Inflation:
from minor phenomenon
to major problem
Inflation & Keynes
$ In the Keynesian model, inflation is only
implicit, the aggregate price level does not
appear explicitly in any of the models we
have been looking at
$ There CAN be


an "inflationary gap", or
a "deflationary gap"
$ These are defined vis a vis the "full
employment level of output"
Full Employment Output
$ The definition of "full employment output"
is vague
$ Most people think about this in technical
terms about what "can be" produced with
the given capital stock & labor
$ But clearly this is flexible. Capacity can be
squeezed, but this puts upward pressure
on prices as business has to pay more for
factors of production
Gaps
$ Suppose Yfe is the full employment equilibrium
level of output
C, I, G
aggregate
demand
deflationary
gap
inflationary
gap
B
Y
A
Y
Inflationary Gap
$ The notion is that if planned aggregate demand
exceeds full employment output there will be
upward pressure on prices (demand pull inflation)
aggregate
demand
C, I, G
deflationary
gap
inflationary
gap
B
Y
A
Y
Deflationary Gap
$ If aggregate demand is less than the full
employment output there will be downward
pressure on prices (prices reduced to sell)
C, I, G
aggregate
demand
deflationary
gap
inflationary
gap
B
Y
A
Y
Gaps & Policy
$ Clearly, the presence of an inflationary
gap or a deflationary gap suggests policy
responses:
$ Inflationary Gap: use monetary & fiscal
policy to reduce aggregate demand
$ Deflationary Gap: use monetary & fiscal
policy to increase aggregate demand (as
in the Great Depression)
Philips Curve
$ With inflation determination only implicit
and no direct way to determine the degree
of inflationary or deflationary pressure in
the models we have been looking at,
Keynesians discussed some of the
problems using a separate theoretical
construct:
$ The so-called Philips Curve

which was not really the curve developed by Philips
Philips' Own Curve - I
$ Philips analysed the trade-offs between
unemployment and wage increases over
the course of the business cycle
$ As the cycle swung up and unemployment
dropped, tightening the labor market,
wages tended to rise ever faster
$ As the cycle dropped into bust and
unemployment rose, wage increases
dropped and eventually wages fell.
Philips' Own Curve - II
$ Studying empirical data Philips
discovered that these changes followed a
pattern:
w/W
U
Keynesian Philips Curve
$ The Keynesians shifted focus from wage
changes (w/w) to price changes (p/p)
and substituted a curve for a loop:
p/p
U
Late 60s & Trade-offs
$ This Keynesian Philips curve became
popular in late 1960s as wage growth
began to outstrip productivity growth and
inflation accelerated.
$ The emphasis was on the trade-off btwn
unemployment & inflation


to get less unemployment you had to accept higher
inflation
to get less inflation you had to tolerate higher
unemployment
The Data
$ Between 1961 & 1969 actual data fit the
Philips curve very well:
1969
p/p
1961
U
Keynesian Antidote
$ But by 1969 after almost a decade of
accelerating inflation, enough was enough
$ So, in 1970 Keynesian policies were used
to precipitate a recession, which,
according to the Philips curve would
result in less inflation and more
unemployment
$ Inflation/unemployment should slide back
down the curve. It did not.
Crisis
$ The 1970 recession dramatically raised
unemployment but inflation barely
wavered: 1969
1970
p/p
1961
U
Crises
$ First crisis: 1970 Keynesian recession
fails to lower wage pressure & inflation
$ Second crisis: 1971 Abandonment of
Bretton Woods signals failure
$ Third crisis: 1974-75 recession repeats
experience of 1970:


higher unemployment
no substantial reduction in inflation
Responses
$ Theoretical


reconstruct macro models to put inflation up front and
at the center of attention
 aggregate supply & demand (treat macro like micro)
revival of monetarism
$ Pactical




shift to floating exchange rates
use inflation against real wages
use inflation to redistribute income from labor to capital
eventually full-scale attack on wages via depression
--END--