Issues in Macroeconomics Theory and policy

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to accompanyto accompanyExploring EconomicsExploring Economics

33rdrd Edition Editionby Robert L. Sextonby Robert L. Sexton

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A Lecture PresentationA Lecture Presentation


Issues in Macroeconomic Issues in Macroeconomic Theory and PolicyTheory and Policy

Chapter 25Chapter 25


25.1 The Phillips Curve25.1 The Phillips Curve

Periods of high unemployment still Periods of high unemployment still occur despite legislation committing occur despite legislation committing the federal government to the goal of the federal government to the goal of full employment and the development full employment and the development of macroeconomic theory purporting of macroeconomic theory purporting to show that full employment can be to show that full employment can be achieved by manipulating aggregate achieved by manipulating aggregate demand.demand.


Unemployment and InflationUnemployment and Inflation Similarly, price stability, which had Similarly, price stability, which had

been achieved for long periods before been achieved for long periods before the 1930s, has not been consistently the 1930s, has not been consistently observed since that time. observed since that time.

In every year in the lifetimes of most In every year in the lifetimes of most students enrolled in this course, the students enrolled in this course, the general level of prices has risen.general level of prices has risen.


We usually think of inflation as an We usually think of inflation as an evil. evil.

But some economists believe that But some economists believe that inflation could actually help eliminate inflation could actually help eliminate unemployment in the short run.unemployment in the short run.


If output prices rise but money wages do If output prices rise but money wages do not go up as quickly or as much, real wages not go up as quickly or as much, real wages fall. fall.

At the lower real wage, unemployment is At the lower real wage, unemployment is less because the lower wage makes it less because the lower wage makes it profitable to hire more, now cheaper, profitable to hire more, now cheaper, employees than before.employees than before.

Hence, with increased inflation, one might Hence, with increased inflation, one might expect lower unemployment in the short expect lower unemployment in the short run. run.


The Phillips CurveThe Phillips Curve An inverse relationship between the rate of An inverse relationship between the rate of

unemployment and the changing level of unemployment and the changing level of prices has been observed in many periods prices has been observed in many periods and places in history. and places in history.

Credit for identifying this relationship Credit for identifying this relationship generally goes to British economist A.H. generally goes to British economist A.H. Phillips.Phillips. In the late 1950s he published a paper setting In the late 1950s he published a paper setting

forth what has since been called the Phillips forth what has since been called the Phillips curve. curve.


Phillips, and many others since, have Phillips, and many others since, have suggested that suggested that at higher rates of inflation, the rate of at higher rates of inflation, the rate of

unemployment is lower, unemployment is lower, while during periods of relatively or falling while during periods of relatively or falling

stable prices, there is substantial stable prices, there is substantial unemployment.unemployment.

The cost of lower unemployment appears The cost of lower unemployment appears to be greater inflation, and the cost of to be greater inflation, and the cost of greater price stability appears to be higher greater price stability appears to be higher unemployment.unemployment.


The actual inflation-unemployment The actual inflation-unemployment relationship for the United States for relationship for the United States for the 1960s is shown in the next slide.the 1960s is shown in the next slide.

U.S. Phillips curve U.S. Phillips curve The curved line is the smooth line that The curved line is the smooth line that

best “fits” the data points.best “fits” the data points.


The Slope of the Phillips CurveThe Slope of the Phillips Curve

It shows an inverse relationship It shows an inverse relationship between the rate of unemployment between the rate of unemployment and the rate of inflation. and the rate of inflation.

The Phillips curve is steeper at higher The Phillips curve is steeper at higher rates of inflation and lower levels of rates of inflation and lower levels of unemployment.unemployment.


This suggests that once the economy This suggests that once the economy has relatively low unemployment rates, has relatively low unemployment rates, further reductions in the unemployment further reductions in the unemployment rate can occur only by accepting larger rate can occur only by accepting larger increases in the inflation rate. increases in the inflation rate.

Once unemployment is low, it takes Once unemployment is low, it takes larger and larger doses of inflation to larger and larger doses of inflation to eliminate a given quantity of eliminate a given quantity of unemployment.unemployment.


Presumably, at lower unemployment Presumably, at lower unemployment rates, an increased part of the economy is rates, an increased part of the economy is already operating at or near full capacity, already operating at or near full capacity, and further fiscal or monetary stimulus and further fiscal or monetary stimulus primarily triggers primarily triggers inflationary pressures in sectors already at inflationary pressures in sectors already at

capacity, capacity, while eliminating decreasing amounts of while eliminating decreasing amounts of

unemployment in those sectors where some unemployment in those sectors where some excess capacity and unemployment still exist.excess capacity and unemployment still exist.


The Phillips Curve and Aggregate The Phillips Curve and Aggregate Supply and DemandSupply and Demand

The relationship between The relationship between ASAS and and ADAD analysis and the Phillips curve analysis and the Phillips curve Increased annual inflation lowering Increased annual inflation lowering

unemployment is a move up along the Phillips unemployment is a move up along the Phillips curve.curve.

We can see the same relationship in We can see the same relationship in ADAD//ASAS model, as a result of an AD shift.model, as a result of an AD shift.

Increasing Increasing ADAD, moving up along an upward-sloping, , moving up along an upward-sloping, short-run short-run ASAS curve, increases the price level and real curve, increases the price level and real output. output.

To increase real output, firms employ more To increase real output, firms employ more workers, so employment increases and workers, so employment increases and unemployment falls.unemployment falls.


25.2 The Phillips Curve Over Time25.2 The Phillips Curve Over Time

In the 1960s it became widely In the 1960s it became widely accepted that policy makers merely accepted that policy makers merely had to decide on the combination of had to decide on the combination of unemployment and inflation they unemployment and inflation they wanted from the Phillips curve and wanted from the Phillips curve and then simply pursue the appropriate then simply pursue the appropriate economic policies. economic policies.


The Phillips Curve—The 1960sThe Phillips Curve—The 1960s

A reduction in the rate of unemployment A reduction in the rate of unemployment came at a cost (more inflation) as did a came at a cost (more inflation) as did a reduction in the amount of inflation reduction in the amount of inflation (more unemployment).(more unemployment).

Nonetheless, policy makers believed Nonetheless, policy makers believed they could influence economic activity they could influence economic activity in a manner in which some goal could be in a manner in which some goal could be met, though with a trade-off in terms of met, though with a trade-off in terms of other macroeconomic goals. other macroeconomic goals.


At first the empirical evidence on At first the empirical evidence on prices and unemployment fit the prices and unemployment fit the Phillips curve approach so beautifully Phillips curve approach so beautifully that it is not surprising that it was that it is not surprising that it was embraced so rapidly and completely. embraced so rapidly and completely.


Economists like Milton Friedman and Economists like Milton Friedman and Edmund Phelps, who questioned the Edmund Phelps, who questioned the long-term validity of the Phillips long-term validity of the Phillips curve, were largely ignored in the curve, were largely ignored in the 1960s. 1960s.


These economists believed there These economists believed there might be a short-term trade-off might be a short-term trade-off between unemployment and inflation, between unemployment and inflation, but not a permanent trade-off. but not a permanent trade-off.

According to Friedman, the short-run According to Friedman, the short-run trade-off comes from trade-off comes from unanticipatedunanticipated inflation.inflation.


Is The Phillips Curve Stable?Is The Phillips Curve Stable?

In the 1970s (and 1980s and 1990s), In the 1970s (and 1980s and 1990s), economists recognized that economists recognized that macroeconomic decision making was macroeconomic decision making was not as simple as picking a point on not as simple as picking a point on the Phillips curve. the Phillips curve.

The data from the 1970s showed the The data from the 1970s showed the Phillips curve started to break down. Phillips curve started to break down.


From 1974 through 1996, every data From 1974 through 1996, every data point was to the right of the 1960s point was to the right of the 1960s Phillips curve, meaning a worsening Phillips curve, meaning a worsening trade-off between inflation and trade-off between inflation and unemployment.unemployment.


The 1970s experienced more of both The 1970s experienced more of both inflation and unemployment than inflation and unemployment than existed in the 1960s. existed in the 1960s.

However, in the 1980s, the Fed However, in the 1980s, the Fed followed a very tight monetary policy followed a very tight monetary policy to combat high inflation rates.to combat high inflation rates.


People altered their expectations of People altered their expectations of inflation downward. inflation downward.

In the mid-1990s, when lower inflation In the mid-1990s, when lower inflation was achieved and expected, the was achieved and expected, the Phillips curve shifted inward, Phillips curve shifted inward, back to the level of the 1960s.back to the level of the 1960s.


The Short-Run Phillips Curve Versus The Short-Run Phillips Curve Versus The Long-Run Phillips CurveThe Long-Run Phillips Curve

The The natural rate hypothesisnatural rate hypothesis states states that the economy will self-correct to that the economy will self-correct to the natural rate of unemployment.the natural rate of unemployment.


The long-run Phillips curve shows the The long-run Phillips curve shows the relationship between the inflation rate relationship between the inflation rate and the unemployment rate when the and the unemployment rate when the actual and expected inflation rates are actual and expected inflation rates are the same. the same.

The long-run Phillips curve is vertical The long-run Phillips curve is vertical at the natural rate of unemployment.at the natural rate of unemployment.

This is equivalent to the vertical long-This is equivalent to the vertical long-run run ASAS curve. curve.


Along the long-run Phillips curve we Along the long-run Phillips curve we see that the natural rate of see that the natural rate of unemployment can occur at any rate unemployment can occur at any rate of inflation.of inflation.

That is, regardless of fiscal and That is, regardless of fiscal and monetary stimulus, output and monetary stimulus, output and employment will be at their natural employment will be at their natural rate in the long run.rate in the long run.


Starting from the natural rate of Starting from the natural rate of unemployment, suppose that the growth unemployment, suppose that the growth rate of the money supply increases.rate of the money supply increases. If it is unanticipated, it will stimulate aggregate If it is unanticipated, it will stimulate aggregate

demand.demand. In the short-run, the increase in aggregate In the short-run, the increase in aggregate

demand will increase output and decrease demand will increase output and decrease unemployment below the natural rate as the unemployment below the natural rate as the economy moves up along the short-run Phillips economy moves up along the short-run Phillips curve, increasing the actual inflation rate.curve, increasing the actual inflation rate.


However, over time, people adjust to However, over time, people adjust to the new inflation rate and the short-run the new inflation rate and the short-run Phillips curve shifts to the right. Phillips curve shifts to the right.

If the higher inflation rate continues, the If the higher inflation rate continues, the adjustment of expectations will move adjustment of expectations will move the economy to where the expected and the economy to where the expected and actual inflation rates are equal at the actual inflation rates are equal at the natural level of output and the natural natural level of output and the natural rate of unemployment. rate of unemployment.


This reveals that there is no trade-off This reveals that there is no trade-off between the inflation rate and the between the inflation rate and the unemployment rate in the long run. unemployment rate in the long run.

The policy implication is that the use of The policy implication is that the use of fiscal or monetary policy to alter real fiscal or monetary policy to alter real output from the natural level of real output from the natural level of real output or unemployment from the output or unemployment from the natural rate of unemployment is natural rate of unemployment is ineffective in the long run.ineffective in the long run.


Say there was a decrease in the rate Say there was a decrease in the rate of growth in the money supply.of growth in the money supply. If unanticipated, it would reduce If unanticipated, it would reduce

aggregate demand. aggregate demand. In the short-run, the decrease in In the short-run, the decrease in

aggregate demand moves the economy aggregate demand moves the economy down along the short-run Phillips curve, down along the short-run Phillips curve, where the actual inflation rate has where the actual inflation rate has decreased and the unemployment rate decreased and the unemployment rate has risen above the natural rate. has risen above the natural rate.


The decrease in aggregate demand has led The decrease in aggregate demand has led to lower production and to a fall in to lower production and to a fall in employment.employment.

When people recognize that prices are not When people recognize that prices are not rising as rapidly as before, they adjust their rising as rapidly as before, they adjust their expectations to reflect that fact, and the expectations to reflect that fact, and the short-run Phillips curve shifts downward.short-run Phillips curve shifts downward.

The inflation rate is now lower and The inflation rate is now lower and unemployment and output have returned to unemployment and output have returned to their natural rates. their natural rates.


In this scenario, the economy’s road to In this scenario, the economy’s road to lower inflation rates has come at the lower inflation rates has come at the expense of higher unemployment in the expense of higher unemployment in the short run, until people’s expectations short run, until people’s expectations adapt to the new lower inflation rate in adapt to the new lower inflation rate in the long run.the long run.

These expectations are called These expectations are called adaptiveadaptive expectationsexpectations—individuals believe that —individuals believe that the best indicator of the future is recent the best indicator of the future is recent information on inflation and information on inflation and unemployment.unemployment.


Supply ShocksSupply Shocks Changes in the expected inflation rate can Changes in the expected inflation rate can

shift the short-run Phillips curve. shift the short-run Phillips curve. So can supply shocks. So can supply shocks. An adverse supply shock, such as higher An adverse supply shock, such as higher

energy prices, causes a leftward shift in the energy prices, causes a leftward shift in the SRASSRAS curve, with a higher price level and curve, with a higher price level and lower RGDP stagflation.lower RGDP stagflation.

But the higher inflation rate and higher But the higher inflation rate and higher unemployment rate that result shift the unemployment rate that result shift the short-run Phillips curve to the right. short-run Phillips curve to the right.


A favorable supply shock, causes a A favorable supply shock, causes a rightward shift in the SRAS curve with rightward shift in the SRAS curve with a lower price level and higher RGDP. a lower price level and higher RGDP. example: lower energy pricesexample: lower energy prices

But the lower inflation rate and lower But the lower inflation rate and lower unemployment rate that result shift unemployment rate that result shift the short-run Phillips curve to the left. the short-run Phillips curve to the left.


The impact of adverse or favorable The impact of adverse or favorable shocks depend on expectations. shocks depend on expectations.

If people expect the changes to be If people expect the changes to be permanent, then the shifted Phillips permanent, then the shifted Phillips curve will stay in the new position until curve will stay in the new position until something else happens. something else happens.

If the shock is expected to be If the shock is expected to be temporary, the Phillips curve will soon temporary, the Phillips curve will soon shift back to its original position.shift back to its original position.


If economic fluctuations are expected to If economic fluctuations are expected to be permanent and are caused primarily be permanent and are caused primarily by supply-side shifts, then there may be by supply-side shifts, then there may be a positive relationship between the a positive relationship between the inflation rate and the unemployment inflation rate and the unemployment rate—a shifting Phillips curve.rate—a shifting Phillips curve.

Higher rates of inflation will be coupled Higher rates of inflation will be coupled with higher rates of unemployment and with higher rates of unemployment and lower rates of inflation will be coupled lower rates of inflation will be coupled with lower rates of unemployment.with lower rates of unemployment.


25.3 Rational Expectations25.3 Rational Expectations Is it possible that people can anticipate Is it possible that people can anticipate

the plans of policy makers and alter the plans of policy makers and alter their behavior quickly, to neutralize the their behavior quickly, to neutralize the intended impact of government action?intended impact of government action? For example, if workers see that the For example, if workers see that the

government is allowing the money supply government is allowing the money supply to expand rapidly, they may quickly to expand rapidly, they may quickly demand higher money wages in order to demand higher money wages in order to offset the anticipated inflation.offset the anticipated inflation.


Can Human Behavior Counteract Can Human Behavior Counteract Government Policy?Government Policy?

In the extreme form, if people could In the extreme form, if people could instantly recognize and respond to instantly recognize and respond to government policy changes, it might be government policy changes, it might be impossible to alter real output or impossible to alter real output or unemployment levels through policy unemployment levels through policy actions unless they can surprise actions unless they can surprise consumers and businesses. consumers and businesses.

An increasing number of economists An increasing number of economists believe that there is at least some truth believe that there is at least some truth to this point of view. to this point of view.


At a minimum, most economists At a minimum, most economists accept the notion that real output and accept the notion that real output and the unemployment rate cannot be the unemployment rate cannot be altered with the ease that was earlier altered with the ease that was earlier believed; some believe that the believed; some believe that the unemployment rate can seldom be unemployment rate can seldom be influenced by fiscal and monetary influenced by fiscal and monetary policies.policies.


The Rational Expectations TheoryThe Rational Expectations Theory

The relatively new extension of The relatively new extension of economic theory that leads to this economic theory that leads to this rather pessimistic conclusion rather pessimistic conclusion regarding macroeconomic policy’s regarding macroeconomic policy’s ability to achieve our economic goals ability to achieve our economic goals is called the is called the theory of rational theory of rational expectationsexpectations..


The notion that expectations or The notion that expectations or anticipations of future events are relevant anticipations of future events are relevant to economic theory is not new; for decades to economic theory is not new; for decades economists have incorporated expectations economists have incorporated expectations into models analyzing many forms of into models analyzing many forms of economic behavior. economic behavior.

Only in the recent past, however, has a Only in the recent past, however, has a theory evolved that tries to incorporate theory evolved that tries to incorporate expectations as a central factor in the expectations as a central factor in the analysis of the entire economy.analysis of the entire economy.


Rational expectation economists Rational expectation economists believe that wages and prices are believe that wages and prices are flexible, and that workers and flexible, and that workers and consumers incorporate the likely consumers incorporate the likely consequences of government policy consequences of government policy changes quickly into their changes quickly into their expectations.expectations.


In addition, rational expectation In addition, rational expectation economists believe that the economy is economists believe that the economy is inherently stable after macroeconomic inherently stable after macroeconomic shocks, and that tinkering with fiscal shocks, and that tinkering with fiscal and monetary policy cannot have the and monetary policy cannot have the desired effect unless consumers and desired effect unless consumers and workers are caught off-guard (and workers are caught off-guard (and catching them off-guard gets harder the catching them off-guard gets harder the more you try to do it).more you try to do it).


Rational Expectations and the Consequences Rational Expectations and the Consequences of Government Macroeconomic Policiesof Government Macroeconomic Policies

Rational expectations theory suggests that Rational expectations theory suggests that government economic policies designed to government economic policies designed to alter aggregate demand to meet alter aggregate demand to meet macroeconomic goals are of very limited macroeconomic goals are of very limited effectiveness.effectiveness.

When policy targets become public, it is When policy targets become public, it is argued, people will alter their own behavior argued, people will alter their own behavior from what it would otherwise have been, from what it would otherwise have been, and, in so doing, they largely negate the and, in so doing, they largely negate the intended impact of policy changes.intended impact of policy changes.


If government policy seems tilted If government policy seems tilted towards permitting more inflation in towards permitting more inflation in order to try to reduce unemployment, order to try to reduce unemployment, people start spending their money people start spending their money faster than before, become more faster than before, become more adamant in their wage and other adamant in their wage and other input price demands, and so on. input price demands, and so on.


In the process of quickly altering their In the process of quickly altering their behavior to reflect the likely behavior to reflect the likely consequences of policy changes, they consequences of policy changes, they make it more difficult (costly) for make it more difficult (costly) for government authorities to meet their government authorities to meet their macroeconomic objectives.macroeconomic objectives.


Rather than fooling people into changing Rather than fooling people into changing real wages, and therefore unemployment, real wages, and therefore unemployment, with inflation “surprises,” changes in with inflation “surprises,” changes in inflation are quickly reflected into inflation are quickly reflected into expectations with little or no effect on expectations with little or no effect on unemployment or real output even in the unemployment or real output even in the short run. short run.

As a consequence, policies intended to As a consequence, policies intended to reduce unemployment through stimulating reduce unemployment through stimulating aggregate demand will often fail to have aggregate demand will often fail to have the intended effect. the intended effect.


Fiscal and monetary policy, according Fiscal and monetary policy, according to this view, will work only if the to this view, will work only if the people are caught off-guard or fooled people are caught off-guard or fooled by policies so that they do not modify by policies so that they do not modify their behavior in a way that reduces their behavior in a way that reduces policy effectiveness.policy effectiveness.


Anticipation of an Expansionary Anticipation of an Expansionary Monetary PolicyMonetary Policy

In the case of an expansionary In the case of an expansionary monetary policy, monetary policy, ADAD will shift to the will shift to the right. right.

As a result of anticipating the As a result of anticipating the predictable inflationary predictable inflationary consequences of that expansionary consequences of that expansionary policy, the price level will policy, the price level will immediately adjust to a new higher immediately adjust to a new higher price level.price level.


Consumers, producers, workers, and Consumers, producers, workers, and lenders who have anticipated the lenders who have anticipated the effects of the expansionary policy effects of the expansionary policy simply built the higher inflation rates simply built the higher inflation rates into their product prices, wages, and into their product prices, wages, and interest rates because they realize interest rates because they realize that expansionary monetary policy that expansionary monetary policy can cause inflation if the economy is can cause inflation if the economy is working close to capacity. working close to capacity.


Consequently, in an effort to protect Consequently, in an effort to protect themselves from the higher themselves from the higher anticipated inflation, workers ask for anticipated inflation, workers ask for higher wages, suppliers increase higher wages, suppliers increase input prices, and producers raise their input prices, and producers raise their product prices.product prices.


Because wages, prices, and interest Because wages, prices, and interest rates are assumed to be flexible, the rates are assumed to be flexible, the adjustments take place immediately. adjustments take place immediately.

This increase in input costs for wages, This increase in input costs for wages, interest, and raw materials causes the interest, and raw materials causes the aggregate supply curve to also shift aggregate supply curve to also shift up or leftward. up or leftward.


So the desired policy effect of greater So the desired policy effect of greater real output and reduced real output and reduced unemployment from a shift in the unemployment from a shift in the aggregate demand curve is offset by aggregate demand curve is offset by an upward or leftward shift in the an upward or leftward shift in the aggregate supply curve caused by an aggregate supply curve caused by an increase in input costs.increase in input costs.


Unanticipated Expansionary PolicyUnanticipated Expansionary Policy An unanticipated increase in An unanticipated increase in ADAD as a as a

result of an expansionary monetary policy result of an expansionary monetary policy stimulates output and employment in the stimulates output and employment in the short run. short run.

The output is beyond the full employment The output is beyond the full employment level, and so is not sustainable in the long level, and so is not sustainable in the long run. run.

The price level ends up higher than The price level ends up higher than workers and other input owners expected. workers and other input owners expected.


However, when they eventually However, when they eventually realize that the price level has realize that the price level has changed, they will require higher changed, they will require higher input prices, shifting input prices, shifting SRASSRAS left to a left to a new long-run equilibrium at full new long-run equilibrium at full employment and a higher price level.employment and a higher price level.


In the short run, the policy expands In the short run, the policy expands output and employment, but only output and employment, but only increases the price level inflation in increases the price level inflation in the long run.the long run.


A correctly anticipated increase in A correctly anticipated increase in ADAD from expansionary monetary or fiscal from expansionary monetary or fiscal policy will not change real output or policy will not change real output or unemployment even in the short run. unemployment even in the short run.

The only effect is an immediate The only effect is an immediate change in the price level. change in the price level.


The only way that monetary or fiscal The only way that monetary or fiscal policy can change output in the policy can change output in the rational expectations model is with a rational expectations model is with a surprise—an unanticipated change.surprise—an unanticipated change.


When an Anticipated Expansionary Policy When an Anticipated Expansionary Policy Change is Less Than the Actual Policy ChangeChange is Less Than the Actual Policy Change

In the rational expectations model, when In the rational expectations model, when people expect a larger increase in people expect a larger increase in ADAD than than actually results from a policy change (say, actually results from a policy change (say, from a smaller increase in the money from a smaller increase in the money supply than expected), it leads to a higher supply than expected), it leads to a higher price level and a lower level of RGDP—a price level and a lower level of RGDP—a recession. recession.

A policy designed to A policy designed to increaseincrease output may output may actually actually reducereduce output if prices and wages output if prices and wages are flexible and the expansionary effect is are flexible and the expansionary effect is less than people anticipated.less than people anticipated.


Critics of Rational Expectations Critics of Rational Expectations TheoryTheory

Rational expectations theory does Rational expectations theory does have its critics. have its critics. Critics want to know if consumers and Critics want to know if consumers and

producers are completely informed about producers are completely informed about the impact that say, an increase in money the impact that say, an increase in money supply will have on the economy.supply will have on the economy.

In general, not all citizens will be completely In general, not all citizens will be completely informed, but key players like corporations, informed, but key players like corporations, financial institutions, and labor organizations financial institutions, and labor organizations may well be informed about the impact of may well be informed about the impact of these policy changes. these policy changes.


Are wages and other input prices Are wages and other input prices really that flexible? really that flexible? Even if decision makers could anticipate Even if decision makers could anticipate

the eventual effect of policy changes on the eventual effect of policy changes on prices, prices may still be slow to adapt prices, prices may still be slow to adapt (e.g., what if you had just signed a three-(e.g., what if you had just signed a three-year labor or supply contract when the year labor or supply contract when the new policy is implemented?).new policy is implemented?).


Many economists reject the extreme Many economists reject the extreme rational expectations model of rational expectations model of complete wage and price flexibility.complete wage and price flexibility.

Most still believe there is a short-run Most still believe there is a short-run trade-off between inflation and trade-off between inflation and unemployment.unemployment.


The reason is that some input prices The reason is that some input prices are slow to adjust to changes in the are slow to adjust to changes in the price level.price level.

In the long run, the expected inflation In the long run, the expected inflation rate adjusts to changes in the actual rate adjusts to changes in the actual inflation rate at the natural rate of inflation rate at the natural rate of unemployment.unemployment.


25.4 Wage and Price Controls 25.4 Wage and Price Controls and Indexing and Indexing

If monetary and fiscal policy are If monetary and fiscal policy are ineffective or counterproductive, what ineffective or counterproductive, what policies are left to control inflation? policies are left to control inflation?

It is possible that the federal It is possible that the federal government could set up a government could set up a comprehensive program over wages comprehensive program over wages and prices—often called and prices—often called incomes incomes policypolicy..


Purpose of Wage and Price ControlsPurpose of Wage and Price Controls

We have imposed such controls three We have imposed such controls three times in modern American history: times in modern American history: during World War IIduring World War II during the Korean Warduring the Korean War in 1971 near the end of the Vietnam Warin 1971 near the end of the Vietnam War


Wage and price controls involve Wage and price controls involve either either a complete freeze on wages and prices a complete freeze on wages and prices

at pre‑control levels or at pre‑control levels or some rigid limits as to the increases in some rigid limits as to the increases in

wages and prices that will be permitted. wages and prices that will be permitted. One or more government agencies are One or more government agencies are

created to monitor the program.created to monitor the program.


Implementing Price Controls Implementing Price Controls Without Government RegulationWithout Government Regulation

Sometimes voluntary guidelines or Sometimes voluntary guidelines or guideposts are established to avoid forcing guideposts are established to avoid forcing companies and unions to limit their price companies and unions to limit their price and wage levels.and wage levels. This approach avoids the expense and political This approach avoids the expense and political

acrimony associated with establishing a control acrimony associated with establishing a control bureaucracy. bureaucracy.

Sometimes the “jawboning” gets pretty intense.Sometimes the “jawboning” gets pretty intense. Such guidelines can come close to being Such guidelines can come close to being

mandatory controls.mandatory controls.


Justifications for Wage and Justifications for Wage and Price ControlsPrice Controls

There are two justifications given for wage There are two justifications given for wage and price controls.and price controls. By limiting price increases by law, the By limiting price increases by law, the

government directly reduces the rate of inflation government directly reduces the rate of inflation legally allowed. legally allowed.

Especially with respect to wage controls, it is Especially with respect to wage controls, it is argued that wage and price controls lower the argued that wage and price controls lower the inflationary expectations of workers and their inflationary expectations of workers and their unions, reducing the “inflation psychology” unions, reducing the “inflation psychology” that contributes to cost‑push inflation.that contributes to cost‑push inflation.


If Wage and Price Controls Have These If Wage and Price Controls Have These Advantages, Why Are They Not Used More Often?Advantages, Why Are They Not Used More Often?

Wage and price controls have several Wage and price controls have several major disadvantages, which are very major disadvantages, which are very likely to be viewed as greater than likely to be viewed as greater than the advantages, except possibly the advantages, except possibly during wartime situations when during wartime situations when aggregate demand is growing very aggregate demand is growing very rapidly. rapidly.


There is the problem of enforcing the There is the problem of enforcing the controls.controls.

Black markets (illegal sales) often Black markets (illegal sales) often develop. develop.

These problems are often very hard These problems are often very hard to solve.to solve.


Another, even more fundamental Another, even more fundamental problem with wage and price controls problem with wage and price controls is that they lead to shortages of is that they lead to shortages of goods, services, and workers.goods, services, and workers.

Inflationary pressures are not Inflationary pressures are not eradicated but rather disguised, eradicated but rather disguised, manifesting themselves not in price manifesting themselves not in price increases but in the lack of desired increases but in the lack of desired goods or human resources. goods or human resources.


Severe and prolonged controls can Severe and prolonged controls can lead to a very serious misallocation lead to a very serious misallocation of resources, as a result.of resources, as a result.


Straightforward supply and demand Straightforward supply and demand analysis indicates the misallocation analysis indicates the misallocation of resources due to wage and price of resources due to wage and price controls. controls.

At the legal price ceiling, the quantity At the legal price ceiling, the quantity demanded exceeds the quantity demanded exceeds the quantity supplied and shortages arise.supplied and shortages arise.

Price Controls Lead to a Price Controls Lead to a Misallocation of ResourcesMisallocation of Resources


Examples of Problems With Examples of Problems With Price ControlsPrice Controls

Problems with price controls are Problems with price controls are illustrated by the 1973 Arab oil illustrated by the 1973 Arab oil boycott, when the federal boycott, when the federal government imposed price ceilings on government imposed price ceilings on gasoline that prevented gas prices gasoline that prevented gas prices from rising as they normally would from rising as they normally would have in response to reduced supply.have in response to reduced supply.


At the ceiling price, quantity demanded At the ceiling price, quantity demanded exceeded quantity supplied; gas stations exceeded quantity supplied; gas stations ran out of gas, were often closed, or ran out of gas, were often closed, or placed a limit on the amount of gas they placed a limit on the amount of gas they would sell. would sell.

When drivers were able to buy gas, they When drivers were able to buy gas, they often not only filled their tanks but also often not only filled their tanks but also several containers they carried along to several containers they carried along to reduce the risk of being unable to buy gas reduce the risk of being unable to buy gas when they needed it.when they needed it.


In the former Soviet Union, where In the former Soviet Union, where price-control‑related shortages were price-control‑related shortages were commonplace, citizens typically commonplace, citizens typically carried briefcases or even suitcases carried briefcases or even suitcases and large quantities of cash, in case and large quantities of cash, in case they were able to purchase a they were able to purchase a normally unavailable good. normally unavailable good.


Rather than just buy the product for Rather than just buy the product for themselves, they would buy several themselves, they would buy several items for their friends and relatives as items for their friends and relatives as well, to keep them from having to well, to keep them from having to stand in line for hours, often in vain, stand in line for hours, often in vain, trying to buy it.trying to buy it.


Examples of Problems Created Examples of Problems Created by Wage Controlsby Wage Controls

In the case of prolonged wage controls, In the case of prolonged wage controls, shortages of personnel can occur. shortages of personnel can occur. Wages serve as market signals. Wages serve as market signals. Rising wages in an occupation increases an Rising wages in an occupation increases an

occupation's attractiveness, leading to new occupation's attractiveness, leading to new entrants of workers. entrants of workers.

If the government decrees that salaries in that If the government decrees that salaries in that field could not rise enough, the increase in the field could not rise enough, the increase in the quantity of new workers supplied will not occur quantity of new workers supplied will not occur and a shortage will arise.and a shortage will arise.


Whether the gains from wage and Whether the gains from wage and price controls in the form of reduced price controls in the form of reduced inflation outweigh the costs in the inflation outweigh the costs in the form of shortages and inefficient form of shortages and inefficient resource allocation is debatable. resource allocation is debatable.

This is a normative issue where This is a normative issue where honest, informed people can differ honest, informed people can differ in their perceptions of costs and in their perceptions of costs and benefits.benefits.


An example was the debate over the An example was the debate over the removal of price controls on natural gas.removal of price controls on natural gas. One side argued that controls should be One side argued that controls should be

removed to end shortages and enhance removed to end shortages and enhance long‑term supply. long‑term supply.

The other side argued that removing controls The other side argued that removing controls would lead to inflated prices for gas and would lead to inflated prices for gas and inflated profits for gas producers, while inflated profits for gas producers, while causing hardships to lower income users of causing hardships to lower income users of gas.gas.


Keeping Prices Down Without Keeping Prices Down Without the Use of Price Controlsthe Use of Price Controls

The attempt to control prices The attempt to control prices politically can take another form. politically can take another form.

The presence of monopolistic The presence of monopolistic elements in an industry can lead to elements in an industry can lead to higher prices for that industry’s higher prices for that industry’s products than would be the case for products than would be the case for a more competitive industry. a more competitive industry.


By stimulating price competition among By stimulating price competition among private firms, the government may be private firms, the government may be able to help in reducing inflationary able to help in reducing inflationary pressures.pressures.

However, there has been relatively little However, there has been relatively little actual use of antitrust laws to try to actual use of antitrust laws to try to reduce inflation pressures. Moreover, reduce inflation pressures. Moreover, monopoly power can also be artificially monopoly power can also be artificially created by government regulations.created by government regulations.


Could Indexing Reduce the Could Indexing Reduce the Costs of Inflation?Costs of Inflation?

Another approach to some of the Another approach to some of the problems posed by inflation is problems posed by inflation is indexingindexing. .

Inflation poses substantial equity Inflation poses substantial equity and distributional problems only and distributional problems only when it is unanticipated or when it is unanticipated or unexpected. unexpected.


One means of protecting parties One means of protecting parties against unanticipated price increases against unanticipated price increases is to write contracts that is to write contracts that automatically change prices of goods automatically change prices of goods or services whenever the overall price or services whenever the overall price level changes, effectively rewriting level changes, effectively rewriting agreements in terms of dollars of agreements in terms of dollars of constant purchasing power.constant purchasing power.


By making as many contracts as By making as many contracts as possible payable in dollars of constant possible payable in dollars of constant purchasing power, those involved can purchasing power, those involved can protect themselves against protect themselves against unanticipated changes in inflation.unanticipated changes in inflation.


Why Isn’t Indexing More Why Isn’t Indexing More Extensively Used?Extensively Used?

Indexing seems to eliminate most of Indexing seems to eliminate most of the wealth transfers associated with the wealth transfers associated with unexpected inflation. Why then is it unexpected inflation. Why then is it not more commonly used?not more commonly used?

One main argument against indexing One main argument against indexing is that it could worsen inflation.is that it could worsen inflation.


As prices go up, wages and certain As prices go up, wages and certain other contractual obligations would other contractual obligations would also automatically increase. also automatically increase. e.g., rents e.g., rents

This immediate and comprehensive This immediate and comprehensive reaction to price increases will lead reaction to price increases will lead to greater inflationary pressures.to greater inflationary pressures.


Other Problems Associated Other Problems Associated With IndexingWith Indexing

If inflation gets bad enough, it may If inflation gets bad enough, it may become almost impossible become almost impossible administratively to maintain the administratively to maintain the indexing scheme. indexing scheme.

There are other inefficiencies, as well. There are other inefficiencies, as well.


During the German hyperinflation of the During the German hyperinflation of the early 1920s, prices at one point rose so early 1920s, prices at one point rose so rapidly that workers demanded to be paid rapidly that workers demanded to be paid twice a day, at noon and at the end of twice a day, at noon and at the end of work. work.

During their lunch hour, workers would During their lunch hour, workers would rush money home to their wives, who rush money home to their wives, who would then run out and buy real goods would then run out and buy real goods before price increases further eroded before price increases further eroded purchasing power.purchasing power.


Indexing also reduces the ability for Indexing also reduces the ability for relative price changes to allocate relative price changes to allocate resources where they are more resources where they are more valuable. valuable.


Not everything can be indexed, so Not everything can be indexed, so indexing would cause wealth indexing would cause wealth redistribution plus the cost of redistribution plus the cost of negotiating cost of living (COLA) negotiating cost of living (COLA) clauses.clauses.

Excessive inflation leads to great Excessive inflation leads to great inefficiency, as well as a loss of inefficiency, as well as a loss of confidence in the issuer of money, confidence in the issuer of money, namely the government. namely the government.

Issues in Macroeconomics Theory and policy

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