Inflation and Stagflation

1
Inflation and Stagflation

• Inflation has often been described as the
  cruelest tax because it eats away at our savings
  and at our paychecks.
• For example, if the rate of inflation exceeds the
  rate of growth in our paycheck, that means our
  real income or purchasing power is declining
  even though our wages are going up.
• But not everyone loses from inflation.
• Inflation that is unanticipated can benefit
  borrowers at the expense of lenders.

Page Down to advance the presentation
2
(No Transcript)
3
Page Down to advance the presentation
4
The Roots of Stagflation

• In the late 1960s, against the strong advice of
  his economic advisors, Johnson increased
  expenditures on the Vietnam War but refused to
  cut spending on his Great Society social welfare
  programs.
• This refusal helped spawn a virulent
  demand-pull inflation.

Page Down to advance the presentation
5
Demand-Pull Inflation

• The essence of demand-pull inflation is too much
  money chasing too few goods, and thats exactly
  what happened when the U.S. tried to finance both
  guns and butter both the Vietnam War and the
  Great Society.
• Do you remember from Lecture One how to use the
  aggregate supply-aggregate demand framework to
  depict demand-pull inflation?

Page Down to advance the presentation
6
Demand Pull Inflation
E'
Page Down to advance the presentation
7
Price and Wage Controls

• In 1972, President Richard Nixon imposed price
  and wage controls and gained the nation a brief
  respite from the Johnson-era inflation.
• However, once the controls were lifted in 1973,
  inflation jumped back up to double digits
  helped in large part by a different kind of
  inflation then emerging, an inflation known as
  cost-push or supply side inflation.

8
Cost Push Inflation

• Cost-push or supply side inflation occurs when
  external shocks such as rapid increases in raw
  material prices or wage increases drive up
  production costs.
• In the early 1970s, such supply shocks included
  crop failures, a worldwide drought, and a
  quadrupling of the world price of crude oil.
• Do you remember from lecture one how to use the
  aggregate supply-aggregate demand framework to
  depict cost-push inflation?

Page Down to advance the presentation
9
Cost Push Inflation
E
E
Page Down to advance the presentation
10
Prior To The 1970s

• Economists didnt believe you could even have
  both high inflation and high unemployment at the
  same time.
• If one went up, the other had to go down. But
  the 1970s proved economists wrong on this point
  and likewise exposed Keynesian economics as being
  incapable of solving the new stagflation problem.

11
The Keynesian Dilemma

• Using expansionary fiscal or monetary policy to
  reduce unemployment will create even more
  inflation while using contractionary policy to
  curb inflation will deepen the recession.
• That meant that the traditional Keynesian tools
  could solve only half of the stagflation problem
  at any one time--and only by making the other
  half worse.

Page Down to advance the presentation
12
The Keynesian Response

• This dilemma was well-illustrated by the
  ill-fated initial Keynesian responses to the
  emerging stagflation crisis.
• During 1973 and 1974, inflation was labeled
  public enemy number one by policymakers even
  though there were clear signs of an accompanying
  recession.
• During both of these years, the Federal Reserve
  under Chairman Arthur Burns ordered sharp
  increases in the discount rate as a form of
  contractionary monetary policy.

13
President Fords Policy

• In addition, in 1974, President Gerald Ford
  responded to the crisis with a Whip Inflation
  Now campaign that included Keynesian calls for
  contractionary fiscal policy in the form of
  fiscal restraint and a tax surcharge.
• The result of these discretionary policies was to
  drive the economy deeper into recession even as
  oil price shocks in particular helped drive the
  inflation rate ever higher.

14
Switching Strategies Didnt Help

• Then, in 1975, the nations policymakers switched
  their Keynesian strategy as they replaced
  inflation with recession as their number one
  policy worry.
• As Congress passed a 23 billion Keynesian tax
  cut to fight recession, the Federal Reserve
  switched to an expansionary Keynesian monetary
  policy.
• The result was a disaster that drives home the
  seemingly unreconciliable dilemma that
  stagflation poses for traditional Keynesianism.

15
Monetarist Perspective

• It was this inability of Keynesian economics to
  cope with stagflation that set the stage first
  for Professor Milton Friedmans Monetarist
  challenge to what had become the Keynesian
  orthodoxy and then later for the emergence of
  supply side economics.
• To better understand the failure of Keynesian
  activism in a world of stagflation, we have to
  delve more deeply now into modern inflation
  theory and the mysteries of the Phillips Curve.

Page Down to advance the presentation
16
In Modern Industrialized Nations

• Most economists believe that there is a core or
  inertial rate of inflation that tends to persist
  at the same rate until some kind of demand or
  supply side shock comes along to change things.
• At the heart of this idea of inertial or core
  inflation is the concept of inflationary
  expectations and a behavioral model known as
  adaptive expectations.

Page Down to advance the presentation
17
Inflationary Expectations

• The expectation of inflation can significantly
  contribute to actual inflation.
• Inflationary expectations strongly influence the
  behavior of businesses, investors, workers, and
  consumers.

18
Adaptive Expectations

• When we assume adaptive expectations, we are
  assuming that people believe that next years
  rate of inflation will be the same as the current
  or last years rate.
• For example, during the 1990s, prices in the U.S.
  rose steadily at around 3 percent annually, and
  most people came to expect that inflation rate.
• This expected rate of inflation was, in turn,
  built into a core rate of inflation for the
  economy through institutional arrangements such
  as negotiated labor contracts.

19
How Inflation Becomes Expected

• Suppose you believe that workers will achieve a
  one percent increase in productivity.
• Because increases in real wages are tied to labor
  productivity, you also believe that auto workers
  deserve at least a one percent increase in their
  real, inflation adjusted wages.
• Assuming last years inflation rate was 3, what
  is the percentage increase in nominal wages that
  you will demand?

Page Down to advance the presentation
20
How Inflation Becomes Expected

• You will demand a minimum four percent increase
  in the nominal wage--one percent to get the real
  increase based on productivity gains and three
  percent to adjust for the expected or forecast
  inflation.

Page Down to advance the presentation
21
Expectations Become Reality
Ford
General Motors
Chrysler
Page Down to advance the presentation
22
An Inflationary Spiral
Page Down to advance the presentation
23
Our Next Questions

• What might cause the core or inertial rate to
  change and, more importantly, how might inflation
  start to spiral out of control such as it did in
  the 1970s?
• To answer these questions, we have to introduce
  one of the most important concepts in
  macroeconomics, namely, the Phillips Curve.

24
Origins of the Phillips Curve

• Developed by A.W. Phillips
• He studied more than a centurys worth of data on
  unemployment and money wages in the United
  Kingdom.
• He found that wages tended to rise when
  unemployment was low but fall when unemployment
  was high.

25

• What do you think happens to the unemployment
  rate as output rises?

AS
Price Level
Real domestic output
Page Down to advance the presentation
26
Page Down to advance the presentation
27
On The Basis Of This Evidence

• Most economists came to believe that a stable,
  predictable tradeoff exists between unemployment
  and inflation.
• The important policy implication is this you can
  always use fiscal or monetary policy to expand
  the economy a bit more to reduce unemployment,
  and the only price you will pay is a bit more
  inflationnot a bad tradeoff to keep people
  employed.

Page Down to advance the presentation
28
Page Down to advance the presentation
29
Page Down to advance the presentation
30
Page Down to advance the presentation
31
From A Macro Policy Perspective

• The virtue of this standard explanation is that
  it preserves the Phillips Curve relationship.
• This means that policymakers can still engage in
  discretionary fiscal and monetary policy to
  expand or contract the economy with the only
  price paid being a little more inflation for a
  little more employment.

Page Down to advance the presentation
32
According To The Monetarists

• According to the Monetarists, this disappearance
  of the Phillips Curve may best be explained
  through the concept of the natural rate of
  unemployment and by distinguishing between a
  short run and a long run Phillips Curve.

33
The Architects

• The modified Phillips Curve theory of the
  Monetarists grew out of the work of Edmund Phelps
  and Milton Friedman, and the theory asserts that
  there is a minimum unemployment rate that is
  consistent with steady inflation.

34
The Natural or Lowest Sustainable Rate

• This rate is what Classical economists and
  Monetarists typically refer to as the natural
  rate of unemployment while in some textbooks it
  is also referred to as the lowest sustainable
  rate of unemployment.

35
The Monetarists Major Point

• It is impossible to drive unemployment below the
  natural or lowest sustainable rate in the long
  run.
• This implies that the long run Phillips Curve is
  vertical rather than downward sloping.

Page Down to advance the presentation
36
The Importance of This
Ron Kahr 59

• The policy implications of the Monetarist's
  natural rate theory strike to the very heart of
  Keynesian activism.
• While the theory allows that a nation can use
  expansionary fiscal or monetary policy to drive
  unemployment below the natural rate temporarily,
  such a Keynesian joy ride along the short run
  Phillips Curve must inevitably come at the price
  of rising inflation.

Page Down to advance the presentation
37
A Deadly Inflationary Spiral
Ron Kahr 59

• Even more to the point, if a nation repeatedly
  uses Keynesian policies to try and keep
  unemployment below the natural rate, the only
  result over the longer run will be a deadly
  upward spiral of wages and prices--such as the
  one we witnessed in the 1970s.

Page Down to advance the presentation
38
How This Might Happen

• We first have to understand one important point
  about the natural rate of unemployment.
• It is not a constant rate but rather it can
  change as the structure of an economy changes.
• For example, in the prosperous decade of the
  1960s, the natural rate of unemployment was
  somewhere in the 4 to 5 percent range.

Page Down to advance the presentation
39
In The 1970s

• The natural rate of unemployment actually climbed
  into the 5 to 6 percent range.
• This increase in the natural rate came about
  because the supply side shocks of the 1970s,
  particularly the energy price shocks, raised the
  real costs of production in the economy.
• These higher costs, in turn, lowered the
  economys potential output relative to what it
  would have been.

40
From The Monetarists Perspective

• Lets use this Monetarist perspective on the
  Phillips Curve to illustrate how inflation can
  begin to spiral out of control if macroeconomic
  policy makers attempt to expand the economy below
  its natural rate of unemployment.

41
An Inflationary Spiral
Page Down to advance the presentation
42
An Inflationary Spiral
Page Down to advance the presentation
43
An Obvious Policy Question

• Now besides demonstrating how politics coupled
  with Keynesian activism can lead to an
  inflationary spiral, this Monetarist-inspired
  story I have told you also raises an obvious
  policy question.
• How do you stop such an inflationary spiral?

44
The Monetarist Solution

• Stop using expansionary Keynesian policies and
  allow the economy to return to the natural or
  lowest sustainable rate of unemployment.
• The problem
• Even if we stop the upward spiral of inflation,
  we still have significant inflation.
• This is because a higher core rate of inflation
  has been built into the economy.

Page Down to advance the presentation
45

• If we stop inflations upward spiral, we may
  still find ourselves stuck at Point a3 in the
  figure with a new and higher inertial rate of
  inflation of 9 percent.

Page Down to advance the presentation
46
The Traditional Keynesian Solution

• Incomes policy Impose wage and price controls
  until the inflation dissipates.

47
One Problem

• It may not work A lesson President Nixon learned
  when his administration imposed temporary wage
  and price controls in 1971.
• He then watched helplessly as inflation jumped
  right back up into double digits once the
  controls were lifted in 1973.

48
The Other Problem

• It runs contrary to the ideological beliefs of a
  majority of Americans.
• Businesses dont want government holding down
  their prices.
• Workers dont want government holding down their
  wages.
• There few advocates of wage and price controls
  today.

Page Down to advance the presentation
49
The Monetarists Solution

• That leaves the Monetarists solution.
• However, from a political standpoint, it is
  equally unpalatable.

50
What the Monetarists Believe

• The only way to wring inflation and inflationary
  expectations out of the economy is to have the
  actual inflation rate below the expected
  inflation rate.
• To achieve this, the actual unemployment rate
  must be above the natural rate of unemployment
  and that means only one thing inducing a
  recession.

51
What the Federal Reserve Did In 1979

• This is one interpretation of what the Federal
  Reserve did beginning in 1979.
• The Fed, under Chairman Paul Volcker, adopted a
  sharply contractionary monetary policy and
  interest rates soared to over twenty percent.

52
Effective But Costly

• The resulting recession was the worst since the
  Great Depression and it probably cost President
  Jimmy Carter the 1980 election and a second term.
  
• Nonetheless, the Feds bitter medicine worked.
• Between 1979 and 1984, inflation fell
  dramatically but at great human and economic
  cost.

53
The Cost of Disinflation, 1980-1984
Initial Rate of Inflation 1979 9 1984 4 C
hange -5 percentage point
Difference between potential and actual GDP (1996
prices) 1980 150 billion 1981
210 1982 470 1983 470 1984
200 Total 1,500 billion Cost of disinflation
1.5 trillion
54
The Cost of Disinflation, 1980-1984
Initial Rate of Inflation 1979 9 1984 4 C
hange -5 percentage point
Difference between potential and actual GDP (1996
prices) 1980 150 billion 1981
210 1982 470 1983 470 1984
200 Total 1,500 billion Cost of disinflation
1.5 trillion
Page Down to advance the presentation
55
The Political Result

• There was a profound political result.
• The hard economic times left a bitter taste in
  the mouths of the American people.
• Enter stage right Supply Side economics.

56
The 1980 Election

• Ronald Reagan ran on a supply side platform
• Cut taxes
• Increase government tax revenues
• Accelerate the rate of economic growth
• Without inducing inflation a very sweet
  macroeconomic cure indeed.

Page Down to advance the presentation
57
Supply Side vs. Keynesianism
Ron Kahr 89

• The supply side approach looks similar to the
  1960s Keynesian tax cut.
• Supply siders did not agree that such a tax cut
  would necessarily cause inflation.

58
A Behavioral Difference

• Supply siders believed people would work harder
  and invest more if they were allowed to keep
  more.
• The end result would be to increase the amount of
  goods and services our economy could actually
  produce by pushing out the economys supply
  curve-- hence, supply side economics.

Page Down to advance the presentation
59
AS
P
P
AD'
Q
QP
Page Down to advance the presentation
60
The Laffer Curve

• Note that the Laffer Curve is backward
  bending--reflecting the behavioral notion that at
  some point people will work less the more they
  are taxed.

Page Down to advance the presentation
61
The Early 1980s

• The Reagan Administration simply assumed that the
  economy was on the backward bending portion of
  the Laffer Curve and that a tax cut would
  increase total tax revenues.
• Based on this assumption, it moved forward with
  one of the largest tax cuts in American history.

62
Reagonomics

• As the corporate tax rate was cut by 25 percent
  over 3 years, the top marginal tax rate on the
  wealthy fell from 50 to 38 percent.
• As part of its Reagonomics program, the
  Administration also cut back sharply on the
  regulation of everything from monopoly and
  oligopoly to pollution and product safety
  important elements that likewise affect the
  aggregate supply curve.

63
Did The Supply Side Experiment Work?

• The Reagan years witnessed significant declines
  in both inflation and interest rates while we
  enjoyed a record-long peacetime expansion and the
  economy roared back to full unemployment.
• As the economy boomed so did Americas budget
  deficit.
• And as the budget deficit soared, Americas trade
  deficit soared with it.

64
The Twin Deficits

• These so-called twin deficits deeply concerned
  Reagans successor George Bush, particularly
  after the budget deficit jumped over 200 billion
  at the midpoint of his term in 1990, and the
  economy began to slide into recession.

65
New Classicals

• To any Keynesian, this onset of recession would
  have been a clear signal to engage in
  expansionary policy.
• However, in the Bush White House, Ronald Reagans
  Supply Side advisors had been supplanted not by
  Keynesians but rather by a new breed of
  macroeconomic thinkers the so-called New
  Classicals who had abandoned the old theory of
  adaptive expectations in favor of a new
  behavioral model known as rational
  expectations.

66
Conclusion

• Well talk more about New Classical economics and
  rational expectations in the lecture on the
  warring schools of macroeconomics and we will
  also look much more closely at the twin deficits.

67
End of Lesson
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voice Ashley West Leonard