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Address by
Lawrence K. Roos
Federal Reserve Bank of St. Louis

Before the
Regional Conference of National
Association of Business Economists
St. Louis, Missouri
April 26, 1978


I am pleased to have the opportunity to talk with this distinguished group of business economists because you, in your responsibilities of interpreting economic events for
the management of American business, are among the Nation's most important economic

This afternoon, I would like to focus on inflation, a phenomenon which is very
much on the minds of all Americans these days, and one which is widely misinterpreted
and misunderstood, even by economists and policymakers.

In recent weeks, inflation has once again become a major topic of economic and
political concern. Public opinion polls show that voters consider inflation to be the number one problem in our society. Politicians fear that inflation will become a major campaign issue. And, economists argue about what causes inflation and how it can best be
dealt with.

This sudden outburst of concern about inflation once again demonstrates that
history repeats itself, that we seldom learn from experience and that our time horizons
are disturbingly short.

I can recall, as recently as one year ago, at a time when the recovery from the
recession of 1973-74 was progressing rapidly,

that many policymakers were urging

that the economy needed additional stimulation, that inflation was not a serious problem,
and that even if inflation were to accelerate, it could be dealt with quickly if it became
a serious threat. So we held down short-term interest rates, permitted the money supply
to expand, and suddenly, (and I might add, as some of us anticipated) inflation has once
again emerged as the Nation's top priority economic problem.

In today's hue and cry to do something about inflation we are being subjected once
again to a familiar laundry list of suggested anti-inflation measures-tired old prescriptions
like voluntary wage and price restraints, a national incomes policy, reduction of oil imports, etc.

One thing that puzzles me is how seldom rapid money growth is mentioned as a
cause of inflation.

This is curious because, basically, inflation is nothing else but "too

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many dollars chasing too few goods." Time and time again, in nation after nation, it has
been demonstrated beyond doubt that acceleration in the growth of money produces
acceleration in the rate of inflation.

But instead of blaming inflation on rapid money growth, many pundits insist on
dusting off the old familiar palliatives. Labor blames management for causing inflation
by earning excessive profits. Management blames unions for demanding excessive wage
increases. Others blame government for running huge deficits. Some even place the full
blame on the Arabs for increasing oil prices.

Each reminds me of the child who excuses his misbehavior by saying, "The devil
made me do it." Each identifies a different devil, and they all refuse to accept any of the
blame themselves or to face up to the real cause of the problem.

I think the time has come to separate fact from fiction in dealing with inflation.
Under the category of fiction are claims that the principal causes of inflation are excessive
wage and price increases, government deficits or the decline of the dollar on foreign exchange markets. I do not deny that all of these factors may have adverse effects on the
economy, or induce policies leading to accelerated money growth. But, none of them
is a fundamental cause of inflation.

Let me illustrate what I mean. When wages increase, the cost of doing business

Under such circumstances, businessmen have two choices. They can either

pass along their increased costs in the form of higher prices to their customers or they
can absorb the increased costs which means reduced profits and eventually a curtailment
of operations.

If prices are raised, sales and output tend to decline. Obviously, when-

ever production is reduced, unemployement will temporarily increase. But neither alternative, by itself, causes the overall price level to rise.

Wage increases, and resulting price increases, cause inflation only if the money
supply is expanded for the purpose of avoiding increased transitory unemployment. Since
we all, understandably, want to keep unemployment to a minimum, any arbitrary increase in wages does create pressure on monetary policymakers to increase money
growth. If policymakers yield to that pressure, inflation results. However, inflation results only if they yield to that pressure. Thus, wage increases cause inflation only when
policymakers, in an effort to prevent unemployment, increase the growth of the money


Similarly with government deficits. A government deficit, when financed through
the sale of government debt in private credit markets, raises interest rates but it does not
generate inflation. If, however, policymakers, in order to prevent interest rates from rising,
inject money and credit into the economy, then inflation will result. Thus, government
deficits cause inflation only when policymakers refuse to tolerate higher short-term interest rates.

The villains currently cited as being the main cause of inflation-high wage settlements and large government def-icits-by themselves, do not, and I repeat, do not generate
inflation. They only cause inflation when there exists an implicit policy of resisting any
increase in unemployment, however temporary, or any increase in short-term interest

If it is public policy that monetary actions be designed to avoid increases in unemployment or rises in short-term interest rates under all circumstances, and if monetary
policymakers must always place considerations of unemployment and interest rates above
all else, monetary policy cannot be an effective tool for fighting inflation.

At this point I want to make it unmistakenly clear that it is not my purpose in any
way to minimize the seriousness of unemployment or to suggest that under certain circumstances increases in short-term interest rates may not have a dampening effect on
economic activity. What I am saying is that, before embarking upon inflationary monetary
policies for the purpose of preventing any rise in unemployment or preventing rises in
short-term interest rates, careful consideration should be given to the relative costs of
such actions in terms of increased inflation, and those costs should be compared with the
costs of unemployment and rising interest rates that would result if the stimulating actions
were not taken.

Only after policymakers and the public in general have compared the

relative costs and benefits of alternative monetary actions can rational policy decisions
be made.

Let me illustrate what I mean.

Let's assume that a top priority concern of the

American people is the reduction of inflation and that the trend rate of inflation can be
reduced by a gradual reduction in the growth of money. Furthermore, let's assume that
a reduction in money growth can be expected to cause a temporary increase in unemployment. Before accepting or rejecting monetary restraint as a tool to reduce inflation because such action might increase unemployment, policymakers should ask: How much


unemployment could be expected from slowing the rate of money growth? How long
would such an increase last? How would future wage demands be affected if inflation
were actually reduced? What ultimate increases in unemployment might be expected if
monetary stimulus caused inflation to accelerate to an extent that would necessitate
severe monetary restraint at a later time?

Until specific questions such as these are

considered and the anticipated consequences of alternative policy options are carefully
weighed, intelligent monetary policy decisions cannot be made.

Similar factors must be considered when deciding whether or not to expand the
money supply in order to hold down short-term interest rates in time of strong credit

Recognizing that the only way to avoid increases in short-term interest rates

under conditions of strong credit demand is to pump more money into the economy, and
that such stimulus has long-term inflationary consequences, the relative costs of alternative options should be carefully examined before policy is formulated. Factors such as
these should be addressed: Just how much higher could short-term interest rates be expected to rise if markets were permitted to operate free from monetary intervention?
What impact would a resulting increase in short-term interest rates have on the economy?
Would inflationary expectations of the consequences of money supply expansion to
counter increases in short-term interest rates not lead to increases in long-term interest
rates? Are increases in short-term interest rates any less threatening to the economy than
increases in long-term interest rates?

These are the kinds of questions that must be answered before monetary policy can
be effectively designed to deal with inflation, unemployment, interest rate fluctuations or
similar subjects of economic concern.

If we fail to address fundamental issues such as

these, we eliminate from public choice a whole series of policy options in which the
public has a legitimate right to participate. What's more, we tend to make snap judgments
based on old bromides and half-truths and usually end up with short-lived solutions to
our problems.

Ours is a Nation dedicated to the belief that free men and women can and must
make the choices that determine their collective destiny.

Economic choices are no

different from others. Whether or not the average citizen has read Adam Smith's "Wealth
of Nations" or listened to debates between Friedman and Galbraith, he does read the
total of his bill at the check-out counter of his supermarket and thus, he does know the
meaning of inflation.

All that remains for Americans to rationally decide what to do

about inflation is for them to have a realistic knowledge of its causes and effects.


The cause of inflation is a consistent growth of the money supply that exceeds the
growth of economic output.

It is not excessive wage demands, large government deficits

or the adverse balance of trade that causes inflation. These are the results of inflation. It
is the growth of the money supply, itself, that is the direct cause!

Only when Americans separate fact from fiction and fully understand the policy
tradeoffs surrounding the issue, will they be in a position intelligently to decide whether
reducing inflation is worth the cost. I, for one, believe that it is!

But I am not asking y o u , or anyone else, to blindly accept my opinion. All I am
asking is that the issue be fully and honestly presented to the public, and that various
policy options, their costs and the tradeoffs involved, be carefully considered in the advocacy of monetary policy. If that is done, I feel confident that the American people,
assisted by able professionals such as you in this audience, will arrive at decisions which
are in the best interests of all of us as individuals and this great Nation as a whole.