III. The Aggregate Demand Relation. The final component of the medium-run model is aggregate demand. For simplicity, the text focuses on real money and writes aggregate demand as follows:
Y=M/P. (9.4)
Equation (9.2) implies
gy =gm-π, (9.5)
where gm is the growth rate of money.
2. The Effects of Money Growth
Assume
that the central bank maintains a constant growth rate of money,
.
In the medium run, the unemployment rate will be constant. From
Okun’s law, a constant unemployment rate implies that output grows
at its normal rate. From the aggregate demand relation, inflation
will equal the difference between the growth rate of money and the
normal rate of output growth. So, inflation is constant. From the
Phillips curve, constant inflation implies that the unemployment rate
equals the natural rate. In medium run, the unemployoment rate is
the natural rate, output growth equals its normal rate, and inflation
equals money growth minus the normal rate of growth.
The implication of this analysis is that money growth affects only the inflation rate in the medium run. Money growth has no effect on medium-run output growth or unemployment. By the same token, inflation is ultimately determined by monetary policy.
If the economy starts in a medium-run equilibrium, then a permanent decrease in money growth will lead to a recession and a fall in inflation in the short run. From the aggregate demand relation, given inflation, a fall in money growth leads to a fall in output growth, so that growth is below the normal rate. From Okun’s law, a rate of growth below the normal rate leads to an increase in the unemployment rate, so that unemployment is above the natural rate. From the Phillips curve, unemployment above the natural rate leads to a fall in inflation. In the medium run, the lower rate of money growth will lead to lower inflation, but have no effect on output growth or the unemployment rate. The path from the short run to the medium run depends upon the path of monetary policy.
The text traces the dynamic effects of a particular path of monetary policy, assuming that the central bank controls real money growth. This assumption is not limiting, since for any given inflation rate, the central bank can adjust nominal money growth so as to achieve any rate of real money growth.
3. Disinflation
Suppose policymakers with to reduce inflation. The Phillips curve implies that a reduction in inflation will require an unemployment rate higher than the natural rate for some time. The issue is the size of the unemployment cost and how the structure of a disinflation program affects the cost.
Define a point-year of excess unemployment as one year of an unemployment rate one point above the natural rate. Define the sacrifice ratio as the number of point-years of excess unemployment required to reduce the inflation rate by one percentage point. The accelerationist Phillips curve implies a sacrifice ratio of 1/, where is the coefficient on the unemployment rate. In the United States, is roughly equal to one, so the sacrifice ratio is roughly equal to one. Moreover, the linearity of the Phillips relation implies that the sacrifice ratio is independent of the path of the inflation rate. Thus, in the United States, a cumulative ten percentage point reduction in the inflation rate implies ten cumulative point-years of excess unemployment. The actual trajectory of the unemployment rate depends upon the trajectory of the inflation rate.
In the mid-1970s, Robert Lucas argued that the disinflation analysis described above was likely to provide a misleading guide to the effects of policy. Necessarily, the estimated Phillips curve and Okun’s law depend on historical data. Changes in policy, however, might change the historical relationships between variables. In particular, the way inflation expectations are formed might vary with the policy environment. This argument has come to be known as the Lucas critique.
The accelerationist Phillips curve assumes that expected inflation equals lagged inflation. In a disinflation, however, if the central bank could actually convince wage setters that it intended to reduce inflation, wage setters might expect inflation to be lower in the future than in the past. In the extreme, if the central bank announced its inflation target, and wage setters believed it, disinflation could be achieved without any increase in the unemployment rate above the natural rate. The accelerationist Phillips curve implies that unemployment equals its natural rate when expected inflation equals actual inflation.
The Lucas critique implies that credibility is an important determinant of the costs of disinflation. If policymakers can convince wage setters that a disinflation will be implemented, the policy can be carried out with relatively little increase in unemployment.
In response to the credibility argument, Stanley Fischer and John Taylor argued that the presence of nominal rigidities implied that even credible disinflations could be costly. Fischer emphasized that inflation would already be built into existing wage agreements and could not be reduced without cost. Taylor emphasized that wages were not all set at the same time. He argued that, assuming that workers cared about their wages relative to the wages of other workers, the existence of staggered wage contracts implied that wages (and hence prices) would adjust only slowly to changes in policy. As a result, a too rapid reduction in nominal money growth would lead to a less than proportional decrease in inflation. The real money stock would decline, leading to a recession and an increase in the unemployment rate.
In the late 1970s, using data on the pattern of wage contracts in the United States, Taylor estimated a path of disinflation for the U.S. economy that would not increase the unemployment rate. The required disinflation began relatively slowly and increased over time. A problem with such a policy course, however, is that wage setters might not find it credible. Why should they believe a central bank that promises disinflation in the future?
The Volcker disinflation, which is analyzed in a box in the text, provides a text of the credibility argument. Over the period 1979-1985, the United States reduced inflation by 10% at a cost of 12 point-years of excess unemployment. There were no obvious credibility gains, even though Volcker had (and has?) a reputation as a tough anti-inflation fighter. Credibility theorists, however, can argue that Volcker lost his credibility when the Fed eased policy in 1980, in response to the recession.
More systematic evidence on the cost of disinflation is provided in work by Laurence Ball, who analyzes 65 disinflation episodes in OECD countries over the past 35 years. Ball concludes that disinflations typically lead to a period of higher unemployment, that faster disinflations are associated with smaller sacrifice ratios, and that sacrifice ratios are smaller in countries with shorter wage contracts. The results provide some support for the credibility argument (since rapid disinflation is usually thought to be more credible) and for the arguments of Fisher and Taylor about wage contracts.