Why Not Inflation?

I advocate a slow, steady growth path for money expenditures on final goods and services. I favor a growth rate equal to the trend growth rate of potential income--the productive capacity of the economy. The result should be a trend growth rate of money incomes equal to the trend growth rate of real income and a price level for final goods and services that is stable on average.

The Federal Reserve, however, favors having slow, steady price inflation. In their view, the CPI should rise about 2 percent a year from where it happens to be. If there is some error, or as they like to describe it, surprise, perhaps causing the price level to rise 4% in a year, then it should just increase at a 2 percent rate from there. In other words, the growth path for the CPI is unachored, but the growth rate is kept rising at 2 percent.

Leaving aside the unanchored path, why not have persistent inflation?

I believe that persistent inflation leads to the phenomenon of explicit or implicit cost of living pay increases. These cause no problem if the economy always remains in equilibrium. Equilibrium money wages increase with the increase in equlibrium real wages plus the inflation rate.

But suppose there is an adverse aggregate supply shock. With money expenditure targeting, the growth path of nominal incomes remains unchanged. The adverse aggregate supply shock causes the price level to move to a higher growth path, and as that adjustment occurs, the inflation rate is higher. Real incomes, including real wages, shift to a lower growth path. This reflects the reduction in productivity.

If the supply shock is permanent, then the price level remains stable at a higher level. If, on the other hand, the supply shock is reversed, then there would be tempory deflation and the price level would revert to its initial value.

Suppose, however, that workers demand "cost of living increases." More importantly, suppose employers believe that they must provide such increases in order to keep and continue to recruit good workers. While the experience of employers and employees is that cost of living increases generally work smoothly, with each firm able to pass on the added costs in the form of higher prices along with growing real sales, with an adverse aggregate supply shock, this is not true.

If employers seek to increase money wages to compensate for the higher inflation, and money expenditures remain on target, the resulting decrease in real expenditures will cause reduction in production and employment. While an adverse aggregate supply shock inevitably has adverse effects on production and might also adversely impact employment because of a need to reallocate labor, trying to avoid the reduced real income by raising money wages and prices is impossible.

Recently, there has been some concern that the run up in food and energy prices might be reflected in rapid increases in wages. If that occurs, it will begin a wage and price spiral. To avoid this, some argue that the Fed should tighten monetary policy to prevent the increase in food and energy prices. A rather unpleasant prospect with unemployment remaining near double digits.

But if the Fed has a policy of having the purchasing power of money drop continuously, and raising wages to compensate for that inflation generally has no adverse impact, should a tendency for employers and employees to raise wages due to a "higher cost of living" be a surprise? Further, with the unachored growth path for the CPI, an error that leads to an excess supply of money and an increase in aggregate demand will result in a higher equilibrium growth path of prices and wages. Here again, compensating workers for the higher cost of living is appropriate.

Consider instead a world where prices are usually stable, and when they rise to a higher level, this implies an adverse aggregate supply shock and any effort to raise money incomes and prices to offset this will have adverse consequences. Here the lesson is that employers are not in a position to compensate employees for higher prices with higher wages.

In my view, what employers and employees should learn is that inflation and higher prices is the result of slow growth or even decreases in productivity. The "answer" is efforts to enhance productivity--for example, working more or harder.

Presumably, if all markets clear like the stock market, there is no problem. Wages will only rise with the trend rate of inflation or shocks to aggregate demand. They won't rise when there is an adverse shock to aggregate supply. Unfortunately, I don't think that is the world in which we live.