Price Theory Inflation and Unemoloyment

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    Price Theory: First Edition

    Chapter 22

    Inflation and Unemployment

    [Note: This chapter was dropped in the second edition]

    An adequate discussion of the nature, causes, and cures of inflation andunemployment requires not a chapter but a book. My purpose here is to show how theideas developed in this book would provide the groundwork for that one. I start, inPart 1, by explaining what inflation is, why it occurs, and what its consequences are.Part 2 discusses the nature and causes of unemployment. Part 3 will combine elementsof Parts 1 and 2 with ideas from earlier chapters in order to suggest reasons why

    governments often follow policies that lead to inflation.

    PART 1--INFLATION

    The prices we have discussed so far are relative prices: the price of oranges measuredin apples, of houses measured in cookies, and the like. If we are talking about relativeprices, it makes not sense to say that "prices in general" are going up. If the price oforanges measured in apples is going up, the price of apples measured in oranges must

    be going down, since one is the inverse of the other. If a house used to cost a millioncookies and now costs two million, the price of houses measured in cookies hasdoubled--but the price of cookies measured in houses has fallen in half, from onemillionth of a house per cookie to one two-millionth.

    People who complain about inflation and say that "All prices are going up" are talkingabout money prices --prices of goods measured in money. During an inflation, theprices of goods measured in other goods may go up, down, or stay the same--but themoney prices of most goods are going up.

    If the prices of one or two goods, measured in money, go up, the reason may be somespecial circumstance affecting those goods: a bad apple harvest or a fire that hasburned down half the houses in a city. If the money prices of almost all goods aregoing up, it is far more likely that the cause involves, not the goods, but the money inwhich their prices are all being measured. One way of describing such a situation is tosay that the money prices of apples, oranges, houses, cookies, and many other thingsare going up. A simpler way is to say that the price of money is going down. If apples

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    used to cost $.50 and now cost $1, then the price of a dollar has fallen--from twoapples to one. During an inflation, the price of goods is rising in terms of one of thethings in which it can be measured--money. The price of money is falling in terms ofalmost all the things in which it can be measured.

    The Price of Money

    The price of money is determined, like the price of everything else, by supply anddemand. The quantity supplied is the amount of currency in circulation; thegovernment can increase the supply of money by printing more of it or decrease thesupply by collecting more money than it spends and burning the excess.

    Note that in economic language, the "supply of money" is the amount of money in

    circulation, not the rate at which new money is being produced. If no new money isprinted (and none wears out), the supply of money is constant, but not zero.If eachyear, the government prints one dollar for every ten in circulation, the supply ofmoney increases at 10 percent per year.

    What about the demand for money? That too is an amount of money, not a number ofdollars per year. Spending a dollar removes it from your pocket, but it does not use itup; someone else gets it. Your demand for money is not the amount you spend but theamount you hold. The total demand for money is the total amount that all of ustogether hold.

    Why do we hold money at all? If I arranged my life so that income and expenditureexactly matched, I would have no need to hold money; as soon as a dollar came in forsomething I had sold, it would go out again for something I bought. This is not theway I (or you) actually live. It is more convenient to arrange income and expenditureseparately in the short run, sometimes taking in more than we spend and sometimesspending more than we take in. When we take in more than we spend, our cashbalances go up; when we spend more than we take in, they go back down again. Thusmy cash balance functions as a sort of shock absorber.

    Demand is not a number but a relationship: quantity demanded as a function of price.The quantity of money demanded--the number of dollars you choose to hold--actuallydepends on two different prices. First, it depends on the price of money; the higher theprice of money--the more it can buy--the less you choose to hold, since the more adollar can buy, the fewer dollars you require to buy things with. Second, the amountof money you hold depends on the cost ofholding money.

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    Suppose I choose to hold, on average, a cash balance of $100. What I gain isflexibility in arranging my income and expenditures. What I lose is the interest Iwould have collected if, instead of holding $100 as currency, I had lent it out andcollected interest on it. So the cost of holding money is the money interest rate--alsocalled the nominal interest rate. The higher that interest rate--the more I could get for

    each dollar I lent out--the more expensive it is for me to hold currency, hence the lessI choose to hold.

    The distinction between the price of money and the cost of holding money--what wemight also describe as the renton money--is crucial to understanding how the generalprice level is determined, and confusion between the two is at the root of many of themore common economic mistakes. Theprice of money is what you must give up toget money; the higher the general price level (the amount of money you must give upto get something else), the lower the price of money. The costof holding money(more precisely, the cost of holding money measured in money, the number of dollarsper year you give up for each dollar you hold) is the nominal interest rate.

    There is one important respect in which the demand for money differs from thedemand for almost anything else. Since money is used to buy goods, the usefulness toyou of a particular bundle of money depends not on how many dollars it contains buton how much it will buy; if all (money) prices doubled, two dollars after the changewould be precisely as useful as one dollar before. Hence your demand is not really fora particular amount of money but for a particular amount ofpurchasing power. Whatyou want is a certain real cash balance, not a certain nominal cash balance.

    The Equilibrium Level of Prices

    This unusual characteristic of the demand for money turns out to be very useful inunderstanding how the price of money changes with changes in supply or demand.Suppose demand and supply for currency are initially in equilibrium. The number ofdollars individuals want to hold is equal to the total number of dollars available to beheld; quantity demanded equals quantity supplied. Suddenly the government decidesto double the money supply; the new dollars are printed up and distributed to the

    populace as a "free gift." What happens?

    Everyone has twice as much money as before. Since, before the change, people werealready holding as much currency as they wanted to, they now find themselves withmore currency than they want to hold. The obvious solution is to spend more thanthey take in, thus reducing their cash balances and converting the surplus into usefulgoods.

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    Oddly enough, this obvious solution cannot work. While each of us individually canreduce his cash balance by spending more than he takes in--buying more than he sells--all of us together cannot. If I buy something, I am buying it from someone else--whois selling it. If I get rid of my surplus currency by giving it to you in exchange forgoods, my cash balance falls but yours rises.

    What is even odder is that although we cannot reduce our nominal cash balances--thenumber of dollars we hold--the attempt to do so does reduce our real cash balances.Since we are all trying to buy more than we sell, on net the quantity of goodsdemanded is greater than the quantity supplied. If quantity demanded is greater thanquantity supplied, price rises. The rise in prices of goods (measured in money)corresponds to a fall in the value of money (measured in goods). We have just asmany dollars as before, but they are worth less. The process continues until real cashbalances are down to their desired level. Everyone has twice as many dollars as beforeand every dollar buys half as much as before; prices have doubled and nothing elsehas changed.

    Another way of understanding the same process is to think of all markets as moneymarkets. If you are selling goods for money, you are also buying money with goods; ifyou are buying goods with money, you are also selling money for goods. If actualcash balances are larger than desired cash balances, that means that the supply ofmoney is larger than the demand, so the price of money falls. It continues falling untilactual and desired cash balances are equal. In nominal terms, the fall in the price ofmoney raises desired cash balances until they equal actual cash balances. In realterms, the fall in the price of money lowers actual cash balances until they equaldesired cash balances.

    I have just described how equilibrium is established on the market for money--howquantity supplied and quantity demanded are made equal. In doing so, I have alsoshown how the general level of (money) prices is determined. The equilibrium pricelevel is that level at which the real value of the existing supply of money is equal tothe total desired real cash balances of the population. If prices are higher than that,then individuals are holding less cash (in terms of what it will buy) than they wish.They attempt to increase their cash balances by buying less than they sell; in theprocess, they drive prices down toward their equilibrium level. If prices are belowtheir equilibrium, the same process works in reverse to drive them back up. Thisdescription of how the general price level is determined and how it changes is asomewhat simplified one, mostly because I have not discussed what happens whilethe system is adjusting and have ignored interactions between prices and interest rates;but it is essentially correct, and it will be sufficient for the purposes of this chapter.

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    Inflation--The Changing Price of Money

    Suppose we observe that prices are rising. Since rising prices of goods (in money)correspond to a falling price of money (in goods), rising prices mean that either thesupply of money is increasing or the demand for money is decreasing.

    A change in prices could be the result of a change in either supply or demand, but, inpractice, almost all rapid changes in the price of money (and hence the general levelof money prices) are due to changes in supply. A change in the demand for moneymeans that individuals are choosing, on average, to hold larger or smaller cashbalances than before--perhaps because of a change in their income, the pattern orpredictability of their expenditures, or some other feature of their lives affecting howmuch money they wish to hold. Such real changes, affecting not merely oneindividual but the average of a large society, rarely occur very fast; it would beunusual, for instance, if the real income of a society grew by more than 10 percent in a

    year. Changes in supply can occur much more rapidly. In a paper money system likeours, the government can double the supply of money in a few days, simply byprinting a lot of large-denomination bills--and some governments have done so.

    Changes in demand can, of course, produce substantial changes in the price level,given enough time. An example is the gradual fall in prices during the final decades ofthe nineteenth century. Money at the time was not paper but gold; it could not beprinted, and not very much of it was being mined, The economies of the countries thatused gold as money were growing, and so was the number of such countries. Demandrose faster than supply, so the price of money rose--and the prices of goods fell. Theprocess was eventually ended by the discovery of the South African gold fields andthe invention of new technologies for extracting gold from lower grade ores.

    Such deflations--periods of falling prices--are much rarer than inflations--changes inthe opposite direction. An inflation occurs when the supply of money increases fasterthan the demand, causing prices to rise. In the U.S., inflation rates of 10 percent ormore a year ("double digit inflation") have occurred several times in recent years. Inmany other countries, inflation rates of 20, 50, or 100 percent per year are common.

    Consequences of Inflation

    The consequences of inflation depend on the degree to which it is anticipated. Ifeveryone in the society knows how prices have been changing, are changing, and aregoing to change in the future, then everyone can allow for the changing value of thedollar over time in setting future prices, making contracts for future payments, and so

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    on. Under such circumstances, inflation is a nuisance, but not much more. If, on theother hand, individuals incorrectly anticipate inflation, failing to expect inflation thatdoes occur, expecting inflation that does not occur, the results are much more serious.We shall first consider the less serious case of fully anticipated inflation, then go on toconsider the problems of unanticipated or incorrectly anticipated inflation.

    Anticipated Inflation. Suppose I am lending you money, in a world of constant 10percent inflation. The interest rate at which I lend it to you will depend on my (andeveryone else's) supply of loans and your (and everyone else's) demand for loans, aswe saw back in Chapter 11. Both you and I know that when you pay the money back,a year from now, each dollar will buy 10 percent less than it does now. What Iultimately consume is not money but goods. What determines the amount I am willingto lend is how much present consumption I must give up by lending you the moneyinstead of spending it myself and how much I shall be able to buy with the money youwill pay me back a year later. So my supply of loans is a function not of the nominalinterest rate, the interest rate measured in money, but of the real interest rate, theinterest rate measured in goods. Similarly, and for the same reason, your demand forloans depends on the real, not the nominal, interest rate.

    I would be equally willing to lend (and you to borrow) at a nominal interest rate of 10percent in a world of 10 percent per year inflation, 20 percent in a world of 20 percentinflation, or zero percent in a world of zero percent inflation; in each case, the realinterest rate is zero, since the money paid back buys the same amount of goods as themoney lent. Similarly, nominal interest rates of 25, 20, or 15 percent in a world of 10percent inflation correspond to real interest rates of 15, 10, and 5 percent--and tonominal rates of 15, 10, and 5 percent in a world of no inflation. The nominal interestrate simply equals the real interest rate plus the inflation rate. Both the supply of loansand the demand for loans depend on the real interest rate, so two economies which areidentical except for their inflation rates will have the same real interest rates. Nominalinterest rates will be different, with the difference just making up for the differentinflation rates.

    In the case of loans, high nominal interest rates compensate lenders for the effects ofanticipated inflation. The same sort of thing happens with other contracts. Just as inthe case of loans, the individuals concerned are ultimately interested in goods, notmoney; so the supply and demand curves that determine prices are functions of thereal, not the nominal, amount of future payments. If you hire me on a five-yearcontract in an inflationary world, both you and I know that the dollars you pay me willbe worth less and less each year. If the real terms we are willing to agree on are, say,$20,000/year for the next five years, we can and will implement them with anagreement for you to pay me $20,000 this year, $22,000 next year, and so on.

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    Similarly, for other contracts that involve payments over time, the number of dollarsadjusts to compensate for the anticipated change in their value.

    This analysis suggests that the main cost ofanticipatedinflation is the time andtrouble of taking account of it in arranging our lives. If, as in most of this book, we

    ignore such transaction costs, then anticipated inflation would seem to have noimportant effects.

    Unanticipated Inflation. So far, we have been considering fully anticipated inflation;everyone--lenders and borrowers, employers and employees--knows what ishappening and what will happen to prices over time. We shall now drop thatassumption and consider the effects of unanticipated inflation. We start with thesimple case where everyone expects an inflation rate of zero.

    We live in a world where prices have been, and are expected to be, stable. I lend you$1,000 at an interest rate of 5 percent. During the next year, to our surprise, prices rise6 percent. At the end of the year, you pay me back $1,050 -- and I find that it will buyless than the $1,000 I lent you. The loan we thought we were making was at a real andnominal rate of 5 percent; it turned out to be at a nominal rate of 5 percent but a realrate of -1 percent.

    As you can see by this example, an unexpected inflation revises the real terms of loansagainst creditors and in favor of debtors. The same is true if we expect inflation--but

    less inflation than we get. If we had both anticipated a 5 percent inflation, we wouldhave agreed to a nominal interest rate of 10 percent. The result, if the actual inflationrate turned out to be 10 percent, would have been a real interest rate of zero instead ofthe 5 percent you thought you were paying and I thought I was getting.

    Unanticipated inflation has a similar effect on other contracts. Suppose I have agreedto work for you for the next five years for $20,000/year, in the belief that prices willbe stable. I am wrong; prices rise--and my real income falls--at 10 percent per year. Ihave gotten a worse deal than I thought and you have gotten a better one. In this case,it is the employer who gains by inflation and the employee who loses. The same thing

    would be true if our original agreement made allowance for inflation, but the inflationrate turned out to be higher than we expected. Exactly the opposite would happen ifwe overestimatedfuture inflation; the increase in nominal wages built into myemployment contract would more than compensate me for the inflation that actuallyoccurred.

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    The effects of unanticipated or misanticipated inflation on debtors, creditors,employers and employees are all special cases of a more general principle: Inflationinjures individuals with net nominal assets and benefits individuals with net nominalliabilities.

    What do I mean by "net nominal assets"? My house is a realasset; it continues toprovide me with the same services, whatever happens to the general price level. Apension of $10,000/year is a nominalasset; since I am receiving a fixed number ofdollars, the real value of my pension--what it can buy--goes up or down with the valueof money.

    When I lend you $1,000 at 5 percent, I acquire a nominal asset: a claim against youfor $1,050, payable a year from now. You acquire a nominal liability: your obligationto pay that amount a year from now. If the inflation rate rises unexpectedly, the realvalue of my asset falls, and so does the real value of your liability--which is bad for

    me and good for you. Similarly, if I agree to work for you for five years at$20,000/year, I acquire a nominal asset: $20,000/year for five years. You acquire anominal liability: the obligation to pay $20,000/year for five years.

    An individual may have both nominal assets and nominal liabilities--an employmentcontract that pays him a fixed number of dollars in the future and a mortgage thatrequires him to pay a fixed number of dollars in the future. If his nominal liabilitiesare larger than his nominal assets, then on net he has nominal liabilities; if the assetsare larger, he has net nominal assets. The comparison is simple if the assets andliabilities all come due in the same year. Otherwise things become more complicated.The same individual may be benefited by one pattern of future inflation, with most ofthe inflation occurring after he collects on his assets and before he must pay on hisliabilities, and injured by a different pattern of inflation.

    So the general principle is that inflation injures those who have, on net, nominalassets, and benefits those who have, on net, nominal liabilities. Deflation--a fall inprices--benefits those who have net nominal assets and injures those who have netnominal liabilities.

    In separating the effects of inflation or deflation from the effects

    ofunanticipatedinflation or deflation, there is a somewhat subtle distinction that mustbe made. In one sense, inflation injures a creditor whether or not it is anticipated; thehigher the inflation rate, the less the value of the dollars paid back to him. Once theloan is made, the higher the inflation rate turns out to be, the worse off the creditor isand the better off the debtor. But creditors are not worse off in a world of (fullyanticipated) 10 percent inflation than in a world of (fully anticipated) 0 percent

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    inflation; the higher nominal interest rate in the inflationary world just compensatesthem for the lower value of the money they get back.

    A slightly different way of putting this is to point out that in a world of fullyanticipated inflation, creditors only lend money (and debtors only borrow it) if they

    are better off making (or taking) the loan than not doing so. In a world of incorrectlyanticipated inflation, the contract is, in effect, revised after it has been made; so thelender (or borrower) may discover that the deal he actually made, unlike the deal hethought he made, is worse than no deal at all.

    Uncertain Inflation. So far, we have considered unanticipated inflation in a situationin which people think they know what is happening to prices and turn out to bewrong. A more realistic situation would be one in which everyone knows that he doesnot know what the inflation rate is going to be. Every long-term nominal contract isthen a gamble. If you borrow or lend, accept a job or offer one, you are agreeing to a

    contract whose real terms depend on what the inflation rate turns out to be. To someextent, one can compensate for this by designing contracts whose terms depend onwhat happens to the price level; but the result is still to increase considerably the cost,complication, and uncertainty of doing business.

    PART 2 -- UNEMPLOYMENT

    In analyzing markets, including the market for labor, we have almost always assumed

    that price adjusts until quantity demanded equals quantity supplied, If your onlysource of economic information is this book, that may seem like an adequatedescription of how the economy works. If you also read newspapers, watch television,or listen to radio, you may have wondered how, if quantity of labor demanded is equalto quantity supplied, there can be several million people unemployed.

    Kinds of Unemployment

    The first step in answering that question is to look at what is meant by"unemployment." The unemployment figure reported in the newspapers is an estimateof the number of people who, if asked whether they are looking for a job and do nothave one, would answer yes; the figure is calculated by asking that question of somesmall fraction of the population, and, from their answers, estimating what the resultwould be of asking everyone. Unemployment is usually given in the form of

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    the unemployment rate, the number of people unemployed as a percentage of the totallabor force.

    Different reasons why someone might answer yes to that question correspond todifferent sorts of unemployment. Some of them involve an inequality between

    quantity of labor supplied and quantity demanded; others do not.

    Search Unemployment. You have just resigned--or been fired--from a job as anengineer with a salary of $40,000/year. You could, if you wished, walk into theneighborhood restaurant and offer to wash dishes; by doing so, you might make asmuch as a quarter of your old income. You decide instead to look for another job as anengineer.

    After a few days spent reading the want ads, you locate a possible job. It requires along commute and pays only $30,000. You keep looking. After another two weeks,

    you find a better job, one that pays $40,000 and is located reasonably close to whereyou live. You go in for an interview and are offered the job. You spend a few moredays looking around in the hopes of finding something better, then accept.

    You spent about three weeks between jobs. During how much of that time were youunemployed? In one sense, all of it; in another sense, none.

    At any time during those weeks, you would, if asked, have said that you wanted a joband did not have one; so from the standpoint of the Bureau of Labor Statistics, youwere counted as unemployed. But during all of that time, you could have had a job--as

    a dishwasher--if you had wanted one. The reason you did not work as a dishwasherwas that you had a better job. You were employed, by yourself, at the job of lookingfor a job. You obviously preferred that to the alternative of being a dishwasher--asshown by your choice.

    Such "search unemployment" makes up a substantial fraction of reportedunemployment. In a market where goods are not identical, such as the housing market,the marriage market, or the labor market, searching is a productive activity, If yoursearch finds you a job close to home instead of one on the other side of the city, a jobutilizing all of your skills instead of half of them, or a job working with people you

    enjoy working with, you have produced something of considerable value while"unemployed."

    In the case of search unemployment, the individual who says that he is looking for ajob is telling the truth. What is deceptive about calling that "unemployment" is theimplication that the supply of labor is greater than the demand. Search unemploymentis a normal and desirable feature of the labor market. One could reduce or even

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    eliminate it--by announcing that anyone who was unemployed for more than a weekwould be shot, for example, or by making it illegal for anyone to quit or be firedunless he already had another job. But the result of such a law would be to make thesituation worse, not better, by eliminating a productive activity--spending timeproducing information necessary to choose the right job.

    Fictitious Unemployment. Another source of measured unemployment consists ofpeople who find it in their interest to say they are looking for a job when they are not.A condition for receiving welfare, for many although not all recipients, is that therecipient be looking for a job. Presumably some of the people receiving such welfarewould rather be unemployed (or employed covertly) and receive welfare than beemployed, at the sort of job they could get, and not receive welfare. If you do not wanta job, it is easy enough not to find one. So some reported unemployment consists of

    people who are pretending to look for a job, would accept a job if a sufficientlyattractive one were offered to them, but prefer unemployment to the sort of job thatwill be offered to them. One study estimated that changes in federal welfare rules thatmade "looking for work" a prerequisite for welfare produced an increase in themeasured unemployment rate of between one and two percentage points. If that resultis correct, it suggests that unemployment of this sort may be responsible for about onefourth of total measured unemployment.

    Involuntary Unemployment. Consider someone so unproductive that he is worthnothing to any employer. He could get a job only by agreeing to work for nothing orless than nothing. So far as a supply and demand diagram is concerned, the quantity ofhis labor supplied is equal to the quantity demanded, just as we would expect.Unfortunately, the equilibrium price is zero.

    This is an extreme case, but it demonstrates the sense in which even the mostinvoluntary unemployment may be "voluntary" so far as the logic of economics isconcerned. In terms of the ordinary meaning of words, someone who can only get ajob by agreeing to work for nothing is involuntarily unemployed. Yet it seems odd tosay that the market is not working merely because an equilibrium price turns out to bezero.

    Individuals who want to work but have an equilibrium wage of zero are probably rare,but there is a similar and even more involuntary type of unemployment which is quitecommon. Under current minimum wage laws, it is illegal, in most fields, for someoneto work for less than the minimum wage. If for some kinds of labor--unskilledteenagers, for example--the wage that equates quantity supplied and quantitydemanded is below the minimum, then at the minimum wage the quantity of such

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    labor supplied is greater than the quantity demanded. The excess workers--people whoare willing to work for the minimum wage and might be willing to work for less butcannot get jobs at the lowest wage that it is legal for employers to pay them--show upin the statistics as unemployed. Minimum wages produce a surplus of labor just asmaximum rents produce a shortage of housing.

    Disequilibrium Unemployment. So far, all but one of the sorts of unemployment Ihave discussed have been consistent with equilibrium on the labor market. Theexception is unemployment due to minimum wage laws; in that case, the marketcannot reach the equilibrium price because the equilibrium price, for some types oflabor, is illegal.

    There remains one further category: unemployment due to disequilibrium. Throughoutthis book, I have limited my discussion of disequilibrium to the demonstration thatmoving a market out of equilibrium creates forces tending to move it back. Such

    forces do not operate instantaneously. In a changing and unpredictable society, a priceat any instant may be above its equilibrium level, with excess supply tending to pushit back down; or it may be below its equilibrium level, with excess demand tending topush it back up. Disequilibrium is particularly likely, and particularly long lived, inmarkets for inhomogeneous goods, such as labor or spouses. If all units of a good areidentical--ounces of pure silver, for example--it is relatively easy to observe price,quantity supplied, and quantity demanded, and adjust accordingly. With a milliondifferent "qualities" of labor (and jobs and spouses), the informational problemassociated with finding the equilibrium price is far harder. It is harder still when whatis being sold is not a day's consumption of the good but a contract for the next severalyears, as is frequently the case on those markets. In that case, the equilibrium pricemust take account not only of supply and demand conditions today, but of estimatedsupply and demand conditions over the entire period of the contract. This is mademore difficult by something we discussed earlier in the chapter--the effect of uncertaininflation on long-term contracting.

    Unemployment and Inflation

    In arguing that search unemployment is a desirable activity, I implicitly assumed thatthe individual had an accurate idea of what sort of jobs were available and wouldtherefore choose to search only if the return was, in some average sense, at least asgreat as the cost. Suppose this is not true. Suppose the worker has somehow beenfooled into thinking that if he only looks a little longer, he can get a job paying$40,000/year, when in fact there are no such jobs available. He may waste monthslooking for a nonexistent job before he realizes his mistake.

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    One possible source of such errors is unanticipated or misanticipated inflation.Consider the effect of an unexpected drop in the inflation rate. Prices have been risingat 10 percent per year for many years; most people expect them to continue doing so.For some reason, the government, which has been producing the inflation with acorresponding increase in the money supply, decides to turn off the printing presses.

    Everyone has gotten used to the old level of inflation; in buying or selling goods, intaking jobs or hiring workers, the universal assumption is that a dollar will be worth10 percent less next year than this year. Initially, after the government stops printingmoney, things continue as before; producers increase the prices of their goods andworkers increase their wage expectations at the usual 10 percent per year.

    The number of dollars available to buy those goods and hire those workers, however,is not increasing. Producers find that at the prices they are charging, they cannot sellas much as they have produced; they reduce their prices. Eventually, when everyone

    has gotten the message, prices fall back to where they were when the governmentstopped increasing the money supply.

    Some people get the message faster than others. Producers are selling their goodsevery day; they quickly discover that their prices are too high and change them. Theindividual worker looks for a new job only once every several years, so it takesworkers much longer to recognize the change and adjust their expectations. In themeantime, workers expect wages above the actual equilibrium wage--the wage atwhich supply and demand for labor are equal. Seen from the standpoint of theemployer, the real wage at which he can get workers has gone up, so he hires fewerworkers. Seen from the standpoint of the worker, he is engaging in search based on anoverly optimistic picture of what can be found, so he keeps searching long beyond thepoint where additional search is worth what it costs.

    In the situation I have described, incorrect search leads to an undesirably high level ofunemployment. It can also lead to an undesirably low level. Consider the casediscussed earlier in the chapter, where prices have been stable for a long time andsuddenly begin to rise. A worker has just quit a $30,000 job in the (correct) belief thathe is worth at least $40,000 elsewhere. The next day, he accepts a job that will payhim $40,000/year for the next five years. What he does not know--and his employerdoes--is that the inflation rate has risen from zero to 10 percent. In real terms, he isbeing offered $40,000 this year, $36,364 next year, and $33,058 the year after. If hehad known that, he would have kept on looking.

    In this case, the unexpected onset of inflation has reduced the unemployment rate, butit has done so in a way that makes the newly employed people worse off; they havebeen tricked into accepting a worse job than they could have gotten by looking a little

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    longer. Employers, on the other hand, are better off. Since the amount of laborsupplied is based not on what the workers are really getting (adjusted for inflation) buton what they think they are getting, the supply curve for labor has shifted out and theequilibrium real wage has fallen. Profits rise. Eventually the workers realize what ishappening, the supply curve for labor shifts back, and profits go back to their normal

    level; but during the adjustment period, the employers are better off and the workersworse off as a result of the workers' mistake.

    PART 3 -- WHY INFLATION HAPPENS: A PUBLIC CHOICE

    PERSPECTIVE

    I have given a simple--some may think oversimple--explanation of inflation: Inflationoccurs because the government expands the supply of money. This raises an obviousquestion. All politicians, including the ones who get elected, are against inflation, asone can easily discover by listening to their speeches. If all they have to do to stop it isto stop printing money, why do they not do so? Why does inflation ever occur; and ifit does start, why is it not immediately stopped?

    There are two possible answers. One is that inflation is a mistake; the politicianscontrolling monetary policy, in the U.S. and elsewhere, do not recognize theconnection between the amount of money they print and the value of that money.

    This is, to put it mildly, implausible. Our understanding of inflation goes back at leastas far as David Hume, who correctly analyzed the causes of inflation more than 200years ago. While the details of the relation between the money supply, the price level,and other economic variables are complicated, there is an enormous body of evidence,from many different societies at many different times, showing that a large increase inthe money supply almost inevitably results in a large increase in prices, and a largeincrease in prices almost never occurs without a large increase in the money supply. Itis hard to believe that if it were in the interest of politicians to know what causesinflation and to use that knowledge in order to prevent it, they would not yet have

    managed to do so.

    The second and more plausible explanation is that politicians frequently find thatinflation benefits them. Their behavior, in campaigning against inflation but not doinganything about it when elected, is then entirely rational. They campaign againstinflation because they want the support of voters who are opposed to it. They act forinflation because they benefit from some of its consequences. They trust to the

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    rational ignorance of the voters to conceal the inconsistency between words anddeeds.

    This brings us to the question of why it may often be in the interest of politicians tocreate or maintain inflation. There are at least two reasons. The first and simplest is

    that government itself is often a major beneficiary of inflation. The second and morecomplicated is that (unanticipated) increases in the inflation rate tend to have benefitsthat are immediate and visible and costs that are delayed and invisible, while(unanticipated) decreases tend to have visible and immediate costs and invisible anddelayed benefits. Because of the public good nature of voting, discussed in Chapter18, voters act mostly on free information, so costs and benefits that are visible andimmediate are much more important, politically speaking, than ones that are not. So itis often in the interest of politicians to increase the inflation rate and against theirinterest to decrease it.

    Government as a Beneficiary of Inflation

    In my earlier discussion of inflation, I pointed out that it benefits debtors, or, moregenerally, people with net nominal liabilities, and injures creditors, or, more generally,people with net nominal assets. Governments, as a rule, have lots of nominal liabilitiesand few nominal assets; hence they are among the largest beneficiaries of inflation.

    One very large nominal liability of the present government of the U.S. is the national

    debt. It owes its creditors--the owners of government bonds--a fixed number ofdollars. If all prices double, the real value of what it owes falls in half. This is whathas happened over the past several decades. The reason why the national debt, in realterms, was lower in 1980 than in 1945 despite the almost uninterrupted deficits of theintervening years is that much of the debt had been inflated away.

    Of course, if the government keeps inflating, it will eventually find that in order toborrow money it must offer higher nominal interest rates to compensate lenders forwhat they expect to lose through inflation. At that point, if investors correctlyanticipate future inflation, the government no longer gains by inflation. Like any other

    creditor, the government succeeds in getting below-market real interest rates only ifinflation is unanticipated.

    The government still has an incentive to continue inflating, even in this situation. If itdoes not, inflation will be below what lenders anticipated, and it will find itself payinga higher real interest rate than either the government or its creditors expected; it willbe, in effect, compensating lenders for inflation that is not occurring.

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    A second large liability of the government is its obligation to make future payments:social security, veterans' benefits, and the like. This is only in part a nominal liability.To the extent that cost-of-living adjustments are built into such obligations, what thegovernment owes is a real, rather than a nominal, quantity, an amount of purchasingpower rather than a number of dollars.

    Inflation as a Source of Revenue. Inflation not only reduces the real value of theliabilities of the governments of the U.S. and similar countries but may also increasetheir real income. Under a graduated tax system, the higher your nominal income, thehigher the percentage of that income that you must pay as taxes. If all prices and allincomes double, your real income before taxes is the same as before, but your tax rateis higher; so the real value of the taxes the government collects from you is higher.This phenomenon, known as bracket creep (inflation makes your income creep intohigher brackets), means that inflation produces an automatic tax increase. Politicians,as a general rule, like to be able to spend more money but do not like to be associatedwith raising taxes, since expenditures are popular with voters and taxes are not.Inflation provides the (political) benefit without the (political) cost.

    At present, this particular device for invisible tax increases no longer exists in the U.S.Changes in the tax law passed in 1981 and coming into effect in 1985 providedfor indexing: the automatic adjustment of tax brackets to allow for inflation. Whetherthat reform will remain in effect or be eventually reversed by congressional actionremains to be seen.

    Bracket creep is not the only way in which government revenue is increased byinflation. When the money supply is increased by the printing of additional currency,someone gets the new money. If the government prints the new money, thegovernment gets it. Printing money is a way in which a government can generaterevenue without any visible tax.

    Deficit Spending and Inflation. It is often claimed that deficit spending is a majorcause of inflation. The usual arguments for this conclusion are wrong; if thegovernment spends more than it takes in and borrows the difference, the effect is toincrease the supply of government bonds, not the supply of money. Of course agovernment could, and some governments do, finance a deficit by printing moneyinstead of borrowing it, but in that case it is the money creation, not the deficit, thatproduces the inflation.

    There is a different sense, however, in which deficit spending may well be linked toinflation. Deficit spending increases the national debt. The larger the national debt, thelarger the benefit the government receives from inflation. So although deficit spendingdoes not cause inflation, it does increase the benefit of inflation to the politicians

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    currently in power and so increases the probability that they will follow inflationarypolicies.

    How to Fool All of the People Some of the Time. In discussing the relation betweeninflation and unemployment, I showed how an unanticipated increase in the inflation

    rate results, in the short term, in an increase in profits and a decrease in theunemployment rate. The increased profits are paid for by a decrease in real wages--butat the beginning of the inflation, that is not yet obvious to the workers. The decreasein unemployment represents a net loss, not a net gain, to the newly employed workers,since they are accepting jobs that they would have rejected if they had understood thereal as well as the nominal terms of what they were being offered. But since they donot yet know that, they believe they are better off. Employers are happy about theirhigh profits, workers are happy about their low unemployment rate; everyone is(apparently) better off. If it happens to be an election year, the incumbent president isreelected by a landslide.

    After a while, people adjust. Unemployment goes back up; profits go back down.Prices rise steadily. The incumbent administration blames the inflation on theunreasonable wage demands of the unions (when giving speeches to the Chamber ofCommerce) or the attempt of corporations to extort "obscene profits" from consumers(when giving speeches to the AFL-CIO). After a while, another election comesaround. The government buys new printing presses and increases the rate ofexpansion of the money supply from 10 percent to 20. Profits rise. Unemploymentfalls. The incumbent administration's ticket is reelected in a landslide. Prices are nowrising at 20 percent per year. The administration blames the inflation on OPEC.

    While this strategy may work for a while, it has some long-run problems. The effectsof inflation on profits and unemployment depend on its being unanticipated. The moreexperience people have with high and rising inflation rates, the harder they are to fool,hence the greater the increase necessary to produce the effect. High and unpredictableinflation rates produce undesirable and politically unpopular effects. At some point,the administration--or its opponents--may conclude that it is politically desirable tostop increasing the inflation rate, and perhaps even to decrease it.

    Doing so can be and generally is politically costly. If people expect the inflation rateto remain at 20 percent per year and the money supply expands at a rate of only 10percent, actual inflation will be lower than anticipated inflation. If people expect theinflation rate to continue to rise, from 20 percent to 30 percent, then even keeping therate at 20 percent will make actual inflation lower than anticipated inflation. In eithercase, the result is the opposite of what happened earlier when actual inflation washigher than anticipated inflation. Profits fall; unemployment rises. The fall of profits isassociated with a rise in real wages, but since workers are not yet aware of the change

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    in the inflation rate, they do not know they are better off. The politicians who cut theinflation rate lose the next election.

    This suggests the possibility of a political business cycle. The administration startsinflating a few months before election day, thus getting itself elected, and stops after

    the votes are all cast, thus re-establishing expectations of stable prices--to be takenadvantage of with another inflation just before the next election. If the presidentcontrolled the process, we would get a four-year business cycle; if the congresscontrolled it, a two-year cycle.

    While this provides an elegant explanation for variations in inflation andunemployment rates, it does not appear to be a correct one; statistical studies so farhave not found any clear relation between the pattern of elections and the businesscycle. What does seem clear is that actions taken by the government have substantialeffects on the inflation and unemployment rates and that those rates, in turn, affect

    how people vote. The resulting connection between policy and votes provides anincentive influencing the policies that incumbent politicians follow, and one that mayexplain much of what they do.

    Two Warnings

    Before ending the chapter, I should warn you of two things. The first is that, in myexperience, economics students have a tendency to confuse the inflation rate and the

    interest rate. The best way to avoid doing so is to analyze everything in real ratherthan nominal terms, thus eliminating money and the price of money from the analysis,That is what I did in Chapter 11, where I first introduced interest rates. One can thengo from results in real terms to results in nominal terms by converting all prices andflows of money from "constant dollars" (purchasing power) to "current dollars" andall interest rates from "real interest rates" to "nominal interest rates."

    The second warning is that this chapter is a short and sketchy explanation of adifficult and complicated set of ideas and relationships. I believe the sketch is inessence an accurate one, although some competent economists might disagree, but it

    is in any case only a sketch. If you want a clearer understanding of the causes andnature of inflation and unemployment, and the relation between both and governmentpolicy, you should take a course or read a book on what used to be called monetarytheory and is now more often described as "macroeconomics." The purpose of thischapter is not to replace such a book but to show you that the study ofmacroeconomics can and should be based on price theory--usually called, with more

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    symmetry than sense, "microeconomics." This is, in two senses, a micro macrochapter.

    OPTIONAL SECTION

    PRICE INDICES

    Relative prices continually change as a result of shifts in demand and supply curves;so during an inflation, money prices increase at different rates for different goods.There may even be goods whose money price falls while most prices are rising--computers and calculators in the 1970s, for example.

    So far, I have said nothing about how we define the inflation rate when the moneyprices of different goods are going up at different rates. The obvious solution is to useaprice index, an average of the prices of many different goods. In calculating such anaverage, we need some way of deciding how much weight each good should have. Itdoes not make much sense to say that if the prices of pins and thumbtacks have gone

    down 10 percent and the prices of food and housing have gone up 10 percent, "onaverage" prices have stayed the same.

    One obvious solution to this problem, and one that is often used, is to define thegeneral level of prices as a weighted average, using the quantity of each itemconsumed in a year as the weight. Such a price index measures the money cost ofbuying the entire bundle of goods and services consumed in a year. It is usuallyexpressed relative to some base year. Suppose the base year is 1980. If the price indexfor 1981 is 1.10, that means that the entire bundle of goods and services consumed ina year cost 10 percent more in 1981 than in 1980.

    This raises a further problem--which year's consumption do we use for our weights?Do we compare what the consumption of 1980 would have cost at the prices of 1981to what it did cost at the prices of 1980, or do we compare what the consumption of1981 cost at the prices of 1981 to what it would have cost at the prices of 1980? Sincethe relative amount of different goods consumed will be different in different years,

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    the two methods of computing the price index can be expected to give at least slightlydifferent results.

    In actually calculating price indices, both methods have been used. The Laspeyresindex is calculated using quantities in the first year, the Paasche index using quantities

    in the second year. If we define the true percentage increase in prices between Year 1and Year 2 as that percentage increase in his income that would make the consumerexactly as well off in Year 2 as he was in year 1, it is possible to show that theLaspeyres index overstates the increase in prices and the Paasche understates it. If theLaspeyres index goes up 10 percent from Year 1 to Year 2, then a consumer whoseincome also went up 10 percent would be better off in Year 2 than in Year 1--hewould be able to buy a bundle of goods that he preferred to what he bought in Year 1.If the Paasche index went up 10 percent, a consumer whose income went up 10percent would be worse off in the second year. Proving these results will be left as anexercise for the reader, in the form of Problems 11 and 12.

    PROBLEMS

    1. Throughout this chapter, I have used "inflation" to mean "an increasing level ofprices." Some economists prefer to use "inflation" to mean "an increase in the supplyof money." Usually a situation is either an inflation in both senses or in neither.Describe some possible exceptions--situations where the money supply is going upand prices are not, or prices are going up and the money supply is not.

    2. In discussing the benefits government receives from inflation, I said that by printingmoney, the government can collect revenue without any visible tax. Precisely what isthe invisible tax associated with money creation? Who pays it? (Hint: Consider asituation in which inflation is fully anticipated, so that many of its effects disappear.Find an unavoidable cost borne by someone as a result of inflation which is notbalanced by a benefit to anyone else, except the government that is printing themoney. This is a hard problem.)

    3. In discussing the relation between the money supply and inflation, I said that alarge increase in the general price level almost never occurs without a large increase

    in the money supply. Consider a city under siege. When the siege has lasted longenough so that people start getting hungry, the price of a loaf of bread may be 100times what it was before the siege. Explain what is happening in terms of theexplanation of the relation between money and the price level that was given in thechapter. (Note: You may not use the example given in this question to answerProblem 1.)

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    4. The only cost of holding money which I have discussed is interest lost by holdingmoney instead of lending it out. Another cost is the possibility that if you have moneyin your wallet, someone may steal it. Suppose the rate of such crimes increasesdrastically. What will the effect be on the price level, according to the analysis of thischapter? According to the analysis of Chapter 19? Do the two effects work in the

    same or opposite directions? Explain. (This is a hard problem.)

    5. Suppose the inflation rate is 12 percent and the nominal interest rate is 10 percent.Are real interest rates high or low? Assuming that you expect the inflation to continue,is this a good or bad time to borrow money and buy a house? Discuss.

    6. Under current tax law, interest payments are deductible and interest income istaxable. How does this affect the relation between real and nominal interest rates--assuming that real rates are defined after tax rather than before tax? How does it affectyour answer to Problem 5?

    7. In discussing the effects of an unexpected increase in the inflation rate, I claimedthat the resulting decrease in the unemployment rate was a cost not a benefit, sinceworkers were being fooled into inefficiently short searches. Does this imply that theincreased unemployment due to an unexpected decrease in the inflation rate is abenefit? Discuss.

    8. If, as I argue, minimum wage laws result in unemployment for unskilled workers,who, if anyone, benefits from such laws? You may want to use the ideas of Chapter13 in answering this. (This is a hard problem.)

    9. How might you test the correctness of your answer to Problem 8? You may wish touse ideas from Chapter 18. (This is a hard problem.)

    10. Laws setting maximum nominal interest rates are called usury laws . What effectwould you expect such laws to have? What relation would you anticipate betweeninflation and difficulties associated with usury laws?

    The following problems refer to the optional section:

    11. Assume that all consumers are identical. Consider a single consumer in Year 1 andYear 2. In Year 1, he has income I. He consumes only two goods: quantity x of goodX and quantity y of good Y. The prices of X and Y are different in the two years.

    a. Use an indifference curve diagram to show that the Laspeyres price index for Year2 based on Year 1 is greater than the percentage increase in income necessary to makethe consumer as well off in Year 2 as he was in Year 1.

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    b. Use an indifference curve diagram to show that the Paasche price index for Year 2based on Year 1 is less than the percentage increase in income necessary to make thecustomer as well off in Year 2 as he was in Year

    (Hint: The answers to this problem and Problem 12 are closely related to the

    explanation of the housing paradox in Chapter 3.)

    12. Redo Problem 11 for a consumer consuming many goods, using a verbal analysisrather than an indifference curve diagram.

    13. You see the following two advertisements on the same day in the same city:

    --"Mrs. Jones went into her local A&P store to do her weekly shopping. After shefinished, she duplicated her purchases at the Kroger's down the block. It cost 5 percentmore at Kroger's than at A&P. Shop A&P; the P stands for better prices."

    --"Mrs. Smith did her weekly shopping at Kroger's then went over to the A&P andbought exactly the same things. It cost her 6 percent less at Kroger's. For better prices,shop Kroger's." Assume that the advertisements are both accurate and both involvedthe same pair of stores.

    a. Explain how the results of the two "experiments" could turn out as reported.

    b. Explain why, if prices on average are really about the same in both stores, youwould expectthe results to turn out as reported.

    c. Explain the connection between this problem, Problem 12, and the housing paradoxof Chapter 3.