Monday: 12-3 FSM Cafe
Tuesday: 2-5 Evans 601
Wednesday: 10:30-12:30; 1-5 with breaks at the Peet's in Sutarja Dai Hall (call 925 708 0467): Evans 601
Unfortunately, I am not complete master of my own schedule this week, alas...
May 08, 2011
May 06, 2011
April 27, 2011
April 26, 2011
April 21, 2011
April 20, 2011
April 18, 2011
April 14, 2011
April 12, 2011
April 07, 2011
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April 04, 2011
IAS 107 Intermediate Macroeconomics March 29, 2011 Inflation Lecture Cleaned-Up Transcript
IAS 107 Intermediate Macroeconomics March 29, 2011 Inflation Lecture Cleaned-Up Transcript
J. Bradford DeLong
U.C. Berkeley
Welcome back from spring vacation. There are five more weeks left of classes--and there is still a lot to do.
Picking up the threads, we are still thinking about situations of inflation. We have left depressions and deep downturns like the one we are currently in behind. We have left long-run growth behind. We are dealing with the economics of inflation.
Right now, at least here in the United States, the economics of inflation is rather boring. There isn't any inflation. If anything, our inflation rate is too low, not too high. But there have been periods in the past when figuring out how or whether to control or reduce the rate of inflation has been the most important economic policy issue. And there may well come times in the future when the same is the case. That is why we are spending time on inflation economics in this course.
You will recall that our consumer price index has risen by a factor of 10 since 1950: $10 today buys about as much as a dollar did in 1950. Of course, $10 a day buys you very different things than $1 bought you in 1950. Yesterday I was on Bloomberg TV with Columbia Business School Professor and former Federal Reserve Governor Rick Mishkin. Rick said that in his new house--I presume it is a large new house, for if he wanted a small house he would be living in a townhouse in Manhattan--he has bought an inordinate number of large screen TVs. Why? Because, he said, they were a lot cheaper than art, and he had to hang something on the walls.
I now have this image of Rick Mishkin's house filled with 60-inch flatscreen TVs with the sound off, all tuned to the Nature Channel. And I draw two conclusions. First, there is definitely a market opportunity for an art channel--or, rather, many art channels. Second, consumer electronics today are extraordinarily, bizarrely cheap--and if you like them, you are in hog heaven.
What we buy now is very different than what we bought back even a generation ago. The Bureau of Labor Statistics has to try to do the best job it can of figuring out what has happened to the "average" level of prices in spite of these enormous shifts in relative prices.
Last time we talked about the burst of inflation during the Korean War, inflation's falling back, and then rising to a new peak during the Vietnam War. And then came the tripling of world oil prices after the 1973 Arab-Israeli war. And then came the Iranian Revolution. The result was the peak of inflation in the early 1980s, after which the Federal Reserve acquired essentially unlimited power to manipulate the economy however it waned without interference or, indeed, much criticism in the interest of avoiding another outbreak of inflation like the 1970s.
Looking at the past generation of inflation, we see a minor uptick in the late 1980s after Alan Greenspan responds to the stock market crash of 1987 by saying, "Uh-oh, I need to make the money stock grow faster. Maybe the stock market crash is going to produce a depression." Monetary ease turned out not to be necessary to prevent a depression. Instead, Greenspan found that had he pumped too much liquidity into the economy, and he had to raise interest rates sharply and bring about a small recession to bring it under control.
Most recently we see our current episode, in which the Federal Reserve wishes that it had been trying to make inflation higher in the mid-2000s in order to cushion the downturn. Worrying about inflation right now is not quite like crying "Fire! Fire!" in Noah's Flood. But it is close.
And last time we talked about Okun's Law--the relationship between real GDP and the unemployment rate. When real GDP is growing rapidly, unemployment falls. When real GDP is growing slowly or shrinking, the unemployment rate rises. Generally you have to keep track of one but not of both unemployment and real GDP relative to potential because of this Okun's Law relationship. And, largely for historical reasons, when we think about inflation we focus on the unemployment rate. The unemployment rate relative to the natural rate of unemployment is a good stationary measure of how much slack or pressure there is in the economy--to what extent the economy is producing in a subnormal condition with lots of idle resources, or to what extent people are scrambling for resources and production is at a level that will prove sustainable. And that got us to the inflation-unemployment relationship, to the Phillips Curve
The Phillips Curve tells us that inflation is in large part a result of expectations. The inflation rate is going to be what people expect it to be, plus or minus a "pressure" term equal to a parameter β times the difference between the natural rate of unemployment to the actual unemployment rate.
π = E(π) + β(u*-u)
When the actual unemployment rate is low, inflation is going to be running ahead of expectations. When the actual unemployment rate is high, inflation is going to be less than expectations.
Thus there are two ways that a central bank like the Federal Reserve that wants to control inflation can actually act to affect it. The first is for the Federal Reserve to do what's called "jawboning": it controls inflation by using its jawbone, by talking. It tries to convince people of what the future is going to bring, and so of adjust their expectations of inflation toward what the Federal Reserve wishes to be the case.
The second thing the Federal Reserve can do if the inflation is higher than it wants to see is for it to hit the economy on the head with a brick. Raise the short term nominal interest rates it controls. That will raise long term real interest rates. That will push down investment spending and exports down. Boosted by the multiplier, that will push real GDP down. That will push the unemployment rate up. With businesses finding themselves with lots of idle capacity and few markets, they won't charge high markups over cost. With workers scared of losing their jobs because unemployment is high, they won't ask for wage increases. Thus the Federal Reserve can bring inflation down, if it really wants to.
A few words about "expected inflation." It is a subtle and fuzzy concept. It is everyone's expectation, and it's something that's formed over a considerable period of time. Right now, my wife and I are paying an interest rate on our home mortgage that we took out 15 years ago. When we were making our economic decision to buy the house 15 years ago, we were thinking what's the inflation rate going to be over the next 30 years. And because we locked in a contract back then, what we expected inflation to be 15 years ago still enters into the market's expectation of inflation today. Expected inflation is an average of all the expectations that people have held into the past, taken at the time they were taken, included to the extent that they still affect what's currently going on in the economy.
Can "jawboning" work? Yes. The classic example comes from Weimar, Germany in 1923 and 1924. The German government in the end stopped the hyperinflation not by printing less money--as NYU's Tom Sargent pointed out, they printed more money faster after the end of the hyperinflation than before--but simply because they changed the name of the currency and made people believe that the hyperinflation was over, that in the future things were going to be different.
Why people believed that things were going to be different is an interesting question. But controlling inflation through "jawboning" is, or at least can under some circumstances be, effective.
Back to the Phillips Curve, which says that inflation depends on what people expect inflation to be and also on the rate of unemployment: when the unemployment rate is high, inflation will be lower than expected; when the unemployment is low, inflation will be higher than expected.
Here once again is the picture of inflation and unemployment in the United States since World War II.
Here are all the data points for the 1960s: all the data points up through the end of Richard Nixon's first year as president. You can see a clear and strong downward relationship here. You can look at this and you can say, "Hmm, it really looks like the expected rate of inflation is something like 2% and the natural rate of unemployment is something like 5.5%." You have some years in which that is the case. And then you have some years in the late 1960s when times are good in the sense that unemployment is low, is below the economy's natural rate of unemployment, but you pay a price for this because you have higher inflation. During the Vietnam War years, especially, people say, "Hmm, the labor market is tight, I can ask for more wage increases" and "Hmm, the product market is tight, I can charge higher margins." And those things push inflation up above the value that people generally expected it to be. But in the 1960s you do not have any big changes in expectations of inflation. Even near the end of the 1960s, it looks as though people are still expecting inflation to be 2% per year.
When Richard Nixon takes office his economic advisors, chiefly Herbert Stein, Milton Friedman, and Alan Greenspan, tell him: "We are going to have to let the unemployment rate go back up to something like 6% or so if we want to get inflation under control. If not, if we keep running the economy with the unemployment rate at 4%, sooner or later, people will stop expecting 2% inflation. And when they stop expecting 2% inflation, we're going to see inflation expectations rise. And then both inflation and unemployment will rise. We do not want to go there."
Nixon agrees. And things start out relatively well in the 1970s. The administration lets the Federal Reserve tighten to raise interest rates and unemployment, and it looks as though the economy moves back down the Phillips Curve.
Note that it is not the same Phillips Curve that we saw in the 1960s. Instead of touching 2% inflation when the unemployment rate was 5.8%, you get to 2% unemployment only with an unemployment rate is 6.7%. It would probably be better to say that in the early 1970s inflation expectations are 4% rather than 2%.
And it is at this point that the consensus is that Richard Nixon's desire to get reelected enters the story. Nixon had been Dwight Eisenhower's vice president in the 1950s, and was an extremely unusual politician--you can see his portrait in our Institute for Governmental Studies. Although Nixon had been Eisenhower's vice president for eight years, Eisenhower didn't like him very much. Eisenhower would end press conferences when people asked, "Well, what important decisions of the administration has Richard Nixon played a significant role in?" with quips like, "Well, if you give me a week, I might be able to think of one. Ask me that question next week."
Richard Nixon deeply believed that if the party in power was trying to win reelection with a high unemployment rate, things were likely to go badly. Come the winter of 1960 Richard Nixon and his friend Arthur Burns went to Eisenhower and Eisenhower's cabinet saying: "Hey, it looks like we're having a small recession right now. We don’t want the economy to be in recession on November 1960 when election day comes around do we? Please do something so I don't have to run against John F. Kennedy in September and October with Kennedy saying the republicans have done a horrible job at the economy. Look, the unemployment rate is up 6%."
And Eisenhower says no.
Richard Nixon loses the 1960 presidential election to John F. Kennedy by the very narrowest, narrowest of margins.
If you go and if you read Nixon's autobiography "Six Crises," he talks unashamedly about how if only and Burns had managed to get Eisenhower to do something to boost the economy, he would have won the election of 1960.
So now, it is 1971, and while the inflation rate is coming down the unemployment rate is at 6% or so. Who is president? Richard Nixon. Who does Nixon appoint to chair the Federal Reserve Board? Arthur Burns. What does Arthur Burns do?...
Expectations of inflation start to take off.
People say: "In the 1960s we were fooled. We didn't understand the government was following policies that would push the unemployment rate down and produce higher inflation. Now we do, we're not going to get caught out by this. We're going to raise our expectations of inflation as fast as the government can pursue stimulative policies to reduce the unemployment rate."
Add to this the 1973 tripling of world oil prices, which also raises everyone else's expectations of inflation.
By late 1973, the economy is up here with 10% inflation and 5% unemployment. And in 1974 Gerald Ford becomes president and makes his highest priority to Whip Inflation Now: W.I.N. Republicans wander around Washington wearing W.I.N. buttons. The Federal Reserve tightens. There is a steep--for the day--recession. But inflation only falls back to 6% or so. And at this point the Carter administration takes office as Jimmy Carter runs against Gerald Ford for presidency ontwo major issues. The first was that Gerald Ford was picked by Nixon the liar. The second is that the Republicans have mismanaged the economy: the Misery Index, the sum of the inflation and unemployment rate, is at sky high levels because the Republicans have clearly mismanaged the economy.
Carter's economic policy team decides to pursue a policy of "gradualism." They hope that they can gradually recover from the recession and gradually reduce inflation expectations. And they were wrong--especially after the additional tripling of world oil prices because of the Iranian Revolution. Come 1979 the United States is stuck with unemployment about at its natural rate of 5% or so, about at the level at which there's neither upward nor downward pressure on inflation from unemployment, and an inflation rate up at 12%.
This is the point at which Jimmy Carter names Paul Volcker to head the Federal Reserve, and Paul Volcker says this has got to stop. America cannot afford a situation where not only are expectations of inflation high, but expectations of inflation are increasing. If people were expecting 4% inflation in the early 1970s and expecting 8% inflation in the mid 1970s, they were expecting 11% inflation in 1980 and were on a trajectory to expecting 15% inflation come the mid 1980s.
At this point Paul Volcker assembles the rest of the Federal Reserve behind him. He says: "We are just going to hit the economy on the head with a brick. We are going to push unemployment up high above 10%. We are going to keep it there and show people that we are serious about fighting inflation until expectations of inflation fall."
And he did.
During the initial stages of the Volcker disinflation, the economy moves back along its early 1980s Phillips Curve. Unemployment rises. Inflation falls but only because Volcker has hit the economy on the head with a brick, creating lots of unemployed workers willing to work for less. But as inflation expectations fall, Paul Volcker allows the unemployment rate to fall. By 1987 when leaves office, the inflation rate is down to 3.5 and the unemployment rate is down to 6.5%.
It is at that point that Alan Greenspan takes over as chair and thinks: "Hmm, there's been the stock market crash, maybe there's a depression threatening, I'm going to let inflation fall or unemployment fall faster than Volcker did and see what happens." And indeed, he lets inflation fall faster than Volcker did--and the inflation rate starts rising again back towards 6%. Then Greenspan reverses course. He raises interest rates and pushes unemployment up.
In the process, he makes it harder for George H.W. Bush to win reelection, and Bush does not--a thing for which the Bush family has never forgiven Alan Greenspan. Talk to Bush family retainers about Alan Greenspan--it is extraordinary.
But Greenspan's reversal of his expansionary course did anchor inflation expectations. And once Alan Greenspan has everyone's attention, he finds in the 1990s that he can let the unemployment rate fall gradually as inflation expectations fall. By the end of the 1990s, we're back essentially to where we were at the start of the 1960s: everyone expecting low inflation around 2% or so, and with a relatively stable Phillips Curve.
And things change again in 2008. The unemployment rate starts to rise like a rocket. It rises far that by now the Phillips Curve is telling us to expect the inflation rate to be -2% or so. But we're not there. We're still stuck here with inflation of maybe 1%, 1.5% even though unemployment is still nearly 9%.
Why is this the case? Is it the case that people now expect inflation to be 4%? What seems to happen is that this Phillips Curve relationship breaks down when the rate of inflation gets very low.
The best hypothesis I've heard for why it isn't true comes from Yale economist Truman Bewley: It is true that people are unhappy if their wage increases don't keep up with the rate of inflation--if inflation is 4% and you get an only 1% wage increase, you're unhappy. But people are furious if your boss cuts your wages--if inflation is 1% and they cut your wages by 2%, you're not just unhappy, you're enraged. There's something about cutting the number of dollars that you're going to be paid for doing the same work in the American psyche that gets people really angry, and makes them really unwilling to put in the effort to be good workers.
And so, Truman Bewley argues, because each company know that cutting people's wages is a way to guarantee that they'll do a lousy job, businesses are overwhelmingly unwilling to cut people's wages at all. They would rather fire more people. And so the Phillips Curve model breaks down whenever you get into situations like we are today, where the inflation rate is very, very low.
The takeaway is that while the general Phillips Curve model for inflation economics is useful, it is fragile. Come the late 2000s and today's situation and the model simply breaks down.
But we think we won't always stay at unemployment of 8.8% or higher forever Things will get better. And when we get back to a more normal unemployment rate, we can bet that the expectational Phillips Curve relationship will reemerge.
So why does all this matter? Should we really care about inflation? If wages and prices rise at about the same rate, why is inflation a problem at all? Wny would anybody deliberately do what Paul Volcker did in 1980, deliberately trigger a very nasty episode because he thinks inflation needs to be reduced?
Back at the start of the 1980s, Paul Volcker and his peers on the Federal Reserve Open Market Committee did explicitly seek to raise unemployment rates to purge inflationary expectations out of the economy. They thought having an economy in which the inflation rate is 4% or 3% or 2% was a very valuable thing as opposed to an economy where the inflation rate was 10% or 15% or 20% per year.They thought that throwing a lot of Americans out of work for a long time was an acceptable price to pay for achieving this particular goal.
One reason is that inflation distorts what your view of the world is. A market economy works by people using prices to calculate what they ought to do and what things were valuable. An ongoing process of inflation makes all these calculations difficult. Thus inflation deranges the price system.
Inflation is also unjust. Let's listen to John Maynard Keynes on this:
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.
The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become 'profiteers,' who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.
As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose...
So it looks as though John Maynard Keynes would have approved of the Volcker disinflation.
But the big reason why governments act like the way that Volcker did is that inflation is politically unpopular. It was Jimmy Carter's chief economist Arthur Okun who decided to run against Gerald Ford by talking about the Misery Index--the sum of inflation and unemployment. And Ronald Reagan and his economic advisors did the same thing to Jimmy Carter four years later in 2000 when things were considerably worse. In Britain Labour party leader James Callaghan was defeated a year or two before Jimmy Carter by the Conservatives precisely because of inflation. By contrast, both Ronald Reagan and Margaret Thatcher win reelection in the early 1980s, even though unemployment was considerably higher, in substantial part because inflation was lower. Sharp reductions in inflation lead the voters to vote with their feet for Reagan and Thatcher for their reelection against Walter Mondale on the one hand and Michael Foot of the Labour Party on the other.
These things made governments think that central banks ought to act to keep inflation low whenever they can--and also politicians would rather that central banks just do what has to be done and not talk to them too much. They want low inflation. They don't want to be on the hook for the decisions necessary to achieve it.
I was going to end this lecture with a brief survey of the Federal Reserve System. I was going to say the Federal Reserve Board consists of a chairman who has a four-year term, a vice chair who has a four-year term and of five other members of the board of governors. There also are the 12 presidents of the regional Federal Reserve banks, who sit as voting or non-voting members on the Federal Reserve's chief decision making body, the Federal Open Market Committee.
I was going to say that the chairman of the Federal Reserve Board is the chairman of the Open Market Committee, but the vice president of the Open Market Committee isn't the vice chair of the board. The vice chair of the Open Market Committee is the president of the Federal Reserve Bank of New York. And I would say that five members of the Federal Reserve Board are voting members of the Open Market Committee and the other seven non-voting members. The president of the Federal Reserve Bank of New York is always a voting member of the Open Market Committee. Of the other 11 regional bank presidents, at any one point in time, only four will vote. The president of the Federal Reserve Bank of San Francisco gets to be a voting member of the FOMC only once every three years. How do you choose four from 11? Well, the Federal Reserve Bank of Cleveland and Chicago are special. Their presidents get to be voting members every other year as opposed to once out of every three.
But I don’t have time to do any of this. So we will pick up the threads on Thursday.
IAS 107 Intermediate Macroeconomics March 17, 2011 Inflation Lecture Cleaned-Up Transcript
IAS 107 Intermediate Macroeconomics March 17, 2011 Inflation Lecture Cleaned-Up Transcript
J. Bradford DeLong
U.C. Berkeley
The main meat of this lecture is Inflation Economics.
Here we see the consumer price index for all urban consumers in the United States of America since 1950. The price level today is 10 times as high as it was in 1950. If you had a dollar in 1950, you could have bought about ten times as much stuff as you can with a dollar today.
You can argue over whether this is right. There are lots of things that we consume and that we like to consume and that we spend our time doing today that are to a first approximation absolutely free today that that were simply unavailable in 1950. In 1950 the number of people who could watch television was in the hundreds. Things that people used to pay substantial amounts of money for in the 19th century or even in 1950 are available to us virtually free through either broadcast media or the internet.
Back in 1890, New England Utopian Edward Bellamy wrote a book--Looking Backward--that was one of the five bestselling novel of the late 19th century. That Looking Backward was a best-selling novel is worth noting because it is execrable. It is close to the worst novel you could imagine. Complete cardboard characters. No interesting plot. Completely unconvincing romantic subplot. Implausible contrivances. Author stepping out of his role to preach at you over and over again. No possible reason for anyone to read it.
Except that millions and millions of people in America did.
They read Looking Backward because it painted a picture, gave them a wonderful dream, told them what life would be like in the rich world of abundance that Bellamy foresaw for 2100.
And of all the marvels of wealth and abundance that Bellamy's protagonist sees in 2100 after he is transferred forward in time by a totally implausible plot device is this:
The house he winds up staying in in 2100 has its own telephone.
Not only does it have a telephone, but it has a speaker phone.
And not only does it have a speaker phone, but you can call up anyone on it.
And not only can you call up anyone on it, you can call up an orchestra that is currently playing in the city.
And you can put that orchestra on the speaker phone so that you can listen to music in your own home.
And you can not just listen to music--you have a choice: you can choose among four different orchestras.
And when confronted with this marvel of technology, Edward Bellamy's protagonist says:
It appears to me, Miss Leete, that if we could have devised an arrangement for providing everybody with music in their homes, perfect in quality, unlimited in quantity, suited to every mood, and beginning and ceasing at will, we should have considered the limit of human felicity already attained, and ceased to strive for further improvements...
Transformations like this are not in the consumer price index because the Bureau of Labor Statistics cannot count them. It can count by how much the prices of those things that people bought last year changed between last year and this year. It can weight those relative price changes by their share of spending last year. That is what the consumer price index does: it tells you how much more expensive than it was last year is it this year to buy our representative basket of goods and services. As new goods and services are invented, the BLS adds them to the basket gradually over the course of time. But the value of adding a new good to the basket--if making it possible to do something that previously had an infinite price--the Bureau of Labor Statistics cannot calculate that. It had an infinite price last year, so the decline in price from last year to this year is infinite. But it had a zero quantity last year, so you multiply infinity by zero to get the contribution of the invention of a new good to the consumer price index. And you cannot multiply infinity by zero to get a sensible answer. So the BLS does not try.
They do do the best job that they can.
Economists believe that the consumer price index by and large, understates how fast we're growing rich that it overstates the actual cost of living. We squabble over what the overstatement of inflation in the consumer price index is. Is it something like a percentage point per year? Maybe. Maybe it is more. Maybe it is less. Keep a CPI inflation-overstatement number of 1% per year in the back of your head. That is what I do.
Our inflation rate has not been even. See this 10% inflation rate rate at the start of the 1950s? This is the Korean War. In 1950 dictator Kim II-Sung of North Korea decided that it was time to reunify the country. He sent his Soviet Union-armed army south. First the American army and then the United Nations force intervened in response. The United States rearmed massively to fight first this hot war and then the Cold War. We had an enormous surge of government demand for goods that were already in short supply. Prices jumped by almost 10% in a year.
After the Korean War ebbed, the rate of inflation fell back to its normal level for the 1950s--1.5% or 2% per year or so.
And then, in the 1960s, inflation started to creep up. It crept up late in Lyndon Johnson's and into Richard Nixon's administration. At the end of the 1960s the Federal Reserve decided that inflation was too high. It decided to raise interest rates, raise unemployment, create a little excess supply on the labor market, create a few more workers looking for jobs who'll say, "I know you are paying this guy $8 an hour, but I'll work for $7 an hour," create a little more excess capacity in the factories so businesses will be a little bit hungrier for business and say, "We know that we were going to charge you $20 for this product but because we have excess capacity and want to sell more, we'll only charge you $19."
And so inflation falls.
The Federal Reserve thinks that it's gotten things under control.
It breathes a sigh of relief.
Then the 1973 Arab-Israeli War comes along. With it comes an oil embargo from the Middle East. The world price of oil triples. U.S. inflation rises to a peak of 12%.
The Federal Reserve hits the economy on the head with a brick again. It raises interest rates again. It so diminishes investment spending, GDP, and employment. With excess supply in the economy, the inflation rate falls back to 5%. The Federal Reserve concludes again that the situation is now under control and will return to normal. But the problem is that the late 1970s sees a new normal--with an inflation rate now of 6% per year rather of the 2% per year in the 1950s and early 1960s.
The economists in the Carter administration squabbled about what to do. When inflation that was at 1.5% or 2% per year, that didn't strike anybody as a problem. At 6% per year inflation, everyone has to change their prices all the time. Memories of what things ought to cost are no longer reliable. But reducing the inflation rate below 6% would require pushing the unemployment rate up. What was the best thing to do?
The Carter administration was still squabbling about what to do when the Iranian revolution arrived. As the Ayatollah Khomeini consolidates control the world price of oil again triples. Inflation in the United States hits a peak of 14%.
At this point newly appointed Federal Reserve Chairman Paul Volcker decides: enough is enough. Perhaps a 6% inflation rate was not something to worry about that much. But a 14% inflation rate certainly is.
Moreover, Volcker believed, the history of the previous 20 years had taught people that the inflation rate always went up.
It was necessary, Volcker decided, to disrupt this pattern of ever-rising inflationary expectations.
The next three years saw what we economists call the Volcker disinflation. The Federal Reserve did indeed raise interest rates and so hit the economy on the head with a brick to create excess supply, reduce inflation, and disrupt inflationary expectations. It keep hitting and hitting. The unemployment rate rose to its post World War II peak of 10.8%. And, when Paul Volcker was finally convinced that he had done enough to break the cycle of inflationary expectations, he eased off.
And he succeeded. He created our post-1984 relatively low inflation regime in which everyone expects there'll be a little bit of inflation. Inflation has been between 2% and 3% in average years--maybe a bit more in years when something unusual is happening like Saddam Hussein's invasion of Kuwait that caused another spike in oil prices, a bit less in depressed times like today.
That is the history of inflation in the United States over the past 60 years.
The next question to ask is: why is inflation a problem? In inflation, prices go up but incomes go up too. What's the big problem? If you have price stability, then your prices stay the same and your wages rise at the rate of real economic growth. If you have inflation, prices rise at the rate of inflation and wages rise at the rate of inflation plus the rate of real economic growth. How does that the fact that a dollar now is really the equivalent of a dime in 1950 or a nickel in 1913 hurt us? A dollar is the equivalent of a dime on both sides: both when we're earning money and when we're buying things.
It would seem to be a big zero.
Now it's not quite a big zero. Even though prices go up and incomes go up too, not all prices and incomes go up evenly. If you're holding dollars in your pocket or in a no-interest bank account, inflation is a clear loss to you. Inflation is a sneaky and underhanded way for the government to impose a tax on all of the cash that you have in your wallet. Inflation is also a big redistribution from those who did not expect inflation back when they made their contracts to those who did expect inflation when they made their contracts, and who as a result incorporated inflation allowances or inflation indexation into the bargains that they made.
More important, I think, is a loss of information carried by prices. When the price level is stable, you can go shopping for a refrigerator after a decade and you remember what a refrigerator should cost, so you can figure out whether this is a good deal or not without much effort. If prices are rising by an uncertain amount that varies from year to year between 5% and 15%, you go into a store after 10 years to buy a refrigerator and you have no idea what it should cost because all your memories of previous refrigerator shopping are inapplicable.
This loss of information carried by prices puts sand in the gears of the market mechanism. It is certainly not a good thing. How bad a thing--economists argue about that.
Most important of all, perhaps, is a redirection of effort and energy to gaming the system. People running businesses and making investments should be focusing on how to make their company's production operations more efficient. They should be focused on which lines of business are likely to produce the highest social returns for more investment. They shouldn't be focusing on what the rate of inflation is going to be, how they can forecast it, and how can they profit from or at least avoid loss from the inflation process. This redirection of effort and energy away from actually making things better and cheaper and more efficiently, to figuring out how to deal with the complexities of the monetary system is probably the biggest loss that comes from an ongoing process of inflation.
High inflation is a very big negative for politicians in office because inflation is taken correctly to be a sign of an incompetent government. A government that presides over high or even moderate inflation is a government that's likely to lose the next election. Thus politicians tend to be quite firmly focused on inflation control--especially after the defeats of Jimmy Carter and James Callaghan in the US and Britain at the end of the 1970s to opponents Ronald Reagan and Margaret Thatcher, who promised to control inflation and then did so.
How should we think about the process by which you get inflation? The easiest way to think about it is simply to go to the quantity theory of money. We all hold money in our pockets, in our bank accounts, in the unspent balances on our credit cards. We all hold money for one reason, to spend it.
If you don’t want to spend it, there are other better things to hold your wealth in than cash money. It is usually much better to hold it in a five-year treasury bond or a five-year treasury index security than to hold it in cash. Money is dominated as an asset if you're holding it for any purpose other than spending it.
And so as economist Irving Fisher a century or more ago said, money has a velocity for which we use the letter V. And the velocity V of money is the pace at which people are used to spending the money in their pockets. V tends to go up when interest rates rise. V tends to go down when interest rates fall. V changes as the banking technology of the economy changes. V is larger if more spending is done by the government, etc, etc. But you take the total amount of money in the economy. You multiply it by the velocity of money (V). You divide it by the level of real spending in the economy (Y). You get the price level (P).
Want to keep the price level from going up? Keep the money stock (M) from going up. And that was Milton Friedman's central career insight: that inflation is ultimately a monetary phenomenon.
How exactly does adding to the stock of money boost the price level? What happens when the central bank expands the money supply? It engages an open market operations: it buys bonds for cash. That pushes down the interest rate on bonds. That tends to make investment and exports grow.That pushes to push up the level of demand in the economy. Workers demand higher wages. Firms find that they can insist on higher markups. And the price level rises.
So there is a link between the income-expenditure model of how the central bank affects production and the inflation economics quantity-theory model of how the central bank's increases in the money stock influence the price level. To look at that link we would like a nice measure of the supply and demand balance, or the gap between the economy's current level of production (Y) and its potential level of production (Y*) so that we could see whether income and expenditure are putting upward or downward pressure on inflation. And we're lucky in that we do have such a measure: the unemployment rate.
Recall Okun's Law: the graph that plots the relation between changes in real GDP along the horizontal axis and changes in the unemployment rate along the vertical axis. Take the change in output relative to the current level of output, subtract off the population growth rate, subtract off the rate of growth of the efficiency of labor, and then multiply the result by -0.5. That is what the change in unemployment should be over a year.
This relationship has broken down somewhat over the past two years. But, by and large, when the level of production in the economy is growing faster than potential output, unemployment will fall. When the level of production is falling or growing more slowly than potential output, unemployment will rise. So we are going to focus on the relationship between the unemployment rate and the change in the price level--the rate of inflation.
We start from our income expenditure model and figure out how fiscal policy, monetary policy and the economic environment have together produced the level of real GDP in the economy. We can compare that to the level of potential output and use Okun's Law to calculate the unemployment rate. But how then do we go from the unemployment rate to the level of inflation?
We write down another equation:
π = E(π) + b(u*-u)
We write this little π for the inflation rate--the proportional rate of change in the price level. Why π? Because we wrote P for the price level. π is the same letter in Greek as in P as in Latin. We're going to write E(π) for the expectation of inflation rate, for what people in the market thought inflation would be when they made their plans and bargains six months or a year or two years ago, or whenever We write u for the unemployment rate. We write u* for the natural rate of unemployment--the non-accelerating inflation rate of unemployment--the rate of unemployment at which production is equal to the economy's potential output and markets are in balance, with producers and purchasers neither being surprised by excess supply or surprised by excess demand.
We write these variables down in this equation:
This equation tells us that the inflation rate this year is going to be what people expected the inflation rate to be plus this parameter b times the difference between the natural rate of unemployment and the actual rate of unemployment.
π = E(π) + b(u*-u)
We think about this equation like so: We think that people last year made their plans about what they were going to ask for in terms of wages and charge in terms of prices. Then this year rolls around. Either the unemployment rate is higher than the natural rate of unemployment or it is lower. Either capacity utilization is lower than its normal value or higher.
If the unemployment rate is higher than its natural rate and if capacity utilization is lower then workers say: "Oh, wow there are lots of unemployed workers out there who might compete with with me for my job. I shouldn't ask for wage increases as high as I had planned on. I should go to the bosses and volunteer to accept a 2% lower wage increase this year--because we understand that we could be replaced and we also understand that business is slow. So whenever capacity utilization is low and unemployment is high, actual inflation is going to undershoot expected inflation. Conversely, whenever the unemployment rate is low and capacity utilization is high, actual inflation is going to overshoot expected inflation.
That is the Phillips Curve.
There are other things that you could throw into this equation. Most important are supply shocks that push up some prices without lowering others: the triplings of world oil prices in 1973 and 1979 had direct effects boosting inflation even though they did not act directly on either expectations or on the rate of unemployment.
How well does this Phillips Curve do? Most of the time expectations of inflation are what economists call adaptive. People just take a look at what the current rate of inflation is and they say inflation next year is probably going to be about the same as inflation this year. Thus people adapt over time if inflation goes up. If inflation this year is higher than what inflation was last year, then people looking forward two years from now are not going to expect that inflation will return to its old value. Adaptive expectations are a pretty good rule of thumb for the United States recently, but not a good rule of thumb for places where inflation is doing something weird or getting out of control--like say Zimbabwe in the late 2000s.
If expectations of inflation are adaptive, then the change in the inflation rate should be strongly correlated with the unemployment rate. When unemployment is high inflation should be falling--if the Phillips Curve is worth much. When unemployment is high inflation should be rising--if the Phillips Curve is worth much.
How does it do?
This is the graph we get for the post-World War II U.S. Not the tightest fit in the world, but by and large and on average unemployment rate is bigger than 6.5%, you can bet that the inflation rate is going to fall. Whenever the unemployment rate is less than 5% you can bet that the inflation rate is going to rise. In between it is not clear whether inflation is more likely to rise and fall.
That is our uncertainty about what the natural rate of unemployment is--and the natural rate of unemployment shifts over time.
This is a relationship that you can take to the bank--not in six months, not in one year, but over a five-year period.
This is the Phillips Curve.
If we are going to graph the Phillips Curve, you need to know three things: the current expected rate of inflation, the natural rate of unemployment, and the slope parameter β. The Phillips Curve goes through the point on the graph where inflation is equal to expected inflation and unemployment is equal to the natural rate--in fact, you might as well take those as the definitions of the natural rate and of expected inflation. And the parameter? We simply look and see. There are theoretical reasons to believe that the more volatile inflation is the steeper the Phillips Curve will be, but we have no good derivation from microeconomic foundations or from behavioral foundations of what the slope of the Phillips Curve is. We just have the data. And the data says: about 1/2, for the U.S. since World War II.
If expected inflation rises, if something happens that makes people think that inflation will be higher than they'd thought before--like the election of François Mitterrand to the presidency of France at the start of the 1980s--the Phillips Curve will jump up. If expected inflation falls--as happened after Paul Volcker had hit the economy on the head with a brick to create excess supply to make firms stop raising their prices, and after people realized he was serious--the Phillips Curve will shift down.
Let me just make one more note: Japan in the 1990s. The actual inflation rate hit 0 and then went a little bit further and stuck. It didn't fall much below 0 even though expected inflation was 0 and unemployment was far above Japan's natural rate. This Phillips Curve relationship does not seem to apply to today to situations of inflation, when consumer prices are actually falling. But in the United States during the whole period since World War II the inflation rate has been positive with the exception of one quarter in 2009.
Another note about what determines the location of the Phillips Curve. When inflation is above expected inflation we expect the Phillips Curve to jump up over time. When inflation is below expected inflation we expect the Phillips Curve to shift down over time. But there are times when inflation expectations are what the Federal Reserve calls "well anchored": just because inflation is high or low this year doesn't mean people are going to change their expectations of inflation. They have confidence the Federal Reserve has a stable inflation target and is going to push the economy to that target.
The natural rate of unemployment is usually stable: 5 or 6% in the US today. Sometimes it won't be. Back in the 1970s when baby boomers like me were entering the labor force, and people in their 20s, they're really lousy at job search. They don't know how to work the system. They tend to mouth off in front of their bosses and get fired. A labor force that has a lot of twenty-somethings will have people who won't keep their jobs very long on average and will have a hard time finding their jobs after they lose them. So we should expect the natural rate of unemployment in an economy to be higher when a baby boom generation is in its 20s than when a baby boom generation is like now in its 50s. And that seem to be true. That the natural rate of unemployment fluctuates with the demography.
And there are worries about structural unemployment. If the structure of the economy is changing rapidly so that a bunch of industries are shrinking rapidly and a bunch more are growing rapidly, those workers who are losing their jobs in the declining industry is going to have a hard time picking up the skills needed in the expanding industries. Won't that push up the natural rate of unemployment? Yes.
And if your unemployment rate is high for a long time--as it is going to be in the United States, people who would normally be busy finding and working at jobs won't really be looking for work or will have lost so many of their job related skills or have lost so much of the ability to actually show up at 9 o'clock five days a week that people will be loathe to hire them. Doesn't a prolonged period of high unemployment itself raise the natural rate of unemployment? Yes.
If you look at the actual history of unemployment and inflation in the United States since 1950 or so, you get what at first glance looks like a complete and total mess. But you can use the idea of the Phillips Curve to make sense of the dynamics of unemployment and inflation in the United States over the past 60 years.
Starting in 1950 we see the Korean War start. By 1951 the unemployment rate is down to less than 3.5% because of expansionary fiscal policy, and our inflation rate is up to 8%. The inflation rate comes down after this big boom of wartime related inflation is over. And then from 1955 to 1960, you can perform--– you see the economy performs a loop. As the unemployment rate falls, the inflation rate tends to rise, as the unemployment rate rises, the inflation rate tends to fall. And by the start of the 1960s, you're more or less back to normal.
So you look at the economy in the 1950s and, yes, there is a relationship between unemployment and inflation, there's a Phillips Curve. It's not a terribly tight relationship, but those times when unemployment was higher were times when inflation was lower, and those times when unemployment was lower where times when inflation was higher.
In the 1960s the Phillips Curve fit is much tighter. Unemployment falls, and inflation rises. It looks like there was a quite stable Phillips Curve in the 1960s.
And then in 1970 something happened. Things went haywire. Unemployment rose and inflation rose too.
What happened in 1970 was the breakdown of static inflationary expectations. Recall that the position of the Phillips Curve is going to change if either the natural rate of unemployment changes or if expected inflation changes. The natural rate of unemployment wasn't changing much over this time period. Neither was the economy's expectations of inflation--until 1970.
In 1970 people wised up. They noticed that inflation was rising, and so they began the process of raising their expectations of inflation. Year by year they raised their expectations of inflation and year by year the Phillips Curve headed up.
And let me stop there. Have a good vacation. I will see you all in a week and a half.
March 30, 2011
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