Chapter 8

1. Chapter 8 Causes and Cures for Inflation

2. What Causes Inflation? • In the long run, inflation is a monetary phenomenon. • In the short run, changes in inflation are closely correlated with changes in unit labor costs, which are wage rates divided by productivity. • Expectations play an important role in both the short and the long run.

3. Inflation as a Monetary Phenomenon • During periods of actual shortages, monetary ease can cause inflation in the old-style sense of “too much money chasing too few goods”. • However, it is more often the case that inflation rates soar during periods of economic slack. In fact, in many cases, the growth rate and the inflation rate are negatively correlated. • That often occurs because the monetary authorities are signaling that labor and business can raise wages and prices without the penalty of losing jobs or sales. Individual economic agents believe they can improve their relative position by raising wages or prices, but in the aggregate, no one benefits.

4. How Monetary Policy Can Cause Inflation • In a typical case, the government runs a large deficit. • The central bank monetizes the debt by issuing additional Treasury securities (sometimes known as “printing money”) • Private investors do not want to buy these securities, so the central bank essentially buys them back. • Capital flees the country, reducing the value of the currency and increasing import prices. • Wages rise rapidly to offset the higher cost of imports, and domestic prices rise because of higher labor costs. • The situation spirals indefinitely until the government – or the International Monetary Fund – reverses the process.

5. Inflation in the Short Run • Economists used to believe that inflation would rise as the economy approached full employment. • We now know that is no longer the case. The unemployment rate in the U.S. economy fell to 4% in the late 1990s, yet the inflation rate did not rise at all. • However, during the previous 10 business cycles, inflation invariably rose as the unemployment rate fell to its full-employment level.

6. Which Determinants of Inflation Changed? • Change in expectations • Greater credibility of the monetary authorities • Faster productivity growth • More open economy and greater reliance on foreign trade • Deregulation • Slower growth in fringe benefit costs • Indexed tax rates • However, NOT because people became more or less greedy.

7. What About the Deficit? • There need not be any correlation between the budget deficit and the rate of inflation. • If the budget deficit is large, that will not be inflationary if the additional Treasury securities issued are sold to private investors (instead of being repurchased by the government) • Inflation was much lower during the large deficits of the 1980s than during the near-surpluses of the 1970s.

8. The Role of Expectations • Expectations affect wages and prices jointly, not just prices • If firms expect they will not be able to pass along cost increases, they will hold the line much more firmly on wage gains. • If workers expect that higher wage rates will result in a permanent decline in jobs, possibly to foreign locations, they will settle for smaller increases. • If labor and business are jointly convinced that the monetary authorities will not accommodate higher inflation, they will settle for smaller gains.

9. Expectations, Slide (2) • Most important, workers have some expectation about where the inflation rate is heading in the future. If they think it is likely to accelerate, they will be more anxious to get larger gains than if they think prices will be stable. • After 1985, the Federal income tax rate tables have been indexed, so workers are not automatically pushed into a higher bracket when inflation rises. As a result, they are willing to settle for smaller increases, which in turn reduces the rate of inflation further.

10. Determinants of Wage Rates, Slide 1 • Foreign competition • Domestic competition • Level of Minimum Wage • Government Regulation • Strength of Labor Unions • Stance of Federal government toward labor. In 1981, Reagan’s decision to fire the striking airline controllers was a major factor in reducing inflation.

11. Determinants of Wage Rates, Slide 2 • Expected rate of inflation • Marginal tax rates, especially whether the tax code is indexed • Value of the currency. If the dollar is strong and rising, wage gains are generally smaller than if it is weak and falling

12. Determinants of Wage Rates, Slide 3: Type of Compensation • Prices are usually closely correlated with unit labor costs calculated from base wage rates. • If the base wage rate remains stable but total compensation rises because of bonuses, profit-sharing, or stock options, inflation is much likely to rise than if compensation rose the same amount through an increase in the base wage rate.

13. Factors Determining Unit Labor Costs • Productivity (output per employee-hour) • Private sector fringe benefits, mainly retirement and health benefits • Social security taxes • When the stock market rises rapidly, firms can contribute less to pension plans, which reduces unit labor costs and inflation.

14. Cyclical Patterns of Productivity • Until the late 1990s, productivity growth always declined near business cycle peaks. • Many factors accounted for that decline, including the “bottom of the barrel” effect, and some employees did not work diligently if they thought they could find alternative employment quickly. • However, in the late 1990s, productivity growth accelerated even as the unemployment rate declined to 4%.

15. Why Did Productivity Accelerate in the late 1990s? • Economists are still not sure whether this is a one-time phenomenon, or will be repeated in future business cycles • However, it does seem likely that the increased pressure from foreign competition removed many of the factors that would ordinarily cause productivity to slump at full employment. • That represents another reason why inflation is likely to remain constant at future business cycle peaks.

16. The Role of “Supply Shocks” • Supply shocks refer to changes in factors that affect prices other than wage rates. • They can be either malign or benign. • The major example of a malign shock has been the various spikes in energy prices. • Benign shocks include an increase in the rate of technological progress, a stronger currency, or a decline in commodity prices.

17. Energy Shocks • The first energy shock, in 1973, had a major impact on inflation. In recent years, though, similarly large changes in the price of energy have had much smaller impacts on the overall inflation rate. • Consumers and businesses have adjusted to these shocks, and energy-intensive users now know how to hedge against major price fluctuations. • Expectations have changed, and most people think spikes in energy prices are temporary. • The “energy coefficient” has been cut in half since 1973. • Even when energy prices spike, there have been no actual shortages since the early 1980s.

18. Currency Shocks • Sometimes, a major decline in the value of the currency boosts inflation substantially; other times, it has no apparent impact. • If the currency falls below its equilibrium value, that will generally boost inflation. But if it is far above equilibrium and then declines back to normal, the impact will be minimal. • Increases in the value of the currency have a significant impact on reducing inflation, but it is much smaller than the increases that usually occur when the currency depreciates below its equilibrium value.

19. Lags in Wages and Prices • If unit labor costs change, prices will usually adjust very quickly. • However, wage rates usually adjust to changes in the inflation rate only with a substantial lag. Most wage rates are adjusted only annually, and in some cases, union contracts are negotiated only once every three years. • As a result, inflation could still be rising even after the initial factors that caused an increase have ended.

20. Causes and Cures of Hyperinflation • Hyperinflation is generally caused by a combination of large budget deficits, excessive growth in monetary and credit aggregates, purchase of Treasury securities by the government, and an outflow of foreign capital. • During periods of hyperinflation, real growth generally declines and often turns negative. • Inflation can be stopped almost immediately with the imposition of a new regime, a return to a balanced budget, and renewed investor confidence. It does not take years to wind down a hyperinflationary spiral.

21. Factors Currently Affecting Inflation • Most economists believe that inflation will remain low and stable in the indefinite future for the following reasons. • Monetary credibility has been restored • Wage gains are being held in check by vigorous domestic and foreign competition • Note that the large budget deficits of the early 2000s are not expected to boost inflation at all. This can be seen by the unusually low rate of long-term interest rates.