Full text of Materials Prepared in Connection with the Study of Employment, Growth, and Price Levels for Consideration by the Joint Economic Committee, Congress of the United States : Study Paper No. 1: Recent Inflation in the United States

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

86ls t firrrfm f8}

JO IN T C O M M ITTEE P RIN T

STUDY PAPER NO. 1

RECENT INFLATION IN THE UNITED STATES
BY
Charles L. Schultze

MATERIALS PREPARED IN CONNECTION WITH THE
STUDY OF EMPLOYMENT, GROWTH, AND
PRICE LEVELS

FOR CONSIDERATION BY THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES

Printed fo r the use o f the Joint Economic Committee

l ib r a r y

JOINT ECONOMIC COMMITTEE
(Created pursuant to sec. 5(A) of Public Law 304, 79th Cong.)

PAUL H. DOUGLAS, Illinois, Chiirman
WRIGHT PATMAN, Texas, Vice Chairman
HOUSE OF REPRESENTATIVES
SENATE
RICHARD BOLLING, Missouri
JOHN SPARKMAN, Alabama
HALE BOGGS, Louisiana
J. WILLIAM FULB RIGHT, Arkansas
HENRY S. REUSS, Wisconsin
JOSEPH C. O’MAHONEY, Wyoming
FRANK M. COFFIN, Maine
JOHN F. KENNEDY, Massachusetts
THOMAS B. CURTIS, Missouri
PRESCOTT BUSH, Connecticut
CLARENCE E. KILBURN, New York
JOHN MARSHALL BUTLER, Maryland
JACOB K. JAVITS, New York
WILLIAM B. WIDNALL, New Jersey
S tudy of E m ploym ent , G row th , a n d P rice L ev els
(Pursuant to S. Con. Res. 13, 86th Cong., 1st sess.)
O t t o E c k s t e in , Technical Director
John
L e h m a n , Administrative Officer
J am es
K n o w l e s , Special Economic Counsel

W.
W.

This is one of a series of papers being prepared for consider
ation by the Joint Economic Committee in connection with
their Study of Employment, Growth, and Price Levels. The
committee and the committee staff neither approve nor dis
approve of the findings of the individual authors. The findings
are being presented in this form to obtain the widest possible
comment before the committee prepares its report.

LETTERS OF TRANSMITTAL
S e p t e m b e r 21, 1959.
To Members of the Joint Economic Committee:
Submitted herewith for the consideration of the members of the
Joint Economic Committee and others is a paper on “Recent Inflation
in the United States.”
This is one of a number of subjects which the Joint Economic Com
mittee has requested individual scholars to examine and report on to
provide factual and analytic materials for consideration in the prepar
ation of the staff and committee reports for the study of “Employ
ment, Growth, and Price Levels.”
The papers are being printed and distributed not only for the use
of the committee members but also to obtain the review and comment
ot other experts during the committee’s consideration of the materials.
The findings are
those of the author, and the committee and
the committee staff indicate neither approval nor disapproval by this
publication.

entirely

P a u l H . D o u g la s ,

Chairman, Joint Economic Committee.
S e p t e m b e r 17, 1959.
Hon. P a u l H. D o u g l a s ,
Chairman, Joint Economic Committee,
U.S. Senate, Washington, D.C.
D e a r S e n a t o r D o u g l a s : Transmitted herewith is the first of the
series of Papers being prepared for the “Study of Employment,
Growth, and Price Levels” by outside consultants and members of
the staff. The author of this paper is Prof. Charles L. Sehultze, of
Indiana University, Bloomington, Ind.
Additional papers in the series will be submitted during the fall.
They will contain further studies of price changes, as well as studies
of potential policies designed to reduce instability in the price level.
Other volumes will deal with the objectives of employment and eco
nomic growth. All papers are presented as prepared by the authors,
for consideration and comment by the committee and staff.

O tto E

c k s t e in ,

Technical Director,
Study of Employment, Growthy and Price Levels.

CONTENTS
Page
Introduction— Statement of findings____________________________________
Chapter 1. General summary----------------------------------------- ----------------------The current controversy: Demand-pull versus cost-push____________
The nature of the recent inflation___________________________________
The importance of the composition of demands_________________
Overhead costs________________________________________________
A detailed analysis of the 1955-57 period___________________________
Demands and prices___________________________________________
Wages_________________________________________________________
Overhead costs________________________________________________
Consumer prices_______________________________________________
Some implications__________________________________________________
Chapter 2. Prevailing theories of the inflationary process________________
Introductory remarks______________________________________________
The current debate____________________________________________
Classification and discussion of various inflationary mechanisms_____
Prices, wages and the level of real demands_____________________
Type A, inflation______________________________________________
Type B, inflation______________________________________________
Type C, inflation______________________________________________
Type D, inflation______________________________________________
Summary of the demand versus cost inflation theories_______________
The mechanics of inflation_____________________________________
Policy implications of existing theories______________________________
The aggregate nature of existing theories___________________________
The changing nature of costs_______________________________________
Chapter 3. The inflationary implication of shifts in the composition of
demand______________________________________________________________
The importance of the composition of aggregate spending___________
The demand and price flexibility requirements of a stable price level. «
The implications of the model for cost-push inflation____________
Aggregate demand inflation____________________________________
The spread of inflation throughout the economy_____________________
The relationship of prices and costs____________________________
Wage determination___________________________________________
From particular to general price increases______________________
Additional considerations___________________________________________
The relationship of relative demands to relative prices_______________
Secular inflation____________________________________________________
Some qualifying comments_________________________________________
Chapter 4. The impact of overhead costs on the inflationary process____
Introduction----------------------------------------------------------------------------------The changing structure of costs, 1947-57___________________________
Overhead costs per unit of output______________________________
Secular aspects_____________________________________________________
Overhead labor________________________________________________
Other fixed costs______________________________________________
Cyclical aspects____________________________________________________
Fixed costs and price policies__________________________________
The self-defeating nature of the premature “ capture” of over
head costs__________________________________________________
Summary__________________________________________________________
Chapter 5. The nature of inflation, 1955-57_____________________________
Some phenomena to be explained___________________________________
Prices, expenditures and output____________________________________
The pattern of demands_______________________________________
Changes in final goods prices; GNP categories__________________
Industrial prices, wages, and output____________________________
Summary_____________________________________________________

1
4
4
8
8
10
13
13
14
14
15
15
17
17
17
20
21
26
31
34
36
39
40
41
42
43
44
44
46
49
50
54
55
59
70
71
73
76
77
78
78
79
82
84
84
87
88
90
91
95
97
97
103
103
105
106
113

VIII

CONTENTS

Chapter 5. The nature of inflation, 1955-57— Continued
Page
The behavior of wages_____________________________________________
113
Summary______________________________________________________
121
Overhead costs_____________________________________________________
122
Factor inputs and unit costs___________________________________
123
Consumer prices___________________________________________________
125
Food prices____________________________________________________
127
Service prices_______________________________________________ 129
Some implications__________________________________________________
132
Appendix A. Notes and sources for charts and tables____________________
135
LIST OF CHARTS
Chart 3-1. Relationship between wage changes and unemployment, 19001958_________________________________________________________________
Chart 3-2. Relationship between wage changes and unemployment,
selected periods______________________________________________________
Chart 3-3. Changes in wages and consumer prices, 1900-1958___________
Chart 3-4. Changes in wages and consumer prices, selected periods--------Chart 3-5. Schematic diagram (supply-demand shifts)__________________
Chart 3-6. Schematic diagram (price-output relationships)______________
Chart 3-7. Schematic diagram (price-output relationships)______________
Chart 4 1. Schematic diagram (capacity, costs, output, 1955-57)________
Chart 4r-2. Schematic representation of changes in costs and output_____
Chart 4-3. Relationship between rate of return and percent of capacity
operated, United States Steel Corp., 1909-58__________________________
Chart 5-1. Changes in industrial prices and output, May-June 1955 to
May-June 1957______________________________________________________

60
61
63
64
73
74
75
89
90
92
110

LIST OF TABLES
Table 1-1. Changes in manufacturing costs and prices__________________
Table 1-2. Indexes of capacity, employment and output in manufacturing
industries____________________________________________________________
Table 2-1. Price changes in the United States and selected other industrial
nations, 1953-57_____________________________________________________
Table 2-2. Changes in prices and costs— Private nonfarm economy______
Table 2-3. Changes in prices and costs— Manufacturing industries______
Table 4-1. Employment by occupation, 1947-57________________________
Table 4-2. Employment in manufacturing, 1947-57_____________________
Table 4-3. Percent change in selected price indexes, 1947-57____________
Table 4-4. Manufacturing costs, 1947-57_______________________________
Table 4-5. Changes in selected manufacturing costs, 1947-57____________
Table 4-6. Prices and unit costs in manufacturing, 1947-57_____________
Table 4-7. Changes in manufacturing prices and costs, 1947-57_________
Table 4-8. Changes in productivity, earnings, and unit costs— Production
and nonproduction workers in manufacturing_________________________
Table 4-9. Indexes of capacity, employment, and output in manufacturing
industries____________________________________________________________
Table 5-1. Change in output— Selected periods_________________________
Table 5-2. Capacity and output: Manufacturing industries_____________
Table 5-3. Changes in expenditures and prices, 1954-57_________________
Table 5-4. Wholesale prices and construction costs, 1955-57_____________
Table 5-5. Relationship of finished goods prices and materials costs—
Selected industries____________________________________________________
Table 5-6. Price and output changes for selected commodity groups,
May-June 1955 to May-June 1957___________________________________
Table 5-7. Changes in output, employment and wage rates— Manufactur
ing industries— Selected periods_______________________________________
Table 5-8. Changes in output/employment and wage rates— Manufactur
ing industries—Selected countries____________________________________
Table 5-9. Regression of changes in output for man-hour on changes in
output— 15 manufacturing industries_________________________________
Table 5-10. Changes in manufacturing productivity in eight industrial
nations___________________ . . . ___________ ____________________________
Table 5-11. Prices and hourly earnings in capital goods and other indus
tries_________________________________________________________________

10
11
25
32
33
80
80
81
82
82
83
83
85
89
100
101
104
107
108
112
114
114
115
117
118

CONTENTS

Table 5-12. Prices, hourly earnings, and unit costs in capital goods and
other industries______________________________________________________
Table 5-13. Employment by industry, 1955-57_________________________
Table 5-14. Changes in total private nonfarm wage and salary employ
ment by occupational groups, April-July 1955 to April-July 1957_____
Table 5-15. Changes in manufacturing employment 4 Q 1955 to 3 Q 1957.
Table 5-16. Changes in manufacturing prices and costs, 1955-57________
Table 5-17. Relative importance of different costs, 1955-57— Manufac
turing industries---------------------------- ---------------------------------------------------Table 5-18. Changes in consumer prices, March 1956 to September 1957.
Table 5-19. Indexes of farm production and marketings_________________
Table 5-20. Distribution of increases in food prices, 1 Q 1956 to 3 Q 1957.
Table 5-21. Components of food marketing margins____________________
Table 5-22. Changes in food marketing margins and components________
Table 5-23. Rate of change in service prices____________________________

Page
119
122
123
123
124
124
126
127
128
128
128
131

EMPLOYMENT, GROWTH, AND PRICE LEVELS*
INTRODUCTION— STATEMENT OF FINDINGS
This study is concerned with the nature of inflation, and in particu
lar with the rise in the general level of prices between 1955 and 1957.
While there is little controversy over the nature and causes of inflation
during periods of war or postwar reconversion, there is substantial
disagreement over the causes of the relatively mild inflation of recent
years. Those who believe that inflation stems, now as always, from
“ too much money chasing too few goods” are ranged against those
who attribute postwar inflation to the upward pressure of wage costs
on prices. This study concludes that creeping inflation can be ex
plained by neither of these two lines of analysis. In particular its
conclusions are:
1. The basic point at issue between the “ demand-pull” and “ costpush” theorists relates to the sensitivity of prices and wages to changes
in the demand for goods and services. If prices and wages are very
sensitive, general monetary and fiscal policy can be designed to achieve
full employment and price stability. The elimination of aggregate
excess demand will choke off inflation without necessarily involving
substantial unemployment. If prices and wages are relatively in
sensitive to moderate changes in demand, the converse holds true.
2. In the modern American economy prices and wages are much
more sensitive to increases in demand than to decreases. As a conse
quence, a rapid shift in the composition of demand will lead to a general
rise in prices, even without an excessive growth in the overall level of
demand or an autonomous upward push of wages. Prices rise in those
sectors of the economy where demands are growing rapidly, and
decline by smaller amounts, or not at all, in sectors where demands
are falling.
3. When the composition of demand changes rapidly, prices of semi
fabricated materials and components tend to rise, on the average, since
price advances among materials in heavy demand are not balanced by
price decreases for materials in excess supply. Wage rate gains in most
industries tend to equal or almost equal those granted in the rapidly
expanding industries. As a consequence, even those industries faced
by sagging demand for their products experience a rise in costs. This
intensifies the general price rise, since at least some of the higher costs
are passed on in prices.

*Those who have aided the author in the preparation of this study are indeed legion. In the course of
innumerable conversations, they provided much needed light through some of the murkier conceptual
depths into which the study continually threatened to disappear. Messrs. David Lusher and Henry
Briefs, of the staff of the Council of Economic Advisers; Jack Alterman, of the Bureau of Labor Statistics;
Norman Ture, of the Joint Economic Committee staff; Prof. Daniel Hamberg, of the University of
Maryland, and Profs. George Stolnitz, Samuel Loescher, and David Martin, of Indiana University, were
particularly imposed upon as critics and advisers. Mrs. Alice Mehling and Mr. Arne Hylin completed
most of the statistical calculations—C h a r l e s L. S c h u l t z e .
1

RECENT INFLATION IN TH E UNITED

STATES

4. The resulting inflation can be explained neither in terms of an
overall excess of money demand nor an autonomous upward push of
wages. Rather it originates in excess demands in particular sectors
and is spread to the rest of the economy by the cost mechanism. It
is a characteristic of the resource allocation process in an economy
with rigidities in its price structure. It is impossible to analyze such
an inflation by looking only at aggregate data.
5. During the 1955-57 period the overall growth of monetary de
mand was not excessive. But there was a strong investment boom,
offset by declining sales of automobiles and houses. This rapid shift
in the composition of demand led to a general price rise, in which the
capital goods industries played the major role.
6. If the rise in prices was not a result of an overall excess of mone
tary demand, neither was it primarily caused by an autonomous up
ward push of wage rates. There are many indications of this. For
example, the capital goods and associated industries accounted for
two-thirds of the rise in industrial prices during the period, but in
these same industries prices rose substantially more than wage costs.
Profits per unit of output rose in the capital goods industries, although
for the economy as a whole they declined.
7. The largest part of the rise in total costs between 1955 and 1957
was accounted for not by the increase in wage costs but by the increase
in salary and other overhead costs. This increase in turn was asso
ciated with the investment boom. Business firms purchased large
amounts of new equipment, hired extensive professional, technical,
sales, and clerical staffs, and speeded up research and development
projects. When output did not rise producers attempted to recap
ture at least some of these increased costs in higher prices. This
“ premature” recapture of fixed costs further accentuated the magni
tude of the general price rise.
8. Overhead costs have been increasing as a proportion of total costs
throughout the postwar period. This has intensified the downward
rigidities in the cost structure of most industries.
9. These downward rigidities in prices and costs put a new floor
under each successively higher price level and thus help create a long
term upward bias in prices.
10. While there is a secular upward drift to the price level, its mag
nitude is not to be judged by the size of the price increases during the
1955-57 period. These years were characterized by an abnormally
large shift in the composition of demand and a particular combination
of events which led to an abrupt rise in overhead costs.
11. Since it does not stem primarily from aggregate excess demand,
but largely from excess demand m particular sectors of the economy,
a slow increase in prices cannot be controlled by general monetary and
fiscal policy if full employment is to be maintained. When, as in
recent years, prices are rising during a period of growing excess capac
ity, a further restriction of aggregate demand is more likely to raise
costs by reducing productivity than it is to lower costs by reducing
wages and profit margins.
12. Monetary and fiscal policies which are directed specifically
toward the sectors where demand is excessive, may, however, limit
the inflationary effect of a rapid shift in the composition of demand.
Between 1955 and 1957 a slower growth in investment demand, cou
pled with a more even rise in purchases of autos and housing would
have resulted in a smaller price increase and a larger output gain.

RECENT INFLATION IN TH E UNITED STATES

13.
The whole subject of selective tax and credit controls is beyond
the scope of this study. Their application involves economic and
social problems of substantial magnitude. This study does indicate
that counter inflationary policy must be designed to take into account
the composition as well as the magnitude of excess demand. By using
monetary and fiscal policy to prevent excess aggregate demand from
emerging, one type of inflation— and that, the most harmful type—
can be controlled. Even should aggregate demand rise no more
rapidly than the supply potential of the economy, however, inflation
can still take place if the composition of demand changes sharply.
Faced with this situation we can attempt to alter the composition of
demand by using selective controls or we can accept the moderate
price increases which will otherwise occur. In either event, the prob
lem cannot be solved by a further repression of demand through gen
eral monetary and fiscal policy.
Public policy statements in recent years have emphasized that wagerate gains must stay within the bounds of productivity advances if
inflation is to be avoided. This study on the other hand stresses the
importance for price stability of the responsiveness of wages and
prices to changes in demand. There is no single formula which can
specify the appropriate relationship between changes in productivity, prices, and costs in particular industries. In a flexible economy
individual wage-price-productivity relationships should reflect the
strength of demands in each industry. If businessmen and labor lead
ers would become more demand conscious and less cost conscious, the
overall wage-productivity relationship would take care of itself, so
long as intelligent monetary and fiscal policies were pursued. Hence,
if one must preach to business and labor about their obligations to the
“ public interest,” the emphasis should lie on the need to orient price
and wage decisions more closely to market conditions. The continual
invocation of the phrase “ wage rate gains on the average should not
exceed productivity gains on the aveiage” is not sufficient to enable
management and labor in an individual business to determine the
kind of price and wage behaviour on their part needed to achieve a
greater stability of the price level in a full employment economy.

CHAPTER 1
GENERAL SUMMARY
T

urrent

ontroversy:

em a n d -P ull

v e r su s C

ost-P u sh

The purpose of this study is to examine the nature of the gradual
inflation to which the American economy has been subject in recent
years. There is relatively little controversy over the basic features
of a wartime or reconversion inflation; rising prices are attributed
to an increase in the effective demand for goods and services over
and above the capacity of the economy to furnish them. There is
wide disagreement, however, about the nature of and remedies for
the more gradual rise in prices which has occurred during the postwar
period. Most of the discussion has centered on the merits of the
“ cost-push” versus the “ demand-pull” theories of inflation. Pro
ponents of the cost-push thesis attribute the major blame for the price
increases, particularly those of the 1955-57 period, to autonomous
upward movements in either wage rates or administered prices or
both. The demand-pull theorists on the other hand, assert that price
increases currently, as always, are the reflection of aggregate excess
demand for goods and services, including the services of the factors
of production.
We have been and shall be using the concept of excess demand
throughout this study in a dynamic sense. In an economy character
ized by steadily improving technology and substantial net investment,
the supply of goods and services forthcoming at full employment is
continually growing. Hence an absolutely stable demand could only
be consistent with full employment if prices declined. Excess aggre
gate demand, in a dynamic context, only exists, therefore, when mone
tary demands for goods and services are rising faster than the constant
dollar value of supplies of goods and services at full employment. The
degree of excess demand will, of course, be influenced by the composi
tion of the aggregate: an increased output in some industries can more
easily be supplied than in others. Moreover, as chapter 4 points out,
we can have a situation in which output is below its potential even
though the labor force is fully employed. If, for example, there is
large-scale hiring of salaried employees, those employees may be re
tained even when output does not rise as expected— we have under
employment. But these refinements aside, the essential point to
remember is that the term “ excess aggregate demand” is used through
out in the context of a growing full employment supply.
In analyzing the process by which price increases are generated
there are two major sets of factors to be considered:
1. The impact of rising prices and wages on aggregate demand
for goods and services.
2. The impact of changes in the demand for goods and for
factors of production on prices and wage rates. Put more simply,
how does the growth of excess capacity and unemployment affect
prices and wages?
4

RECENT INFLATION IN TH E UNITED STATES

Prices and wages have a dual nature when considered in the aggre
gate: they are costs to buyers and incomes to sellers. Thus an increase
in the general level of prices does not automatically mean a reduction in
the quantity of goods and services demanded as it normally would in
the case of a single commodity. The increased cost of purchasing any
article or any factor of production is matched by the higher incomes re
ceived by the seller. So long as the increase in prices is accompanied
by an equal increase in money expenditures, real purchases of goods
and services will not be affected and employment will not be reduced.
There are, however, indirect influences on the level of real demand ex
erted by a rising price level. If the tax system is progressive, the
higher money incomes lead to a higher proportion of income taken in
taxes. With a constant money supply, higher prices normally lead to
a tighter money market, which in turn has some depressing influence
on investment demand. If these and other indirect effects are im
portant, their depressing influence on demand must continually be
offset by demand increases from other sources, if the rising price level
is not to result in rapidly growing unemployment. If, on the other
hand, these indirect effects are relatively unimportant, then a rising
price level will not bring about excess capacity and unemployment, or
at least will do so only very slowly.
If prices and wages are sensitive to changes in demand, then no
inflation can continue unless aggregate excess demand is constantly
being renewed. The appearance of unemployment and excess
capacity would quickly halt any price rise. Consequently the strength
of the indirect influences discussed above determines how large an
inflation will result from a given initial excess demand. There can
be no inflation without the excess demand, however. Hence monetary
and fiscal policy, appropriately handled, can achieve full employment
and price stability; all that needs to be done is to prevent the excess
demand, without which wages and prices would cease to rise. If, on
the other hand wages and prices are relatively insensitive to changes
in demand, then the indirect influences of the price level on aggregate
demand will determine not how large the price rise will be but how
much unemployment it will generate. For if prices and wages do not
respond to growing excess capacity and unemployment, then the
limitation of aggregate demand will not halt the inflation—it will only
lead to unemployment.
The responsiveness of prices and wages to changes in demand is thus
the central issue. Let us call prices and wages which are sensitive to
changes in demand “ flexible” and those which do not respond to
demand, “ cost-determined.” The latter category includes both those
cases in which prices and wages adjust solely to changes in costs 1
and those in which there occur autonomous increases in prices and
wages. We can distinguish four types of situations, depending on
the nature of price and wage behaviour and the impact of rising prices
and wages on demand.
I.
Eising prices and wages tend to reduce demand and em
ployment:
1. Prices and wages flexible.
2. Prices and wages cost-determined.

i Changes in consumer prices are equivalent to changes in costs for the purpose of wage determination.

RECENT INFLATION IN TH E UNITED

STATES

II.
Rising prices and wages do not tend to reduce demand and
employment:
1. Prices and wages flexible.
2. Prices and wages cost-determined.
So long as prices and wages are cost-determined, then a cost-push
inflation is possible, regardless of whether case I or case II holds.
If the indirect effects of a cost-push inflation are relatively weak, so
that real aggregate demand is not reduced (case I I ), then the inflation
is self-validating— a cost-push inflation will not, of itself, lead to un
employment. If the indirect effects of rising prices and wages on ag
gregate demand are significant (case I), then unemployment and excess
capacity will result. But since prices and wages are not flexible, the
inflation will continue. In this situation, the maintenance of full
employment requires a positive Government monetary and fiscal policy
to provide the validating demand. In either situation the failure of
aggregate demand to keep pace with a growing full employment out
put would not eliminate the inflation, so long as price and wage de
cision making does not respond to demand conditions.
If, on the other hand, prices and wages vary in response to changes
in demand as well as costs, then the failure of demand to match full
employment supply will quickly bring an inflation to a halt. The
effect of rising prices and wages on aggregate demand determines how
much of an inflation will result from a given initial excess demand.
If a general price and wage rise leads to a large reduction in demand,
then the economic system has a built-in self-correction factor. The
Government need only exercise self-restraint; so long as excessive
deficits and money supply increases are avoided, inflation is not a
serious problem. If, on the other hand, the self-corrective influence
of a rising price level is weak, then positive government counterinflationary policy may be a recurrent necessity. In either event, the
flexibility of prices and wages implies that full employment can be
maintained without price inflation. If prices and wages start to rise,
a restriction of aggregate demand will lead to a cessation of price and
wage gains rather than a growth in unemployment.
The controversy between the demand-pull and cost-push theorists
is in reality, therefore, a debate about the consistency of full employ
ment and price stability.
Given an appropriate monetary-fiscal policy, the answer to the question whether
we can continue to enjoy a large, growing, and reasonably stable volume of
production and employment * * * lies in the relations of prices, costs, and
profits.2

D o labor unions and monopolistic firms largely disregard the state of
the market in setting prices and wages? Are prices marked up as
costs rise with little regard for demand conditions? Does a rise in
the cost of living lead to an equivalent wage increase even in periods
of unemployment? Few would take an extreme position on these
questions. There is rather a spectrum of opinion. Toward the one
end of the spectrum are those who feel that prices and wages do
respond rather quickly to changes in demand. The possibility that
strongly organized groups can push up their cost prices in the absence of
ex ante excess aggregate demand is not “ an empirically important
possibility,” 3 according to these demand-pull theorists. Further,
2 Edward Mason, “Essays in Honor of John H. Williams,” p. 189.
3 Milton Friedman, in “The Impact of the Union,” edited by D. M. Wright, p. 244.

RECENT INFLATION IN TH E UNITED STATES

according to this theoretical approach, the existence of inflation implies
that the excess demand must be an aggregate excess. If prices and
wages are responsive to demand conditions, excess demands in par
ticular areas of the economy, balanced by deficient demands in other
sectors, will merely lead to a realinement of relative prices. Only if
demands in the aggregate are too high will the general level of prices
rise.
Toward the other end of the spectrum are those who feel that prices
and wages are, within a substantial range, set independently of de
mand conditions. No one would deny that there is some level of
unemployment and excess capacity which would halt a price-wage
spiral. But the cost-push theorists feel that the degree of unemploy
ment and excess capacity required to break through the cost-deter
mined nature of wages and prices is quite large. The power of big
business and big labor to determine prices and wages is so great, that
under conditions of relatively full employment, even without excess
demand, a secular rise in the price level is unavoidable.
The validity of either approach in this controversy cannot be dis
covered from the historical relationship of a few large aggregates.
The fact that in recent years wages have risen faster than productivity,
for example, is often cited as evidence that we have been experiencing
a cost-push inflation. But this relationship tells us absolutely nothing
about the nature of inflation. In the purest sort of demand-pufl
inflation, wages would also rise more rapidly than productivity. By
the same sort of “reasoning” we could cite the fact than money ex
penditures rose more rapidly than output as a proof of demand-pull
inflation. An equally strong condemnation applies to demonstrations
which point to the rise in the money supply or its velocity as proof
of the demand-pull nature of inflation.
Even the timing of wage and price increases cannot be offered, by
itself, as evidence of the nature of the inflationary process. Suppose,
for example, that prices are marked up mainly in response to rising
wages. Then an excess demand inflation will first lead to a rise in
wage rates through its impact on the labor market, and only there
after in a price rise. The historical data would indicate that the
increase in wages preceded the rise in prices, yet the inflation would
be one which was initiated by excess demands.
A cost-push inflation need not arise solely from an autonomous
upward push of administered wages or prices. If prices are set by
applying a constant margin to costs, and if wages are determined by
movements in the level of consumer prices, then an initial general
price rise, stemming from any source, can perpetuate itself, as wages
and prices successively adjust upward to each other. The greater
the insensitivity of the price and wage “ markups” over cost to unem
ployment or excess capacity, the greater the inflationary possibilities.
The shorter the lag between the mutual adjustment of prices to wages
and wages to prices, the faster the inflation will proceed.
The response of prices and wages to changes in demand cannot, in
reality, be forced into the simple categories of “ flexible” and “ costdetermined.” The most important fact about their behavior, for the
purpose of analyzing creeping inflation, is its asymmetry. Prices and
wages tend to be more flexible upward in response to increases in
demand than they are in a downward direction in response to decreases
in demand. As a consequence, the composition of demand as well as
44975— 59------2

RECENT INFLATION IN TH E UNITED

STATES

its aggregate magnitude, takes on a central role in the generation of
inflation. The further development of this point is one of the major
features of the present study.
T

ature

the

ecent

I n f l a t io n

An examination of recent economic history suggests that creeping
inflation is not a phenomenon which can be dealt with in aggregate
terms. In particular the price increases from 1955 to 1957 stemmed,
in the main, neither from autonomous upward “ pushes” of adminis
tered prices or wages nor from the existence of an aggregate excess
demand. Neither of these explanations can satisfactorily account for
a number of apparent paradoxes during this period: The dissipation
of a relatively modest 5 percent per annum rise in money expenditures
in a 3K percent price rise and only 1% percent output gain; the ap
parent correlation of price increases with demand increases industry
by industry, but with an upward bias, so that the overall level of prices
rose while the overall level of demand was not excessive; the fact
that prices rose more rapidly than unit wage costs, while at the same
time net profit margins were shrinking; and finally the high level of
investment activity followed by disappointing gains in productivity
and consequent increases in unit costs.
The th oretical and empirical analysis of the economic processes
which lead to creeping inflation is not easily summarized. It is not
a relatively simple matter which can be condensed into a short formula,
like the popular “ too much money chasing too few goods.” Nor is
it a “ devil” theory in which abound the villains of most cost-push
theories— the union boss and the greedy monopolist. We shall at
tempt in the remainder of this chapter however, to sketch the char
acteristics of economic behavior which lead to creeping inflation and
indicate briefly the application of the analysis to the 1955-57 period.
The importance of the composition of demands

Prices and wages in the modern American economy are generally
flexible upward in response to excess demand, but they tend to be
rigid downward. There is, as we noted earlier, an asymmetry in their
behavior. Even if demands in the aggregate are not excessive, a
situation of excess demand in some sectors of the economy balanced
by deficient demand in other sectors will still lead to a rise in the
general level of prices. The rise in prices in markets characterized
by excess demand will not be balanced by falling prices in other
markets.
Excess demand in particular industries transmits its impact to the
rest of the economy through its influence on the prices of materials
and the wages of labor. Crude materials prices are normally quite
sensitive to changes in demand, and are unlikely to rise significantly
unless demands for them in the aggregate are excessive. Prices of
intermediate materials supplies and components, on the other hand,
are more likely to be rigid downward, but flexible upward in response
to an increase in demand or costs. Prices of those materials chiefly
consumed by industries with excess demand rise, since excess demand
for the final goods usually implies excess demand for specialized
materials. Materials used mainly in industries with deficient demand
will not fall in price, unless the demand deficiency is quite large.
Thus excess demand in particular sectors of the economy will result

RECENT INFLATION IN TH E UNITED STATES

in a general rise in the prices of intermediate materials, supplies, and
components; industries which are not experiencing excess demands
will find themselves confronted with rising materials costs.
Wages will also be bid up in excess demand industries. Wages in
other industries will tend to follow. Even though demand for labor
is not excessive, firms cannot allow the wage differential between them
selves and other firms to get too large; this is not because they fear
the wholesale desertion of their work force, but because they do not
wish to experience the inefficiencies and lowered productivity which
result from dissatisfaction over widening differentials. Rising wage
rates, originating in the excess demand sectors thus spread throughout
the economy. Because productivity gains in the short run are greatest
where demand and output are increasing, firms in those sectors where
demand is rising slower than capacity will often be faced with even
larger increases in unit wage costs than firms in the areas of excess
demand. In some cases the size of wage increases will be determined
by long-term contracts concluded in earlier periods. Except as such
increases are modified by changes in the cost of living (through
escalator clauses) they will have little relationship to the current
state of the market.
The spread of wage increases from excess demand sectors to other
parts of the economy accentuates the rise in the price of semifabricated
materials and components. Thus the influence of rising costs and
the resistance of prices to declining demands will be larger at the later
stages of the production process, other things being equal. The
opportunities for rigidities to build up and for rising costs, particu
larly labor costs, to affect prices are multiplied as products approach
the finished state.
Producers of finished goods will be confronted with a general rise
in the level of costs, even when the demand for their products and
their own demands for materials and labor are not excessive. The
more cost determined are the pricing policies of the industries involved,
the greater will be the price rise. In competitive sectors of the
economy the rising costs will be at least partly absorbed. But in
very many industries they will be more fully passed on in higher
prices. Markups will of course be shaded when excess capacity begins
to rise. As inflationary pressures spread out from excess demand
sectors, their force will be somewhat damped in the absence of excess
aggregate demand. Similarly the tendency of wages to follow the
pattern set in the rapidly expanding industries will be modified as
unemployment rises. But so long as markups and wages are more
sensitive in an upward than in a downward direction, a rise in the
general level of prices can be initiated by excess demand in particular
industries.
This kind of inflationary process cannot be neatly labeled. It arises
initially out of excess demand in particular industries. But it results
in a general price rise only because of the downward rigidities and cost
oriented nature of prices and wages. It is not characterized by an
autonomous upward push of costs nor by an aggregate excess demand.
Indeed its basic nature is that it cannot be understood in terms of
aggregates alone. Such inflation is the necessary result of sharp
changes in the composition of demand, given the structure of prices
and wages in our economy.

RECENT INFLATION IN TH E UNITED STATES

The downward rigidities and cost-oriented nature of prices and
wages act like a ratchet on the price level. Most maladjustments of
prices relative to each other and of prices relative to wages tend to be
corrected by upward movements in the out-of-line prices or wages
rather than by a mutual adjustment to a common center. The short
run inflationary mechanism which we have been describing thus im
parts a longrun secular bias to the price level. A floor is placed under
each higher level, from which later increases take off. During earlier
periods in our history, the recurrence of substantial and lengthy de
pressions broke through these rigidities and forced large declines in
the levels of prices and wages. The widespread bankruptcies and
reorganizations of depression periods also led to massive writedowns
in the value of fixed assets. This removed an additional feature of
the ratchet mechanism. Moreover, a much larger proportion of total
value produced originated in the demand sensitive raw materials in
dustries— particularly agriculture. Even if rigidities in the industrial
sector were as great then as now, they played a smaller role in the
overall economy.
Overhead costs

A second major factor influencing the determination of prices and
the movement in the general price level in recent years has been the
rapid growth in the proportion of overhead or fixed costs in total costs.
This development played a particularly important role in the 1955-57
period.
Between 1947 and 1955 a very large part of the rise in total costs was
accounted for by the rise in relatively fixed costs. Of the total increase
in employment during those years, 65 percent represented employ
ment of professional, managerial, clerical, sales, and similar personnel.
Only 20 percent of the increase was accounted for by operatives,
laborers, and craftsmen. In manufacturing, nonproduction worker
employment rose 40 percent and production worker employment only
2 percent. During this same period fixed capital costs per unit in
creased very rapidly. Prices of capital goods rose relative to other
prices, and the proportion of short-lived equipment to long-lived plant
rose sharply. Depreciation charges thus expanded very substantially.
Depreciation and salary costs per unit, taken together accounted for
more than 40 percent of the increase in total unit costs in manufactur
ing between 1947 and 1955. Adding profits per unit we account for
two-thirds of the cost increase.

T able

1 -1 .— Changes in manufacturing costs and prices

[In percent points]
1947-55
“Price” of value added in manufacturing________________________
Unit wage cost___________________________________________________
Unit salary cost__________________________________________________
Depreciation per unit_____________________________________________
Profits per unit__________________________________________________
Indirect taxes per unit_____________________________________________

29.8
9.0
7.7
4.2
7.2
1.6

Source: App. A. (The derivation of all tables and charts will be found in this appendix.)

1955-57
9.6
3.9
5.6
1.0
-2.2
1.3

RECENT INFLATION IN TH E UNITED STATES

The period between 1955 and 1957 was characterized by a very
sharp rise in investment outlays accompanied by a quite modest
growth in aggregate demand and output. Not only was capacity
expanded rapidly but there was a continuation, indeed an acceleration,
of the postwar growth in the number of overhead employees. Unlike
earlier postwar booms however, the expansion in these relatively fixed
inputs was not matched by a corresponding rise in output (table 1-2).
Fixed costs per unit of output therefore rose sharply, not because
output was falling but because it did not rise rapidly enough. Prices
were raised almost, but not quite enough to cover these higher costs.
Of the total rise in unit costs (including profit margins) some 55 percent
was accounted for by higher salary costs per unit as compared to
40 percent by higher wage costs. Book depreciation charges are
unreliable for most purposes; nevertheless, in combination with other
costs, they put pressure on profit margins and to some extent on prices.

T able 1-2.— Indexes of capacity, employment, and output in manufacturing industries
[1947=100]
1955
Capacity:
A 1........- ................................. — .......................... ......... .........................
B 2__________ ___________________________ — ................................
Nonproduction worker employment_________________________________
Production worker man-hours______________________________________
Output_________________________________________________________

1957
156
146
140
103
140

175
163
155
100
145

1A—McGraw-Hill Department of Economics estimates.
2 B—Fortune magazine estimates. (See app. A.)
The fact that a large part of the increased employment during the
period was in the nature of overhead employment helps explain why
the general price rise, during a period in which monetary demands
were not excessive, did not lead to significant unemployment. By
the same token the lack of rise in output relative to fixed inputs
accounts for the disappointing gain in productivity. The rise in
prices was accompanied by a relatively moderate increase in money
expenditures. Real expenditures and output rose by substantially
less than the “ normal” postwar rise to be expected from growth in
the labor force and productivity gain. Yes instead of a rise in unem
ployment, there occurred a shortfall of productivity below its poten
tial. Output per production worker man-hour continued to increase
fairly sharply throughout the period— indeed production worker
employment declined. But the failure of output to match the rise in
overhead labor input substantially moderated the overall gain in
productivity. In general, the more important fixed costs become,
the more sensitive productivity will be to changes in output.
The failure of output to rise toward the levels implicit in the expan
sion of fixed inputs was partly due to the fact that declining demand
in particular sectors of the economy—housing and automobiles—
largely offset the rising demands for investment goods. But in addi
tion the attempt to recapture in prices a substantial expansion in
fixed costs at existing levels of output tended to raise the level of
prices relative to any given money income; the gross saving rate at

RECENT INFLATION IN THE UNITED STATES

any given level of output was increased. This in itself damped the
rise in output, so that the process tended to be self-defeating. Had
output risen along with capacity, overhead costs would have been
spread over a larger volume of output. But, by restricting the growth
in real demand, the very pricing policies which attempted to recover
fixed costs at low levels of output, led to a rise in fixed costs per unit.
To some extent a kind of “ vicious circle” occurred. The failure of
aggregate output to increase raised fixed costs per unit. Insofar as
prices were marked up relative to wage and salary rates in order to
recover these higher unit costs, the forces impeding the growth in
output were strengthened. This kept fixed unit costs high, and so on
around the circle again.
The major part of the general rise in prices during recent years
may thus be attributed to two sets of factors:
1. The downward rigidity and cost oriented nature of prices
and wages in most of industry. During a period in which
dynamically stable aggregate demand veils a fairly violent shift
in the composition of demands, such market characteristics will
result in a general rise in the level of prices. This rise cannot
be said to result either from excess aggregate demand or from
autonomous upward adjustments of administered prices and
union wages. Rather it stems from excess demand in par
ticular markets, and is propagated throughout the rest of the
economy by a cost mechanism.
2. The attempt to recapture in prices at least some of the
increase in fixed unit costs which occurred when a vigorous
investment boom and a rapid substitution of fixed for variable
labor input impinged on a situation of sluggish growth in output.
Further, the fact that most of the employment rise was in over
head labor helps explain why the subnormal growth in output
did not involve a rise in unemployment. It did however lead to
the growth of excess capacity.
None of the foregoing is designed to indicate that all inflations are
mainly the result of these processes. Excess aggregate demand has
been the basic cause of all of our major inflations, including the post
war reconversion inflation. And for a short while in late 1955 there
seemed to be some excess aggregate demand. But the major thesis
of this study is that the creeping inflation of 1955-57 is different in
kind from such classical inflations, and that mild inflation may be
expected in a dynamic economy whenever there occur rapid shifts in
the mix of final demands. It is, in effect, a feature of the dynamics
of resource adjustment where prices and wages tend to be rigid down
ward. Moreover, it gives a secular upward bias to the price level so
long as the major depressions which “ broke” the ratchet in the past
are avoided in the future.
Similarly there is no attempt here to prove that autonomous upward
pressures of wage rates have had no impact on the price structure.
Such pressures may have played a role in recent inflation. But the
role was not a major one. The mere showing that wage rate increases
exceeded productivity gains proves anything at all with respect to the
magnitude of this role. (It is interesting to note, however, that the
substitution of overhead for direct labor implies that wage rates can
not rise as fast as the statistical number called output per production
worker if total unit costs are to be stable.)

RECENT INFLATION IN T H E UNITED STATES
A

e t a il e d

n a l y s is

the

1955-57

P e r io d

The reader is referred to chapter 5 for the detailed examination of
the 1955-57 period. In this summary it is impossible to do more than
list some of the more important characteristics of the general rise in
prices which occurred during those years.
Demands and prices

1. As the economy recovered from the 1954 recession it reached a
situation of aggregate excess demand in late 1955. Demands in all
sectors of the economy were high and rising. The three major
volatile sectors— capital goods, automobiles, and housing— were ex
panding particularly sharply. Production rose even more rapidly
than sales, as inventory accumulation speeded up. Raw materials
prices, which are especially sensitive to the state of existing and
expected demand, rose steeply during the last half of the year. This
aggregate excess lasted only briefly however. After the end of the
year purchases of automobiles and houses fell rapidly, and remained
at reduced levels in 1956 and 1957. Business demand for capital
goods, on the other hand, continued to boom throughout the period.
2. On balance aggregate money outlays, after mid-1955, rose at a
rate of about 5 percent per year. Prices rose at a 3K percent annual
rate and output by only 1% percent. The normal postwar rate of
growth in output during prosperity periods has been about 4 percent
per year.
3. The slow rate of growth in output and productivity cannot be
explained by the “ indigestion” hypothesis— (i.e., the very size of the
investment boom itself caused such dislocations that normal pro
ductivity gains were temporarily impossible). Output per man-hour
of production workers did rise significantly; producers were able to
substitute overhead for fixed labor; most importantly there was a
strong interindustry correlation between output and output per
man-hour. Those industries whose output rose also achieved sub
stantial productivity gains.
4. Thus the difference between the rise in aggregate money expend
itures and output did not represent aggregate excess demand. The
output rise was clearly less than the economy’s potential. The growth
of widespread excess capacity is a good commonsense indicator of this.
5. The magnitude of price rises among different sectors of the
economy and among different industries was associated with the
magnitude of the rise in demand in each sector or industry. On the
average, however, prices rose, even though demand, in the aggregate,
was not excessive. There was, in other words, a substantial upward
bias in the relationship of price changes to demand changes.
6. The magnitude of price rises among industrial commodities was
related to two major factors: In general, commodities which experi
enced the largest price rises were those which had the largest increases
in demand. With some important exceptions, most commodities
with large price rises were those associated with the boom in capital
goods. The frequency of price declines and the magnitude of average
price increases among different groups of commodities differed also
according to the stage of fabrication. Very few finished commodities
were reduced in price; price increases were, on the average, somewhat
smaller and the evidence of price flexibility slightly greater for semi

RECENT INFLATION IN TH E UNITED

STATES

manufactured materials; the smallest average price rise, after late
1955, and the most flexibility occurred among crude materials.
7.
Steel and automobiles were the major exceptions to the pattern
described in the preceding paragraph. Relative to the change in
demand and output price increases were much larger than those
associated with similar changes in demand and output in other
industries.
Wages

1. Wage rate increases were fairly uniform among different indus
tries. Wages in industries with stable or declining output rose by the
same amount as they did in rapidly expanding industries. A United
Nations study has found this uniformity of behavior to exist among
industrial countries generally.
2. Productivity gains were closely associated with the degree of
rise in output. Industries with rising output tended to have larger
productivity gains than other industries, and vice versa.
3. As a consequence of these characteristics of wage and produc
tivity behavior, wage costs per unit of output rose less in expanding
than in contracting industries.
4. Price increases in the capital goods and associated industries
accounted for two-thirds of the rise in the industrial wholesale price
index between 1955 and 1957. Their prices rose 15 percent compared
with an average increase of 4 percent for all other industries. Yet
wage rate increases in the two groups were almost identical. Because
of the relationship between productivity and output mentioned above,
unit wage costs in the industries with large price increases averaged
less than in other industries. Prices in industries which accounted
for the bulk of the overall inflation also rose substantially more than
wage costs. In other industries unit wage costs rose proportionately
(but not absolutely) more than prices.
Overhead costs

1. All of the employment rise during the period was in overhead
type employment. In fact the employment of direct labor fell
substantially.
2. More than 50 percent of the rise in total units costs in manu
facturing was accounted for by rising unit salary costs, and an addi
tional 20 percent by rising depreciation. Net profit margins declined
from the high levels reached in late 1955.
3. The rise in salary costs per unit was not only due to an increase
in salary rates— which rose by about the same amount as wage rates—
but also by the rising ratio of salaried employment to output. The
increase in this ratio stemmed chiefly from the failure of output to
rise along with capacity. Had it done so, evidence from other postwar
years indicates that the salaried employment-output ratio would not
have increased.
4. Since productivity of both direct and overhead labor is output
sensitive, it is clear that, within moderate limits, a further rise in out
put could have resulted in lower unit costs. The data suggest an
elasticity of minus one-half; i.e., a 1 percent further rise in output in
industries operating below capacity could have yielded a one-halfpercent decline in total unit costs.4
* This assumes that the additional demand for production labor would not have led to even more rapid
wage increases. Considering the reductions in production worker employment during the period, this is a
most reasonable assumption.

RECENT INFLATION IN TH E UNITED STATES

Consumer prices

1. In the Consumer Price Index, food, nonfood commodities, and
services each account for approximately one-third of the total weight.
Even among nonfood commodities manufacturers’ prices make up not
much more than half of the total price, the rest being transportation,
wholesaling, and retailing costs. The service component of the CPI is
made up of a long list of heterogeneous items, including such things as
auto, real estate, and medical insurance, public utility rates, haircuts,
postage, and interest rates. Thus it would seem that the direct impact
of changes in industrial prices and wages on the Consumer Price Index
is relatively limited. Yet an increase in the prices of manufactured
products diffuses itself throughout the economy by many indirect
routes. Steel prices rise, school construction costs go up, and prop
erty tax rates are adjusted upwards; an initial rise in the CPI on ac
count of an increase in industrial prices leads, with some time lag, to
rising wages in the service industries and e.g., auto-repair charges rise;
and the examples could be multiplied ad infinitum.
2. About one-third of the rise in the Consumer Price Index was
contributed by increasing food prices. In turn, half of the rise in
food prices was attributable to rising farm prices for livestock and
half to increased marketing costs. The livestock rise chiefly reflected
changing supply conditions. But an examination of the details of the
increase in marketing costs shows that the same factors were operative
as in the industrial sector generally.
3. The heterogeneity and institutional character of service prices
make any simple characterization suspect. The rise in consumer
prices generated in other sectors of the economy, and the general rise
in wage rates, however, did lead after some time lag to a significant
speedup in the rate of increase in service prices after mid-1956. And
the rise in service prices in turn had repercussions on the increase in
wages and prices in the industrial sector of the economy.

SOME IMPLICATIONS
Although it may not be obvious at first, this analysis is fairly opti
mistic with respect to its implications for the magnitude of the poten
tial secular upward drift in the price level. In particular the size of
the price increases between 1955 and 1957 are not a good indicator of
the kind of problem which may be confronting us (assuming, of course,
we do not allow classical excess aggregate demand inflation to get
started).
The magnitude of the shifts in demands between mid-1955 and mid1957 were unusually great, even for a dynamic economy. We should
not be continually subject, for example, to a 2-year increase in expend
itures for fixed business investment of some 25 percent (and a much
larger rise in order backlogs) accompanied by 20 percent decline in
residential construction and automobile sales.
The upward price pressure arising out of attempts to recapture
fixed costs at reduced “ standard volume” is not a continuing phe
nomena. It is unlikely, indeed impossible, for the average operating
rate at which entrepreneurs attempt to recapture fixed costs to fall
indefinitely. Indeed the very size of the current ex ante profit margin,
at full utilization of capacity, which resulted from this reduction in
standard volume should become a moderating factor, offsetting price

RECENT INFLATION IN TH E UNITED

STATES

pressures from other sources as output rises toward full utilization of
capacity.
This study does not attempt to evaluate the policy aspects of creep
ing inflation. It does, however, lead to certain general conclusions
which are relevant in the formulation of antiinflationary policy.
In the first place it is quite obvious that monetary and fiscal policies
designed to combat an inflation arising out of excess aggregate demand
are not suitable to a situation in which demand in the aggregate is not
excessive. When, as in recent years, a rise in the general level of
prices accompanies a growth in excess capacity, further restriction of
the general level of demand may be positively harmful. Since produc
tivity is sensitive to changes in output when output is running below
capacity, a general reduction in demand is more likely to raise unit
costs by its effects on productivity than to lower them by its effects on
wage rates. This will be particularly true if the restriction of aggre
gate demand continues to leave the booming sectors of the economy
relatively unaffected.
Monetary and fiscal policies which do not restrain aggregate de
mand, but impinge only on the sectors where demand is excessive may
indeed limit the inflationary forces during a period of creeping infla
tion. Had investment demand risen more slowly between 1955 and
1957, and automobile and housing demand more evenly, we would
have experienced a larger rise in aggregate output and a smaller rise
in prices. The question of selective tax and credit controls is far too
broad to be discussed here; their application involves a host of eco
nomic and social questions which cannot be casually answered. At
the same time however, our analysis does indicate that counterinflationary monetary and fiscal policies must take into account the
composition as well as the magnitude of demand. The use of mone
tary and fiscal policy to prevent the emergence of aggregate excess
demand can prevent one type of inflation— indeed the most harmful
type. But inflation can still arise in a situation of dynamically stable
aggregate demand. Under these circumstances we can either attempt
to alter the composition of demand by using selective monetary and
fiscal policy or we can accept the moderate price increases which
take place. This is our choice. We cannot solve the problem, indeed
we shall do positive harm, by a further restriction of aggregate demand
through general monetary and fiscal restraint.
There is one final implication of this analysis. The moderate infla
tion of recent years was part of the process of resource allocation.
Simply because it is called inflation, one cannot attribute to it the dire
consequences associated with classical hyperinflation. It does indeed
benefit some individuals and harm others—like many other aspects of
the resource allocation process. In fact it is, in part, a reflection of
the attempt by individuals and groups in society to ease the adjust
ments in relative incomes which result from a shift in the composition
of demand. Such an inflation probably disturbs the social structure
less than do the rapid changes in technology, the shift of income
between industries, and the movement of industries from one region to
the other, which we take to be the marks of a dynamic economy.

CHAPTER 2

PREVAILING THEORIES OF THE INFLATIONARY PROCESS
I ntroductory R

em arks

In some senses the present chapter represents a lengthy detour
from the main stream of analysis. A characteristic feature of almost
all current discussion about inflation is its tendency to deal in aggre
gates, whereas one of the main features of this study is its insistence
that creeping inflation can only be understood when one goes beneath
the aggregates. Yet it is necessary to lay this aspect aside for the
moment and examine closely the differences and similarities between
the two prevailing approaches to inflation— “ demand-pull” and
“ cost-push.” Because demand influences costs while conversely,
changes in costs are a determinant of the state of monetary demand,
and because these cross effects are simultaneous in their operation,
the disentangling of the basic factors in the inflationary process is
most complicated. Historical data do not allow the easy separation
of these mutually determining factors. As a result much faulty
analysis has been constructed, using simple historical time series to
demonstrate the overriding importance of costs or of demands,
whereas, in fact, such data in themselves disclose the primacy neither
of the one nor of the other. In order to evaluate the factual evidence,
we shall have to lay the groundwork by carefully distinguishing the
basic meaning of the concepts, cost-push and demand-pull. Indeed,
we must ask whether, in the light of the mutual interaction of costs and
demands, such a distinction has merit. Granted that the difference
between the two is meaningful, in what does that difference really
consist; what assumptions with respect to economic behavior charac
terize each of the two approaches to the analysis of inflation? What
kind of data is, and what kind is not, relevant to the support of either
hypothesis? Certain aspects of both hypotheses, considered in a frame
work which stresses the composition as well as the magnitude of
aggregate demand, will prove valuable in analyzing the recent in
flation. As a consequence— this lengthy, and to some readers I fear
tedious, digression.
The current debate

The controversy over the nature and origin of rising prices in recent
years finds the protagonists generally divided into two groups: those
who stress the importance of aggregate excess demand for goods and
services as the casual factor, and those who attribute the price rise to
an independent increase in wage rates or administered prices. The
terms “ demand-pull” and “ cost-push” have generally been applied to
the respective theories. In actuality, however, those contributors to
the controversy who recognize the complexity and interrelationships
which characterize all economic processes bridle at being so neatly
assigned to one of two categories, particularly when the categories are

RECENT INFLATION IN TH E UNITED

STATES

considered as mutually exclusive. In fact, of course, they are not.
Various theories of the inflationary process may preliminarily be
thought of as constituting a spectrum. The place of any particular
theory in that spectrum depends on what it postulates about the like
lihood of significant and sustained increases in prices without the prior
and continuing stimulus of rising demands for commodities and fac
tors of production. The greater the degree of “ independence” one
assigns to price and wage decisions, the closer one is to the “ costpush” end of the spectrum; and, of course, vice versa.
Few, except pamphleteers turned economists and economists trying
their hand at pamphleteering, belong at either extreme of the spec
trum. But without trying to slice the spectrum precisely in half, it
is clear that there are sharp enough differences in the emphasis placed
by the different protagonists on demand and on independently deter
mined costs to allow of useful distinction. Until quite recently most
explanations of inflation emphasized the role of excess demand.
There has, indeed, been a cleavage between those who stress the im
portance of the money supply as a final and fundamental limitation
on demand, and the followers of Lord Keynes who emphasize the
primary role of changes in spending decisions relatively independent
of the money supply. Nevertheless both groups give primacy in the
inflationary process to the existence of excessive monetary demands.
The “ new inflation” school, whose major prophet has been Professor
Slichter, is of more recent vintage. The attribution of price increases
to autonomous upward advances in wages, mainly in union organized
industries, has been put forward as an explanation of the relatively
modest creeping inflation of recent years. This particular variant of
the cost-push thesis was quickly adopted by many" business organiza
tions and by individual businessmen in their speeches and other
public pronouncements.1 The concept of cost-push inflation not only
fits in with the overall philosophy of most business organizations but
it confirms the experience of many' a businessman, who first sees in
flation when it confronts him in the form of higher costs. Even if
those higher costs result from excess demands for factors of production,
the time sequence of his own experience makes a cost-push theory
seem eminently reasonable. Not surprisingly another branch of the
new inflation thesis has been adopted by most union leaders— the
inflation of recent years is blamed mainly on advances in administered
prices not justified by either increased wage costs or increased demand.
Finally, in recent months, two new books by well-known economists
have appeared which purport to show that wage inflation is not
something new—it has been the basic cause of all inflations.2 As
we shall note later on, however, the mere fact that wage increases
are often the primary mechanism in the process of inflation, tells us
nothing about the basic causes operating to produce the inflation.
An excess demand inflation can, and often does operate by causing
the prices of factors of production to be bid up, with commodity prices
being marked up in response thereto.
Unfortunately it is in the very nature of ex post economic data that
on superficial examination they can be called upon to support either

1Although Professor Slichter’s policy conclusion—accept creeping inflation as inevitable and learn to live
with it—has not won an equally hearty response from the same groups.
2 Harold G. Moulton, “Can Inflation Be Controlled?,” Anderson Kramer Associates, 1959. Sidney
Weintraub, “A General Theory of the Price Level, Output, Income Distribution, and Economic Growth,”
Chilton, 1959 (Weintraub’s book had not been published at the time this was written. A summary of its
contents had been released by the publishers however).

RECENT INFLATION IN TH E UNITED STATES

of the two camps. Professor Slichter, for example, has utilized a table
showing, for recent years, the excess of the increase in average hourly
employee compensation over the increase in output per man-hour in
support of his contention that wage increases, in some independent
sense, are the major cause of inflation.3 Indeed he labels this excess
the “ inflationary gap.” But in any sustained general price rise, re
gardless of its basic causes, wage rates will rise more rapidly than pro
ductivity. In the purest sort of excess demand inflation, taking place
in an economy with perfectly competitive labor markets, the demand
for factors of production will become excess—in the sense of demand
exceeding supply at current prices. There is no doubt that had we
but records of the inflation which scourged ancient Rome, we would
find a sharp rise in unit labor costs. One might just as easily “ prove”
the case for excess demand inflation by constructing a similar table
showing that expenditures in money terms rose more rapidly than
real output; whenever the general level of prices rises such a discrep
ancy in rates of increase will show up in the data.
Precisely because any inflation is normally characterized by rising
prices, increasing unit labor costs, and a rise in money expenditures,
the mere demonstration that, ex post, money demands have been
“ excessive,” that either the supply of money or the velocity of its
circulation has risen,4 or that wage increases have outstripped pro
ductivity gains, proves nothing whatsoever about the basic forces
which generated the inflation. Economic processes are, by their very
nature, complicated interactions of many variables. Simple answers
are usually deceptive answers. The principle of Occam’s razor is
often of immense value in excising unnecessarily complicated explana
tions. But like any razor, it can severely wound the user who indis
criminately hacks about with it.
One final introductory remark. Most of the cost-push versus
demand-pull debate is carried on in terms of aggregate measures of
economic activity. In particular, those who attribute the recent
inflation to demand phenomena think solely in terms of excess aggre
gate demand. Indeed, as a general rule, excess demands in specific
sectors of the economy, so long as they are balanced by deficient
demand in other sectors will not give rise to general inflationary
pressures according to current excess demand theories. And for the
cost-push theorists, so long as wage increases, on the average, do not
exceed average productivity gains, general price increases should not
take place. It is one of the major theses of this discussion that creep
ing inflation— and in particular the 1955-57 rise in the general price
level— can only be analyzed by delving beneath the aggregates.
More specifically, a rise in the price level can occur without either a
prior excess aggregate demand or an autonomous upward push of
wages and administered prices. This makes the use of simple ex post
comparisons of aggregate economic data doubly dangerous: because
they are after-the-fact they may simply illustrate tautological iden
tities; and because they are aggregate, they may hide the basic forces
operating during the period. But of this, more anon.

3 Sumner Slichter, “Reconciling Expansion with a Stable Price Level,” in “Problems of United States
Economic Development,” vol. I, Committee for Economic Development, New York, 1958, p. 237.
4 See for example, Richard T. Selden, “Demand-Pull versus Cost-Push Inflation,” Journal of Political
Economy, February 1959.

RECENT INFLATION IN TH E UNITED STATES
C l a s s if ic a t io n

and

is c u s s io n

a r io u s

I n f l a t io n a r y

e c h a n is m s

Differences between existing theories of the inflationary process
hinge, as we noted above, on the postulated behavior of wages and
prices with respect to the influence of changes in demand. Are prices
flexible in the face of changes in demand or are they set mainly by
applying a constant markup to costs; further, are there significant
areas of the economy where the market structure is such as to allow
producers to raise prices without either an increase in cost or an
increase in demand? The same questions may be posed with respect
to changes in wages; in this case, of course, the relevant changes in
“ costs” are changes in the level of consumer prices. The particular
behavior of prices and wages will, of course, differ from industry to
industry. But we may classify the various types of inflationary
processes by what they assume to be the most characteristic descrip
tion of price and wage behavior for the economy as a whole.
Ralph Turvey has classified four types of inflation on this basis.5
Classification of inflations

Type

Prices

A......................................
B.....................................
0 .........................................
D.....................................

Cost determined_________________
Flexible________________________
Cost determined___ _____________
Flexible................................................

Wages
Cost determined.
Cost determined.
Flexible.
Flexible.

The distinction between cost-determined and flexible wages and prices
is not a clear-cut one. In general, flexible wages and prices are those
which behave as the orthodox theory of pricing says they should
behave. They consequently respond to changes in both costs and
demands. If both prices and wages are flexible, however, then any
increase in costs— to which wages and prices do indeed respond—
stems fundamentally from excess demands. Excess demand in turn
may be defined as the excess of the sum which would be spent on
commodities, services, or factors of production if they were in un
limited supply at their current prices over the value of the commod
ities, services, or factors which would be forthcoming at those prices.6
Usually, but not always, a flexible price will decline in the face of
falling demand, despite constant costs. Similarly flexible wages will
fall in periods of unemployment, even if the cost of living remains
unchanged.
For the sake of avoiding too many possible permutations of cate
gories we include under cost-determined prices and wages, two kinds of
behavior. Wage movements can be either “ compensatory” —i.e.
responding to changes in the cost of living, or “ autonomous,” i.e.,
resulting neither from excess demand for labor nor from changes in
the cost of living, but arising out of union bargaining power.7 The
same terminology can be used to classify changes in prices. Both of
these types we shpll call “ cost determined.” The key distinction

5“Some Aspects of the Theory of Inflation in a Closed Economy,” Economic Journal, September 1951.
• A. J. Brown, “The Great Inflation, 1939-1951,” Oxford University Press, 1955, pp. 15-16.
7 These terms are employed in the discussion of European wage movements in the “Economic Survey of
Europe, 1956,” U.N. Economic Commission for Europe, Geneva, 1957.

RECENT INFLATION IN TH E UNITED STATES

between “ flexible” and “ cost determined,” therefore, is that the latter
excludes the influence of demand, the former does not.
Strange as it may appear at first, we can use one basic model to
examine certain aspects of all four types of inflation. Assume, for
example, that prices and wages are generally “ cost determined” —
type A— and that an inflationary process is started, e.g., by an increase
in the Consumer Price Index following upon a rise in farm prices.
If the subsequent increase in prices and wages is not to lead to un
employment, money expenditures must rise along with the rising
prices. Without such an increase in expenditures the rise in the
aggregate supply price would exceed the rise in aggregate demand,
and unemployment and excess capacity would begin to grow.8 In
the case of an excess demand inflation, e.g., type D, the rising unem
ployment of factors of production would halt the inflation. Thus
the forces controlling the rise in money expenditures determine
the employment effects of a cost-push inflation, but do not halt
it so long as prices and wages remain “ cost determined.” Con
versely the behavior of money expenditures will determine the degree
of price rise in demand-induced inflation; growing unemployment and
rising prices are incompatible when prices and wages are flexible.
We can express this point yet another way; if rising wages or ad
ministered prices themselves continue to generate monetary demand
sufficient to clear the market, despite the rising aggregate supply price
of full employment output, cost-push inflation and full employment
can coexist. The possibility of attaining this result depends on the
impact of rising prices and wages on aggregate demand. An inflation
originating in the prior existence of excess demand will continue so
long as the rising prices and wages do not wipe out the initial excess
demand— i.e., so long as aggregate demand continues to rise in step
with the aggregate supply price of full-employment output. An initial
inflationary gap will, therefore, continue to generate inflation so long
as the rising prices and wages do not reduce real aggregate demand.
Thus we need to examine the impact of rising prices and wages on
aggregate demand— in the cost-push case in order to determine the
employment effects, in the demand-pull case, in order to determine the
extent of the inflation.
In the basic Keynesian model an initial increase in aggregate demand
beyond the full employment point will generate an indefinitely large
wage and price increase unless something intervenes to reduce the
level of real aggregate demand; i.e., limit the rise in money demand
to something less than the rise in aggregate supply price. Similarly
an initial attempt by wage earners to increase their real wages beyond
the advance in productivity 9will give rise to a price increase which will
wipe out the original gains. But so long as the wage and price in
creases do not lead to reductions in real demands for goods and serv
ices, money expenditures will rise in step with prices, and full employ
ment will be maintained.
Prices, wages, and the level of real demands

Only the briefest kind of attention can be given to the various ways
in which overall wage and price increases might be expected to influence

8 For a diagrammatic presentation, see Sidney Weintraub, “A Macro-economic Approach to the Theory
of Wages,” American Economic Review, December 1956.
• Which may arise either autonomously or from a compensatory increase in wages in response to an exog
enously introduced rise in the consumer price index.

RECENT INFLATION IN TH E UNITED

STATES

the level of real demands. The following is more in the nature of a
catalog (and a partial one at that) than an exhaustive discussion:
1. Demand for consumption goods: (a) As a first approxima
tion, at any given level of output, equiproportionate increases in
wages and prices might be expected to leave real demand for con
sumption goods unchanged. Both wage earners and property
income recipients, taken all together, would find their money
income changed in the same proportion to prices.10
(6) A progressive tax system would tend to damp real con
sumption demand, for obvious reasons. The entire system,
including sales, property, excise taxes, etc., must, however, be
on the average progressive.
(c) Given a constant supply of money in the hands of con
sumers, rising prices will lower the real value of consumer liquid
assets. This in turn will tend to reduce real consumption
demand.11 However it is most likely that money balances in the
hands of consumers would rise along with the price level, as an
automatic accompaniment of higher money incomes, except in a
period such as the end of World War II when liquid assets are
unusually high and widely distributed. With a constant overall
money supply, this implies that if the “ real balance” effect is to
be significant it must show up mainly in reduced liquidity among
firms and financial institutions.
(See below p. 23.) The
influence of rising prices on the purchasing power of liquid assets
will depend on the elasticity of consumer demands with respect
to real liquid assets. For moderate changes in prices the elasticity
is probably quoted low.
(d) Expectations: Here one is in a morass of possibilities. Let
it suffice to say that the role of expectations in a creeping infla
tion— as opposed to more violent inflationary movements— is
often exaggerated. A glance at the history of price movements
in the United States does not appear to confirm the impression
that a creeping inflation must necessarily become a galloping one
through the influence of expectations.
(e) If wages are cost-determined and prices flexible [type B]
any tendency of real demands to fall will lead to a rise in wages
greater than the rise in prices. But this in turn redistributes
income from profits to wages. Even if the marginal propensity
to consume out of dividends is no lower than the marginal pro
pensity to consume out of wage income, such a redistribution
should increase real consumption. The largest part of before-tax
profits are siphoned off in profits taxes and retained earnings.
Hence, despite a constant marginal propensity to consume out
of disposable income at different income levels, the marginal pro
pensity to consume out of wage income is larger than the marginal
propensity to consume out of profit income. The net impact of
this is to weaken the damping influence on real consumption
which might be exerted by other factors during a general pricewage rise.
2. Investment demand: (a) In the first place, we should begin
with the caveat that we are discussing only the impact of general

10Although there would be a shift in income between fixed income recipients and owners of equities.
11 The Pigou-Friedman-Patinkin “real balance” effect.

RECENT INFLATION IN TH E UNITED STATES

wage and price increases on real investment demand. Quite
obviously shifts in investment demand arising from innumerable
other factors can bring the rise in overall monetary expenditures
to a halt, or reduce it below the rate of increase in prices— and
hence lead to unemployment.
(b) If we consider only an equiproportionate rise in wages and
prices, there is no a priori reason why money outlays on invest
ment should fail to rise in proportion to the supply price o±
investment goods. Expectations of continuing rises in wages and
prices may indeed stimulate increased real investment, but, as in
the case of consumption, there is little warrant in past history to
conclude that creeping inflation will necessarily lead to such a
result.
(c) With a constant money supply, however, rising prices
should have a twofold depressing effect on investment: First, the
declining real value of firms’ liquid balances combined with
greater working capital requirements and a higher money outlay
per unit of real investment will increase the need for outside
financing. As Duesenberry has convincingly shown, this fact alone
is likely to have an unfavorable impact on real investment, even
if the nominal cost of outside funds does not increase.12 But,
of course, with a higher level of money incomes and expenditures
to be financed the nominal cost of outside financing will rise.
And even when the nominal rate of interest does not fully reflect
the increasing demand for funds, credit rationing will do the
trick just as effectively. This is particularly evident in the case
of residential housing.
In the postwar economy, however, with a substantial volume
of near-moneys available,13 the interest rate elasticity of the de
mand for cash balances has been quite high. It has been possible
to finance a fairly substantial increase in money expenditures with
a constant money supply, by mobilizing idle cash balances, offer
ing in return riskless securities of only slightly less liquidity than
cash. It was by this route that the large increase in bank loans
during 1955-57 took place in the face of a small increase in bank
reserves. The higher the interest elasticity of the demand for
cash, the smaller the damping influence on investment demand
of any given rise in prices and wages.14 And the larger the vol
ume of near-moneys available the higher is the interest elasticity
likely to be.
(d) If prices are flexible and wages cost determined, any damp
ing influence of prices and wages on real demands is likely to be
strengthened by the consequent impact of declining margins on
investment. Unlike its impact on consumption, (1(6)) a rise in
wages not matched by an equivalent rise in prices is most likely,

is James Duesenberry, “Business Cycles and Economic Growth,” McGraw-Hill, 1958, ch. 5. Duesen
berry argues persuasively that the cost of outside funds, from management’s viewpoint, is substantially
higher than the opportunity cost of internal funds.
i* Especially Government securities. But in addition the “cash-saving” aspects of shares in savings and
loan institutions, mutual savings banks, etc. must be included.
14 Selden, op. cit. p. 18, argues that an increase in the velocity of circulation was the “cause” of the 1955-57
inflation. He points out, quite correctly, that the rise in the demand for funds to finance the rising money
expenditures, by bidding up the interest rate increased the velocity of circulation, i.e., made possible the
mobilization of otherwise idle balances to finance the increase in working capital needed to support the
higher price level. But this merely indicates that the relation between money supply and expenditures is
quite flexible. Whether prices rose “because” velocity increased, or velocity increased “because” higher
prices raised the demand for funds we cannot determine from the aggregate ex post data on money supply,
interest rates | and velocity.
44975— 59-------3

RECENT INFLATION IN TH E UNITED STATES

on balance, to have adverse effects on real investment demand,
particularly in the later stages of a boom. There are three major
ways in which declining profit margins should affect investment.
First, internal sources of funds for investment would be reduced,
leading, as we have noted previously, to an increase both in the
cost of financing a given volume of investment and in the effect
iveness of “ credit-rationing.” Secondly, the marginal profit
ability of “ scale” investment would be reduced; by scale invest
ment is meant an expansion of capacity with given capital in
tensity. The third effect of lower margins, i.e., higher real wages,
works in the opposite direction, for it encourages the substitution
of capital for labor. In the context of a short-run cycle, I would
judge that the first two effects would normally outweigh the third.
3. Government expenditures, taxes, and monetary policy:
(a) Quite obviously, if we confine ourselves to aggregate demand,
a pattern of fiscal and monetary policies could be chosen such as
to offset any adverse effects on real demand induced by rising
prices and wages. But, at the moment we are interested in the
automatic response of the economic system to an inflationary
situation. Hence we shall leave, for later mention, the implica
tions of such policies.
0b) We noted previously the automatic damping effect on real
consumption exercised by a progressive tax structure.15 A
progressive tax on corporate profits (e.g., an excess profits tax)
would similarly tend to reduce real investment insofar as it
reduced the level of retained earnings. And insofar as a progres
sive profits tax was shifted forward or backward (an unlikely
possibility in the short run) it would simply add to the restraining
force of progressive personal income taxes.
(c)
Any tendency for Government expenditures to be fixed in
money terms would result in a decline in real Government outlays
during a period of general price increases. A mere lag in the
adjustment of Government money outlays to the inflationary
situation would not eliminate the original inflationary pressure
of demand, although it would reduce the rate at which prices
rose. We shall need to discuss at length, later on, the effect of
various types of lags on the inflationary process.
4. Exports, imports, and balance of payments: (a) In an
“ open” economy, a rise in prices and wages can operate
to reduce aggregate real expenditures by its effect on the
real volume of imports and exports and through a drain of
gold not compensated by central bank monetary action. How
ever, if prices abroad are rising at a similar or faster rate, the
restraining effect of higher domestic prices is canceled out.
During the postwar period the rise in U.S. prices and wages has,
in general, been somewhat less than abroad. Even in recent
years, despite increasingly vociferous warnings that we are
“ pricing ourselves out of the market,” U.S. price movements
have compared quite favorably with most other countries if we
look at aggregate measures only. On the other hand, U.S. prices
of durable goods for industrial use have risen significantly more

w For an analysis of progressive taxes as an automatic inflationary dampener, cf. E. Cary Brown, “The
Static Theory of Automatic Fiscal Stabilization” Journal of Political Economy, October 1956. Brown
shows rigorously, as we have not done here, that a proportional tax system does not of itself restrain
inflation.

RECENT INFLATION IN TH E UNITED STATES

than in most other industrialized nations. The damping effect
of wage and price increases in reducing real expenditures via the
foreign trade sector has thus been only partly offset.

T able 2 -1 .— Price

changes in the United States and selected other industrial
nations, 1953 to 1957

[Percent change]
United United
Germany
States Kingdom France Federal Italy
Republic
Gross national product deflators,
total..............................................
Consumption______________
Producers durable equipment.
Consumer Price Index:
All items........... ........................
Food......... ....................
Average hourly earnings in manu
facturing.......................................

9
6
17
5
2
17

16
14
14
16
5
30

11
11
7
6
3
33

9
7
5
6
9
32

8
8
6
10
11
21

Norway
21
14
n.a.
12
13
28

The reader will recall that our purpose in investigating the
effects of price and wage increases on real aggregate demand differs,
depending on whether we are considering a flexible price or a
cost-determined price situation. In the former case the degree
of inflation resulting from any given initial inflationary pressure
would be indefinitely large, except as real demands are moderated
by rising prices and wages. In the latter, cost-determined, case
the volume of real demand does not affect price and wage deci
sions,16 but rather determines the degree of unemployment
resulting from such an inflation.
In summary the effects of wage and price increases on real aggregate
demand will depend principally on:
1. The elasticity of consumption and investment with respect
to changes in the real value of money balances; there is reason
to believe investment would be more affected than consumption,
insofar as firms are reluctant to finance increasingly larger pro
portions of their needs from outside sources. The greater the
elasticity, the more limited the demand inflation, and the greater
the unemployment accompanying a cost-push inflation.
2. The interest elasticity of the real demand for idle balances:
The higher the elasticity the greater the possibility of mobilizing
“ idle” funds for financing the increase in money expenditures
needed to maintain real expenditures.
3. The interest elasticity of investment demand: The higher
the elasticity the greater will be the impact of a rise in prices on
aggregate real demand, given in turn, the elasticity of the demand
for funds in 2, above.
4. The progressivity of the tax system.
5. The elasticity of Government outlays with respect to a rise
in prices. The more Government outlays tend to be fixed in
money terms, the greater the impact on real demands of a rise
in the price-wage level.

We are taking an extreme situation for purposes of exposition. No one would deny that there is some
level of unemployment and excess capacity at which price and wage increases would cease.

RECENT INFLATION IN TH E UNITED STATES

6.
The response of consumption and investment to changes in
the price-wage ratio. Changes in the price-wage ratio— and even
the direction of change will depend on the type and degree of
inflation— will tend to have offsetting effects: a rise in the ratio
will dampen consumption and raise investment, and vice versa
for a fall in the ratio.
For ease of exposition we have been discussing the rise in prices and
wages in terms of whether or not it reduces real aggregate demand.
But the avoidance of unemployment and excess capacity in a dynamic
setting requires that real expenditures rise, at a rate sufficient to clear
the market of a growing output.
1. If prices and wages are “ flexible” with respect to changes in
demand, then to achieve full employment, aggregate money de
mand must increase even when prices are stable. For any given
full employment output will be supplied at declining prices, so
long as overall factor productivity continues to rise. Hence the
demand for output must increase at a faster rate than the increase
in labor force in order to bid up wage rates to the point where
prices will not decline. The “ required” increase in money
expenditures during an inflation must be measured from this
rising base.
2. In a situation of cost-push inflation, where wages are deter
mined by costs or autonomous factors and prices are marked up
to reflect cost increases, the avoidance of unemployment requires
that money demand rise faster than the growth in the labor force
to a degree roughly 17 determined by the relationship of wage
increases to productivity gains.
These considerations simply mean that the requirements for bring
ing a demand-pull inflation to an end, or for generating unemployment
in a cost-push inflation, must be reinterpreted. Price and wage
increases must now reduce real demand below the rate of growth
given by the increase in the labor force and in productivity.
The prior discussion may otherwise be left intact.
Type A inflation: Prices and wages both cost determined

Inflation theories of the cost-push variety assume that both wages
and prices are cost-determined. The current controversy over the
nature of inflation generally centers on the possibility of an independ
ent cost-push exerted by union pressure to increase wages faster than
productivity. But in actuality there are many additional possibilities,
granted this type of wage-price structure. A wage-price spiral may
be initiated not only by a rise in wages greater than the rise in pro
ductivity, but by rising import prices, an increase in margins in
administered price industries, or a bad agricultural harvest. In
addition, if we relax our strict assumption that all wages and prices
are purely cost-determined and admit the possibility that a large
enough excess demand can initiate a price rise,18 then price increases
“ inherited” from a period of excess demands can lead to a continuing
price-wage spiral even when the initial excess demand is removed.19
Even though the initial inflationary pressure stems from an excess

17 We use the term “roughly” because changes in the capital-output ratio change the wage-productivity
relationship consistent with stable unit costs.
18 In other words, prices and wages can increase because of excess demands, but regardless of the state of
demand they will rise if costs rise.
19J. C. R. Dow, “The Analysis of the Generation of Price Inflation,” “ Oxford Economic Papers,” vol. 8,

1956.

RECENT INFLATION IN TH E UNITED STATES

aggregate demand, the insensitivity of prices and wages to downward
movements in demand results in a continuation of the spiral after the
original excess demand has disappeared. Thus a sharp rise in demand,
occasioned perhaps by a leap forward in expectations, can generate an
inflation which continues for some time, even should it become clear
after a short period that the expectations were unjustified. As we
shall discuss later, this was one element in the 1955-57 inflation.
A number of analyses have been constructed to show the general
nature of a wage-price spiral, in an environment in which demand
conditions are not the major factors determining prices and wages.20
The rate of inflation resulting from an initial cost-push 21 it is shown,
will depend on numerous factors, but perhaps none so important as
the lags between a rise in costs, the subsequent rise in prices, and the
further rise in wages and other costs. If there were no lags, then any
continuing attempt by labor or management to raise their share of
income would result in an indefinitely large increase in prices. On
the other hand, with no lags in the system, as soon as each party gave
up its attempt to increase its share of income at the expense of the
other, the inflation would cease. With lagged responses of wages to
prices and prices to wages a definite rate of price and wage increases
will be determinable. However, the mere cessation of the initial cause
of the spiral will not necessarily bring about a cessation of the
inflation.
With the use of a simple model, adapted from one constructed by
J. C. R. D o w 22we can investigate the various inflationary possibilities,
given cost-determined prices and wages. First let us assume some lag
between increases in costs and increases in prices. The relevant costs
are labor and raw materials costs; we shall assume that we can make
assumptions about the behaviour of raw material prices, independent
of the behaviour of costs, principally because raw materials prices are
likely to be demand and supply oriented (even in an economy of
administered prices and union monopolies). We shall also assume that
there is a further lag between a rise in prices and a rise in wages, and
that the two lags are approximately equal. All of our variables are
expressed in terms of chain indexes, i.e. 1 plus the percent change
from the prior period. Thus if prices rise 5 percent from period £-1
to period t, then price* equals 1.05.
L et:
P =in dex of change in price,
M = index of change in raw material prices,
W = index of change in average hourly compensation of labor,
-X*=index of change in output per man-hour,
X=ratio of labor costs to the sum of labor costs and raw material
costs,
7 r = r a t io o f p r o fits t o th e v a lu e o f o u t p u t ,

0 = percent change in w, from period (t) to (t- 1).
Then,

-Pi+i=^X^-,+ [ l —

(l+7r</>)

(1)

*• The most outstanding are the models of Duesenberry (“The Mechanics of Inflation,” Review of
Economics and Statistics, May 1950); Brown (“The Great Inflation 1939-1951”) and Dow (op. cit., footnote
19).
21
Remembering that a rise in the cost of living is a cost increase from the standpoint of wage determina
tion.
23 Op. cit., footnote 19 above.

RECENT INFLATION IN

THE UNITED STATES

This equation indicates that prices will rise by the same percent as the
weighted rise in raw material and labor costs per unit, adjusted for
any change in the markup of prices over prime costs.
+ Z ) P l. l
M t=(l~{-g)Pt

(2)
(3)

The second equation states that wages rise in excess of productivity
by the amount cf the price increase in the prior period, or alternatively,
that real wages adjust to productivity after a one period lag. Z is a
coefficient to allow us to assume that unions attempt to push up real
wages faster than productivity ( Z > 0 ) , or conversely that real wages
lag behind productivity gains (Z<^0). For simplicity we have as
sumed that the cost-of-living index, which is presumably the one
which influences wage bargaining, moves with our general level of
prices, P t. The third equation simply states that raw material
prices move proportion at ety with the current movement in the general
level of prices, q allows us 4to modify this assumption for a more or
less rapid expansion in raw materials costs. If, for simplicity, we
assume X t to be constant in all periods, i.e., that productivity grows
at a constant rate, equation (1) now becomes:
P

< 2+ [ l —\][l + g ] P ( 1 + 7 T 0 )

(1)'

This second order difference equation can be solved for different values
of the coefficients, and different lengths of the time lags, to allow us
to see the implications of assuming certain conditions.
An examination of price-wage data for the United States shows the
impossibility of selecting any specific lag which holds good under all
conditions.23 Professor Brown has found the average time in the
United States for a turn of the spiral to be about 6 months: Some 3
months between wage changes and price changes and a further 2 or 3
months between price changes and induced wage changes.24 For
purposes of illustration we adopt this 3-month lag between each half
of the spiral.
One of the immediate conclusions which emerges when we substitute
specific values into the equation, is that a cost-push model of this sort
generates a substantial inflation for a fairly small initial disturbance.
If we use values for X and tt which seem to characterize U.S. manu
facturing industry as a whole,25 we can calculate the rates of price
increase for manufactured goods which result from making specific
assumptions about the behavior of real wages, raw material costs,
and profit markups.
I.
Consider the situation in 1946 when price-income relations,
mainly on account of World War II price controls, yielded profit mark
ups which by historical standards were quite low for a period of very
high demand.26 Between 1946 and 1947 the percentage of net profits

23 See Bert Hickman, “An Interpretation of Price Movements Since World War II,” in “The Relation
ship of Prices to Economic Stability and Growth,” Joint Economic Committee Compendium, 1958, or a
discussion of the varying lengths of price-wage lags during the postwar period.
24 Brown, op. cit. p. 127.
25 Taken from table 4-6.
26 Strictly speaking, this departs from a rigid cost-determined system. In reality, however, what we have
done is construct a model in which we can modify cost-oriented behavior in the face of demand changes
by varying Z, q, and 4>.

RECENT INFLATION IN TH E UNITED STATES

in total value produced (in manufacturing) rose from c. 15 percent
to c. 18 percent. Our <t> is 20 percent per year, or 5 percent per
quarter. We have introduced this into the model and assumed that
real wages are adjusted to productivity gains and that raw materials
prices follow the course of finished goods prices.27 During the first
year after such an increase in markups prices will rise about 3 percent,
and by the end of the year they are rising at a
percent per annum
rate. Even if we now assume no further increase in markups, prices
will continue to rise at a rate of about 5 percent per year. If the lag
is reduced to 2 months, the steady rate of increase wall be some 7
percent per year.
II. Assume that labor unions attempt to raise real wages by 3 per
cent per year faster than the growth in productivity. Further, assume
there is no change in markups, and that raw material prices advance
in step with finished goods prices. Since prices adjust up with a
3-month lag, labor will not of course be successful in achieving its goal.
But so long as labor continues to strive for this objective prices will
not only rise but the increase will accelerate. At the end of the first
year prices will be rising at an annual rate of about 8 percent, at the
end of the second year by 17 percent, and at the end of the third
year by 26 percent. Even if, after 1 year of trying, the unions give
up their attempt to raise real wages faster than productivity, prices
will continue to increase at a steady pace, somewhat in excess of 7
percent per year.
III. If we simply assume an “ inherited” price increase, resulting,
for example, from a once and for all rise in agricultural prices, then
prices will continue to rise at the “ inherited” rate, so long as real
wages rise with productivity, raw materials prices move with the
general price level and markups remain unchanged. However any
tendency for wage rate increases to lag behind price and productivity
gains, for markups to decrease, or for raw material prices to level
off will bring the spiral to a halt. Using our simplified model we
find, for example, that an initial price increase of 5 percent during a
6-month period will be damped down to a zero increase as follows :
1. In seven additional calendar quarters if wage rates succeed
only in keeping up with prices, but not with productivity, assum
ing in turn that productivity grows at 2% percent per annum.
2. In only 6 calendar quarters if, in addition to the failure of
wage rates to rise with productivity, we assume that over a period
of a year margins are squeezed such as to reduce profits from 15
percent of the value of output to 12 percent.
3. In only 2 calendar quarters if, in addition to the wage rate
lag and the decline in ex ante margins we assume that raw material
prices remain stable. And since we are discussing a situation in
which ex ante aggregate demand is not excessive, this rates quite
high as a possibility.
The purpose of this exercise in running a wage-price spiral through
our mechanistic model is not to forge a claim that the model is a real
istic interpretation of any particular inflationary process. But two
striking conclusions do stand out. First, any continuing inflationary
force would lead to an accelerating price increase, while even a once-

27 There is also the implicit assumption that the Consumer Price Index moves with manufacturing prices

RECENT INFLATION IN TH E UNITED STATES

and-for-all inflationary impetus would result in a steady price rise,
if decision making processes with respect to prices and wages were not

influenced by demand conditions. If efficiency wages continue to rise
as rapidly as prices, if raw materials prices advance in line with prices
in general, and if profit margins are maintained, there is no end to the
inflation. On the other hand, the second major conclusion of the model
is that relatively modest damping of the three basic cost factors can
bring price stability in a relatively short period of time.
Experience in the United States strongly indicates that the damping
factors do come into operation when the initial excess demands are
exhausted. We do not get cumulative and accelerating movements in
prices resulting from a continuing attempt by labor or business to
increase its share of the product. Nor do we even seem to get the
steady inflation which would result from an initial inflationary im
pulse, were the damping factors completely absent. In all three of
the major upsurges in prices during the postwar period, for example,
raw materials prices reached an early peak and either declined or at
worst remained relatively stable in the face of further rises in finished
goods prices. Profit margins, after rising rapidly in 1947, 1950-51,
and 1955, declined thereafter, even though prices and total aggregate
expenditures continued to rise for some time.
A pure “ cost determined” price spiral, in the absence of continuing
“ validating” aggregate demand increases would, it seems, gradually
taper off. We discussed above the factors which tend to reduce real
expenditures below full employment requirements when prices and
wages rose in the face of a constant money supply and a fixed fiscal
policy. Other influences on demand will of course also occur, tend
ing either to offset these depressing factors or to reinforce their effect.
We noted that in a pure cost-push spiral, any shortfall of aggregate
demand below the aggregate supply price of full employment output
would tend to produce unemployment and excess capacity rather
than to halt the spiral. We must now modify this. Even if one
believes wages and prices to be mainly cost-determined, it is clear
that they are so only within a certain range. Falling demand for
commodities does tend to reduce margins and to moderate or reverse
the rise in materials prices. Lower demands for labor, during a period
in which prices are continuing to adjust upward to prior cost in
creases, will often prevent real wages from rising as rapidly as pro
ductivity. The difference between the cost-push and demand-pull
explanations of inflation thus devolves into a debate about the degree
of unemployment and excess capacity required to break through the
strict cost-determined nature of price and wage decisionmaking.
This in turn is really a debate about the compatibility of full employ
ment growth with price stability.
In essence type A inflation theories, or at least the meaningful ones,
incorporate the following propositions:
1. Wages and prices are not sufficiently sensitive to moderate
changes in the level of demand. Hence initial inflationary
impulses are not quickly damped, as they would be if demand
sensitivity were greater. The price increase resulting from
any given inflationary stimulus is thus magnified, but is never
theless limited.
2. Since wages (or in some cases administered prices) are often
raised not merely to compensate for prior changes in costs, but

RECENT INFLATION IN TH E UNITED STATES

also autonomously, we can have an inflation in which excess
demand is not the initial generating force.
3. Even when price and wage increases are brought to a halt
by weakening demand, downward rigidities prevent any signi
ficant decline. Hence, secularly there is a “ ratchet” operating
to lift the economy in discrete steps, to higher and higher price
levels.
4. The demand insensitivity of price and wage decisions is so
great, that while not complete, it would require a substantial
volume of unemployment and excess capacity to damp the
secondary effects of initial inflationary pressures (whether due to
autonomous wage-push or excess demand) and reduce prices to
their original levels.
To make sure the preceding discussion is quite clear, it may be
worth taking the risk of inducing boredom by recasting some of the
implications. First, the existence of a cost-price spiral is not a sign
that we have an inflation of type A. A purely excess demand inflation
will induce a continuing cost-price rise if, once the initial excess demand
has been injected into the system, real demands do not fall. The
fact that prices are flexible does not mean that they are unresponsive
to cost increases; and the same with wages. However, since flexible
prices and wages also respond to demand changes, an increase in
aggregate demand influences their levels; since prices are “ costs”
to labor, and wages are costs to management the effect of demand is
then reinforced by a rise in costs. Second, the mere fact that wages
rise more rapidly than productivity does not signify a cost-push
inflation— such a phenomenon is also the essential mechanism by
which an initial “ inflationary gap” is perpetuated. Third, ex post
data on the labor or profits share of output is not a conclusive proof
of the nature of the inflation. Assume, for example, that the inflation
is initiated by an attempt on the part of labor to raise real wages faster
than productivity. If ex ante markups are unchanged and raw
material prices follow other prices up, labor will not achieve its objec
tive, except insofar as the existence of a lag will cause some slight
redistribution to labor.28 The same reasoning applies to an autono
mous rise in ex ante markups in administered price industries. The
dangers of attempting to trace the basic “ cause” of inflation by the
use of ex post aggregate data should be sufficiently clear. We shall
discover additional problems in the interpretation of inflationary
phenomena as we discuss other types of inflation theories.
Type B inflation: Prices flexible, wages cost determined

Inflation of type B arises when wages are cost determined and prices
are flexible. Many of the typical Keynesian inflationary gap models
operate with such a mechanism. Aggregate demand affects prices
while wages tend to rise with the resulting increase in the cost of living.
In such a case, efficiency wages are assumed to be mechanically ad
justed upward in line with the cost of living. An initial rise in prices,
due to the appearance of an inflationary gap, can perpetuate itself
so long as real aggregate demand is not reduced, either by the rise in
prices and wages or by factors exogenous to the inflationary process as
such. Conversely once the inflationary gap in the commodity markets
has been eliminated, the spiral will come to an end; for stability in
prices also means stability in efficiency wages.

*8 There will, of course, be some redistribution of income between receivers of fixed and variable property
incomes. But this is a phenomenon common to all types of inflation.

RECENT INFLATION IN TH E UNITED STATES

This particular analysis of the inflationary process has recently been
attacked, for its lack of attention to the effects of excess demand in the
labor market.29 Even if the excess demand for commodities is wiped
out, it is possible to have continuing inflation in prices, if excess
demand continues to exist in the labor market. If, for example, a
vigorous inflation has substantially raised profit margins, producers
will wish to increase the level of output, even though some reduction
in the margin is necessary to clear the market of the additional
production; i.e., there is no aggregate excess demand for commodities,
but, at the high margins that now exist, producers are eager to sell
additional output. Should employment already be at a maximum
wage rates will be bid up. Even though margins may fall, the price
level can increase— all, it should be remembered, in the absence of
excess demand for commodities.
An examination of price and cost data seems to indicate that this
kind of situation prevailed in the United States from 1951 to 1953.
In tables 2-2 and 2-3 we note that gross profit margins rose sub
stantially in 1951. They reached levels well above the postwar
average. The Korean war and the expectations it engendered gave a
significant fillip to the price level while labor costs lagged behind.
After mid-1951 the growth in aggregate demand slowed to a moderate
rate. Inventories of consumer goods were huge, and despite a con
tinuing buildup of military production the overall rate of inventory
accumulation fell from an annual rate of $14.5 billion in the second
quarter of 1951 to $2.5 billion in 1952.30 During this period, however,
the unemployment ratio ranged between 1% and 2% percent of the
labor force, a very low level by any historical standard. Wage rates
rose more rapidly than productivity, not merely as an adjustment to
earlier rises in the Consumer Price Index, but also as a direct result of
excess aggregate demand for labor. The Consumer Price Index ceased
rising rapidly in the latter months of 1951, and rose very gradually
thereafter.
During this 2-year period (mid-1951 to mid-1953) profit margins
declined. But the upward movement in costs was sufficient to raise
the overall price level moderately. In the face of substantial increases
in labor costs, average prices of manufactured goods fell, but only
because of a sharp decline in raw material prices.
T able 2-2.— Changes in prices and costs— private nonfrrm business 1

[Percent change]
1947-51
Price 2-.______________ _____ ________________ _______ _______ ____
Labor cost per unit_________________________________ -_________
Gross margins per unit _______________________________________
Indirect taxes_____________________ -_________________________

1951-53
18
13
28
11

3
7
-6

1Total gross business product less farm and real estate.
2 Price deflator for gross business product less the sectors noted in footnote 1.
N o t e . See ch. 4, pp. 82, 83, for a discussion of derivation of unit cost and price measures.
29 Cf. Bent Hansen’s brilliant discussion in “The Theory of Inflation” (chs. 1, 2, and 7). This is a work
upon which wc shall rely heavily at a later point. Also, Turvey, op. cit., p. 531.
so For an analysis of the economic developments of this period, cf John Lewis, “The Lull That Came To
Stay,” Journal of Political Economy, February 1955; Bert Hickman, op. cit., pp. 178-191; also by the same
author, “The Korean War and U.S. Economic Activity,” NBER Occasional Paper No. 49; and the present
author’s “The Construction of Consistent Price, Output, and Unit Cost Estimates,” in the forthcoming
Studies in Income and Wealth, vol. 25, National Bureau of Economic Research, Conference on Research
in Income and Wealth.

RECENT INFLATION IN TH E UNITED STATES

Table 2-3.— Changes in prices and costs— manufacturing inustries

[Percent change]
1947-51
Price of manufactured products_____________________________________
Raw materials prices____________________________________________
Deflator for manufacturing value added______________________________
Labor cost per unit_____________ _________ __________ ____ _____
Gross margins per unit- ___ __________________________________
Indirect taxes__________ __________________ __________________

1951-53
20
15
24
16
51
6

—2
—10
0
6
—14
4

During these 2 years the level of wage costs did advance despite
the lack of significant excess demand for finished goods. Yet, the
rise in wage costs which occurred was, quite probably, the result of
excess demands in the labor market. In a sense, the basic inflationary
pressure had subsided, and demand factors were operating to reduce
margins. But the initial upsurge of profit margins in 1950 and 1951
created a situation in which inflationary pressures of a moderate
nature continued in the labor market.
Thus, an inflationary gap model of type B cannot be used to explain
the complicated effects of excess demands in the labor market. In a
classic monetary inflation, models of type B are sufficiently descriptive
of actual results to be workable; wage rates do tend to move up with
prices, although possibly at a retarded rate. Whether the wage rise
is to be mainly explained by the rise in the cost of living or by the
excess demand for factors of production is relatively unimportant.
Once the inflationary gap in the commodity market has been elimi
nated however, the possibility of continuing excess demand for factors
of production still exists. Most particularly it will exist if abnormally
high profit margins are one of the legacies of the prior excess demand
for commodities. The resultant further rise in the price level will
have a determinate limit, so long as aggregate demand conditions are
such as to continue the squeeze on margins. At some reduced margin
the excess demand for labor will disappear, and with flexible prices
the spiral will be brought to a halt.
Type B inflation ignores the impact of changes in aggregate demand
on the factor market. However, it is entirely possible to postulate
assymmetrical behavior in the labor market; wages being responsive
in an upward direction to excess demands, while at the same time
relatively unresponsive to declines in aggregate demand. Hence, a
type B model could generate a cost-push inflation via two distinct
routes;
1.
An initial upsurge in aggregate demand could set off a spiral
which would continue even after the excess demand had been
eliminated. The spiral would eventually cease however; with
prices flexible, margins would decline, and as we saw in the Dow
model used previously, this would bring the spiral to a halt.
Since wages do not respond to unemployment, the degree of price
rise would be greater than if wages were flexible. And, for any
given level of real aggregate demand the resulting unemployment
would be larger. As a consequence price stability and full employ
ment would be incompatible, even though prices were flexible.
The degree of incompatibility would depend on the amount of un
employment required to “ break” the cost-determined nature of

RECENT INFLATION IN TH E UNITED STATES

wages. Further, the damping effect of flexible prices would be
relatively slight if we wished to maintain conditions favorable to
full employment. Relying on price flexibility alone to half the
spiral would probably be inconsistent with sustaining the level and
rate of increase in investment required for full employment.
Hence, if the economy were actually characterized by flexible
prices and cost-determined wages many of the same results would
emerge as if type A behavior were characteristic. And of course
the “ ratchet” problem of downward rigidities in costs would still
be with us. The problem of price stability and full employment
would be the same in the long run, even though in the short run,
price flexibility would damp the inflationary process.
2.
Inflation could also originate in a type B economy through an
autonomous increase in wages or other costs. Generally speaking
the course of the inflation and the implications for price stability
and full employment would be of the same nature as those dis
cussed in the prior paragraph, except that the problem would be
somewhat greater. In the former case some excess demand is
required to start the inflationary engine. In the latter case,
even if monetary and fiscal policy were so phenomenally suc
cessful as to prevent any such excess demand, a limited spiral
could still occur.
Type C inflation: Prices cost determined, wages flexible
With prices cost-determined and wages flexible, the inflationary
process raises prices through the mechanism of excess demand in the
commodity market leading to excess demand in the factor market.
Wage rates are bid up and prices are raised as constant markups are
applied to increasing costs. Insofar as prices are strictly cost deter
mined, the inflationary process is damped not by the growth of excess
capacity, but only by the elimination of excess demand in the labor
market. There has appeared a growing body of evidence, both
theoretical and empirical, that some form of modified full-cost pricing
provides the best explanation for prevailing pricing practices in a
large segment of industry. We shall have occasion to discuss this at
some length in the next chapter.31 At the moment we are only inter
ested in discovering the impact of full-cost pricing on the inflationary
process.32 By full-cost pricing is meant the setting of prices by the
addition to prime costs of a markup, designed to cover fixed costs and
return some desired rate of return on investment. The markup is
most usually calculated to recover costs and earn the desired profit at
some standard or average volume of operations. The use of this
technique, while it violates the economist’s criteria for short-run profit
maximization, does not necessarily preclude its being a tool for longrun
profit maximization, particularly in a world of uncertainty.33 Nor
does the acceptance of full-cost pricing as the basic method of pricesetting deny the existence of deviations from the basic pattern when
demand changes drastically. In terminology we have used before,
prices are cost determined only within some moderate range of changes
in demand.
31 See below pp. 55-59.
32 Actually our aim is even more limited than this. We are confining ourselves in this chapter to aggre
gate analysis. Full-cost pricing takes on a more significant meaning for inflation analysis when we consider
the problem of relative shifts in demand.
33 William Fellner, “Average Cost Pricing and the Theory of Uncertainty,” Journal of Political Economy,
June 1948.

RECENT INFLATION IN TH E UNITED STATES

Granted such a pricing mechanism, inflation of the excess demand
variety first appears as a rise in costs. A situation of this sort is par
ticularly likely to mislead those who attempt to determine the causality
of an inflation by examining the timing of price and wage changes.
For inflation operates, in a type C situation, by causing wages to rise
first, with prices following on behind. Yet it can be a purely excess
demand inflation. Indeed possibilities of a cost-push inflation in this
kind of environment are minimal.
1. Assume an “ inherited” price increase. As soon as excess
demand in the factor market is eliminated, wage rate increases
begin to lag behind price increases and, as we have shown, the
inflation tapers off rather quickly. In type A or B inflation
where wages are cost determined, the same inflationary impulse
would result in a much larger inflation.
2. Even if we begin a sort of cost-push inflation via an increase
in administered prices, labor costs will not continue to rise in the
face of any decline in real aggregate demand. And since unit
labor costs account for a much larger proportion of total price
than do unit profit margins, any factors tending to limit the rise
in aggregate money demands will quickly bring an incipient spiral
to a halt. Flexibility in the prices of the most important factor
of production will normally be sufficient to prohibit any extensive
inflation not characterized by a continuing excess demand.
Thus, an inflationary development in a situation where wages are
flexible and prices cost determined is unlikely to take place unless there
be excess demand. At the same time the mechanism of inflation will
operate primarily by raising wages, and indeed raising wages ahead of
prices.
We referred previously to two recent books by distinguished authors
which describe the inflationary process exclusively in terms of wage
inflation.34 In both cases the authors have in mind a price system
which fully passes on the rising unit wage costs. Even should this
description of the process be correct— and there is reason to believe
that full cost pricing is widespread enough to make it approximately
so—we gain very little by knowing that wages are the prime agent of
inflation. The response of wages to changes in the aggregate demand
for labor remains the key problem. The more strictly cost-determined
wages are, the greater the unemployment necessary to damp the
spiral, and the greater the potential incompatibility between full
employment and price stability. The more responsive wages are to
the demand for labor, the easier it is to eliminate a wage-price (or
price-wage) spiral without a significant degree of unemployment.
Consequently the argument that all inflations are wage inflations
reduces to the statement that prices are generally cost-determined.
Such a position is quite compatible with either a demand-pull or a costpush theory of inflation.
The possibility of an excess demand for factors coexisting with the
absence of excess demand for commodities is present in a type C
inflation. We discussed this situation in connection with type B
inflation, where, strictly speaking, it could not exist (i.e. wages are
cost-determined) in order to indicate the shortcomings of the type B
inflationary gap model. The discussion developed there is applicable
3* P. 18 footnote 2.

RECENT INFLATION IN TH E UNITED STATES

to a type C inflation with appropriate modifications to take account
of a full cost pricing system.
In brief, a type C inflation is not substantially different from the
pure excess demand inflation which we shall discuss below. The
economic response mechanism is somewhat more rigid, on account of
the cost-determined nature of prices.35 The aggregate demand
“ dampers” must be somewhat stronger to halt a given inflationary
impetus than if prices were flexible.36 But unit profit margins are a
much smaller proportion of price than are unit wage costs. Hence,
the insensitivity of wages to demand is a more important require
ment for generating a cost-push inflation than is the insensitivity of
prices. A type B environment (prices flexible, wages cost-determined)
is much more likely to permit a cost-push inflationary situation than
is a type C environment (prices cost-determined, wages flexible).
Type D inflation

While demand-pull inflation theory has usually concentrated on the
impact of excess demand in final goods markets, assuming wages to
adjust upward mechanically with rising prices,37 pure demand theories
of inflation usually postulate the flexibility of both wages and prices.
The reader will recall that the definition of flexible pi ices and wages
does not exclude the influence of costs. Prices in particular markets
are influenced by changes in marginal costs and marginal revenues.
The wages of the various grades and skills of labor in different markets
are set both by the demand for labor and by the supply of labor
forthcoming at different wage rates; in turn this schedule of the
amounts forthcoming will be influenced by the cost of living. Rea
sonable flexibility of prices and wages does not require that we have
a completely competitive system, nor that workers be unorganized.
The essence of flexibility, however, is that the markets for both goods
and factors be so structured that excess demand tends to increase
and deficient demand to decrease prices of both goods and factors, at
any given level of costs.
* * * it is not true that demand theories rest on the assumption of marketclearing prices. All that is necessary is that, given stable cost conditions, an
increase in demand will soon result in higher prices, whether administered or not,
for a large segment of the economy.38

The existence of flexible jjrices and wages does not mean that general
price and wage increases will wipe out the initial excess aggregate
demand. An equiproportionate rise in wages and prices will, in
itself, eliminate an inflationary gap only through the indirect effects
on real demand which were discussed at some length above. There
are, however, two distinctly different approaches to the problem of
demand inflation. Those who employ the monetary approach con
centrate on the demand creating aspects of increases in the quantity
of money. By the very nature of their theory, they tend to stress
the limitation imposed by a constant quantity of money on the

as One qualification should be added. J. C. R. Dow and Dicks-Mireaux have noted that a chronic labor
shortage may in itself reduce excess demand for labor. Employers, who themselves are often pricing on a
conventional markup less than that which would clear the market, finally resign themselves to the situation,
and no longer even attempt to find the work force they might like to have. Effectively, demand for labor is
reduced. The economy exists in a perpetual state of disequilibrium in both labor and commodity markets.
But the disequilibrium does not lead to the kinds of price and wage increases which would normally be
expected with a labor market in which wages are flexible upward with respect to excess demand.
*« Cost-determined prices are not rigid: if costs decline, so also will prices.
37 I.e., type B inflation.
38 Richard T. Selden, “Comment” on a paper by Gardner Ackley, American Economic Review, May
1959, p. 455. It is also crucial that a decrease in demand “soon result” in lower prices.

RECENT INFLATION IN TH E UNITED STATES

degree to which money expenditures can rise. The Keynesian
approach, on the other hand, operates with income and expenditure
categories. While formally the two approaches may be reconciled,39
in actual practice they tend to lead to different conclusions with
respect to the conditions necessary for an inflationary movement to
exist. Further, the Keynesian theory, because it emphasizes the
demand creating aspects of cost increases, lends itself much more
easily than does the “ quantity” theory to an acceptance of costpush inflation.
We discussed at some length the conditions under which aggregate
demand would support a wage-price spiral; we noted that the spiral
could continue so long as real aggregate demand was not reduced
by rising prices and wages. Further it was pointed out that in the
case of flexible wages and prices the reduction of real aggregate
demand would stop the spiral, while in the case of strictly cost-determined wages and prices a reduction in real demand would lead to un
employment and excess capacity. The “ quantity” theorists generally
hold that the reduction of the real value of money balances which will
occur when the money supply is constant, will act very quickly to
reduce real expenditures. In other words the velocity of circulation
of money is alleged to have a relatively limited range of fluctuation.
In the terminology used earlier in this chapter, such an economic
structure implies that the interest elasticity of the demand for idle
cash balances is quite low, and that the interest elasticity of invest
ment demand is high.40 Often, these implicit assumptions are not
spelled out. Professor Bailey for example, in his comment on the
possibilities of a cost inflation raised by Prof. Gardner Ackley states
flatly—
Given that aggregate (money) demand is unchanged, as it uill be if there is no
monetary expansion , the fall in prices in the competitive sector will offset the rise
in the noncompetitive sector, and the general price level will stay where it is.41

According to Professor Selden the velocity of circulation may indeed
rise as excess demand develops, but will not increase in response to
inflationary pressures created by autonomously rising costs.42 We, on
the contrary, have argued that the cause of the initial inflationary
pressure is, to a large extent, irrelevant. Given a constant money
supply, the increase in aggregate demand (and, consequently, the
rise in the velocity of circulation) will be determined, inter alia, by
the elasticities discussed above.
Those who employ Keynesian income and expenditure categories in
discussing the inflationary process are prone to emphasize the wide
range within which aggregate demand can fluctuate, given a constant
quantity of money. Velocity is treated as a determined residual, not
a fixed parameter of the economic system. Implicitly this involves
assumptions about the interest elasticities of the demand for cash
balances and the demand for investment just the converse of those
generally ascribed to the quantity theorists.

39 Through the interrelationship between real money balances and spending decisions, see for example,
Don Patinkin, “Money, Interest, and Prices,” Row, Peterson, New York, 1956.
40 Supra, pp. 23-25. The technically minded reader will note that we have ignored the “real balance
effect” in the consumer goods market. The reasons for doing so were given above on p. 22.
41 Martin Bailey, “ Comment” on Ackley’s paper, American Economic Review, May 1959, p. 461. (Em
phasis supplied.)
42 Richard T. Selden, op. eit., p. 456; also, the same author, “Cost Push vs. Demand Pull Inflation/’
Journal of Political Economy, February 1959.

RECENT INFLATION IN TH E UNITED STATES

There is no need, for the purposes of this chapter, to delve further
into the controversy between the two schools. Their conclusions
differ with respect to the limit placed on aggregate demand by the
money supply. Both are in agreement, however, that the state of
aggregate demand is the major determinant of the movement of
prices and wages. Or, to put this another way, if one conceives the
major characteristic of prices and wages to be their flexibility, he is
driven to the conclusion that price flexibility and full employment are
compatible goals. It does not require a substantial amount of unem
ployment to break an inflationary spiral. While arguments may
persist as to how effective monetary management is in regulating
aggregate demand, there is agreement that control of aggregate
demand can control inflation.43
In actuality, of course, an analysis of inflation in type D terms
does not preclude the possibility of some autonomous upward move
ment of costs and prices not related to changes in aggregate demand.
In the early postwar years, for example, the leading “ quantity”
theorist, Professor Friedman, voiced grave doubts that the economy
could simultaneously achieve economic growth, full employment, and
price stability, so long as powerful organized labor and oligopolistic
industries could influence prices and wages.44 In later years, how
ever, he has stated on numerous occasions that a wage-push inflation
is quite unlikely; in the face of monetary restrictions on aggregate
demand, growing unemployment and excess capacity would soon both
reduce union demands and “ stiffen the backs” of management.45 He
holds that wages and prices are relatively flexible in the face of de
ficient aggregate demand, despite the apparent monopoly power of
organized labor and business. And, even if prices are fairly inflexible
in some sectors of the economy, downward price flexibility in com
petitive sectors will not only offset the price rises in administered
price sectors, but increase the tendency for cost-induced price in
creases in those sectors to run up against the barrier of declining
demands.46 Professor Morton has taken a similar view, in two
strongly worded articles condemning the adoption of a governmental
policy guaranteeing full employment.47 Prices and wages are not
inflexible in the face of actual or even potential unemployment and
excess capacity— trade unions will not butt their heads against a
stone wall, nor will prices be set independently of demand conditions.
The attitude upon which the pure demand-pull analysis rests is
well summed up as follows:
Certainly union leaders * * * confronted with falling labor demand will
hardly be encouraged to adopt an inflationary wage policy, however tempting the
prospect might be.48

To Morton, Friedman, Selden, Bailey, et al, the flexibility of prices

« It is of interest, however, that the emphasis on the demand-creating aspects of wage rate changes which
characterizes Keynesian economics has led a very large number of Keynesian or neo-Keynesian writers to
adopt a cost-push theory of inflation. In other words, the possibility that autonomous cost increases will
provide their own “validating” demand, and hence not lead to unemployment, is conducive to the possi
bility of a self-perpetuating, cost-induced inflation Because of the limits on aggregate demand implied
in the “quantity” theory model, such a self-induced spiral is unlikely.
« Friedman, “A Monetary and Fiscal Framework for Economic Statilbity,” American Economic Re
view, June 1948.
Friedman, “Some Comments on the Significance of Labor Unions for Economic Policy,” in “The
Impact of the Union,” edited by Wright, pp. 204-234; also, “Rejoinder” to Professor Neff’s criticism of
“Monetary Framework, etc.,” American Economic Review, September 1949, pp. 949-956.
« Friedman, “Some Comments, etc.,” pp. 226-227. Also cf. the quote from Bailey, supra, pp. 2-48.
« Walter Morton, “Trade Unionism, Full Employment, and Inflation,” American Economic Review,
March 1950; and “Keynesianism and Inflation,” Journal of Political Economy, June 1951.
« Gorter and Hildebrand, “Is Price Control Really Necessary,” American Economic Review, March
1951. (The article deals with price controls during the Korean war.)

RECENT INFLATION IN TH E UNITED STATES

and wages implies that inflation stems almost exclusively from excess
aggregate demand for factors and commodities. In turn this excess
demand is only possible if the quantity of money supplied by the
banking authorities rises at an excessive rate. Hence the traditional
analysis and the traditional policy implications are vindicated.
It has, in fact, been argued that the existence of inflexible wages and
prices is a restraint on the inflationary process. Insofar as some
wages and prices do respond sluggishly to increases in demand, the
wage-price spiral will be slowed, not only because of the time lag it
self, but, possibly, because of the expectational and income-redistribution effects of such a lag.49 But, as Samuelson notes, such a find
ing still does not exclude the possibility of a cost-push inflation, in
situations where, ex ante, aggregate demand is not excessive.50
Summary

the

em and

ersus

ost

I n f l a t io n T

h e o r ie s

The analysis in this chapter of the various types of inflation theories
has attempted to isolate the fundamental conditions for the existence
of a cost-push as opposed to a demand-pull inflationary process. We
have seen that the distinction between the two does not lie in the
relationship of wage increases to productivity gains, nor in the rela
tive timing of cost increases and price increases, nor even in whether
or not cost-push inflation can fully provide its own validating demand.
Rather the sensitivity of wages and prices to the state of demand
proves to be the crucial factor. Those who maintain that prices and
wages are characterized chiefly by their flexibility stand near one end
of the spectrum, believing with Friedman that while it is logically
conceivable for strong organized groups to push up their cost prices,
it is not “ an empirically important possibility.” 51 There are those
who like Bach, take a middle position; a sustained rise in wages and
prices in the face of limited demand is not likely, but the degree of
demand restriction required to break the cost-determined nature of
prices, given the current market structure, is probably larger than
consistent with a policy of sustained full-employment growth.52
Finally, at the other end of the spectrum, are those who believe that
price, and particularly wage, determination has been so far divorced
from the state of aggregate demand that it would take really sub
stantial unemployment and excess capacity to achieve price stability.
Professors Slichter, Reder, and the late Henry Simons, although
differing in many other respects, are characteristic of those who .hold
this view.
Ralph Turvey, whose classification of inflationary processes we have
used in this chapter, summarizes the possibilities as follows:
1.
Excess demand for commodities: Inflation arises from the
attempt on the part of the economy to increase its aggregate real
expenditures faster than it can increase its real output, at con
stant prices. Inflation stems primarily from excess demand in
the commodity markets.

49 Friedman, op. cit. p. 226; Boulding, “The Impact of the Union,” p. 244. Rees cautiously suggests the
same conclusions in his “Postwar Wage Determinations in the Basic Iron and Steel Industry,” American
Economic Review, June 1951.
50Paul A. Samuelson, “The Impact of the Union,” p. 245.
“ Friedman, “The Impact of the Union,” p. 244.
52 George L. Bach, “Economic Requisites for Economic Stability,” American Economic Review, May
1950; also, “Monetary and Fiscal Policy Reconsidered,” Journal of Political Economy, June 1951.
44975— 59-------4

RECENT INFLATION IN TH E UNITED

STATES

2. Excess demand for factors: Inflation arises primarily from
the attempt by producers to raise output at a faster rate than the
existing supply of resources and the current state of technology
make possible. Inflation stems from the excess demand for
factors of production.
3. Income share inflation: Inflation arises out of the competi
tion of various groups to maintain their real incomes at a higher
level than the real output of the economy can accommodate.
The first and the second kinds of inflation generally, but not always,
exist together. They represent the two aspects of demand-pull
inflation. Income-share inflation is simply another, and perhaps
better, name for cost-push inflation.
The mechanics of inflation

It is important to make a careful distinction between the mechanics
of the inflationary process and its basic nature. An examination of
the mechanics of inflation has led Gardner Ackley to deny the validity
of the distinction between demand-pull and cost-push.53
In our model of demand inflation * * * buyers of final output are attempting t°
procure a larger total supply than can be produced. As a result prices are bid up.
To be sure, wages and other cost-prices may promptly rise too; but it is important
that the causal sequence is this; prices are bid up, costs follow. If the causal
sequence is reversed— if costs rise and therefore prices rise— we have the case of
cost inflation.54

Ackley proceeds to argue that neither prices nor wages are set in the
instantaneous market clearing manner described by orthodox pricing
theory. Prices are determined by applying a markup to costs; wages
are generally set with reference to some “ markup” over the cost of
living. The demand and supply oriented pricing of the textbook
variety does not exist in the real wrorld outside of markets for agricul
tural products and some other raw materials. Hence inflations gen
erally proceed by a cost mechanism, both prices and wages being set
with reference to costs. Ackley points out, however, that the markups
applied to costs will vary with the state of the market, excess capacity
and unemployment generally tending to reduce markups. Demand
and cost phenomena are thus inextricably intermingled. He proposes
the term “ markup” inflation to describe the process, and suggests
discarding the concepts of demand-pull and cost-push inflation.
As a first approximation it is eminently reasonable to describe the
inflationary process in terms of costs and markups. The fact that
markups are not instantaneously adjusted in response to excess or
deficient demand is a major feature determining the timing and speed
of inflation. But this provides no warrant for denying the validity
of the distinction between demand and cost inflation. If the only
difference between demand and cost inflation were the one suggested
by Ackley— i.e. whether prices or costs rise first— the distinction
would indeed be useless. But, as we have repeatedly emphasized,
the essential difference is to be found not in the timing of price and
wage increases, but in their sensitivity to changes in demand con
ditions. Using Ackley’s terminology, the crucial problem is the
response of markups to excess or deficient demand. We noted earlier

« Gardner Ackley, “Administered Prices and the Inflationary Process,” American Economic Review,
May 1959; “A Third Approach to the Analysis and Control of Inflation/’ “The Relationship of Prices to
Economic Stability and Growth,” Joint Economic Committee, 1958.
« Ackley, “Administered Prices, etc.,” op. cit., p. 419.

RECENT INFLATION IN TH E UNITED STATES

how an inflation can quickly be brought to a halt when markups are
reduced, particularly when wage rates are “ marked up” by less than
the combined rise in prices and productivity. If markups are quite
sensitive to growing excess capacity and unemployment, them only
a continuation of excess demand will keep inflationary pressure alive.
If markups are fairly rigid on the downward side, then inflations of
both the excess demand and cost-push varieties are possible; sub
stantial unemployment and excess capacity may be required from
time to time if the price rise is to be halted.
P o l ic y I m p l ic a t io n s

x is t in g

h e o r ie s

Since those who analyze recent developments in terms of cost-push
inflation believe that it would require substantial unemployment to
make cost-determined wages and prices flexible, they normally con
clude that the cost of restraining price increases through the traditional
methods of limiting aggregate money demand is too great. Here two
variants branch off. There are those, whom we may call the “pulver
izers” who would attempt to solve the problem by strengthening the
various antitrust laws, applying them, in modified form perhaps, to
labor as well as to business.55 This view implies that by sufficiently
vigorous action we can create an economy in which prices and wages
behave with the flexibility now ascribed to them by the demand-pull
theorists. Indeed, many of the latter would also emphasize the
necessity of achieving an even greater demand sensitivity of prices
and wages by “ pulverizing” existing power structures.
On the other hand there are the Slichterians who feel that the possi
bility of attaining the requisite price and wage sensitivity is quite
small in view of the economic and political facts of life. As a con
sequence they recommend that we no longer make obeisances in the
direction of secular price stability, but face the inevitable and accept
creeping inflation. Indeed such inflation is not only necessary, if
we are to maintain full employment in the face of rising costs, but
perhaps desirable, as a lubricant on the wheels of progress.
Similarly there are two policy variants among the demand-pull
theories. There are some who feel that cost-determined wages and
prices are not a problem. Our inflations have always stemmed from
excess aggregate demand, which in turn usually arises from overexpan
sionary monetary and fiscal policies. Control the latter, and you can
control inflation, without sacrificing reasonably full employment.
There are some, however, who believe that cost-determined wages
and prices have been, in a proximate sense responsible for recent infla
tion. But the insensitivity of business and union wage-price policies
to demand conditions ultimately stems from the knowledge that the
Government will intervene to assure full employment. A firm policy
of maintaining only such a growth in monetary aggregate demand as
is necessary to clear the market of full employment output at stable
prices would soon teach union and business leaders that any attempt
to push up prices and wages will cost them dearly in terms of excess
capacity and unemployment. Put more succinctly, the cost of en
forcing wage and price flexibility would be only a few sharp recessions.

68 Needless to say, of course, the unions, who attribute cost-push inflation to rising administered prices
have a different view of the required antitrust action than do most business organizations, to whom the
villains in the piece are the unions.

RECENT INFLATION IN TH E UNITED STATES

“ Admittedly deflationary unemployment is unattractive in itself,
but it will serve as a convincing proof of unsound wage policies.” 56
One is tempted to call this the “ Pavlov technique;” rap the child
over the head whenever he eats sweets excessively, and he will soon
achieve a positive distaste for candy. How business and labor
leaders are to distinguish between price and wage increases which are
desirable (and presumably rewardable) for resource allocation pur
poses, and those which are antisocial (and presumably punishable)
one cannot discover.
T

ggregate

ature

x is t in g

h e o r ie s

A common characteristic of all of the various types of inflationary
processes discussed to date is their aggregate nature. Cost-push in
flation is normally discussed in terms of average wage and productivity
relationships. Demand-pull inflation is also analyzed as an aggregate
phenomenon. Since wages and prices are considered to be flexible
with respect to changes in demand, only an aggregate excess demand
can lead to inflation.
In the traditional body of economic literature * * * it seems universally to have
been concluded that inflation is necessarily the result of a general excess of demand.
This conclusion follows understandably from the classical assumption of a per
fectly competitive market in which prices and wages are continuously adjusted
so as to eliminate any excess demand or excess supply. In such a market, if
there is no excess demand (or supply), prices will come to rest; if, therefore, prices
are rising cumulatively it can only be because excess demand is constantly tending
to reemerge.57

A theory of inflation which is based primarily on the flexible nature
of prices and wages is not only a demand-oriented theory, it is neces
sarily an aggregate-oriented theory. Excess demand in some sectors
of the economy, balanced by deficient demand in other sectors will
indeed result in changes in relative prices and wages, the degree of
relative price change depending on the mobility of resources. But an
increase in the general price level will not occur in such a situation.
Price decreases in the declining demand sectors will offset price in
creases in excess demand sectors. Further, in such a situation there
is no overall excessive demand for factors of production, although the
relative demands for, and hence relative prices of different factors may
indeed change. Shifts in the composition of demands, within a stable
aggregate, thus lead to a change in resource allocation, but not to any
movement (except perhaps a temporary one) in the general price
level. Prices and wages always move so as to eliminate excess or
deficient demands in particular commodity and factor markets.
In the real world, however, prices and wages are not so flexible. In
'particular wages and prices are much less likely to be flexible in a down
ward than in an upward direction. This is not to deny any downward

flexibility; rather it simply maintains that the the degree of excess
demand needed to raise prices is significantly less than the degree of
deficient demand required to reduce them. There is an upward bias
in the general level of prices such that a large change in the composition
of demand, even when aggregate demand is not excessive, will lead to a
general price rise. The rise in prices will be aggravated by the impact
of excess demand in particular sectors of the economy on the prices of

56 Gorter and Hildebrand, op. cit., p. 80.
« United Nations, “World Economic Survey, 1957,” p. 5. (Emphasis supplied.)

RECENT INFLATION IN TH E UNITED STATES

raw materials and wage rates. For there is a similar asymmetry in
the response of material costs and wages—particularly the latter—
to changes in demand. Hence, the absence of excess aggregate de
mand for factors of production provides no guarantee against an
induced rise in the average level of their prices.
Under such circumstances inflation can take place without either an
excess aggregate demand or an autonomous cost push. Inflation of this
kind originates in excess demand in particular sectors of the economy
and spreads, via cost increases, to other sectors in which demands are
not excessive, and indeed to those in which there is unused capacity and
unemployment. The difference between this type of inflationary
movement and the aggregate demand-pull and cost-push processes of
most existing inflation analysis is not merely an interesting academic
refinement. It has important implications for anti-inflationary
policy. Chapter 3 is devoted to a more rigorous examination of this
type of inflation and the process by which it tends to spread through
out the entire economy. In chapter 5 the theoretical analysis de
veloped here and in chapter 3 is applied to the economic events of
1955-57.
T

h a n g in g

ature

osts

In most analyses of inflation discussions, of costs center on prime
costs; i.e., raw materials and wages. In recent years, however, the
very rapid growth of overhead costs— particularly overhead labor—
has substantially increased the share of such costs in the total. Chap
ter 4 discusses the significance of overhead costs in the generation of
price increases. Part of chapter 5 will investigate the influence of
changing overhead costs on prices and productivity during the 1955-57
period.

CHAPTER 3
THE INFLATIONARY IMPLICATIONS OF SHIFTS IN THE
COMPOSITION OF DEMAND
T

I mportance

the

o m p o s it io n

ggregate

S p e n d in g

In a dynamic economy the process of change involves not only move
ments in aggregate output and income but also shifts in their composi
tion. During periods of substantial inflationary pressure induced by
war or its aftermath demand presses hard upon supply availabilities
in all sectors of the economy. The overall pressure of excess demand,
while not uniform, is usually so large and pervasive as to minimize
the need for attention to the components of demand. Aggregate
excess demand is the driving force behind the rise in prices, and
efforts to eliminate the excess quite rightly concentrate on reducing
total purchasing power.
Inflations of the peacetime variety are usually quieter and more
selective. Very often they are characterized by the rapid expansion of
demand in only certain sectors of the economy; in other sectors de
mands may be relatively stable, and in still others may be declining.
If prices and wages were flexible, in the face of both positive and nega
tive excess demand, then we might still concentrate our analysis on
aggregate demand aspects only. It is implicit in the existing demandpull theorities of inflation that the composition of demand is not of
major significance in the analysis. The use of the term “ implicit” is
deliberate. A search of recent economic literature for an extensive
discussion of this point reveals only scattered references. Nor is this
surprising. Universal price flexibility has long been considered the
mechanism for allocating resources in the economy. To use the
economises jargon, this is the province of the micro theorist. To be
sure, a major part of the work of the micro theorist is precisely the
analysis of deviations from that price flexibility characteristic of a
competitive market structure, and an evaluation of the impact of such
deviations on the allocation of resources. Inflation, on the other hand,
has been the domain of the macro theorist—who up until 1936 was
usually also a “ money” theorist. He normally assumed relative price
flexibility—his colleague in the next office could worry about the anti
social implications of rigid prices— and concentrated on the movement
of overall price levels, employment, and output. Except to students
in the economic principles course, it was unnecessary to repeat the
assumptions with respect to relative price flexibility, upon which the
aggregate demand analysis rested.1 There are a few exceptions.
Some have spelled out, briefly, the assumption upon which they were
proceeding. Gorter and Hildebrand, in an article questioning the

i “Invalid dichotomies” are not confined to the field of monetary theory, but, in this case, apply to the
whole division of labor between micro and macro price theory.
44

RECENT INFLATION IN TH E UNITED STATES

need for price and wage controls during the Korean inflation state the
case in the baldest terms: if aggregate demand is only held in check,
the rapid shift from civilian to military production cannot cause any
inflation.2 A policy of “ no monetary expansion with free prices” is
the one which “ alone can lead to an economy untouched by the ravages
of inflation.” 3 Further, “ With prices free to move up or down, the
reactions of entrepreneurs will lead them to do precisely what the
preparedness program requires.” 4
Professor Friedman makes essentially the same point when he notes:
If fiscal and monetary policy prevent total demand from falling or rising sharply,
they will thereby prevent any general decline or rise in wages and prices from
developing into a rapid spiral and becoming cumulative. Declines or rises in
particular prices and wage rates can then serve the useful and indispensable func
tion of facilitating adjustments among different sections of the economy.5

In general, the demand-pull theorists have a picture of a self-adjusting
price and wage system, which will channel resources in the appro
priate directions through relative price changes, all within the
framework of overall price stability so long as aggregate demand is
appropriately restrained. Messrs. Friedman, Selden, and Bailey have
in fact suggested at various places that universal price flexibility is not
necessary; the existence of cost determined prices in some sectors of
the economy would not be inconsistent with price stability. Given
stable aggregate demand, rising prices and wages in “ administered”
price sectors of the economy would simply force greater price and wage
adjustments in the flexible sectors. (This would be fine, granted the
premise, if the rising and falling sectors of demand were evenly dis
tributed between flexible and administered price industries.) The
basic agent for guaranteeing aggregate price stability remains, how
ever, the flexibility of prices and wages. More precisely, wages and
prices must be roughly as flexible in a downward direction as in an
upward direction. Otherwise the prevention of excess aggregate
demand will not guarantee price stability if the composition of demand
is shifting rapidly.
In the contemporary American economy prices and wages generally
tend to be substantially more flexible in an upward than in a down
ward direction. Prices of many commodities do, of course, decline
under the impact of falling demand or rising supply. We need only
glance at a chart of agricultural prices to confirm this. In the indus
trial sector of the economy, and even more so in the service and related
industries, prices tend to be rigid against declining demands. This
does not mean that such prices never fall. Nor does it deny that
there is substantial variation from commodity to commodity, depend
ing on the structure of the particular industry involved. But, as a
general proposition it takes a fairly sizable decrease in demand, lasting
over a significant period, to induce price cuts. The magnitude of the
excess demand needed to raise prices, is almost universally smaller;
and the speed of reaction is generally larger in an upward than in a
downward direction.
The same characteristics are even more applicable with respect to
wages. The downward rigidity is far greater than any sluggishness
in wage response to an increase in demand for labor. Moreover, as

2 Qorter and Hildebrand, “Is Price Control Really Necessary,” American Economic Review, March 1951.
3 Ibid., p. 78.
<Ibid., p. 78.
4Dissenting comment by Friedman in the American Economic Association Committee Report, “The
Problem of Economic Instability” American Economic Review, September 1950, p. 534.

RECENT INFLATION IN TH E UNITED STATES

we shall discuss at some length later on,6 the tendency of wage in
creases in one sector of the economy to induce similar wage increases
elsewhere, makes the rigidities even greater.
Formally, in order that the absence of excess aggregate demaned b
a sufficient condition for the stability of the general price level, it is
necessary that the “ price reaction coefficients” of all goods and factors
of production be equal; further the coefficients must be the same
(though of opposite sign) for deficient or for excess demand.7 The
“ price reaction coefficient” of a good or factor specifies the time rate
of change in its price for a given amount of excess or deficient demand.
It therefore incorporates not only the magnitude of the price change in
response to changes in demand, but also the speed of the change.
The statement that price reaction coefficients are larger for positive
excess demand than for negative, is another way of stating that
prices (and wages) are more rigid downward than upward. The
consequence of this is to impart an upward bias to the general price
level whenever the composition of demand is changing rapidly, even
though aggregate demand is not excessive. Further, since the prices
of one industry are often the costs of another, while consumer prices
are a “ cost” in the determination of wage rates, a further upward
pressure on the price level is exerted. Prices rise in sectors with
excess demands; offsetting price declines do not occur where demands
are deficient. The rising costs in excess demand sectors tend to “ feed
out” into other sectors, so that prices there often rise even in the face
of falling demands. While a very rapid and sustained increase in the
general price level is unlikely to occur from these factors alone, a
substantial part of the creeping inflation of recent years may be
attributed to such “ asymmetries” in price and wage behavior.
In the next section we shall attempt to incorporate the argument of
the preceding few pages into a general model of the economy, in order
to show rigorously the implications of the argument. (Those who
are quite satisfied with the “ literary” demonstration presented in the
prior discussion, and who have no taste for mathematical manip
ulations may omit the section without losing the thread of the
analysis.)
T

emand

and

P r ic e F

l e x ib il it y

P r ic e L

e q u ir e m e n t s

of a

Stable

evel

The presentation which follows is basically derived from Bent
Hansen’s “ Theory of Inflation,” and the later work of Alain
Enthoven.8 Both of these authors utilize a modified Walrasian general
equilibrium model as their basic tool, but introduce certain dynamic
elements. We shall do the same, adding some additional modifications
to bring out more clearly the implications of introducing downward
price and wage rigidities.
Assume a typical Walrasian system with “n” demand and supply
functions for commodities, claims, and factors of production.

• See below 65-70.
i Bent Hansen, “The Theory of Inflation,” ch. VIII. Alain Enthoven, “Monetary Disequilibria and the
Dynamics of Inflation,” Economic Journal. June 1956.
8 Enthoven, op. cit., passim.

RECENT INFLATION IN TH E UNITED STATES

Let :
P t—price of the ith commodity, claim, or factor
D i =qu an tity demanded of the commodity, claim, or factor
S {=qu an tity supplied of the commodity, claim, or factor
X i — excess demand for the commodity, claim, or factor (in terms
__ of quantity)
M —M —the quantity of money: assumed given exogenously.
r = “ the” interest rate.
i
The Tfcth “ commodity” is money, and P n= l ;
B y Walras’ la w :9

i= l

1=1

i —1

( 1)

In other words if we know the demand and supply of all but one of
the commodities, claims, and factors, we also know the demand and
supply of the remaining commodity, claim, or factor. W e have
chosen money as that remaining good. As Lange points out, the
demand and supply of money are used in an unusual sense: the
demand for money is equal to the supply of commodities;10 in other
words sellers offer commodities in exchange for money. Conversely
the act of demanding a commodity is equivalent to an act of offering
money. The difference, during a specified time period, between the
total demand for money (supply of commodities) and the supply
of money (demand for commodities) represents the demand for addi
tional cash balances over and above those held at the beginning of
the period. If D c represents the total demand for cash balances and
Sc the supply of cash balances, then, since the excess of aggregate
supply over aggregate demand is the demand for additional cash
balances,

^ P iS t-^ P iD ^ D -S c
i —l

i= l

(2)

g P iD i-g P A -S .-l? .

(2)'

Sc- D c^ S n- D n^ - X n

(3)

From equation (1)

In other words the excess demand for money, in the rather unusual
sense originally employed turns out to be identical to the excess de
mand for cash balances. W e shall continue to use the symbols S n,
D n, and X ny but now signifying the demand and supply of cash bal
ances. With a given money supply S n=M . The demand for cash
balances has an independent existence in its own right:

D n= t S P J 3 i+ L ( r )
i= l

(4)

9 Cf. Oscar Lange: “Say’s Law: A restatement and criticism,” “Studies in Mathematical Economics and
Econometrics,” ed. by O. Lange etc., the University of Chicago Press, Chicago, 111.
10To save the repetition of writing “commodities, claims, and factors” each time, we shall use “com
modities” to cover all three. Where some distinction needs to be made, the text will so indicate.

RECENT INFLATION IN TH E UNITED STATES

The first term tells us that the demand for cash will depend on the
total value of transactions— the familiar transactions demand for
money. The second term represents “ speculative” demand for cash,
or, if you will, the demand for “ idle” balances. The second term
may also be considered as incorporating the diversification or portfolio
demand for cash.11
If we assume, preliminarily, that an equiproportionate change in all
prices (including factor prices) would leave the real demand and sup
ply of individual commodities unchanged, the individual demand and
supply functions would have the following form:
Di=fi(^iy r)

(5)

S i — fpiiwij r)

(6 )

and, consequently the excess demand equation have the general form,
r)

where the

(7)

represent relative prices, i.e.,

(8)
*

n -1

But this leaves us with only the interest rate as a link between the
money market and the commodity markets. Aggregate excess de
mand in the commodity market is unaffected by the general price
level. Any level of aggregate demand can exist with any price level,
except as the interest rate is affected. Yet by Walras’ law the aggre
gate excess demand for commodities is equal to the excess supply of
cash balances [equations (1) and (3)], while equation (4) tells us that
the excess supply (or demand) for cash balances will be affected by
the general price level. A determinate price level is only made pos
sible by effects of excess demand on the interest rate. Excess de
mands in the commodity markets lead to higher prices, thus increasing
the transactions demand for cash, which in turn requires a higher
interest rate, if the money market is to be in equilibrium. A higher
interest rate in turn restricts investment spending, thus damping the
excess demand.12
Following Patinkin, let us directly introduce the absolute price
level into the excess demand functions,
X t= x ( * {, r ^ ;

(9)

where P Trepresents some appropriately weighted general price index.13
Rising absolute prices now affect excess demands not only through
the medium of higher interest rates but also through the reduction

n Although strictly speaking to represent the portfolio demand the current flow of saving should enter as
a variable. Also the demand schedule would shift as the volume and degree of liquidity of near-moneys
changed.
12 The so-called “Keynes effect” applied to inflation analysis.
13 The problem of the “appropriate” weights is not really important for our purposes. The shape of the
Xi functions would depend on the appropriate index chosen, but so long as |^has the right sign, some equi
librium general price level is possible.
J^1

RECENT INFLATION IN TH E UNITED STATES

in the real purchasing power of money balances thereby achieved.
Apart from periods in which cash balances are abnormally high and
quite widely distributed, it is likely that the major impact of the real
balance effect is on the demand for investment goods .14
There is consequently only one absolute price level at which the
system is in aggregate monetary equilibrium. For, in equilibrium,

ft= S M
= G P A + X ( r ) ;Z B= 0
*=i

(10)

while, at the same time, by (1), and (3)

^ P iDi^ P i8 i=J2PiX i= X n= 0
i= l

i=l

(11)

The implications of the model for cost-push inflation

In type A inflation theories, in which prices and wages are costdetermined, the following assumptions are made (implicitly):
1.

*n ° ^ er words only relative prices are im

portant in determining the state of excess demand. As a con
sequence any level of prices is consistent with equilibrium in the
goods and factor markets. Put another way, the disequi
librium in the money market caused by a rising price level does
not affect real quantities demanded or supplied. The real bal
ance effect doesn’t operate and investment is interest inelastic.
An alternative possibility is that

but that ^ * “£= 0 0 '

The demand for idle balances is infinitely elastic with respect to
the interest rate. Hence changes in the transactions demand
for money (because of higher prices) can be financed out of idle
balances without a rise in the interest rate.16
2 . Even if

® and/or

£ 7^ 00, so that excess

demand falls with a rise in the general price level, the rate of change
in prices (and wages) is not affected. Rather excess capacity and
unemployment show up—recession cum inflation.
The first set of assumptions is necessary if the cost-determined
inflation is not to result in unemployment. Or, if the shapes of the
functions are such that unemployment would result from a cost-price
spiral, monetary and fiscal policy are necessary to “ validate” the
inflation, thus preserving full employment. The second set of as
sumptions is inherent in the definition of cost-determined. In actu
ality, of course, few people adhere to the extreme limit of these impli
cations. This we stressed at length (some would say, ad nauseam)
in chapter 2 . But the cost-push theorists generally believe the shape
of the functions to be about as depicted in 1 . above for moderate
ranges of price variation. And, more importantly, they believe that

This was discussed more fully on p. 22, above.
15 For practical purposes we confine the effect of interest rate changes to the investment goods sector.
16 The liquidity trap has a “top” as well as a “bottom.”
14

RECENT INFLATION IN TH E UNITED STATES

it takes substantially excess, and most particularly, substantially
deficient demand to swerve wages and prices from their fixed course.
Aggregate demand inflation

We are particularly interested at this point in the specific implica
tions of price and wage behaviour for aggregate demand inflation.
Demand-pull theories hold that inflation stems from a situation in
71— 1

which ^P/PiXi^O and will not continue when the sum total of excess
i= l

demands is zero.

Those associated with the quantity theory of

money hold, in addition, that the shapes of

and

are

such, that without an increase in the quantity of money, relatively small
increases in the price level would be sufficient to eliminate any excess
demands which might arise.
Within a stable aggregate demand, individual demands may indeed
be excess, counterbalanced by deficient demand in other sectors. In
order that price stability be maintained it is not necessary to have
71—

perfect equilibrium, i.e. X 1= X i= . . . X n^t—0, only that

Prices will rise to wipe out the excess demand in the areas of
rising demand and decline sufficiently to clear the market in the areas
of falling demand. If marginal cost curves are relatively flat and
resources are highly mobile, only small changes in relative prices will
be forthcoming. If, on the other hand marginal cost curves are
steep— if costs rise rapidly in the neighborhood of plant capacity—
and if resources are immobile, a much larger shift in relative prices
will be forthcoming; but these price shifts will always take place
within the framework of a stable general price level, so long as the
economy is not afflicted with aggregate excess demand. Further, it
is possible to achieve this result, say the demand-pull theorists, even
if some prices or wages are autonomously “ pushed” upward— the
resultant deficient demand will force price reductions in the flexible
price sectors of the economy; this in turn will lead to even larger
unemployment and excess capacity in the administered price sectors,
tending to “ break” the cost-determined nature of such prices.
The process by which excess demand leads to increases in price is
not an instantaneous one. Were prices and wages immediately to
adjust to any tendency for demand to be excessive, the economy
would instantly “ explode” to the new equilibrium price level, however
much of an increase that might require. Indeed, if reactions were so
quick, excess demand as an actual phenomenon would never exist.17
It would only be a potential ex ante force, never an actually existing
situation. In reality, of course, the economy moves through a series
of disequilibrium positions toward a neighborhood of “ equilibrium” —
a position which it seldom reaches, the equilibrium having changed in
the interim. Not only are we faced with lags in the spending and pro
duction processes, but with lags in the adjustment of wages and prices
to demands and costs. In the Chicago wheat pit there may indeed be

17 Cf. Duesenberry, “Mechanics of Inflation,” op. cit., p. 145.

RECENT INFLATION IN TH E UNITED STATES

instantaneous adjustment, but in few other markets. The firmest
believers in the applicability of traditional pricing theory conceive it
to explain the basic level and movement of prices; it need not hold
true at every moment of time. Wage rates in the most competitive
of labor markets are fixed for some minimum period. Prices of almost
all commodities, apart from raw agricultural products, cannot be
changed from day to day. Contracts, convenience, public relations,
and not least, the sheer cost of making price decisions, combine to
insure some lag between the emergence of changes in demand and
costs and the resultant change in prices.
What really interests us in any event is not the theoretical level of
prices implicit in various degrees of excess demand, but rather the
rate of increase in prices to which the excess demand will give rise.
There is a world of difference between the statement that a given
excess demand will lead to a price rise of 10 percent in 6 months, and
that it will lead to a 2 percent per year price increase, for the next 5
years. While most analyses of demand inflation have concentrated on
the “ equilibrium” increase in prices stemming from excess demand,
some recent works have concentrated almost exclusively on the rate of
increase aspect— determinate systems stressing continuous disequi
librium have been the major feature of these works.18 We shall follow
their example.
We define the price reaction coefficient kiy to be the relationship
between the magnitude of excess demand for commodity i and the
time rate of price increase to which the excess demand gives rise.
More precisely,
<>2 >

a A,

(is)

where p if x{, and q_{ represent the initial price, the excess demand, and
the equilibrium quantity respectively. In other words the rate of
increase in prices during a given time interval is proportional to the
magnitude of excess demand relative to the equilibrium quantity.
Given a three sector economy, whose aggregate variables are denoted
as follows:
T =gross national product
C = consumption, planned
S — savings, planned
/== investment, planned
Q— Government expenditures (planned and actual)
R —Government revenues,
then at the beginning of any time period, the aggregate excess demand in
the economy will be equal t o :
I + G —S—R

(14)

I + D - S ; ( D = 6 —R)

(14)'

or, what is the same, to:
___________

18 In particular, Bent Hansen, Duesenberry, and Enthoven, all op. cit. The derivations which follow are
those of Hansen and Enthoven. Most of the later implications are not.

RECENT INFLATION IN THE UNITED STATES

In turn,
(15)

i= l

If the existence of excess aggregate demand is the necessary and
sufficient condition for a rise in the general price index, that index
71— 1

must rise or fall as I + D —8 = ^ , P ^ n O .19
i=l

The standard general

price indexes now in use for both consumer and wholesale price meas
urement are Laspeyres, i.e.,

i 8 r p'

(16)

or
S

g< ( P i + A p i) _ 1 , S g< A V t _ T >
2 iip\
+ S2«2»i
'

(17)

This index will rise, remain unchanged or fall as
Z k iA

(18)

From (12) we see that,
^ q t A p t='^,qi-Pi-ki^ A t
2<

(19)

I f the kt are all equal, then,

y'.aiAvt=JcAty',Vi xt

(20)

Since in the usual case k A t will not be negative, a Laspeyres index will
rise or fall as

\ v a ^ O . the time rate of change being given by the

size of k. Without excess aggregate demand (an excess of planned
investment plus Government deficit over planned saving)— there will
be no inflation. If, however, the k{ are not equal, then the only type
of index whose stability will depend on the absence of excess aggregate
(n -l

demand I X ) Pi%t=0 I will be an index of the form;

___________ V > = 1
19Enthoven, op. cit., p. 262.

RECENT INFLATION IN THE UNITED STATES

21 )

(

But this is a nonsense index. It weights prices by the reciprocal of
their reaction coefficients. The more volatile the price the less its
weight. Rigid prices on the other hand receive very heavy weights.
Even apart from the question of zero coefficients, the resulting index
is useless.21 Thus, so long as price reaction coefficients differ, the only
price index whose movements will depend solely on the degree of
aggregate excess demand is a nonsense index, one which achieves
stability by weighting stable prices heavily relative to volatile prices.
Staying with the standard Laspeyres index, and assuming the kt to
differ we find that equation (19) now reduces to

(22 )

2 qt A Pi = 2 Pi ki Xi

Our Laspeyres index will therefore rise, remain unchanged, or fall as
(23)
Now if there were only minor variations in timing or in reaction speed
among different commodities this would be an interesting but trivial
result. Within a stable aggregate demand, changes m composition
could lead to a price rise, or a price fall depending, fortuitously, on
the relative magnitude of reaction coefficients in expanding versus
declining sectors. However, once we recognize that prices, and par
ticularly wages, are much more rigid downward than upward, a sub
stantial shift in the composition of demand necessarily tends to increase
the price level, even if aggregate demand is stable. If the kt are positive

for increases in aggregate demand and zero for decreases in aggregate
demand, then a mere shift in relative demands can lead to a rise in
the price level. Moderate changes in demand mix, of course, need
not lead to such a result. But shifts in demand larger than can be
taken care of by resource mobility at constant prices, will be inflation
ary. We need not assume that deficient demand has no impact on
price. All that is required is that the ki be systematically larger for
positive than for negative excess demand. In that case an index,
the change in which depends on 2) pt kt xu can rise even if 2) PiXt = 0 .
Let us designate positive excess demand as xs and the k associated
therewith as
(j = 1 .............m), and negative excess demand and its
associated k as xr and kr respectively ( r = n .............z). If all of the
kj are larger than the kr with no overlapping (i.e. the smallest kj
exceeds the largest kr)> then whenever
2 p ix i = ' 2 p j x j + 2 p 1x r = 0

20Derived as follows:

; from equation (12) we have 2
curs only when "Spai>0
21Cf. Enthoven, op. cit., p. 269.

|A p » = H e n c e , a rise in P i oc

RECENT INFLATION IN THE UNITED STATES

it will always occur that,
2p ihxi =

2 p rkrXr> 0 .

It is of course possible that there could be some overlapping. Even
if, for any given commodity, the k associated with positive excess
demand is larger than the k associated with negative excess demand,
it could happen that a particular shift in demand would be so struc
tured that the decreases in demand would be concentrated among
industries with particularly sensitive prices. In general, however, if
the ki are significantly and systematically larger for increases in de
mand than for decreases, a large shift in the composition of demand
will lead to a rise in the general level of prices. The greater the
variation in the xt around a zero mean, the larger the price rise is
likely to be.
In a growing economy a mere rise in demand need not be equated
with excess demand. Supply functions are constantly shifting to the
right, in response to the increase in the labor force and rising pro
ductivity. Hence our condition for excess demand,
I+ D -S > 0 ,

must be modified to take account of this fact.

Thus we have:

2 p tx{=^0 as (I-\-D—S ) —A (2piS i) = 0 , for p f ^ p i 1

(24)

The conditions for a stable price level are unchanged, insofar as they
involve excess demands. The only difference is that demand can
grow by a certain amount before becoming excess. With a systematic
bias in the ki} the more uneven is the pace of expansion the greater
is the rate of price increase likely to be. If demand and supply grow
at approximately the same rate in all sectors of the economy, then a
demand-induced inflation will not occur so long as the growth in aggre
gate demand is no more rapid than the growth in aggregate supply.
If on the other hand there are very diverse rates of demand growth
relative to supply in different sectors, then a demand-induced rise in
the general price level may occur, despite the fact that aggregate
demand and supply are growing at the same rate. An overall price
increase may thus take place which stems neither from an excess
aggregate demand nor from an autonomous upward “ push” of ad
ministered prices and wages. Given downward rigidity of commodity
and factor prices, the dynamics of shifting resource allocation involve a
general price increase, even in the absence of excess aggregate demand.
T

Spread

I n f l a t io n T

hroughout

the

conom y

So far, the kind of general price increase which results from down
ward price rigidities, has been ascribed to a kind of “ averaging proc
ess.” Prices rise where excess demand occurs and do not fall where
deficient demand is present. Hence the average price level rises.
But the inflationary pressure generated by a rapidly changing com
position of demand is not confined to this averaging process. The
prices of one industry are the costs of another. Excess demands for
certain materials, components, and parts lead to a rise in their price.
Declining demands for other materials do not result in offsetting de

RECENT INFLATION IN TH E UNITED STATES

clines in their prices. Hence industries in which demands are not
excessive are faced with rising materials costs; so also, though to a
lesser degree, are some industries with declining demands. Similarly
wage rates in particular occupations, and in particular industries are
bid up. Declining demand for other types of labor does not result in
falling wage rates. Increases in the cost of living also tend to raise
wage rates generally. Insofar as prices and wages are relatively in
sensitive to downward shifts in demand, but responsive to increases
in costs, inflationary pressures originating in particular industries will
gradually “ feed out” into the economy as a whole. The weaker the
demand, however, the less complete will be the pass-through of cost
increases into price increases, and the greater the pressure on profit
margins.
The relationship of prices and costs

Both theoretical and empirical investigations have led a growing
number of economists to believe that prices in a large part of American
industry do behave in the manner described above. Prices tend to
be set at a level sufficient to cover average unit costs plus some margin
designed to realize a “ satisfactory” rate of return on invested capital.
The rigid version of full-cost pricing, is clearly not an accurate descrip
tion of price behavior. Margins are not immutable, and are varied
in the light of market conditions. The variance, however, is not so
great as would be suggested by orthodox marginal price theory. As
a consequence prices are less sensitive to shifts in demand (particu
larly in a downward direction) and more sensitive to changes in costs
than would be the case were they set in accordance with orthodox
theory. The list of those who have accepted this “ modified full-cost”
explanation of the pricing process is impressive.22 The literature on
the subject is already so extensive that a survey of it would itself be
a major work. At this point we can only indicate a few of the reasons
why some form of full-cost pricing is likely to characterize pricing de
cisions in a large segment of industry.
The major objection to full-cost pricing as a description of business
behavior has been that it appears to be inconsistent with the attain
ment of maximum profits. The business firm which inhabits the
world of economic textbooks has known or certainly expected demand
and cost curves; profits are maximized by producing that output at
which expected marginal revenue and expected marginal cost are
equal.23 There are indeed problems where demand curves are recog
nized to be mutually interdependent— the “ mutual dependence
recognized” situation in an oligopolistic industry; but even here the
marginal concepts are usually retained with a discontinuity in the
revenue schedules, and the formal solution of profit maximization is
basically unchanged.
Perhaps the most persuasive and realistic alternative description of
business price behavior has been formulated by Richard Heflebower.24
In any industry characterized by large firms a sort of balance is
achieved through a process of evolution. Each firm in the industry
22 In addition to the original work of Hall and Hitch and their successor, P. S. Andrews, others who have,
in whole or in part, accepted this view of the pricing mechanism include: Mason, Chamberlin, Harrod,
Fellner, Robertson, Ackley, Duesenberry, Bain, Heflebower, Gordon, Lanzilotti, and Rothschild.
23 If one wants to be quite precise, it is expected discounted marginal revenue and costs which are relevant.
24 “ Toward a Theory of Industrial Markets and Prices,” American Economic Review, May 1 9 6 4 , and,
“ Full Costs, Cost Changes, and Prices,” “ Business Concentration and Price Policy,” National Bureau of
Economic Research, Princeton University Press, 1 9 5 5 .

44975—59------5

RECENT INFLATION IN TH E UNITED STATES

acquires a market position, which depends on a host of variables in
addition to price; the network of relationships with particular suppliers,
dealers, and customers built up over the years, the reputation of the
firm with respect to particular product specialties, the services furnished
in connection with its products, its selling organization and advertising,
and its own internal organization. Market position, in other words,
is “ that composite of attributes which governs the ability of the firm
to compete.” 25 It is an asset which must be preserved, for it is a
means of profit maximization under conditions of uncertainty. The
firm’s response to unanticipated developments must be made within
the framework of these attributes. As one firm put it, in answer to a
survey of pricing policies.
Our objective is to build for the long term a solid market that will stick to our
ribs through periods of adversity as well as prosperity.26

The balance achieved in an industry, with each firm possessing its
own— partly unique;—market position, is not something to be lightly
disrupted. In particular, long run profit maximization requires the
maintenance of market position. Customers once lost to other firms
are not easily regained, for supplier-customer relationships are not
the ephemeral connections implicit in orthodox price theory. During
a period of declining demand firms are faced with excess capacity,
and price cuts by rivals are viewed as threatening not only current
but future market positions. Retaliation must be swift, and all
firms know this. Changing a firm’s relative price position is appro
priate only when a radical change in market position is contemplated.
This in turn usually involves changes in many of the variables which
make up the market position, price being only one among many other
factors. It is a substantial step, not to be taken lightly, and in
particular not in response to relatively moderate changes in demand.
Nonprice competition is a much more satisfactory weapon for the
maintenance or gradual improvement of market position. Because
of their history, existing market positions, and internal structures,
individual firms have differential advantages in particular directions.
An improvement in market position is most likely to be sought in
those areas where the firm has a unique advantage, or in strengthen
ing other aspects of its operations where it is disadvantaged with
respect to competition. Moreover, an initial gain from nonprice
competition is likely to be maintained for a longer time than is the
gain from a price cut, which will almost certainly prove temporary.
As demand declines, marginal price concessions— kept as secret as
possible— will begin to be made. But an overt price cut is likely to
be made only when such adjustments on the part of all firms have
undermined the existing structure of prices.
Unlike changes in price made to improve market positions, price
changes in response to changes in factor costs are not likely to upset the
industry balance. A general wage increase affects firms in the indus
try in more or less the same way. Corresponding changes in price
are likely to be recognized for what they are, and are not interpreted
by other firms as a challenge to the existing structure of the industry.
Moreover public pronouncements, speeches, and press interviews by
25 Heflebower, op. cit., p. 125.
21 Robert Lanzilotti, “ Some Characteristics and Economic Effects of Pricing Objectives in Large Cor
porations,” “ The Relationship of Prices to Economic Stability and Growth,” Joint Economic Committee,
1958.

RECENT INFLATION IN TH E UNITED STATES

industry leaders are a workable27 method of agreeing in advance
what sort of price change is called for by the change in factor prices*
The necessity of maintaining long run profit opportunities, there
fore, tends to discourage attempts to maximize short run profits via
competitive price cuts. But price changes in response to changes in
factor costs, since they do not threaten to disturb relative market
positions in the industry, are not so inhibited. “ Forseeable profits
are not maximized, in order to ‘maximize’ those conditions which are
a sine qua non for any profits at all over the long run.” 28 It might,
of course, be said, that such behavior will, in the long run, correspond
to orthodox pricing theory—i.e. long run marginal costs will be equated
to long run marginal revenue. Aside from reducing the description
of entrepreneurial behavior to an ex post tautology (whatever the
entrepreneur does, it can be rationalized into marginal terms, ex post)
this is irrelevant from our point of view. The basic fact is that short
run decreases in demand are less likely to induce price changes than
are changes in factor costs.
Price and output decisions are made in an environment of un
certainty. Not only are demand and cost curves imperfectly known,
but the likelihood of unforeseen changes in demands and costs is
quite great. William Fellner has pointed out that under these cir
cumstances if maximum safety margins are to be maintained, prices
will be set on the basis of average costs.29 There will always be some
uncertainty with respect to the outcome of decisions taken in accord
ance with some “ best guess” as to demands and costs. Maximum
safety margins are the highest available margin by which the outcome
may be worse than the best guess without causing losses. B y pro
ducing at that output where the gap between prices and average cost
is the greatest, the effect on profits of “ guessing wrong” will be
minimized.30 Normally this will not be the same price or output
which, in the short run, would yield maximum profits if expecta
tions were held with certainty. If the rate of output for which
the difference between price and average cost is at a maximum
also yields what are considered to be a satisfactory rate of profits,
firms will be reluctant to sacrifice safety margins for the sake of in
creasing short-run profits. In reality, of course, there will be some
compromise between maximum profits and maximum safety margins.
But, to moderate downward shifts in demand, firms are likely to be
unresponsive. Prices will normally be set on the basis of average
total costs plus an uncertainty premium, and—
* * * the output policy actually adopted will be described as a policy of producing
whatever output the market will take. The implication is: at a price which the
firm can afford to sell, i.e. given the policy just described.31

The fact that most large firms also produce a variety of products
is another reason to expect that prices will be set on the basis of average
unit costs. Many costs will be common to the production of a variety
of products. In theory the incremental costs of adding to the output
of any particular product should be separable. In practice however
37 “ Workable,” i.e. not subject to antitrust action.
28 r . a . Gordon, “ Short Period Price Determination in Theory and in Practice,” American Economic
Review, June 1948, p. 271.
29 William Fellner, “Average Cost Pricing and the Theory of Uncertainty,” Journal of Political Economy,
June 1948.
80 Unless deviations of actual from expected normally take the form of lump-sum losses not influenced by
the size of output—an unlikely possibility. Cf. Fellner, op. cit., p. 250.
« Fellner, op. cit., p. 252.

RECENT INFLATION IN TH E UNITED

STATES

the existence of numerous products with common costs makes im
perative the use of shortcut approximations. In the first place the
distinction between what is a fixed and what is a variable cost becomes
blurred. At full capacity all costs are variable. But even at less
than full capacity the existence of many different processes within one
firm lends importance to fixed-cost allocation. Some departments
will reach capacity well before others; the decision to concentrate on
the production of one item will, of necessity, preclude capacity opera
tions in others. Decisions cannot be made and unmade at every
shift of wind in the marketplace. Hence the “ absorption” of over
head at a normal volume of operations must be taken into account,
even when operations are below normal. The full opportunity costs
of producing one item instead of another must include at least some
portion of overhead and “ target” profits as they would be at normal
operations. In the second place, the mere complexity of defining,
much less allocating correctly true marginal costs in a constantly
changing environment forces the use of an average cost system,
usually incorporating a full allocation of overhead. Indeed the choice
between the pjcaduction of different products in one firm is somewhat
equivalent to
several industries, so long as decisions
cannot profitam^^^fe^ rsed quickly.
consequence the total
unit costs must D'e don&nered in the short .run, just as they are in the
long run.32 Unless prices are set to yield full costs plus a margin
(all calculated at some standard volume) an intelligent choice between
various products cannot be made.
For both the long and the short period, the existence of common costs—particu
larly if numerous products are involved— creates an almost irresistable tendency
to price on an average cost basis.33

A world of uncertainty is a world in which longrun price strategy
and shortrun price tactics take on far more meaning than in the simple
two variable world of certainly known marginal cost and marginal
revenue schedules. Quite often the achievement of maximum profits
is most nearly approximated by a policy which aims at maintaining
“ satisfactory” profits over the long haul. Considerations of entry,
of public relations, of potential antitrust action, of union power, and
the maintenance of the complex of attributes which Heflebower has
called “ market position,” all play a role in defining the level of “ satis
factory.” A recent Brookings Institute study, and several articles by
one of its authors, have emphasized the prevalence of this “ target
rate-of-retum” pricing among large firms.34 No simple rule of thumb
is ever pursued single mindedly in business pricing decisions. Yet
the establishment of a price designed to yield some target rate of
return at a normal level of operations seems, from these studies, to be
a common practice.
The principal type of target return pricing is building prices directly from
standard costs plus a margin sufficient to provide the desired profit target; but in
many cases firms select a price first (via consumer surveys, comparisons with
prices of substitute products, or determinations of economic value to user'), and
then tailor engineering design and costs to fit the product requirements. In the
second method; the profit margin added may be the customary margin on direct
32 D. H. Robertson makes this point in “ Some Recent Studies in the Theory of Pricing,” “ Economic
Commentaries,” Staples Press, London, 1956.
33 Gordon, op. cit., p. 274.
34 Kaplan, Lanzilotti, and Dirlam, “ Pricing Policies of Large Corporations,” Brookings Institute, 1958;
Robert Lanzilotti, “ Some Characteristics and Economic effects of Pricing Objectives in Large Corpora
tions.” “ The Relationship of Prices to Economic Stability and Growth,” Joint Economic Committee,
1958; and the same author, “ Pricing Objectives in Large Corporations,” American Economic Review, Decem
ber 1958.

RECENT INFLATION IN TH E

UNITED STATES

or full costs, or a flexible margin on direct or full costs, which are expected to
yield the prescribed return at anticipated volume of sales.35

Such a price policy is, of course, the base from which many deviations
are made. And the particular mechanisms used to arrive at the price
are quite different among different firms. Some firms, indeed, start
with a price and work back to costs, deciding then if the item in
question can be produced at that cost. But the concept of attaining
some longrun profit objective seems to dominate the basic decision
making process, according to the Brookings study.
Now of course the mere fact that businessmen say they operate in
this fashion does not deny the possibility that they are rationalizing
processes actually carried out in a much different fashion. Never
theless, the fact that they do describe their own behavior in a manner
quite consistent with the theoretical considerations adduced in support
of the full-cost pricing hypothesis is not to be lightly dismissed.
The downward rigidity and cost-determined nature of prices do not
imply aberrations from rational behavior, nor can they be explained
by such simple concepts as “ kinked” demand curves. We have seen
that these characteristics of price behavior derive from the complex
nature of modern big business, and reflect the desire to maintain longrun profit opportunities at a maximum level. That deviations from
full-cost pricing are plentiful there is no doubt. In particular, the
typical business firm will not be at all adverse to making a little hay
while the sun shines. Nor to a lesser degree will it be able to resist
the temptation of margin shaving when excess capacity rears its ugly
head. Most prices will eventually fall if demand slackens enough,
and the degree to which increased costs will be reflected in higher
prices will be conditioned by the state of the market. But the bias
is there; to elicit a price cut requires a substantial decrease in demand,
while a price advance, not surprisingly, is more easily forthcoming
when demand rises, and almost sure to occur when costs increases.
Wage determination

Three characteristics of wage behavior are of particular importance
for our analysis of inflation: First, their insensitivity to declining
demand; second, their tendency to be influenced strongly by changes
in the cost of living; and third, the imitative pattern in wage agree
ments, which tends to force up wages in industries with declining
demand for labor as much as wages in industries where excess labor
demand exists.
Charts 3-1 and 3-2 depict the relationship between wage rate
changes and unemployment since 1900. The overall relationship
shown in chart 3-1 is very loose. If we use 4 percent unemployment
as a rough, but convenient division, with higher unemployment ratios
denoting deficient demand and lower ratios excess demand, and specify
2 y2 percent as the annual wage increase consistent with stable unit labor
costs (i.e., we assume 2% percent annual growth in average productiv
ity) then we find that of the 34 years in which wage increases were in
excess of 2K percent, 17 were years of excess demand, and 17 were
years of deficient demand. It is true that of the years in which wage
increases were less than 2% percent, more were years of deficient than
of excess demand. But most of these years, and all of the ones in
which wage rate changes were negative, were years of declining con
sumer prices. An examination of the mild recessions during the last
^Robert Lanzilotti, “ Some Characteristics, etc.,” op. cit., p. 446.

RECENT INFLATION IN TH E UNITED STATES

100 years, reveals that in the recessions of 1861, 1867, 1870, 1885,
1888, 1891, and 1904, the annual average of hourly earnings did not
decline, while in the recessions of 1854, 1900, 1911, 1924, 1927, 1938,
1949, 1954, and 1958, they rose moderately. All but one of the wage
increase cum recession situations were in the latter half of the period.36
Chart 3 -1

•is

RELATIONSHIP BETWEEN WAGE CHANCES AND UNEMPLOYMENT
1900-1958

percent change in wagea

4*
20 -

11
12
10

49 /6

8
03
53

k
2

°v
07

5*
*

*4.

sf 4*49
ii /a

j 3,9

-2

09
k

.//

I__ I__ 1__ L

805 10

*•
39

38
unemployment
ra te

-U
-6
-8
-1C -

3* Sumner Slichter, “ Do Wage Fixing Arrangements in the American Labor Market Have an Inflationary
Bias,” American Economic Review, May 1954, p. 324.

RECENT INFLATION IN TH E UNITED STATES

C h a r t 3-2

Chart 3-2 presents the same data for two sets of years; the first,
1900-1915, the second, 1947-58. The line describing the post-World
War II relationships is much higher than that characterizing the early
part of the century. If we ignore 1947-48 as influenced by the pe
culiar nature of the postwar reconversion, the slopes of the two lines
are about the same. But a 4 percent unemployment rate roughly im

RECENT INFLATION IN THE

UNITED

STATES

plied a 3 percent wage increase in the earlier period, whereas it seems
to imply an annual increase of some 5 percent in the postwar period.
In general, however, the relationships after the First World W ar are
so poor as to warrant drawing few conclusions— except that the level
of unemployment required to keep wage increases below 2%, to 3 per
cent appears to be quite substantial.
If one is willing to stretch the data a bit further than they perhaps
warrant, the postwar relationships shown in chart 2 suggest one addi
tional hypothesis. Fairly sizable levels of unemployment do affect
the magnitude of the annual increases in average hourly earnings.
However, the relationship between wage rates and unemployment
breaks down once unemployment falls below 5 percent. The rate of
increase in average hourly earnings then seems to depend very little
on the level of unemployment, and much more on the rate of change in
the cost of living and other factors. (See chart 3 -4 .) Otto Eckstein
has reached similar conclusions with respect to the relationship be
tween changes in earnings and changes in employment.37 Decreasing
job opportunities seem to have a noticeable effect on the size of annual
wage increases. But when employment is rising, the rate of increase
appears to have little relationship to the rate of employment increase.
This may be, in part, explained by the fact that the level of frictional
unemployment varies with the degree to which the composition of
demand is shifting. A rise in employment, spread evenly throughout
all of the major sectors allows of a larger utilization of the labor force,
and raises the level of full employment as a percentage of the total
labor force.
Charts 3-3 and 3 -4 present annual comparisons between changes in
average hourly earnings and changes in the Consumer Price Index.
There is a decidedly better relationship here than in the earningsunemployment case.
If, as in chart 4, we select 1900-15 and 194758 as two separate periods for comparison, we achieve a clearer rela
tionship between changes in consumer prices and changes in average
hourly earnings. Again as in the case of the earnings-unemployment
comparison, the post World War II period has an upward bias in com
parison with the early part of the period. In the 1900-15 period
years of small changes in the level of consumer prices were associated
with small wage-rate gains. The years in which wage gains were less
than that suggested by the line of average relationship were with one
exception also years of relatively high unemployment. In the post
war period changes in wage rates continued to exhibit some relation
ship to changes in consumer prices. However the average line of
relationship shows a much higher level of wage-rate change for a given
change in the price index. In part this may be explained by the
larger average gains in productivity which took place in the postwar
years, compared to those which occurred in 1900-15. A t any given
level of prices the change in the demand for labor will be greater, the
greater the change in productivity, other things being equal.38
37 Otto Eckstein, “Inflation, the Wage-Price Spiral, and Economic Growth,” “ Relationship of Prices,
etc.,” Joint Economic Committee, 1958, pp. 365, 366.
3s In technical jargon, the marginal revenue productivity curve, and hence the demand for labor shift
further to the right, the greater the shift in productivity—other things being equal.

RECENT INFLATION IN TH E UNITED STATES

An examination of monthly data for the postwar period shows a wide
variation in the speed with which wage-rate changes adjusted to
changes in the cost of living. In general, wages lagged behind the
sharp upsurge of prices in 1946-48, and again in 1950-51. On the
other hand wage advances preceded the rise in consumer prices
(although not the rise in industrial wholesale prices) during the 1955-57
period.39 As we have repeated innumerable times, leads and lags do
Chart 3 -3

OHAKG E S I N W AGES AN D CO NSUMER P R I C E S

1900-1958
p ercen t
ch an g e
in
20 _
w ages

18
*

___

4-7
43

___

37
•

t'
,6..A8

___

*5)
'•

6
49*5

53 44
• .SO * S7
03
o* : ° 6 *
rti3»**'3
°l \S8

• 2 -i36 /4

-« ,»

07
to
•

tt
*

percent
i

-2
30

-2

-u
22

-6
-8

C f. Hickman, op. cit., passim, and Eckstein, op. cit., p. 366.

“

p r ic e

RECENT INFLATION IN THE UNITED STATES

Chart 3 -4

CHANGSS IN WAGES AND CONSUMER PRICES
Selected Periods
percent
ctange

wages
18
16

u* —
12

10
8
6

1 1 1 *0

-6

-U

-2

®
S

“
ja M*. *
* \2 IIt I6

1 1 IT

percent

1U price

-2

-U
—6

-8

not in themselves reveal the basic nature of the inflationary process.
However the postwar behavior of wages relative to prices does tend
to strengthen the hypothesis that the administered nature of the wage
bargain slows down the typical excess demand inflation while it rein
forces a creeping, cost-oriented inflation.

RECENT INFLATION IN THE UNITED STATES

The downward rigidity of wage rates in the face of all but very sub
stantial cutbacks in unemployment is not a new phenomenon. Sum
ner Slichter has ascribed it mainly to the sizeable decreases in worker
efficiency which are likely to accompany a wage cut. While we often
talk about wage increases and decreases as if they were general, in the
real world they take place firm by firm, plant by plant. To the indi
vidual worker any wage cut means a cut in relative income. The dis
satisfaction thereby caused is widely recognized as a potential source
of poor efficiency, and lowered productivity.40 Despite the existence
of many unemployed and willing sellers of labor, the effect on plant
efficiency of dissatisfaction among employed workers has always
been a deterrent to reducing money wage rates.
The increased rigidity of wage rates to changes in the demand for
labor has been ascribed to a number of factors.41 The cessation of
large-scale immigration is one such factor. The growth of unions is
another. Whatever one believes about the power of unions to raise
wages, it is surely true that they are a major force in strengthening
the (already existing) floor under money wages. That workers and
their unions will resist money wage cuts more strenuously than cuts
in real wages due to rising prices has been labeled a “ money illusion,”
implying, it would seem, some sort of irrationality. As a matter of
fact, this attitude is eminently sensible. A union has some measure
of control over the money wage paid its members, very little over the
price of the product sold by the employer, and none at all over the
general level of prices. If the worker or his union agrees that the
price of the product should fall, and so offers to take a wage cut—
* * * his loss is immediate, tangible, and measurable, while only an economist
would have the colossal effrontery to assure him that his real income would not
suffer from the choice.42

While the overall downward rigidity of wage rates and the upward
influence exerted on wages by rising consumer prices help explain the
spread of inflationary pressures throughout the economy, an even
more important characteristic is the tendency of wages in different
industries to move in a roughly uniform pattern. Although we shall
examine the evidence for this in some detail in chapter 5, a brief
r6sum6 of recent experience is warranted at this point.
The average increase in output for all manufacturing industries
between 1953 and 1957 was 6% percent; the average increase in
average hourly earnings of production workers was 17 percent. The
top 25 percent of industries in terms of production increase had an
average production gain of 18 percent, almost three times the average
for all industries. But the average increase in hourly earnings for
these rapidly expanding industries was almost exactly the same as the
average for all industries (18 percent versus 17 percent). Whereas
production changes ranged from —5 percent to + 2 5 percent, the
smallest increase in average hourly earnings was 10 percent and the
highest 23 percent. A plot of the change in average hourly earnings
against changes in output reveals no systematic relationship. A
comparison between changes in average hourly earnings and changes
« Cf. Slichter, op. cit., p. 323; also Alfred Kuhn, “ Market Structures and Wage Push Inflation/* Industrial
Labor Relations Review, January 1959, p. 249.
« Cf. Slichter, op. cit., p. 327, and Harold Levinson, Unionism, Wage Trends, and Income Distribution/*
Michigan Business Studies, vol. X .
« Kuhn, op. dt., p. 246.

RECENT INFLATION IN TH E UNITED

STATES

in production worker employment reveals a similar lack of rela
tionship.
If earnings, output, and employment are compared for the period
between mid-1955 and mid-1957 the same results emerge. Indeed,
in this case, the average earnings increase for the most rapidly ex
panding industries (12 percent output gain) was slightly lower than the
average increase for all industries (2.7 percent output gain). Yet, in
the rapidly expanding industries production worker employment rose
2 percent, while for all manufacturing it declined 4 percent.
The same interindustry comparisons between changes in wage rates
and changes in output and employment have been made by the United
Nations covering some nine industrial countries of the West for the
period 1950-56.43 Strikingly similar results occurred. There was
very little difference between the average wage increase for all in
dustries and that for industries which had experienced the most rapid
expansion in output.
A more significant comparison, perhaps, is between price changes
and wage changes industry by industry. Presumably those industries
whose prices advanced most rapidly would be the ones in which excess
demands were most in evidence. Between mid-1955 and mid-1957
industries producing capital goods or closely allied to capital goods
production, though accounting for only 30 percent of the total weight
of industrial products in the wholesale price index, accounted for 62
percent of the total price increase. Prices in these industries rose
15 percent compared to an average 4 percent increase for all other
industrial products. Yet average hourly earnings in the industries
with the largest price advance rose 11 % percent compared to 10 per
cent for all other industries 44 Thus, the industries in which excess
demand was slight or nonexistent experienced wage increases almost
matching those granted in the areas where excess demands were
clearly present.
The tendency for wage increases to be relatively uniform through
out the economy implies that most industries match the increases
granted in rapidly expanding sectors. This uniformity is, of course,
what one would expect if there were a very high degree of short-run
mobility in the labor market. But we know that this is not the case.
Unemployment in some industries and regions of the country exists
for long periods of time during which there are labor shortages in
other industries and regions. Similarly shortages in some occupational
categories coexist with a surplus of labor in others. Depressed areas
and “ sick” industries continue to suffer their malaise in the midst of
all but the most vigorous of booms. Yet even in the short run wages
in most industries move closely together, with little evidence, in recent
periods at least, of systematically larger gains in industries with the
largest increases in the demand for labor.
Alfred Kuhn, building particularly upon the work of Ross and
Garbarino has evolved an explanation for this phenomenon which
appears both eminently reasonable and in accord with the facts as we
know them.45
In the short run the fairly large fluctuations in demand which con
front many firms are met primarily by changes in the work force. It
43 United Nations, “World Economic Survey, 1957,” table 8, p. 37, reproduced below, p. 114 as table 5-8.
44 See pp. 113-117 below for a more detailed discussion.
45 Alfred Kuhn, “ Market Structures and Wage Push Inflation,” Industrial and Labor Relations Review,
January 1959.

RECENT INFLATION IN T H E UNITED STATES

is clearly preferable in such circumstances to meet the demand for
increased output by adding to employment rather than to fixed costs.
During periods of full employment, such firms must attract workers
from other employers. Generally, however, workers have a low wageoriented but a high job-oriented mobility. Relatively small differences
in wage rates will not induce a large scale exodus of workers from one
firm to another, particularly where senioiity, pensions, and job security
are in question. As a consequence the employer who wishes to increase
his labor force must draw upon the small but steady stream of those
who are quitting their jobs in good times and bad in order to improve
their positions, to change surroundings, or for a host of other reasons.
The employer must attempt to insure that such people will first seek
work at his establishment. He must therefore establish a reputation as
a permanently high wage firm.

The combination of substantial fluctuations in short run demand
for labor and an inelastic supply means that large employers, in order
to have ready access to additional labor, have a strong incentive to
keep wage levels above the market average. When we further con
sider the nature of the oligopolistic industries who make up a large
part of the demand side of the industrial labor market, these con
clusions are reinforced. Any gains from higher productivity, for
example, can be disposed of in three fundamental ways: By a reduc
tion in price, an increase in profits, or an increase in wages. Unlike
a cost reduction due to lower factor prices, one which stems from
higher productivity is likely not to be equal in magnitude and simul
taneous in timing throughout the industry. A price reduction would
entail the danger of upsetting the balance within the industry. And
unless the specific technique which led to the advance in productivity
is somehow protected, any advantage gained by a price cut is likely to
be quite temporary. Passing along at least part of the gain in the
form of higher wages would, on the other hand, enable the firm to
achieve the high-wage reputation which it requires if it is to maintain
its market position. An attempt could be made, of course, to hold
the line on both prices and wages. Clearly, some of the productivity
gain may be maintained to build up the profit position of the firm.
And part of it will be used for research and development, the exploita
tion of new products, and the like. But, as we discussed in the prior
section, there is good reason to believe that most large firms aim at
some “ satisfactory” level of profits. Insofar as the firm fears that
too lush a growth in current profits may endanger future profits by
encouraging entry of new firms into the industry, a wage increase is
as efficient a barrier against entry as a price cut. Yet it involves
none of the dangers of retaliation and market disruption which might
result from a price cut; finally it promotes a positive objective of
management, the acquisition of a high-wage reputation. The same
reasoning applies to the “ divvying up” of gains from a booming mar
ket. At least part of the profits accruing from higher prices and
increased utilization of capacity will flow into wages, not only because
the union will fight for it, but also because it is in management's
interest to do so.
There seems to be no need to argue that workers and their unions
will press for money wage advances where productivity gains or price
advances have occurred. In theory the worker would be just as well
off if the productivity gains were passed on in the form of lower prices,

RECENT INFLATION IN THE UNITED STATES

or if the price increases were of the one-round variety, rather than
being compounded by a wage-price spiral. In actuality, of course,
there is a world of difference. Money wage increases are tangible and
immediate. Price reductions are out of the worker’s control, and in
the case of oligopolistic industries, there is substantial doubt about
the certainty of their occurring. Further, wage increases do, and
price cuts do not win union elections. If lowering steel prices would
present a problem to Mr. Blough of United States Steel, how much
more of a problem would they present to Mr. MacDonald if he were
to offer a price cut to his union members in lieu of a wage advance.
As wages are raised in industries which have experienced large
excess demands or gains in productivity, other firms will find it
necessary to raise wages also. It is not so much that the higher wages
elsewhere reduce the work force in these firms. Indeed in many cases
they may be laying off workers because of lower demand. As we
noted above, labor force mobility tends to be job oriented rather than
wage oriented. But this does not mean that the appearance of a
wage differential in a particular labor market will not cause trouble
for employers paying at the low end of the spread. Worker dis
satisfaction is a marvelously efficient way of insuring inefficient pro
duction. It is the threat to productivity rather than the threat to
the size of his working force which presses the typical employer to
give in to the pattern of wage increases established by the leading firm
or firms in the market. Even within a particular firm the problem of
worker response to job differentials guarantees an upward bias in
wage rate determination. An oligopolist, given the particular nature
of his production process and the particular labor market confronting
him, may need to establish a high wage reputation only for certain
skills and occupations. To some extent, of course, differentials will
be changed as a result. But there is a fairly narrow limit, particularly
in the short rim, to the degree of change in differentials which can be
made without inducing dissatisfaction. Hence the whole wage struc
ture of the firm may be shifted to create a high wage reputation for
certain skills. And, in turn, this interfirm differential has its impact
on the wages which must be paid by other firms, regardless of their
own market situation.
Oligopolistic firms, therefore, find it to their own advantage to pass
on a goodly part of the increased revenue from improving markets or
productivity in the form of wage increases. A high wage reputation
is a distinct asset from a business standpoint. And the pecuniary
motives are strengthened by considerations of prestige, public rela
tions, and general community good will.46 In competitive industries
wages are as low as the particular labor market permits. But pressure
to restore differentials forces these industries to keep pace with the
increases granted by their larger and more affluent competitors in the
labor market.
If all markets were more nearly competitive, and if small wage
differentials were effective in shifting workers from industry to in
dustry, the situation described above could not exist. Wages would
be flexible in the truest sense of the word. If aggregate demand were
<« The spate of recent pronouncements from high government sources deploring the effects of “ excessive”
wage increases may, however, remove some of the nonpecuniary advantages from large wage settlements.
If the public becomes convinced that these settlements are the basic “ cause” of inflation, then well-pubilcized industrywide wage settlement may become a liability rather than an asset to the industry in its
public relations.

RECENT INFLATION IN THE UNITED STATES

stable, industries whose output was expanding could bid labor away
from other industries with only small wage differentials. Larger than
average productivity gains would tend to result in price reductions;
slower than average productivity advances would lead to price rises.
The very nature of oligopolistic product markets, the lack of wage
oriented labor mobility, and the effect of growing wage differentials on
efficiency in low wage industries, combine to insure some rough degree
of uniformity in wage increases. The uniformity, however, does not
flow from some averaging procedure. Rather it is a uniformity in
which wage rates in most industries and for most skills tend to imitate
the behavior of wages in the most rapidly expanding sectors of the
economy.
The pattern setting nature of wage increases in oligopolistic indus
tries does not depend on the existence of labor unions. It is explain
able in terms of the nature of the product market and certain charac
teristics of the labor market which would exist even without unions.
There is no doubt, however, that unions strengthen this tendency
toward uniformity. As Garbarino has pointed out, the existence of
administered prices and large productivity gains establishes a po
tential “ kitty” out of which wage gains can be paid.47 Following
Kuhn, we have summarized the reasons why it is usually advantageous
to the oligopolistic employer to use the “ kitty” for wage advances
rather than for price cuts or for boosting profit rates to unsustainably
high levels. Further, we have indicated why the wage advances in
such firms will be matched by other firms not so advantageously
situated. Clearly the existence of powerful trade unions adds still
another reason why the pattern of wage determination should be as we
have described it. That unions are able to exert pressure on manage
ment to distribute the gains of productivity or improved market
position in the form of wage increases should come as no surprise.
And in firms which have, at any given moment, no “ kitty” to dis
tribute, the organized dissatisfaction which a union can muster prob
ably hastens the inevitable response to wage increases initiated
elsewhere. Industrywide bargaining institutionalizes the tendency
toward pattern setting which would exist in a weaker form without
unions.
Such a brief summary of the reasons for uniform wage advances
carries with it the danger of misinterpretation. A few caveats are
thus in order. In the first place, there is only a tendency to uni
formity. Important differences in the pattern of wage increases do
exist, and we do not wish to adopt a rigid version of the theory. In
some important cases wage rate increases in industries with no excess
demands exceed the gains in other industries; the steel industry in
recent years is a notable example. The central feature that we wish
to stress, however, is that on the average wage rates in industries with
declining demands show no systematic tendency to be lower than in
industries with rising demands. This rough uniformity of behavior
does not reflect a simple averaging of positive and negative changes
in the demand for labor. The average wage bargain is more strongly
influenced by the conditions existing in industries with above-average
demand and productivity gains than by those in industries with belowaverage gains. Second, we do not wish to be accused of a conception
47Joseph Garbarino, “ Theory of Inter-industry Wage Structure Variation,” Quarterly Journal of Eco
nomics, May 1950.

RECENT INFLATION IN TH E UNITED

STATES

of wage bargains in which benevolent employers vie with each other
to see who can provide their workers with the largest increase in money
wages. The foregoing analysis simply attempts to spell out the
reasons why an oligopolist, confronted with a fluctuating demand,
finds it to his advantage to acquire the reputation of a high-wage
firm. There are benefits accruing to the employer from paying
out “ monopoly gams” in the form of high wages. This does not mean
that union demands will be limited to the size of those gains, or that
employers will not wage a vigorous fight to keep the wage increase to
the lowest level consistent with the other objectives of the firm.
Henry Ford was neither a beneficent philanthropist nor an incompe
tent businessman when it came to the payment of high wages— he
simply recognized the substantial advantages of having a favorable
wage differential compared to his competitors in the labor market.
From particular to general price increases

Excess demand in particular industries transmits its impact to the
rest of the economy through its influence on the prices of materials
and the wages of labor. Crude material prices are normally quite
flexible, and are unlikely to increase significantly in the absence of
excess aggregate demand. Prices of intermediate materials, supplies,
and components, however, tend to be more cost determined, and
fairly rigid downward. Prices of those materials which are chiefly
consumed by industries with excess demand rise, since excess demand
for the final good will normally (though not inevitably) imply excess
demand for specialized materials. On the other hand, prices of
materials and supplies used mainly by industries in which demand is
deficient do not decline, unless the demand deficiency is very large.
Substantial excess demand in particular sectors of the economy will
result, therefore, in a general increase in the cost of intermediate
materials; industries which have no excess demand will nevertheless
find themselves confronted with advancing materials costs.
In the industries with excess demand, wages will be bid up and
wages in other industries will tend to follow. In some cases the size
of wage increases will be determined by long-term wage contracts
concluded in periods of excess demand; the annual increments will
continue even when demand is no longer excessive. Further, there is
abundant evidence that in the short run productivity gains tend to be
associated with output gains.48 Hence industries with rising demand
and rising output will have a twofold advantage in bidding for labor—
rising prices and rising productivity. Increases in the cost of living
will further accentuate the tendency for wages to rise.
The spread of wage increases from industries with excess demand to
other industries strengthens the rise in materials costs. The influence
of rising costs and the resistance of prices to declining demands will
be the greater the closer the product is to the finished state, other
things being equal. Finished products have usually passed through a
number of intermediate stages, each requiring a determination of
prices. As the degree of fabrication increases so also does the pro
portion of wage costs to total costs. The opportunities for rigidities
to build up and for rising wages to affect prices are multiplied.49
« See below pp. 115-117 for the evidence on this point.
« See below, pp. 105-106 for some recent evidence of this. The tendency for price rigidity to be asso
ciated with the degree of fabrication has been pointed out by a number of writers; cf. for example F. C.
Mills, “ Price and Quantity Interactions in Business Cycles,” National Bureau of Economic Research.

RECENT INELATION IN THE UNITED STATES

Rising costs will thus confront most producers of finished goods
including those the demand for whose products is stable or declining.
Even under the purest classical maximizing principles prices
would tend to rise with increasing prime costs. But under most
conditions the rise of prices would be less than proportional to the
rise in factor costs. With full-cost pricing the upward adjust
ments are more nearly proportional. In competitive sectors of the
economy the rising costs will be partly absorbed. And even in the
industries in which full-cost pricing prevails, markups will tend to be
shaded when excess capacity begins to rise. As inflationary pressures
spread out from excess demand sectors, their force will be somewhat
damped in the absence of an aggregate excess of demand. So long
as markups are more sensitive in an upward than in a downward
direction, and wages tend to follow the pattern set in the rapidly
expanding industries, however, the general level of prices will rise.
The kind of inflationary process we have described is difficult to
label. On the one hand it owes its origin to the emergence of excess
demands in particular sectors of the economy. On the other hand
such localized excess demand leads to a general price increase only
because of the downward rigidities and cost-determined nature of
prices and wages generally. The creeping inflation that results is
attributable neither to aggregate excess demand nor to a generalized
autonomous push of wages against prices. Indeed its major character
istic is that it cannot be understood in aggregate terms; it is the in
evitable accompaniment of a rapid shift in the composition of demand
in an institutional environment in which price and wage flexibility is
far from perfect.
A

d d it io n a l

o n s id e r a t io n s

So far we have attempted to isolate various types of inflationary
processes in their “ pure” form. In the real world, however, we seldom
find such ideal types. Aggregate demand is usually not in exact
balance with aggregate supply. Even if demand, both in the aggre
gate and in each of the major sectors of the economy were never
excessive, it may well be (though I know of no way of demonstrating
it) that our wage and price making institutions have so altered that
we would experience a modest upward push on the general level of
prices. The actual course of any inflation will be a mixture of many
phenomena, but each particular one will have its dominating char
acteristics. In chapter 5 we shall attempt to demonstrate that the
1955-57 inflation can be largely explained by the spread of inflationary
pressure from excess demand in the capital goods sector; the general
rise in prices was not, in the main, the result of either aggregate excess
demand or an autonomous cost-push. However the rapid and quite
generalized rise in monetary demand during the recovery of 1955 did
eave a legacy of built-in price and wage increases which added to the
selective inflationary pressures emanating, during the succeeding
2 years, from the capital goods sector of the economy.
In chapter 2 we pointed out that if prices and wages are cost deter
mined, and if there is a lag in the response of one to the other, an
initial excess demand inflation can continue after the excess demand is
eliminated. All of our recoveries from postwar recessions have been
relatively sharp and rapid. Expectations usually proceed at an even
more exuberant pace. Even before physical output reaches capacity,

44975— 59------ 6

RECENT INFLATION IN THE UNITED STATES

demands may become excessive, insofar as order backlogs begin to
pile up and long-term commitments are made in response to expecta
tions that demands will continue to rise. Productivity almost in
variably advances sharply, reflecting the technological improvements
made earlier, but not translated into specific performance during the
recession period when output was falling. Between 1910 and 1957
the average gain in output per man-hour (for the private nonagricultural economy) during the first year of recovery from recession or
depression was 5.2 percent compared to an average annual gain over
the whole period of only 2.1 percent.50
Margins improve dramatically; at the later stages of the recovery
the inflated margins lead to a sharp rise in the demand for factors of
production. Even when the demands are specialized they transmit
their impact to the prices of other factors, through the pressure of
unions and workers to maintain differentials. Wage contracts may
be signed for two, three, or even more years ahead, incorporating
built-in annual wage increases, and provisions for escalation with the
cost of living.
During the period of recovery itself, productivity gains are so large
and capacity so ample that prices of most finished goods do not rise.
Indeed the highest gains in output and the smallest increases in prices
are normally found during recovery. But as Bent Hansen has stressed,
an inflationary situation can arise when prices of finished goods are
stable, if margins are such as to lead to excess demands for factors of
production. And unlike finished goods, raw material prices do norm
ally rise sharply during recovery periods. Ruth Mack has pointed
out that this fact alone can provide a “ ratchet” under the price level,
for even when the excess demand tapers off, the downward rigidity
of prices results in a permanent incorporation of higher costs into the
price structure.51
If prices and wages were flexible, the initial tendency for rising
demands and expectations to result in rising wage and raw materials
prices would cease, so long as the recovery did not turn into a fullfledged boom. But the cost-determined nature of prices and wages
tends to perpetuate the influence of buoyant expectations during the
recovery, even when a quieter mood takes hold. Advance commit
ments and long-term wage contracts formally bring into the present
the events of the past. Lagged adjutments of prices to rising costs
and of wages to rising prices even in the face of falling demand play a
similar role. In this way the rapid surge of the economy in 1955 led
to changes in the structure of costs and prices which had an inflation
ary impact lasting into 1957 and 1958, even though, in the aggregate,
demands were only excessive for a short period of time in late 1955.
Had this delayed impact of excess demands been the only inflation
ary force at work, however, the price rises of 1955-57 would have been
significantly smaller. Without the stimulus of substantial excess
demand in the capital goods industries, the increase in the general
level of prices would soon have tapered off; we have already noted how
quickly a reduction in markups, of prices over wages and wages over
prices and productivity, will damp a rise in prices.
“ Productivity, Prices, and Income/' Joint Economic Committee, 1957, table 3, p. 89.
si Ruth Mack, “ The Destabilizing Influence of Raw Materials Prices,” “ TheRelationship of Prices, etc.,”
Joint Economic Committee, 1958, pp. 269- 284.

RECENT INFLATION IN THE UNITED STATES

Thus our explanation of creeping inflation rests on a combination
of factors. It originates in the general excess demands which tem
porarily emerge as we pass from recession to full employment, and from
the particularized excess demands which often remain when the ag
gregate excess has been eliminated. But it is perpetuated and spread
throughout the economy by the downward rigidities and cost-oriented
nature of our price and wage making institutions.
T

e l a t io n s h ip

e l a t iv e

em ands

e l a t iv e

P r ic e s

If the hypothesis we have presented is substantially correct we
should find that the relative rise in prices among different commodities
is related to the relative strength of demand, but with an upward bias.
A given increase in demand will lead to a price increase significantly
larger than the price decline accompanying a fall in demand of the
same magnitude. This result emerges from the existence of downward
rigidities in prices and from the influence on prices of cost increases
generated in areas of rising demands.
We have no measures of excess demand. However, we can use the
relative rates of growth in output as a rough and ready substitute.
A growing labor force and rising productivity imply a constantly in
creasing level of full employment output; supply curves are continually
shifting and to the right. If prices and wages were perfectly flexible,
price increases would only be associated with increases in output larger
than the rightward shift in supply curves. Schematically, the situation
is depicted below in chart 3-5.
Chart 3 -5

As the supply curve shifts rightward demand does not become excess,
and prices do not rise, unless demand increases by a larger amount
than supply. A plot of price changes against output changes industry
by industry during some given period, say a year, should produce a
relationship about like that shown in chart 3-6. If aggregate demand

RECENT INFLATION IN THE

UNITED

STATES

is not excessive, then aggregate output can rise moderately with no
increase in the average level of prices. For illustrative purposes we
have assumed a 4 percent rightward shift in supply curves. Prices
should fall in industries whose output gain is less than average, while
industries with larger than average output gains will experience price
increases. If resources are very mobile, then a significant dispersion
in the mix of demand should yield a price-output curve like B a b o v e relative prices need change only modestly to reallocate resources. If
resources are immobile, larger than average output gains will generally
require substantial price increases, and declining output will involve
large price decreases— curve A.52
Chart 3 -6

In our explanation of creeping inflation, however, the composition
of demand is an important determinant of the general price level.
Sharp increases in demand in some areas, balanced by decreases in
others, lead to an overall rise in the price level. If we plot the relation
ship of changes in prices to changes in output, our hypothesis would
lead to us expect a relationship of the following nature:
*2 The greater the mobility of resources the more elastic will be the supply curves of chart 3-6.

RECENT INFLATION IN THE UNITED STATES

Ch art 3 -7

There will be an upward bias in the relationship of prices to demand.
Industries with no excess demands— under our rough assumptions,
those whose output is expanding modestly—will nevertheless be char
acterized by rising prices. Only those industries with substantial de
ficiencies of demand will be marked by falling prices. I f we match, in
some detail, changes in industrial prices and output during the 1955-57
period we find a relationship exactly as depicted above.53 There was a
positive association between price increases and output increases; but
the relationship is not the one that would exist if prices and wages
were symmetrically flexible. Although the average gain in output
was quite small, there was a significant rise in the general price level.
Many industries whose output rise was significantly less than the
rightward shift in their supply curves nevertheless raised their prices.
Generally speaking, prices were reduced only in situations where pro
duction was sharply curtailed.
A demonstration that price increases tend to be associated with
demand increases, industry by industry, is, therefore, no proof that
inflation is generated solely by excess aggregate demand.54 The mere
fact of such a relationship is quite consistent with the hypothesis we
have presented in this chapter. Indeed the specific shape of the re
lationship and the values of its parameters during recent years tend
to confirm the fact that the inflation was not primarily generated by
excess aggregate demand.
53 For an extended discussion of this relationship see below, pp. 110-113.
54 Richard Selden in a recent article (“ Cost-push vs. Demand-pull Inflation,” Journal of Political Econ
omy, February 1959) has convincingly shown that the 1956-57 price increases were greatest in industries
with excess demand. He then proceeds to argue, however, that this fact demonstrates the excess aggregate
demand nature of the inflation.

RECENT INFLATION IN THE UNITED STATES
S e c u l a r I n f l a t io n

The mechanism by which shifts in the composition of demand tend
to generate a rising price level did not suddenly emerge in the post
war period. Many prices and most wages have always been relatively
insensitive to moderate downward shifts in demand. The magnetic
effect of rising costs in particular sectors of the economy on the gen
eral level of costs is not a novel phenomenon. But the recurrence of
sharp and prolonged general depressions was usually sufficient to
break through these rigidities and enforce a reduction in the most
insensitive prices and wages.
During depression years the widespread bankruptcies and reorgani
zations also led to massive write-downs in the value of fixed assets.
This provided an additional damper 011 secularly rising prices. In
creases in capital goods prices which accompany a short run inflation
normally leave a legacy of continued upward pressure on the level of
costs. Even after capital goods prices cease to rise the replacement
of lower priced assets— valued at the prices ruling before the inflation
began—with new, higher priced assets tends to raise the level of costs.
The fact that the new capital goods are more efficient than the ones
they replace is no offset, for the rise in productivity so generated will
normally be absorbed by higher returns to factors of production.
One may argue over the importance of capital costs per unit in shortrun pricing decisions. In the long run it is quite clear that they do
affect prices. The downward revaluations of capital assets during
severe depressions removed this legacy of rising capital costs left by
prior inflations. Thus by breaking through the ratchet which holds
up prices and costs, the severe depressions of earlier periods inter
rupted the tendency of prices and wages to rise secularly. There is
little likelihood that any administration would permit a recurrence of
such protracted depressions in the future.
There is yet another way in which downward rigidities in the price
system tend to engender a secular rise in the price level. We pointed
out earlier that productivity increases most rapidly during the early
phases of a recovery as the fruits of earlier investment outlays are
realized. Even though wages increase moderately during such per
iods, profit margins rise dramatically. Prices, based on the level of
costs incurred during the prior boom, are too high relative to the new
and lower level of costs. Had prices been reduced during the reces
sion, profit margins would simply return to a normal level during re
covery. Downward price rigidity, however, implies excessively high
margins when recovery occurs. Ex ante profit margins, at a full em
ployment level of output are too high in the recession, even though
ex post margins are somewhat lower than normal. The excessive
margins lead in turn to overexuberant expectations when the economy
moves back to full employment. As a consequence, even though
prices of final goods do not rise during the typical recovery, factor
prices are bid up. We have the kind of process emphasized by Han
sen and Turvey— a factor price inflation. The sharp rise in profit
margins is halted, and then reversed well before the succeeding down
turn in economic activity.56
55 The cyclical behavior of profit margins suggested here, is confirmed by the study of Osborne and
Epstein; “ Corporate Profits Since World War II,” Survey of Current Business, Department of Commerce,
January 1956.

RECENT INFLATION IN TH E UNITED STATES

If prices were flexible during recession, the rapid growth in pro
ductivity during the subsequent recovery would restore margins to
normal levels, with costs somewhat lower than at the prior peak.
The sharp productivity advances in recovery years would thus pro
vide an offset to the rise in costs and prices during other periods.
Instead, with rigid commodity prices, the productivity gains are
dissipated in higher factor prices.
The rigidities in costs and prices are thus sufficient to provide a
ratchet under the price level, preventing its falling back from levels
attained during periods of inflation. Adjustments in relative prices
tend to be accomplished by upward movements only, even though
aggregate demand is not excessive. Imbalances in general price-wage
relationships also tend to be overcome by a rise in one relative to the
other, rather than by a mutual adjustment toward a common center.
S o m e Q u a l if y in g C

om m ents

The kind of inflation which results from the process we have
described in this chapter is a gradual process. So long as aggregate
demand is not excessive, inflation will be mild. The rigidities and
cost-oriented characteristics of prices and wages are not so firm that
they completely withstand the influence of deficient demand. Our
exclusive concentration on the inflationary consequences of sharp
changes in the composition of demand should not be interpreted as
a sign that the resulting inflation is a particularly awesome affair.
Popular articles on inflation often begin by reciting all of the evils of
a hyperinflation, and then assign those evils as the consequence of
any inflation, no matter how gradual. The inflation we have here
described need have none of these characteristics. Mild inflation is,
in fact, one of the ways in which an economy with downward rigidities
in its cost and price structure allocates resources. There are arbi
trary income gains and losses accompanying any shifting about of
resources. Whether individual well-being and social equity are better
preserved when resource shifts entail only relative price changes in
stead of overall price increases I do not pretend to know. Certainly,
however, it is not a question whose answer is obvious.

CHAPTER 4
THE IMPACT OF OVERHEAD COSTS ON THE INFLATIONARY
PROCESS
I n t r o d u c t io n

We have argued that the average level of prices is influenced not
only by changes in aggregate demand, but also by changes in its
composition. Even if aggregate money demand is not rising at an
excessive rate, a sharp change in the mix of demands will entail a
rise in the general price level. Any given increase in money demand
will thus involve a smaller increase in actual output, the greater is
the shift in its composition. If aggregate money demands are rising
at a rate about equal to the increase in output which might be ex
pected from labor force and productivity growth, then a rise in the
general level of prices will reduce the rate of growth in real output.
Assume, for example, that output normally must rise by some 4
percent per year to absorb the growing labor force; if aggregate money
outlays rise at 4 percent per year, any increase in the price level will
reduce the growth in output below 4 percent and normally lead to
rising unemployment. This is simply another way of saying that an
increase in prices not caused by excess aggregate demand will lead to
an increase in unemployment unless sufficient money demands are
forthcoming to clear the market at the higher prices.
During the 2 years from mid-1955 to mid-1957 aggregate money
expenditures rose by about 5 percent per year, only slightly faster
than the rate of increase in real output which has normally character
ized the American economy since World War II. Yet prices rose
3% percent and real output by only 1% percent. The proportion of
the rise in money expenditures which was dissipated in higher prices
was much larger than might have been expected on the basis of ag
gregate analysis alone. The rise in output was only slightly larger
than the increase in the labor force during these years. Had produc
tivity risen at its “ normal” postwar rate, substantial increases in
unemployment would have occurred. In fact productivity did not
rise and unemployment remained for the entire 2 years at a stable 4
percent of the labor force.
We shall argue in this chapter that the failure of productivity to
rise was not a technological phenomenon. Rather it resulted from
the combination of rapidly increasing overhead costs and slowly grow
ing output.1 All of the additional employment during the period was
concentrated in jobs which are generally considered in the category of
fixed expenses. When output failed to grow such employees were
not discharged. As a consequence the statistical measure of produci We shall present in the next chapter evidence that the disappointing productivity rise was not caused
by disruptions in output associated with the large investment boom.
78

£ IM l

RECENT INFLATION IN THE UNITED STATES

tivity showed a disappointing rise, and the unemployment ratio
remained low.
This rise in overhead employment during a period of small gains in
output led to substantial increases in fixed unit costs. Other elements
of overhead costs— research and development, capital consumption
allowances, and so forth— also increased rapidly. In fact fixed costs
were by far the largest component of the increase in total unit costs.
Thus overhead costs have a twofold importance in our analysis; they
not only help explain the fact than unemployment failed to increase
in the face of a rise in prices not fully “ validated” by rising aggregate
expenditures, but they also help explain part of the rise in prices. In
the rapidly expanding sectors of the economy price increases stemmed
largely from the influence of excess demands. In other sectors, how
ever, the smaller, but still significant, rise in prices is traceable not
only to the advance in wages and materials prices, but also to the
substantial rise in overhead costs.
T h e C h a n g in g S t r u c t u r e o f C o s t s , 1947-57

One of the major, though little noticed, features of the postwar
period has been the rapid change in the cost structure of the American
economy. The proportion of total costs accounted for by relatively
fixed items of expense has risen sharply. This has resulted not only
from a change in the internal structure of costs within individual
industries, but also from a shift in the importance of different industries.
The distinguishing characteristic of “ fixed” or “ overhead” costs is
their inescapability.2 The longer the time period under consideration
the more any given cost will be escapable. There is, consequently,
no absolute criterion by which to define what are and what are not
fixed costs. Rather, we are faced with a spectrum of costs, ranging
from those which can be quite readily varied in accordance with
fluctuations in output, to those which will continue for long periods
of time regardless of the level of output. In many cases the fixed
nature of a particular cost arises not from the physical impossibility of
escaping it, but from the economic nature of its contribution to the
production process. The salaries of managers, engineers, technicians,
salesmen, administrative personnel and the like represent costs which
fall into this category. Except for those cases in which long-term
employment contracts are in effect, there is no physical or legal im
pediment to reducing the employment of such people when output
declines. But, in fact, such personnel are hired in the context of
longer run requirements. Their services do not contribute to the
profitability of the firm in a way which depends closely on the level of
output. Just as in the case of plant and equipment outlays, or re
search and development expenditures, their salaries represent an
investment in the long-term future of the firm.3 Over the long run,
outlays for these fixed or quasi-fixed costs are adaptable in the light
of the firm’s actual experience. But a temporary shortfall in sales
and production below expected levels is not likely to induce a large
scale reduction in these costs. Of particular relevance to our analysis
of the 1955 -57 period is the fact that a temporary failure of output to
2 Cf. W. Arthur Lewis, “ Overhead Costs,” Unwin Bros. Ltd., London, 1949, pp. 9-30.

3 Even if the employment of such personnel simply reflects the operation of “ Parkinson’s law” in corporate
bureaucracies, they are presumed to have been hired with some longrun requirement in mind.

RECENT INFLATION IN THE UNITED STATES

rise to the levels anticipated when the costs were initially incurred
does not necessarily induce firms to pare them down. An inspection of
nonfarm employment data classified by occupations (Census) and
manufacturing employment classified between production and non
production workers (BLS) confirms this view. Of the total decline in
employment during recessions, almost all is accounted for by occupa
tions other than those we would classify as “ fixed” or “ overhead” ; sim
ilarly in manufacturing, almost the entire reduction in employment
takes place among production workers— employment of nonproduction
workers declines very slightly.
T a b l e 4 - 1 . — Employment by occupation, 1947-57
Employees (millions)

Percent of total
change

Percent change

Occupation
1947

1955

1957

1947-57

1955-57

1947-57

1955-57

Total nonfarm employment___

49.8

56.5

58.8

18.1

2.8

100.0

Overhead type employment1.............
Direct labor2.......................................
Service workers and miscellaneous___

20.2
23.6
6.0

24.6
24.7
7.2

26.5
24.9
7.4

31.2
5.5
23.3

7.7
.8
2.8

70.0
14.4
15.6

92.6
8.7
8.7

1 Professional and semiprofessional, managerial, sales, clerical, and kindred personnel, and proprietors.
2 Craftsmen, foremen, operatives, and laborers.

Between 1947 and 1957 total nonfarm employment rose by slightly
more than 8 million. More than 6 million of this rise was accounted
for by increased employment of overhead type personnel, and only
1 % million by direct labor. From 1955 to 1957 the relative gain of
overhead personnel was even larger; total nonfarm employment rose
2.3 million, employment in those occupations whose payrolls are
normally considered direct costs accounted for only 200,000 of this
rise.
T a b l e 4 - 2 . — Employment in manufacturing, 1947-57
Employees (thousands)

1947

1955

1957

Total manufacturing employ
ment........................................ 15,290

16,563

16,782

Production workers............................. 12,795
Nonproduction workers...................... 2,495

13,061
3,502

12,911
3,871

Percent change

Percent of total
change

1955-57

1947-57

9.8

1.3

100.0

1.0
55.0

-1 .1
10.5

7.8
92.2

-68.0
168.0

1947-57

1955-57

Within manufacturing the shift to overhead labor has been even
more radical. All of the postwar gain in employment has taken
place among nonproduction workers. From 16 percent of total
employment in 1947 they have risen to 23 percent in 1957. Between
1955 and 1957 the relative growth was even more rapid, as nonproduc
tion worker employment rose 10 percent while production worker
employment was declining.
It is not only overhead labor costs which have risen. Other types
of relatively fixed costs have increased as a proportion of total costs.
The rapid growth of research and development expenditures is partly
reflected in the rising employment of technical personnel. But it

RECENT INFLATION IN THE UNITED STATES

also shows up in increased plant, equipment, and materials outlays—
inseparable in the data from the total outlays on such items for all
purposes. There is some evidence that the overall capital-output
ratio has risen during the past 10 years, although not back to its earlier
peaks prior to World War I.4 More importantly the ratio of relatively
short lived equipment to long lived plant has risen substantially.5 As
a consequence, even with capital output ratios constant, depreciation
as a proportion of total cost would tend to rise. The much sharper
increase in plant and equipment prices relative to the average price
level has further accelerated the rise in unit depreciation charges
compared to other costs. As table 4-3 brings out, prices and con
struction costs have risen far more rapidly than any of the standard
general price indexes. Reflecting this rise in relative prices, and also
the fact that throughout the postwar period depression-priced plant
and equipment was continually being replaced by higher priced
equipment, the average “ price” of a unit of capital “ services” rose
very rapidly.6
Ta b le 4-3. — Percent change in selected price indexes, 1947-57

GNP deflator________________________________________________________ 30.3
Wholesale price index: all commodities_________________________________23. 7
Wholesale price index: industrial commodities__________________________ 32. 2
Consumer Price Index________________________________________________ 29. 2
Producers’ durable equipment deflator_________________________________ 50. 8
Private nonresidential construction deflator_____________________________54. 4
Average price of a unit of capital equipment services in manufacturing 1__ 54. 7
1 Cf. footnote 6, above

There is no generally acceptable way of calculating depreciation on
an economic basis. However calculated, it is clear that depreciation
charges have risen quite substantially as a proportion of total costs.
While we have no data allowing us to attempt a breakdown of costs
for all industries, it is possible to construct a set of cost estimates for
manufacturing. In tables 4-A and 4-5 the rapid growth in the im
portance of overhead costs stands out clearly.
< Cf. Machinery and Allied Products Institute, Capital Goods Review No. 22; Daniel Creamer, “ Studies
in Capital Formation and Financing,” Occasional Paper 41, National Bureau of Economic Research, 1964;
Israel Borenstein, “ Capital and Output Trends in Mining Industries,” Occasional Paper 45, National
Bureau of Economic Research, 1954; Melville Ulmer, “Trends and Cycles in Capital Formation by U.S.
Railroads,” Occasional Paper 43, National Bureau of Economic Research; “ U.S. Income and Output,”
Department of Commerce, 1959, table V-15, p. 196; also the forthcoming publication of the National Bureau
of Economic Research on “ Capital Formation and Financing in Manufacturing and Mining” by Creamer,
Borenstein, and S. P. Dobrovolsky.
* See the following:
Ratio of equipment to plant (based on constant values in 1954 dollars)
1929
Total private economy______________________________________________
Manufacturing________ ________________ _____________________________

0.52
.47

1947
0.63
.73

1957
1.00
1.04

•The average price of a unit of capital services is taken to be the implicit deflator used in converting
depreciation charges based on current replacement cost values into values expressed in constant dollars.
Cf. Donald Woodin and Robert Wasson, “ Manufacturing Investment Since 1929,” Survey of Current
Business, Department of Commerce, November 1956.

Re c e n t In f l a t i o n i n t h e u n i t e d s t a t e s

T a b l e 4 - 4 . — Manufacturing costs, 1947-57
[Index, 1947=100]
1953
Total gross income originating____________________________
Wage payments 1____ . . _____________________________
Salary payments 2...... ................................................. ......
Capital consumption allowances _ . . ....... .................... .
Profits and other property income *__________ _____ ____
Indirect taxes.. ................................. ......... ..........................

1955

168.8
163.6
179.5
226.8
169.1
150.6

181.6
165.1
203.3
294.5
191.5
162.6

1957
197.4
178.3
252.3
335.3
177.8
183.1

1Includes an estimated allocation of “ supplements” to wages.
2 Includes an estimated allocation of “ supplements" to salaries.
3 Includes corporate profits, income of unincorporated business, and net interest.

T a b l e 4 —5 . — Change in selected manufacturing costs
Percent change
1947-57
Total gross income_________ _______________
Wa?e payments_________________________
Overhead__________________ __________
Salaries_____________________________
Capital consumption_____ ___________
Addendum: Profits plus capital consumption.

97.4
78.3
171.4
153.3
235.3
103.6

Percent of total change

1953-57
16.9
9.0
42.8
40.6
47.8
14.1

1947-57
100.0
39.9
34.7
25.6
9.1
24.8

1953-57
100.0
24.9
53.7
39.3
14.4
20.7

N o te —See footnotes to table 4-4.

The capital consumption allowances used in the tables are based on
bookkeeping records, and hence reflect original cost valuation of
assets. They also reflect changes in depreciation methods (acceler
ated tax amortization, 1954 Revenue Code liberalization, etc.).
Despite these shortcomings the evidence is clear that “ fixed” costs
have risen quite rapidly as a proportion of total costs. In 1947 salary
payments and depreciation together accounted for 21 percent of total
income originating in manufacturing. By 1957 they were 29 percent
of the total. Of the $68 billion increase in total value added in manu
facturing between 1947 and 1957, $25 billion went to the overhead
cost categories, about the same as the amount accounted for by the
increase in the wage bill. After 1953 the relative growth of overhead
items is much more striking; $12 billion of the $22 billion rise in total
value added went to salaries and depreciation, only $4 billion to
wages.
Overhead costs per unit of output
The aggregate dollar costs developed in table 4 -4 can be converted
to costs per unit of output. Using 1947 as a base period, we can
extrapolate the gross product in manufacturing (equals gross income
originating) by an output index and thus obtain a constant dollar
measure of output. Dividing the current dollar estimates of gross
product by its constant dollar equivalent, we obtain the implicit price
deflator of manufacturing gross product. Since price per unit is
simply the sum of charges against output, calculated per unit of output,
we can convert our cost aggregates into unit costs which sum to an
index of the price of value-added.7 The cost data become “ points”
7 See the author’s “ Construction of Consistent Price, Output, and Unit Cost Estimates,” (to be pub
lished as a comment in the 1958 Conference on Income and Wealth (vol. 25), National Bureau of Economic
Research, for a fuller description of the process and some of the index number problems involved.

RECENT INFLATION IN THE UNITED STATES

in the price index. Similarly by appropriately weighting the valueadded deflator and an index of the prices of raw materials purchased
by manufacturers, an overall product price index can be constructed,
and compared with the published BLS index of manufacturers' prices.
T able

4-6.— Prices and unit costs in manufacturing, 1947-57
[Index, 1947=100, and index points]

Manufacturers’ price index:
Actual1........................ ............................. .............................
Calculated2_________________ _____ ____________________
Raw materials price index_________________________________
Price index of value added3.............. ............ ................... .........
Wage cost..____ __________________ ____ _______________
Salary cost____________________________________________
Gross margin_________________ ____ _____ __ _________
Capital consumption_________ ____ ________________
Profits and interest________________________________
Indirect taxes_________________ ____ ___________________

1947

1951

1953

1955

1957

100.0
100.0
100.0
100.0
49.9
17.0
22.3
(3.8)
(19.5)
9.9

120.4
120.9
114.6
123.5
57.5
20.0
35.6
(5.1)
(30.4)
10.5

117.6
117.3
103.1
123.4
59.7
22.3
30.4
(6.3)
(24.1)
10.9

119.9
120.4
98.4
129.8
58.9
24.7
34.7
(8.0)
(20. 7)
11.5

128. 5
127.8
100.8
139.4
62.8
30.3
33.5
(9.0)
(24. 5)
12.8

1BLS index.
2 Calculated by weighting the raw materials index by 0.3 and the price of value added by 0.7.
3 “Value added” is equivalent, in this context, to gross product originating.
T able

4-7.— Changes in manufacturing prices and unit costs, 1947-57
Percent change

Manufacturers’ price index: Actual.
Raw materials price index________
Price index of value added________
Wage cost___________________
Salary cost---------------------------Gross margin------------------------Capital consumption...........
Profits and interest....... ......
Indirect taxes.............................

Percent of total change
allocated to each item

1947-57

1953-57

1955-57

1947-57

1953-57

28.5
.8
39.4
25.9
78.2
43.8
136.8
25.6
29.3

9.3
-2 .2
13.0
5.2
35.9
10.2
42.9
1.7
17.4

7.2
2.4
7.4
6.6
22.7
-3 .5
12.5
-8 .2
11.3

100.0
32.7
33.8
25.9
13.2
12.7
7.4

100.0
19.4
50.0
19.4
16.9
2.5
18.8

1955-57

100.0
40.5
58.1
-12.1
10.8
-23. 0
13. 5

W e shall be using the data in these tables extensively in chapter 5.
A t this point the major feature to warrant attention is the very large
proportion of the increase in total unit cost (equals price) accounted
for by salaries and depreciation. Of the 40-point rise in the valueadded deflator between 1947 and 1957, 19 points were accounted
for by these overhead costs.
Salary costs and gross margins
together accounted for 62 percent of the rise in total unit costs. After
1953 the rise in salaries and depreciation charges per unit was equal
to four-fifths of the rise in price. Wage costs, on the other hand,
which were one-half of total charges against gross product in 1947,
accounted for less than one-third of the increase in costs during the
next 10 years. In the latter years of this period they accounted for
an even smaller proportion of the rise in costs. Whatever one’s in
terpretation of the significance of these data, they clearly bring out
the radical change in the cost structure of manufacturing over the past
10 years.

These cost data are, of course, ex post reflections of a complicated
interaction between costs and demands. We do not mean to imply
that the increase in any particular component of costs “ caused an
equivalent rise in prices. We shall, in fact, spend the remainder of

RECENT INFLATION IN THE UNITED STATES

this chapter attempting to unravel the effects on prices, productivity,
and incomes of rising overhead costs, both in a secular and in a cyclical
context.
Secular

A spects

It is convenient to consider the influence of overhead costs on other
economic variables under two different sets of conditions: First, the
situation in which output is proceeding according to the expectations
of entrepreneurs when they committed themselves to the additional
overhead expenses; second, the situation in which output falls short of
expectations. In analyzing costs under the first set of conditions we
shall not need to worry about unutilized capacity, unemployment,
or output variations as such; technically speaking we are dealing only
with changes in costs associated with changes in the shape and position
of cost curves; changes in costs brought about by movements along
a specific curve we shall, temporarily, ignore.
Overhead labor

To a large extent the growing employment of overhead personnel
represents a substitution for production labor. Technological im
provement in the postwar period has led not only to a reduction in
labor requirements per unit of output but also to a change in the kind
of labor used. Automation of production methods, instrumentation
of control functions, mechanization of office and accounting procedures,
self-regulating materials handling equipment— all of these develop
ments require a growing complement of professional and semipro
fessional personnel in supervisory, operating, and maintenance roles.
The growth of formal research and developments as a separate
function in many firms has displaced the more informal catch-as-catchcan type of research performed in production departments. As the
nature of production processes has been altered, so also has the com
position of the labor force required to service them.
Statistically this substitution has yielded a rate of growth in
production worker output per man-hour larger than the overall
growth in labor productivity. It is never correct, of course, to impute
to any one factor of production the “ causal” role in the advance of
average productivity. However, so long as the capital-output ratio
and the rate of return on capital investment are constant, wages can
rise as rapidly as the advance in average labor productivity without
causing any rise in total unit costs. The substitution of overhead
for variable labor8 is in some respects analogous to the substitution
of capital for labor. Both involve the replacement of one kind of
input by another. In the case of capital, however, the maintenance
of some “ satisfactory” rate of return per unit of capital is normally
sufficient for dynamic equilibrium. In the case of overhead labor,
however, the rate of return per unit of input— the average salary— will
inevitably tend to rise along with rising wage rates. Even if the
growth of overhead labor is proportioned to the growth in output—
analagous to a constant capital output ratio— the average overhead
cost per unit of output will rise. In other words, if the increase in
the productivity of wage labor involves a substitution of salaried for
9 We use the terms “ overhead” and “ salaried” labor interchangeably; so also, “ wage” and “ variable”
labor.

RECENT INFLATION IN THE UNITED STATES

wage labor, then total unit cost stability requires that wage rates rise
by less than the growth in wage labor productivity.
Table 4-8 summarizes the changes in man-hour requirements per
unit of output,9 average compensation, and unit costs for manu
facturing production and nonproduction workers. The 1947-55 time
period was chosen, instead of 1947-57, because the 2 years after 1955
were dominated by cyclical, rather than secular behavior.
T a b le 4 -8 . — Changes in 'productivity, earnings, and unit costs— Production and

nonproduction workers in manufacturing
[ Percent]

1947-55
Salary cost per unit of output__________________________________________
Man-hours per unit of output______________________________________
Compensation per employee man-hour_____ _____ ____________________
Wage cost per unit of output___________________________________________
Man-hours per unit of output__________________________ ____ ________
Compensation per employee man-hour___ ____ ______________________
Total labor cost per unit of output______________________________________
Man-hours per unit of output_______________________________________
Compensation per employee man-hour___ ______ _____________ _______

46.0
.3
45.6
18.0
-26.5
60.5
25.0
—22.2
60.7

1951-55
22.2
2.7
19.0
2.7
—14.1
19.9
7.8
—11.3
21.4

The increase in employment of salaried labor between 1947 and 1955
was just about equal to the increase in output. The increase in
salaries was somewhat lower than the rise in wage rates, but solely in
the early part of the period. It was during the years after 1951 that
the relative growth of salaried employment to wage employment was
most striking, and this development reflected itself in an increased
rate of growth in salary rates.
Using the data in tables 4-6 and 4-8, we can compute the amount
by which wage rate increases must fall short of wage-labor productivity
gains if unit cost stability is to be maintained.
Let:
I L =Index of total unit labor costs
I w= Index of wage rates
I s = Index of salary rates
Z w=Index of wage labor output per man-hour
Z s = Index of salaried labor output per man-hour
J* =Base period proportion of wage costs in total labor costs
When the F s and Z 1s are expressed as lower case letters, i and z,
they represent the annual percent change in the index, (eg.,
if Iw —105, %ug—-5)
Then:

M s ) +0 -?Xz:)

(i>

Assume that the increase in salary rates will keep pace with the
increase in wage rates. Then,

(2 )
•A measure of unit man-hour requirements is the reciprocal of productivity.

RECENT INFLATION IN THE UNITED STATES

If the employment of salaried labor keeps pace with the rise in output,
as it did between 1947 and 1955, then the second term of equation (1)
reduces to :

(3)

(4)

i + ( i - / > ) ( Z „ - 1)

(5)

and

{ —
"

V'Zw
1 + Z w( l - P )

(6)

During the 1947-55 period the average annual rate of growth in
wage-labor output per man-hour was 3.9 percent. The proportion
of wage costs in total labor costs was approximately 0.75.10 Substitut
ing in equation (6) we find that with a 3.9-percent rate of growth in wage
labor output per man-hour, any rise in vnge rates larger than 2.9 percent
leads to rising unit labor costs. W e have, of course, assumed that salary
rates tend to rise pari passu with wage rates, whereas during the period
under consideration they actually rose at a somewhat lower rate.
However, there are two important considerations which suggest that
this assumption is the most useful one to make. Wage rates can in
deed rise more rapidly than our equation suggests if salary rates lag
behind. But in this case unit labor cost stability is only maintained
by one group falling behind in the improvement of real incomes.
Secondly, it is doubtful, in any event, that salary rates would continue
to fall behind wage rates, particularly in view of the relative shift in
the demand for labor away from wage labor toward salary labor.
In fact, after 1951 the rate of increase in average salaries was about
equal to the wage increase, and after 1955 somewhat larger.11 Quite
probably the larger rise in wage rates between 1947 and 1951 reflects
a readjustment of the wage-salary structure which had gotten some
what out of line during the depression and war years.
Where the employment of overhead labor is rising relative to direct
labor, therefore, one of the conditions for price stability is that wage
rates rise less than direct labor productivity. This in itself does not
imply that the growth in overhead costs inevitably leads to price
increases. Nor does a rise in wage rates greater than that implied in
our equation (6) tell us anything about the “ cause” of the price rise
which will usually follow such an occurrence. This we stressed at
length in chapter 2. W e have only specified a requirement for price
stability, not provided a means for ascertaining the causes of price
increases. However, the fact that the requirement for price stability
is a more stringent one than the matching of wage increases with
direct labor productivity, probably does make it more likely that the
10This ratio gradually falls as salaried labor replaces wage labor. A more “ sophisticated” formula would
allow for this. For purposes of short period analysis, the results we obtain from our formula are, however,
satisfactory enough.
11 The reader should be warned, at this point, that the average salary data is not particularly reliable for
measuring short-term movements. Small differences in the rates of increase are probably not too mean
ingful.

RECENT INFLATION IN THE

UNITED STATES

requirement will be violated. In any event, the one clear implication
of equation (6) is that the impact of wage increases on total unit costs
cannot be ascertained from a mere comparison of wage rates and
productivity growth. The fact that, ex post, wages have increased
during a particular period by no more than the rise in productivity,
does not tell us that they had no effect 011 total unit labor costs.

Other fixed costs
The rise in unit overhead costs during the postwar period has not
been confined to the category of salaried personnel. W e noted earlier
the impact on overhead costs of rising capital-output ratios and in
creases in the relative price of capital goods.12 In the long run this
will be reflected in prices not only through the medium of higher de
preciation charges, but also through higher profits. For in the long
run profits become a cost. If dynamic equilibrium is to be maintained,
some reasonably satisfactory rate of return must be earned on invested
capital. Fellner has investigated this phenomenon, and pointed out
the long run stability of profit rates over the past century.13 After
correcting both profits and net worth to reflect replacement cost de
preciation, George Terborgh has similarly discovered an almost exact
equality between net profit rates in the 1920’s and in the postwar
period. If profits are not to fall below some minimum level, given
by the “ reservation price of capital,” than any increase in the value
of capital stock per unit of output will, other things being equal, lead
to a rising price level.
L e t:
pr= tlie total flow of gross income to asset owners
O =output
q=profits per dollar of invested capital
k =physical capital-output ratio
2? = the average price per unit of invested capital
d= th e ratio of annual depreciation, in dollar terms, to the value
of invested capital
Then capital cost (including profits as a cost) per unit of output equals

(7)
Granted a stable q in the long run, then stability in unit capital costs
will depend on the total expression, (q-\-d) kp remaining unchanged.
Any rise in any one of dyk , or p must be offset by changes in the others.
W e noted that d has risen in the postwar period because of the shift
in the mix of investment toward a higher proportion of short-lived
equipment, k appears to have risen slightly for a variety of reasons,
but in particular because it was abnormally low at the end of the war.
p has risen, not only in line with other prices— in which case it would
not be a separate phenomenon— but faster than other prices. As we
pointed out, p will continue to rise even after prices stabilize. For p
is really a moving average of input prices of capital equipment. Hence
it will rise as lower priced capital equipment purchased some years ago
is replaced by the new equipment purchased at current prices. This
assumes that q is a “ required” rate of return based on the book cost
12 a ctually an absolute rise in the price of capital goods will tend to raise unit depreciation charges. We
are, however, interested in those aspects of unit fixed costs over and above those generated by the common
impact on all costs of a general rise in the level of prices and wages.
w William Fellner, “ Trends and Cycles in Business Activity,” appendix to pt. 3.

RECENT INFLATION IN TH E UNITED STATES

of assets. If during the inflation, however, producers have been able
to raise their selling prices to cover depreciation and a “required”
rate of return based on replacement costs, then further increases in
price will not be necessary to cover the higher cost of replaced equip
ment; selling prices already include a “p ” which reflects current
replacement costs.
If we combine the requirements for stability in unit labor costs and
unit capital costs, we nnd that we have a fairly complicated set of
relationships, depending on a variety of factors. While the require
ments in themselves tell us nothing directly about the likelihood of
achieving price stability, stating them in the explicit form as we have
done has one major advantage. It makes it quite obvious that, even
in the long run, price stability will not necessarily follow from the equality
of wage increases and productivity gains. Wages of direct labor are
now less than 50 percent of total value added in manufacturing, and
an even smaller proportion of total price, when we take raw materials
into account.
One of the major results of the growth in fixed unit costs has been
to increase the output sensitivity of total unit costs. Even when the
rise in overhead takes the form of special equipment for model changeovers (which is usually written off in a short period of time) the cost
of such equipment is fixed; the actual level of unit costs will depend
heavily on the level of output. Quite apart, then, from the secular
impact on prices of a rising proportion of fixed costs, there is a cyclical
impact— the higher the proportion of fixed costs, the greater will be
the fluctuations in total unit costs accompanying cyclical fluctuations
in output. It is this aspect of the cost structure which warrants
particular attention in an analysis of the creeping inflation to which
we have been subject in recent years.
C y c l ic a l A sp e c t s

The rate of increase in overhead costs per unit accelerated signifi
cantly after 1955. On examination, this is seen to be the result not
of an acceleration in the technological shift to overhead costs, but of
the failure of output to continue rising after late 1955. The behavior
of overhead costs is shown schematically in the following diagram,
while relevant data are given in table 4 -9 .
Taking the period from 1947 to 1955 as a whole, capacity, overhead
employment, and output rose at about the same rate. W ith respect
to overhead employment (i.e., nonproduction workers) two distinct
processes were involved; first the staffing of additional capacity
required an expansion of nonproduction worker employment; secondly
the new production techniques required a larger ratio of overhead to
production workers than the old techniques. By the middle of 1955
output had recovered from the recession of the prior year— output, em
ployment, and capacity were more or less in a “ normal” relationship
to each other.
During the following 2 ygaxa^apacity was added at an even more
rapid pace. Just as in J ^ ^ P & S ^ ^ e a r s , overhead employment was
expanded to staff the
to provide the complement of
managerial, t e c h n i c a lf c ^ i^ ^ f ^ ^ vglrsonnel required by changing
technology and m a n a | | i^ ^ fi| l^ j(m e s. However, output, in the
aggregate, did not ris^ vei^ mii6briipfci 1955 to 1957. In fact after

RECENT INFLATION IN THE UNITED STATES

C h a r t 4r-l

the end of 1955, it did not rise at all. The increase in overhead costs
per unit up until 1955 had resulted mainly from rising prices of over
head inputs— inputs of overhead per unit of output did not change
significantly. From 1955 on, however, the failure of output to match
the growth in capacity and in overhead employment, resulted in a
sharp rise in overhead inputs per unit of output.
T a b l e 4-9.— Indexes of capacity, employment, and output in manufacturing
industries
[1947=100]
1955
Capacity:
A ________________________________________________________________________
B ...... ........... ..................................................................................................... .........
Non-production-worker employment___________________________________________
Production-worker man-hours_________________________________________________
Output:
x ________________________________________________________________________

y ______________________________________________________________________________________

1957

156
146
140
103

175
163
155
100

140
140

145
142

A: McGraw-Hill department of economics estimates.
B: Fortune magazine estimates.
X* Federal Reserve Board index of manufacturing production.
7 :Deflated value added in manufacturing industries.

Average prices of fixed inputs also increased, at a somewhat faster rate
than during prior years. Fixed costs per unit of output therefore rose
sharply. Calculated at levels of output for which the new capacity
had been installed and the overhead personnel hired, fixed unit costs
did not rise so sharply; but calculated at actual levels of output they
rose quite abruptly. Stated in an alternative form, cost curves were
shifting out to the right ; the optimum points on these new curves were,
indeed, somewhat higher than the optimum points on the old curves,
because the rise in factor prices was greater than the rise in produc
tivity associated with optimum ou tpu t;14 however, the failure of out
h See below,

pp. 94,95.

RECENT INFLATION IN THE UNITED STATES

put to grow in accordance with the shift in cost curves, led to an even
larger rise in unit costs. Schematically the situation is depicted in
chart 4-2 below. Curve A represents total unit costs with 1955
C h art

4-2

capacity and techniques; B represents the new curve as it would look
after 2 years of heavy investment, with factor prices unchanged;
C is curve B with allowance made for higher factor prices. Cost b,
is the unit cost which would have been experienced had output
risen along with capacity, i.e. to point B on the output abscissa. Cost
c represents the actual unit cost, in 1957; it is on the same cost curve
as is cost b, but is substantially higher because of the shortfall in out
put. Thus the rise in fixed unit costs between 1955 and 1957 and the
associated lack of rise in productivity appears to have arisen not from
technological causes but largely from the behavior of output. In
chapter 5 the detailed discussion of the 1955-57 period will examine
further the evidence for this hypothesis.

Fixed costs and price policies
The fact that fixed costs statistically account for the largest part of
the rise in total costs is not, of itself, evidence that they were respon
sible for part of the price increases between 1955 and 1957. Even
in terms of ex post reasoning, we must take account of the fact,
pointed out earlier, that stability of total labor costs per unit requires
a fall in wage costs. The contribution of wage costs to the total
rise in costs is thus somewhat larger than the bare statistics would
indicate. Even after allowing for this, however, we must still ask,
what is the influence of variations in fixed costs on short run pricing
decisions?
The standard answer of orthodox pricing theory to this question is
that fixed costs have no impact on pricing decisions in the short run.
Even full cost pricing theories normally do not attribute any import
ance to changes in fixed costs arising out of variations in output

RECENT INFLATION IN THE

UNITED STATES

around the “ standard” operating rate. W e can conceive of full cost
pricing as a markup either over prime costs or over total unit costs.
In the former case the markup is designed to cover fixed costs plus a
desired profit rate calculated at some standard volume of operations.
In the latter case the markup is applied to a total unit cost figure;
but the fixed cost component is also calculated on a standard volume
basis. Fluctuations around the standard volume are assumed to be
ignored, even though they do affect actual unit costs. Now it is
quite clear that an actual decrease in output will seldom lead to a
price rise, despite the resulting rise in fixed unit costs. However, we
are dealing in this case, not with a decline in output but with its
failure to rise at the same rate as capacity and overhead employment.
Producers incurred higher costs. W ith the new capacity and addi
tional staff personnel, an output larger than actual level could have
been supported. Yet such output was not forthcoming. In a situation
characterized not by declining sales and output, but by stable or slowly
rising output, it is not at all unlikely that these higher costs formed
the basis for price increases. The distinguishing characteristic of the
1955-57 period was a continued investment boom in the face of stable
aggregate output; all industries were expending their capacity and
their employment of overhead personnel, yet only a select few were
enjo3dng a concomitant rise in sales. Finding themselves faced with
shrinking margins during a period of supposed prosperity, it is quite
likely that producers attempted to recapture some part of their
increasing costs in higher prices.15 Large firms with permanent ac
counting staffs were presented with direct evidence of rising paj^roll
costs— the fact that a large part of the payroll increase was caused
by the enlarged employment and higher salaries of overhead personnel
was quite probably irrelevant to much of the decision making involved.
Smaller firms may have only attained to a knowledge of their mounting
unit costs indirectly via shrinking net profits. In both cases, however,
the implications were clear. Price increases were “required.”
Insofar as direct labor costs are concerned, they can be varied with
output. The disappointment of sales expectations has a much smaller
impact on unit variable costs than on fixed costs. It is evident from
table 4 -9 , that production worker employment was reduced when
output failed to rise appreciably between 1955 and 1957. Measured
from mid-1955 to mid-1957, rather than from year to year, the cut in
production worker employment was quite large.
The self-defeating nature of the premature “ capture11 of overhead costs
The attempt to recover an expansion in fixed costs and a target rate
of return at levels of output which fall increasingly short of optimum
can be likened to a reduction in the “ standard volume” on which
pricing decisions are based. Chart 4 -3 is an example of this pheno
menon. Adapted from one presented by John Blair 16 it shows for
the United States Steel Corporation the relationship between net
profits as a percent of stockholders' equity and the operating rate.
is The influence of rising overhead costs on prices is here presented as a hypothesis, there is no way to
“prove” that the specific cause of some of the price increases was an increase in overhead costs. In ch. 5.,
however, we shall attempt to show that this hypothesis is capable of explaining a number of the particular
and to some extent puzzling, features of the 1955-57 price rise.
16“Administered Prices: A Phenomenon in Search of a Theory,” American Economic Review, May 1959.

RECENT INFLATION IN THE UNITED STATES
C h art

4r-3

R a te o f r e t u r n U

1 / A d ap ted from a c h a r t b y Joh n B l a i r ;

s e e A p p e n d ix A .

( E x c lu d e s 1 9 4 1 -4 6 and 1 9 5 1 - 5 2 .)

2 / A f t e r t a x r a t e o f r e t u r n on s t o c k h o l d e r s ' e q u i t y .

The line of regression labeled “ A ” was computed for the years 1920-56.
According to the Brookings study, as cited by Lanzilotti,17 the corpo
ration’s target was an 8 percent after-tax rate of return when opera
tions were at a “ normal” rate, 80 percent of capacity being considered
» Op. cit., p. 447.

RECENT INFLATION IN THE UNITED STATES

normal. The regression indicates that price-cost relationships were
so maintained as to yield this target— indeed to yield about 9 percent
return at 80 percent of capacity. Starting in 1955, however, a new
relationship appears. Prices were set relative to costs to yield 8 per
cent, not at 80 percent of operations but at 60 percent. Looked at
from another standpoint, price-cost margins were set to yield a 12 to
13 percent rather than an 8 to 9 percent rate of return when operations
were at 80 percent of capacity. For our present purposes it makes
little difference whether the reason behind the shift to a new pricing
policy was to compensate for the understatement of depreciation
forced on the company by original cost depreciation regulations (as
some officials of the industry avowed), to provide for a greater cash
flow for investment purposes (as other officials indicated), or simply
to earn a higher net profit.
In one respect the U.S. Steel case is not representative of the kind
of changes in pricing policies which characterized the 1955-57 period.
In many industries price increases were, in part, a response to the
growth in fixed unit costs associated with the failure of output to
rise; the implicit reduction in the standard volume used to calculate
costs was probably an unintended end result, rather than a deliberate
technique. In the case of the steel industry, on the other hand, the
price increases were much larger than could be explained by the in
crease in fixed costs. However, the basic phenomenon is the same—
at any given rate of operations profits will be higher if prices are set
to recapture costs at a reduced volume of operations.
An attempt to recapture increased overhead expenses (including a
target rate of return) at constant levels of output, when capacity and
overhead outlays are rising, will yield a higher schedule of ex ante
profit rates. In other words the schedule of profit rates earned at
any given rate of operations will be raised. Whether, for any parti
cular firm, this will result in higher ex post profits depends mainly on
the price elasticity of demand for its products— what will be the effect
of the higher price on its sales. But for all firms taken together, the
move is almost certain to be self-defeating. For in this case we are
dealing with the income elasticity of demand. The general rise in
prices will lower real incomes; i.e., at any given level of employment
and wage and salary payments, prices will be higher. Hence the
real volume of sales is almost certain to be reduced below what it
otherwise would have been, unless the ex ante rise in margins further
stimulates real investment. During the 1955-57 period, however,
the capital goods industries were already operating at capacity; it
was the other sectors of the economy in which excess capacity existed.
Hence the net effect of the price policies of the period was to impede the
growth in real output.

The analysis of the preceding paragraph may be clearer if reworked
in another way. An expansion of capacity and overhead personnel
is normally based on the expectation of a rise in sales and output.
The attempt to cover the higher costs at existing levels of output
raises the ex ante profit margin at all output levels. This in turn
raises the ex ante gross saving rate for the economy, and thus tends
to reduce real consumer purchases and to block a rise in output to
planned levels. Unit overhead costs, instead of increasing only moder
ately— as would be the case if the planned output were attained—rise
abruptly when output fails to increase. Ex post, therefore, net profit

RECENT INFLATION IN THE

UNITED

STATES

margins may rise very little, or perhaps not at all, despite the upward
shift in the price-wage ratio. To some extent, a kind of “ vicious
circle” occurs. The failure of production to grow leads to a rise in
fixed unit costs. Insofar as prices are increased relative to wage and
salary rates in order to recover these higher unit costs, the forces
impeding the growth in output are strengthened. This in turn keeps
fixed unit costs high, and prevents the realization of the efficiencies
of which the new plants and new techniques are capable.
W e do not mean to aver that the failure of output to match the
growth in capacity during the 1955-57 period may be solely attributed
to the pricing policies pursued. There were, as W"e shall see, many
other factors involved. Even if prices had been set to recapture fixed
costs at full capacity utilization, it is clear that this alone would not
have been sufficient to raise output to full capacity levels. More
formally this can be shown as follows:
Let
F = total fixed costs, including an allowance for a target rate of

return. We assume that output can rise to full capacity
levels without any change in F.
b =direct labor and raw materials cost per unit of output. We
assume that b is constant over the range of output with
which we are dealing.18
0 = t h e output at which unit fixed costs are calculated.
0 F= fu ll capacity output, i.e., the output in expectation of which
the fixed costs were incurred.
P = price.

(7= cost per unit [including a profit margin].
If we hypothesize a situation like the one we have been describing, in
which prices are set to recapture fixed costs at some actual output
less than full capacity, then

P—C =^+b; 0=m0F; m> 1 .
where m represents the ratio of actual output to full capacity output.
Then the percent change in price accompany a percent change in the
output level at which fixed costs are calculated equals,
_dC 0 _
F
vp~ d 0 ‘ C
F+bO

But

is the ratio of fixed costs to total costs.

Taking manu-

facturing as an example we find from table 4 -6 that fixed costs were
about 50 percent of total value added in 1955; assuming that raw
material purchases from outside the manufacturing sector equal 30
percent of total costs, then we may take fixed costs to be some 35
percent of total costs. Hence a change of 1 percent in the level of
output upon which fixed costs are calculated leads to 0.35 percent
reduction in price. Assume that fixed costs and capacity together
increase, say 10 percent, but actual output does not rise. Suppose
that prices have been raised to cover the increase in fixed costs at the
existing level of output. A redetermination of prices to cover costs
at full capacity output would lower prices by 3% percent. If the
real income elasticity of demand is equal to or less than one (an income
19 But see pp. 116-117 below for evidence that direct labor productivity is also positively correlated with
changes in output.

RECENT INFLATION IN THE UNITED STATES

elasticity of greater than 1 is quite unlikely) output will rise by no
more than 3% percent; actual— ex post— fixed costs per unit will be
higher than costs calculated at full capacity output, and less than a
“ target” rate of return will be earned.
To recapitulate: the failure of output to rise significantly after 1955,
in the face of a sharp increase in investment outlays and overhead
employment tended to lower productivity and raise fixed costs per
unit. The attempt to pass along these increased costs in higher prices
was in itself a partial cause of the disappointing rise in output, and
the consequent increase in unit costs. Pricing policies during the
period were, in a word, unimaginative. J. C. R. Dow in discussing
a similar association between output, productivity and prices in Great
Britain put the matter as follows:
[There was] no tendency for prices to be reduced in anticipation of the increase
in productivity which would occur if output were increased and which would
make it possible to reduce prices. * * * Expansion of output, undertaken in
order to reduce costs and prices, would tend to create the increase in real demand
which would justify the increase in output.19
Summary

In the last two chapters we have attempted to lay out some of the
basic factors which contribute to the phenomenon of creeping infla
tion. Because of the downward rigidity and cost oriented nature of
wages and prices, and the tendency for wage changes in rapidly ex
panding industries to be matched in most other industries, excess
demand in particular sectors of the economy can initiate a rise in the
general price level, even if aggregate demand is stable. The larger
the shift in the composition of demand, the larger will be the price
increase accompanying a given increase in aggregate demand. It was
in part for this reason that the relatively modest rise in aggregate
demand between mid-1955 and mid-1957 was accompanied by such
a large rise in prices and such a small rise in output.
The postwar growth in the proportion of fixed costs to total costs
has made productivity increasingly sensitive to cyclical fluctuations
in output. The period after 1955 witnessed not only an investment
boom but also a continuation, indeed an acceleration, of the substitu
tion of fixed for variable labor inputs. Hence the failure of aggregate
real expenditures to rise significantly, resulted in underutilization of
capacity, a disappointing increase in p rod u ctiv e, and a sharp rise
in fixed unit costs, rather than a growth in unemployment. The up
ward shift in ex ante profit margins which occurred when producers
attempted to recapture the rising fixed costs at actual rather than
capacity output, led to additional price increases. A t the same time
such “ premature” recapture of investment outlays itself helped pre
vent a rise in output to capacity levels.

In a secular context, the downward rigidities and cost orientation
of prices and wages give a mild upward bias to the price level. Ad
justments in the structure of prices and in the relationship of prices
and wages to each other are normally accomplished by increases,
rather than by mutual changes around a stable center. The growing
importance of fixed costs and the substantial rise in the relative prices
of capital goods during the past decade have further accentuated the
*• Dow, op. cit., p. 296.

RECENT INFLATION IN THE UNITED STATES

rigidities in the structure of costs. In earlier periods of our history,
and in particular during the 19th century, the importance of the
agricultural sector with its very flexible prices, and the generally
larger weight of raw materials in total costs, moderated whatever
inflexibilities existed in the industrial price structure. Even more
effective was the occurrence of massive depressions which broke
through the “ ratchets” beneath the price and wage level. In recent
years the economy has not been nor is it likely in future years to be
administered such strong purgatives, whose ill effects far outweigh any
good they might do.
With some exceptions we have, to this point, presented the analysis
in the form of hypotheses. We have asked the reader to take many
things on faith, liberally scattering footnotes directing his attention to
the pages which follow. The detailed examination which is there pre
sented, of the process of inflation during 1955 and succeeding years,
will show, we believe, that the events of the period are consistent with
our hypotheses, and that the analytic schema developed in the pre
ceding pages is a useful tool for explaining the phenomena associated
with creeping inflation.

C H APTER 5

THE NATURE OF INFLATION, 1955-57
S ome

te n o m e n a

To Be

E x p l a in e d

t the end of 1957 consumer prices were 56 percent higher than 12
years earlier, at the end of World War II. Wholesale prices had
rise \ by 70 percent and the price deflator for gross national product
by 53 percent during these years. There were three distinct periods
of increase, in the intervals between which prices were relatively
stable. The first major period of rise was between the end of 1945
and autumn 1948; the second period between the middle of 1950 and
the middle of 1951 (or late 1951 in the case of consumer prices \ The
overall level of wholesale prices began to rise again in the middle of
1955, and consumer prices in early 1956. The increase continued
throughout 1956, 1957, and into 1958. The three periods of relatively
sharp price rise account for slightly less than half of the time but for
a ll1 of the total increase in the consumer price index between the end
of 1945 and 1957. The increases amounted to 35, 11, and 6 percent
in each of the respective periods.
The last upsurge of the general price level differs in one major
respect from the other two. From 1946 to 1948 and again from 1950
to 1951, inflation was associated with war or the aftermath of war.
In 1946 the removal of price controls, the highly liquid condition of
consumers and firms, and the release of pent-up waitime demands
gave rise to substantial aggregate excess demands whose effects were
felt in every sector of the economy. Faced with major problems of
reconverting from military to civilian output, capacity in every major
industry was nevertheless strained to the limit. The number of new
firms mushroomed, and business failures were at an alltime low.
Unemployment remained below 4 perceit of the labor force, despite
a rise of more than 7 million in the civilian labor force. The shorter,
but equally rapid increase in the price level after mid-1950 was
directly attributable to the sharp rise in aggregate demand associated
with the opening of hostilities in Korea. Although deliveries of mili
tary goods did not immediately rise orders were placed in large vol
ume. Anticipatory buying on the part of consumers and business
firms reached huge proportions; in early 1951 inventory accumula
tion was proceeding at an annual rate of almost $15 billion. The
Nation’s resources in terms of plant capacity, labor force, and raw
materials were fully, indeed over-fully utilized. Industrial produc
tion rose from an index of 113 in June 1950 to 123 in December 1951;
by early 1951 the unemployment ratio had fallen to V/% percent of
the labor force, and in the second half of the year it fell to less than
3 percent, where it remained until the 1953 54 recession intervened.
1 La fact the compounded price increase for the three inflationary periods was greater than the total post
war rise. Consumer prices declined during 1949.

RECENT INFLATION IN THE UNITED STATES

As in the case of the immediate postwar reconversion, here was a
clear case of aggregate excess demand. However much one might
wish to add other considerations to the analysis, there is little dispute
that the major part of the inflation during these two periods is
explainable by orthodox aggregate demand theory.
The 1955-57 period is another matter. There is evidence that as
the economy approached a state of full employment during its recov
ery from the 1954 recession, excess demand did begin to make itself
felt. The three major volatile sectors— business investment, housing,
and automobiles— were all rising rapidly, and the latter two had
reached record levels. But this state of affairs lasted only briefly.
Demand for housing, autos, and other consumer durables fell off
sharply. Nonfarm inventory investment reached a peak in the first
quarter of 1956, and declined steadily thereafter. The output of
most nondurable consumer goods expanded quite slowly. Only in
the industries supplying capital goods did the boom continue, although
there it was indeed quite a boom.
After the third quarter of 1955 total gross national expenditures
rose at a rate of 5 percent per year. This is little more than the
4 percent per year gain in output which we have come to expect in
“ normal” periods from increases in the labor force and productivity.
Nevertheless the overall price level rose by 3X percent per year and
output by only 1% percent. Excess capacity began to appear in more
and more industries. In late 1955 manufacturers were operating at
about 92 percent of capacity, slightly above the rate, which on the
average they considered “ desirable.” B y the end of 1956 they were
operating at 86 percent, and by the middle of 1957, just before the
recession began, at about 83 percent.2
Y et prices rose. Industrial wholesale prices between June 1955
and December 1957 increased by 9 percent; consumer prices began
rising in March 1956, and in the next 21 months rose 6 percent.
Industrial prices rose most sharply in the industries closely related
to the boom in capital investment, but prices rose in other industries
as well, even where excess capacity was growing. The increase in
consumer prices was more evenly distributed, in food, services, and
both hard and soft goods.
Some might argue that the 5 percent per year rise in money expendi
tures represented substantial excess aggregate demand. Due to the
time lag involved in installing and breaking in new plant and equip
ment, the very investment boom itself, according to this argument,
slowed up the rise in productivity and kept supply curves from shifting
to the right by as much as the postwar “ norm” would suggest. In
other words the 1% percent annual increase in real output reflected
the limit of the economy's capabilities during the period; the differ
ence between the rise in money outlays and real output thus repre
sented the excess demand of the period. Were this correct we should
be wrong in our implicit assumption that the actual increase in output
was less than the shift in the aggregate supply curve.

There are two basic reasons why this line of reasoning is not valid.
In the first place the 5 percent annual increase in money expenditures
is an ex post magnitude. It most assuredly overstates the ex ante
increase in money demand. At least part of the rise in money outlays
2 Data are those published annually by the McGraw-Hill Publishing Co, in its annual survey of business
men’s investment plans.

RECENT INFLATION IN THE UNITED STATES

would not have occurred had not prices risen in the first place. In
other words, if our hypotheses in chapters 3 and 4 have any application
to the 1955-57 period, the price increases in many sectors of the econ
omy had nothing to do with excess demand in those sectors. A . J.
Brown put it quite nicely—
Not only may prices go up because people want to overspend, but people may
want to overspend because prices have gone up.3
Since higher prices per unit mean higher incomes to at least some fac
tors of production, aggregate money income and money demand will
rise when price increases occur. W e discussed at length in chapter 2
the factors which determine the response of money demand to higher
prices and wages. While money demand may not rise pari-passu
with prices, there is no doubt that it will rise to some extent. Up to
this point we have not demonstrated the validity of our hypotheses—
hence the preceding is hardly an answer to the contention that the
rise in aggregate monetary demand was excessive. However, in
judging whether aggregate excess demand (in an ex ante sense) did
exist during the period, it is essential for the reader to bear in mind
the fact that the magnitude of the rise in ex ante aggregate money
demand was less than the 5-percent increase in money outlays which
finally occurred.
Even if the 5-percent annual rise in money outlays did reflect the
size of the increase in ex ante aggregate demand, there are a number
of reasons for rejecting the hypothesis that the 1^-percent increase in
actual output measured the rightward shift in supply curves, and
hence the increase in ex ante aggregate supply. In the first place the
data on equipment expenditures bv producers is based on installa
tions of equipment. In theory at least, expenditures on producers’
equipment do not enter the national income accounts until the equip
ment is installed. The boom in investment activity reflected in expendtures on producers durable equipment thus represents a boom
in installations of equipment, not simply in plans or orders. Simi
larly the McGraw-Hill figures on capacity in manufacturing indus
tries are based on the response of business firms to a questionnaire
which requests data on capacity in being and capable of production.
The index developed from the responses rose from an average of 130
in 1955 to 146 in 1957. This gives us another measure of instal
lations. For these reasons the “ indigestion” hypothesis— i.e., that
the investment boom itself temporarily disrupted productivity
gains and the growth in output potential— cannot rely on a lag
in installations but only on a lag in breaking in the expanded
and technologically more advanced facilities.
But there is no
warrant in the historical data to conclude that periods of
investment boom are normally accompanied by subnormal rates of
growth in output. Table 5-1 shows the output increases which
have occurred in a number of selected years during which invest
ment activity was particularly high. There seems to be no tend
ency for high investment years to be associated with small rises in
output. An examination of changes in productivity during the past
50 years (see, for example, table 3, “ Productivity Prices and Incomes,”
Joint Economic Committee, 1957) also shows no evidence of a poor
productivity performance in years of heavy investment. True, pro
* “ The Great Inflation, 1939-51,” Oxford University Press, 1955; p. 16,

100

RECENT INFLATION IN THE UNITED STATES

ductivity gains are largest during recovery years and tend to taper off
in the remaining years of cyclical upswing. But subnormal increases
in output and pr3ductivity are not particul rly associated with years of
high investment.

T a b l e 5 - 1 . — Change i>i outpi t, selected periods 1
[Percent change per annum]

1928-29

Gross national product in constant dollars........
Industrial production..........................................

5.8
11.0

1st quarter
3d quarter
1947 to 3d
1950 to 2d
quarter 1948 quarter 1953
4.1
3.7

5.2
5.4

3d quarter
1955 to 3d
quarter 1957
1.4
2.5

1Selected to include years of high investment, but to exclude recovery periods.

A more convincing r eason for r j ctim; th •“ in d i; stion” hypoth sis,
however, is the behavior of production work r output p r man-ho^r.
As we not d in the previous chapter postwar technological chan<* s
have involved a rapid substitution of nonproduction workers for
production workers. This process accel rated during th ■ inv stm nt
boom of 1955-57. Production worker output per man-horr in manu
facturing rose at an annual rate of 2.3 percent between 1955 and 1957
compared to a rise of only 0.7 p rcent in output p r man-hour of all
employees (i.e., production workers plus nonproduction work rs).
Using another measure of manufacturing output, the increases are
3.5 percent and 2 percent respectively.4 Between the fourth quarter
of 1955 and the second quarter of 1957 (i.e., before the 1957-58
recession began) production worker employment declined about
300,000, some 2% percent, and production worker man-hours about
4 percent (seasonally adjusted); nonproduction worker employment
during the same period rose by 325,000, an increase of about 9 percent.
Manufacturers were able, therefore, to utilize the changed production
techniques incorporated in their investment programs— otherwise
they would not have been able to substitute nonproduction for produc
tion workers.
Finally, and perhaps the most convincing evidence of all, is the fact
that, during the period, there was a high correlation between output
and output per man-hour in manufacturing industries.5 Those
industri s whose output rose significantly did in general achieve a
substantial gain in efficiency. Since the average rise in output was
* The first set of output per man-hour estimates was based on a Bureau of Labor Statistics output m easure
the second on the Federal Reserve Board index. This brings up one of the major statistical problems con
fronted in this study. There were two basic measures of manufacturing output available, the Federal
Reserve Board index of manufacturing production and the Bureau of Labor Statistics current year weighted
net output index. The latter is not published but can be derived from the output per man-hour figures
given in table 3a, p. 778, Joint Economic Committee, “ Hearings on the January 1959 Economic Report of
the President.” There are a number of differences in the composition of the two indexes. Through 1955
they move fairly closely together. Between 1955 and 1957, however, the BLS index shows a smaller rise
than the Federal Reserve index, 1.2 percent versus 3.6 percent. While this is not particularly large in terms
of the level of the index it does make a significant difference in the computation of changes in productivity
and unit labor cost. Wherever possible we have used the B LS index for two basic reasons. 1. For industries
incorporating about half the weights, the FRB index during recent years is constructed by applying an
assumed productivity gain to man-hour data; the BLS study is based solely on deflated value data. 2. A
calculated index of manufacturing prices built up from unit cost indexes agrees closely with the published
index of manufacturing prices (see table 4-6) if the BLS output measure is used in deriving the unit cost
indexes; if the Federal Reserve index is used, however, the calculated price index rises substantially less
than the published index. This is no proof that the BLS output index is superior. Use of the BLS index,
however, does allow us to achieve greater consistency in our various measures of prices, costs, and
productivity.
fiSee below pp. 115-118, for a fuller discussion of this relationship. The coefficients of correlation for produc.
tion worker output per man-hour against output was 0.79, and for all employee output per man-hour, 0.71.

101

RECENT INFLATION IN THE UNITED STATES

small th' average gain in productivity was limited. But the industries
which had 1 ss than average output and productivity increases did
not have la-rpr than average invstm<nt programs. In other words
th “ indi;;estion” hypoth sis finds no confirmation in the data.
Conversely, the- hypoth sis that the pot ntial gains in output were
larger than the actual gains does appear to be borne out.
Table 5 -2 summarizes the changes in capacity and output in manu
facturing industries between 1953 and 1957 and between 1955 and
1957. To avoid reflecting the 1957-58 recession, third quarter 1957
production data were used. In almost all industries the increase in
capacity was substantially larger than the increase in production,
particularly during the 1955-57 period. There are a number of
qualifications on the meaning of the growth in excess capacity. In
the first place the capacity data are developed by weighting— with
Federal Reserve Board index weights— responses to questionnaires
address d to business firms. Since there is no control over the
consistency of the capacity concepts employed in responding to the
questionnaire, th> resulting capacity measures are very rough esti
mates at best. Small differences in the relative growth in output and
capacity ar * probably not significant.

T a b l e 5 - 2 . — Capacity and output: Manufacturing industries
Capacity 1 (December 1950=100)

Production
(1947-49=100)

Industry

All manufacturing ...................
Ferrous metals......................
Nonferrous metals .................
Nonelectrical machinery...........
Electrical machinery_________
Autos, trucks, and parts...........
Other transportation equip
ment .................... ...............
Chemicals and allied products..
Pulp and paper.........................
Rubber products ....................
Stone, clay, and glass products.
Petroleum refining4 ...............
Food and beverages .................
Textile mill products ..............

Percent change

3d
1953-57
1955-57
quar
ter,
1957J Capac Produc Capac Produc
ity
tion
ity
tion

1953

1955

1957

1953

1955

118
114
131
126
131
130

130
121
149
142
156
146

146
132
170
171
185
168

136
133
129
143
194
126

140
138
143
135
194
153

147
129
137
151
213
129

+23.7
+15.8
+29.8
+35.7
+41.2
+29.2

+8.1
-3 .0
+6.2
+5.6
+9.8
+2.4

+12.3
+9.1
+14.1
+20.4
+18.6
+15.1

+5.0
-6 .5
-4 .2
+11.9
+9.8
-15.7

160
128
116
114
114
113
108
110

188
147
130
132
124
124
116
114

220
170
146
146
140
134
127
124

276
147
130
128
133
130
107
104

272
345
167
185
149 3154
138
143
149
158
142
135
109
113
107
101

+37.5
+32.8
+25.9
+28.1
+22.8
+18.6
+17.6
+12.7

+25.0
+25.9
+18.5
+7.8
+ 18.8
+9.2
+5.6
-2 .9

+17.0
+15.6
+12.3
+10.6
+12.9
+8.1
+9.5
+8.8

+26.8
+10.8
+3.4
-3 .5
+6.0
+5.2
+3.7
-5 .6

1Average of beginning and end of year.
2 Seasonally adjusted.
3 Average for year.
4 Production figures are for petroleum and coal products.

In addition to this statistical qualification there are a number of
substantive factors which must be taken into account in evaluating the
results. In the nonelectrical machinery, electrical machinery, and
automobile industries between 1953 and 1957, there was a substantial
shift away from defense production and toward civilian production.
This necessitated an increase in capacity for producing civilian goods.
As a consequence of these developments, some of the apparent growth
of excess capacity is spurious and results from a changed production
mix. Similarly, the machinery industries manufacture both invest
ment goods and consumer durables. On the basis of data on capital
goods purchases, order backlogs, prices, etc., it is very unlikely that

102

RECENT INFLATION IN THE UNITED STATES

there was any excess capacity in establishments manufacturing invest
ment goods before the beginning of the recession. But since establish
ments producing consumer durables did build up substantial excess
capacity, the overall machinery industry figures show a growth in
capacity well in excess of the growth in output.
Thus, a partial answer to the question as to what factors were
responsible for the limited increase in production during a period of
rapid capacity expansion is that this phenomenon reflects a change in
the pattern of demands within the economy. Not only does this
factor help explain the developments in individual industries, but also
the general growth in capacity relative to output. Through late 1955
almost all sectors of the economy were expanding very rapidly. There
after, while most industries were continuing to order and install new
plant and equipment in very large volume, demand for output in a
number of important sectors fell off noticeably, in particular housing
and automobiles. On balance therefore aggregate demand and output
rose very slowly, not because each sector in the economy was rising
slowly, but (in a proximate sense) because the effects of the very
rapid demand increases in the investment goods sector were sub
stantially moderated by declining or only slowly growing demands
elsewhere.
In summary then, there is no reason to believe that the relatively
small gains in output— 1% percent per annum for the economy as a
whole— represented the supply potential. The gap between the 5-per
cent annual rise in money expenditures and the l^-percent increase in
output does not reflect the magnitude of ex ante excess aggregate de
mand. Indeed if we compare the 5-percent rise in expenditures with
the 3 K- to 4-percent rise in output of which the economy is normally
capable, and remember that the expenditure rise overstates, to some
unknown degree, the ex ante increase in money demands, it is clear
that after late 1955 acgregale excess demand was insignificant. Once
we have eliminated the “ indigestion” hypothesis, the widespread
growth of capacity relative to output is a good common sense indicator
of this fact.
The rise in prices during a period in which aggregate excess demand
was absent might suggest the existince of an autonomous wage push.
Yet, insofar as we can tell from the data, prices rose at a faster rate
than unit wage costs. Between 1955 and 1957 the deflator of value
added in manufacturing rose about 7% percent. Unit wage costs
rose by 6.7 percent (table 4 -7 ). Prices of manufactured products
began to rise in mid-1955; unit wage costs only very late in the year.
Moreover unit wage costs in 1955 were still lower than in 1953 (table
4 -6 )— it was not until 1956 that they surpassed those levels. W e do
not have similar data on wage costs (separate from salary costs) for
the rest of the economy, but insofar as manufacturing is concerned,
price advances were earlier and somewhat larger than the increase in
unit-wage costs.
Despite the rise in prices relative to wage costs, profit margins de
clined. Manufacturing gross profit margins per unit of output were
about the same in 1957 as in 1955. But since prices had risen, gross
profits as a percent of total gross income originating declined. Total
corporate gross margins as a percent of gross corporate product also
declined, from a 1955 level somewhat above the postwar average to a
level in 1957 slightly below average.

RECENT INFLATION IN THE UNITED STATES

103

There are, therefore, a number of features in the 1955-57 period
which require explanation, and which can be explained neither by an
aggregate excess demand nor an autonomous wage-push theory of
inflation. To summarize them briefly:
1. Total money expenditures rose 5 percent per year. Instead
of a 4 percent rise in output and a 1 percent gain in price, we
experienced a 3%-percent rise in prices and only 1^-percent rise
in output.
2. Overall labor productivity rose very slowly after late 1955.
Yet installations of new and improved facilities were proceeding
at an unparalleled rate. And the industries whose output did
rise achieved substantial gains in productivity.
3. Prices rose earlier and somewhat more rapidly than unit
wage costs, yet gross profit margins declined.
P r ic e s , E x p e n d i t u r e s ,

and

O u tput

The pattern of demands

Between the trough of the 1954 recession and late 1955 the rise in
expenditures in both current and constant dollars was quite large.
It was also spread widely throughout the economy (table 5-2).
Military outlays for durable goods were the only expenditure category
which declined during the period, and most of the decline had occurred
by early 1955. Residential housing and consumer purchases of
automobiles led the recovery, and by the third quarter of 1955 were
at peak rates. Total automobile sales for the year were 7.2 million,
while housing starts totaled 1.4 million. Although starts had begun
to decline after mid-year, actual construction in progress continued
to rise through the third quarter. Business investment in plant and
equipment only began to rise in the second quarter of 1955, but
thereafter increased very rapidly. Personal consumption expend
itures on durables, nondurables and services also rose sharply; the
personal saving rate averaged less than 6 percent during the first
three quarters of the year, lower than it had been at any time since
early 1951.

44975—59---- -8

104

RECENT INFLATION IN THE UNITED STATES
T able

5-3.— Changes in expenditures and prices. 1954-57
[Percent change at annual rates]
3d quarter 1954 to
3d quarter 1955

Expenditure category

Gross national product.....................................
Durable goods pnd construction___ _____
Fixed business investment..................
Producers equipment1..................
Construction..................................
Government purchases of durables___
Public construction...........................__
Net exports.................... .......................
Personal consumption_______ _______
Autos pnd parts 1......... .................
Other durables....................... ........
Residential construction......................
Inventory investment2________ ____
Nondurable goods................... ..................
Personil consumption................ .........
Food ?nd beverages.......................
Clothing ?nd shoes.......................
Other nondurable*.........................
Inventory investment2........................
Services......................................................
Pers^ml consumption..........................
Government purchases of services___

Expendi Expendi
tures in ture? in
current const?nt
dollars
dollars
11.4
19.1
11.7
9.2
14.6
-10.3
0
0
31.0
48.1
14.2
19.6
4.9
8.6
5.4
3.3
8.8
7.3
3.6
7.6
7.5
7.9

9.8
16.5
8.5
6.1
11.1
-13.4
-2 .5
0
30.2
45.5
16.1
15.2
4.9
8.9
5.8
5.2
8.3
5.6
3.6
5.0
5.6
3.6

3d quarter 1955 to
3d quarter 1957

Price

1.5
2.1
3.0
2.9
3.5
3.5
2.8
.7
2.0
-1 .7
3.9
-•4
-.3
-1 .8
.5
1.6
2.5
1.7
4.3

Expendi Expendi
tures in tures in
current constsnt
dollars
dollars
5.2
4-4
11.0
12.3
9.7
10.8
9.2
25.0
-2 .0
-6 .1
3.2
-5 .3
.6
14
5.7
6.1
3.2
6.6
—1.5
7.8
7.5
8.5

1.4
-•4
3.6
4.3
2.8
4.5
3.4
15.6
-4 .3
-9 .2
1.1
-8 .2
.4
2.0
3.0
3.2
1.2
3.8
-1 .9
H
4.5
3.4

Price

S. 6
4.8
6.9
7.3
6.2
6.0
5.6
2.6
3.9
2.0
3.4
2.4
2.5
2,6
1.7
2.6
8.S
2.7
4.6

* Business purchases of automobiles reallocated from producers equipment to personal consumption.
2 Inventory changes given in dollar terms. In some cases the change was from a negative to a positive
figure.

Industrial production increased rapidly and by the latter part of
1955 the excess capacity which existed in 1954 had been generally
eliminated.
Finished goods prices during the recovery period were relatively
stable. Productivity rose very rapidly, and despite increases in wage
and salary rates, unit labor costs did not rise significantly. Uapidly
increasing consumption and inventory accumulation of nonagricultural raw materials did lead to fairly sharp increases in prices of these
commodities. B y the end of the year prices of nonagricultural raw
materials had risen 9 percent from their 1954 lows. Farm prices,
however, continued to fall throughout the year, offsetting part of the
increase in other raw materials prices. The overall deflator for gross
national product rose 1% percent during the recovery mainly in its
latter stages. This was a relatively small amount considering the
vigor of the rise in demand and output. The average price increase
among nonfarm products was somewhat larger than this, the overall
total being held down by declining farm prices. Profit margins, both
gross and net increased rapidly during 1955. Corporate profits
(adjusted for inventory valuation) reached $46 billion in the fourth
quarter, 40 percent above the 1954 trough and 15 percent higher than
the prerecession levels of first half 1953. In manufacturing, gross
profit margins per unit of output for the year 1955 as a whole were
equal to the peak levels of 1951, and in the final half of the year were
even higher.
While the economy may have approached a state of aggregate excess
demand in late 1955, this situation was not long maintained. Housing
starts and automobile sales had reached unsustainable rates, and

RECENT INFLATION IN TH E UNITED STATES

105

after the third quarter of 1955 expenditures on autos and housing
declined quite rapidly. Fixed business investment on the other hand
continued to rise vigorously. As table 5-2 indicates, the result was a
sharp dispersion in the movement of expenditures during the next
2 years.
We have not attempted to construct a model to explain the behavior
of expenditures during the period. The fall in housing outlays and
the increase in the personal saving rate associated with the decline in
purchases of automobiles, moderated the effect on disposable income of
the substantial investment boom. Total gross national expenditures
rose at the moderate rate of 5 percent per year and disposable income
increased at a 5^-percent rate.
Changes in Jinal goods prices: GNP categories

If we look down the final column of figures in table 5-2, the associa
tion of large price increases with large expenditure increases in indi
vidual sectors is clear. But prices rose, not only in those sectors in
which expenditures were increasing rapidly but in all sectors.6 The
sharp dispersion among expenditures in individual sectors is not
matched by a similar dispersion of price changes. On the average
money demand rose quite moderately; on the average prices rose
significantly.
In the sectors where demands increased rapidly, price increases
were quite large. Business investment, public construction outlays,
and net exports of durable goods rose very sharply for 2 straight
years. Military outlays on durable goods reversed their earlier decline
and, particularly towards the end of the period, moved quickly up
ward. Price increases ranging between 5% and 7% percent per year
characterized these sectors of the economy. Even after deflation for
price changes, however, real purchases advanced. Capacity limita
tions undoubtedly limited the rise in some cases; nevertheless the
constant dollar value of producers’ outlays on durable equipment and
military purchases of hard goods increased by 9 percent over the 2-year
period; slightly smaller increases occurred in the real value of business
and public construction.
The size of the expansion in investment demand is not fully reflected
in the expenditure data. The surge of new orders was substantially
larger than the capacity of the capital goods industries could accom
modate. Between early 1955 and mid-1956 new orders ran continually
at a rate some 10 percent higher than sales in the machinery indus
tries.7 Backlogs of unfilled orders rose from $31 billion in the second
quarter of 1954 to $42 billion in the same quarter of 1955 and to
$52 billion in the second quarter of 1956, at which level they remained
until early 1957.
The major areas of declining demand, automobiles and housing, also
impinged on the durable goods and construction sectors of the
economy. Taken altogether, current outlays on durable goods and
construction rose by some 9 percent over the 2-year period. Real
output, however, changed little; this shows up both in the deflated
GNP data and in the Federal Reserve Board’s index of durable manu
• Prices of consumer appliances did fall slightly. But increases in other consumer durable goods prices
(e.g., furniture) outweighed these declines. The price deflator for the category “ Other durables” thus
shows an increase.
7 And since most consumer appliance firms are classified within the machinery industry in the sales and
new order data, these figures understate the excess of capital goods orders over sales; the appliance industry
was not generally expanding during the period.

106

RECENT INFLATION IN THE UNITED STATES

facturing production. The deflator for durable goods and construction
rose almost 10 percent; although the largest increases occurred in the
sectors with rapidly expanding demands, there were increases in the
declining sectors as well.
Outlays on nondurable goods rose only moderately. Prices never
theless increased, and the rise in the real value of purchases was quite
small. Part of the price increase was accounted for by rising farm
prices; but prices of other major categories of nondurable goods also
advanced.
Outlays on services rose more rapidly than the other two major
categories of expenditures. Government purchases of services repre
sent mainly the compensation of Government employees, and the price
increase is really an increase in the average salary of employees. Con
sumer expenditures for services rose quite substantially; although part
of the increase was dissipated in higher prices, there was a 9-percent
rise in the real value of service output over the 2-year period.
In summary, the 1955-57 period was characterized by a substantial
business investment boom, largely offset by falling demand for auto
mobiles and housing. As a consequence aggregate demand rose at a
relatively moderate rate. There did occur, nevertheless, a significant
rise in the general price level. Although price increases were largest
in those areas of the economy where excess demands emerged, they
also occurred in all other major sectors where demands were not ex
cessive, and indeed were in some cases deficient. We argued at
length, in chapter 3, that such behavior could be partly explained by
the downward rigidity of prices and wages, and by the “ feed out” of
cost increases from excess demand sectors to the rest of the economy.
Finished goods prices not only failed to decline in areas of weak de
mand but actually increased. We shall be able to observe this process
more closely by an examination of the behavior of industrial wholesale
prices and wages.
Industrial prices, wages, and output
The first two columns of table 5-4 show the increase in selected
wholesale price indexes and construction costs during the 1955-57 in
flation. The wholesale price index is broken down by economic sec
tors rather than by commodity groupings. During the latter half of
1955, when demands were generally expanding, the overall index rose
very little. Industrial prices, however, were rising quite rapidly— 3.6
percent in a half year. Prices of producers equipment, of most semi
fabricated durable goods, and of industrial raw materials increased
sharply. The steep decline in farm and processed food prices—
mainly attributable to a very large rise in meat supplies— kept the
overall index from rising.

107

RECENT INFLATION IN THE UNITED STATES
T a b l e 5 - 4 .— Wholesale prices and construction costs, 19 55 -6 7
[Percent change]

June 1955 Decem
to De
ber 1955
cember to August
1955
1957

Number
of com
modities
in index

Percent rising
or falling [June
1955 to August
1957]
Rising Falling

Wholesale price index, all commodities - ______ _
r.
Industrial products...... . . . . .
__ ________ __ „..

0.9
3.6

5.5
4.9
159

Producers equipment......................................
Consumer durables....................................... .
Consumer nondurables...................................

4.6
2.6
1.2

10.8
4.2
3.2

53
45
61

100
89
90

0
11
10

Intermediate materials, supplies and compo
nents....................................................................

Finished goods......................................................

n.a.
n.a.

3.8

5.3

194

Materials for durable manufacturing.............
Components for manufacturing..... ................
Materials and components for construction
Containers, nonretumable..............................
Supplies for manufacturing............... .............
Supplies for nonmanufacturing (excluding
animal feeds)...............................................
Processed fuels and lubricants........................
Materials for nondurable manufacturing .

5.5
7.3
3.9
4.8
4.0

6.9
8.2
3.4
8.6
4.2

22
30
42
10
19

68
100
83
80
84

32
0
17
20
16

2.3
1.6
1.3

4.8
6.5
2.1

22
8
41

100
100
76

0
0
24

Crude materials for further processing.................
Farm products..............................................................
Processed food............. ...............................................
Construction costs:
Residential..... ........... .................................................
N onresidential_____ _____ _______________________
Special index, manufactured products_________________
Durable_______________________________________
Nondurable_____________________________________

11.5
-9 .7
-5 .5

—.2
9.7
9.2

21
23
20

67
43
60

33
67
40

1.4
2.1
1.9
4.8
-.9

5.5
9.0
6.2
7.4
5.0

n.a.
n.a.
n.a.
n.a.
n.a.

The pattern of price increases after the turn of the year fits in quite
closely with our hypothesis. Industrial output was approximately
stable, despite rising capacity. Industrial prices nevertheless con
tinued to rise. We may classify the commodity groupings in table
5-4 in two ways: by sector of final demand and by stage of fabrication.
The largest increases among finished goods were those for capital
goods— producers’ durable equipment and nonresidential construction.
Prices of finished consumer durable and nondurable goods rose by a
much smaller amount, and most of the rise in consumer durable prices
was accounted for by automobile prices.
Among the intermediate materials, supplies, and components, those
mainly used by the durable goods industries had the largest price in
creases. Crude material prices did not rise at all. In general the
more advanced the stage of fabrication of a commodity, the more
likely it is to be cost-determined. The closer it is to a raw material,
the greater will be the influence of demand. In general the table
bears this out. The stability of aggregate industrial output is re
flected in the stability of the prices of industrial raw materials.
Among the semifabricated materials, supplies, and components, the
categories most advanced in the stage of fabrication— components
and containers— had the largest price increases. Although industrial

108

RECENT INFLATION IN THE

UNITED STATES

production was not rising, the cost increases arising out of excess
demands in the investment goods industries led to price increases in
these semifabricated products.
The last two columns give some further evidence of this tendency.
In general the more advanced the stage of fabrication the less the
prevalence of price declines among the various commodities making
up each category. The greater the number of production stages
behind each commodity the greater the possibility that rigidities in
the price structure and increases in wages and other costs will affect
its price. The table is not so finely broken down as to give more than
the roughest sort of information on stage of fabrication. Take for
example the category “ Materials for durable manufacturing.” Almost
one-third of its product classifications experienced a price decline. In
turn almost all of these were accounted for by the primary nonferrous
metals, copper, lead, and zinc. These are products with very little
fabrication, only one step removed from the raw material stage.
They are not normally sold in the form of ore, and first reach the
market in the form of primary refinery shapes. Had we a finer
breakdown of economic categories by stage of fabrication, the greater
rigidity of more fabricated products would be seen more clearly.
This is not a universal rule, of course, only a general tendency. The
relative magnitude of price changes and the frequency of price declines
in each category were also affected by the influence of final demands
for particular goods and services on the commodities which make up
the category. But without a much more detailed classification of
economic sectors, combined with an input-output table—enabling us
to relate changes in the demand for final goods to changes in the
demand for particular materials—we cannot construct the appropriate
cross classification of stage of fabrication and relationship to final
demand.
Table 5-5.— Relationship

of finished goods prices and materials costs, selected
industries

Situation and commodity group

Percent
change in
price
June 1955
to August
1957

Lumber______________________________________________
Millwork______________________________________________
Construction materials___________________________________
Residential building costs_________________________________

—4. 1
0
7. 4
7. 0

Plant, animal, and synthetic fibers__________________________ ___ —.9
Textile products________________________________________ ___ 0

I
I

Apparel, wholesale______________________________________ ___ 1. 6
Apparel, retail_________________________________________ ___ 2. 9

Hides and skins______________________________ _________
Leather_______________________________________________

10. 4
9. 3

Footwear, wholesale____________________________________ _
Footwear, retail________________________________________

8. 6
9. 1

Iron and steel and nonferrous metals________________________
Consumer durables, wholesale_______________ ______________
Consumer durables, retail___________ ______ ____ __________
Consumer durables, excluding autos, wholesale________________
.Consumer durables, excluding autos, retail______________ ____

17. 8
7. 0
3. 5
5. 0
3. 1

p |Iron and steel and nonferrous metals________________________

1Producers durable equipment (less autos)____________________

17. 8
20. 9

RECENT INFLATION IN THE UNITED STATES

109

Table 5 -5 illustrates the kinds of price behavior we are attempting
to describe.
Eaca bank in the table gives the price increase at various stages
in the production and distribution process of a particular group of
commodities, e.g., lumber, millwork, total building materials, and
residential construction costs.
Situation A represents a case of declining, or at best slowly rising
demand for the final product accompanied by falling prices of basic
raw materials. As the degree of fabrication mounts, increased costs—
particularly labor costs— lead to larger and larger increases in prices.
In the case of residential construction, the average price of intermediste materials going into homebuilding was additionally raised by
the sharply rising outlays for business investment and public con
struction (which do not impinge heavily on the demand for lumber).
No such outside factors appeared in the gradual progression of apparel
price changes, from a modest fall in fiber prices to a moderate rise in
retail clotiling prices. In situation B we are similarly concerned with
finished commodities, the demand for which is either falling or at
best slowly rising; but in this case we add the ingredient of steeply
rising materials prices. Final goods prices also rose, but by less than
the increase in materials prices. Finally, in case C, we have a pure
excess demand situation. Producers’ equipment prices rose very
sharply, even more so than the increase in the price of metals used in
tneir production.
Excess demands in the capital goods and related sectors of the econ
omy thus led not only to steeply rising prices for the commodities
directly involved, but to price increases for almost all classes of goods
and services. Prices of materials and supplies whose chief use is in
the capital goods industries were bid up; prices of most other materials
fell slightly or not at all. The magnitude of wage increases in excess
demand industries was matched by increases in industries with no
excess demands (the evidence for this we shall examine later). Prices
of commodities at advanced stages of fabrication were marked up in
response to cost increases which cumulated as the stage of fabrication
progressed. And downward rigidities in most prices tended to block
the spread of any influence which excess inventories and rapidly de
clining demands for autos and housing might otherwise have exerted.
Another aspect of the pattern of industrial price behavior is shown
in chart 5 -1 . Cnanges in industrial prices are there plotted against
changes in industrial output for the period between mid-1955 and
mid-1957. Commodity price data from the BLS wholesale price index
were matched in detail with industry output measures from the Fed
eral Reserve Board index of industrial production. The processedfood industries were omitted in view of the particular impact of chang
ing agricultural supply conditions on their prices. In a number of
industries there were no price data available for matching purposes;
e.g., aircraft, shipbuilding, and instruments. In some cases price
indexes were combined, with appropriate weights, to match a larger
industry total. In a few cases both output and price measures were
combined to provide matching groups. The industries for which
matching prices were finally provided account for two-thirds of the
total weight in the Federal Reserve Board index (after excluding
processed foods from the total).

110

RECENT INFLATION IN THE UNITED STATES

In general there is a positive relationship between price changes and
output changes. The simple correlation coefficient is quite low, how
ever (0.20). If we exclude the nine commodities or commodity group
circled on the chart and recompute the regression, the correlation
coefficient is substantially improved (0.66). In other words, if we
assume that the change in output was a rough measure of the change
in demand, there was a positive relationship between changes in
demand and changes in prices for most industries. The average
C hart 5-1

Changes in Industrial I>rices and Output
May-June 1955 to May-June 1957
percent
change
in
( > price

Uo
©
35
30
25
A
© 20

®
0

■S'

11$ ___

B
•

-25

“

------ •

1
|
- 2 0 ^ < c f " ^10
.

^
-5

’
*
___ •
,
•

*0
/

i
5

*
percent
I
10

I
15

i
20

dr - .
output

-5

•
•10
-15 —

-20

A. Regression line excluding circ led points (see text fo r industries
omitted).
B. Regression line including a ll points.

RECENT INFLATION IN THE UNITED STATES

111

(unweighted) change in output for all of the industries covered was
— 1 percent; the average price change, + 8 .7 percent. After excluding
the nine “ out of line” industries, average output change was zero,
while the average price rise was 6.6 percent. If we weight the price
and output changes by the 1955 relative importance of each item or
group in the Federal Reserve index, the correlation is further im
proved (0.947). Also, since the industries with the larger price and
output changes generally had higher than average weights the weighted
output and price averages were both higher. (For all industries, the
average price increase is 10.1 percent; after excluding the nine in
dustries, the averages are 4.3 and 8.9 percent respectively.)
The average line of relationship cuts the price axis at a price change
of 6.8 percent (using the smaller group of industries). On the average,
stability of output was associated with a substantial price rise. W ith
aggregate output rising less than capacity, however, there was no
aggregate excess demand over the period. Had prices been flexible,
the average relationship between changes in output and changes in
prices should have been such that moderate increases in output were
not on the average accompanied by price increases. This we discussed
at some length in chapter 3.
An examination of the details of individual price-output relation
ships provides additional insights into the nature of the general price
rise during the period. The three points above the regression line and
furthest out to the right represent industrial and commercial machin
ery, electrical machinery and equipment (excluding appliances) and
fabricated structural metal products. These were the three major
industries which benefited from the investment boom. They ac
counted for 40 percent of the (weighted) price increase. The weighted
average output rise of these three industries was 15 percent, compared
to an overall rise of only 2 percent. Indeed, the average change in
output for all other industries was a — 2 percent. Yet the average
(weighted) price rise for all other industries was over 8 percent. If
we remove the nine industries whose price-output relations were out
of line, and again exclude the three capital goods industries, the aver
age price rise was 6 percent. The capital goods industries were thus
the major areas in which industrial output rose. All other output com
bined actually declined slightly. Prices in these other industries
nevertheless rose substantially on the average, though by less than
the prices of capital goods.

We excluded nine industries from some of the calculations because
their price-output relationship was “ out of line.” On closer examina
tion these cases, despite their “ out of lineness,” throw additional light
on the nature of price behavior during the period. One of the in
dustries, softwood plywood, had a sharp increase in output and a
substantial fall in price. It is the one industry which is far out of line
below the regression relationship. The combined effects of rapid tech
nological advance and a substantial piling up of inventories in the
face of declining demand explains its behavior. Plywood, together
with residual fuel oil and lubricating oil (the two points far up on the
price axis) have very small relative weights. Their exclusion improves
the unweighted regression, but makes little difference to the weighted
one. The other six commodity groups are another matter. They are
listed below with their price and output changes.

112
T able

RECENT INFLATION IN THE UNITED STATES

5-6.— Price and output changes for selected commodity groups, May—June
1955 to May-June 1957
[Percent change]
Commodity group

Pig iron and ferroalloys________________________________________________
Steel rrill products____________________________________________________
Fonndrv and forcrfi shoo n rodlints
Tin nans
Passenger cars_________________________________________________________
Motortrucks__________________________________________________________

Price
19.9
20.4
18.9
16.7
11.8
9.3

Output
1.4
—5.4
—11.6
—6.9
—23.1
-12.8

Note.— Addendum: Relative importance of above groups in total, 15 percent.

The first four groups are closely associated with the steel industry,
the remaining two with the auto industry. As we have seen, the
magnitude of the average price increase among industries other than
capital goods is increased by a third (from 6 to 8 percent) upon the
inclusion of these industries. Because steel enters into so many in
dustrial commodities, the sharp increase in its price becomes even
more important when its role as a factor input is considered. The
fact that steel and auto prices were so much out of line with the aver
age relationship of price and demand changes in other industries—
which relationship itself was biased upward— strongly suggests that
administered increases in ex ante gross margins were responsible for
part of the price advance. We have already examined the shift in
ex ante margins in the steel industry.8 The evidence for such a shift
in the auto industry is much weaker. In the first place the auto
mobile companies, especially General Motors, produce such a di
versified list of products that the profit data for the companies as a
whole cannot be related to the production of automobiles alone.
Further, the mere counting of the numbers of automobiles produced
does not give a representative measure of output, in view of the
changing nature of the product itself. An indirect test of the hy
pothesis was therefore made. By weighting the price indexes of
various materials and components according to the importance of
their use in the automobile industry (as shown in the 1947 inter
industry relations study), an index of materials costs was constructed.
Between mid-1955 and mid-1957 this index— representing the average
price paid for materials by the automobile industry— rose about 14
percent. During the same period average hourly earnings in auto
mobile manufacturing rose by 7 percent; basic wage rates rose by
more than this, but overtime declined substantially. Manufacturers’
prices of automobiles rose some 10 percent over the same period.
Even if we assume no gain in productivity, the price increase seems
to be almost equal to the average rise in labor and materials costs
combined. If we assume a modest increase in productivity of only
1% percent per year, then it would appear that price increases were
somewhat greater than cost increases. A rise in prices equal to or
perhaps slightly greater than the rise in unit variable costs during a
period in which automobile sales declined substantially, seems at nrst
to confirm the hypothesis of a rise in ex aute margins, i.e., at the 1955
volume of car sales margins would have expanded. However, we
have made no allowance for the increases in costs associated with the
8 See above, pp. 91-93.

RECENT INFLATION IN THE UNITED STATES

113

widening, lengthening, and general styling changes occurring during
the period. It is impossible to say how much this invalidates our
data— which are, in any event, but rough approximations. As a con
sequence we cannot judge how much of the “ out-of-lineness” of the
change in prices relative to the change in demand in the automobile
industry represents an attempt to increase ex ante margins, and how
much it represents a particularly sharp rise in materials costs. A t a
minimum, the fact that prices could rise so much in the face of a sharp
decline in automobiles sales, suggests a price structure very sensith e
to cost increases and insensitive to declines in demand.

Summary
During the 2 years after 1955, total aggregate output and industrial
production rose very slowly, and by significantly less than the increase
in productive capacity. Aggregate demand was not excessive. The
demands for capital goods, for exports, and for military equipment
however, was in excess of potential supply, while housing and auto
demand fell well below the capacity of the two industries. Instead
of a realinement of relative prices around a stable center, prices of
almost all final goods and services rose. Price increases were generally
largest for those goods in excess demand, but were not confined to
those goods alone. Among semifabricated materials and components,
price increases also tended to be larger in the case of those materials
consumed by the capital goods and allied industries; but again price
increases were not confined to such commodities. The downward
rigidity of prices in areas of deficient demand and rising costs of semi
fabricated materials generally, gave an overall upward bias to the
relationship of demands and prices during the period.
T

e h a v io r

ages

The effect of excess demands in the capital goods industries spread
throughout the economy, not only by the mechanism of higher mate
rial costs but even more importantly through the mechanism of rising
wage rates. In chapter 3 we examined some of the theoretical reasons
why rising wage rates in industries with strong output and produc
tivity gains should induce similar wage increases in industries not so
fortunately situated. Evidence was presented that wages have be
haved in this manner during recent years. That evidence is recapitu
lated in tables 5 -7 and 5 -8 . Between mid-1955 and mid-1957 the
increase in output in the most rapidly expanding manufacturing indus
tries 9 rose almost five times more than the average rise for all indus
tries; the lowest quartile experienced on the average a 6 percent decline
in output. Because, as we noted earlier, productivity gains tend to
be largest in industries with the largest output increases, the variation
of employment change was less than the variation of output change.
Nevertheless employment in the lowest output quartile fell about
9 percent while it rose by 2 percent in the industries whose output
was increasing most rapidly. Changes in average hourly earnings were
insignificantly different, however. Despite the larger rise in demand
and productivity in the expanding industries, the increase in wage
rates was about the same as the average for all manufacturing, and
only slightly higher than the rise for the lowest quartile. The same
* The top 5 out of the 21 two-digit industry groups.

114

RECENT INFLATION IN THE UNITED STATES

relationship between output, employment, and wages prevailed during
the longer period, 1953 to 1957. The average rise in hourly earnings
was about 2 percent lower than the rise in the top output quartile and
1% percent higher than the lowest quartile. But the difference be
tween the average increase in wages and the increase in the two outer
quartiles was only one-half of 1 percent per year. The United N a
tions study of these relationships for a number of industrialized
nations between 1950 and 1956 and between 1954 and 1956 matches
our findings exactly. There is a systematic tendency for the average
wage increase to equal the increase in the most rapidly expanding
industries.
T able

5-7.— Changes in output, employment, and wage rates,* manufacturing
industries, selected periods
[Percent]

Output

1953 to 1957:
All industries_____________________________ ____ ______
Average of highest quartile2___________________________
Average of lowest quartile2__________ _____ ___________
May-June 1955: AH industries_________ _______________ ___
to
May-June 1957:
Average of highest quartile2________________ ____ ______
Average of lowest quartile2____________________________

Production
worker em
ployment

Average
hourly earn
ings

6.7
18.1
-1 .4
2.7

4.0
—1.4
-10.4
-3 .1

16.1
18.2
14.5
9.8

12.0
-6 .0

1.8
-9 .1

9.5
9.0

* All average are unweighted.

2 Highest and lowest quartile selected in all cases on the basis of change in output.

T able

5-8.— Changes in output, employment, and wage rates in manufacturing,
selected countries
[Average annual percent change]
1950-56 i

Output

Canada:
All industries ________________________________
Average of highest quartile________ _____________
Denmark:
All industries.____ ________ ______ ______________
Average of highest quartile______________________
Germany, Federal Republic:
All industries___ ____________ _________________
Average of highest quartile______________________
Netherlands:
All industries _ _______________________________
Average of highest quartile______________________
Norway:
All industries__________________________________
Average of highest quartile______________________
Sweden:
All industries
__ ____________________________
Average of highest quartile______________________
United Kingdom:
All industries__________________________________
Average of highest quartile_____________________
United States:
All industries__________________________________
Average of highest quartile______________________

1954-56 i

Average
hourly
earnings

Output

Average
hourly
earnings

4.2
10.1

7.7
8.1

7.0
14.5

3.8
4.2

2.2
7.0

4.7
4.5

5.0
11.5

4.0
3.8

16.5
28.4

8.9
8.6

13.0
18.6

7.9
8.4

7.0
11.3

6.8
6.4

9.5
14.3

9.6
10.2

5.6
9.5

9.5
9.3

6.5
11.9

5.5
5.6

2.8
7.8

14.0
15.6

5.5
11.6

6.4
7.2

3.5
5.6

9.1
9.5

3.0
4.6

8.4
9.2

4.7
8.7

5.8
6.0

7.0
11.0

4.7
5.1

* For Denmark: 1951-55 and 1953-55; fo: Netherlands, Norway, and Sweden: 1950-55 and 1953-56.

115

RECENT INFLATION IN THE UNITED STATES

Before further discussion of the relationship between wage changes
and demand changes, a digression on the relationship between output
and productivity is necessary. During a period in which capacity is
being increased and improved production methods introduced, it is
quite likely, a priori, that increases in output per man-hour will, up to a
point, be associated with increases in output. Only as the new capac
ity and improved facilities are utilized will be potential efficiencies
incorporated therein be realized. Over a very long period of time the
variation in output changes among different industries will reflect
mainly changes in capacity. In the short run, however, a much larger
proportion of the total variance will be due to changes in output rela
tive to capacity. To borrow the terminology used by Friedman in
his study of the consumption function, the part of the total inter
industry variance in output changes contributed by temporary com)onents (i.e., changes in output relative to capacity) will be quite
arge in the short run; over a long period however most of the variance
in output changes will be contributed by variations in permanent com
ponents (i.e., changes in capacity). There appears to be no reason
why the mere expansion of capacity itself should influence the rate of
change in productivity; but the rate of utilization of capacity will
certainly effect the rate of productivity change. The combination of
a large expansion of capacity and a small expansion of output in the
period under consideration meant that the proportion of interindustry
variance contributed by temporary components was quite high. As
a consequence we should find a significant relationship between the
change in output and the change in productivity.
The results of correlating changes in output with changes in produc
tivity in manufacturing industries are summarized in table 5 -9 . Since
a large number of the Federal Reserve Board industry output indexes
are derived by applying an assumed productivity gain to man-hour
data, we were unable to utilize the Board’s measures. A set of output
estimates was constructed by deflating industry sales and inventory
changes, considering the sum of the two to approximate a measure of
output. Comparable sales, inventory, and price data were only
available for 15 of the 21 manufacturing industries. Hence our esti
mates suffer from incompleteness, as well as from all the other prob
lems associated with deflated sales data. However, there is no
reason to believe that the method biases the results in any systematic
way.

{

T a b l e 5 - 9 . — Regression of changes in output per man-hour on changes in output,
15 manufacturing industries

1953-57: Production worker man-hours...................................................................
All employee man-hours. _- _______________________________________
1955-57: Production worker man-hours___________ ___________ ______ _____ __
All employee man-hours___________________________________________

10.0
6.4
3.0
.5

0.71
.58
.59
.54

0.78
.73
.79
.71

N ote.—“a” and “6” in the column headings are the regression coefficients in the equation, Z=a-\-bxt
where Z represents the percent change in output per man-hour and x represents output, “r” is the coeffi
cient of correlation.
Because so much of the interindustry variation in output change was
associated with changes in the relationship of capacity to output,10 the
i° The average unweighted rise in output of these industries from 1953 to 1957 was only 5.4 percent, while

from 1955 to 1957 output fell 1 percent-

116

RECENT INFLATION IN TH E UNITED STATES

correlation between output and productivity changes is rather high.
Because of the rapid substitution of nonproduction for production
workers, the average rise in output per man-hour for total employees
is less than the rise for production workers in both periods. More
importantly, the rise in productivity associated with a zero change in
output is significantly smaller for all employees than for production
workers. When employees are hired whose continuing employment
is not affected by moderate short-falls in output below expectation,
then output increases are essential for productivity growth and unit
labor cost stability.
The extension of our cross section study to aggregates is a tricky
business. But so long as we keep the range of output variations
within moderate limits, so that aggregate restraints, such as the
availability of labor, are not violated, we may usefully proceed. On
the basis of the coefficients in table 5-9, a “ norma!” increase of 8 per
cent in aggregate manufacturing output over the 1955-57 period
would have implied an increase in total employee productivity of
about 4.8 percent— 2% percent per year. But a uniform expansion
of output in all industries would not have achieved this result. We
have used a linear regression, while a priori reasoning would suggest
a curvilinear relationship— past a certain point, as output approaches
the physical limits of capacity, further increases in output will not
lead to gains in productivity. It was the industries whose output
expanded less than capacity in which potential productivity gains
were unrealized. Hence an aggregate rise in production chiefly com
posed of increases in industries in which excess capacity had emerged
would have been the pattern most likely to have resulted in an overall
gain in productivity.
The positive relationship between changes in output and pro
ductivity is confirmed by the United Nations study cited earlier.
For a number of industrial countries changes in productivity for in
dustries whose output expanded most rapidly were compared with the
average rise in productivity. Without exception, productivity gains
in the rapidly expanding sectors were greater than average.
The data for Germany also illustrates our proposition about the
mix of output changes. From 1953 to 1957 the average annual gain
in outnut for all manufacturing industries was 16.5 percent. (See
table 5-8.) Under these circumstances only a small part of the inter
industry variation in output gains could have been due to “ temporary”
components (i.e., changes in output relative to capacity); most of the
variation was probably attributable to permanent components (i.e.,
relative changes in capacity). As a consequence there was only an
insignificant difference between the productivity rise in the most
rapidly expanding industries and the average rise for all industries.
A faster rise in output, even had that been physically possible, would
most probably not have induced larger gains in productivity. It is
only when the growth in output is less than the rise in capacity that
productivity is output sensitive.

RECENT INFLATION IN TH E UNITED

T a b l e 5 - 1 0 .—

117

STATES

Changes in manufacturing 'productivity in 8 industrial nations
[Average annual percent change]
1950-56

Canada:
All manufacturing............................... ............................................................................
Average of highest quartile1 __________ ____ „
Denmark:
All manufacturing___________________________________________________________
Average of highest quartile___________________________________________________
Germany, Federal Republic:
All manufacturing___________________________________________________________
Average of highest quartile___________________________________________________
Netherlands:
All manufacturing___________________________________________________________
Average of highest quartile___________________________________________________
Norway:
All manufacturing___________________________________________________________
Average of highest quartile_____________________________ ___________________
Sweden:
All manufacturing_______________________________________________________ ___
Average of highest quartile___________________________________ _______________
United Kingdom:
All manufacturing___________________________________________________________
Average of highest quartile__________________________________________________
United States:
All manufacturing___________________________________________________________
Average of highest quartile___________________________________________________

1954-56

2.4
6.8

1.9
7.1

1.5
3.5

3.1
6.3

6.7
7.0

5.4
6.3

2.6
4.8

4.1
7.0

3.0
5.1

3.8
7.5

2.8
6 4

2.0
7. 2

1 2
1.7

1. 9
3.0

2.3
3.0

3.1
5.0

i Highest output quartile in all cases.

Within the limits we have suggested, then, the relationship of pro
ductivity changes to output changes suggests two important hy
potheses with respect to the behavior of wages and unit labor costs.
In chapter 4 we analyzed the reasons why firms in oligopolistic or
quasi-oligopolistic industries would find it to their advantages to
distribute, in the form of wage increases, a good share of the gains
accruing from rising demand or from advancing productivity. But
productivity gains are closely related, in the short run, to increases
in output, while output gains, up to the limit of capacity increases,
are related to the strength of demand. Hence the firms which ex
perienced larger than average increases in demand during the 1955-57
period quite probably benefited also from larger than average gains
in productivity. Even though the overall demand for labor was
not excessive, the combination of these two factors induced rather
large increases in wage rates in those firms whose sales were rising
sharply. And, as we have seen, wage rates in other industries followed
closely behind.
The uniformity of wage rate changes among different industries and
the positive association of output and productivity increases, imply
that unit wage costs among different industries will be negatively
correlated with output changes, unless output in most industries is
pressing on capacity. An inspection of tables 5-8 and 5-10 shows
this to be the case for all of the nations covered. Wage-rate increases
were about the same for the top quartile of industries as for all in
dustries. Productivity gains were much larger, however, for the top
quartile than the average for all manufacturing. As a consequence
unit labor costs rose far less among the rapidly expanding industries
than among other industries.

118

RECENT INFLATION IN THE UNITED STATES

This finding does not, of course, mean that an expansion of aggre
gate output is always a means of achieving lower unit costs and hence
lower prices. An additional expansion in output, even though it might
be achieved in part through higher productivity, would still require
additional labor and raw materials. The possible impact of rising de
mand for factors on factor prices cannot be ignored. However be
tween 1955 and 1957, output in a large number of industries failed to
keep up with the increase in capacity, while at the same time output
in one major sector of the economy was pressing hard on capacity.
In this case a discussion of output increases or decreases solely in ag
gregate terms misses the central point. It is the composition of
output changes which so strongly influenced changes in wage rates and
productivity, and hence unit labor costs. Under such conditions, the
restriction of aggregate demand is a two-edged sword. So long as
particular sectors of the economy continue to “ boom,” a reduction in
aggregate demand may modify the increase in wage rates very little,
but the increase in productivity very much.
By matching up changes in industrial prices as closely as possible
with changes in associated wage rates, some additional insight can be
gained into the price-cost relationships of the period. In table 5-11
the average increase in the prices of capital goods and materials heavily
used by the capital goods industries (including steel) is compared to
the average increase in the prices of all industrial other commodities
in the wholesale price index.
T a b le

5-11.— Prices and hourly earnings in capital goods and other industries f
1955-57
1955-57 price increase
Commodity group

Weight in
industrial
wholesale
price index1

A . Capital goods and associated commodities
B. Other industrial goods i n W P I 3___________

30
70

All industrial commodities....................
A / A , plus autos and paper products.................
B / B, minus autos and paper products..........

Percent
change

Percent
contribution
to total
change

Increase in
average
hourly
earnings2

15.0
4.0

62
38

100

7.3

100

10.5

41
59

13.5
3.1

75
25

10.8
10.3

11.7
10.1

1 Relative importance, December 1954.
2 Production workers only.
3 Wholesale price index.

The selected commodity groups (25 in all) account for 30 percent of
the total weight of the wholesale price index (excluding farm and food
products). But these same groups accounted for 62 percent of the
rise in industrial prices over the period. On the average their prices
rose 15 percent, compared to an average rise of 4 percent for all other
commodities. At the same time, however, wage rates rose only slightly
faster in the industries producing capital goods and associated prod
ucts than in all other indstries. If we add to our selected group of
commodities two other groups, automobiles and paper products, we
account for 41 percent of the weight, but 75 percent of the total price
rise. Yet wages increases in these industries averaged almost exactly
the same as the rise in all other industries.

119

RECENT INFLATION IN TH E UNITED STATES

T a b l e | 5 -1 2 .— Prices, hourly earnings> and unit costs in capital goods and other

industries, 19 55-57
[Percent change}

Prices

Average
hourly
earnings

Unit wage costs
I

Capital goods and associated commodities.
Other industrial goods in W P I___________
All industrial commodities__________

15.0
4.0
7.3

11.7
10.1
10.5

II
4.3
2.8
3.2

III
6.7
5.1
5.5

5.2
5.6
5.5

In table 5-12 we attempt some illustrative conversions of the wage
changes into unit cost changes under varying assumptions. In the
first illustration (I) we assume that production worker productivity in
both groups of industries rose by the same as the average for all in
dustries.11 In this case wage costs are seen to rise by less than prices
in both groups of industries. In illustration (II) we have corrected
the rise in productivity to allow for the effect on costs of substituting
indirect for direct labor. The reader will recall that in chapter 4 we
pointed out that if some of the increase in direct labor productivity
was made possible by a substitution of indirect labor, an increase in
wage rates equal to the increase in direct labor productivity would
still lead to a rise in unit labor costs. If salary rates rise by the same
amount as wage rates, the latter must rise less than direct labor
productivity if unit labor costs are to be stable. Correspondingly,
any given rise in wage costs per unit will imply a somewhat larger rise
in total labor costs per unit. When salary rates rise with wage rates
and salaried employment increases in a 1-to-l relationship with output,
then unit labor cost stability requires that
—

P . zw

— i

1 + 2*0(1 —P)
where ^ is the wage rate increase, zwthe direct labor productivity gain,
and P the proportion of wage costs in total labor costs. The right
hand term will clearly be less than zw; i.e. wage rates must rise by less
than direct labor productivity.
_
By substituting the actual 1955-57 values of Z w and P into the
equation, we can calculate the wage rate increase which would have
been consistent with stable labor costs. The excess of the actual wage
increase over the “ required” increase then reflects the labor cost
increase attributable to wage advances. Those cost increases are the
ones entered in column II of table 5-11. As a matter of fact salary
rates rose more than wage rates during the period. However this part
of the rise in costs cannot be attributable to wage increases, and so
we have not altered the formula to take account of this. Similarly
salaried employment rose more rapidly than output, whereas the
correction formula assumes an equal rise. But again, the rise in
salaried employment relative to output was not a consequence of
technological change, but rather of the failure of output to rise with
capacity. The data for the 1947-55 period suggest that secularly,
11 We have used the Federal Reserve Board index of industrial production in computing productivity,
Use of the BLS output measure would raise unit costs by an additional 3 percent on the average.

44975— 59------ 9

120

RECENT INFLATION IN TH E UNITED

STATES

overhead employment is rising equally with output. Any additional
relative rise, stemming from a shortfall in output, we do not want to
incorporate in our correction formula.
Finally in column III we have attempted to take account of the
fact that the industries in which prices rose most rapidly also had the
largest rise in output. Hence productivity most probably increased
more in those industries than in the others. Unfortunately our pro
ductivity data are not available in sufficient detail to allow an actual
matching up. Moreover we have included the steel industry in the
industries associated with capital goods; since output and productivity
in the steel industry did not rise particularly sharply from 1955 to 1957
the degree to which productivity gains in the capital goods industries
exceeded the average is reduced. Primary steel products account for
less than one-quarter of the weight in the group, however, and output
of most of the other commodities in the group did expand substantially.
Consequently there is a high probability that the average productivity
gain for the group exceeded the average for all industrial commodities.
For our illustration we have conservatively estimated that direct labor
productivity in the capital goods and associated group of industries
rose by 4% percent per year compared to an average of 3K percent for
all manuf acturing. This implies a 3-percent rise for all other industries.
The application of these various “ corrections” to the raw wage
data suggests, as indicated by column III, that unit wage costs in
the industries with the largest price increase advanced by no more
than in other industries. Further, it suggests that the rise in prices
in the industries with large price increases was substantially greater
than the increase in unit wage costs. Conversely prices in other
industries rose by a smaller amount than the increase in wage costs.
Since prices of capital goods seem to have risen substantially more
than wage costs and slightly more than materials costs (see table
5-4), an expansion of profit margins must have occurred. It is diffi
cult to determine the precise degree of margin expansion, since the
profits and sales data available for the machinery industry include
the profits and sales of many firms producing consumer durables.
Despite the inclusion of such consumer goods producers, whose
margins were probably declining during the period, the overall gross
margin (profits plus depreciation) on sales in the nonelectrical machin
ery industry rose from 12.6 percent in the first three quarters of 1955
to 13.5 percent in the same three quarters of 1956; gross margins
then declined slightly, to 13.1 percent in the first three quarters of
1957. (Since the fourth quarter of 1957 was sharply affected by the
recession, only the first three quarters of each year were used for
comparison purposes.) During the same period, gross margins for
manufacturing industry as a whole were declining. The increase in
machinery industry gross margins per dollar of sales, during a period
in which prices rose by some 15 percent, implies an even larger in
crease in gross margins per unit of output. Further, the inclusion
in the data of a number of consumer goods establishments, whose
margins were probably declining, suggests that the figures cited above
understate the rise of margins in establishments producing capital
goods. Net profit margins also rose in the machinery industry, but
by a smaller amount than gross margins.

RECENT INFLATION IN TH E UNITED STATES

121

The hypothesis that the 1955-57 inflation was mainly traceable to
an autonomous rise in wage costs appears to be sharply contradicted
by these data. Commodities which account for less than one-third
of the weight in the industrial wholesale price index accounted for
almost two thirds of the price rise. Yet in these same industries
prices rose by a substantially larger amount than did wage costs. To
suggest that wage increases originated in the industries with little rise
in output, demand, or productivity and were somehow transmitted to
the industries facing excess demand would fly in the face of any reason
able theory of wages. Neither can the rise in wage costs be traced to
an aggregate excess demand for wage labor. It is true that in late
1955 aggregate excess demand was for a short time in evidence. The
sharp rise in profit margins during the period did raise expectations
and quite probably lead to a general demand for factors of production
which had some lasting effects, particularly where long-term labor
contractu were involved. But during the succeeding 2 years demands
in the aggregate were not excessive and capacity increased more rapidly
than output. This we have already discussed in detail. The un
employment rate, while only 4 percent of the labor force, did not fall
any lower. Most importantly, the employment of direct labor de
clined throughout the period; census statistics on employment by
occupation and Bureau of Labor Statistics data on manufacturing
production workers both give evidence of this fact. Hence, while
wage rates may have been subject to the lagged influence of the
excess demand and swollen profit margins of late 1955, there was no
current aggregate excess of demand for factors of production during
1956 and 1957 to account for the wage advances of the period.
Summary

The data we have examined on the interrelationships among ex
penditures, output, prices, wages, and productivity seem to confirm
our hypothesis with respect to the nature of the 1955-57 inflation.
During those years the economy attempted to accomplish a sharp
change in the allocation of resources. Because of the limited mobility
of resources and the nature of price and wage making processes, this
resulted in a rise in the general level of prices rather than a mere shift
in relative prices. Overall demand was not excessive, and aggregate
output rose very little. Industries confronted with excess demand
raised prices however and bid up costs of materials and wages. In
deficient demand sectors neither goods prices nor factor prices fell
significantly. In fact the rising cost of materials, and the advance in
wage rates in the expanding sectors, spread throughout the economy.
As a consequence, prices not only failed to decline, but actually rose
in many industries characterized by growing excess capacity. The
tendency for most prices to rise was greatest among finished goods,
where cost pressures built up in earlier stages of fabrication, and
weakest among crude materials where demand conditions played a
more important role. The cost increases which did occur throughout
industry appear to have spread out from the sectors in which excess
demands were present. An examination of the relationship between
prices and wages does not confirm the hypothesis that the cost in
creases resulted mainly from an autonomous wage push; indeed the
data seem to contradict this view.

122

RECENT INFLATION IN TH E UNITED STATES
O verhead C

osts

In chapter 4 we distinguished between an increase in overhead costs
per unit stemming from long-term secular factors and an increase
originating in the failure of output to match the growth in capacity.
Both of these factors were at work during the 1955-57 period. The
secular trend toward substitution of overhead for direct labor con
tinued; the addition of new capital facilities proceeded at a very rapid
pace; the price of capital goods rose relative to other prices; research
and development outlays continued to increase at an exceedingly
sharp rate; and, in many consumer goods lines, the investment in
new tools and equipment required by elaborate model changeovers
swelled the fixed costs which had to be written off during the life of
the model.
Not only was the relative proportion of fixed to variable costs rising
within each industry, but the shift in the interindustry composition
of employment led to the same results on an economywide basis.
The industries which absorbed the largest part of the rise in employ
ment were those in which employment is not particularly sensitive
to moderate changes in output (table 5-13). About two-thirds of
the rise in employment came in service, finance, and government.
If we add manufacturing nonproduction workers the proportion rises
to more than three quarters. The rest is accounted for by the dis
tribution industries. The volatile industrialized sectors of the econ
omy—mining, construction, manufacturing, transportation, and pub
lic utilities— accounted for only 13 percent of the increase in employ
ment, and all of this represents increased nonproduction worker
employment in manufacturing. If we exclude nonproduction workers,
employment in these industries, which amounted to 40 percent of
total nonfarm employment in 1955, did not increase at all.
T a b le

5-13 .— Employment by industry, 19 55 -6 7
Employment
(thousands)

Change

Thou
sands

Percent
of total
change

1955

1957

Total nonfarm wage and salary employment___

50,056

52,162

2,106

4.2

100.0

Mining_________________________________________
Construction_______________________ ____ _______
Manufacturing. ..................................................... .

777
2,759
16, 563

809
2,808
16,782

32
49
219

4.1
1.8
1.3

1.5
2.3
10.4

Production workers________________________
Nonproduction workers. _ _________________

13,061
3,502

12,911
3,871

-1 5 0
369

-1 .1
10.5

- 7 .1
12.8

Transportation_________________________________
Communications. _________ _____________ ______
Public utilities_________________________________
Wholesale trade.. _____________________________
Retail trade. __________________________________
Finance, insurance, and real estate_____________
Service.______ _________________________________
Federal Government___________________________
State and local government_____________________

2,727
750
585
2,873
7,973
2,219
5,916
2,187
4,727

2,741
810
600
3,065
8,237
2,348
6,336
2,217
5,409

14
60
15
192
264
129
420
30
682

.5
8.0
2.6
6.7
3.3
5.8
7.1
1.4
14.4

.7
2.8
.7
9.1
12.5
6.1
19.9
1.4
32.3

Addendum:
1. Mining, construction, transportation, public
utilities, and manufacturing production
workers_______________________ ___________ _
2. Service, finance, etc., government and manu
facturing nonproduction workers___________
3. Wholesale and retail trade_______ - __________

20,659

20,679

20,181
11,302

1,630
456

8.8
4.3

77.4
21.7

18,551
10,846

Percent

RECENT INFLATION IN TH E UNITED STATES

123

One of the characteristics of employment in the service and dis
tribution areas is its relative inflexibility in the face of moderate
fluctuations in output. Just as in the case of nonproduction workers
in manufacturing, therefore, unit costs are particularly sensitive to
output changes. Of course, a large part of the rise in service-type
employment was in State and local government. The concepts of
prices and unit costs have a quite different meaning in this case, but
they are not meaningless. A significant portion of the Consuiner
Price Index, for example, represents various taxes and charges levied
by State and local government. The levels of these taxes per unit of
services furnished are by no means insensitive to changes in the costs
of providing the services.
Factor inputs and unit costs
Even after the overall level of output ceased to expand rapidly,
entrepreneurs continued to add to their plant and equipment and to
undertake heavy research and development expenditures. Employ
ment of all types expanded rapidly during the recovery period in
1955; after the latter part of that year, however, direct labor require
ments fell off; output failed to increase while direct labor productivity
continued to rise moderately. At the same time that business firms
were expanding their facilities and bidding vigorously for professional,
clerical, and other overhead personnel to staff these facilities, they
were reducing their employment of production labor (tables 5-14 and
5-15).
T a b le

5-14.— Changes in total 'private nonfarm wage and salary employment,1
A pril-Ju ly 1955 to A pril-J u ly 1957
Occupation group

Thousands of
employees

Percent

Professional and technical__________________________________________________
Clerical and kindred_______________________________________________________
Operatives and laborers____________________________________________________
Other______________________________________________________________________

727
743
—660
938

26.6
11.2
—5.6
5.0

Total.....................................................................................................................

1,748

4.0

1 Excludes self-employed and unpaid family workers.
T a b le

5-15.— Change in manufacturing employment,* 4th quarter 1955 to 3d quarter
1957
Category

Production workers________________ _____ _________________________________
Nonnroduction workers_____________________________
_
_
Total_________________

Thousands
of employees

Percent

—474
345

—3.5
9.7

-1 2 9

-.8

1 Seasonally adjusted.

The investment boom, thus carried with it a substantial expansion
in relatively fixed commitments, not only in terms of capital but also
in terms of labor inputs. Had output expanded in line with the
expectations held when the commitments were undertaken, these
factor inputs per unit of output would not have risen very signifi
cantly. But the stability of output, on the average, resulted in a
sharp increase in the ratio of such inputs to output. Even without
the rise in factor prices there would have been a rise in unit costs.
44979— 59------ 10

124

RECENT INFLATION IN

TH E UNITED STATES

The cost data presented in chapter 4 are amplified in table 5-16.
Changes in unit costs in manufacturing are allocated between the
change in factor price and the change in the factor input-output ratio.
The capital input measure is the roughest sort of estimate. It is a
measure of the constant dollar value of depreciation charges (depre
ciation being calculated by applying to historical estimates of capital
inputs estimated rates of depreciation).12 While neither capital nor
overhead labor inputs had risen significantly faster than output be
tween 1947 and 1955— when output increases matched capacity in
creases— the ratio of fixed inputs to output rose sharply between 1955
and 1957. From midyear 1955 to midyear 1957 the increase was
even greater.
In terms of the absolute contribution to cost increases, overhead
costs were substantially more important than wage costs during the
period. More than half of the total increase in costs is accounted for
by higher salary costs per unit, and three-quarters by salaries and
depreciation together.
T a b le

5-16.— Changes in manufacturing prices and costs, 1955 -5 7
[Percent]
A 1

B »

Deflator of gross product___________________________________________________

4.9

7.4

Unit wage costs________________________________________________________

4.4

6.7

Factor price________________________________________________________
Factor input per unit of output____________________________________

11.4
- 7 .0

11.4
- 4 .8

Unit salary cost________________________________________________________

19.3

21.9

Factor price.......................... ..........................................................................
Factor input per unit of output_______________________ ____________

12.0
6.7

12.0
9.2

Unit gross margins_____________________________________________________

- 2 .6
1

-.3
- 6 .8
6.5
CO
00

Unit indirect taxes_________________________________ ___________________

ooo

Factor price________________________________________________________
Factor input per unit of output2___________________________________

5.8

t The estimates in col. A are based on Federal Reserve Board output measures, col. B estimates on BLS
output measures.
2 Gross margins per constant dollar of depreciation.
T a b le

5-17.— Relative importance of different costs, 1955—57, manufacturing
industries1

Cost category

Deflator of gross product___________________________________________________
Unit wage cost______ ____________________ _________ ___________________
Unit salary cost___________________________ . . . _________________________
Gross margins_________________________________________________
Capital consumption_______________________________________________
Profits_____________________________________________________________
Indirect taxes__________________________________________________________
Addendum: Salaries plus depreciation per unit..________ ____ ____ ___. . . .
1 Based on BLS output measures.

12Cf. Woodin and Wasson, op. cit., passim.

Percent
change

7.4
6.7
21.9
-.3
(19.4)
(~7.0)
6.8
21.2

Percent of
total change
accounted for
by each cost
category
100.0
39.5
54.2
-1 .0
(19.8)
(-2 0 .8 )
8.3
74.0

RECENT INFLATION IN TH E UNITED STATES

125

The increase in prices, in excess of the rise in wage costs, can be at
least partly explained by the phenomenon of rising overhead costs.
Outside of the capital goods and associated industries excess capacity
was growing. Prices were not increased to reflect fully the rise in
fixed-unit costs, and margins declined. Nevertheless some recapture
of the higher fixed costs was attempted, with the result that on the
average the rise in prices exceeded the rise in prime costs. And the
increase in fixed costs was itself a result, in part, of the failure of output
to increase during an investment boom accompanied by the extensive
incurrence of overhead outlays of all sorts.
As we discussed in chapter 4, the attemp 1c recover fixed costs in
higher prices at a reduced level of output, when carried out by a large
segment of industry, is likely to prove self-defeating. Had prices not
risen so much, output could have been higher, enabling manufacturers
to spread their fixed costs over a larger volume of output. We noted
that the elasticity of costs to output was substantially less than unity,
a 1-percent increase in output reducing costs by about 0.35 percent.
This calculation however, takes account only of the output sensitivity
of fixed costs per unit. But direct labor productivity is also sensitive
to changes in output, within moderate ranges. Our regression co
efficients in table 5-9 indicate that a change of 1 percent in output
between 1955 and 1957 was associated with a 0.5-percent increase in
direct labor productivity, and an equivalent reduction in wage labor
costs. Appropriately weighted, this gives an elasticity of total costs
of 0.25. Combining our two cost elasticities, fixed and variable, we
find that a 1-percent additional increase in output during the period
could have resulted in a 0.6-percent decline in unit costs.
The failure of output to rise was thus a major factor in the increase
in costs during the period. In turn the lack of advance in output
resulted from the demand situation of the period, aggravated by the
attempt to recapture unit fixed costs at less than optimum rates of
output. This is not to say that output expansion is always the answer
to rising unit costs. Nor would any random pattern of output increases
have filled the bill. But rising output in those numerous industries
which experienced growing excess capacity after 1955 would have led
to a significant reduction in unit costs and possibly a somewhat lower
rate of price increase. If, in addition to an increase in the demand
for the products of those industries there had been a moderate reduc
tion in the demand for capital goods, there is little doubt but that the
overall price increase would have been substantially smaller and the
output increase significantly larger.
C

o n su m er

P r ic e s

An analysis of the way in which developments in the industrial
sector influenced the price level—particularly the consumer price
level—must take into account the tremendously diverse and complex
mechanism by which the effects of price increases in one part of the
economy get diffused throughout the whole. In the Consumer Price
Index, food, nonfood commodities, and services each account for
approximately one-third of the total weight. Even among nonfood
commodities manufacturers’ prices make up not much more than half
of the total price, the rest being transportation, wholesaling, and
retailing costs. The service component of the CPI is made up of a

126

RECENT INFLATION IN TH E UNITED STATES

long list of heterogeneous items, including such things as auto, real
estate, and medical insurance, public-utility rates, haircuts, postage,
and interest rates. Thus it would seem that the direct impact of
changes in industrial prices and wages on the CPI is relatively limited.
Yet an increase in the prices of manufactured products diffuses itself
throughout the economy by many indirect routes. Steel prices rise,
school construction costs go up, and property-tax rates are adjusted
upward; an initial rise in the CPI on account of an increase in industrial
prices leads, with some time lag, to rising wages in the service indus
tries and, e.g., auto-repair charges rise; and the examples could be
multiplied ad infinitum. There are in addition special factors in
fluencing the prices of particular groups of consumer prices. An
appreciation of the nature of the overall price rise requires an exam
ination of these particular influences.
T a b le

5-18 .— Changes in consumer prices, March 1956 to September 1957
Item

Percent Percent
change of total
change

Item

Percent Percent
change of total
change

Consumer prices, all items..

5.6

100.0

Food...................................................

7.3

37.4

Rent............................................

3.1

3.3

Meats, poultry, and fish..........
Other foods................................

18.9
3.9

21.8

Other services............................

6.2

31.3

Durable commodities......................

4.1

10.3

New automobiles......................
Used automobiles.....................
Tires and tubes.........................
Appliances.................................
Furniture and bedding............

2.6
1.8
-1.2

1.3
5.6

Nondurable commodities........... .
Apparel.......................................
Textile housefurnishings.........
Gasoline......................................
Motor oil-----------------------------Solid fuels and fuel oil.............
Toilet goods..............................
Tobacco products.....................
Alcoholic beverages..................
Newspapers...............................

21.4

4.1
2.4
1.7
5.5
9.5
4.7
3.8
5.9
3.8
14.6

15.7

-.7
1.2
16.9
4.0

2.4
3.8

1.2
.8
2.1
1.6
2.6

5.8

Medical care except hos
pital and group insur
ance...................................
Hospital rates........ ...........
Group hospitalization___
Auto repairs........................
Auto insurance...................
Transit fares.......................
Railroad fares, coach.........
1st mortgage interest_____
Residential water rates.. .
Residential telephone
service............ ...........
Gas and electricity____
Miscellaneous................
Men’s haircuts___
Beauty-shop services.
Domestic services____
Refinishing floors___
Repainting rooms___
Repainting roof_____
Repainting garage___
Laundry services____
D ry cleaning
and

4.2

12.6
9.7
5.3

10.6
5.1
10.4

35.4

2.9
.5

2.0
1.1
1.7
1.1

10.6

.5
3.1
.4

2.4

1.8

.5
.7

6.9

5.6

7.5
5.7
4.3
6.4

1.0

9.2
17.7
5.0

.5
.5
.7

5.6

11.6
6.0

.3
.4

.6
1.4

The Consumer Price Index began to rise in March 1956. Between
then and September 1957, before the recession set in, the index rose
5.6 percent. (See table 5-18.) Of that increase 72 percent was con
tributed by food and services, and only 28 percent by nonfood com
modities. The level of consumer commodity prices is of course
mainly determined by manufacturers7 prices of those goods. Since
we have discussed the factors at work in the manufacturing sector we
shall not spend much time on the price behavior of these commodities,
but rather concentrate on food and services prices. Before doing so
however, there are a few important features in the behavior of nonfood
commodity prices which deserve comment. Appliance prices were
the one major group of prices to decline during the period of general
price rise. Retail appliance prices fell despite a gradual increase in

RECENT INFLATION IN TH E

127

UNITED STATES

manufacturers’ prices. The fall in appliance prices during 1956 and
1957 was the continuation at a reduced rate, of a decline begun in 1951.
It reflects mainly a revolution in distribution techniques, characterized
by the rise of the discount house, the belated attempt of standard
distributors to match discount prices, and the gradual abandonment of
attempts to fair-trade this merchandise. In view of the fact that the
declining prices were accompanied by a decrease in the distributive
services rendered per unit of sales, the price index overstates the
decline in price— i.e., in part the price decrease represents a fall in the
“ quality” of product. This is at least a partial offset to the opposite
bias in the indexes for other commodities where quality improvement
is reflected in a price increase.
It is surprising to learn from table 5-18 that the increased price of
newspapers contributed more to the rise in the index than the increased
new car price. In part this is spurious, because discounts on new cars
are seasonally greater in September (the last month of our comparison)
than in March (the first month of comparison). Nevertheless,
newspapers, alcoholic beverages, and tobacco products together
account for about 25 percent of the rise in nonfood commodity prices.
Used cars account for another 20 percent. Used-car prices had fallen
to very low levels in 1955, as sales of new cars rose to peak levels.
The fall in demand for new cars during 1956 and 1957 did not lead to
a price fall, but the accompanying rise in demand for used cars,
combined with the relatively low stock of cars available, resulted in a
very sizable rise in prices— an interesting example of asymmetry in
demand-price relationships.
Food prices

Food prices accounted for 36 percent of the rise in consumer prices.
After 1951 prices of farm products declined steadily until early 1956.
Livestock prices fell particularly sharply, hogs most of all. In 1956,
however, supplies of livestock leveled off, after the large increases
between 1953 and 1955, and prices received by farmers rose from the
postwar lows of late 1955.
T a b l e 5 - 1 9 . — Indexes of farm production and marketings
[1947-49=100]
Production
Livestock and products

Volume
of food
marketed

Crops

Total
Total

1953........................
1954........................
1955........................
1956........................
1957........................

108
108
112
113
113

114
117
120
122
121

Meat
animals
116
121
127
123
120

Total

103
101
105
106
106

Food
grains
96
85
80
84
79

Vegetables

96
94
96
101
96

113
116
121
126
127

Rising retail prices of meat accounted for 65 percent of the increase
in food prices between the first quarter of 1956 and the third quarter of
1957. Of this 65 percent about 9 percentage points was due to increased
marketing margins; the other 56 points represented higher prices for
meat on the farm. Foods other than meat contributed 35 percent of
the food-price rise. The farm value of these foods actually fell, but

128

RECENT INFLATION IN TH E UNITED STATES

marketing margins rose by more than the decline in farm value so
that prices to the consumer increased. Taking both meat and other
foods together, table 5-20 indicates that about one-half of the rise in
food prices was brought about by increasing marketing margins and
the other half by higher farm prices.
T a b l e 5 -2 0 .—

Distribution of increases in food prices, 1st quarter 1956 to
8d quarter 1957
Percent of
total change
contributed
by each
item

Percent
change

Total food____________________________________________________ _____ ______
Meat________________________________________________________________
Marketing costs____________________________________________________
Farm value________________________________________________________

8.0

100

24.5

6.4
46.8

9
56

Other foods___________________________________________________________

4.3

Marketing costs____________________________________________________
Farm value________________________________________________________

7.5
- 1 .2

39
—4

Total marketing costs______________________________________________________
Total farm value_________________ _______ ___________ _______ _____________

7.3
12.2

48
52

T a b l e 5 -2 1 .— Components of food marketing margins
[Indexes, 1947-49=100]
1

Food marketing margins_________________________________________
Labor costs 1_________________________________________________
Rail and truck transportation costs__________________________
Corporate profits before tax__________________________________
Other costs2_________________________________________________

1952

1953

1954

1955

1956

114
121
122
95
120

115
124
125
99
122

117
125
125
94
124

119
125
124
111
128

120
127
129
123
136

1957
128
128
136
121
141

1 Includes the earnings of wage and salary workers and the self-employed, in the processing, distribution,
and transportation of food.
2 Includes costs of nonfood materials and supplies, depreciation, and earnings of unincorporated business.
T a b le

5 -2 2 . — Changes in food marketing margin and its components,1 1955—57
Percent of
total change
contributed
by each
item i

Percent
change

Index of food marketing margins___________________________________________
Labor costs.. _________________________________________________________
Rail and truck transportation costs_____________________________________
Corporate profits before tax____________________________________________
Other costs_____________________________________________________________

7
3
10
9
10

100‘
21
19
7
53

i Based on the relative importance of each item in total unit margins in 1955.

Or, putting it in terms of the total Consumer Price Index, the increase
in farm prices of foods was responsible for about 1 point of the 5.6
percent rise in the Consumer Price Index, while marketing costs were
responsible for another 1 point. This contribution of food marketing
margins was larger than that of either durable or nondurable com
modities (other than food) taken separately.

RECENT INFLATION IN TH E UNITED STATES

129

Marketing margins cover all of the charges, including profits, of
transporting, processing, and distributing food. Table 5-21 gives a
breakdown of margins into component cost items; table 5-22 sum
marizes changes in margins and cost components during recent years.
Margins increased quite slowly from 1952 to 1956, but in 1957 in
creased 6X percent. The sharp rise in margins coincided with a year
in which, for the first time in years, the volume of food marketed did
not rise significantly. All elements of costs rose. Profit margins,
which from 1952 through 1954 had been below the 1947-49 levels, rose
abruptly in 1955 as farm prices fell. They rose again in 1956 despite
the recovery of farm prices, and then fell slightly in 1957. Unit labor
costs contributed about one-fifth of the increase in costs between 1955
and 1957; average hourly earnings in the food marketing industries
rose 10 percent, but productivity also rose significantly. In the
food processing industries, production worker employment declined
while nonproduction worker employment rose; consequently it is
quite probable that a large part of the rise in labor costs was attri
butable to rising overhead labor costs—just as it was in manufacturing
generally. The sharp increase in margins occurred at a time when
the volume of food marketed was not rising. The largest contributor
to the rise in margins was the component labeled “ other costs.”
Two factors were mainly responsible for this increase—rising depre
ciation charges and increased prices of supplies and equipment pur
chased by the food processing industries.
Of the total rise in consumer food prices, therefore, half was ac
counted for by rising marketing margins. In turn the increase in
marketing margins arose from factors quite similar to those which
affected industry generally— the spread of wage and material cost
increases from excess demand sectors and the rise of fixed costs per
unit. Some unknown part of the increase in marketing margins was
attributable to the gradual secular rise in the “ built-in maid services”
incorporated in processed food. But this can hardly explain the
sharp jump in margins in 1957.
The other half of the rise in food prices is traceable to the increase
in farm prices. Here, changes in livestock supply conditions rather
than excess consumer demand for food were mainly responsible.
Since meat prices had fallen to an abnormally low point in late 1955,
the price increases from that point on were more in the nature of a
return to normal than a new inflationary force. Indeed, one might
interpret the direct and indirect consequences of this change in farm
prices as a factor changing the timing rather than the degree of infla
tion. Part of the price stability from 1951 to 1955 was due to the
fall in farm prices to abnormally low levels. Part of the general price
rise thereafter may conversely be interpreted as a postponement of
increases which would normally have taken place earlier.
Service prices

Consumer services cover a wide variety of economic activities, rang
ing from the highly industrialized public utilities to men’s haircuts and
domestic service. Included in this category are also a heterogeneous
collection of items whose prices are regulated through political or insti
tutional decision making, and reflect only gradually, and in discrete
steps, the general forces at work in the economy. Such items include

130

RECENT INFLATION IN TH E UNITED STATES

real estate taxes, property insurance premiums, automobile insurance
and registration fees, mortgage interest, and public utility rates. It is
quite difficult to trace the influence of general economic developments
on the specific timing and magnitude of price changes in the service
industries. However, such interrelationships do exist. Changes in
wage rates in the highly industrialized sectors of the economy exert an
attractive influence on wages in the service industries. Rising prices
of materials and supplies gradually affect the costs of providing serv
ices, even those which are generally thought to consist mainly of labor;
higher prices of building materials raise the cost of providing State
and local services and eventually force an increase in tax rates; higher
prices of parts and supplies increase the cost of auto repairs and lead
to an advance in insurance premiums; hospital rates and group hos
pitalization charges reflect the increase in the costs of building and
maintaining hospitals. Finally, the rise in consumer prices itself,
regardless of cause, exerts a powerful force on the wages and other
labor costs incurred by the service industries. There is undoubtedly
a lag involved, but inflationary pressures in the industrialized sectors
of the economy will spread to the service industries. And, of course,
vice versa.
Ever since World W ar II service prices have been rising steadily,
through economic expansion and contraction. They have risen not
only absolutely but in relation to the prices of commodities. Service
prices, however, rose quite slowly during the war. Their subsequent
increase has only recently brought them back to the prewar relation
ship to other prices. The prewar relationship represents, of course,
no fixed standard. However the relatively low level of service prices
at the end of World W ar II may explain at least part of their steady
rise since then. It is another example of those adjustments in relative
price levels which seem to take place only by the lower group of
prices rising toward the higher— the reverse selaom occurs.

In table 5-18 the increases in service prices during 1956 and 1957
are given in some detail. In general prices of most services rose at a
somewhat faster rate than prices of other major categories, except
food. Gas, electric, and telephone utility prices, however, increased
quite slowly. Prices of such utilities, being regulated, tend to adjust
to inflationary pressures with some timelag. During the period
immediately following the opening of Korean hostilities, when other
prices were rising rapidly, public utility prices increased quite slowly.
Thereafter, when commodity prices were stable, utility rates increased
more rapidly. Similarly in 1956 and 1957 the rise in utility rates
was less than the general price rise; starting in late 1957 and continuing
into 1958, however, they rose at a much faster rate.
The rise in the “ prices” of such items as real estate taxes, insurance,
postage, and mortgage interest was in part determined by institutional
factors. Many of these prices were introduced into the index only
in 1952. Since then, taken as a group, they have increased more
rapidly than service prices generally. In the long run such items
tend to be influenced by general economic conditions; the specific
timing of price changes, however, is usually determined by noneco
nomic considerations.
Prices of other services are generally characterized by a very low
degree of industrialization, and a high proportion of labor costs in total
costs. Productivity gains tend to be smaller than the average for the

RECENT INFLATION IN T H E UNITED STATES

131

economy; indeed in some cases, e.g., domestic service, the price of the
service is the wage rate. Even conceptually productivity gains are
excluded. Prices of such services will tend to rise with increases in
wage rates. In turn wage rates will be closely influenced by changes
in the cost of living and by the behavior of wages in other industries.
Since these services constitute a large portion of total service prices,
and since other service prices are also influenced by wage rate changes,
though to a lesser degree, we should expect to find some relationship
between the rate of change in service prices and the general conditions
in the economy which determine the behavior of wage rates and the
Consumer Price Index.
In table 5-23 the quarterly rates of change in service prices do show
a sensitivity to conditions elsewhere in the economy. Changes in
consumer prices tend to affect service prices after some lag. In 1949
consumer prices fell, and were more or less stable during the first
6 months of 1950; service prices in 1949 and 1950 rose at a reduced
rate. Between late 1951 and early 1956 consumer prices in general
moved up very little. Service prices in 1952 continued to rise at a
fairly rapid rate, although less than in 1951. In 1953, the rate of
increase moderated further, and in 1954 and 1955, when wage rates
rose gradually and consumer prices were stable, the rate of increase
in service prices was quite small. Starting in 1956, however, service
prices began to rise more rapidly and continued to do so in 1957.
Again the cessation of increases in consumer prices and the lower
rates of wage increases in 1958 affected the rate of increase in service
prices during that period.
T a b l e 5 - 2 3 . — Rate

of change in service prices

[Percent change at quarterly rates
Year or quarter
1947....................................
1948....................................
1949....................................
1950....................................
1951...................................
1952....................................
1952—1st quarter_______
2d quarter_______
3d quarter_______
4th quarter______
1953—1st quarter_______
2d quarter_______
3d quarter..............
4th quarter.......... -

Change
1.4
1.5
.9
.9
1.3
1.1
1.1
1.2
1.2
1.1
1.0
.8
1.0
.9

Year or quarter
1954—1st quarter_______
2d quarter_______
3d quarter_______
4th quarter______
1955—1st quarter _____
2d quarter_______
3d quarter_______
4th quarter______
1956—1st quarter_______
2d quarter.._____
3d quarter___ ___
4th quarter........ ...

Change
0.6
.4
.5
.4
.4
.4
.5
.5
.3
.5
.9
.8

Year or quarter
1957—1st quarter_______
2d quarter_______
3d quarter_______
4th quarter__ - ___
1958—1st quarter_______
2d quarter_______
3d quarter__ - ___
4th quarter______

Change
1.0
1.1
1.0
.9
1.1
.8
.5
.4

i Data are averages of quarterly changes for 2 quarters, centered on the last quarter, e.g., 1957,2 quarters
change is the average quarterly rate of change from March to September 1957.

Increases in service prices influence and are influenced by changes
in other sectors of the economy. It is impossible to trace the specific
links in this interrelationship in any detail, partly because of the very
nature of the service industries and, in the case of a number of services,
because of the institutional nature of price decisions. Changes in
wages and prices in the industrial and agricultural sectors of the
economy do spread to the service industries, however gradual the
process may be. Conversely, service prices have themselves been an
independent influence on other prices. Partly because of their
relatively low level at the end of World W ar II, and partly as a result

132

RECENT INFLATION IN TH E UNITED

STATES

of the small productivity gains in many service industries, prices of
services have risen relative to other prices during the postwar period.
Through its effect on the overall level of consumer pi ices this trend in
service prices influenced wage rates throughout the economy, and thus
became an independent factor in the behavior of the general price
level. The demand for services has also been strong throughout the
period. The major feature of the demand for services, however, has
been the constancy rather than the magnitude of increase. Between
1947 and 1957, for example, the increase in real expenditures on
consumer services was substantially less than the rise in consumer
purchases of durables. Yet service prices rose much more rapidly
than those of consumer durables.
S o m e I m p l ic a t io n s

The major part of the rise in the general level of prices during the
1955-57 period we have attributed to two sets of factors.
1. The downward rigidity and cost-oriented nature of prices
and wages in most of industry. During a period in which dynam
ically stable aggregate demand veils a sizable shift in the compo
sition of demand, such market characteristics result in a general
rise in the level of prices. The years after 1955 were such a
period. Prices rose where demands were excessive and failed
to decline elsewhere. Rising prices of materials led to cost
increases for industries not faced with excess demands. Wage
rates were bid up rapidly in expanding industries, and attracted
other wages up to the same levels. Thus the excess demand in
the capital goods industries not only led to price increases not
balanced by price declines elsewhere, but to general cost increases
which forced prices up even where demands were stable or
declining. The degree of price increase in various industries was
generally associated with the magnitude of the rise in demand,
but with an upward bias, so that on the average prices rose, even
though on the average demand did not rise excessively. Cost
increases tended to be more uniform throughout industry, so
that the increase in prices was greater than the rise in costs in
rapidly expanding industries and less in stable or declining
industries.
2. The attempt to recapture in prices the rise in fixed unit costs
which occurred when a vigorous investment boom and a rapid
substitution of fixed for variable labor input impinged on a situ
ation of sluggish growth in output. This process was to some
extent self-defeating. The rise in ex ante gross margins which
resulted from the attempt to cover fixed costs at low rates of
output itself impeded the rise in output. Had output in the
industries with excess capacity been higher, overhead costs per
unit would have increased by a smaller amount. And since
even direct labor productivity was positively correlated with
production, there is even more reason to believe that a rise in
output would have led to somewhat lower unit costs.
None of the foregoing analysis is designed to indicate that all infla
tions are the result of these processes. Excess aggregate demand has
been the basic cause of all of our major inflations. And even the 195557 price increase bore the imprint of the influences of the temporary

RECENT INFLATION IN TH E UNITED

STATES

133

aggregate excess demand of late 1955. But the major thesis of this
study has been that the creeping inflation of 1955 to 1957 was different
in kind from classical excess demand inflations. Such mild inflation
may be expected in a dynamic economy whenever there occur sharp
changes in the composition of demand. It is, in effect, a feature of
the dynamics of resource allocation where prices and wages tend to
be rigid downward. Moreover, these rigidities give a secular upward
bias to the price level so long as the major depressions which “ broke”
the ratchets in the past are avoided in the future.
The conclusions of this analysis with respect to the future possibility
of inflation are not so pessimistic as it might appear at first glance.
There is an upward bias imparted to the price level by the nature of
our price and wage setting mechanisms. But the magnitude of the
secular bias is not given by the degree of inflation we faced in the
last several years— assuming, of course, that we do not allow classical
excess aggregate demand to get started.
1. The magnitude of the shifts in demand between mid-1955
and mid-1957 were unusually great. We should not be contin
ually subject, for example, to a 2-year increase in fixed business
investment of some 25 percent (and a much larger rise in order
backlogs) accompanied by a 20-percent decline in residential
construction and automobile sales.
2. Rising overhead costs were particularly troublesome because
of the nature of the shift in demand. The very fact that it was
investment in fixed facilities and overhead labor which expanded
rapidly, while other sectors of the economy did not keep pace,
was a major source of difficulty from the cost side.
3. The upward price pressure arising out of attempts to re
capture fixed costs at reduced “ standard volume” is a “ one-shot”
phenomenon. It is unlikely, indeed impossible, for the average
operating rate at which entrepreneurs attempt to recapture fixed
costs to continue falling indefinitely. Indeed the very size of the
current ex ante profit margin, at full utilization of capacity,
which resulted from this reduction in standard volume should
become a dampening factor, offsetting price pressures from other
sources as output rises toward full utilization of capacity.
We have not attempted in this study to deal with the policy aspects
of creeping inflation. Nor shall we do so. However there are certain
obvious implications which are relevant to the formulation of policy.
In the first place it is quite clear that monetary and fiscal weap
ons designed to combat inflations stemming from aggregate excess
demand are of limited value in situations characterized by the absence
of aggregate excess demand. When, as in recent years, prices are
rising during a period of growing excess capacity, a further restriction
of aggregate demand is more likely to raise costs by reducing produc
tivity than it is to lower costs by reducing wages and profit margins.
Monetary and fiscal policies which do not restrain aggregate de
mand, but impinge only on the sectors where demand is excessive
may indeed limit the inflationary forces during such a period. Between
1955 and 1957 a slower growth in investment demand, coupled with
a more even rise in auto and housing demand would undoubtedly
have resulted in a smaller price increase and a larger output gain.
The whole question of selective tax and credit controls is far too
broad to be discussed here. Their application involves economic and

134

RECENT INFLATION IN TH E UNITED

STATES

social problems of substantial magnitude. At the same time however,
our analysis does indicate that counterinflationary policy must be
designed to take into account the composition as well as the magnitude
of excess demand. By using monetary and fiscal policy to prevent
excess aggregate demand from emerging we can control one type of
inflation. With a dynamically stable aggregate demand inflation can
still arise. Faced with this situation we can either attempt to alter
the composition of demand by using selective controls or we can accept
the moderate price increases that ensue. This is our choice. We
cannot solve the problem, indeed we shall do positive harm, by a fur
ther repression of aggregate demand through monetary and fiscal
policy.
Creeping inflation is associated with the dynamics of resource allo
cation. One cannot, simply because it is called inflation, attribute to
it all the evil effects of a classical hyperinflation. Like many other
aspects of the resource allocation process, it benefits some individuals
and harms others. It is, in part, a reflection of the attempt by groups
of income recipients to ease the adjustments in relative income status
which accompany a change in the use of resources. It probably dis
turbs the social structure less than do the rapid changes in technology,
the shifts in income among industries, and the movement of industry
between regions which are continually taking place in a dynamic econ
omy.

A P P E N D I X

A
N

otes

and

p p e n d ix

Sources

for

C h arts

and

ables

Table 1-1, page 10: See notes to tables 2-3 and 4-6.
Table 1-2, page 11: Capacity estimates, McGraw-Hill Department of
Economics and Fortune magazine. McGraw-Hill does not publish estimates
from 1947 to 1950. For these years the McGraw-Hill series was extrapolated
backward by the Fortune estimates. Employment and man-hours, Bureau of
Labor Statistics, U.S. Department of Labor (BLS). Output, Federal Reserve
Board index of industrial production.
Table 2-1, page 25: Deflators and prices from the Economic Report of the
President, 1959, table C-8, page 97. Average hourly earnings from various issues
of the United Nations Statistical Bulletin and BLS.
Table 2-2, page 32: The construction of these price and cost estimates are
briefly described in chapter 4, page 4-11, and more fully in the author’s paper in
the forthcoming “ Studies in Income and Wealth” , volume 25, National Bureau
of Economic Research.
Table 2-3, page 33: Price of manufactured products and of raw materials
from BLS. For the construction of the manufacturing deflator of value added,
and its cost components see the notes to table 2-2. In brief the technique is as
follows: An estimate of capital consumption allowances and indirect taxes was
added to the Department of Commerce data on national income originating in
manufacturing, to arrive at gross national product originating. An adjustment
was made to change the profits, interest, capital consumption, and indirect tax
estimates from a “ firm” to an “ establishment” industry classification. An esti
mate of constant dollar gross national product originating in manufacturing was
constructed by moving the 1957 GNP originating with a BLS measure of manu
facturing net output. This series is described in BLS Bulletin 100. Revised
estimates, through 1957, are incorporated in the BLS manufacturing productivity
estimates presented in table 3a, page 778, in the Joint Economic Committee”
Hearings on the 1959 Economic Report of the President.” Division of the
current dollar by the constant dollar GNP yields the price deflator. Division
of the various cost components by the output index yields costs per unit of output.
Labor costs include wages, salaries, and supplements. Gross margins include
corporate and unincorporated business profits, net interest paid, and capital
consumption allowances. Indirect taxes are allocated on the basis of the industry
making the actual tax payment, regardless of final incidence.
Charts 3-1 and 3-2, pages 60 and 61: Wages, average hourly earnings in
manufacturing, 1900-14, from Paul Douglas, “ Real Wages in the United States,”
1914-58, BLS. Unemployment, 1900-40, Stanley Lebergott, Annual Estimates
of Unemployment in the United States, “ The Measurement and Behaviour of
Unemployment,” NBER, table 1, page 215.
Charts 3-3 and 3-4, pages 63 and 64: Wages, see note to charts 3-1 and
3-2. Consumer prices, Ethel Hoover and George Taylor, “ Hearings before the
Joint Economic Committee,” April 9, 1959; table 2, page 397.
Table 4-1, page 80: Employment data by occupation from the Census Monthly
Report on the Labor Force.
Table 4-2, page 80: Employment data from BLS.
Table in footnote 5, page 81: Based on table V-15, “ U.S. Income and Out
put,” Department of Commerce, 1958 and on data supplied by the Machinery
and Allied Products Institute.
Table 4-3, page 81: Prices from BLS wholesale price index. Deflators from
“ U.S. Income and Output.” “ Average Price” of a unit of capital equipment
services in manufacturing derived as described in footnote 6, pages 4-8.

135

130

RECENT INFLATION IN

THE UNITED STATES

Table 4-4, page 82: See notes to table 2-3. The breakdown of labor costs into
wages and salaries is based on a comparison of BLS payroll data with Department
of Commerce data on combined wage and salary payments. Indexes of wage and
salary costs furnished by Murray Wernick of the Federal Reserve Board were also
utilized in constructing the estimates. Finally the estimates were checked againts
the unpublished data on wages and salaries which underlie the Department of
Commerce “ wage and salary disbursements’ ’ figures. “ Supplements” were allo
cated to wages and salaries on the basis of the relative magnitudes of the two.
The resulting estimate of supplements checks closely with the new estimates pre
sented by Albert Rees in “ Wages, Prices, and Productivity,” the American
Assembly, Columbia University Press, 1959; table 1, page 15, which was not
available until this study was completed.
Table 4-5, page 82: Derived from table 4-4.
Table 4-6, page 83: See notes to table 2-3. Since the “ price” of value added
is equal to current dollar GNP divided by constant dollar GNP, the various cost
components (which add up to total current dollar GNP) can be converted into
“ points” in the price index.
Table 4-7, page 83: Derived from table 4-6.
Table 4-8, page 85: Wage and salary data from table 4-4. Employment
and output from BLS.
Table 4-9, page 89: See notes to table 1-2. The “ B ” output index is the
BLS measure referred to in the notes to table 2-3.
Chart 4-3, page 92: Adapted from a chart by John Blair, “ Administered
Prices: A Phenomenon in Search of a Theory,” American Economic Reveiw,
May 1959. The 1958 rate of return has been adjusted to make it comparable
with other years; during most of 1958, the United States Steel Corp. did not make
payments into its pension fund, having overpaid in earlier years. The regression
line for 1955 through first quarter 1959 is a freehand line.
Table 5-1, pages 100: GNP in constant dollars, “ U.S. Income and Output.”
Industrial production, Federal Reserve Board.
Table 5-2, pages 101: Capacity from McGraw-Hill, Department of Economics.
Production, Federal Reserve Board.
Table 5-3, pages 104: The GNP in current and constant dollars, classified by
. economic sector is published by the Department of Commerce only on an annual
basis. Many of the components are available quarterly, however, in the new
quarterly deflated GNP series. The other components were estimated by the
author from various sources. About 25 percent of total automobile purchases
are allocated to “ producers durable equipment” in the Commerce GNP series.
Such purchases were reallocated back to consumer expenditures on “ autos and
parts” to emphasize the dispersion in changes in demand during the period.
Table 5-4, pages 107: Wholesale prices and the special index of manufactured
goods prices from BLS. Construction costs from the Department of Commerce.
The number of “ commodities” in each economic sector, is really a count of the
product classes and subclasses used by BLS in constructing the indexes. In some
cases the same product class is assigned to two or more economic sector classi
fications.
Table 5-5, pages 108: Price data from BLS.
Chart 5-1, page 110: Prices of 49 commodity groups were matched as closely
as possible with equivalent Federal Reserve Board production indexes. In some
cases BLS product classes were combined to match a Federal Reserve Board
classification. In other cases the opposite procedure was followed. Price and
output indexes were averaged for May and June of the initial and terminal years
to minimize “ freak” deviations. Another regression was calculated using AugustSeptember data (1955 and 1957) to check the results of the May-June regression.
Similar results were obtained.
Table 5-6, page 112: BLS wholesale prices, and Federal Reserve Board
. output data.
Table 5-7, pages 114: Federal Reserve Board output data; BLS employment
and average hourly earnings data.
Table 5-8, pages 114: From table 8, page 37, “ United Nations World Economic
Survey, 1957.”
Table 5-9, page 115: Production worker man-hours from BLS. Nonproduc
tion worker employment from BLS. Working hours of nonproduction workers
were assumed to remain constant at 40 hours per week. Output indexes derived
by deflating individual industry sales and inventory changes. It would have been
more accurate to use changes in finished and goods-in-process inventories only.
Inventories by stage of fabrication are not published in sufficient detail for this

RECENT INFLATION IN TH E UNITED STATES

137

purpose, however. The sales and inventory data are those published monthly
by the Department of Commerce, Business Structure Division. Appropriate
BLS price data were matched with the industry sales and inventory data to obtain
the deflators. The inventory deflators were lagged from 1 to 4 months, depending
on the industry involved.
Table 5-10, page 117: See notes to table 5-8.
Table 5-11, page 118 Capital goods and associated industries includes 12
machinery industries, commercial furniture, iron ore, iron and steel blast furnaces
and roiling mills, iron and steel foundries, 4 fabricated metal products industries,
trucks, cement, structural clay products, coal, and coke. Prices and average
hourly earnings from BLS were matched as closely as possible with each other.
Table 5-12, page 119: The estimation of unit wage costs is described in the
text.
Table 5-13, page 122: BLS employment data.
Table 5-14, page 123: Census data on employment by occupation, adjusted
to exclude the self-employed and unpaid family workers. Data are collected
•every third month. Two months (April and July) were averaged in the initial
margin and terminal years to minimize “ freak” variations.
Table 5-15, page 123: BLS employment data.
Table 5-16, page 124: For unit wage and salary costs, see notes to table 4-8*
Gross margins include capital consumption allowance, profits, and net interest
The “ factor price’ ’ in this case is the gross margin per constant dollar of depre
ciation. The “ factor input per unit of output” is constant dollar depreciation
per unit of output. Constant dollar depreciation from table V-13, “ U.S. Income
.and Output.”
Table 5-17, page 124: Derived from table 4-6.
Table 5-18, page 126: BLS Consumer Price Index. The contribution of each
item or group to the total price increase is based on the December 1955 relative
importance of each item or group in the total. Not all of the components of the
index are shown in the table. A few are not published. The remainder were
iitems of very small weight in the index.
Table 5-19, pages 127: Data from various issues of the Marketing and Trans
portation Situation, and the Demand and Price Situation, U.S. Department of
Agriculture.
Table 5-20, pages 128: The change in the retail cost of a constant basket of
food (Department of Agriculture) was divided between meat and other foods and
in turn, within each of these two categories, between farm value and marketing
margins. The relative importance of margin and farm value changes was then
assigned to the change in the BLS price indexes for meat and for “ other foods.”
During the period in question the retail cost of a constant basket of food (Depart
ment of Agriculture) and the BLS price index for “ food at home” moved in a very
similar fashion. The corresponding Agriculture and BLS subindexes for meat
and for “ other foods” also moved parallel to each other.
Table 5-21, pages 128: Unit cost indexes from various issues of the Market
ing and Transportation Situation.
Table 5-22, pages 128: Changes in the various unit cost indexes of table 5-21
were combined with weights representing the relative importance of each cost
component in total marketing margins. The relative importance of each cost
component was taken from the Marketing and Transportation Situation, July
1958; table 5, page 13.
Table 5-23, pages 128: Service price component of the BLS consumer price
rindex.

Full text of Materials Prepared in Connection with the Study of Employment, Growth, and Price Levels for Consideration by the Joint Economic Committee, Congress of the United States : Study Paper No. 1: Recent Inflation in the United States

FRASER