CHAPTER 29 (13)
INFLATION AND ITS RELATIONSHIP TO
UNEMPLOYMENT AND GROWTH
Economics is the only field in which two people can share a Nobel Prize for saying opposing
things. Specifically, Gunnar Myrdahl and Friedrich S. Hayek shared one.
CHAPTER OVERVIEW: What’s It All About?
The quantity theory of money and inflation and the institutionalist views of inflation,
unemployment, and growth exhibit two worldviews. The quantity theory views a world in which
market forces predominate with insignificant sociological and institutional factors. The
institutionalist theory views a world in which significant sociological and institutional factors
interact with market forces. These two worldviews dominate the discussion facing government
as it decides what to do about its fiscal and monetary policies regarding inflation, unemployment,
CHAPTER OBJECTIVES: Students Should Be Able To …
1. State some of the distributional effects of inflation. In an inflation, the winners are those who
can raise their prices or wages and still keep their jobs or sell their goods. Losers are those
2. Explain how inflation expectations are formed. When expectations of inflation are high,
people tend to raise their wages and prices, causing inflation. Expectations can become self
3. Outline the quantity theory of money and its theory of inflation. The first assumption of the
theory is that the velocity of money (V) is constant. If V is constant, the quantity theory can
be used to predict how much nominal GDP will grow if we know how much the money
supply grows. The second assumption of the theory is that real output (Q) is autonomous,
that is, independent of the money supply. If Q grows, it is because of incentives in the real
economy – that is, on the supply side, not the demand side. The third assumption is that the
direction of causation goes from money to prices. Thus, the quantity theory of money says
that the price level varies in response to changes in the quantity of money.
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4. Outline the institutionalist theory of inflation. According to these theorists, the source of
inflation is in the price-setting process of firms. Firms find it easier to raise prices than to
lower them, and firms do not take into account the effect of their pricing decisions on the
overall price level.
5. Differentiate between long-run and short-run Phillips curves. The short-run Phillips curve –
a representation of the relation between inflation and unemployment – has unemployment
measured on the horizontal axis, with inflation on the vertical axis. The short-run Phillips
curve shows us what combinations of those two phenomena are possible. The long-run
Phillips curve is thought to be a vertical curve at the unemployment rate consistent with
potential output. It shows the trade-off (or complete lack thereof) when expectations of
inflation equal actual inflation.
6. Explain the different views on the relations between inflation and growth. In the AS/AD
model, as the economy expands and output increases, at some point input prices begin to rise,
shifting the AS curve up. The problem is that no one knows where that point is. The
government prefers a point where the output level is high as possible while keeping inflation
low and not accelerating. The institutionalists argue that it is best to err on the high side.
The quantity theorists argue that this is like “being a little bit pregnant.” For them, erring on
the low side pays off – it stops any chance of inflation. They argue that while there is no
long-run tradeoff between inflation and unemployment, there is a long-run tradeoff between
inflation and growth. Low inflation leads to higher growth.
DISCUSSION STARTERS: Get Your Class Rolling
1. Considering that the “natural rate of unemployment” consists of the frictionally and
structurally unemployed, is there anything that could be done to reduce this “natural rate?‟
2. Why have Republicans historically generally favored contractionary monetary and fiscal
policy while the Democrats have generally favored expansionary policy?
3. Are people as rational in their calculations of future inflation as the Classicals (monetarists)
4. Will people‟s expectations about the effects of fiscal and monetary policy likely be the same?
5. What role does government play in the insider/outsider model?
6. What would happen to the Phillips curve if there were another dramatic increase in the world
price of oil similar to that experienced during the OPEC oil embargo of 1973-1974?
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ON THE WEB: Integrating New Media into the Classroom
http://www.ideachannel.com/Friedman.htm is the Web site of “a listing of the best and most
comprehensive online resources pertaining to Nobel laureate Milton Friedman.” If you adore
Friedman, this is the place to worship. Politics: conservative.
STUDENT STUMBLING BLOCKS: Common Areas of Difficulty
A Total Chapter In-Class Review
Suppose you are stopped on the street and asked by a local TV news crew what you think about a
particular Presidential candidate‟s promise to keep both unemployment and inflation at current
levels, (that is, very low) if elected. The Presidential candidate has not been specific as to how
this may be accomplished, but has promised not to use wage and price controls. How would you
respond based on what you have learned in this chapter?
ANS: A pragmatic response based upon a synthesis of both Classical and institutionalist views
might be as follows: “In the short run (a couple of years), and not even considering wage and
price controls, simultaneously keeping unemployment and inflation at very low rates is
technically impossible to do. It has long been felt that there was a tradeoff between these two.
And yet we see the opposite in this economy since we have both low inflation and quite low
unemployment. I would think he would try to work cooperatively with the Federal Reserve to
keep the present situation intact. Inevitably, the trade off between unemployment and inflation
would begin to appear and appropriate action would have to be taken.
“This means contractionary monetary and fiscal policies would have to induce a recession and
wring out any inflationary expectations. That would have to be followed by only modest (not too
inflationary) expansionary fiscal and monetary policies measures to put people back to work.
Assuming just the right policy were enacted and a lot of luck from forces outside the control of
government, this President will likely have expired his term of office before the benefits are
“In the meantime, the President might find it difficult politically to survive the rising
unemployment that would accompany his induced recession. The short-run cost of higher
unemployment and the human hardship accompanying recession might make one question
whether the benefit of reducing inflation below its then current level would be worth it. If the
economy were beginning to experience hyperinflation or if it is teetering on the edge of collapse,
it would be his duty to intervene vigorously. Reasonable people will likely disagree on the
„benefits‟ and „costs‟ of such economic austerity.”
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TIES TO THE TOOLS: Bringing the Boxes into the Classroom
Beyond the Tools: The Keeper of the Classical Faith: Milton Friedman
Among those leading the charge against government intervention in the market was Milton
Friedman, 1976 Nobel Prize winner. He argued that fiscal policy did not work since it led to an
expansion of government. He also disliked activist monetarist policy. He preferred the Fed
publicly announce a specific desired increase in money supply and then disband for a while.
Knowing the Tools: Dieting and Fighting Inflation
This box argues that fighting inflation is analogous to dieting. Those believing in the quantity
theory of nutrition would specify that if you wanted to lose x pounds you would have to cut you
caloric intake by y calories. The institutional nutritionists would offer a cafeteria of choices as to
how to achieve your weight-loss goal: hypnotism, a liquid diet, finding the roots of your eating
LECTURE OUTLINE: A Map of the Chapter
I. Some basics about inflation.
A. Inflation is a continuous rise in the price level. It is measured with price indices.
B. The distributional effects of inflation (Chapter Objective 1).
1. In an inflation, the winners are those who can raise their prices or wages and still keep
their jobs or sell their goods.
2. Losers in an inflation are those who cannot raise their wages or prices.
3. On average, winners and losers balance out.
4. Lenders and borrowers, because they often enter into fixed nominal contracts, are also
affected by inflation.
5. The composition of the winners and losers from an inflation changes over time.
a. People who do not expect inflation and who are tied to fixed nominal contracts will
likely lose in an inflation.
b. If these people are rational, they probably do not allow it to happen again; they will
be prepared for a subsequent inflation.
C. Expectations of inflation (Chapter Objective 2).
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1. Some economists argue that if expectations are rational, they will always be based on
the economist‟s model.
a. The term “rational expectations” has been used for this type of model-consistent
b. Rational expectations are the expectations that the economists‟ model predicts.
2. Other economists argue that rational expectations cannot be defined in terms of
economists‟ models. These economists focus on the process by which people develop
3. There are two ways people form expectations.
a. Adaptive expectations are those based, in some way, on what has been in the past.
b. Extrapolative expectations are those that assume a trend will continue.
D. Productivity, inflation, and wages.
1. There are two key measures that policy makers focus on to determine whether inflation
may be coming.
a. Changes in productivity.
b. Changes in wages.
2. The basic rule of thumb is that wages can increase by the amount that productivity
increases without generating inflationary pressures. In other words:
Inflation = Nominal wage increases – Productivity growth
1. The low inflation rates in the early 2000s brought fear of deflation – the sustained fall
in the price level.
2. In a deflation, the Fed may not be able to lower the interest rates enough to stimulate the
economy as much as desired.
3. Deflation causes prices on the stock exchanges and real estate to fall resulting in (1)
people seeing their wealth disappear and (2) assets held as collateral for loans would
make financial institutions vulnerable to collapse.
II. Theories of inflation.
A. The quantity theory of money and inflation.
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1. The quantity theory of money is summarized by the sentence: Inflation is always and
everywhere a monetary phenomenon (Chapter Objective 3).
2. The logic of the quantity theory of money goes back to the equation of exchange:
MV = PQ
M = Quantity of money
V = Velocity of money
P = Price level
Q = Quantity of real goods sold
3. The first assumption of the theory is that V is constant.
a. The velocity of money is the number of times per year on average, a dollar goes
around to generate a dollar‟s worth of income.
b. How fast money is spent is determined by the institutional structure of the economy.
c. If V is constant, the quantity theory can be used to predict how much nominal GDP
will grow if we know how much the money supply grows.
4. The second assumption of the theory is that real output Q is independent of the money
a. Q is autonomous, meaning real output is determined by forces outside the quantity
b. If Q grows, it is because of incentives in the real economy – that is, on the supply
side, not the demand side.
5. The third assumption is that the direction of causation goes from money to prices.
6. The conclusion of the quantity theory is ΔM →ΔP.
a. With both V and Q unaffected by changes in M, the only thing that can change is P.
b. Thus, the quantity theory of money says that the price level varies in response to
changes in the quantity of money.
c. Another way to write the quantity theory of money is:
%ΔM = %ΔP
7. Examples of money‟s role in inflation.
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a. The simple view connecting inflation with money-supply growth lost favor in the late
1980s and early 1990s as formerly stable relationships between certain measurements
of money and inflation broke down. See Figure 29-1.
(1) This was because of enormous changes in financial institutions that were
occurring because of technological changes and changing regulations.
(2) Another reason was the increasing interdependence of financial markets globally.
b. In the 1990s, the close relationship between the price level and money ended. This
was because of the:
(1) Enormous changes in financial institutions because of technological changes
and changing regulations.
(2) Increased global interdependence of financial markets.
8. The inflation tax.
a. Developing nations such as Argentina and Chile sometimes increase money supply to
keep the economy running.
(1) When their governments run a budget deficit and try to finance it domestically,
their central banks often must buy the bonds to finance that deficit.
(2) In essence, the increase in money supply is caused by the government deficit.
b. Financing the deficit by expansionary monetary policy is not costless.
(1) It causes inflation.
(2) The inflation that results from the increases in the money supply works as a kind
of tax on individuals, and is often called an inflation tax: an implicit tax on the
holders of cash and the holders of any obligations specified in nominal terms.
c. Should central banks bail out their own governments with an expansionary monetary
9. Policy implications of the quantity theory.
a. In terms of policy, the quantity theory says that monetary policy is powerful, but
unpredictable in the short run.
b. Because of its unpredictability, monetary policy should not be used to control the
level of output in an economy.
(1) Paradoxically, supporters of the quantity theory oppose an activist monetary
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(2) Instead, they favor a monetary policy set by rules, not by discretionary monetary
c. The type rules being used now by many central banks are feedback rules.
(1) A monetary rule takes monetary policy out of the hands of politicians.
(2) Many economists are persuaded to exert pressure to create central banks so
politicians are separated from the control of money supply.
(3) The Fed does not have strict rules governing money supply, but it works hard to
establish credibility that it is serious about fighting inflation.
B. The institutional theory of inflation (Chapter Objective 4).
1. Supporters of institutional theories of inflation accept much of the quantity theory.
2. While they agree that money and inflation move together, they have different causes and
3. According to the quantity theory, the direction of causation moves from left to right:
MV → PQ
4. Institutional theories see it the other way round, that is, an increase in prices forces
government into positions where it must increase money supply or cause
MV ← PQ
5. According to these theorists, the source of inflation is in the price-setting process of
a. Firms find it easier to raise prices than to lower them.
b. Firms do not take into account the effect of their pricing decisions on the overall
6. Focus on the price-setting decisions of firms.
a. Any increase in firms‟ wages, rents, taxes, and other costs are simply passed on to
consumers in the form of higher prices.
b. This works so long as the government increases the money supply so that demand is
there to buy the goods at the higher prices.
7. Price-setting strategies depend on the labor market.
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a. Whether the firm selects this price-raising strategy depends on the state of the labor
b. The state of the labor market plays a key role in firms‟ decisions whether to give in
to workers‟ demands for higher wages or not, which is the reason economists look at
unemployment to measure inflationary pressures.
8. Changes in the money supply follow price-setting by firms.
a. The institutional theorists see the nominal age- and price-setting process as
(1) One group pushes up its nominal wage and/or price; another group responds by
doing the same.
(2) More groups follow.
(3) Now the first group finds its relative wages and/or prices have not increased, so
they raise them again.
(4) Thus, the process begins anew.
b. At this point, government has two options:
(1) Increase money supply, thereby ratifying the inflation.
(2) Refuse to ratify the inflation, thereby causing unemployment to rise.
9. The insider/outsider model and inflation.
a. The insider-outsider model is an institutionalist story of inflation where insiders bid
up wages and outsiders are unemployed.
(1) Insiders are workers with good jobs and excellent long-run prospects and
(2) If markets were purely competitive, wages, profits, and rents would be pushed
down to equilibrium levels.
(3) Insiders don‟t like this, so they develop sociological and institutional barriers
such as unions, laws restricting the firing of workers, and brand recognition.
(4) Outsiders (often minorities), as a consequence, must take dead-end, low-paying
jobs or try to undertake marginal businesses that pay little return per hour worked.
(a) They are the first to be fired.
(b) Their businesses are the first to fail in a recession.
b. The economy is only partially competitive – the invisible hand is thwarted by social
and political forces.
(1) Insiders push to raise their nominal wages to protect their real wages.
(2) Outsiders, as the unemployed or business bankrupts, suffer.
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10. Policy implications of institutional theories.
a. The quantity theorists have a simple solution for stopping inflation – just cut money
b. The institutional theorists agree with this prescription, but they argue that is not only
inefficient but unfair. It causes unemployment among those least able to handle it.
(1) They suggest that contractionary monetary policies be used in combination with
additional policies that directly slow down inflation at its source.
(2) This additional policy is often called an incomes policy, a policy that places
direct pressure on individuals and businesses to hold down their nominal wages
(a) Formal policies have been out of favor for a number of years.
(b) Informal incomes policies exist in many European nations.
C. Demand-pull and cost-push inflation.
1. When the majority of industries are at close to capacity and they experience increases in
demand, the inflation that results is called demand-pull inflation: inflation that occurs
when the economy is at or above potential output.
2. When significant portions of markets experience price rises not related to demand
pressure, we say there is cost-push inflation: inflation that occurs when the economy is
below potential output.
III. Inflation and unemployment: the Phillips curve.
1. The AS/AD model expresses a tradeoff between inflation and unemployment.
a. A low unemployment rate is generally accompanied by high inflation.
b. A high unemployment rate is generally accompanied by low inflation.
2. The tradeoff can be represented graphically in a curve (see Figure 29-3a), called the
short-run Phillips Curve – a representation of the relation between inflation and
unemployment (Chapter Objective 5a).
a. In it, unemployment is measured on the horizontal axis, with inflation on the vertical
b. The Phillips curve shows us what combinations of those two phenomena are
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B. History of the Phillips curve.
1. In the 1950s and 1960s, whenever unemployment was high, inflation was low and vice
versa. See Exhibit 29-3b.
2. In the 1960s, the short-run Phillips Curve began to play an important role in discussions
of macroeconomic policy.
a. Republicans generally favored contractionary monetary and fiscal policy that meant
high unemployment and low inflation.
b. Democrats generally favored expansionary monetary and fiscal policy that meant low
unemployment and high inflation.
C. The breakdown of the short-run Phillips curve.
1. In the early 1970s, the relationship began breaking down.
a. Unemployment was high, but so was inflation.
b. This phenomenon was termed stagflation -- the deadly combination of high and
accelerating inflation and high unemployment. See Figure 29-3c.
2. As they looked at the data, economists began rethinking what caused inflation.
D. Economists began distinguishing between short-run and long-run Phillips curves (Chapter
1. The importance of inflation expectations.
a. The short-run Phillips curve is one showing the trade-off between inflation and
unemployment when expectations of inflation (the rise in the price level that the
average person expects) are fixed.
b. The long-run Phillips curve is thought to be a vertical curve at the unemployment
rate consistent with potential output. It shows the trade-off (or complete lack
thereof) when expectations of inflation equal actual inflation.
c. When expectations of inflation are higher, the same level of unemployment will be
associated with a higher level of inflation.
d. It makes sense to assume that the short-run Phillips curves moves up or down as
expectations of inflation change.
e. However, the only sustainable combination of inflation and unemployment rates on
the short-run Phillips curve is at points where it intersects the long-run Phillips curve,
because that is the only unemployment rate consistent with the economy‟s potential
income. See Figure 29-4
2. Moving off the long-run Phillips curve.
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a. If government decides to increase aggregate demand, this pushes output above its
b. Demand for labor goes up pushing wages higher than productivity increases.
c. Workers are initially satisfied that their increased wages will raise their standard of
living with the expectation of zero inflation.
d. But if productivity does not go up, inflation will wipe out their wage gains.
3. Moving back on to the long-run Phillips curve.
a. When workers find their initial raise did not keep up with unexpected inflation, they
ask for more money, giving a boost to a wage-price spiral.
b. The general relationship is the following:
(1) Anytime unemployment is lower than the target level of unemployment
consistent with potential output, inflation and the expectation of inflation will
(2) The short-run Phillips curve will shift up.
(3) The short-run Phillips curve will continue to shift up until output is no longer
(4) Thus, the level of unemployment is consistent with the target level of
unemployment if the cause of that inflation is expectations of inflation.
E. Stagflation and the Phillips curve.
1. Economists theorized that the stagflation of the late 1970s and early 1980s was caused
when government attempted to push down inflation through contractionary aggregate
2. The lower aggregate demand pushed the economy to the point where unemployment
exceeded the target rate.
3. The higher unemployment put downward pressure on wages and prices, shifting the
short-run Phillips curve down.
F. The rise and fall of the new economy: the experience of the late 1990s.
1. The cause of the good times was a combination of factors:
a. The economy was experiencing a temporary positive productivity shock because
Internet growth and investment were shifting potential output out.
b. Competition increased because of globalization.
c. Price comparisons were made possible by e-commerce.
d. Workers were less concerned with real wages and more concerned with protecting
their jobs, so firms did not raise wages even with extremely tight labor markets.
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2. Some economists argued that these conditions were permanent.
3. Others argued that this combination of effects was temporary and that the U.S. economy
would come out of its “Goldilocks period.”
4. Alas, in 2001, the economy went into a recession and the stock market bubble burst.
IV. The relationship between inflation and growth (Chapter Objective 6). See Figure 29-5a, b.
A. Economists agree that below potential output there will be no inflationary, and possibly
deflationary, pressures, and above high potential output that there will be significant
1. The problem is that no one knows where that point is.
2. The government prefers a point where the output level is high as possible while keeping
inflation low and not accelerating.
B. The institutionalists argue that it is best to err on the high side.
C. Quantity theory and the inflation/growth tradeoff.
1. The quantity theorists argue that this is like “being a little bit pregnant.”
a. For them, erring on the low side pays off – it stops any chance of inflation.
b. It also builds credibility for the Fed.
c. They also argue that while there is no long-run tradeoff between inflation and
unemployment, there is a long-run tradeoff between inflation and growth. Low
inflation leads to higher growth.
(1) Low inflation reduces price uncertainty, making it easier for businesses to invest
in future production.
(2) Businesses are more able to enter into long-term contracts.
(3) Low inflation makes using money much easier.
2. There is no solid empirical evidence showing who is correct, the quantity theorists or
D. Institutional theory and the inflation/growth trade-off.
1. Supporters of the institutional theory of inflation are less sure about this negative
relationship between inflation and growth.
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a. While they agree that price-level rises have the potential of generating inflation, and
that high accelerating inflation undermines growth, they do not agree that all price
level increases start an inflation.
b. If inflation does get started, the government has some medicine to give the economy
that will get rid of inflation relatively easily.
2. This was highlighted in the debate about monetary policy in early 2000.
a. The economists who focused on the quantity theory argued that inflation was just
around the corner, and unless government instituted contractionary aggregate demand
policy, the seeds of inflation would be sown.
b. Other economists argued that the institutional changes in the labor market had
reduced the inflation threat and that more expansionary policy was needed.
c. The Fed deftly sailed between these two positions.
CHAPTER SUPPLEMENTS: Other Classroom Aids to Use
Classic Readings in Economics: "Why Lombard Street is Often Very Dull and Sometimes
Extremely Excited," pp. 86-88. Walter Bagehot's 1873 essay focused on the role of
confidence as a necessary foundation of a banking system. This confidence is a
psychological phenomenon that makes the conduct of monetary policy an art rather than a
Classic Readings in Economics: "Policy Implications of the Phillips Curve," pp. 101-103.
This 1959 article by Paul Samuelson and Robert Solow, is the original Solow-Samuelson
discussion of the Phillips curve. It is a useful reading since it shows how tentative they were
in drawing policy conclusions about inflation.
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1. Which of the following statements is false?
a. Contractionary monetary and fiscal policies tend to lower unemployment but raise
b. All economists agree that for substantial inflation to continue the money supply must rise.
c. Expectations based on what has been in the past are called adaptive expectations.
d. High money growth and high inflationary expectations inevitably accompany high inflation
2. Which of the following statements about a short-run Phillips curve is true?
a. Expectations of inflation are assumed to be the same at each point on the curve.
b. The curve shifts up if people expect a lower rate of inflation.
c. The curve shifts down if the Fed lowers the money supply.
d. If expectations of inflation are less than actual inflation, then there is movement down
along the curve.
3. Quantity theorists argue:
a. that inflation is everywhere and is always a fiscal phenomenon.
b. for a monetary rule because they believe that the short-run effects of monetary policy are
unpredictable and the long-run effects are on the price level, not real output.
c. that to stop inflation you must increase the growth rate of the money supply.
d. higher inflation creates higher growth.
4. Institutionalists argue:
a. that changes in the money supply affect only the price level in the long run.
b. for a steady growth in the money supply.
c. that money supply increases are a necessity, not a causal link in the inflationary process.
d. that most real-world markets are highly competitive.
5. The Phillips curve:
a. trade-off implies that contractionary fiscal and monetary policy are effective in reducing
unemployment but at the expense of higher rates of inflation.
b. trade-off implies that expansionary fiscal and monetary policies are effective in
simultaneously reducing unemployment and inflation.
c. trade-off apparently has not existed since the late 1980s.
d. trade-off implies that when employment is low, inflation tends to be high.
514 Chapter 29 (13): Inflation and Its Relationship to Unemployment and Growth
6. Which of the following statement is true?
a. Expansionary monetary or fiscal policy will cause movement down along the short-run
b. The long-run Phillips curve shows that there is an inverse relationship between the price
level and unemployment.
c. The long-run Philips curve is vertical at the target or natural rate of unemployment.
d. At each point of the long-run Phillips curve, expectations about inflation are lower than the
actual inflation rate.
7. Which of the following about the natural rate of unemployment is true?
a. It is the rate that prevails when actual inflation exceeds anticipated inflation.
b. If the actual rate of unemployment is above the natural rate, the inflation rate will increase.
c. If the natural rate of unemployment is below the natural rate, the inflation rate will
d. The long-run Phillips curve analysis suggests that any attempts to reduce unemployment
below the natural rate will only result in higher rates of inflation.
8. Which of the following arguments is true?
a. The quantity theory of inflation focuses on the institutional process of setting prices and
cost-push pressures as the underlying causes.
b. Institutionalists think once nominal wage and price levels have risen, the government has
the option of either increasing the money supply and accept inflation, or leave the money
supply fixed and cause unemployment.
c. Quantity theorists argue that it is often easier for firms to meet worker‟s demands for
higher wages since it helps maintain morale and prevents turnover of key workers.
d. Quantity theorists argue that insiders prevent their wages, profits, and rents from being
pushed down to equilibrium levels by developing sociological and institutional barriers that
prevent outsiders from competing.
9. Which of the following statements is true?
a. Quantity theorists argue that low inflation rates sometimes will be accepted by individuals
without leading them to immediately increase their nominal wages and prices.
b. Institutionalists believe increased unemployment may not significantly reduce inflation in
the short run since many workers have insulated themselves from unemployment through
implicit and explicit contract.
c. Institutionalists believe that for small changes in the rate of inflation, the short-run Phillips
curve can be relatively stable.
d. The short-run Phillips curve is based on the notion that actual inflation and expected
inflation are always equal.
10. An incomes policy:
a. is really government wage and price control.
b. is advocated by quantity theorists to combat inflation.
c. has as one of its objections that it too often creates surpluses.
d. is designed to stimulate growth in labor productivity while holding wages constant.
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ANSWERS TO POP QUIZ
1. a 2. a 3. b 4. c 5. d 6. c 7. d 8. b 9. c 10. a
CASE STUDIES: Real-World Cases of Textbook Concepts
Case Study 29-1: The Failure of Incomes Policy
According to James M. Collins, incomes policies have had 40 centuries of failure. Virtually all
instances of incomes policy were presented by rulers seeking an end to inflation and/or scarcities
caused in large part by their own political and economic blunders.
A significant portion of Hammurabi's code for Babylon specified the wage and price
agreements that would meet with the king's approval.
In Egypt, Joseph's Old Testament stewardship of the Pharaoh's granaries was the exception
that proved the rule -- the Pharaohs ended up owning all the agricultural land and the people
experienced repeated cycles of famine and feast.
Pericles's Athens was essentially a sea-based commercial city possessing little tillable land.
The Athenian assembly passed laws establishing a group of grain price regulators known as
"Sitophylaces" while mandating the death penalty for those caught selling their wares above
approved price levels. Despite the many merchants and bureaucrats so dispatched, Athenian
grain prices fluctuated according to supply. The entire system eventually collapsed in
In response to an empire-wide inflation, Diocletian, in 301 A.D., set himself up to regulate
wages and prices for all major commodities and prescribed the now-familiar death penalty for
those violating his superior brand of macroeconomics. A Christian writer Lactantius
described the results: "There was also much blood shed upon very slight and trifling
accounts, and the people brought provisions no more to market, since they could not get a
reasonable price for them, and this increased the scarcity so much that at last, after many had
died, the law itself was laid aside."
Most everyone has been taught that George Washington's valiant army nearly starved to death
at Valley Forge, Pennsylvania, during the bitter winter of 1777-1778. What is generally not
known is that the soldiers' miseries were in large part due to an enactment of the Continental
Congress that established mandated prices in the area. The Continental Congress soon
thereafter repealed the unwise price-control experiment and food became readily available.
Hitler's Germany tried comprehensive wage and price controls before and during World War
II. Hermann Goring, the man responsible for the wartime economy remarked in 1946 as a
prisoner of war: "Your America is doing many things in the economic field, which we found
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out caused us so much trouble. You are trying to control people's wages and prices --
people's work. If you do that, you must control people's lives. And no country can do that. I
tried it and failed."
Richard Nixon's presidency was marred by his New Economic Policy. During the first month
of the initial period of relaxed controls, the consumer price index, led by record food price
increases, experienced its sharpest month-to-month gain in 22 years.
The record shows that while incomes policy may work in the very short run, eventually the steam
in the kettle will blow the top off.
A recent attempt at a national incomes policy was tried in Finland in December 2002. Its
agreement between the majority of nation‟s unions for the two-year program of modest wage
increases in exchange for a government tax cut and “employment package” covered 90 percent of
all wage earners. Time will tell if this effort succeeds.
Sources: James M. Collins, "Price Controls: 40 Centuries of Failure," Business Week, December
18, 1978, p. 13; and “New Incomes Policy Agreement Covers over 90% of Wage Earners,”
European Industrial Relations Observatory On-Line, December 2002: www.eiro.eurofound.ie.
1. If the record of incomes policy is so awful, why do governments insist on trying it?
2. How would the Classicals explain the failure of incomes policies?
3. How would the Keynesians explain the failure of incomes policies?
4. Do incomes policies have any relationship to the Phillips curve?
5. What do you suppose Milton Friedman would have to say about incomes policy?
Case Study 29-2: The Perils of Deflation
In March 2000, the stock market bubble finally burst. At the present, the U.S. has two more
bubbles to worry about that were created by the stock market bubble: the housing market and
consumer spending. Puncturing them both raises the grave risk of deflation.
The evidence of a housing bubble abounds. Nationwide, from 1997 to 2002, there has been a 27
percent increase in inflation-adjusted house prices, the sharpest five-year increase since 1945. As
property values rise, consumers have been quick to extract purchasing power from their homes,
taking advantage of some of the lowest mortgage rates in 40 years to refinance their property and
use the savings to buy cars, furniture, appliances, and luxury goods.
The consumer-spending bubble will probably be the last to pop. Short of savings and long on
debt, the aging American population has to come to grips with the realities of retirement. This
must be done at a time of trashed 401(k) plans amid a devastating bear market. How would this
bubble burst? A sudden rise in oil prices, the possibility of a war with Iraq, another 9/11 attack, a
surge of white-collar layoffs, or the collapse of housing prices.
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If these happen, it could usher in a protracted period of deflation (a continual fall in the price
level) that has burdened Japan for about 10 years. Deflation is most hurtful to wage earners and
debtors. In order to stay profitable, companies would have to cut jobs or wages, eventually
throttling consumer purchasing power. The fixed obligations of indebtedness would have to be
paid back in deflated dollars, squeezing overextended borrowers all the more.
Prices are already falling for certain goods. Only in services, where statistics are notoriously
unreliable, are prices still rising.
Globalization is also hurting American prices, especially due to imports from Japan and China,
both of which are experiencing deflation. The growing share of these increasingly cheap foreign
goods helps drive down prices of products made at home, thereby deepening deflationary
History teaches us that when major asset bubbles burst, deflation is often the result. This
happened in the U.S. in the 1930s and Japan in the 1990s. And it could happen again.
Source: Stephen S. Roach, “Deflation Looms If Bubbles Burst,” Sacramento Bee, September 29,
2002, p. E1.
1. What are the distributional effects of a deflation?
2. Who would be helped?
3. Who would be badly hurt?
4. Is it possible for deflation to lead to growth?
5. Do you think the average American even thinks about deflation? Why?
Case Study 29-3: The “S” Word Reappears
In the 1970s, Keynesians were startled to find that one of their central beliefs was wrong. A new
word was coined, stagflation, to describe a period of negative real GDP and rising prices. After
the U.S. muddled through that painful period, economists agreed that it was highly unlikely this
would ever be repeated. No more, for the following reasons:
One study affirmed: “Oil at $45 a barrel is a stagflation problem.” The writers, by their analysis,
argued that sustained oil prices at that level would slow global growth rates by almost half a
percentage point in 2005 and approximately one percentage point in 2006. They expected that
such prices would also push inflation up by the same amount.
Europe is slowly recovering from a three-year slump. The effect in Europe will not be felt as
much because of how the continent buys oil. Oil prices are quoted in dollars, and because of the
euro‟s recent strength against the dollar this will soften the blow.
It‟s another story in Asia.
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The economies of China, Japan, and India depend on their burgeoning manufacturing sectors.
“They need to burn more fuel as a percentage of economic output that the more service-oriented
economies of the West.”
Not all economists buy this gloomy outlook. “If global growth slows a lot more, it could bring
prices back down, snuffing out inflation before it becomes a major problem. That has occurred
in many past periods when inflation rose.”
Source: Partick Barta, “A Central Banker‟s Nightmare: Inflation and Slow Growth Together,”
The Wall Street Journal, August 16, 2004, p. A2.
1. In the case of the Asian nations, should their central banks use an expansionary monetary
2. Perhaps they should use a contractionary monetary policy. Why?
3. What type of political pressure would be brought against nations with stagflation?
4. Would there be international problems in facing up to stagflation?
5. If this trend continues, what would likely happen to the financial markets of the nations
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