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The Reduction of Inflation
by Slack Demand
Phillip Cagan

The persistence of inflation in the past decade has undermined confi­
dence in our capability of reducing it. To many it appears intractable.
While the inflation rate has declined in periods of business recession, it
has revived and intensified in the subsequent periods of business ex­
pansion. The dissatisfaction with traditional monetary and fiscal meas­
ures has brought forth schemes to restrain price increases directly by
taxes or subsidies, though these hold no more promise of being effective
than have direct controls on prices or incomes policies in the past.
The dissatisfaction reflects in part the failure of inflation, in a busi­
ness recovery such as 1975-1977, to continue to decline while excess
unemployment is reduced. The belief that inflation should decline is
based on the presumption that it always tends to decline so long as re­
sources are not fully employed and markets exhibit slack. But that is
not an accurate view of historical price behavior. The inflation rate has
always fluctuated over the business cycle, falling during business con­
tractions and rising during expansions, invariably beginning to rise
early in business recoveries long before economic slack gives way to
full-employment output, for a reduction in the inflation rate that out­
lasts the business cycle, the rate will be lower in corresponding stages of
successive business cycles. For such a reduction in inflation, policy must
reduce the expected rate of inflation. This rate reflects the anticipated
long-run equilibrium trend of prices and underlies explicit and implicit
contracts for future payments and the setting of wages and prices genI am indebted to William Fellner, John Taylor, and the authors of this volume for
helpful comments and to Fred Kittler for computer assistance.



erally. The expected rate gradually adjusts when actual rates deviate
above or beloxo it for an extended period. Even though the actual infla­
tion rate continues to rise and fall over the business cycle, the expected
average rate can still decline if business expansions do not intensify in­
flationary pressures and the actual rate remains below the expected rate
on the average.
Estimates are presented of the effect of slack demand on the ex­
pected rate of inflation under two models, one based on adaptive ex­
pectations and the other on rational expectations. These two models
are formulated to be consistent with the existence of slack markets and
the procyclical fluctuations in the inflation rate, but they are neverthe­
less quite different in their theoretical assumptions and practical impli­
cations, though actual behavior may well be a mix of both. The effect
of slack demand on the expected inflation rate, though hard to estimate
with precision, is confirmed by the evidence. The effect of one per­
centage point average unemployment in excess of the level at full em­
ployment, maintained over a typical four-year business cycle, is esti­
mated to reduce the expected, and therefore the actual, average annual
inflation rate by about three percentage points under adaptive expec­
tations, and by about half as much under rational expectations. The
latter effect is smaller because rational expectations allow for cyclical
fluctuations in the economy and so only an average amount of slack
that is larger than expected over an entire business cycle reduces the
expected inflation rate.
The small estimates of the effect help to explain the loss of confi­
dence in policies to maintain it. The effect is hidden by the larger cycli­
cal fluctuations in the inflation rate. In assessing an anti-inflation pol­
icy, however, the authorities and the public should not be misled by
normal cyclical fluctuations in the inflation rate, characterized as "stag­
flation” ; what matters is the noncyclical changes between correspond­
ing stages of successive business cycles.
Expectations are likely to respond more strongly to restraints on
nggfegate demand once policy makers demonstrate their determination
and ability to hold inflation at a lower rate. One reason the effect of
excess unemployment is small is that policy has demonstrated the oppo­
site since the mid-1960s by accommodating a rising average rate of in­
flation. A policy of reducing inflation, coming after a decade of accom­
modation, is hampered by pessimistic expectations of its capability.
Despite the general pessimism, however, an anti-inflation policy
has a good chance of succeeding if it can avoid past errors of overstimu­
lating business expansions to the point of reviving inflationary pres­
sures, which is not an impossible task. Since the economic capability


exists, the pessimism in fact pertains to the political capability of trans­
lating concern over inflation into effective measures of restraint. Here
the recent record has not been encouraging.

Current economic policy is directed toward reducing inflation and un­
employment. The Economic Report of the President in January 1978
states that "W e must contain and reduce the rate of inflation as we
move toward a more fully employed economy/'1 That has been the
unquestioned intention of policy since inflation intensified in 1965, and
it was the guiding spirit, even if not always the practical objective, in
the previous years since World War II. The method of achieving the
objective is to stimulate aggregate demand by monetary and fiscal meas­
ures to expand production and jobs up to— but not beyond— the point
where new inflationary pressures emerge. The assumption is that it is
possible in theory even if difficult in practice to reduce inflation by
maintaining some slack in labor and product markets in the aggregate.
A period of economic slack is accepted as the cost of subduing inflation.
The maintenance of slack in the economy, with the accompanying
excess unemployment, is not, of course, attractive to policy makers.
Monetary and fiscal measures designed to reduce inflation result in
slack as a byproduct, not as an objective, of anti-inflation policy. U.S.
policy has faced the dilemma of choosing between inflation and unem­
ployment by targeting a path of aggregate demand which, in deference
to political pressures, will produce as little slack as possible and still re­
duce inflation, even though the reduction of inflation will be slow. The
justification for keeping the slack mild and reducing inflation gradually
is based on the nature of the assumed trade-off between inflation and
unemployed resources. Each addition to the amount of slack is thought
to have diminishing effects in reducing the inflation rate. To avoid en­
during a large amount of slack for little benefit, therefore, a slow reduc­
tion of inflation with mild slack has appeared optimal.2
In comparison with the precise objectives of policy, the large dis­
crepancies between the results and the targets and the wide swings in
business activity have been discouraging. When the Vietnam inflation
1 Economic Report of the President, 1978, p. 5.
2The policy argument for reducing inflation slowly is discussed in Phillip Cagan,
"The Reduction of Inflation and the Magnitude of Unemployment/' in William
Fellner, ed., Contemporary Economic Problems 1977 (Washington, D.C.: American
Enterprise Institute, 1977), pp. 41-50.



stepped up in early 1966, it was initially cut down by monetary re­
straint imposed during the second half of that year. But the monetary
authorities, fearful of precipitating a business recession, switched to
stimulus in early 1967 and the inflation revived. By 1969 inflation was
firmly entrenched and escalating. The monetary restraint applied in
1969 was stronger than in 1966 and this time precipitated a recession
in 1970, but the reduction in inflation appeared to be slight up to August
1971 when price and wage controls were imposed. In the meantime,
monetary policy stimulated the economy during and following the 1970
recession to remove all but the minimum amount of slack thought suffi­
cient to reduce inflation. The stimulus was carried too far, in part be­
cause policy was misled by the umbrella of controls, and by the end of
1972 the overexpansion of domestic aggregate demand was joined by
worldwide inflationary pressures to produce an explosion of prices in
1973-1974. The ensuing disruption and confusion in business activity
brought on a severe business contraction from the fourth quarter of
1973 to the first quarter of 1975. The considerable slack remaining in
the economy after the contraction was viewed as excessive, and policy
makers sought to remove most of it, though the recovery of activity in
fact proceeded slowly. Despite policy targets which have consistently
called for mild slack in the economy to subdue inflation, the amplitude
of fluctuations in activity have been large and increasing. The latest
business contraction of 1973-1975 was the most severe in the postWorld War II period.
Although recovery from the 1973-1975 contraction was slow and
appreciable slack continued at least through the end of 1977, the infla­
tion did not continue to decline.3 To be sure, the explosion of prices in
1973-1974 reflected in part world influences which proved to be tempo­
rary, and the rate of inflation fell sharply during the business contrac­
tion. But the average inflation rates for 1976 and 1977, based on the
consumer price index, remained in the 5 to 6 percent range, well above
the 3V2 percent for 1971-1972 and on a par with the previous high rates
of 1969-1970. At the beginning of 1977 the Council of Economic Ad­
3 Rates of increase of major price indexes in 1977 rose over 1976 but remained be­
low 1975. The following rates in percent are from fourth quarter to fourth quarter,
except for the consumer price index ( c p i ) which is December to December.
Consumer price index
Deflator for:

Private business sector
Nonfarm business sector












visers (c e a ) had predicted that the inflation rate would continue un­
changed at 5 to 6 percent for the year, which turned out to be accurate.1
Inflation rose to higher rates unexpectedly during the severe winter
months, but it is not clear whether this made any difference for the year
as a whole. The positive deviations of the inflation rate from the basic
trend in the winter were subsequently offset by negative deviations
later in the year.
The c e a 's prediction, though correct, departed from the widely
accepted view that a slack economy would reduce inflation. The c e a
chose to ignore previous estimates of the relation between changes in
the rate of inflation and excess unemployment based on post-World
W ar II data. These previous estimates had implied that, given the aver­
age unemployment rate of 7 percent for 1977, the inflation rate would
decline one percentage point during the year.r> For 1978 the new c e a
again concludes that, apart from the effect of higher social security
taxes and minimum wages, "prices would be expected to rise this year
at a rate of 6 percent or somewhat above— the underlying rate for the
past 2Vi years."6 Unit labor costs are projected to continue rising at an
unchanged rate from 1977, and profit margins do not appear large
enough to provide room for a decline which would allow prices to rise
less than the rise in unit labor costs. Hence no progress against infla­
tion is seen as likely to occur until these basic trends change. The c e a 's
projection seemed to imply that inflation would not be reduced by the
previously accepted policy of maintaining slack in the economy, nor
could inflation even be prevented from increasing in the unlucky event
of supply shortages or excess aggregate demand.
The theory that economic slack reduces inflation was unquestioned
for over a decade but is no longer widely accepted as viable. In recent
years forecasters have predicted little or no decline in inflation despite
their predictions of continued slack in the economy. Some prominent
economists, doubtful of the desirability of traditional monetary re­
straints and even of straightforward price and wage controls, have pro­
posed a system of taxes and subsidies to induce restraint in wage and
price setting.7 Another prominent economist with experience as a price
controls administrator points to the regulatory morass and doubtful
4 Council of Economic Advisers, Annual Report, 1977, p. 41.
r*See Cagan, "The Reduction of Inflation/' pp. 21-26.
* c e a , Annual Report, 1978, p . 80.
7 Walter Heller, Arthur Okun, Robert Solow, James Tobin, Henry Wallich, and
Sidney Weintraub, Letter to the Editor, New York Times, March 12,1978. See also
Nancy A. Jianakoplos, "A Tax-Based Incomes Policy ( t ip ) : What's It All About?"
Federal Reserve Bank of St. Louis Review, vol. 60 (February 1978), pp. 8-12, and
the discussions by Gottfried Haberler and Herbert Stein in this volume.



Figure 1
Percent per year

(centered two-quarter change at annual rate)




47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77
Note: Business contractions are shaded.
Source: Department of Labor, Bureau of Labor Statistics.

success of such a system/ The fact that these proposals are even seri­
ously considered is a symptom of the low confidence with which our
capability of subduing inflation is now viewed.
Was the previously widely accepted presumption that the inflation
rate is related to the amount of economic slack justified? Casual in­
spection of the post-World War II data does raise doubts. Figure 1
presents two-quarter changes in the consumer price index at annual
rates plotted quarterly from 1947 to 1977. The figure shows periods of
expansion and contraction in general business activity. The dates of
business cycles are those of the National Bureau of Economic Research
with the addition of the minor downturn from the fourth quarter of
1966 to the second quarter of 1967, which did not qualify as a fullfledged recession but produced a significant effect on prices. Apart
rom t e upward trend since 1965, the inflation rate displays a typical
pattern within each cycle. A steep drop in the rate of change during
recessions (even below zero in the earlier cycles) is followed by a sharp

Winter i^ S ) p £ ™ 9


n S cNCW Tax~®asec* Incomes-Policy Proposal/' Economic
Y Research Ce*ter, The University of Michigan,


recovery in the first part of the ensuing business expansion. The re­
covery in the rate tends to level off in the later stages of expansions
and finally to decline, usually before the next downturn in business/'
This pattern is also characteristic of prices in earlier business cycles.10
The latest two recessions display the same pattern but with a de­
layed peak or trough in the inflation rate. In 1973-1975 the rate rose
through most of the business contraction; it then declined well into the
business recovery, as it did in 1971-1972. The upturn in the rate in
1971-1972 was delayed partly or wholly by price and wage controls
instituted in August 1971. Moreover, most of the price increases pre­
vented by the controls may have been posted later.11 (The recorded
price increases in the data may also understate the actual increases
owing to the controls.) When most of the controls were removed in
January 1973, prices rose sharply. A substantial part of the rise in 1973
and 1974 reflected temporary world influences on basic commodities
(feed grains and metals as well as petroleum). When these influences
abated in 1975, the inflation rate came down rapidly, which countered
the normal tendency of inflation rates to rise in a business recovery.
The rise in the inflation rate in the first part of 1978 suggests that the
normal tendency is now appearing, though this rise also reflects a re­
duction of economic slack to levels that have traditionally marked the
beginning of renewed inflationary pressures. The altered timing in the
last two cycles may therefore reflect special developments and not in­
dicate a change in cyclical pattern that will be repeated.
Whether the cyclical pattern has changed or not, it is evident from
the historical record that the rate of inflation is not to be explained
simply by the amount of slack in the economy. Full employment of re­
sources is not normally reached until late in business expansions. If a
simple relation existed between the inflation rate and economic slack,
the rate would continue to decline until the later stages of business
expansions when slack finally begins to disappear. Actually, as the
figure shows, the inflation rate fluctuates over business cycles in a pro­
cyclical pattern and begins to rise early in business recoveries at or
shortly after the trough in activity. The only continuing declines in the
y This pattern of price behavior has long been noted by business cycle analysts. For
example, see Geoffrey H. Moore, The Cyclical Behavior of Prices, Report 384
(Washington, D.C.: Bureau of Labor Statistics, 1971), and "Lessons of the 19731976 Recession and Recovery/' in William Fellner, ed., Contemporary Economic
Problems 1977 (Washington, D.C.: American Enterprise Institute, 1977), especially
pp. 141-158.
10 See Frederick C. Mills, The Behavior of Prices (New York: National Bureau of
Economic Research, 1927).
11 See Michael Darby, 'The U.S. Economic Stabilization Program of 1971-74/' The
Illusion of Wage and Price Controls (Vancouver, B.C.: Fraser Institute, 1976).



rate, apart from business contractions, are in 1951-1952 following the
sharp run-up of prices at the outbreak of the Korean War and in the
early recovery stage of the last two cycles. The first of the latter two
exceptions appears to be attributable to price controls and the second
to foreign influences.
The theory that the reduction of inflation depends upon the
amount of economic slack evolved in the 1960s from earlier theories of
price behavior. The 1960s theory was a departure from traditional
views and appeared for a time to rectify certain of their deficiencies.
Its own deficiencies have in turn led to new theories of price behavior.

Old and New Theories of Price Behavior
Standard economic theory teaches that markets adjust to demand and
supply with a rise in prices when demand exceeds potential supply and
a decline in prices when demand falls short of potential supply. This
was the virtually universal view of price behavior up to the 1930s and
is still, with qualifications, commonly held. Strictly interpreted, it im­
plies that the level of prices should generally rise in business expan­
sions and decline in business contractions, propelled by associated
fluctuations in aggregate demand. Such behavior is most clearly ex­
emplified by prices sold on organized exchanges, such as agricultural
products and basic commodities, and those sold in highly competitive
markets. These prices are highly flexible, even volatile, and respond
quickly to the shifting forces of demand and supply.
It has long been recognized, however, that prices of many other
products, particularly manufactures and services, display considerably
less flexibility and often decline quite slowly in the face of slack market
conditions. Price inflexibility has often been viewed as somehow un­
natural. In the 1930s Gardiner Means gained attention with his theory
that inflexible prices were “administered" by producers in disregard of
market conditions and thus did not respond to cyclical changes in de­
mand. Such behavior was attributed to the "market power" of pro­
ducers, which they wielded to enhance their profits (exactly how was
never clear). The prime example of inflexibility, of course, is wages,
which have always displayed an extreme stickiness in the face of de­
clining employment and even mass unemployment. It was no doubt the
C Means' Indus*ri*l Prices and Their Relative Inflexibility, Senate Doc.
f' 0 Q
° n| r*ss' lst. session' 1935. See also Hearings on Administered Prices,
m .AntittrU0St and Monopoly, 86th Congress, 1st session,
A i r i n ' $1
A^ai!°nal Reso«rces Committee, The Structure of the
American Economy, pt. 2 (Washington, D.C., 1939), p. 143.



inflexibility of wages in Britain during the mass unemployment of the
1920s that led Keynes largely to ignore cyclical changes in prices and
wages in his influential General Theory of Employment, Interest, and
Money, published in 1936. He assumed that wages and prices were
constant when aggregate demand declined; and, though he acknowl­
edged that they often increased when aggregate demand rose, the in­
crease played no role in his theory. As so often happens with an influ­
ential work, the assumption made for simplification became widely
accepted as fact and extended. For years thereafter theoretical eco­
nomics usually treated price and wage levels in macro models of the
economy as generally fixed until aggregate demand becomes excessive
and then pulls them up. This view gained further currency in the 1950s
with the notion that downward rigidity characterized wages and many
prices— which meant that they never declined, even when markets were
slack. Such price behavior was condemned in the 1950s as the major
reason for the creeping inflation of that decade. If prices rose in the
later stages of business expansions when demand was strong and failed
to decline during business contractions, the price level would rise from
cycle to cycle, and its long-run trend would be persistently and inex­
orably upward.13 Shifts in demand among sectors of the economy, in­
creasing prices in some and failing— because of downward rigidity— to
reduce them in others, would have the same effect of raising the overall
level of prices.14 Downward rigidity was thought to be at variance with
the normal behavior of prices in competitive markets; it reflected the
inertia of custom in economic behavior and, since the 1930s, allegedly
the growth of labor unions, product oligopolies, and the institutional
rigidities of regulation.
By the end of the 1960s it began to appear that downward rigidity
was only half the problem. Prices and wages could continue rising, and
not merely fail to decline, when demand was slack. The theory that de­
veloped to account for such behavior combined a Phillips curve with
price expectations. As described by the Phillips curve, prices respond to
excess or deficient demand too slowly to keep markets cleared. A short­
fall in aggregate demand, for example, produces a gap at prevailing
prices between demand and the potential supply of output. The slack
generates pressures for prices to fall below their trend path. Since
prices respond slowly, markets in the meantime remain slack. What
prevents prices and wages from adjusting rapidly to clear markets and
13 Arthur F. Burns, Prosperity Without Inflation (New York: Fordham University
Press, 1957).
14 Charles L. Schultze, "Recent Inflation in the United States/' U.S. Congress, Joint
Economic Committee, Study of Employment, Growth, and Price Levels, Study
Paper no. 1,86th Congress, 1st session (September 1959).



reduce the gap to zero? The main reasons usually given are that
changes in market conditions may at first be viewed as temporary, and
firms find it costly and awkward to adjust prices to temporary fluctua­
tions in demand and supply; that explicit and more often implicit con­
tracts bind firms to offer their products and purchase resources at a
predetermined price or to make changes only under specified condi­
tions, particularly with respect to wages; and that firms in all but highly
competitive industries seek to coordinate prices (without overt collu­
sion) so as to avoid the confusion to buyers and the disarray in the
market of selling the same product at different prices. For all these rea­
sons prices are constrained from deviating from the expected equi­
librium path. Unanticipated disturbances and short-run fluctuations
in demand are largely ignored, and firms base selling prices on their
unit costs of production at a standard level of output. They rely on
these unit costs as an indicator of the long-run equilibrium path of
prices likely to prevail in the industry.
The gradual response of prices to a gap between demand and sup­
ply is expressed in the Phillips relationship by the dependence of the
rate of change of prices upon the size of the gap. But this dependence
does not explain why prices rise when demand falls short of potential
supply and is deficient by any reasonable measure. Such behavior is
explained by expectations. When the growth trend of nominal aggre­
gate demand exceeds that of output, the expected equilibrium path of
wages and prices has an upward trend. Economic decisions are geared
to this expected upward trend of prices. Deviations of aggregate de­
mand from the expected trend are generally not anticipated. A fall in
aggfegate demand in a business recession, for example, reduces the ac­
tual rate of price increases below the trend rate. Unless the recession is
unsually severe, however, most prices continue rising, though at a
slower rate. During business expansions prices rise faster than the
trend rate. As long as the growth trend in aggregate demand does not
c ange from cycle to cycle, long-run expectations are confirmed and the
trend rate is maintained. A persistent deviation above or below the
trend would indicate a change in the trend, however, and lead gradually
to the revision of expectations.
Expectations are also influenced by the monetary regime and politi­
cal environment in which monetary and fiscal policies operate. The
gold standard was less inflationary than managed currencies, and ex­
pectations under the present managed currency system undoubtedly
take that difference into account. There is evidence that prices have
gradually become less responsive to changes in aggregate demand in
e usmess cycles since World W ar II. This diminishing responsive­
ness is caused in part, no doubt, by a decline in the expected capability


of monetary and fiscal policies to contain inflation, as demonstrated by
the accommodation of higher and higher rates of inflation.1" Although
the statistical analysis reported below ignores changes over time in the
way expectations are formed, there is no intention to deny the impor­
tance of such changes.
The rate of change of prices at any time, p t (where the overhead
dot denotes the rate of change), may therefore be represented by two
influences: (1) the pressure of the concurrent gap between demand and
potential supply— deficient or excess demand as measured by the dif­
ference between the actual rate of unemployment of resources, Ut, and
the full-employment rate of unemployment, U ; and (2) the anticipated
trend path of prices, p\, which has been incorporated into wage con­
tracts and past pricing decisions and so raises input costs as it is passed
along the production pipeline:

Pt = H U t - U ) + p%

This is the standard Phillips curve__combined with expectations. F is a
function which declines as Ut — U increases. The coefficient of pe is
unity on the assumption that there is no long-run trade-off between in­
flation and unemployment. The equation summarizes the view that
policy can reduce the inflation rate by restraining aggregate demand, in
which the amount of restraint is measured by the amount of slack that
results. If p is thereby kept below pe, pe will eventually be revised
downward, after which the slack can be removed and p and pe will be
equal at a reduced rate of inflation.
W hen applied to experience in 1977, such an equation, as noted
earlier, seems to suggest that inflation should have declined. In that
year U was about 6 percent of the total labor force. This may seem
high by past standards, but the rate of unemployment at which infla­
tion neither increases nor decreases has been rising because structural
changes in the labor force have added to recorded unemployment. The
actual unemployment rate averaged 7 percent in 1977, giving unem­
ployment in excess of U of one percentage point. (Most estimates of
excess unemployment for 1977 were even higher.) W ith this excess
unemployment the actual rate of inflation should have been below the
expected rate, which would then gradually decline, thus reducing the
actual rate for any given amount of excess unemployment. But the
inflation rate did not decline in 1977. The c p i increased at the same 4.3
percent annual rate from the third to the fourth quarters of both 1976
15 See Phillip Cagan, The Hydra-Headed Monster: The Problem of Inflation in
the United States (Washmgtpxi. D.Cg A raflraji Ente/prise Institute, 1974).

ttN T L M T '




and 1977. Year over year the rate actually rose, from 4.9 percent in
1976 (December to December) to 6.7 percent in 1977. (Most forecasts
for 1978, including the c e a ' s , see no decline in the inflation rate, but, as
noted, this is not inconsistent with the above equation. Unemployment
fell to the 6 percent level in the first part of 19 78, which by the pre­
ceding estimate of U is the full-employment level and puts the economy
at the threshold of increasing inflationary pressures.)
What explanation can be given for a rise in the rate of inflation or
even constancy early in business recoveries, when aggregate demand
still falls short of the potential supply? Prices of crude materials, which
are highly sensitive to market conditions, contribute to this rise (see
Figure 2). They typically decline sharply in business recessions (that is,
have negative rates of change) and then begin to rise as the forces of
recovery spread through the economy. They exemplify the behavior
that economic theory attributes to competitive prices. Their fluctuations
contribute to procyclical movements in the rate of change of a general
price index. But they do not dominate the behavior of the general price
level and by themselves cannot account for its procyclical fluctuations.
The inflation rate for most intermediate and finished goods also dis­
plays a procyclical pattern. Crude materials make up too small a part
of the total cost of production of most intermediate and finished goods
to dominate the movements in their input costs.
One explanation for a rising inflation rate when slack demand
exists pertains to the price expectations term in equation [1]. A reduc­
tion in p(' is presumed to occur whenever p falls below pe. If pe changes
too slowly, however, the cyclical fluctuations in the first term of equa­
tion [1] will dominate to produce a procyclical pattern in p. A slackinduced reduction of inflation that outlasts the business cycle therefore
requires that pe respond to p and that the net effect be downward. If
over the business cycle p rises above pe as much as it falls below, there
will be no net reduction in pe. Inflation has escalated since 1965 be­
cause U on the average has been below U. The reduction of inflation
requires that for a while U be above U on the average.
This relationship can be expressed in simple mathematical terms
which provide a form for regression analysis. If price expectations are
revised gradually, an adaptive revision may be described by


= HPt - p t ),

which by [1] equals bF. The coefficient b may change over time, but
for simplicity it is assumed to be constant. In theory it can be any posi­
tive number. To incorporate such adaptive expectations into the modi24

Figure 2
19 4 7-19 7 7
(centered two-quarter change at annual rate)
it per year







Business contractions are shaded.
s: Department of Labor, Bureau of Labor Statistics.



fied Phillips relationship, equation [1] is differentiated with respect to
dpt _ , dUt
dt ~ F dt



and [2] substituted into [3],

If the F function is a simple proportional relationship F = a(Ut ~ U),
and differentials are treated as discrete first differences, and U is con­
stant, then

p t - Pt-1 = a(Ut - Ut-1) + ba(Ut - U).

An indication of the effect of slack demand on the inflation rate that
outlasts the business cycle is given by estimates of ba, which is the
product of the speed of revision of price expectations, b, and the cyclical
effect of slack on the inflation rate, a. Estimates of this effect of slack
demand are presented below.1*
A different way of formulating the effect of slack demand on in­
flation is suggested by the new theory of rational expectations. This
theory starts from the presumption that expectations formed about
A similar equation was derived by Lucas Papademos, "Optimal Aggregate Em­
ployment Policy" (Ph.D. diss., Massachusetts Institute of Technology, September
1977), p. 23 (equation 23). The equation usually given in the Phillips curve litera­
ture is quite different in theory and implications. It has the same right side as [5]
above but with the inflation rate rather than its change on the left. (For a review
of empirical work on such equations, see R. A. Gordon, "Wages, Prices, and Unem­
ployment, 1900-1970," Industrial Relations, vol. 14 [October 1975], pp. 273-301.)
Such an equation is unable to explain rising prices in a recession since both vari­
ables are then positive, and, given the appropriate negative coefficients, the two
terms will be negative. What the standard Phillips curve lacks is a term represent­
ing long-run price expectations, which equation [5] includes.
Much of the literature finds that the rate of change of wages is more closely
related to changes in the unemployment rate than to the rate itself. (See E. Kuh,
"A Productivity Theory of Wage Levels—An Alternative to the Phillips Curve,"
Review of Economic Studies, vol. 34, no. 4 [October 1967], pp. 333-360.) In the
literature the change in the unemployment rate has been interpreted as reflecting
short-run expectations of changes in demand. (See William G. Bowen and R.
Albert Berry, "Unemployment Conditions and Movements of the Money Wage
Level," Review of Economics and Statistics, vol. 45 [May 1963], pp. 163-172.) This
implies a relation between changes in the rate of change of wages and the second
derivative of the unemployment variable. Such a relation has no importance for
the effect of slack demand on inflation as formulated here.



economic developments make full use of all available information.
Given the incentives to market participants to use information to full
advantage, expectations of price changes and other variables will not
be subject to repeated errors of forecast in the same direction insofar
as available information could avert such biased forecasts, though
errors can of course be large because of developments that no one is
able to foresee. The theory evolved in reaction to the assumption, com­
monly made in economic analysis, that expectations adjust slowly to
new developments as new information is absorbed gradually through
an adaptive error-learning process. Slow revisions of expectations pro­
duce a series of similar and avoidable errors during the time in which
new information is being acquired by economic agents and behavior
has not yet fully adjusted to it. Such lags in response may pertain to
habitual behavior, but, when substantial costs can be avoided or profits
are to be made by fully utilizing new information, economic agents will
try to avoid lags in revising expectations. New information will thus
be reflected rapidly in prices that are influenced by expectations of
future development. Rapid— virtually instantaneous— use of new in­
formation is certainly characteristic of commodity and financial ex­
changes, where expectations of future movements are critical and new
information is extremely important. Analysis of price movements on
exchanges indicates that errors of expectations, insofar as they can be
measured, are unsystematic, essentially unpredictable, and reflect only
new developments which were not foreseen. Such prices are charac­
terized by jumps from one position to another, because everyone is
aware of a new development that justifies a change in price, and all
transactions occur immediately at the changed price.
In its extreme form the theory of rational expectations requires
that prices clear markets at every moment. Since a price that does not
equate demand and supply is subject to pressures to change until it does
so, market participants acquire and make rational use of information
about such pressures and do not transact at a price that they know is
subject to further change in a particular direction. Prices so determined
always equate all demand and supply offers at the moment. The theory
offers no explanations for most prices and wages in the economy, which
change smoothly and usually follow the same trend for months at a
time in markets often characterized by persistent slack or excess de­
mand. Most prices and wages are either subject to institutional con­
straints or, if influenced by "rational" expectations, not as yet fully
understandable by economic theory.
But a modified form of the theory can be espoused which seems
more realistic and accommodates prices which do not clear markets.
Faced with a fall in demand, an individual firm or industry, given its



costs of production and the desire to maximize profits or minimize
losses, will not cut prices far enough to prevent a decline in its sales in
real terms and the necessity of reducing its output. Explicit or implicit
contracts to supply labor and materials at predetermined wages and
prices are one reason for lack of market clearing and a decline in sales,
but it seems doubtful that such contracts are the only reason. Another
likely reason is the sheer complexity of a full adjustment of the entire
price system to changes in demand. The restoration of demand to its
original level in real terms only through changes in prices, after a gen­
eral fall in aggregate demand in a recession, would require a quite large
decline in the general level of prices and wages, in which each indi­
vidual firm and industry plays a small part.17 Individual firms and in­
dustries do not know to what extent deflation in the whole economy
will reverse a decline in aggregate real demand, and we may suppose
that they act on the basis of the demand they face at the moment.
There is no reason to suppose that rational expectations of develop­
ments elsewhere in the economy, of which individual firms and indus­
tries can have only limited knowledge, would significantly affect prices
in individual markets, nor that such knowledge would therefore imply
an immediate fall in all prices to a level that would restore a shortfall
in demand to its original real level. When demand falls, individual
firms and industries will cut prices and output, and their action may still
be based on rational expectations in that their estimate of sales and the
prices that will prevail is neither high nor low on the average. Their
reduction of output will, of course, contribute to a continuation of the
decline in aggregate demand. With each fall in demand, prices and out­
put will be cut further. If expectations are rational, however, there is
no systematic delay in the response of prices to changes in demand.
Hence the level of demand will determine the level, not the rate of
change, of prices.18 Such a relationship is formulated below.
Rational expectations may thus be made consistent with the exist­
ence of slack markets, but an explanation of rising prices in a recession
is still missing. To explain that anomaly, we may also suppose that the
anticipated long-run trend of prices is upward, and price changes over
the business cycle occur as cyclical deviations from the trend. Then it is
'•This is the implication of the theory of aggregate disequilibrium. The spillover
effects of reduced output and employment in one industry make demand lower in
other industries. The restoration requires an increase in the purchasing power of
money balances through a decline in the price level—an increase sufficient to raise
the demand for goods and services to the original level of expenditures in real
A rational expectations model with this relationship is presented in Allan H.
Meltzer, Anticipated Inflation and Unanticipated Price Change/' Journal of
Money, Credit, and Banking, vol. 9 (February 1977), pp. 182-205.



possible that cyclical declines in prices combined with the rising trend
can produce prices that rise in a recession— a rise that is less than the
trend, to be sure, but a rise nevertheless. The long-run trend would
presumably also be subject to rational expectations. The long-run ex­
pectations would be based on the anticipated trend of prices from cycle
to cycle, after the cyclical ups and downs are netted out. An upward
trend would affect prices in recessions as well as expansions for at least
two reasons. First, an anticipated rising trend would be incorporated
into price and wage contracts for resource inputs and would continue
to inflate costs in recessions. Second, the price trend would influence
the cyclical price at which storable materials and goods as well as some
labor services would be supplied; sellers would withhold supplies as
prices in a recession fell further and further below the anticipated trend
price. The withholding of supplies would limit the decline in prices
during a recession and would even cause prices to continue rising if the
anticipated trend were rising fast enough.
Under rational expectations, the anticipated trend of prices would
presumably not be influenced by anticipated developments within the
business cycle that were reflected in cyclical price changes; rational ex­
pectations allow for cyclical fluctuations. But trends can and do change
without being clearly foreseen. Rational economic agents will revise
their expectations of the price trend when they become aware of a
change occurring or about to occur, for example, a business recession
more severe or a period of slack demand more prolonged than expected.
Hence slack demand may also affect anticipated price trends under ra­
tional expectations, but the effect would depend upon the amount of
slack in the economy both currently and in the past. Certainly it would
not depend upon the current amount only, since the current amount
would be largely indistinguishable from expected cyclical fluctuations.
This means that the expected trend of prices would be related to the
cumulative amount of slack over an extended period. Such a relation
contrasts with the modified Phillips equation, in which expected price
changes can be related to the discrepancy between actual and expected
changes (and this discrepancy can in turn be related to the current
amount of slack). The two theories differ because, in accordance with
the slow adjustment of prices underlying the Phillips curve, economic
decisions are based, not on rational expectations of current price move­
ments, but on an adaptive error-learning process in which current price
movements contain relevant unused information for the revision of
We can express the theory of price behavior under rational expec­
tations in a mathematical form for regression analysis. The theory im­
plies that the level of prices depends upon both the expected price level



and the level of demand or, equivalently, the gap between demand and
potential supply as indicated by unemployed resources; namely,

pt = G(Ut - D) + p\ ,

where the symbols are the same as those introduced above and G is a
function which declines when Ut — U increases. When differentiated
with respect to time, the relationship becomes

pt = G (- ^ - J + p t ,

where as above the overhead dots denote the rate of change on the as­
sumption that the price variables are measured in logarithms.
On the proposition that the expected price trend is influenced by
the cumulative amount of slack over an extended period,

p\ — [noncyclical trend of prices] 4* c0(Ut — ii) + c^(Ut-i — U)
+ ... + c„(l/, „ - 0 ) .

The noncyclical trend of prices may be represented by the average in­
flation rate over the length of a typical business cycle, which is roughly
four years. Whether the average is a little more or less than four years
will not materially affect the results. Substituting [8] into [7] and as­
suming a proportional G function and discrete first differences, we have

Pt ~ j t i ^rjr = a(U, - U,.,) + c„(U, - 0) +
i i

- U)

where the average rate of inflation, which has a coefficient of unity,
has been transferred to the left side of the equation. The coefficient a
of the first term reflects the temporary effect of changes in slack demand
on the inflation rate. The lasting effect over a business cycle is given by
the sum of the c coefficients.19
An alternative formulation suggested by other rational expectations models
would be to use past monetary growth and other basic determinants of the price
level, known to rational economic agents, as indicators of the expected noncyclical
trend of prices. Then, in theory, slack demand would be superfluous and would
not affect the inflation rate. (For example, see Meltzer, "Anticipated Inflation and
Unanticipated Price Change.") In such models, however, a decline of monetary
growth and consequent reduction in inflation still produces a period of slack de­
mand. Equation [9] can be interpreted as reflecting the amount of slack which is
associated in such models with reductions in the expected trend of prices.



Figure 3

Q corresponds to 0.

Collecting terms into a form suitable for regression analysis, we

p, ~ £


= (« + C0)(U, - U ) + (c, - a)(Ut.i - U)
+ c.,(Ut-2 ~ U) + . . . + c„(Ut-K~ U).

In theory n should be the length of a business cycle, but for statistical
convenience most of the estimates of this equation, presented below,
are based on only six U terms. Results for fifteen and seventeen terms,
however, are not dissimilar.
The difference between rational and adaptive price behavior is
illustrated in Figure 3. The price at any particular time is influenced by
the expected shift in demand and supply schedules owing to inflation
and by deviations of the actual schedules from the expected ones. Only
one set of expected schedules is shown in the figure, although rational
and adaptive expectations would not ordinarily have the same set.



Given the expected price under either theory of behavior, the actual
demand and supply will cause the price to deviate from the expected
price. The adaptive response will result in a price that partially reflects
the actual change in demand and supply in relation to the expected
change. The rational response will result in a price which equates ac­
tual demand and supply. As argued above, this rational price will not
ordinarily prevent a fall in output because contracts predetermine some
prices and because supplies may be held off the market in anticipation
of more favorable prices in the future.
Therefore, when the earliest and the most recent theories of price
behavior are modified to account for procyclical fluctuations in the in­
flation rate, they are not necessarily inconsistent with a Phillips type of
relation between the inflation rate and the amount of excess capacity.
As suggested above, however, the correlation between procyclical fluc­
tuations in the inflation rate and in the amount of excess capacity is evi­
dence of only a temporary effect of slack in reducing inflation. For a
lasting effect economic slack must reduce the expected trend rate of in­
flation. Let us examine the record for evidence of an effect of economic
slack on price expectations. In estimating this effect, we shall analyze
the data in terms of the two theories discussed above.2"

Statistical Estimates of the Effect of Slack Demand
The two theories formulated above allow for a noncyclical effect of
slack demand on the inflation rate through price expectations. In the
first theory the current amount of slack determines long-run expecta­
tions, but in the second it does not because it is largely reflected in
short-run expectations and the current price level. Equations [5] and
[10], each based on one of the two theories, were designed to distin­
guish the cyclical and noncyclical effects of slack demand on the infla­
tion rate. Statistical regressions of these equations were fitted to U.S.
quarterly data beginning in the first quarter of 1953, which avoids the
large price swings associated with the Korean War, and ending in the
fourth quarter of 1977, the latest date available, and alternatively in
Although equations [5] and [10] have many apparent similarities, they differ
crucially in the form of the left-hand variable. Their difference does not# however,
provide an acceptable statistical test for choosing between the two theories. The
fit of these equations to the data is not sufficiently close to produce a clear prefer­
ence for one or the other, nor to indicate whether or not certain forms of the vari­
ables or their lags should be included in the regression equation. A satisfactory
test of the two theories of price behavior requires different techniques and evi­
dence from that provided here. Nevertheless, we may examine the reasonableness
of the estimates from the two theories for the effect of slack demand on the infla­
tion rate.



1969 to exclude the last two business cycles. Various series were used
to provide a broad indication of how the parameter estimates are
affected by different measures of prices and slack demand. The results
are presented in the appendix to this chapter.
The regression equations do not in general fit the data closely, as
is evidenced by the low levels of significance of many of the regression
coefficients. (The total correlation coefficients are high simply because
they include an adjustment for serial correlation in the error terms;
they have not been reported.) Our principle interest here is the values
of the coefficients as estimates of the effect of slack demand on the in­
flation rate. The lack of a close fit does not appear to bias the estimates
of the coefficients and so does not invalidate the statistical results,
though it does of course widen the range of error of the estimates.
For equation [5] the estimates of ba represent the noncyclical effect
of slack demand on the inflation rate. These are reproduced in Table 1
for the regressions using the unemployment rate to measure slack de­
mand.2' The estimated effect of slack demand is similar for the con­
sumer price index and wholesale finished goods prices (and is statis­
tically significant, as shown in the appendix, Table 3, except for the
wholesale price series over the shorter period). The estimated effect
differs for the other price measures. The estimates for wholesale crude
and intermediate materials prices are erratic and reflect their lack of
regular cyclical pattern. The estimates for average hourly earnings
are quite small, reflecting the lower response of wages to the business
cycle. The estimated effect for the g n p deflator is also small (and ac­
tually nonexistent in the 1953-1969 regression), apparently because of
its broader coverage of industries.22 Many of the results are not
strongly significant for the basic reason that moderate slack works
slowly and its effect is hard to identify. But it seems to exist overall in
these data, and the estimates appear credible in magnitude.
If we tentatively accept the results for the consumer price index
and wholesale finished goods, which are statistically the strongest,
as the clearest indication of the size of such an effect, the estimates are
around 0.2 and imply that excess unemployment maintained at one per21 The other measures of slack give a similar result if we note that they register the
same slack with two and a half to three times the magnitude shown by the unem­
ployment rate.
2:2 Results for the g n p deflator of the private nonfarm sector (not shown) are simi­
lar. In a recent study of 1954-1971, Robert J. Gordon ("The Impact of Aggregate
Demand on Prices/' Brookings Papers on Economic Activity, no. 3 [Washington,
D.C.: Brookings Institution, 1975], pp. 613-662) also finds, for the g n p chain de­
flator of the private sector excluding food and energy, that current and lagged
changes in the g n p gap affect the inflation rate while the current and past levels
do not.



Table 1
(change per quarter in annual percentage rate from excess
unemployment of one percentage point)

Measures of the Period of Change
Inflation Rate
Consumer price
gnp deflator

Wholesale crude
Wholesale inter­
mediate goods



Change in
Rate for
1977 over

Total Due to





























Wholesale finished
Average hourly



va, ue ° f b ,s derived byjiividing ba by a. Estimated change for 1977
over 1976 is a (—0.65) + Aba (4.6 — U), where U for each row is given in Table 3.
( e unemployment rate for prime-age men in 1977 was 4.6 percent, and the
decline in the average level from 1976 to 1977 was 0.65.)
Dash (

) indicates not calculated because estimates of ba and b are of wrong

Source: Based on regressions in appendix, Table
prime-age men.



u n e m p lo y m e n t

rate of

centage point would reduce the annual inflation rate by 0.2 percentage
points per quarter and by 0.8 percentage points per year. By this evience the noncyclical trend of inflation is reduced by economic slack,
ut quite slowly when the amount of slack is moderate. The slowness
o t e effect reflects the small revision of the expected price change per
period of time, shown by the value of b. The immediate effect, shown
by a, is larger, but the part of the effect that has not been translated


into a reduction of the expected price change disappears when the slack
is removed.
The results in Table 1 seem to suggest that the effect of slack on
inflation has increased in recent years; the estimates of ba generally
have larger negative values for the full than for the shorter period.
This would be consistent with the theory that the increasing variability
of inflation rates in recent years has caused fluctuations in aggregate
demand to be translated more into prices than into output (which
would increase the value of a), contrary to evidence cited earlier that
prices have become less responsive to the business cycle. The larger
values of ba for the full period can indeed be attributed to a, which may,
however, simply reflect the large rise and subsequent decline in the in­
flation rate in 1973-1975 stemming from the extraneous foreign in­
fluences. The estimates for average hourly earnings suggest that b is
higher for the full period, but the overall effect shown by bn, though
larger, remains low, indicative of the smaller and slower response of
wages to economic slack compared with the response of prices. It is
therefore doubtful that the effect of slack in reducing inflation has in­
creased much at all, although there is no indication of a decrease either.
The failure of the inflation rate to decline continually when slack
exists is reflected in the large negative value of a, which represents the
cyclical effect of changes in slack and which dominates the noncyclical
effect. In a business expansion the continued existence of slack works
to reduce the expected rate of inflation, but, until the decline in slack
slows down, the net effect can be no change or even an increase in the
current inflation rate. The last column of Table 1 gives the change in
the inflation rate as estimated by each regression for 1977. Despite the
existence of substantial slack in the economy in 1977, but because of
the decline in amount of slack, most of the estimates show a slight de­
cline— practically no change— in the inflation rate for the year. Actu­
ally, as noted earlier, the inflation rate increased in 1977; this upward
deviation from the equation suggests that the severe winter generated
direct upward pressures on prices which were accommodated by
aggregate-demand policy but did not affect the measures of excess
The implications of the regressions can be derived for 1978, based
on estimates of the slack that will exist. The c e a projects an unemploy­
ment rate for all workers of 6 to 6lk percent for the end of 1978.
Since the rate in December 1977 was 6.4 percent, the implied average
rate for 1978 is only slightly above 6 percent, close to the fu n ­
employment rate cited earlier. This would represent a decline of about


Annual Report, 1978, p. 79.



T a b le 2

(change per indicated period in annual percentage rate from excess
unemployment of one percentage point)

per year
(0.37 X col.
Sum of c

Effect over
Cycle, Con­
tinuous Ad­
(1.72 X col.

Measures of the
Inflation Rate

Period of

Consumer price





Wholesale fin­
ished goods





Average hourly






a See footnote 24.
b Estimated from regression with fifteen terms of U.
Source: Appendix, Table 4.

three-fourths of a point from the average rate of 7 percent for 1 9 7 7 .
(Although the results in Table 1 are based on the unemployment rate
for prime-age men, we may assume that it will change roughly by the
same amount as the rate for all workers.) According to the estimates
for the consumer price index in Table 1, the decline in the unemploy­
ment rate would raise the annual inflation rate in 1 9 7 8 over 1 9 7 7 by a
half to three-fourths of a percentage point, while the small average
amount of excess unemployment in 1 9 7 8 would reduce inflation very
little. According to these estimates we shall have to look beyond 1 9 7 8
for any progress in reducing inflation.
The results for equation [10], based on rational expectations, are
presented in the appendix, Table 4, and summarized in Table 2. The
sum of the c coefficients gives the lasting effect of slack demand in re­
ducing the expected trend of prices. The additional c coefficients be­
yond the first two are not collectively significant statistically, and this
remains true when the number of them in the regression is increased.
Consequently, the estimate of their sum is subject to a wide range of


error. The lack of significance may also mean that rational expectations
are an inappropriate basis for describing these data, or it may possibly
mean that expectations of the inflation trend cannot be adequately rep­
resented by past unemployment. We may nevertheless examine these
estimates as an alternative indication of the effect of slack demand on
inflation, since they suggest a slower response than does the adaptive
expectations model.
The estimates of the sum of the c coefficients in Table 2 vary from
0.8 for the shorter period 1953-1969 to over 1.5 for the full period
1953-1977. The larger sum for the full period probably reflects the un­
usual fluctuations of 1973-1975, however. As the number of U terms
in the regression is increased to provide a longer perspective on the
cumulative effect of slack demand, the sum declines toward unity (third
row of table). We may therefore take a value of unity or a little lower
as the central estimate of the effect. The implications for the average
inflation rate are shown in columns (2) and (3) of the table. Column
(2) shows the effect per year for an assumed four-year business cycle.
Column (3) shows the cumulative effect over a full business cycle of
any length, under the likely assumption that adjustments in the ex­
pected trend are made continuously.24 For the central estimate of the
sum of c coefficients of unity in the third row, the annual inflation rate
would be reduced by 0.37 percentage points per year for each one per­
centage point of average slack maintained over a business cycle, and
reduced as much as 1.70 percentage points over the entire business
cycle with continuous adjustments. This effect is about a half or less
of the effect estimated above for adaptive expectations over the same
length of time. Rational expectations have a smaller effect because it
24 The sum of the c coefficients gives the estimated effect of excess unemployment
on the difference between the current inflation rate and the noncyclical trend. For
a business cycle of n periods in which this difference is maintained at C,




Ci(UM-O) =


the cumulative effect can be expressed by
fc.n = c ( l + - ^ )


S - ^ r = C ( 1 + 7r )


For n—16 quarters, the average rate is 1.48C or .37C per year.
The estimate of C is not affected greatly by changes in n beyond a small num­
ber, and we may assume C remains the same as n increases. In particular, we may
derive the effect for continuous adjustments where the periods approach zero in
length and n approaches infinity, for which the limit of ^1

is e or 2 72-

Hence the total effect for a full cycle of continuous adjustments, which is inde­
pendent of the length of the cycle, is 1.72C.



is assumed that most of the cyclical fluctuation in slack demand is ex­
pected and already incorporated in the expected trend, and that only
the cumulative amount of slack, if more or less than expected, affects
the expected trend of prices.
Although these estimates show a small effect of slack demand,
they pertain to the initial effect within the span of a business cycle;
the longer-run effect could well be larger. Presumably the slack pro­
duced by a business recession will not reduce the expected trend of
prices very much if it is expected that the pressure on prices of slack
markets in the recession will be offset in the subsequent expansion.
The recent cyclical fluctuations, in which the final stages of the expan­
sion have encountered increasing inflationary pressures, give a rational
basis for such an expectation. For policy makers to restrain inflation
effectively given the recent history of failures, they must demonstrate
over the course of a business cycle that the restraint will persist. Once
this is demonstrated for one business cycle, however, the effect is likely
to be considerably stronger in the next."' In the late 1950s the inflation
rate was widely viewed as intractable because it was not eliminated by
the recession of 1957-1958 (see Figures 1 and 2). Yet the subsequent
business expansion did not overshoot, and the inflation rate remained
lower than it had been in the previous expansion. Although the infla­
tion stubbornly resisted further decline in the subsequent business con­
traction of 1960-1961, it rapidly disappeared during the second half of
1961 when the business recovery proved to be mild. W ith the benefit
of hindsight, it appears that the inflation of the 1950s was finally con­
quered not so much by the business recessions as by the avoidance of
renewed inflationary pressures during the business expansions.
The adaptive and rational models imply different time patterns for
the effects of slack demand on the expected rate of inflation. The
effects under adaptive expectations occur faster and, for a given initial
period of excess unemployment, appear to be about twice as large.
Given the cyclical fluctuations in slack demand over the business cycle,
however, the initial change in the expected inflation rate will be par­
tially or fully offset over a full cycle. Under rational expectations, al­
though slack demand has an immediate effect on price levels, its effect
on the expected trend of prices is slight initially, may even be negligible
during a recession, and occurs mainly with a lag the length of the busi­
ness cycle. But the response of the expected rate of inflation to slack
demand is likely to be stronger— and this applies to adaptive expecta­
tions as well when a change in aggregate-demand policy demonstrates
This is emphasized in William Fellner, Towards a Reconstruction of Macroeco­
nomics (Washington, D.C.: American Enterprise Institute, 1976).



that the change will be maintained by outlasting the course of a busi­
ness cycle.
Although our statistical results slightly favor adaptive over ra­
tional expectations, it is not clear which model describes economic be­
havior more accurately. Actual behavior may well be a mix of both.

The Political Problem of Reducing Inflation
The statistical results add an important qualification to the proclaimed
policy goal of reducing both inflation and unemployment. The goal
can be accomplished only if the reduction of unemployment is not car­
ried all the way to full employment but stops short of that goal and
maintains some excess unemployment for a long period. No such limi­
tation has been evident in the pursuit of the goal over the past decade.
Business expansions, whether intended by policy or not, have carried
aggregate demand up to and beyond the zone of increasing inflationary
pressures. Policy makers have also set up an unattainable goal by
claiming that cyclical rates of both inflation and unemployment can be
reduced at the same time.
Although there are no economic barriers to reducing inflation, a
political problem has erected a barrier. The problem centers on two im­
plications of the economic relation between inflation and slack demand.
First, changes in the amount of slack reflect cyclical fluctuations in
aggregate demand which produce cyclical fluctuations in the rate of
inflation. Restraint imposed on the growth in aggregate demand in­
creases the amount of economic slack and reduces the inflation rate.
But while the restraint is being applied the rate declines far more than
can be maintained after the economy begins to recover. As the amount
of slack declines, the inflation rate increases, which makes it appear as
though the hard-earned gains against inflation are slipping away. In
fact, however, most of those gains are temporary cyclical fluctuations
and cannot be counted as reductions in the long-run inflation rate. The
real progress against inflation is to be measured by the rate that pre­
vails after slack has declined to an acceptable level. At that point the
inflation rate can be somewhat lower, compared with the average for
the previous cycle, because of the cumulative effect of economic slack
during the business contraction and recovery. It is conceivable that
fluctuations could be avoided by imposing an amount of slack which,
once reached, is kept constant thereafter until the long-run rate of infla­
tion has declined to an acceptable level. But fluctuations in business
activity owing to policy measures as well as to other sources of cyclical
fluctuations in the economy have not been avoided in the past and are
well beyond our capability of avoiding in the foreseeable future. Since



cyclical fluctuations in the inflation rate will surely continue, a "true"
reduction in the rate would mean that the expected rate has declined,
as implied by a decline in the actual rate between corresponding busi­
ness cycle stages in which the amount of slack is the same.
A second implication of the relation between inflation and slack
demand is an obvious one with touchy political consequences. It is that
the reduction of inflation "almost" certainly requires slack demand. The
qualification is added to cover the possibility implied by the theory of
rational expectations that an announced and widely believed change in
policy which reduced the growth path of nominal aggregate demand
would immediately reduce the expected growth path and thereby its
contribution to the trend of prices. An argument sometimes made for
controls is that, if accompanied by announced restraints in aggregatedemand policy, they could help to reduce expected price changes along
with the targeted decline in the inflation rate, thus avoiding the period
of slack demand produced by a discrepancy between actual and ex­
pected price changes. The purpose of the controls would be to make the
announced change in aggregate-demand policy believable, though in
the light of past experience it is questionable whether they ever have or
now would have such an effect. There is no doubt, however, that the
stance and credibility of policy affects expectations. Market decisions
about wages and prices are guided at least in part by rational expecta­
tions of the direction of policy. To the extent that prices behave ac­
cording to the theory of rational expectations, the persistence of the
trend rate of inflation in the face of slack demand is consistent with
the proclaimed desire of policy makers to subdue inflation only if they
are generally not believed to be capable of carrying it out. Since the
evidence suggests that the economic capability exists, the lack of credi­
bility concerns the political capability. In such circumstances and in
view of our past experience, the desire to subdue inflation is obviously
not enough and must be confirmed by performance. The conclusion
appears inescapable, therefore, that the reduction of inflation requires
the maintenance of slack demand, and the less that policy hides its in­
tention to maintain it, the faster the reduction will be.
The political incentives to hide the intention have created serious
barriers to achieving it. Hidden intentions can mislead economic agents
into expecting higher inflation than policy measures are designed to
allow, thus slowing down the reduction in the expected rate of inflation
and holding back the reduction in the actual rate. In addition, policy
makers are trapped into publicly adopting targets of economic slack
which are unrealistic and, if pursued, unable to reduce inflation. The
4 percent level of unemployment held as a goal in the HumphreyHawkins bill can no longer be considered a reasonable estimate of the


noninflationary rate of full employment— if it ever was. Budget projec­
tions in 1978 are also based on a full-employment rate of less than 5
percent. More realistic estimates, as noted, indicate that this rate is now
close to 6 percent. If these higher estimates are correct and if policy
makers mistakenly try to achieve a lower unemployment rate, it will
not be possible to reduce the actual unemployment rate much below 6
percent. Nor will the widely deplored high rates for youths and minor­
ity groups be reduced much by any degree of economic stimulation that
would conceivably be undertaken. But the attempt to achieve these un­
attainable goals would, of course, push the economy into the zone of
increasing inflationary pressures. Even if realism prevails in the adop­
tion of goals and the maintenance of a credible amount of slack demand
is acknowledged as necessary, the chances of success are greatly dimin­
ished by targeting too little slack, because the slightest disturbance
raising aggregate demand or restricting supplies can rapidly eliminate
a small amount of slack and set off new inflationary pressures. In times
past, when the general price level was relatively stable, such disturb­
ances were not important and the response of prices to them was weak;
but in recent years, when experience with inflation alerts everyone to
the likelihood of new outbursts, the response is rapid.
Although the maintenance of slack demand is necessary to subdue
inflation, the imposition of slack can give the appearance of not work­
ing, because it takes time and is dominated by cyclical fluctuations that
inevitably accompany the attempt to restrain the growth in aggregate
demand. This behavior of the inflation rate is hardly ideal for maximiz­
ing political statesmanship or for resisting the political temptation to
make promises whose impracticality is revealed much later. But despite
all the hand wringing over the political obstacles to subduing inflation,
it is still true that avoidance of new outbursts of inflation is viewed as
politically acceptable and that the rising trend of inflation has largely
reflected the failure of policy to contain new outbursts. The evidence
gives more support than denial to the traditional view that, without
outbursts and with the maintenance of some slack in the economy, in­
flation will gradually decline. There is a basis for hope that each of the
various kinds of mistakes which allow the economy to overheat will be
made only once, and that eventually policy makers will proceed without
further serious mistakes to bring inflation effectively under control.

For Tables 3 and 4 in this appendix, regressions were fitted to quarterly
data by the Cochrane-Orcutt method, which adjusts for first-order
serial correlation in the residuals. (The total correlation coefficient is


Table 3



/tA - U,-A , t ( U , + U,-, + u ,- ,


Regression Eq. [5]: p, - p,_, = a I ------ ^------ 1 + ba 1 ------------^----------- -


Regression Coefficients
(and t Values)

Price Series




U : Unemployment rate
Consumer price index


-0.95 (3.4)




-0.57 (1.8)

-0.12 (1.2)







-0.58 (1.2)
-2.38 (2.0)



Wholesale finished goods


-0.28 (1.5)


Average hourly earnings

-0.66 (1.6)
-0.56 (1.5)
-0.52 (1.4)



d e fla to r

Wholesale crude materials
Wholesale intermediate


U : Excess capacity
Consumer price index



-0.08 (3.4)



-0.11 (1.7)




+0.01 (0.3)




-0.77 (3.3)

Wholesale finished goods


-0.16 (1.7)



Average hourly earnings


-0.11 (1.3)
-0.11 (1.5)




d e fla to r

Wholesale crude materials
Wholesale intermediate

U : Potential in excess of actual g n p ( cea )
Consumer price index
-0.17 (1.4) -0.08(2.1)
-0.27(2.2) -0.12(3.4)
g n p d e fla to r
-0.21 (1.3) -0.01 (0.2)
-0.19 (1.4) -0.07(1.8)





Table 3 (Continued)
Regression Coefficients
(and t Values)
Price Series
Wholesale crude materials
Wholesale intermediate
Wholesale finished goods
Average hourly earnings





+0.16 (0.2)
-1.12 (1.1)

-0.14 (0.7)



-0.28 (1.4)
-0.60 (2.4)
-0.19 (1.1)
-0.07 (0.4)

-0.20 (1.3)
-0.10 (1.7)
-0.16 (2.3)
-0.03 (0.6)
-0.04 (1.0)




U: Potential in excess of actual
Consumer price index


Wholesale crude materials
Wholesale intermediate


(St. Louis)
-0.08 (2.2)
-0.11 (2.9)


-0.21 (1.7)
-0.37 (3.0)
-0.19 (1.2)
-0.23 (1.6)
-0.07 (1.0)


Wholesale finished goods




Average hourly earnings


-0.09 (0.5)

-0.12 (0.6)
-0.01 (0.1)
-0.13 (0.8)
-0.08 (1.4)
-0.13 (1.7)
-0.04 (0.8)



Note: The values of the t statistic omit negative signs and were not calculated
for U.
Dash (—) indicates not calculated because of wrong signs.
Source: Consumer price index (all items), wholesale prices, average hourly
earnings of production workers (adjusted to exclude overtime and interindustry
shifts), and unemployment rate of prime-age men aged twenty-five to fifty-four
are from the Department of Labor, Bureau of Labor Statistics, g n p deflator is
from the Department of Commerce, Bureau of Economic Analysis. Excess ca­
pacity in manufacturing (the complement of capacity utilization) is from the
Federal Reserve Board. Potential in excess of actual g n p as estimated annually
by the Council of Economic Advisers (logarithmic interpolations used to derive
quarterly data) is given in the Annual Report, 1978, p. 84, and as estimated quarterly
by the Federal Reserve Bank of St. Louis is given in Robert H. Rasche and John A.
Tatom, "Potential Output and Its Growth Rate—The Dominance of Higher Energy
Costs in the 1970s," U.S. Productive Capacity: Estimating the Utilization Gap, Center
for the Study of American Business, Washington University, Working Paper
no. 23 (December 1977), p. 80.
All series are seasonally adjusted.


Table 4

16 A .



Regression Eq. [10] : p <- S “
= (a + c0X U t - U) + (c, - a X ^ - i ,-i 10



U) + Z )

- U)

U: Unemployment rate

Regression Coefficients
(and t Values)
a + Co

___ (1)

Ci — a






Sum of cols.

p: Consumer price index







p: Wholesale finished goods
- 1 .0 0
(1 5 )
(11 )






p: Average hourly earnings








(22 )

(1 7 )


Source and note: Same as for Table 3.












made misleadingly high by this adjustment and is not shown.) The
period of fit began and ended with the first quarter of the years indi­
cated, with certain exceptions because of unavailability of data. Units
of inflation rates are percent per year, and of unemployed resources are
percent. Hence units of coefficients are the change per quarter in annual
percentage rate for each unit of quarterly change in U for a and for each
unit of excess U for ba and the c's. The noninflationary rate of unem­
ployed resources, U in percent, is estimated by the constant term of the
regressions divided by ba in Table 3 and by the sum of c's in Table 4.
The method of calculating the variables was as follows.
pt is the rate of change between quarterly levels of the price series
in t and t—1 (not the two-quarter change as used in Figures 1 and 2 to
smooth the rate).
U t is an average for the quarter. For equation [5] in Table 3,
where the dependent variable is the change in the inflation rate, the
two independent variables representing the change and level of unem­
ployed resources have three-quarter spans. Thus all the variables in
equation [5] have the same span of coverage. For equation [10] in Table
4, even though p t covers two quarters of data and Ut only one quarter,
a comparable span was not necessary because the set of six lagged U
variables covers six quarters.
The unemployment rate of prime-age men aged twenty-five to
fifty-four years was used in preference to the rate for all workers, be­
cause structural changes in the labor force have affected the total rate
but are far less important for prime-age men. (See Cagan, "The Reduc­
tion of Inflation and the Magnitude of Unemployment.") This rate
was about half the rate for all workers in 1977.