Baumol & Blinder MACROECONOMICS (11th ed)
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If workers and firms behave this way, and if they forecast inflation accurately, then the real wage will remain unchanged as the price level rises. (Notice that, in Table 2, the expected future real wage is $10 per hour regardless of the expected inflation rate.) Prices and wages will go up together. So workers will not lose from inflation, and firms will not gain. But then there is no reason for firms to raise production when the price level rises. In a word, the aggregate supply curve becomes vertical. In general:
If workers can see inflation coming, and if they receive compensation for it, inflation does not erode real wages. But if real wages do not fall, firms have no incentives to increase production. In such a case, the economy’s aggregate supply curve will not slope upward, but, rather, will be a vertical line at the level of output corresponding to potential GDP.
Such a curve is shown in Panel (a) of Figure 10. Because a vertical aggregate supply curve leads to a vertical Phillips curve, it follows that even the short-run Phillips curve would be vertical under these circumstances, as in Panel (b) of Figure 10.3
If this analysis is correct, it has profound implications for the costs and benefits of fighting inflation. To see this, refer once again to Figure 9 (page 323), but now use the graph to depict the strategy of fighting inflation by causing a recession. Suppose we start at point e, with 5 percent inflation. To move to point c (representing 2 percent inflation), the economy must take a long and unpleasant detour through point a. Specifically, contractionary policies must push the economy down the Phillips curve toward point a before the selfcorrecting mechanism takes over and moves the economy from a to c. In words, we must suffer through a recession to reduce inflation.
But what if even the short-run Phillips curve were vertical rather than downwardsloping? In this case, the unpleasant recessionary detour would not be necessary. Instead, inflation could fall without unemployment rising. The economy could move vertically downward from point e to point c.
Does this optimistic analysis describe the real world? Can we really slay the inflationary dragon so painlessly? Not necessarily, for our discussion of expectations so far has made at least one unrealistic assumption: that businesses and workers can predict inflation accurately. Under this assumption, as Table 2 shows, real wages are unaffected by inflation—leaving the aggregate supply curve vertical, even in the short run.
But forecasts of inflation are often inaccurate. Suppose workers underestimate inflation. For example, suppose they expect 4 percent inflation but actually get 6 percent. Then
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3 Test Yourself Question 1 at the end of the chapter asks you to demonstrate that a vertical aggregate supply curve leads to a vertical Phillips curve.
FIGURE 10
A Vertical Aggregate
Supply Curve and the
Corresponding Vertical
Phillips Curve
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real wages will decline by 2 percent. More generally, real wages will fall if workers underestimate inflation at all. The effects of inflation on real wages will be somewhere in between those shown in Tables 1 and 2.4 So firms will retain some incentive to raise production as the price level rises, which means that the aggregate supply curve will retain some upward slope. We thus conclude that
The short-run aggregate supply curve is vertical when inflation is predicted accurately but upward-sloping when inflation is underestimated. Thus, only unexpectedly high inflation will raise output, because only unexpected inflation reduces real wages.5 Similarly, only an unexpected decline in inflation will lead to a recession.
Because people often fail to anticipate changes in inflation correctly, this analysis seems to leave our earlier discussion of the Phillips curve almost intact for practical purposes. Indeed, most economists nowadays believe that the Phillips curve slopes downward in the short run but is vertical in the long run.
THE THEORY OF RATIONAL EXPECTATIONS
Rational expectations are forecasts that, while not necessarily correct, are the best that can be made given the available data. Rational expectations, therefore, cannot err systematically. If expectations are rational, forecasting errors are pure random numbers.
However, an influential minority of economists disagrees. This group, believers in the hypothesis of rational expectations, insists that the Phillips curve is vertical even in the short run. To understand their point of view, we must first explain what rational expectations are. Then we will see why rational expectations have such radical implications for the trade-off between inflation and unemployment.
What Are Rational Expectations?
In many economic contexts, people must formulate expectations about what the future will bring. For example, those who invest in the stock market need to forecast the future prices of the stocks they buy and sell. Likewise, as we have just discussed, workers and businesses may want to forecast future prices before agreeing on a money wage. Rational expectations is a controversial hypothesis about how such forecasts are made.
As used by economists, a forecast (an “expectation”) of a future variable is considered rational if the forecaster makes optimal use of all relevant information that is available at the time of the forecast. Let us elaborate on the two italicized words in this definition, using as an example a hypothetical stock market investor who has rational expectations.
First, proponents of rational expectations recognize that information is limited. An investor interested in Google stock would like to know how much profit the company will make in the coming years. Armed with such information, she could predict the future price of Google stock more accurately. But that information is simply unavailable. The investor’s forecast of the future price of Google shares is not “irrational” just because she cannot foresee the future. On the other hand, if Google stock normally goes down on Fridays and up on Mondays, she should be aware of this fact.
Next, we have the word optimal. As used by economists, it means using proper statistical inference to process all the relevant information that is available before making a forecast. In brief, to have rational expectations, your forecasts do not have to be correct, but they cannot have systematic errors that you could avoid by applying better statistical methods. This requirement, although exacting, is not quite as outlandish as it may seem. A good billiards player makes expert use of the laws of physics even without understanding the theory. Similarly, an experienced stock market investor may make good use of information even without formal training in statistics.
4To make sure you understand why, construct a version of Table 2 based on the assumption that workers expect
4percent inflation (and hence set next year’s wage at $10.40 per hour), regardless of what the actual rate of inflation is. If you create this table correctly, it will show that higher inflation leads to lower real wages, as in Table 1.
5To see this point, compare Tables 1 and 2.
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Rational Expectations and the Trade-Off
Let us now see how some economists have used the hypothesis of rational expectations to deny any trade-off between inflation and unemployment—even in the short run.
Although they recognize that inflation cannot always be predicted accurately, proponents of rational expectations insist that workers will not make systematic errors. Remember that our argument leading to a sloping short-run Phillips curve tacitly assumed that workers are slow to recognize changes. They thus underestimate inflation when it is rising and overestimate it when it is falling. Many observers see such systematic errors as a realistic description of human behavior. But advocates of rational expectations disagree, claiming that it is fundamentally illogical. Workers, they argue, will always make the best possible forecast of inflation, using all the latest data and the best available economic models. Such forecasts will sometimes be too high and sometimes too low, but they will not err systematically in one direction or the other. Consequently:
If expectations are rational, the difference between the actual rate of inflation and the expected rate of inflation (the forecasting error) must be a pure random number, that is:
Inflation 2 Expected inflation 5 A random number
Now recall that the argument in the previous section concluded that employment is affected by inflation only to the extent that inflation differs from what was expected. But, under rational expectations, no predictable change in inflation can make the expected rate of inflation deviate from the actual rate of inflation. The difference between the two is simply a random number. Hence, according to the rational expectations hypothesis, unemployment will always remain at the natural rate—except for random, and therefore totally unpredictable, gyrations due to forecasting errors. Thus:
If expectations are rational, inflation can be reduced without a period of high unemployment because the short-run Phillips curve, like the long-run Phillips curve, will be vertical.
According to the rational expectations view, the government’s ability to manipulate aggregate demand gives it no ability to influence real output and unemployment because the aggregate supply curve is vertical even in the short run. (To see why, experiment by moving an aggregate demand curve when the aggregate supply curve is vertical, as in Figure 10(a) on page 327.) The government’s manipulations of aggregate demand are planned ahead and are therefore predictable, and any predictable change in aggregate demand will change the expected rate of inflation. It will therefore leave real wages unaffected.
The government can influence output only by making unexpected changes in aggregate demand. But unexpected changes are not easy to engineer if expectations are rational, because people will understand what policy makers are up to. For example, if the authorities typically react to high inflation by reducing aggregate demand, people will soon come to anticipate this reaction. And anticipated reductions in aggregate demand do not cause unexpected changes in inflation.
An Evaluation
Believers in rational expectations are optimistic about reducing inflation without losing any output, even in the short run. But are they right?
As a piece of pure logic, the rational expectations argument is impeccable. But as is common in the world of economic policy, controversy arises over how well the theoretical idea applies in practice. Although the theory has attracted many adherents, the evidence to date leads most economists to reject the extreme rational expectations position in favor of the view that a trade-off between inflation and unemployment does exist in the short run. Here are some of the reasons.
Contracts May Embody Outdated Expectations Many contracts for labor and other raw materials cover such long periods of time that the expectations on which they were
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based, although perhaps rational at the time, may appear “irrational” from today’s point of view. For example, some three-year labor contracts were drawn up in 1996, when inflation had been running near 3 percent for years. It might have been rational then to expect the 1999 price level to be about 9 percent higher than the 1996 price level, and to have set wages for 1999 accordingly. By 1997, however, inflation had fallen to below 2 percent, and such an expectation would have been plainly irrational. But it might already have been written into contracts. If so, real wages wound up higher than intended, giving firms an incentive to reduce output and therefore employment—even though no one behaved irrationally.
Expectations May Adjust Slowly Many people believe that inflationary expectations do not adapt as quickly to changes in the economic environment as the rational expectations theory assumes. If, for example, the government embarks on an anti-inflation policy, workers may continue to expect high inflation for a while. Thus, they may continue to insist on rapid money wage increases. Then, if inflation actually slows down, real wages will rise faster than anyone expected, and unemployment will result. Such behavior may not be strictly rational, but it may be realistic.
When Do Workers Receive Compensation for Inflation? Some observers question whether wage agreements typically compensate workers for expected inflation in advance, as assumed by the rational expectations theory. More typically, they argue, wages catch up to actual inflation after the fact. If so, real wages will be eroded by inflation for a while, as in the conventional view.
What the Facts Show The facts have not been kind to the rational expectations hypothesis. The theory suggests that unemployment should hover around the natural rate most of the time, with random gyrations in one direction or the other. Yet this is not what the data show. The theory also predicts that preannounced (and thus expected) antiinflation programs should be relatively painless. Yet, in practice, fighting inflation has proved very costly in virtually every country. Finally, many direct tests of the rationality of expectations have cast doubt on the hypothesis. For example, survey data on people’s expectations rarely meet the exacting requirements of rationality.
But all these problems with rational expectations should not obscure a basic truth. In the long run, the rational expectations view should be more or less correct because people will not cling to incorrect expectations indefinitely. As Abraham Lincoln pointed out with characteristic wisdom, you cannot fool all the people all the time.
WHY ECONOMISTS (AND POLITICIANS) DISAGREE
This chapter has now taught us some of the reasons why economists disagree about the proper conduct of stabilization policy. It also helps us understand some of the related political debates.
Should the government take strong actions to prevent or reduce inflation? You will say yes if you believe that (1) inflation is more costly than unemployment, (2) the short-run Phillips curve is steep, (3) expectations react quickly, and (4) the economy’s self-correcting mechanism works smoothly and rapidly. These views on the economy tend to be held by believers in rational expectations.
But you will say no if you believe that (1) unemployment is more costly than inflation,
(2) the short-run Phillips curve is flat, (3) expectations react sluggishly, and (4) the selfcorrecting mechanism is slow and unreliable. These views are held by many Keynesian economists, so it is not surprising that they often oppose using recession to fight inflation.
The tables turn, however, when the question becomes whether to use demand management to bring a recession to a rapid end. The Keynesian view of the world—that unemployment is costly, that the short-run Phillips curve is flat, that expectations adjust slowly, and that the self-correcting mechanism is unreliable—leads to the conclusion that the
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benefits of fighting unemployment are high and the costs are low. Keynesians are therefore eager to fight recessions. The rational expectations positions on these four issues are precisely the reverse, and so are the policy conclusions.
THE DILEMMA OF DEMAND MANAGEMENT
We have seen that policy makers face an unavoidable trade-off. If they stimulate aggregate demand to reduce unemployment, they will aggravate inflation. If they restrict aggregate demand to fight inflation, they will cause higher unemployment.
But wait. Early in the chapter we learned that when inflation comes from the supply side, inflation and unemployment are positively correlated: They go up or down together. Does this mean that monetary and fiscal policy makers can escape the trade-off between inflation and unemployment? Unfortunately not.
Shifts of the aggregate supply curve can cause inflation and unemployment to rise or fall together, and thus can destroy the statistical Phillips curve relationship. Nevertheless, anything that monetary and fiscal policy can do will make unemployment and inflation move in opposite directions because monetary and fiscal policies influence only the aggregate demand curve, not the aggregate supply curve.
Thus, no matter what the source of inflation, and no matter what happens to the Phillips curve, the monetary and fiscal policy authorities still face a disagreeable tradeoff between inflation and unemployment. Many policy makers have failed to understand this principle, which is one of the Ideas we hope you will remember well Beyond the Final Exam.
Naturally, the unpleasant nature of this trade-off has led both economists and public officials to search for a way out of the dilemma. We conclude this chapter by considering some of these ideas—none of which is a panacea.
IDEAS FOR BEYOND THE FINAL EXAM
ATTEMPTS TO REDUCE THE NATURAL RATE OF UNEMPLOYMENT
One highly desirable approach—if only we knew how to do it—would be to reduce the natural rate of unemployment. Then we could enjoy lower unemployment without higher inflation. The question is: How?
The most promising approaches have to do with education, training, and job placement. The data clearly show that more educated workers are unemployed less frequently than less educated ones are. Vocational training and retraining programs, if successful, help unemployed workers with obsolete skills acquire abilities that are currently in demand. By so doing, they both raise employment and help alleviate upward pressures on wages in jobs where qualified workers are in short supply. Government and private job placement and counseling services play a similar role. Such programs try to match workers to jobs better by funneling information from prospective employers to prospective employees.
These ideas sound sensible and promising, but two big problems arise in implementation. First, training and placement programs sometimes look better on paper than in practice. In some cases, people are trained for jobs that do not exist by the time they finish their training—if, indeed, the jobs ever existed.
Second, the high cost of these programs restricts the number of workers who can be accommodated, even in successful programs. For this reason, publicly supported job training is done on a very small scale in the United States—much less than in most European countries. Small expenditures can hardly be expected to make a large dent in the natural rate of unemployment.
But many observers believe the natural rate of unemployment has fallen in the United States despite these problems. Why? One reason is that work experience has much in common with formal training—workers become more productive by learning on the job. As
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the American workforce has aged, the average level of work experience has increased, which, according to many economists, has lowered the natural rate of unemployment. (For some other possible reasons, see “Why Did the Natural Rate of Unemployment Fall?”)
INDEXING
Indexing refers to provisions in a law or a contract whereby monetary payments are automatically adjusted whenever a specified price index changes. Wage rates, pensions, interest payments on bonds, income taxes, and many other things can be indexed in this way, and have been. Sometimes such contractual provisions are called escalator clauses.
Indexing—which refers to provisions in a law or contract that automatically adjust monetary payments whenever a specific price index changes—presents a very different approach to the inflation-unemployment dilemma. Instead of trying to improve the terms of the trade-off, indexing seeks to reduce the social costs of inflation.
The most familiar example of indexing is an escalator clause in a wage agreement. Escalator clauses provide for automatic increases in money wages—without the need for new contract negotiations—whenever the price level rises by more than a specified amount. Such agreements thus act to protect workers partly from inflation. Nowadays, with inflation low and stable, relatively few workers are covered by escalator clauses. But they were far more common when inflation was higher.
Interest payments on bonds or bank accounts can also be indexed, and the U.S. government began doing so with a small fraction of its bonds in 1997. The most extensive indexing to be found in the United States today, however, appears in government transfer payments. Social Security benefits, for instance, are indexed so that retirees are not victimized by inflation.
Some economists believe that the United States should follow the example of several foreign countries and adopt a more widespread indexing system. Why? Because, they argue, it would take most of the sting out of inflation. To see how, let us review some of the social costs of inflation that we enumerated in Chapter 6.
One important cost is the capricious redistribution of income caused by unexpected inflation. We saw that borrowers and lenders normally incorporate an inflation premium equal to the expected rate of inflation into the nominal interest rate. Then, if inflation turns out to be higher than expected, the borrower has to pay the lender only the agreed-on nominal interest rate, including the premium for expected inflation; he does not have to compensate the lender for the (higher) actual inflation. Thus, the borrower enjoys a windfall gain and the lender loses out. The opposite happens if inflation turns out to be lower than expected.
Why Did the Natural Rate of Unemployment Fall?
In 1995, most economists believed that the natural rate of unemployment in the United States was approximately 6 percent—and certainly not lower than 5.5 percent. If unemployment fell below that critical rate, they said, inflation would start to rise. Experience in the late 1990s belied that view. The unemployment rate dipped below 5.5 percent in the summer of 1996—and kept on falling. By the end of 1998, it was below 4.5 percent. For a few months in 2001, it even dipped below 4 percent. And still there were no signs of rising inflation.
One reason for such amazing macroeconomic performance was discussed in this chapter: A series of favorable supply shocks pushed the aggregate supply curve outward at an unusually rapid pace. But it also appears that the natural rate of unemployment fell in the 1990s. Why?
Economists do not have a complete answer to this question, but a few pieces of the puzzle are understood. For one thing, the U.S. working population aged—and mature workers are normally unemployed less often than are young workers. The rise of temporaryhelp agencies and Internet job searching capabilities helped match workers to jobs better. Ironically, record-high levels of incarceration probably reduced unemployment, too, because many of those in jail would otherwise have been unemployed. It is also believed (though difficult to prove) that the weak labor markets of the early 1990s left labor more docile, thereby driving down the unemployment rate consistent with constant inflation.
Whatever the reasons, it does appear that the United States can now sustain a lower unemployment than it could, say, 15 years ago.
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But if interest rates on loans were indexed, none of this would occur. Borrowers and lenders would agree on a fixed real rate of interest, and the borrower would compensate the lender for whatever actual inflation occurred. No one would have to guess what the inflation rate would be.6
A second social cost mentioned in Chapter 6 stems from the fact that our tax system levies taxes on nominal interest and nominal capital gains. As we learned, this flaw in the tax system leads to extremely high effective tax rates in an inflationary environment. But indexing can cure this problem. We need only rewrite the tax code so that only real interest payments and real capital gains are taxed.
In the face of all these benefits, why does our economy not employ more indexing? One obvious reason is that inflation has been low for years. Indexing received much more attention years ago, when inflation was much higher. A second reason is that some economists fear that indexing will erode society’s resistance to inflation. With the costs of inflation so markedly reduced, they ask, what will stop governments from inflating more and more? They fear that the answer is: Nothing. Voters who stand to lose nothing from inflation are unlikely to pressure their legislators into stopping it. Opponents of indexing worry that a mild inflationary disease could turn into a ravaging epidemic in a highly indexed economy.
| SUMMARY |
1.Inflation can be caused either by rapid growth of aggregate demand or by sluggish growth of aggregate supply.
2.When fluctuations in economic activity emanate from the demand side, prices will rise rapidly when real output grows rapidly. Because rapid growth means more jobs, unemployment and inflation will be inversely related.
3.This inverse relationship between unemployment and inflation is called the Phillips curve. In the United States, data for the 1950s and 1960s display a clear Phillips-curve relation, but data for the 1970s and 1980s do not.
4.The Phillips curve is not a menu of long-run policy choices for the economy, because the self-correcting mechanism guarantees that neither an inflationary gap nor a recessionary gap can last indefinitely.
5.Because of the self-correcting mechanism, the economy’s true long-run choices lie along a vertical long-run Phillips curve, which shows that the so-called natural rate of unemployment is the only unemployment rate that can persist indefinitely.
6.In the short run, the economy can move up or down along its short-run Phillips curve. Temporary reductions in unemployment can be achieved at the cost of higher inflation, and temporary increases in unemployment can be used to fight inflation. This short-run trade-off between inflation and unemployment is one of our
Ideas for Beyond the Final Exam.
7.Whether it is advisable to use unemployment to fight inflation depends on four principal factors: the relative social costs of inflation versus unemployment, the efficiency of the economy’s self-correcting mechanism, the
shape of the short-run Phillips curve, and the speed at which inflationary expectations are adjusted.
8.If workers expect inflation to occur, and if they demand (and receive) compensation for inflation, output will be independent of the price level. Both the aggregate supply curve and the short-run Phillips curve are vertical in this case.
9.Errors in predicting inflation will change real wages and therefore the quantity of output that firms wish to supply. Thus, unpredicted movements in the price level will lead to a normal, upward-sloping aggregate supply curve.
10.According to the rational expectations hypothesis, errors in predicting inflation are purely random. As a consequence, except for some random gyrations, the aggregate supply curve is vertical even in the short run.
11.Many economists reject the rational expectations view. Some deny that expectations are “rational” and believe instead that people tend, for example, to underpredict inflation when it is rising. Others point out that contracts signed years ago may not embody expectations that are “rational” in terms of what we know today.
12.When fluctuations in economic activity are caused by shifts of the aggregate supply curve, output will grow slowly (causing unemployment to rise) when inflation rises. Hence, the rates of unemployment and inflation will be positively correlated. Many observers feel that this sort of stagflation is why the Phillips curve collapsed in the 1970s. Similarly, a series of favorable supply shocks help explain the 1990s combination of low inflation and strong economic growth.
6 For example, an indexed loan with a 2 percent real interest rate would require a 5 percent nominal interest payment if inflation were 3 percent, a 7 percent nominal interest payment if inflation were 5 percent, and so on.
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13.Even if inflation is initiated by supply-side problems, so that inflation and unemployment rise together, the monetary and fiscal authorities still face this trade-off: Anything they do to improve unemployment is likely to worsen inflation, and anything they do to reduce inflation is likely to aggravate unemployment. (This is part of one of our Ideas for Beyond the Final Exam.) The reason is that monetary and fiscal policy mainly influence the aggregate demand curve, not the aggregate supply curve.
14.Policies that improve the functioning of the labor market—including retraining programs and employment services—can, in principle, lower the natural rate of unemployment. To date, however, the U.S. government has enjoyed only modest success with these measures.
15.Indexing is another way to approach the trade-off problem. Instead of trying to improve the trade-off, it concentrates on reducing the social costs of inflation. Opponents of indexing worry, however, that the economy’s resistance to inflation may be lowered by indexing.
Demand-side inflation 318 Supply-side inflation 318 Phillips curve 319
Stagflation caused by supply shocks 321
Self-correcting mechanism 322
| KEY TERMS |
Natural rate of unemployment 323
Vertical (long-run) Phillips curve 323
Trade-off between unemployment and inflation in the short run and in the long run 323
Rational expectations 328 Indexing 332
Real versus nominal interest rates 333
| TEST YOURSELF |
1.Show that if the economy’s aggregate supply curve is vertical, fluctuations in the growth of aggregate demand produce only fluctuations in inflation with no effect on output.
2.Long-term government bonds now pay approximately 5 percent nominal interest. Would you prefer to trade
yours in for an indexed bond that paid a 3 percent real rate of interest? What if the real interest rate offered were 2 percent? What if it were 1 percent? What do your answers to these questions reveal about your personal attitudes toward inflation?
| DISCUSSION QUESTIONS |
1.When inflation and unemployment fell together in the 1990s, some observers claimed that policy makers no longer faced a trade-off between inflation and unemployment. Were they correct?
2.“There is no sense in trying to shorten recessions through fiscal and monetary policy because the effects of these policies on the unemployment rate are sure to be temporary.” Comment on both the truth of this statement and its relevance for policy formulation.
3.Why is it said that decisions on fiscal and monetary policy are, at least in part, political decisions that cannot be made on “objective” economic criteria?
4.What is a Phillips curve? Why did it seem to work so much better in the period from 1954 to 1969 than it did in the 1970s?
5.Explain why expectations of inflation affect the wages that result from labor-management bargaining.
6.What is meant by “rational” expectations? Why does the hypothesis of rational expectations have such stunning implications for economic policy? Would believers in rational expectations want to shorten a recession by expanding aggregate demand? Would they want to fight inflation by reducing aggregate demand? Relate this analysis to your answer to Test Yourself Question 1.
7.It is often said that the Federal Reserve Board typically cares more about inflation and less about unemployment than the administration. If this is true, why might presidents often worry about what the Fed might do to interest rates?
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8.The year 2007 closed with the unemployment rate around 5 percent, real GDP barely growing, inflation above 2 percent and apparently rising a bit, and the federal budget showing a large deficit.
a.Give one or more arguments for engaging in expansionary monetary or fiscal policies under these circumstances.
b.Give one or more arguments for engaging in contractionary monetary or fiscal policies under these circumstances.
c.Which arguments do you find more persuasive?
Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.