Akerlof 1969

Relative Wages and the Rate of Inflation
Author(s): George A. Akerlof

Source: The Quarterly Journal of Economics, Vol. 83, No. 3 (Aug., 1969), pp. 353-374
Published by: Oxford University Press
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THE
QUARTERLYJOURNAL
OF ECONOMICS
Vol. LXXXIII August 1969 No. 3
RELATIVE WAGES AND THE RATE OF INFLATION*

GEORGE A. AKERLOF
I. Introduction, 353.-II. A price-price inflation, 355.-III. A wage-wage

inflation, 363.- IV. Spontaneous inflations and general equilibrium, 371.- V.
Conclusions, 373.
Monetary theory in the post-Keynesian era has, to a good ex-

tent, centered around the question "is money neutral?" This is an
important question, of course, because the existence of such eco-
nomic animals as the Phillips Curve may well depend on the answer.
Patinkin's famous book argues for the neutrality of money: with
different levels of the money supply in a perfectly competitive
world all equilibrium real variables will be the same.' Naturally in
such a world the Phillips Curve cannot exist, but, as Patinkin him-
self writes, this is more a matter of definition than of empirical
fact -for, in the long run, irrespective of the money supply (or
its rate of increase), equilibrium is approached; and by definition
this equilibrium precludes unemployment.
The question which presents itself is whether Patinkin's results
generalize to a world which has "stickiness" and various "market
imperfections." Friedman, in his American Economic Association
Presidential address, has asserted that it does: the long-run level of
* The author would like to thank Bent Hansen, Stephen A. Marglin,
William Nordhaus, Albert Fishlow, Giorgio La Malfa and Bagieha Minhas for
valuable comments and the Indian Statistical Institute, New Delhi for finan-
cial support. All mistakes. however. belong to the author.
1. D. Patinkin, Money, Interest and Prices (2d ed.; New York: Harper
and Row, 1965). It should be stated at the outset that the models here at-
tempt an argument essentially different from the Tobin and Gurley-Shaw
portfolio balance type of argument. For this reason the portfolio, or capital
investment, decision is intentionally ignored. J. Tobin, "Money and Eco-
nomic Growth," Econometrica, Vol. 33 (Oct. 1965); and J. G. Gurley and E.
S. Shaw, Money in a Theory of Finance (Washington: Brookings Institution,
1960).

354 QUARTERLY JOURNAL OF ECONOMICS
unemployment, irrespective of market structure, stickinesses, etc.,

will be independent of the long-run rate of increase of the money
supply.2 For, his argument goes, in the long run if a given rate of
inflation is universally expected, all persons will hedge against this
rate of inflation -and since all bargains are rationally decided by
real considerations, real transactions (excluding capital formation)
will take place as if this rate of inflation did not exist. At first glance
Friedman's argument appears perfectly general: but the question
remains whether Friedman's logic is still valid if contracts are made
according to real considerations, but for the duration of the contract
some price variables remain fixed in money terms. The obvious ex-
ample of such an institution is the union wage bargain with both
the union and management aware of the "real" aspects of the bar-
gain - but with the form of contract restricted so that money wages
change at only yearly intervals.3
It is quite clear from all historical accounts of hyperinflation
that such fixed-money contracts break down as the rate of inflation
becomes large.4 But for the usual Phillips-Curve watcher such cases
of hyperinflation are not in the relevant range: rather the question
is whether some "moderate" rate of inflation (say 2 or 3 per cent per
annum) is better than none at all.5 In this range, given the con-
venience of fixed-money contracts - one of the major reasons it-
self for the policy goal of price stability - it is not unreasonable
to expect the form of contract to remain unchanged.6
Of course, it is easy to show the existence and nature of a short-
run Phillips Curve with fixed expectations about the future rate of
inflation. In the long run if expectations about the rate of inflation
are actually realized, the Phillips Curve is far more restricted; but
in the models below there is an interpretation whereby such a
Phillips Curve exists and the neutrality of money, in turn, is false.7
2. M. Friedman, "The Role of Monetary Policy," American Economic
Review, LVIII (Mar. 1968), 7-10. Lindahl foresaw Friedman's argument
thirty years ago: ". . . anticipated changes in the price level have no eco-
nomic relevance, since they neither influence the relative prices of factors
of production and consumption goods, nor the extent and direction of pro-
duction." E. Lindahl, Studies in the Theory of Money and Capital (London:
Allen and Unwin, 1939), p. 148.
3. The models presented must be slightly altered to include "wage drift."
4. In particular see C. Bresciani-Turroni, The Economics of Inflation
(London: Allen and Unwin, 1937).
5. A. W. Phillips, "The Relation between Unemployment and the Rate
of Inflation in the United Kingdom, 1861-1957," Economica, N.S. XXV (Nov.
1958).
6. An excellent justification for the convenience of temporarily fixed
prices is given by 0. Eckstein and G. Fromm, "The Price Equation," Ameri-
can Economic Review, LVIII (Dec. 1968), 1159-60.
7. Many besides Friedman have wondered about the relation between

RELATIVE WAGES AND THE RATE OF INFLATION 355
II
The specific view of the economy which underlies this paper
is that of Triffin's Monopolistic Competition and General Equilib-
rium Theory.8 The economy, as pictured, consists of many monop-
olists who all compete for a given total level of demand (which is
in turn correlated with the level of employment). Perhaps the best
way to view the meaning of this model is that the producers in each
oligopolistic industry reach a pricing decision not far from the de-
cision that would be reached if the industry were in fact a monopoly.
(This process is not dissimilar to what Professor Fellner describes in
Competition Among the Few.)9 In turn these industries (acting as
monopolies) compete amongst themselves in a Chamberlinian fash-
ion for a fixed level of real aggregate demand.
The natural worry, of course, is that the problem of oligopolistic
interdependence has been seriously ignored; but this would be a mis-
understanding of the spirit of the argument. Rather monopolistic
competition is quite naturally chosen as the simplest example of the
imperfect (and interdependent) world we wish to picture - and any
of the other classical bargaining solutions might give different re-
sults algebraically - but would give the same results qualitatively.
Also, Chamberlinian independence is undoubtedly a bad model for
the behavior of large firms in many industries; but, on the contrary,
it may be a good description of interindustry pricing behavior. As
Triffin points out cotton textiles and automobiles may compete as
much for a consumer dollar as any two types of cloth or any two
types of automobile; but it is also implausible that the automobile
manufacturers and the textile producers take account of the mu-
tual interdependence of their pricing decisions.
In this spirit an economy is pictured with only two firms (where
this small number of firms is an abstraction of some true multidi-
mensional many-unit economy). And in accord with monopolistic
competition theory each firm (or industry) chooses a price level
such that marginal cost equals marginal revenue - without taking
the other firm's reaction into account. But there is nothing inherent
in the approach (except perhaps a desire for algebraic simplic-
the long-run and the short-run Phillips Curve. See especially, R. G. Lipsey,
"The Relation between Unemployment and the Rate of Change of Money
Wage Rates in the United Kingdom, 1861-1957: A Further Analysis," Eco-
nomica, N.S. XXVII, 1960; and E. Kuh, "A Productivity Theory of Wage
Levels -an Alternative to the Phillips Curve," Review of Economic Studies,
XXXIV (Oct. 1967).
8. Cambridge, Mass.: Harvard University Press, 1940.
9. New York: Knopf, 1949.

ity) which dictates this particularsolutionto the oligopolyproblem.

To give the demandcurvesform and substancelet
(1) DI=a-P1/P2
and let D2 be, symmetrically,
(2) D2= a-P1/P2
whereD and p are demandand prices,wheresubscriptsone and two

refer to firms one and two, and where a is a parameter. If Pi = P2,
D= = a-1. In Chamberlinianlanguage the "dd" curves of
firm one are the demand curves with P2 fixed. And the "DD"
curve with P1=P2 is a vertical line. The parametera, accordingly
correspondsto the level of total output, which is close to the level
2a-2. These demandcurves are slightly less than ideal for several
reasons. (1) Ideally, the demand curves for the two firms should
add up to some given constant irrespectiveof relative prices. But
the simplificationin algebra made possible by (1) and (2) should
justify their choice- at least for expository purposes. It should
also be noticed that in the neighborhoodof P1/P2=1, D1+D2 =
2a-2, up to second order. (2) An argumentis also necessary to
justify the use of a as a parameter. If the demand curves were
written more generally
(1') D1=a-bpl/p2
and
(2') D2= a- bp2/p1
all solutions would depend on the value of a/b -or a parameter
which reflectsthe elasticity of demand. On the other hand, it makes
sense to vary a as a proxy to reflectwhat is happeningin another
part of the market: as full employmentis approachedthere is a
decreasein the elasticity of supply of labor. In the exampleused in
this section, marginalcosts are assumedto be zero, to simplify the
mathematics. In the next section the supply variable is given the
wrong dimensionality (again to simplify the mathematics)- but
the artificialdevice of varying a relative to b gives qualitatively the
same results as changingthe supply elasticities. A later footnote
justifies this procedurerigorously.
Judgment is suspended (until later) about the determinants
of a; but two commentsmust be made now. First of all, a, which
correspondsto the level of aggregatedemand,is considereda param-
eter which is, in turn, controlled by the governmental controls

of monetary and fiscal policy. Second, quite clearly this is a

closed economy - for otherwise a third "firm" must be added whose
pricing behavior is exogenously given. For this reason alone the
model described would be a much better picture of the American
economy, for example, than of the British.
To continue, the model assumes that firms operate in the
following way; they are Chamberlinian monopolistic competitors.
That means that each firm sets its price so that MR= MC, where
marginal revenue represents the change in revenue from selling an
additional unit of output -if the competitor leaves his price un-
changed. It should be emphasized here, as in the next section, that
this particular assumption is not in any way essential to the overall
point of view.
Temporarily it is assumed that neither firm one nor firm two
has any variable costs (or that MC equals zero for both firms). As
such this section should be considered a finger exercise for the in-
creasingly complex models of later sections.
The second important element of the model is the nonsyn-
chronization of pricing decisions by firms one and two. By this it
is meant that firm one makes a pricing decision each January and
firm two makes a pricing decision each July. It is also an important
feature of the model that these prices remain constant throughout
the year. Measuring time in half-years, firm one makes its price
decisions at even times 2t, and firm two makes its pricing decisions
at odd times 2t+1, and
(3) P1, 2t=P1, 2t+1
(4) P2, 2t+1 = P2, 2t+2.
This constancy of money prices over a two-period interval is the

major feature which differentiates our thinking from Friedman's.'
The justification for this assumption is that it does describe a real-
world form of market imperfection. This assumption becomes con-
siderably more realistic in the next section where the "price-vari-
ables" which are yearly constant are money wages instead of goods
prices.
Firms one and two have symmetric demand curves and bargains
are made in real terms; with the same expectations about the rate
of inflation and a given level of aggregate demand, firm one's view
of the world at even times will correspond exactly to firm two's
view of the world at odd times. As a result -which can be rigor-
1. Friedman, op. cit.

ously proved - firm one at even times will have exactly the same
real possibilities as firm two at odd times. And the relative price
chosen determines the point attained. As a result, the relative price
chosen by firm one at even times will be the same as the relative
price chosen by firm two at odd times.
At this point, since the model is nearly complete, it is worth-
while to pause and summarize the assumptions already made: (A)
There are just two firms. (B) Demands are given by (1) and (2).
(C) Each firm sets a price once a year, equations (3) and (4). (D)
In setting this price each firm maximizes its expected profits over the
two-period interval for which this price will be maintained. It
fails, however, to take account of the reaction of the other firm in
the next period. (E) At least temporarily, the marginal cost of each
firm is zero.
The two assumptions of nonsynchronization and the symmetry
of the relative pricing decisions can be coupled together:
by the symmetry of (1) and (2) and with identical cost curves
and expectations about the rate of inflation,
Pl, 2t P2, 2t+1 Pl, 2t+2
(5) - ==
P2, 2t Pl, 2t+1 P2, 2t+2
and together with (3) and (4)
P 2t+ P2 2t+1 P2t+2 by (5)

Pl, 2t+1
= P2, 2t+1 P2, 2t+l by (4)

Pl, 2t+1
Pi, 2t
P22t+1 by (5)
P2, 2t
= ( P',2t
P2, 2t
) Pl,2t+1 by (5)
( P122t) Pl,2t by (3)
or, rewriting:
(6) P1, 2t+2 (Ply 2t )2

P22 2t P22 2t
Prices rise over the year by a multiple equal to (Pip 2t). Relative
prices determine this rate of inflation.2
2. Similar equations can be derived if the demands for firms one and

RELATIVE WAGES AND THIE RATE OF INFLATION 359
Equation (6) occasions some remarks. It should be clear that

it is independent of the particular market behavior: it depends only
on symmetry and nonsynchronization. Equation (6) should also
make clear that the assumptions both of nonsynchronization and
of noncompetitive markets are necessary (as well as sufficient) for
this view of inflation.
For nonsynchronization allows the economy to depart from
static equilibrium at all times: in this economy firms one and two
can only be simultaneously satisfied if the rate of inflation is zero.
Later it will be shown that the desired relative price (P1/P2) de-
pends on the level of aggregate demand. In the normal case there
is only one level of aggregate demand for which the desired relative
price is equal to one. Without nonsynchronization any other level
of aggregate demand is incompatible with equilibrium - because
PI/P2 and P2/P1 cannot both simultaneously attain their "desired"
values. The level of output for which the desired relative price is
one therefore corresponds to Friedman's long-run equilibrium.
The dynamics of this assertion demand a sneak preview of
what follows. In Friedman's dynamics, with a given money supply
or rate of growth of the money supply, if the desired relative price
is larger than one, prices will rise sufficiently to reduce real balances
and therefore aggregate demand - and vice versa if the desired
relative price is less than one. Friedman's system does not allow-
which nonsynchronization does allow - a continued dynamic ten-
sion so that relative prices never fully adjust. This is discussed
further in Section IV below.
Equation (6) should also make clear the importance of noncom-
petitive markets. If monopoly power is unimportant, in the presence
of unused resources the relative price set by each decision-maker
will be very low; with the full use of resources the relative price
set by each decision-maker would be high. Thus large changes in
the rate of inflation result from small changes in aggregate demand.
In the limit this corresponds to the traditional quantity theory
point of view.
Returning to the specific model of monopolistic competition
and to the demand curves (1) and (2) allows an exact evaluation
of the inflationary process. As a Chamberlinian monopolistic com-
petitor, each January the manager of firm one sets the price of the
good produced by firm one to maximize revenue for the whole year.
There will be some slight differences of behavior if revenue is dis-
two are not symmetrical and also if the expectations of firms one and two are
different.

counted by a rate of return or the rate of inflation. For the sake

of exposition we shall assume for the moment that the revenue
maximized is undiscounted.
Revenue is Pl, 2t D1i 2t+Pl 2t+1 DI) 2t+i. D1, 2t+1 depends, how-
ever, on the unknown price charged by firm two at time 2t+1. But
suppose that firm one expects this price to rise by a multiple (ye) 2,
or that
Pe2,2t+I=7e2P2,2t (where "e" refers to "expected"). In this
case expected revenue Re will be:
Re= Pi, 2t (a- P, 2t' +Pl,

P2, 2t
2t+1 (a-Pi 2t+-)
')2+
Py
=P1, 2t a- +P2t a- 2t)
Given these expectations firm one chooses pI, 2t to maximize Re. Be-
ing a monopolistic competitor he maximizes Re with respect to PI
as if P2 were independent of his choice of pi. This yields the condi-
tion that
Pl, 2t aye2
P2, 2t 1+ye
If firm two has the same expectations as firm one about the rate of
inflation, by (6),
(7) yA = a
(7) y +ye
where (7A) 2 represents the yearly multiple of price change.

Equation (7) gives the actual rate of inflation as a function of
the level of aggregate demand and the expected rate of inflation.
With given expectations this could be considered a short-run Phillips
Curve.
In the long run, however, according to Friedman's argument the
expected and the actual rates of inflation should coincide.3 In func-
tional notation this gives two equilibrium conditions
(8) yA= F (a,ye)
(9) yA=7e
or, rewriting, in equilibrium

(10) y=F(a, y),
where y denotes an equilibrium rate of inflation.
3. Friedman, op. cit.

The natural question is whether there is a unique y = y (a) for

each level of aggregate demand a. Such a function would correspond,
of course, to a long-run Phillips Curve.
With only static considerations, there is no such unique y which
can be associated with each a. For a >2 the solutions of (10) are
a=' (a2- 4)/2
y=O, andy= 2 Fora=2thesolutionsarey=Oandy=1;
and for a <2 the only real solution is y=0.
Considering a >2, there is some reason for choosing the upper
roots as the end result of the process described. Figure I graphs 7A
as a function of ye. It is seen that with static expectations, 0 and
(a+ (a2-4)/2) /2 are stable roots (follow the zigzags in Figure I).
rA
/a a2
I+
+r2
Stable
Unstable
Stable re
FIGUREI
Startingwith nondeflationarybut static expectationsabout the

rate of inflation, with a >2, the upper root will be approached.
Choosingthis root as "the solution"then
(11) /= (a+ (a2 -4)1/2)/2 a>2
and dy/da =l/2(1+a/(a2- 4)?2) > 0; or, the long-runequilibriumof
the economy given an initial condition of nondeflationaryexpecta-
tions, is an increasingfunction of the level of overall aggregatede-
mand. With the restrictionsmentionedand the appropriatequali-
fications (11) can be taken as a long-runPhillips Curve.
While the theory laid down is satisfactory in this stability of

the upper roots -and the consequent gravitation toward these

upper roots with initial nondeflationary expectations, one fact is
particularly unsettling. The double roots are inherent in the prob-
lem and depend on the specific nature of neither the cost nor the
demand functions. And if y= 1 is a solution of system (8) and (9),
it will also be a double root. This can be shown formally -but a
heuristic argument clarifies the reason for this happening.
The profit-maximizer controlling firm one chooses a relative
price x to maximize the sum of its profits in both the early and the
later periods. In the noninflationary case the relative price which
maximizes profits in the first period and in the second period are
exactly the same. With an expected (nonzero) rate of inflation, how-
ever, there is a conflict between maximizing profits in the first and in
the second periods. If x1 is the profit-maximizing relative price
in the first period, then Xlye2 is the profit-maximizing relative price
in the second period. Since the demand functions are second dif-
ferentiable and the same weight is placed on both the first and second
period, the profit-maximizing solution is approximately (up to
second order) to let x be the average of these two relative prices.
Therefore, in the neighborhood of x= 1,
1+ye2
x= 27 2 with the result that
dx
dye l.
At the same time this shows the natural way to elude the
double-rootedness problem. A high rate of time discount, which
causes the decision-maker to place a low weight on the second
period, reduces dx/dye and can lead to single-solution results with all
the desirable properties. Clearly this is the case in the limit where
only the early period is considered and
ye = yA = pi/p2 = a/2.
The next step is to add money to the system. This is done in

the simplest way. The parameter a, or real demand, is associated
with real balances. Suppose that a= g (M/p), or that a is function-
ally dependent on real balances.
There is a slight problem of representing real balances in our
model, because "the price level" is well defined only if Pi equals
P2. Therefore real balances are not uniquely well defined. There
is the further problem that it is unreasonable to assume that an in-
dividual firm considers the effect of its price decision on the level

of real balances. All of this suggests that in constructing an ex-

ample needless complication will be avoided if the demand curve
for firm one depends upon M/p2, where P2 is interpreted as the price
level of "other" goods and similarly the demand curve for firm two
should depend on M/pl. In this spirit let:
_i=M Pi
P2 P2
M P2
Pi Pi
Further suppose that the nominal money supply is increasing at a
positive rate A. Given initial nondeflationary price expectations,
and, initially M/p2 and M/pl > 2, an equilibrium will be approached
with A equal to the rate of inflation. For suppose that Pi and P2 are
increasing at a rate less than A, then according to the previous argu-
ment a will increase, and therefore the rate of inflation. Similarly
if Pi and P2 are increasing at a rate greater than A, real balances
(or a) will be decreasing.
As a consequence, in the long run prices and the money supply
will be increasing at the same rate. The rate of increase of the
money supply determines the level of real balances so that prices
and the money supply are increasing at the same rate. The rate
of increase of the money supply therefore determines the long-run
level of real balances and of real activity.
III
From the last section we preserve the assumption that there
are just two firms which act as monopolistic competitors in dividing
up a total aggregate demand-and that the demand curves for
firms one and two are given by equations (1) and (2) respectively.
But other assumptions are changed: First, the prices of goods
are free to adjust in each period. But money wages, in contrast,
must remain fixed throughout the year. Second, each firm is given
a simple production function-but third, the nature of the wage-
bargain must be specified (and therefore given restrictive form).
Finally, the framework of this section, being less restrictive, allows
easy modification to solve the problem of the dimensionality of a.
To begin, it is assumed that the short-run production function
of each firm is
Qi =El

or, output of each firm is proportional to its employment.

The cost function of each firm can be specified then:
C1= w1Qi
C2 = W2Q2;
or the cost of production for each firm is the wage rate of its work-
ers times the level of output.
A bit of algebra shows that if marginal revenue equals marginal
cost
(a-2D,)p2=wi
(a-2D2)p1 =w2
or, equivalently,
pi = 1/2 (ap,2+wl)
p2 =1/2 (api+W2)
Countervailing the oligopoly power of the firms, we picture

yearly bargains made between unions and employers. The best
justification for this kind of bargaining solution is a desire to in-
corporate some elements of Professor Galbraith's theory.4
But different structures, closer to perfect competition, could
yield similar results. Specifically in mind are Becker's comments
about the returns to specific training costs.5 It is clear from his
argument that the division of the returns to specific training costs,
by their nature, involves some sort of bargaining between the em-
ployer and the employee. Also several empirical studies of "learn-
ing-by-doing" in specialized tasks give some evidence -although
the connection is not necessary -for the importance of specific
training."
In our particular model there are just two unions: the union
which deals with firm one and the union which deals with firm two.
Bargaining occurs yearly -and once a year a money wage is set:
this money wage is constant throughout the year. Bargaining for
union one occurs every January. Bargaining for the second union
occurs every July. Again measuring time in half years, the bar-
gaining between firm one and its union occurs at times 2t (for in-
4. J. K. Galbraith, American Capitalism, The Concept of Countervailing
Power (Boston: Houghton Mifflin, 1952).
5. G. S. Becker, Human Capital (New York and London: Columbia
University Press, 1964).
6. See references given by K. J. Arrow, "The Economic Implications
of Learning by Doing," Review of Economic Studies, XXIX (June 1962) and
also S. Hollander, The Sources of Increased Efficiency: A Study of du Pont
Rayon Plants (Cambridge, Mass.: M.I.T. Press, 1965).

tegers t); and bargaining for union two occurs at times 2t+1 (for
integers t).
One simple example of the union-employer bargaining process
is given as follows. Each union realizes that higher wages induce
higher prices in its own industry. In turn higher prices lead to less
demand and therefore less employment. High wages consequently
induce high unemployment rates for the given union; low wages
mean the opposite. Thus there may be some level of wages (neither
o nor oo) which maximizes total union income. Each union, we
say, wishes to maximize its money income over the coming year.
(This is based on a model of union behavior suggested by John
Dunlop.) 7 The union demands that wage which it thinks will
maximize its money income. The firms accede to these demands.
Again, it is important to emphasize that the exact nature of the
bargaining solution is not important in the phenomenon described.
A similar model is given by assuming that each union maximizes
a() E+ (1 - a ) XwE
P
or that the union maximizes some function of employment and real
income. As employment rises (or as u the unemployment rate falls)
the weight on real income rises. This formulation solves the prob-
lem of the artificial nature of the parameter a: we can assume a
constant but that a varies with the level of aggregate demand. But
another, probably less serious, problem occurs. Since there are
two goods, the price level p is not well defined; some device for
defining p in terms of p, and P2 is needed before a Phillips Curve can
be derived.
In the text, however, the original model will be assumed: union
one then wishes to maximize wl, 2t E1, 2t+W1, 2t E1, 2t+1 where the
period 2t represents periods from January to July and 2t+1 repre-
sents periods from July to January.
Exactly the same problems with the expected and actual rates
of inflation occur in the more complex model here that occurred in
the last section (and exactly the same analysis can be used). If
union one expects P2, 2t+1 to be higher by a multiple ye, then
Ee, 2t+1 = 1/2 (a-W 2t+1
<x-_ e2,2)
= 1/2 a
W1, 2t)
vYeP2sok
7. J. T. Dunlop, Wage Determination Under Trade Unions (New York:

Macmillan, 1944), Chap. III.

(where e refers to "expected")

and union one chooses its wage to maximize
WI, 2t E1, 2t+Wl, 2t+1 Eel, 2t+1, or,
using calculus,
WI, 2t aye
P2, 2t 1+Ye
(The difference in ye between here and Section II may be noted;

this is only a matter of notational convenience).
Also there is an analogue of equation (6). Because of the
rationality of economic agents and because the economy is closed,
all bargains will occur in real terms, and it can be asserted that
W1, 2t=f (P1 2t, P2, 2t, W2, 2t; ye, a)
Pl, 2t =q (P2, 2t Wl, 2t, W2, 2t; ye, a)
P22 2t= h (Pi, 2t, W1, 2t, W2, 2t; ye, a).
With a given expected rate of price increase, and a given level of
aggregate demand, the price of each good or factor (subject to
change at a given time) is a linear-homogeneous function of the
prices of all other goods and factors.
With W2,2t fixed there are three equations and three unknowns.
Because all three equations are homogeneous of degree one (in the
goods and factor prices), if (Pol, 2t, P02, 2t, W01,2t) is a solution with
W2, 2t==W02, 2t, then (Ap01,2t, AP02, 2t, AW01,2t) is a solution with
W2,2t = AW02t, 2t. Therefore,if there is a uniquesolutionof these equa-
tions for given ye, a and W2, 2t,
WI;,2t ye 2a) .
2
W2, 2t
Symmetry dictates with constant ye that:

WI, 2t W2, 2t+1 W1, 2t+2
W2) 2t W1, 2t+1 W2, 2t+2
Combined with nonsynchronization
(12) W1, 2t+2 (Wit 2t )2

Wi, 2t W2, 2t
But also P 2t+2 W1, 2t+2 and therefore the rate of inflation
Pl, 2t Wl, 2t
is given by the relative desired wages of the various labor groups.

This is exactly analogous, of course, to the results of the last sec-

tion.
Also equation (12) is the justification for the title of this
paper: the relative wages of labor groups one and two determine the
rate of inflation. It should also be mentioned that the wage bar-
gains pictured here correspond closely to the wage determination
process of The General Theory. At the time when each labor group
makes its bargain in The General Theory it is either restrained or
empowered by the at-least temporary fixity of the wages of other
labor groups. Keynes's system of bargaining (which is also his
reason for the "constancy" of the money wage) is much akin to the
nonsynchronized procedures assumed here.8
There has been some discussion in the literature on inflation
of "leapfrogging," alias "the wage-wage spiral." 9 Equation (12)
corresponds to such a phenomenon: the changes in relative wages
("leapfrogging") determine the rate of inflation. The rate of this
"wage-wage spiral" is seen below as determined by the level of
the parameter a and the structure of the economy: this consists
of the demand curves of the firms, the bargainings between the
unions and the firms, and the behavior of the firms in setting prices.
It is worth noting that the assumptions necessary to arrive
at (12) were symmetry, nonsynchronization and invertibility.
Therefore the particular monopoly and union-bargaining behavior
assumed - as important as they may be for particular solutions -
are not, by themselves, the keys to the inflationary processes de-
scribed.
Finally returning, as in the last section, to the specific ex-
ample, and collecting equations:
MR= MC yields:
(13) P1i t='/2(ap2, t+Wli 0) for all t
(14) P2, t=1/2(apl, t+w2, t) for all t.
The condition that unions maximize income yields:
(15) W1,2t=a2- for all t
12, 2t 1 +ye
8. J. M. Keynes, The General Theory of Employment, Interest and

Money (New York: Harcourt, Brace, 1936), p. 14. "In other words the strug-
gle about money wages primarily affects the distribution of the aggregate
real wage among labor groups and not its average amount per unit of employ-
ment, which depends, as we shall see, on a different set of forces. The effect
of combination on the part of a group of workers is to protect their relative
wage. The general level of real wages depends on the real forces of the eco-
nomic system."
9. See, in particular, W. Fellner, et al., The Problem of Rising Prices
(Paris: Organizationfor European Economic Cooperation, 1961), pp. 53-54.

368 QUARTERLYJOURNALOF ECONOMICS
(16) W2,2t+1 =a 1' for all t.

P1,2t+1 1+ye
The condition that bargaining occurs in January for union one gives
us:
(17) Wi,2t=Wl,2t+1 for all t
and that bargaining occurs in July for union two gives us:
(18) W2, 2t+1 =W2, 2t+2 for all t.
Using (13), (14), (17) and (18) equations (15), (16), (17) and
(18) can be rewritten as:
(15') Ply2t = az where Z= 2( y

P2, 2tZ=(y)
(16') P2, 2t+1 az

P1, 2t+1
(17') 2pi, 2t-aP2,2t=2p1y 2t+1-aP2, 2t+1
(18') 2P2, 2t+1-api, 2t+l=2p2, 2t+2-api, 2t+2.
Solving (15'), (16'), (17') and (18') we find that
(19) Pl, 2t+1 = (2_a2z)zP1i 2t
a2z (2z - 1)
(20) Pl, 2t+2= - 2-a2z P, 2t+1
and, most importantly,

ra
P121t+ 2-)1
(2) Ply,2t 2-a z
It is also possible to check that the relative wage W1,2t/W2, 2t is also

equal to a (2z-1) / (2-a2z).
Equation (21) gives the short-run Phillips Curve. This short-
run Phillips Curve has the expected properties that:
(l2t+2)
P
Pl, 2t
>
Da >0o
and
aPl, 2t+2
Pi, 2t
>0
Dye

as long as 2- a2z>0. This, however, is the relevant range in our

model, since otherwise equation (20) would denote inconsistent
(negative) price behavior.
But the next question which arises is the nature (or the exis-
tence) of a long-run Phillips Curve. In long-run equilibrium, as
before, price expectations should be realized. Remembering the
definition of ye the expected multiple of increase of P2 between
2t and 2t+1 - and applying symmetry, it is possible (using (20))
to write yA (the actual multiple of inflation of P2 between 2t and
2t+1 as a function of the expected inflation ye and a.
(22) A a2z (2z-1) a2ye (1+2ye)
'Y 2-a2z 2(1+ye)2_a2(1+2ye) (+l1ye)
and in equilibrium
(23) yA = ye
Equation (22) is remarkably similar to our old friend (7). First, for
a = 4/3, ye =1 is a double root. This should occasion no surprise -
considering the remarks of the last section. Second, for a > 4/3,
yA (ye) has the same shape as the function in Figure I. Upper roots
are, therefore, stable; lower roots are therefore unstable. Exactly
the same analysis with exactly the same qualifications which ap-
plied to the system in the last section can be repeated here. Begin-
ning with nondeflationary static expectations with a>4/3 the sys-
tem will gravitate to a rate of inflation determined by a. This rate
of inflation is locally stable and it increases with higher values of
a. In this restricted and qualified sense there is a long-run Phil-
lips Curve.
Money enters just as money entered before. Suppose that ag-
gregate demand is the sum of consumption demand, investment de-
mand, and government demand (assuming that the economy is
closed). There will be a relation between a and monetary policy.
Static macroeconomic theory shows that this sum will depend on
(a) the level of government expenditures, (b) the level and rates
of real taxation, and (c) the level of real balances. Suppose that
(a) and (b) are fixed; and suppose that the nominal level of the
money supply is increasing at a given rate A. In Figure II if the
rate of employment is larger than P(A), real balances and hence
aggregate demand are decreasing. Similarly if the rate of employ-
ment is less than P (X), real balances (and hence aggregate demand)
are increasing. P(X) represents the equilibrium rate of employment
for the rate of increase of the money supply X- with given policies

(dp/dt)/ p Phillips Curve
P(A) Employment
FIGUREII
in real terms for the level of government taxation and expenditure.

But there is one additional warning due: while a rise in real
balances can raise demand to any given level, even with negligible
real balances, demand may exceed supply. This is one clear element
in Bresciani-Turroni's account of the 1923 German hyperinflation:
the reduction in demand from the reduction in real balances was not
sufficient to allow the government to finance its operations from the
expansion of the money supply.' The sum of private plus public
real demands exceeded the full employment potential of the econ-
omy.
In the traditional Keynesian model of inflation 2 and also in
Friedman's Studies in the Quantity Theory of Money 3 a further com-
plication is added: the aggregate demand relations depend on the
rate of price inflation. In the Keynesian view the level of consump-
tion, investment and possibly also government demand depends on
the rate of inflation: because the spending today depends on bud-
gets made yesterday. This should not affect the earlier analysis:
suppose that the money supply is increasing at the rate A. In the
long run if prices are rising at a rate less than A, real balances are
rising (which shifts the consumption function outward), or if prices
are rising at less than A, real balances are falling. Eventually as
long as the many functions of the economy are stable (the consump-
tion function, investment function, tax function (in real terms) and
government expenditure), equilibrium is approached. Friedman,
1. Bresciani-Turroni,op. cit. Cagan shows the regularity with which real
balances decline in hyperinflation. P. Cagan, "The Monetary Dynamics of
Hyperinflation," in M. Friedman (ed.), Studies in the Quantity Theory of
Money (University of Chicago Press, 1956).
2. J. M. Keynes, How to Pay for the War (New York: Harcourt, Brace,
1940).
3. Chicago University Press, 1956.

on the other hand, emphasizes the shift of the demand for money
due to the rate of inflation. The relevant rate of interest for the
holder of money is the nominal rate of interest: the real rate of
interest plus the rate of inflation. Again, however, the same logic
holds: if the price level increases at a slower rate than the money
supply, real balances rise (and hence aggregate demand), and sim-
ilarly if the price level rises at a faster rate than the money supply,
real balances (and hence aggregate demand) decline. The result
will be the equilibrium previously described - but again the same
caveat applies: an overambitious program of expenditure (public
plus private) will result in hyperinflation -for the aggregate de-
mand curve and the aggregate supply curve may never meet
even at zero real balances.
IV
The theory of the last sections would appear all very special
were it not possible to motivate the results in far greater generality.
This generalization is provided by Bent Hansen's Chapter IX
of A Study in the Theory of Inflation.4
Following Hansen a system is considered which has n goods
or factors of production. As in A Theory of Inflation it is a condition
of economic rationality that the demand curves and supply curves
of each of these goods or factors be homogeneous of degree zero for
a given level of real balances. Therefore we write
(24) Di=Di(pi, . . ., pn;;M/pi) i-=, . . ., n
(25) Si= Si(pi, . .,pn; M/lp) i = 1 . . . , n
and in static equilibrium
(26) Di = Si.
Each of the n Si and Di equations can be considered as equa-
tions in relative prices and real balances. Therefore without loss of
generality (24), (25) and (26) can be written
(28) D=sD(,1?,,'j~P2 )nM

(28) Si =Si (1, P * p P
and, in equilibrium
(29) Di = S
4. London: Allen and Unwin, 1951.

And, if nothing unusual occurs, it can be seen (in the so-called

normal case) equations (27), (28) and (29) can be solved for the
unknowns
D ,i=l, . , n
Sii=1, . . ., n
and pi/pi, i= 2, . . . , n and M/pl.
This, of course, is the reasoning behind Patinkin's famous volume

- and monetary neutrality holds.
But in Sections II and III there is a system of lagged adjust-
ment to price changes. This can be approximated, following Hansen
(in turn following Samuelson), by saying that (dpi/dt) /p, =
Fi(Di-Si). The rate of change of the ith price depends on the dif-
ference between the demand and the supply of the ith commodity.
Fj has the property that Fi(O) =0, F'i>O: price changes are zero
if demand equals supply; and the greater the excess demand the
greater the rate of price increase.
In this case, for long-run equilibrium, the rate of change of
the price level is equal to the rate of change of the money supply
(which was previously called A). Therefore in the long run it is
not true that Di=Si, which would imply that (dpi/dt)/pi would be
zero. Rather, in the long run
(30) Di= Di (1 P2/Pl) . . . X Pn/Pl;MIPI) A)
(31) Si=Si (1; P-2/Pi; . .. X Pn/Pl;MIPli A)
and
(32) F. (Di,-S.) =A
It may be possible to solve these equations for the 3n unknowns
Pi/Pi i=2, . .. , n, M/pl
Dj, i=l,..., n
and
Se, i = 1 . . . ,n.
And in general the real solution to the system will depend on the
value of A (which is the rate of increase of the money supply).5
5. Another way to look at this problem is that we have a system of
balanced growth equations as in P. A. Samuelson and R. M. Solow, "Balanced
Growth Under Constant Returns to Scale," Econometrica, Vol. 21 (July 1953).
Both M. Morishima and F. M. Fisher have suggested that such systems could
be used to talk about inflation. See M. Morishima, "Proof of a Turnpike
Theorem: The 'No Joint Production Case,"' Review of Economic Studies,
XXVIII (Feb. 1961); and A. Ando, F. M. Fisher, and H. A. Simon, Essays

The "Keynesian" theory of wage adjustment of Section III

gives a precise rationale for an adjustment mechanism of the Han-
sen-Samuelson variety; in turn it leads to the nonneutrality of
money -and therefore a Phillips Curve. Reinterpreting the as-
sumptions of Sections II and III, nonsynchronization gives form to
the various Fi's -and the presence of noncompetitive markets
keeps the Fe's from degeneracy: with the markets assumed, the
greater the degree of competition the greater is the slope of the Fj
functions; in the limit money is again neutral.
V
Our model differs considerably from most of the standard
models of inflation: it has been shown that there are considerable
differences from the usual quantity-theory-of-money approach to
inflation: in the long run, the rate of increase of the money supply
determines the degree of full employment.
On the other hand, in the usual demand-pull theories of in-
flation price rises have a purpose: "to cheat the slow to spend of
their desired shares" of total income.6 This is the heart of Keynes 7
and Smithies.8 But in our model inflation occurs without any tele-
ological purpose of destroying aggregate demand - although, as
seen in Section III, this can be easily incorporated into the model.
And yet this is not a simple model of cost-push either, for the
wage rises would not occur without the price rises just as the price
rises would not occur without the wage rises. Rather this is a
model of spontaneous inflation in which the chicken and the egg of
wage and price rises are mutually the causes of each other. Han-
sen's Walrasian model of inflation is most similar.9
The heart of our system is the gaps between the supply and
demand equilibria, whose continued incompatibility is allowed by
the nature of the adjustment process. Examples have been given
before of systems where the system of adjustment allows a toler-
ance for continued disequilibrium, with resulting rising prices and
wages. The notion of "leapfrogging" has already been mentioned.'
J. C. R. Dow has suggested a situation in which unions and firms are
on the Structure of Social Science Models (Cambridge, Mass.: M.I.T. Press,
1963).
6. P. A. Samuelson and R. M. Solow, "Analytical Aspects of Anti-Infla-
tion Policy," American Economic Review, L (May 1960).
7. Keynes, How to Pay for the War, op. cit.
8. A. Smithies, "The Behavior of Money National Income," this Journal,
LVII (Nov. 1942).
9. Hansen, op. cit.
1. Fellner, et al., op. cit.

each biddingfor sharesof output,whose sum exceedsUnity.2Turvey

has suggested a similar process.3 The additional element of the
spontaneous inflation here, whatever kind of spiral it may be, is
its explicit dependence upon demand and expectations.
Finally this paper has left us with many exercises unfinished
and several questions to be answered. First of all, many different
industrial structures could be substituted for the example of monop-
olistic competition and applied to this framework. Similarly vari-
ous different bargaining solutions between unions and employers
can be substituted. One possible variant on this theme is an econ-
omy with a monopolistic and a competitive sector - where the
monopolistic sector represents "industry" and the competitive sec-
tor represents "agriculture." Such a model could be used to describe
inflationary processes in underdeveloped economies.
But more important is the introduction of many grades of labor.
For it is important to know the mechanism whereby labor-training
programs, etc., shift the Phillips Curve and thereby make more
employment possible. In addition it is necessary to have such a
macroeconomic view in order to compare the costs and the benefits
of such training programs. Similarly it is important to have models
with several types of employers to evaluate the effects of such pro-
grams as additional government employment of low-skilled workers.
Further, the high councils of the United States government
appear to believe some Phillips-Curve theory.4 But as Professor
Kuh has urged,5 in a model with heterogeneous labor (and seg-
mented markets) the competition between the "top" and the "bot-
tom" of the labor force may be weak. The implication is that
unemploymentmay, in past cycles, be correlatedwith the bargain-
ing power of wage earnersbut at the same time it may be structur-
ally independent. If this is the true view of the economy, the
Phillips Curve can perhapsbe structurallyaltered; a structurefor
inflation theory is necessary to decide whether this is in fact the
case.
UNIVERSITY OF CALIFORNIA
2. J. C. R. Dow, Oxford Economic Papers, N.S. Vol. 8 (Oct. 1956).

3. R. Turvey, "Some Aspects of the Theory of Inflation in a Closed
Economy," Economic Journal, LXI (Sept. 1956).
4. In particular, see Economic Report of the President, 1962, p. 44, for
an especially clear and authoritative statement of the believed relation be-
tween unemployment and inflation.
5. See Kuh, op. cit.


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Relative Wages and the Rate of Inflation

Author(s): George A. Akerlof

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

RELATIVE WAGES AND THE RATE OF INFLATION*

I. Introduction, 353.-II. A price-price inflation, 355.-III. A wage-wage

Monetary theory in the post-Keynesian era has, to a good ex-

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unemployment, irrespective of market structure, stickinesses, etc.,

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This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

ity) which dictates this particularsolutionto the oligopolyproblem.

whereD and p are demandand prices,wheresubscriptsone and two

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

of monetary and fiscal policy. Second, quite clearly this is a

This constancy of money prices over a two-period interval is the

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and together with (3) and (4)

P 2t+ P2 2t+1 P2t+2 by (5)

= P2, 2t+1 P2, 2t+l by (4)

( P122t) Pl,2t by (3)

(6) P1, 2t+2 (Ply 2t )2

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

Equation (6) occasions some remarks. It should be clear that

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

counted by a rate of return or the rate of inflation. For the sake

Re= Pi, 2t (a- P, 2t' +Pl,

where (7A) 2 represents the yearly multiple of price change.

or, rewriting, in equilibrium

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The natural question is whether there is a unique y = y (a) for

Startingwith nondeflationarybut static expectationsabout the

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the upper roots -and the consequent gravitation toward these

The next step is to add money to the system. This is done in

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

of real balances. All of this suggests that in constructing an ex-

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or, output of each firm is proportional to its employment.

Countervailing the oligopoly power of the firms, we picture

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Ee, 2t+1 = 1/2 (a-W 2t+1

7. J. T. Dunlop, Wage Determination Under Trade Unions (New York:

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

(where e refers to "expected")

(The difference in ye between here and Section II may be noted;

Symmetry dictates with constant ye that:

W2) 2t W1, 2t+1 W2, 2t+2

Combined with nonsynchronization

(12) W1, 2t+2 (Wit 2t )2

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

This is exactly analogous, of course, to the results of the last sec-

8. J. M. Keynes, The General Theory of Employment, Interest and

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

(16) W2,2t+1 =a 1' for all t.

(15') Ply2t = az where Z= 2( y

(16') P2, 2t+1 az

(18') 2P2, 2t+1-api, 2t+l=2p2, 2t+2-api, 2t+2.

Solving (15'), (16'), (17') and (18') we find that

(19) Pl, 2t+1 = (2_a2z)zP1i 2t

and, most importantly,

It is also possible to check that the relative wage W1,2t/W2, 2t is also

This content downloaded from 195.34.79.79 on Tue, 17 Jun 2014 05:48:20 AM

as long as 2- a2z>0. This, however, is the relevant range in our