Inflation and Price Stablility

Many Market Monetarists, starting with Scott Sumner, believe that there is a long run Phillips Curve.   In their view, higher inflation leads to lower unemployment.   Further, many, again starting with Scott Sumner, believe that unemployment reduces social welfare, and so support higher inflation for that reason.  

However, inflation has its own costs, mostly due to taxing nominal returns on capital.    The higher the inflation rate, the higher the real rate of taxation on capital.   Excessive taxation of capital prevents an efficient intertemporal allocation of resources.  If capital income was properly indexed for inflation, this could be avoided.   And with a stable trend inflation rate, a reduced tax rate for capital income would solve this problem as well.   A consumption tax, which Sumner favors anyway, would solve the problem altogether.    Presumably, Sumner would then favor much higher inflation rates if his preferred tax regime was introduced.

Why is it that expected and persistent inflation leads to a lower unemployment rate?    The argument was made during the heyday of Keynesian demand management.   Firms don't cut nominal wages, and so when real wages need to fall in contracting sectors of the economy, inflation allows no or slower growth in nominal wages to generate the necessary drop in real wages.  

The alternative to falling real wages is increased layoffs of workers in those industries.    Since people who are laid off become unemployed, fewer layoffs would seem to imply less unemployment, more production in contracting industries, and higher levels of social welfare.    The higher the inflation rate, the larger the decrease in real wages that can be imposed without a decrease in nominal wages.   And so, the fewer layoffs in those industries where real wages need to fall and the lower the unemployment rate.    

At some very high level of inflation, there would never be a decrease in equilibrium real wages so great as to require constant nominal wages, and so further increases in trend inflation would provide no benefit.    The most likely scenario is that the higher the inflation rate the smaller the decrease in the unemployment rate and the less the improvement in social welfare.   Assuming there are costs to inflation (and with taxation of unindexed capital income, there are such costs,) there is a trade off for inflation.   The inflation rate should be increased to a point where gain due to reduced unemployment is offset by the loss due to excessive capital taxation.

I certainly grant that there is an element of truth to this story.   However, unemployment is not simply a matter of how many layoffs occur.   There are also new hires.   How fast do the expanding industries hire new workers?     While I do think that it is generally wise for people unhappy with their current place of employment to first find a new job and then quit, rather than quit and begin a full time search, I think it is likely that a regime where workers that need to go are pushed out the door will also be a regime where expanding firms increase employment more quickly.    If workers in contracting sectors procrastinate while they fall further and further behind, the other side of that coin is that expanding sectors will grow more slowly.  

Now, if we imagine a scenario there there is no need to reallocate labor at all, but rather an increase in the real demand for money that requires lower prices and nominal wages, then a failure of wages to adjust and instead have workers laid off is a waste.   In my view, the problem is that firms are getting the signal that they should contract and reduce employment, but in reality, there is no reason for them to do so.    

More realistically,  there are firms that should contract production and employment and other firms that should increase it.   But the firms that do need to contract production and employment are getting an exaggerated signal.   Meanwhile, many of those firms that should be expanding output and employment are getting a dampened signal.   And worse, some firms that should be expanding production and employment get the false signal to instead contract.

But if there is no such imbalance in the supply and demand for money, and there is instead a change in the composition of demand between various sectors,  so some firms need to expand and other firms need to contract so that labor and other resources are allocated to producing what people want most, then those firms that are contracting are receiving the correct signal.   They should be using fewer resources because those resources are better used elsewhere in the economy.

If labor markets were auction markets, then the firms with lower demand for labor would bid less, and the firms that needed more would bid more.   The firms that needed more labor would be the highest bidders, and they would obtain the labor.

Of course, labor markets are nothing like this.  (Nor are most other markets much like this.)   

Still, we can imagine employers in contracting industries cutting the wages they set for their workers while firms in expanding industries raising the wages they set for their current workers and for those they hope to hire.    Then some of the workers in the contracting industry will quit because of the pay cuts and obtain new, better paying jobs in the expanding industries.   It is more or less like an auction market.  

But firms do not operate in this way.   For one thing, rather than cut all the workers' pay and let the workers best able to find alternative employment quit, they prefer to decide which workers they want to keep.    Now, it would be entirely possible, then, to cut the pay of the workers that the firm  does not want to keep.   Then those workers, that the firm doesn't want, can find new jobs in expanding industries and quit after  they find the new jobs.

The long run Phillips curve amounts to the claim that firms are less willing to cut the pay of workers they don't want to keep and more willing to give them smaller (or no) cost of living pay increases.     If they must absolutely cut their pay, the firms would prefer to lay them off, but if they are simply singled out for no raises, while the other employees the firm wants to keep continue to get productivity and cost of living pay increases, then firm is willing to keep them on until they choose to quit.

There is a need to reallocate labor between sectors of the economy.   Rather than cut some workers' wages so that they quit and go work somewhere else, firms and workers appear to prefer to lay off those workers and have them go work somewhere else.   However, supposedly if there is inflation, the firms and those workers they want to leave will continue their current employment temporarily with nominal wages staying constant or growing less than inflation, until the falling real wages cause them to find new jobs and then quit.   This involves less unemployment because the workers leave their current job only after they already have a new job.   They don't need to spend any time searching.

In my view, what is happening here is that firms and workers who really prefer no wage cuts (for some reason,) are one or the other being exploited.  

Is there money illusion?  Perhaps.  

If there is money illusion, is it morally right to exploit it in order to lower a statistic?    Or, of course, to try to change labor markets so that workers suffering a loss in real wages in their current place of employment wait until they find a new job before quitting rather than being forced to leave, and then spend time searching for a new job, and then start on their new career?

We live in a world of growing real wages.    We live in a world where it is desirable to reallocate labor between areas of the economy.  Why shouldn't real wage cuts be a limit, so if the amount of labor currently allocated to some firm or industry can only be profitably employed at lower real wages, it is better to reduce employment enough so that real wages  do not fall and have those workers do something else?   Why is it desirable to exploit money illusion to interfere with that labor institution?

The proper way to look at this is whether the monetary regime is providing an appropriate macroeconomic environment for those within in it to achieve their own goals.   I think that looking at it as something that is manipulated by an outside God-King economist to maximize his conception of social welfare is wrong.    

In the situation where there is no need to reallocate labor, but rather an increase in the demand to hold money, having all prices fall and all wages grow more slowly, or even shrink, is undesirable.   Every firm and worker gets the signal that they need to produce less and workers need to go find something else to do.   But there is nothing else to do, or rather, not all industries need to shrink at once.    Real wages don't need to decrease for anyone, and any money illusion where people wrongly take the decrease in nominal wages as a decrease in real wages is an error.   Avoiding this sort of confusion is useful for those producing and consuming within the monetary regime.

This implies that a stable price level is the best approach.   Fixing the quantity of money implies that any shift in the demand to hold money creates false signals for an unnecessary reallocation of resources and labor.   A commodity standard would be the same if the stock of the commodity were truly fixed, but in reality, both shifts in the supply and demand for the commodity create false signals to reallocate resources when all that is needed is a realignment of nominal prices and wages.   Or rather, shifts in the demand for the commodity creates very exaggerated signals for what is a minor need to shift resources towards or away from production of the commodity defining the standard. 

However, a monetary regime that keeps the price level stable also has problems when there is a shift in the supply of some particular good.    If the supply of a good falls, and that leads to a higher price for that good, a stable price level requires that the prices of other goods fall.   It also requires that wages (and other nominal incomes) fall, or grow more slowly, to reflect the slightly lower real incomes.    To the degree the higher price level is to due a decrease in supply, there is little or no need to reallocate resources.   And further, lower, or more slowly growing, real wages would not provide an appropriate signal to reduce employment in nearly all of the economy and shift it elsewhere.   

That is why I think that slow, steady growth of spending on output provides the best macroeconomic environment for microeconomic coordination.   In my view, the best rate of spending growth matches the growth rate of the productive capacity of the economy.   And that will generate a stable price level on average.    If there are shifts in demand between various sectors of the economy, prices in contracting sectors will fall and nominal and real wages will grow more slowly.   If firms and their employees refuse to cut real wages, then if the contraction is severe enough, workers will be laid off in those sectors.   In the growing sectors, prices and profits will rise, and real wages will increase more rapidly, providing opportunities for workers laid off in contracting sectors as well as an incentive for other workers to quit their current jobs, shift to expanding industries, and receive higher pay.

If there is an adverse supply shock in some particular market, the price of that good will rise.  And everyone in the rest of the economy will have a lower real income because they will not be able to afford as much of the good with the higher price.   It is likely that little or no reallocation of resources would  be desirable.   Of course, to the degree there is a shift in demand away from other goods and towards substitutes of the good with reduced supply, then the appropriate signals and incentives for reallocated resources, including labor, are generated.

If there is an increase in supply of some good, the result would be a lower price for that good, a lower price level, and higher real incomes.   People will be able to afford more of the good with the increased supply because of its lower price.   Forcing up other prices and nominal incomes, including more rapid increases in wages, creates the wrong signal--suggesting that the production of everything else should be increased.  

Avoiding false signals due to monetary disturbances makes money better serve the purposes of those using it.   The problem with having prices and wages adjust to make the real quantity of money match the demand is that it creates false signals.   The problem with stabilizing the price level in the face of supply shocks is that it creates false signals.   If people have "money illusion" and treat money as an unchanging macroeconomic background, then when the value of money changes, or when it is stabilized despite shifts in supply, the result is systematic errors.   A monetary regime that avoids these false signals allows people to better treat money as an unchanging macroeconomic backdrop for their microeconomic choices.

It is completely different when persistent inflation is used to try to exploit money illusion to keep them from doing what they want.   And that is what exploiting the long run Phillips curve seems to be doing.

I also believe that the "long run" Phillips curve is not stable and that there will be a tendency for the target inflation rate to become the new zero.   All the reasons why firms and their employees reject absolute cuts in wages will become reasons why they insist on "cost of living" raises.    It is only recently that the Fed explicitly admitted that it had no interest in price stability and instead intended 2 percent inflation.  

Worse, the institution of cost of living raises creates an incentive for employers and their workers to increase nominal wages more rapidly when there are adverse supply shocks.   That is a very bad consequence and would cause unemployment to rise due to such shocks.

A much simpler and clearer message is that when prices rise on average, it is because supply has grown more slowly, likely because of decreases in the supplies of some particular goods.    The answer is to conserve the use of those goods and purchase substitutes.   Pleading for or demanding higher wages is never the proper response.    This is in contrast to a  regime of persistent trend inflation, which makes insisting on cost of living raises reasonable.  

No cost of living raise this year?  You must want to get rid of me.  I'll show you!   What do you mean a 2% cost of living raise.   The cost of living rose 4%, when was the last time you purchased gasoline?

In my view, trying to take advantage of money illusion is wrong.   Instead, create a monetary regime that is attractive to those using it.   Create a regime where money illusion creates as few problems as possible.  Don't try to exploit money illusion to improve "social welfare."