Ch.

9: Inflation

Lecture IX

1
 Inflation
• Definition: Inflation is a sustained rise in
general level of prices.
• Analytical apparatus of inflation analysis
– Different versions of Phillips curve
– Cost-push theory of inflation

2
 The original Phillips curve
• The original Phillips curve was an empirical
relationship b/n the rate of change of money wage
(W) and the rate of unemployment (U) in the UK
discovered by Phillips (1958).
• It was an inverse relationship b/n the two, convex
to the origin, which appeared to be stable.
• Phillips estimated the relationship on the data
from 1861 to 1913, and found the the combinations
of wage change and unemployment recorded in the
periods 1913-48 and 1947-57 remained very close
to the relationship estimated on the earlier data.

3
• The original Phillips curve

0 U

4
• Lipsey (1960) provided a theoretical rationale for Phillips’
empirical relationship.
• He started from individual labor markets, disaggregated
from the overall national labor market by region or by
skill, and worked upto the overall macroeconomic
relationship.
• First, he made the simple dynamic assumption that the
rate of wages varies positively with the proportionate
amount of excess demand for labor [(DL-SL)/SL] in the
individual labor market.
  φED , φ  0
W L

• Where W  is the proportionate rate of change of wages, that

is ΔW/W and φEDL is the proportionate amount of excess
demand for labour, that is the demand minus the supply,
divided by the supply  φED  D - S 
L
L L

 SL 
5
Lipsey’s diagrammatic representation

6
 Relationship b/n unemployment and the excess
demand for labour (Lipsey, 1960)

• Oa is the amount of frictional unemployment, which exists as

the result of the normal process of turnover in the labour
market, when the excess demand for labour is zero and the
labour market is in balance.
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• As excess demand rises above zero, unemployed workers
who are changing jobs find new jobs more quickly and so
the rate of unemployment tends asymptotically towards
zero, and the line is convex to the origin.
• As excess demand for labor falls below zero, there is a one-
for-one increase in unemployment and the line is straight.
• These two assumptions are combined to construct an
”adjustment function” for the individual labour market by
considering the rate of wage change and the rate of
unemployment associated with each particular level of
excess demand.
• Since the relationship b/n wage change and excess demand
is linear, that between wage change and unemployment has
the same shape as that b/n excess demand and
unemployment.
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Relationship b/n wage change & unemployment

9
• The final stage in Lipsey’s analysis is to construct a ’macro
adjustment function’ by aggregating the individual labor
market adjustment functions, which he assumed to be
identical.
• He showed that the macro adjustment function (the
Phillips curve for the economy as a whole) is nonlinear
below the horizontal axis if the unemployment rates in
individual labour markets differ.
• It is further away from the origin, the greater is the
difference b/n the rate of unemployment in the various
individual labour markets.
• In principle, the gov’t could shift the overall Phillips curve
inwards towards the origin if it could reduce the dispersion
of unemployment rates b/n individual labor markets.

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 The important result from the Phillips-Lipsey
analysis
The Phillips curve was interpreted as showing that there was a
”trade off” b/n inflation and unemployment: less unemployment
was possible only with more inflation; less inflation could be
obtained only at the cost of higher unemployment.
The problem for macro policy was then presented as the
problem of choosing and attaining the preferred combination of
the two.
• Some economists also argued that the trade-off could be
favourably modified by the use of an incomes policy which
could make wages rise more slowly at any given level of
unemployment and would therefore shift the Phillips curve
inwards towards the origin.

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Expectations-augmented Phillips curves

• In the late 1960s and early 1970s many countries began to

experience combinations of inflation and unemployment
well outside the estimated Phillips curves.
– That is, the original Phillips curve experienced an ’empirical
breakdown’.
• Before the ’empirical breakdown’, Friedman (1968) and
Phelps (1967) had a strong criticism on the original
Phillips curve.
• They argued that the supply of and demand for labor
depend on real wages and not money wages, and hence the
amount of excess demand for labor should determine the
rate of change of real wages, not that of money wages.

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• The latter is more relevant for the study of inflation:
Friedman and Phelps argued that the connecting link
in this process is expectations of inflation.
• That is, employers are concerned about what is
likely to happen to the price of their output since this
partly determines what they can afford to pay for
labor and so how much labor they want to employ at
any particular level of money wages.
• Workers, on the other hand, are concerned about the
real value of any particular level of money wages,
and so about the likely change in the prices of the
goods and services they buy.
• Thus both sides of the labor market in effect work
out what they think will happen to prices over the
period for which they are entering into agreements
on wages and employment.
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• They form expectations about inflation, and these
expectations feed into the wages on which they
agree.
• When expected inflation is zero, employers and
workers expect the rate of change of money wages
to be the same as that of real wages, and in this
situation the original Phillips makes sense.
• But for any other level of expected inflation there
must be another Phillips curve above or below
that curve by the amount of the inflation expected,
and these curves are called ’expectations-
augmented’ Phillips curves.
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– The lower of the two curves in this figure is for zero
expected inflation and the upper for expected inflation of
5%.
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Adaptive & rational expectations
• The existence of a long-run Phillips curve which is
vertical at the natural rate of unemployment
depends on two things:
1. The absence of money illusion, which ensures
that expected inflation is fully incorporated
into the determination of actual wage change
and inflation.
2. The existence of some mechanism by which
actual inflation is fully incorporated into
expected inflation.

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• Two main hypotheses as to how expectations
are formed:
1. adaptive expectations hypothesis
2. rational expectations hypothesis.

1. The adaptive expectations hypothesis is that

economic agents adapt or adjust their
expectations in the light of the errors they find
they have made in the past.
– Agents are assumed to change their expectations b/n
one period and the next by some fraction of the
difference b/n their expectations and the actual rate
of inflation in the first period.
Pte  Pte1   ( Pt 1  Pte1 ), 0    1
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• This can be rearranged to give
P te  δ( P t1  P te1 ) P te1
 δ P t 1 (1  δ) P te1

• This equation expresses current expectations of

inflation as a weighted average of previous period
inflation and previous period expectations of
inflation.

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• Since the weights on past inflation sum to 1, if actual
inflation has always been the same then expected inflation
must be equal to it.
• Expectations of inflation in the end, though not
immediately, fully incorporate or fully adjust to actual
inflation.
• It suggests that people adjust their expectations or forecasts
in the light of the mistakes they find they have made.
• One problem with adaptive expectations is the possibility of
making systematic error if inflation is continuously rising
or systematically falling. It works if inflation sometimes rise
and sometimes fall.
• Another problem with adaptive expectations is that it
assumes that people take no notice of any information
about future inflation other than their past errors, despite
considerable amount of such information available in the
forecast reporting.
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2. The rational expectations hypothesis (first outlined
by Muth, 1961) was not applied until Robert Lucas
(nobel prize winner) and others began using it in
the 1970s in conjunction with the natural rate
hypothesis.
– The rational expectations hypothesis says that
economic agents use all the information available
to them in trying to forecast the future.
• The hypothesis involves two main assumptions:
1. Economic agents make their forecasts on the
basis of a correct model of the economy;
2. This current model includes the systematic
element in gov’t policy.
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• Two main points from the rational
expectations hypothesis literature:
1. It would be odd if economic agents
continuously made erroneous forecasts, and
there are some situations when they have
financial incentive to obtain the best possible
forecasts.

2. Many of the expositions pay little attention to

the problems and costs of acquiring the
information necessary to make accurate
forecasts.

21
• Policy implications of the rational expectations hypothesis
when combined with natural rate hypothesis:
– Systematic stabilization policy has no effect on
unemployment or output, because policy is anticipated
by private-sector economic agents who revise their
expectations of inflation accordingly, and the result is
that the entire effect of policy falls on prices and none of
it on real demand and output.
– Hence, no short-run tradeoff b/n inflation and
unemployment, which policymakers can make use of.
• This is as opposed to the original Phillips curve where
there is a long-run trade-off and adaptive
expectations-augmented curve where there remains a
short-run (but no long-run) trade-off.
– Under the natural rate hypothesis with rational
expectations, unemployment and output are affected only
by ’surprises’ or ’shocks’ which cannot be predicted.

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 Cost-push theory of inflation and a
wider perspective
Cost-push theory of inflation
• It was important in the 1960s and 1970s, being one
of the key elements of the Keynesian side of the
Keynesian-Monetarist debates, but became less
important since then.
• Still, it has some bearing on the supply side shocks
in the mainstream economics.
• The simplest way to approach the cost-push
theory of inflation is by thinking of the price of an
individual good produced by a particular firm.
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• The price can be decomposed into the cost of the
materials used, the cost of labor used, any indirect
tax or subsidy and the profit.
• Profit is the difference between average cost
(excluding the cost of capital) and average revenue
(net of any tax or subsidy)
• At macro level, material costs disappear except for
imports because the output of one firm becomes
the input of another and they will cancel each
other.
• So the value of the total output of goods and
services available for domestic use can be
expressed as the sum of the value of imports, total
labor costs involved, totoal profits and indirect
taxes less subsidies.
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• Concentrating on output at factor costs (which
excludes indirect taxes and subsidies) rather than
at market prices, we will have:
• The value of output PQ can be decomposed into
import costs F, labor costs W and Profits R.
PQ  F  W  R
• Cost-push theory assumes that firms set their
prices to give a constant mark-up above costs.
• This means that the profit margin is constant,
and that profits are a constant proposition, say r,
of other costs.
R  r(F  W)
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• Hence,
PQ  F  W  r(F  W)
 F(1  r) W(1  r)

• The average price of a unit of output P is

F(1  r) W(1  r)
P 
Q Q
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• The rate of change of P can be expressed as a
weighted average of the rates of change in import
and labor costs:
(1  r) (1  r)
ΔP  ΔF  ΔW
Q Q
ΔP (1  r) (1  r)
 ΔF  ΔW
P PQ PQ
ΔP (1  r)F (1  r) W
 ΔF  ΔW
P PQ F PQ W
ΔF F(1  r) ΔW W(1  r)
 
F PQ W PQ
ΔF ΔW
α β
F W
  αF
P   βW

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• Where   F (1  r ) / PQ and   W (1  r ) / PQ are the
weights on the rates of change of import and labor costs
respectively. And
   1
• With profit margins constant, the change in prices can be
decomposed in this way into the change in import costs and
the change in labor costs.
• Changes in labor costs are singled out as the main cause of
inflation. Thus, inflation is seen as caused by increases in
costs.
• Variations in demand have no direct effect on prices and
indeed no indirect effect either since cost-push theorists
generally consider that the rate of change of wages is also
independent of demand conditions.
• The appropriate way to prevent inflation is therefore the use
of an income policy to reduce the rate at which wages increase.28
 Cost-push and real demand
• Even if variations in demand do not cause inflation, in the
IS-LM framework, for example, an increase in prices shifts
the LM curve to the left, reducing real AD, and therefore
output. If the LM curve were horizontal b/c of liquidity
trap or if the IS curve is vertical b/c inv’t was interest-
inelastic, demand and output would not be affected.
• If these extremes are excluded, cost-push inflation must
lead directly to lower output and higher unemployment.
• However, real experience in DCs has not supported this,
and cost-push theorists have usually regarded inflation as
”orthogonal” to the level of economic activity.

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• An increase in price, shifting the LM curve
to the left, and reducing real AD.

30
• The cost-push inflation increases the price level, the
LM curve shifts to the left, interest rate tends to
increase and the levels of AD and output fall.
• However, gov’t intervenes to prevent this from
happening by increasing nominal money supply,
proportional to price changes, causes the LM curve
to shift backward to its original position.
• Thus, the growth of money supply is caused by and
endogenous to inflation, eliminating the effect
inflation would have otherwise had on the level of
economic activity.
• The endogeneity is consistent with observed
tendency for prices and money to rise together over
long time periods.
31
• Effect of monetary policy (increase in nominal
money supply in proportion to increase in price
level)

32
 A wider perspective on inflation
• In classical economics: Quantity theory of money
• In the 1940s and 1950s: Cost-push and demand-pull theories of
inflation
• Demand-pull theory of inflation:
– Excess demand ’pulls up’ prices in its wake.
– Related to the augmented Phillips curve, in which the excess
demand for labour determines the rate of change of wages,
while prices are determined either indirectly (via wage
costs) by the excess demand for labor or directly by the
associated excess demand for goods & services.
– Excess demand was assumed to be dominated by fiscal
policy, so that demand-pull inflation was primarily the
result of errors in the govt’s macro policy causing an
overheating of the economy.
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• Since the Phillips curve emphasizes market forces rather
than trade union power, its influence tended to strengthen
the support for demand-pull rather than the cost-push
analysis.
• During 1960s, the Friedman-Phelps critique of the original
Phillips curve was succeeded by the empirical breakdown of
the relationship, and this led to a greater polarization of
economists’ views on inflation.
• The Keynesian economists interpreted the empirical
breakdown as evidence that inflation was after all essentially
a cost-push rather than a demand-pull phenomenon.
– Keynesian economics identified with the view that the basic cause of
inflation was some kind of social conflict and pressure outside
economic sphere and outside the scope of economic analysis, while
excess demand was not even a minor cause of inflation.
– The endogeneity of the money supply in response to inflation was
given more emphasis as increasing evidence of a stable demand for
money accumulated.

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• The earlier concept of demand-pull inflation was now
subsumed in the revised, expectations-augmented,
version of the Phillips curve associated with Friedman and
Phelps (situated in a monetarist framework).
• The monetarist theory of inflation had three main
components:
1. The argument that there was a powerful transmission
mechanism from money to aggregate demand, so that
excess demand was dominated by monetary factors as
in the monetarist version of the IS-LM model.
2. The assumption that the growth of the money supply
was exogenous, that is both able to be controlled and in
fact controlled by the monetary authorities.
3. The expectations-augmented Phillips curve analysis with
the natural rate hypothesis. Thus exogenous monetary
growth determined excess demand which, together with
expectations of inflation, determined actual inflation.
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By the mid-1970s there were two well-articulated
theories of inflation:
1. The Keynesian cost-push emphasis on trade
union.
• This was against the monetarist emphasis on excessive monetary
growth resulting from expansionary gov’t policy as the basic
cause of inflation.
• This was the introduction of the rational expectations hypothesis
into the monetarist analysis.
• The effect was to introduce a direct and strong connection b/n
monetary policy and inflation expectations, in place of the
indirect connection via excess demand and actual inflation
which characterized the adaptive expectations analysis.
• However, the link now depended on the extent and nature of the
systematic (and predictable) element in the monetary policy.
• Expectations of inflation could be affected by the announcement
of targets for monetary growth, inflation or other variables, by
changes in gov’t or in exchange rate regimes, and so on.
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2. The Keynesian advocacy of incomes policy
• This was against the monetarist prescription of tight
monetary control.
• This was the introduction of the ’real wage resistance’ or
’target real wage’ hypothesis on the cost-push side.
• This hypothesis became more important in the 1980s,
although it was put forward earlier.
• Real wage resistance means that workers and trade unions
resist not merely cuts in their real wage which result from
cuts in their money wages but also cuts in their real wages
which result from rises in the price level.
• The workers and trade unions seek to obtain wage
settlements which will provide them with a certain target
growth in their real wages net of tax.
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In formal terms the hypothesis can be stated as
 θW  *  θW  
  ψ 
W    , 0  ψ  1, 0  θ  1
 P  t  P  t 1 
where W is money wage
P is the price level
ψ is a partial adjustment parameter
θ is the 'retention ratio', i.e., the proportion(1 - t)
which is retained after(direct) tax has been paid.
*
 θW 
  is the ' aspiration wage' , i.e., the target or desired level
 P t
of real post - tax wages, and
 θW 
  is the acutal level in the preceding period.
 P  t 1

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• Alternatively, a slackness in the system of monetary
control may cause money supply to respond to inflation.
• E.g., cost-push inflation might have the effect of increasing
the budget deficit, if it raises nominal gov’t expenditure by
more than it raises nominal tax revenue.
– If monetary authorities do not react by increasing the
govt’s borrowing from the private sector, the money
supply will increase.
• If cost-push inflation leads companies to borrow more to
maintain the real value of their working capital, bank
lending and the money supply will increase in line with
prices.
• In general, some mechanism that makes the money supply
endogenous to inflation is essential to the cost-push theory.

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The decline of cost-push views in the 1980s and 1990s.
– One factor was the widely perceived reduction in the strength of
trade unions.
• Over 1980s, repeated waves of industrial relations legislation, trade
union defeats in some key areas, structural changes in employment
patterns, and a substantial rise in an unemployment
– A significant rise in inflation, despite these factors, towards the end
of the 1980s, generally due to a boom, clearly demand-led.
– A broader, partly political, trend to emphasize market forces rather
than social conflict as explanations of economic phenomena, and to
emphasize monetary rather than incomes policy as the cure for
inflation.
– The dev’t of the target real wage hypothesis, where excess demand
gained a role within the cost-push views and workers were no longer
perceived as suffering from money illusion.
– The cost-push theory of inflation had almost vanished by the mid-1990s.
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