-market slack has
been demonstrated generally by George Perry, "Slowing the
Wage-Price Spiral: The Macroeconomic View" (The Brookings
Institution, April 1978).

Capped cost-of-living escalators set a maximum limit on the
annual rate of wage increases; for both the Teamsters and the
Electrical Workers, these contractual limitations in combination with the rapid inflation caused real wages in the mid1970s to lag behind their long-term trend growth.

TABLE 8:

ESTIMATED WAGE ADJUSTMENTS DURING THE 1976 BARGAINING YEAR
Previous Costof-Living Adjustment (COLA) Protection

First Year
Increase
(percent)

Total Increase
Over 3-year Life Employment
of Contract a/ Shortfall b/
(percent)
(percent)

Trucking

Capped COLA

9.1

31.9

-10.7

Electrical
Equipment

Capped COLA

13.1

32.7

-13.7

Tires

No COLA

17.1

39.5

-18.3

Automobiles

Uncapped COLA

6.1

27.2

-0.4

Assuming steady 6 percent inflation.

The percent difference between production worker employment at the time
of the contract reopening and the prerecession employment peak in 1974;
the Standard Industrial Classification (SIC) code used to obtain the
employment data was chosen to correspond as closely as possible to the
actual bargaining unit involved in the negotiations.

As the 1976 example illustrates, formal and informal mechanisms of income catch-up to past price increases have contributed
significantly to the momentum of inflation during the recent period
of economic slack. High inflation in one period has led to compensating income adjustments in later periods for a substantial share
of the population; these income increases—to the extent they are
business costs—are subsequently reflected in further price increases, and the spiral continues.
Fiscal and Monetary Policies
It has been argued that smaller budget deficits and slower
money growth would have retarded the rise in prices over the past
three years. While this statement is true, the cost of such
measures must also be considered, and previous experience indicates that this cost in terms of lost production and employment
would have been high.
According to conventional economic analysis, restrictive
fiscal and monetary policies slow inflation largely by increasing
slack in the economy. The less responsive wages and prices are to
unemployment and idle plant and equipment, the greater are the lost
production and employment needed to reduce inflation. The available data since 1975 show that the recent price advance was relatively insensitive to widespread economic slack (see Table 9 ) . The
rate of increase of consumer prices—stripped of some of its
components that are more responsive to supply conditions than
demand—decelerated only slowly despite substantial excess productive capacity, and labor compensation growth remained quite high.
Once inflation gets started, it tends to persist, largely because
of the formal and informal indexing of wages and other income
claims to past price increases. As a result, the amount of economic slack necessary to reduce inflation quickly is very large.
Simulations with the large macroeconomic models confirm this
conclusion. One recent review of the estimates provided by six
different models found that it takes an extra one percentage point
of joblessness for one year to reduce inflation on average by 0.3
percentage point. If sustained for three years, this degree of
additional labor market slack would lower the rate of price rise by

TABLE 9.

INFLATION AND ECONOMIC SLACK, 1975-1977
Annual Average
1949-1974

1975

1976

1977

Inflation (Annual rates of increase, end of year from end of previous year)
Stripped CPI
(percent) a/
Compensation per hour
(percent) b/

2.9

6.8

6.3

5.5

8.1

9.2

8.7

4.8

8.5

7.7

7.0

Economic Slack
Unemployment rate
(percent)
Manufacturing capacity
utilization rate
(percent)

SOURCES:

U.S. Department of Labor, Bureau of Labor Statistics;
Board of Governors, Federal Reserve System.

Excluding food, energy, used cars, and mortage interest,

Private nonfarm business.

between 0.6 and 1.8 percentage points. 4/ While the estimates vary
somewhat, the message of these models is clear: restrictive
economic policy can slow an inflationary momentum, but the cost in
terms of lost output and employment is high.

Arthur M. Okun, "Efficient Disinflationary Policies," a paper
presented at the meetings of the American Economic Association, December 28, 1977.

Expectations
Some economists have argued that, contrary to the econometric
model simulations just mentioned, more restrictive fiscal and
monetary policies in the circumstances of the past three years
would have resulted in only moderate additional joblessness and
that the downturn would have been relatively short-lived. This
argument is derived from the view that the current momentum of
inflation is a consequence of generalized expectations of continued
rapid price change* It is asserted that formal or implicit contracts governing prices and wages increasingly have come to be
formulated on the basis of the parties1 expectations of future
inflation. If these expectations are maintained, then they become a
self-fulfilling prophecy.
According to this view, an essential goal of fiscal and
monetary policies is to change expectations of inflation. Proponents argue that the most effective way to change such expectations is to convince the parties to wage-price decisions that the
growth of demand will be insufficient to accommodate their price
anticipations. Once convinced that future inflation will slow, the
private sector will revise downward its planned wage and price
adjustments, slowing inflation with little impact on real activity.
The expectations approach challenges the orthodox view that a
macroeconomic policy designed to combat inflation will necessitate
a period of extensive resource underutilization. The conditions
under which an expectations-based policy would work should be
examined closely. There are at least two necessary conditions
for the success of this approach:
o

A stringent and credible macroeconomic policy designed to
constrain the growth in current dollar demand must be
announced in advance.

Adjustments in current income claims must be based on
expectations of future—not on past—inflation.

The second condition is particularly significant. There is no
doubt that expectations of future inflation significantly affect
prices in financial markets, especially longer-term interest
rates. Anticipations of higher future price increases reduce the
willingness of investors to make their savings available at
accustomed rates of return, and the capital costs of business

increase. Financial costs, however, are a relatively small share
of the total costs of production. And the expectations-based
rationale is less convincing once attention is turned to the
determination of labor compensation, which accounts for more
than two-thirds of total business costs.
As has been seen, the nature of the wage adjustment process—
characterized by formal and informal cost-of-living escalators and
first-year catch-ups—causes wage movements to reflect past inflation. In addition, these adjustments were shown to be relatively
insensitive to fluctuations in total demand. To the extent that
wage gains are indeed a catch-up to past real income loss and
are not responsive to rising economic slack, then the imposition of
restrictive fiscal and monetary policies would not be quickly
reflected in significantly reduced inflation. Rather, they would
result in an extended period of high unemployment and lost production.
THE RECENT ACCELERATION OF INFLATION
Why has inflation accelerated since the beginning of the
year? Sane point to the occurrence of price shocks during this
period, while others contend that the surge in prices resulted from
widespread shortages of labor and capital.
Price Shocks
Examination of the data indicates that the acceleration in
inflation at the beginning of this year resulted primarily from the
simultaneous occurrence of three events:
o

Food prices accelerated rapidly, up at a 22 percent
annual rate during the first five months of the year
after rising at only a 2.4 percent annual rate during
the second half of 1977.

)

The value of the dollar against other major currencies
fell sharply, down about 6 percent on a trade-weighted
basis since last autumn.

Sharply increased payroll taxes used to fund social
security programs and a 15 percent hike in the minimum
wage went into effect on January 1, 1978.

Indeed, these three factors are estimated to have accounted for
about 90 percent of the acceleration in prices during the first
half of this year.
Food Prices. The sharp upward movement in food prices was
widespread. In part, the acceleration was the result of production
and marketing difficulties caused by the harsh winter. A similiar
movement occurred last year, and it is expected that some of the
recent increases will be reversed later in the year, as they were
in 1977.
Sane of the 1978 acceleration in food prices, however, was
the result of reduced cattle supplies. Although the exact timing
was uncertain, an increase in beef prices had been widely expected.
As a result of relatively low cattle prices in recent years, herds
have been reduced sharply. Efforts to rebuild cattle stocks require
the withholding of heifers from slaughter, and such rebuilding
efforts appear to have begun recently. Largely as a result of this
reduced supply, meat prices have increased at a 43 percent annual
rate since the turn of the year—accounting for about a third of
the overall acceleration of consumer prices (see Table 1 0 ) .
Typically, beef prices drop somewhat after a rapid run-up, and a
decline may occur during the second half of 1978. Since the
rebuilding phase of the cattle cycle takes about five years,
however, this reduction will probably be temporary as beef prices
accelerate again next year. Overall, food price rises are responsible for about half the acceleration of the CPI from the second
half of last year. ,
Depreciation of the Dollar.
Currency depreciation directly
affects domestic prices in three ways. First, import prices rise;
since the dollar fell most dramatically relative to the Japanese
yen (down 15 percent in the 6 months since October) and to the
German mark (down 11.5 percent over the same period), (see Table
11) imports from these two countries have shown a significant
increase in price.
Second, prices of domestically produced products that are
competitive with imports from Japan and Germany—such as steel and
autos—also have increased as competitive pressures eased. Price

TABLE 10.

RECENT POOD PRICE MOVEMENTS
Percent Change, Seasonally Adjusted Annual Rate
Relative
Importance

Dec. 1976
to
June 1977

100.0

14.0

2.4

22.1

Meats, poultry, fish
and eggs

32.2

6.8

1.5

43.1

Fruits and vegetables

14.4

8.4

10.9

20.5

Cereals and bakery
products

12.5

5.0

6.0

11.0

Total Food at Home

SOURCE:

June 1977 Dec. 1977
to
to
Dec. 1977 May 1978

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

competition in the subcompact auto market—where imports from Japan
and Germany are particularly strong—was lessened significantly
when foreign auto prices rose 10 percent or more as a result of the
dollar depreciation. For example, some domestic subcompacts
increased in price 8 percent from the start of the new model year
last fall to mid-1978—well above the price increases recorded for
larger models. The effect of depreciation is equally evident in
recent steel price behavior. The steel industry had been losing an
increasing share of its domestic market to imports, especially from
Japan. Following the dollar depreciation and the announcement of
the new reference price system, finished steel prices at wholesale
rose at a 7.5 percent annual rate between January and June of
1978.

TABLE 11. CHANGE IN THE VALUE OF THE DOLLAR AGAINST OTHER CURRENCIES
Percent Change from 6 Months Earlier a/
1978

1977
April

October

April

-0.8

-1.9

-6.0

Japanese Yen

-5.8

-8.0

-14.8

German Mark

-2.3

-4.2

-11.5

Change Against:
Trade-weighted Average,
Major Currencies

Not annual rate.

The third way that a currency depreciation can raise domestic
prices is through rising export sales increasing the level of
aggregate demand. Depending on the degree of capacity utilization
in the domestic economy, such an increase in demand could lead to
higher prices.
Based on past behavior of the economy, it is estimated that
6 percent depreciation eventually may add 1-1/4 percentage points
to the rate of growth of the CPI as a result of these three
factors. If half the recent currency depreciation was reflected
in consumer prices by midyear, then about one-quarter of the recent
acceleration in inflation resulted from rising import prices.
Government Actions. Increases in payroll taxes and the
minimum wage also increased production costs significantly at the
beginning of 1978. It is estimated that a full pass-through of
these cost increases would increase the rate of change in prices by
one-half to three-quarters of a percentage point. (See Chapter IV
for detailed estimates of the economic effects of the payroll
tax changes.) Even though the full effect Of this rise will not
occur until later in 1978, it is probable that these government

actions caused nearly one-fifth of the acceleration in prices since
the beginning of the year. Other government cost-raising programs
also may have contributed to the recent acceleration of inflation,
but they are much more difficult to quantify. 5/
Taken together, it is estimated that higher food prices, the
dollar depreciation, and cost-raising programs accounted for
about 90 percent of the acceleration of inflation from the last
half of 1977 to the first half of this year.
Resource Shortages
While most analysts agree that the recent acceleration in
inflation is rooted in large part in food prices, currency depreciation, and government cost-raising actions, it is possible that
the increase is also the result of shortages in available labor and
capital.
Labor Shortages. It may seem odd to be analyzing the possibility of widespread labor shortages when the jobless rate has just
recently fallen below 6 percent and is still well above the postwar
average unemployment rate. It may be argued, however, that recorded joblessness today presents an overly optimistic picture of
the available labor supply relative to past experience. This
argument has two parts:
o

As a result of the coming of age of the postwar baby
boom and rising participation rates, a growing share of
the labor force is composed of new entrants and reentrants to the work force; since these workers typically experience higher joblessness as they search—often

For a review of existing government cost-raising programs, See
Robert W. Crandall, "Federal Government Initiatives to Reduce
the Price Level11 (The Brookings Institution, April 1978).

through trial-and-error—for satisfactory jobs, the
overall recorded jobless rate consistent with a given
degree of true labor-market slack may increase. It is
estimated that this demographic change may have added
about 1 percentage point to the total unemployment rate
over the past 20 years.
As a result of liberalized public and private income
support programs for the jobless, it may be rational for
sane persons to choose to be unemployed even when there
are suitable job openings; thus, the recorded jobless
rate may include a greater share of voluntary unemployed
who are not truly available for work. 6/
In view of the uncertainty about the overall unemployment
rate as a guide to labor-market tightness, some more specific
alternative measures of current availability of workers may be
useful (see Table 12). These supplementary indicators—unemployment rates for men aged 35 to 54, married men (spouse present),

Conversely, a significant way in which the recorded jobless
rate may underrepresent the true degree of labor-market slack
is by exclusion of persons who would take jobs but, because
they believe none are available, have not actually looked for
work in the past month. The Bureau of Labor Statistics (BLS)
estimates that 842,000 persons—approaching one percent of the
civilian labor force—were not in the labor force in the
second quarter of 1978 because they thought they could not get
a job.

women who head families, craft workers and managers—typically fall
sharply in periods of general labor scarcity, yet they should be
less sensitive to the factors that distort the overall jobless
rate. 7/ As can be seen, the available evidence does not show any
widespread shortages, at least when measured against previous
postwar experience. Recent unemployment rates for these selected
groups are still well above those in periods of labor market
tightness, such as 1966, 1969 and 1973.
Although the recent acceleration of inflation resulted from
price shocks rather than from a scarcity of available workers, this
does not mean that widespead labor shortages will not occur in the
next year and a half. Indeed as can be seen in Table 12, jobless
rates at midyear were roughly similar to the levels recorded in
1972; by early 1973, continued rapid economic growth led to a
general scarcity of labor and excess demand inflation. As in 1972,
the economy is now entering a zone of caution for policymakers,
where appropriate action depends on the assessment of the future
course of nonfederal demands. If these demands slow as projected,
and unemployment remains near its midyear level, then there is
little likelihood of upward pressure on prices from labor shortages
through 1979* However, if economic' growth remains strong and the
jobless rate continues to drop significantly, general worker
scarcities could occur within the forecast period, and wage and
price inflation could accelerate.

Martin Feldstein has shown that liberalized unemployment
compensation should have the greatest distorting effect on the
job-seeking activities of household members other than the
principal breadwinner; the alternative jobless rates given in
Table 3 measure labor-market slack largely among principal
household earners and, therefore, should be less influenced
by the demographic or income-support changes. See Martin
Feldstein, "Unemployment Compensation: Adverse Incentives and
Distributional Anomalies," National Tax Journal (June 1974).

TABLE 12.

MEASURES OF LABOR-MARKET SLACK—UNEMPLOYMENT RATES
FOR SELECTED GROUPS (IN PERCENTS)

1964

1966

1969

1972

1973

June
1978

Total

5.2

3.8

3.5

5.6

4.9

5.7

Men, Aged
35-54

3.0

2.0

1.5

2.7

2.1

2.7

Married Men,
Wife Present

2.8

1.9

1.5

2.8

2.3

2.7

Women Who
Head Families

4.4

7.2

7.0

8.8

Managers,
Administrators

1.4

1.0

0.9

1.8

1.4

1.8

Craft and Kindred
Workers

4.2

2.8

2.0

4.3

3.7

4.2

SOURCE:

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

Plant and Equipment Shortages.
Available data on current
utilization of plant and equipment show a picture similar to that
of the labor market. Manufacturing operating rates have increased
significantly from their exceptional recession lows, but there has
been little further improvement over the past year, and utilization
remains at its postwar average. As can be seen in Table 13, the
picture is about the same in the critical primary processing
sector.
Other evidence also indicates that there were no widespread
shortages of plant and equipment during the recent period of
accelerating prices (see Table 13). Vendor performance (change in
the time elapsed between orders and delivery of industrial materials) remains well below previous periods of extensive shortages

such as 1966 and 1973* In addition, manufacturing overtime hours—
a typical way to adjust for shortages in plant and equipment—were
little changed in June 1978 from a year earlier, and there have
been few reports of third shifts being started. Moreover, there
has been to date little apparent rush by business to accelerate
spending on expansions of heavy equipment, an area that has lagged
badly since the recession* It has been argued that this lagging
rate of investment has resulted in part from a persistent overhang
of unused industrial capacity, both in the United States and
abroad.

TABLE 13: MEASURES OF CAPACITY UTILIZATION
Postwar
.
Average 1964 1966 1969 1972 1973

June
1978

Capacity Utilization
(percent)
Manufacturing

0.83 0.86

0.91 0.86 0.83 0.88 0.84

Primary Processing

0.85 0.88

0.91 0.89 0.88 0.92 0.86

Vendor Performance a/

0.51 0.63

0.73 0.65 0.63 0.88 0.66

Manufacturing
Overtime Hours

3.1

3.9

3.6

3.4

3.8

3.5

SOURCES: Federal Reserve; U. S. Department of Commerce, Bureau of
Economic Analysis; U. S. Department of Labor, Bureau of
Labor Statistics.
a/

Percent of purchasing agents reporting slower deliveries of
materials.

Looking ahead, however, it is possible that more general
shortages of plant and equipment may be encountered during the next
year and a half. As with labor availability, the prospect for
manufacturing capacity scarcities depends on the future rate of
growth in demand. If growth is unexpectedly strong through
1979, production bottlenecks would increase, placing additional
upward pressure on prices.
SUMMARY
The available evidence indicates no widespread shortages of
labor and capital during the first half of 1978. The acceleration
of inflation resulted from other causes—particularly the rapid
runup in food prices, the dollar depreciation, and the January
increases in the payroll tax and the minimum wage. This acceleration, however, will contribute to the continuing momentum of
inflation as wages and other incomes catch up to these higher
prices later this year and in 1979. Moreover, if economic growth
is stronger than expected, increased shortages of labor and capital could be encountered before the end of next year and result
in a further acceleration of inflation.

CHAPTER IV.

POLICY ALTERNATIVES

In the last six months, since the CBO forecast was prepared
for the first concurrent resolution, the outlook for inflation has
significantly worsened and the likelihood of slower real growth in
1979 has increased. J/ Policymakers must also contend with structural problems. In particular, unemployment rates are likely
to remain extremely high for some labor force groups—such as black
teenagers—and the outlook for business investment falls short of
the amount needed to return productivity growth to its earlier
higher rates.
What are the implications of this forecast for the second
concurrent resolution? Unfortunately, there appears to be no single
policy change that can solve all of the problems mentioned above,
and solutions to one problem may make others worse. Macroeconomic
policymakers may have to choose which battles to fight—inflation,
unemployment, budget deficits, the size of the public sector,
long-term growth, and so forth—since they are not likely to
achieve all goals simultaneously.
The recent flare-up in inflation and the projected slowdown in
economic growth make fiscal policy decisions especially difficult.
The analysis presented in the previous chapter suggests that the
most recent bulge in inflation is due primarily to supply-related
factors, and not to generalized demand pressing against available
resources. This situation creates a serious policy dilemma.
Restrictive aggregate-demand policies can have little direct effect
in retarding an inflation that stems from such supply shocks.
In these circumstances, such policies can reduce the overall rate

Congressional Budget Office, The Economic Outlook (February
1978). The current inflation forecast is one percentage point
higher for 1979. Economic growth, with the fiscal stimulus of
the first concurrent resolution, is now expected to be-slightly
less than projected in the earlier report. The risk of a
serious credit squeeze is now much greater. But the recent
drop in unemployment has lowered the unemployment rate that,
with the projected growth, now appears to be attainable.

of inflation only at the cost of substantially lower growth in
output and higher unemployment. At the same time, the amount of
slack in the economy has been reduced considerably, and the economy
is entering a caution zone in which stimulative policies risk
accelerating inflation*
RESTRICTIVE FISCAL POLICY OPTIONS
If the Congress believes that the fiscal policy of the first
resolution provides too much stimulus at this stage of the expansion—particularly in light of the persistence of inflation—it can
take steps to reduce the fiscal year 1979 deficit. A reduction in
fiscal stimulus could be achieved by either higher taxes or
lower spending. One way of achieving this goal would be to forego
all or part of the planned tax cut.
No Tax Cut Option. The first concurrent resolution provided
for a $15 billion cut in taxes for fiscal year 1979 (effective
January 1979 at a $20 billion annual rate) as compared with revenues from current policies. 2/ According to CBO estimates, if the
entire tax cut were dropped, real growth from the fourth quarter of
1978 to the fourth quarter of 1979 would be about 0.5 percentage
point lower and the unemployment rate would be 0.2 percentage point
higher than the baseline forecast. As shown in Table 14, the
restrictive effect of the no tax cut policy option would be somewhat greater by the end of 1980. The price level, as measured by
the Consumer Price Index, would be only around 0.2 percent lower by
the end of 1980; however, inflation would be dampened more in the
years that follow.
Reduced Spending Option. A restrictive economic effect could
also be attained by cutting expenditures. Achieving a significant
reduction in spending would, however, require difficult actions,
such as foregoing the October pay raise for federal employees and
sharply reducing the planned new spending initiatives for defense,
agriculture, urban aid, veterans1 benefits, and other programs that
have not yet been enacted. Alternatively, to achieve a spending
reduction and still provide room for sane new spending initiatives,

2/ Current policy is assumed to include an extension of the
temporary tax cuts enacted in 1977.

TABLE 14.

ESTIMATED ECONOMIC EFFECTS OF THE NO TAX CUT OPTION

Economic Variable

1979:4

1980:4

GNP (billions of current dollars)

-17

-31

GNP (billions of 1972 dollars)

-10

-16

Unemployment Rate (percent)

+0.2

+0.4

Employment (millions)

-0.3

-0.4

Consumer Price Index (percent
change from base)

-0.02

-0.2

savings could be sought in existing programs. Assuming that the
Congress could cut spending by $10 to $15 billion beyond the
estimated $4 billion shortfall, the effect of this cut on economic
activity would be roughly similar to the effect of eliminating the
tax cut (described above), depending on the composition of the
reductions.
The Risk of Restrictive Policies.
If the Congress were to
forego the tax cut or make comparable cuts in spending, fiscal
policy would be more restrictive in fiscal year 1979 than in 1978.
To the extent that the economy is approaching a general condition
of shortages of labor or manufacturing capacity, such a reduction
in fiscal stimulus could diminish the risk of generating inflation.
However, real growth appears to be slowing, and there is a substantial danger that monetary and fiscal policies will become simultaneously restrictive—a shift that in the past has generally been
followed by recession.
AN EXPANSIVE FISCAL POLICY OPTION
In contrast to the restrictive measures described above, the
Congress has before it a proposal for reducing taxes sharply
without altering expenditures. This proposal calls for a one-third
reduction in personal income taxes and a smaller cut in corporate

income taxes, phased in over a three-year period. 3/ In the first
calendar year, this tax cut would be about 50 percent larger than
the tax reduction included in the first concurrent resolution. If
the CBO forecast of reduced growth and continued slack is correct,
then the first-year tax reduction probably would not significantly
worsen the outlook for inflation. But the commitment to very large
subsequent tax cuts would clearly involve a substantial risk of
such an outcome in the second or third years. Conventional economic analysis indicates that, as a result of such a policy, the
budget deficit would rise sharply. With the economy likely to
encounter a general scarcity of labor and other production bottlenecks during the second or third year, a large stimulus of this
kind would be highly inflationary.
Sane proponents of this policy option, however, argue that the
conventional view is incorrect. They contend that large tax cuts
greatly increase incentives to work, save, and invest, and they
argue that the resulting growth in production and income would be
so rapid that the tax cuts would "pay for themselves" in the first
or second year, resulting in no increase in the deficit. According
to this view, the tax cuts would have such large effects on aggregate supply that they would not be inflationary.
CBO has not found any empirical support for the view that
supply-side effects from tax cuts such as those proposed in H.R.
8333 are so large and so quick. The evidence available to us
supports the mainstream view that individual and corporate income
tax rate reductions, while stimulative, are not self-financing.
Moreover, this evidence indicates that the stimulative effects of
most types of tax cuts occur primarily through increased aggregate
demand and that such large tax cuts therefore carry a great potential for accelerating inflation, unless there is a great deal of
slack present in the economy.
THE COMPOSITION OF FISCAL POLICY AND THE
MONETARY-FISCAL POLICY MIX
Although the Congress cannot expect to achieve all of its
economic goals quickly, some combinations of policies that would
help improve the performance of the economy are available. For

3/ H.R. 8333, the Kemp-Roth Tax Reduction Act.

example, it may be possible to improve the tradeoff between
inflation and unemployment by changing the composition of the
budget or by introducing structural changes. This section looks at
possible changes in the composition of macroeconomic policies; the
final section looks at some structural ways of improving the
performance of the economy.
The Composition of Fiscal Policy
Cutting Both Revenues and Expenditures. Cuts in both spending
and taxes have been proposed as a way to reduce the size of
the federal sector. The precise effects of this type of policy
would depend on the size of the cuts, the particular taxes and
expenditures that were cut, and the timing of those cuts. CBO
analyzed an illustrative $10 billion, annual rate, cut in spending
and taxes. The tax cut ($7.5 billion for the fiscal year 1979) was
the same composition and timing as the tax cut included in the
first concurrent resolution. A $10 billion across-the-board cut in
government spending (except for interest payments), was assumed to
become effective the fourth quarter of 1978. It is estimated that
such a program is, on balance, contractionary, partly because of
the earlier effective date of the expenditure cut: in the fourth
quarter of 1979, real GNP would be lower by roughly $4 billion (in
1972 dollars), and the unemployment rate would be slightly higher
(by 0.1 percentage point). If the cut in spending were solely in
purchases of goods and services and were combined with the tax cut,
CBOfs simulations suggest that the resulting reduction in output
would be approximately twice as large as that resulting from the
across-the-board cut in spending and the tax cut, because changes
in purchases generally have more powerful effects on economic
activity than do changes in transfer payments. V
Of course, if
income taxes were cut more than spending, the size of the federal
sector could be reduced with no aggregate effect, or even an
overall stimulative effect, on economic activity.
Reducing Payroll Taxes Instead of Personal Income Taxes.
It
has been recommended that the Congress slow inflation by cutting
payroll taxes instead of personal income taxes. Considerations

4/ See Congressional Budget Office, Understanding Fiscal Policy
(April 1978).

other than macroeconomic effects, such as keeping the financing of
the social security system separate from the rest of the federal
budget, enter into such decisions; but from the economic perspective alone, there appear to be significant advantages to this
proposal*
The short-run impact of a cut in the employee share of a
payroll tax appears to be quite similar to a cut of similar size in
the personal income tax. But while a reduction in the employer
share appears to have similar real effects, its impact on the price
level is more favorable than a cut of similar size in personal
income taxes. According to CBO analysis, a reduction in the
employer share of payroll tax will, on balance, lower prices, while
a cut in personal taxes leads to an increase in the price level.
The size of the effect on prices is, however, uncertain. There is
disagreement over the extent to which employers may shift the
burden of the payroll tax to workers by paying lower wages than
would otherwise be the case. It is probable that the effect of
lower taxes shows up partly in lower prices and partly in higher
wages.
CBO recently compared the economic effects of $10 billion
reductions in social security taxes and personal income taxes;
the results are summarized in Table 15. Bearing in mind that the
estimates are subject to a good deal of uncertainty, the CBO
analysis suggests that such a payroll tax cut would decrease
the CPI by about 0.3 percent by the end of the first year, whereas
the personal income tax cut would increase the price level.
Investment Incentives.
As discussed in CBOfs report, The
Economic Outlook, there are several fiscal tools available for
stimulating business investment.
Probably, the most effective
tools (per dollar of budget cost) are increasing the investment tax
credit and accelerated depreciation. These instruments are specifically focused on the investment decision. Two other instruments—reductions in the corporate income tax and reductions in
capital gains taxes—are sometimes mentioned as ways of stimulating
investment, but substantially less evidence relating to their
effectiveness is available.

TABLE 15. APPROXIMATE EFFECTS OF TWO ILLUSTRATIVE $10 BILLION
TAX REDUCTIONS a/

Economic Variable

Personal
Income Tax

Payroll Tax

7 b/

-0.2

-0.2 b/

200

200 b/

After 4 Quarters
GNP (billions, 1972 dollars)
Unemployment rate
(percent)
Employment (thousands)
General Price Level,
(percent change)

-0.2

After 8 Quarters
GNP (billions, 1972 dollars)
Unemployment rate
(percent)
Employment (thousands)
General Price Level,
(percent change)

10 b/

-0.3

-0.3 b/

400

400 b/

+0.1

-0.3

a/ Calculations assume the general economic conditions of 1978.
b/ Data shown for GNP, unemployment rate, and employment are the
estimated effects of a personal income tax cut. It is assumed
that a payroll tax cut of the same size would have approximately the same GNP and employment effects.
c/ Less than +0.05 percent.

The Monetary-Fiscal Policy Mix
Improved coordination of fiscal and monetary policies could be
an important step in helping the Congress achieve its short-run
goals for employment and prices. In addition, some hold that a
different policy mix might improve the long-run performance of the
economy.
Coordination and Short-Run Goals.
Past experience suggests
that some instances of poor performance by the economy have resulted from excessive monetary and fiscal policy shifts in the same
direction. Perhaps fiscal and monetary policymakers each assumed
that the other would not take appropriate action in response to
current trends, and together they overreacted. Such an overreaction cannot be discounted at the present time. If fiscal and
monetary policies are both used to reduce inflationary pressures,
the chances of a recession are great.
Aside from the possibility of an overreaction, some argue that
the short-run economic outlook would be improved by a coordinated
policy involving a more restrictive budget and a more expansive
monetary policy. The case for this change seems to rest on the
assumption that with such a policy it would be possible to avoid
higher short-term interest rates and the resulting movement of
funds from thrift accounts into higher yielding short-term market
instruments, which would lead to a serious downturn in housing.
The Monetary-Fiscal Mix and Long-Run Goals. It also has been
argued that the long-run performance of the economy would be
improved by a tighter fiscal policy and an easier monetary policy.
That mix might have a number of desirable outcomes, including:
o Reduction of federal deficits and, perhaps, decreasing the
size of the federal sector as well; and
o Encouraging investment spending, with the resulting growth
in industrial capacity reducing inflationary pressures.
A recent economic study by Data Resources, Inc., for example,
indicates that a reduction in government spending and a concomitant

easing of monetary policies reduces short-term interest rates,
substantially stimulates housing, and provides some small impetus
to business fixed investment. 5/
Some of the advantages of a fiscal-monetary policy shift,
however, could be achieved through fiscal policy instruments
alone. As discussed above, if the nation wants to stimulate
business investment, it could rely more heavily on such fiscal
tools as the investment tax credit or accelerated depreciation.
Implementing Coordination. There are several difficulties in
instituting a shift in the monetary-fiscal mix for short-term
objectives. Economic knowledge of the size and timing of monetary
and fiscal policy effects is limited. More important, adequate
arrangements for choosing specific economic goals and implementing
a coordinated policy do not now exist.
Although attempts at closer coordination of fiscal and monetary policies are not without their risks, the benefits in terms
of economic stability and growth could be substantial. Hence, this
may be an appropriate time to examine mechanisms for improving
coordination of monetary and fiscal policies, such as requiring the
Federal Reserve to:
o Clearly specify its money and credit targets for the
ongoing and upcoming fiscal year, before enactment of the
budget resolutions;
o Reveal its estimates of the level of unemployment, production, and prices for the end of the fiscal years; and
o Explain periodic revisions of its objectives and plans.

5/ Allen Sinai, "The Conduct of Monetary Policy: Performance and
Prescription," DRI Review, July 1977. In one of these simulations, the growth in federal expenditures was held to 1 percent
per year and money growth was increased so that the path of
real output for the economy remained approximately • unchanged
from that with higher federal expenditures and slower money
growth.

OTHER (NON-AGGREGATE) APPROACHES
The dilemma facing policymakers could also be made less acute
by a variety of structural changes that directly reduce inflation
and/or unemployment. While not cure-alls, such measures could be
helpful supplements to traditional fiscal and monetary policies.
Policies to Reduce Inflation
In general, the Congress can use three types of measures to
reduce inflation directly:
o

Modify government actions that raise costs and prices;

Intervene directly iri the wage-price determination process
with sane form of incomes policy; and

Promote measures to increase the supply of goods and
services.

Government Actions. A number of government actions have the
effect of raising costs and prices. Included are the various
limitations on the import of foreign goods, the minimum wage,
agriculture price supports, the regulation of transportation,
federal excise taxes, state sales taxes, and payroll taxes.
It has been estimated that the direct effect of a modification of
these programs would be a one-time decline in the price level by
more than 5 percent. 6/ As noted in Chapter III, environmental
standards and worker health and safety regulations also have added
significantly to the current momentum of inflation.

The impact was estimated using the gross private domestic
deflator. See Robert W. Crandall, "Federal Government Initiatives to Reduce the Price Level11 (The Brookings Institution,
April 1978).

Of course, just because these programs increase prices does
not mean that they should be scrapped. It does mean, however, that
any effort to reduce inflation would be incomplete unless it
included a careful weighing of the advantages and disadvantages of
government actions that directly raise costs and prices.
Incomes Policies. Public debate on incomes policies typically
centers on direct wage-price controls. There is currently little
public enthusiasm for direct controls; indeed, no statutory authority for such a program exists. Other less extreme types of incomes
policies, however, have received some support.
A mild form of incomes policy is public monitoring of wageprice developments combined with exhortation of labor and management to restrain increases. This is the approach used in the
Administration's "deceleration" program. The White House has been
attempting to secure voluntary commitments from labor and business
to hold wage and price increases below the average of the previous
two or three years. The problem is that such voluntary cooperation
has been difficult to obtain. As explained in Chapter III, unions
are under great pressure from their members to maintain traditional
real income growth, which would likely not be possible under the
deceleration program.
Another type of incomes policy that does not rely on voluntary
cooperation has received a considerable amount of attention recently. Tax-based incomes policies (TIP) either impose a tax penalty
on firms and/or workers for exceeding preestablished wage-price
norms or they offer a tax incentive for staying below the norm. An
advantage of the TIP approach is that it involves less interference
in specific wage and price decisions than occurs under direct
controls. A disadvantage is that it would impose another major
function on the tax system. Relatedly, the administrative burden—
public and private—could be substantial, especially under the tax
incentive variant.7/

For a full discussion, see Arthur M. Okun and George Perry,
eds., Brookings Papers on Economic Activity, 2, 1978.

Supply-Enhancing Policies. A fundamental source of inflation
is supply shortages resulting from production capacity inadequate
to meet demand or from shocks such as adverse weather or foreign
trade embargoes. The Congress could deal with the problem of
supply shortages in a variety of ways:
o

As discussed earlier in this chapter, tax changes—
especially an increased investment tax credit and accelerated depreciation—would increase the rate of return on
business fixed investment and encourage greater expansion
of productive capacity. 8/

Greater public and private investment in the development
of labor skills and the dissemination of labor market
information could be encouraged.

Establishment of carefully managed government stockpiling
programs—selling when prices are high as well as buying
when prices are low—could help smooth price changes of
commodities, such as grains and petroleum, that are
subject to weather and foreign shocks; these programs
cuold help dampen rapid price run-ups that ultimately
raise the general levels of wages and prices.

Policies to Reduce Unemployment
Labor market data indicate that, after three years of expansion, there still exists significant unemployment by mid-year—
especially among particular groups in the economy. The extremely
high jobless rate of black teenagers is unprecedented since the
1930s for any major group in the country (see Figure 8.) The
unemployment rate for young black adults (aged 20 to 24) is also
exceptionally high at more than 20 percent, and the ratio of the
jobless rate for blacks of all ages compared to whites is 2.4:1.
The current level of joblessness for poverty sections of metropolitan areas also remains very high (see Table 16).

For a more detailed analysis of the various options, see
Congressional Budget Office, The Economic Outlook (February
1978).
64

Figure 8.

Teenage Unemployment Rates (Age 16-19), By Race

1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978
Calendar Years

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

TABLE 16. TOTAL AND NONWHITE UNEMPLOYMENT RATES IN POVERTY AND
NONPOVERTY AREAS, 1973 AND FIRST QUARTER OF 1978
a/
1978:1

1973
Total

Nonwhite

Total

Nonwhite

Poverty Areas
Metropolitan
Nonmetropolitan

6.5
9.0
4.7

10.8
11.6
9.3

9.4
13.0
7.2

15.8
17.8
12.4

Nonpoverty Areas
Metropolitan
Nonmetropolitan

4.6
4.7
4.3

7.5
7.4
8.2

6.3
6.2
6.6

11.1
11.0
11.7

All areas

4.9

8.9

6.2

12.3

SOURCE:

U. S. Department of Labor, Bureau of Labor Statistics,
Employment and Earnings, January 1975 and April 1978
issues,

NOTE: "Poverty areas" are census tracts where at least 20
percent
of persons with incomes below the Census Bureaufs poverty
standard in the 1970 census. In 1978:1, approximately 16
percent of the civilian labor force lived in "poverty areas"
but 45 percent of all nonwhite workers lived in such areas*
a/

Not seasonally adjusted, except for all areas.

In dealing with the unequal burden of unemployment, the
Congress has available both macroeconomic tools and structural
programs. Fiscal and monetary policies that sustain rising
total demand have a significant impact on the relative employment
prospects of blacks; an analysis of past relationships indicates
that job opportunities of this group are especially responsive at
the later stages of an economic expansion (see Table 17).

TABLE 17. EMPLOYMENT GROWTH SINCE THE RECESSION TROUGH, BY DEMOGRAPHIC GROUPS, PERCENT CHANGE
1975:1 to 1976:3
Total Employment
White Teenagers, Age 16-19
Nonwhite Teenagers, Age 16-19
White Adult Females
Nonwhite Adult Females
White Adult Males
Nonwhite Adult Males

1976:3 to 1978:1

4.1

6.0

4.0
0.2

5.5
8.3

6.2

8.1
11.1

7.7

2.5
4.2

4.1
7.6

SOURCE: Calculated from Bureau of Labor Statistics data.
NOTE: "Adult" refers to persons aged 20 and older.
There is a major limitation on the use of fiscal and monetary
policies to solve the problem of the unequal distribution of
joblessness. Inflationary production bottlenecks would likely be
encountered before unemployment was reduced to an acceptable level.
Therefore, it has been recommended that the Congress supplement
traditional macroeconomic policies with a greater effort to expand
the productive capacity of the economy. Measures that could
encourage such an expansion were noted above. Manpower programs
could be increased and tightly targeted on disadvantaged groups;
such programs could include tax credits to encourage private-sector
skill training. In addition, it has been argued that a youth
differential in the statutory minimum wage would encourage business
to hire and train teenagers.
The problem of the unequal distribution of unemployment could
also be alleviated to same extent by expanded public employment
programs. These programs provide both an alternative to public
income support and work experience that may enhance the worker's
chances of obtaining a private sector job.

Even if successful, however, training and public employment
programs are best used as complements to, not substitutes for,
fiscal and monetary policies that hold down the level of cyclical
unemployment. Clearly, the effectiveness of structural programs is
improved when labor demand is high*
CONCLUSION
Past experience indicates that monetary and fiscal policies
have little capability for dealing with high inflation without
incurring substantial costs in terms of output and employment.
This limitation of macroeoonomic policies suggests that, in the
present circumstances, it would be useful to investigate closely
other measures, such as policy composition and structual programs,
that could eventually improve the tradeoff between inflation
and unemloyment. Such structural improvements, however, are not
a panacea for the current economic ills, and the near-term resolution of the inflation-unemplyment dilemma still will depend on
whether the Congress, the Administration, and the Federal Reserve
give greater emphasis to inflation or to sustaining economic
growth.

68
U. S. GOVERNMENT PRINTING OFFICE : 1978 O - 31-331

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