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This article presents information on the short-run demand for money. The author examines the relationship between short-run demand and four variables that relate to the general demand for money including the nominal money supply, real output, the price level and the interest rate. The author suggests that an examination of these variables will shed light on the larger, macroeconometric relationships related to the short-run demand for money. The author discusses how individuals are impacted by short-run demand adjustments as well as larger, economy-wide implications.

While the early history of the Phillips curve up to 1975 is well known, less well understood is the post-1975 fork in the road. The left fork developed a theory of policy responses to supply shocks in the context of price stickiness in the non-shocked sector. Its econometric implementation interacts shocks with backward-looking inertia. The right fork approach emphasizes forward-looking expectations that can jump in response to anticipated policy changes. The left fork approach is better suited to explaining the postwar US inflation process, while the right fork approach is essential for understanding behaviour in economies with unstable macroeconomic environments. [ABSTRACT FROM AUTHOR]

Presents information on the economy of the United States. Details on the nonaccelerating inflation rate of unemployment (NAIRU); Basic data and the extent of the inflation surprise; Actual and simulated values of price and wage changes, using alternative indexes and constant NAIRU.

This article comments on the article "Assessing the Federal Reserve's Measures of Capacity and Utilization," by Matthew Shapiro in U.S. industry. From a broader perspective, Shapiro is unconvincing in making his case that the Federal Reserve "should avoid giving a structural interpretation to high capacity utilization." As you shall see, Shapiro steps into the fatal pitfall of confusing changes in absolute prices, which the Federal Reserve should care about, with changes in relative prices, about which it should not. The main problem with the measurement part of Shapiro's paper is that he does not make an adequate distinction between measurement issues and conceptual issues, as he could have by examining more closely industries with good measures of physical output and capacity. In such industries, it becomes clear that, even when the measurement issues are completely absent, it is impossible to interpret a given level of a utilization index as indicating a given degree of "tightness." Shapiro's central policy objective is to evaluate the conventional view that "if capacity constrains real output growth, inflation must increase."

The article focuses on European unemployment. Many economists would agree that the two greatest macroeconomic puzzles of the twentieth century are the persistence of unemployment in the U.S. in the 1930s and in Europe in the 1980s. Although there are significant differences in the situations faced by America in 1939 and Europe today, the similarities are striking. With inflation in Europe no longer decelerating, many analysts believe that Europe must today be operating at or close to its nonaccelerating inflation rate of unemployment, and that today's non-accelerating inflation rate of unemployment (NAIRU) is much higher than it was in the 1960s and early l970s. Two different interpretations of the high NAIRU have been offered, each with quite different policy implications. Perhaps the dominant view, termed as structuralist, explains high unemployment by supply constraints, including high real wages, government intervention in the free operation of labor markets, and other structural maladjustments, most notably inadequate capacity available to equip presently unemployed workers. According to this view, unemployment cannot be reduced until the supply-side constraints are directly addressed by supply-oriented changes in government policies.

This article it attempts to identify elements of continuity and change in the inflation data regarding the U.S. within the context of some earlier research, and it contains no review of the literature. It also follows up a 1984 paper by the author, which created a measure of potential GNP that corresponds to a series for the natural rate of unemployment developed in the earlier research. In the article potential GNP has been referred to as natural GNP to emphasize its correspondence with the natural unemployment rate. In the series the natural unemployment rate starts at about 5 percent in the 1950s, and rises in response to demographic changes to about 6 percent beginning in the early 1970s. Rather than start from scratch with another investigation of alternative unemployment concepts, this paper takes as its basic measure of aggregate demand pressure the ratio of actual real GNP to the natural GNP series developed in 1984. A major purpose here is to determine whether the natural GNP series understates or overstates the economy's noninflationary operating level.

The article focuses on the output cost of disinflation in traditional and vector autoregressive models. The speed of adjustment of the aggregate price level to demand and supply shocks has long been a leading topic of controversy in macroeconomics. Among the many issues requiring for their resolution solid empirical evidence on the dynamics of price adjustment is the prediction of the output loss that would accompany a strategy of monetary disinflation. Four years ago economist Arthur M. Okun surveyed a variety of econometric evidence and reached the pessimistic conclusion that the inflation process in the postwar United States is so inertia prone that the cumulative sacrifice of 10 percent of a year's GNP would be required to achieve a permanent 1 percentage point reduction in the inflation rate. This article compares the dynamic response patterns of prices and output that emerge from two quite different approaches to time-series econometrics, the traditional structural framework imbedded in most econometric models, and the more recent nonstructural or a theoretical vector autoregressive technique.

This article provides information on the analysis of cost and price trends by Charles Schultze which gives great significance to the inertia of an inflation norm originating in the past experience of market participants. This inflation norm has characteristics of a rule of thumb or convention. Aside from factors that may be regarded as exogenous, the price level is viewed as dependent on the size of this inflation norm and on the level of "real" activity. The influence of the level of activity can be seen in the fact that keeping real activity supernormal by the standards of an economy raises the price level, though it causes no acceleration as long as the inert inflation norm remains unchanged, and keeping the level of activity subnormal reduces the price level, though it causes no deceleration as long as the inert inflation norm remains unchanged. Schultze states that, in contrast to the experience of the 1960s, the inflations brought about by the two world wars did not break the earlier convention of the small and inert inflation norm because these inflationary times were regarded as atypical events. But he should have added the Korean inflationary explosion as a third illustration under the same heading, but regardless of whether two or three instances are included, the essential point is that at those times the authorities succeeded in convincing he public that in postwar periods they would not continue to accommodate inflation, and therefore no extended period of underutilization was needed to prevent a large inflation norm from becoming incorporated into postwar market practices. These events do fall in place for the hypothesis suggesting the effect of credible policy postures on expectations but not for the hypothesis of the inert inflation norm.

This article comments on a research which discussed an economic model which would assess wage-setting process that underlies macro inflation. Today most disputes about inflation, focus on the speed of adjustment of inflation to shifts in nominal aggregate demand. Three main views of the inflation process compete for attention, differing mainly on this adjustment speed. First is the mainline view by George Perry which in its usual version makes wage change a function of lagged consumer price inflation, lagged wages, and a single demand variable, the inverse of an unemployment rate weighted to remove the impact of demographic shifts. At the other extreme is the second major approach to inflation, the Lucas-Sargent proposition of policy ineffectiveness. Although usually stated as a theory of output determination, it implies that the contemporaneous elasticity of price change to a fully anticipated change in aggregate demand is exactly unity. finally, teh credibility hypothesis of William Fellner also assumes a high elasticity of price change to a credible shift in demand growth engineered by policymakers, but he is vague about the length of time needed for the public to conclude that a given policy shift is permanent rather than temporary.

This section critiques a paper by Edward Gramlich published in this same issue of Brookings Papers on Economic Activity, which summarizes and pinpoints the implications of various models of supply shocks and the inflationary process. According to the first commenter, Gramlich's skillful and provocative paper presents an econometric assessment of the benefits and costs entailed by a monetary policy of accommodating supply shocks. Gramlich's paper expresses a number of reservations on his part about the desirability of the Keynes-Phelps vision. Gramlich's analysis of the staggered-contract model with rational expectations, with which he concludes his paper, leads him to the proposition that the effects of a supply shock on employment are entirely extinguished in finite time even when monetary policy is completely passive, for example. According to the first commenter, this property of Gramlich's model leads him to downgrade accommodation. The second commenter notes that one weakness of Gramlich's paper is that it contains too much. Every alternative is considered, presenting an enormous number of permutations of policy responses. Without whittling down his menu of possibilities, the reader really is left in the dark about when policy should deviate from the basic recipe of complete accommodation.

This article examines the proposition by Robert J. Gordon that wage inflation rises or falls of its own accord, independent of money or other determinants of demand. The wage-push hypothesis is supported by any evidence that wages behave in a way that is not predictable from the behavior of money and other determinants of demand. The extreme wage-push hypothesis requires, moreover, that demand have no role in predicting wages. The believer in wage push is hoping for a wage equation with large unexplained residuals and low coefficients for money and the real output gap. Obviously, Gordon's research cannot fail to turn up some evidence in favor of wage push. Everyone grants the wage equation some residuals. Just the opposite evidence would support the monetarist hypothesis. Wages should be highly predictable and money should have an important role in the prediction. The monetarist hopes that the wage equation will fit well and that demand will matter. It is noteworthy that, from the perspective of this paper, much of Gordon's past research has been devoted to establishing a monetarist proposition--namely, the success of the Phillips curve. Still, there is an evident bias in the procedure of this paper in favor of the wage-push hypothesis--every user of econometrics knows how easy it is to run unsuccessful regressions.

This article explores various hypothesis aimed at explaining the observed conduct of monetary policy and the relationship between monetary policy and inflation. The international-monetarist approach begins from the proposition that under fixed exchange rates the world inflation rate is determined primarily by previous changes in the rate of growth of the world money supply. This follows from two basic propositions which previously had been emphasized by U.S. monetarists addressing issues of a closed economy: the stability of the demand-for-money function, and the lack of any long-run tradeoff between inflation and unemployment. Both of these elements have been tested by international-monetarist economists who have estimated structural equations describing the behavior of the demand-for-money function and the expectational Phillips curve for the world. Further, reduced-form tests have found that changes in the world rate of monetary growth have preceded changes in the world inflation rate. The behavior of individual countries is characterized not only by stable national demand-for-money functions and vertical long-run Phillips curves, but by two additional features. First, capital is mobile among nations, so that international reserves tend to flow in or out as necessary to set a nation's money supply equal to its demand for money, which depends primarily on its price level, real output, and interest rate. Second, commodity arbitrage maintains the tradable-goods portion of the domestic price level fairly close to the world price level of tradable goods, while labor mobility communicates changes in prices of tradable goods to the nontradables sector.

This article examines the performance of a price-wage model in tracking the inflation in the U.S. in the 1970s. Most econometric models base their inflation forecasts on structural price and wage equations, either a single pair for the aggregate economy, or a larger set of disaggregated equations. The paper is divided into three sections, one on the price equation, one on the wage equation and one on dynamic simulations in which the two equations interact. Considerable experimentation with lag structures suggests that the effect of the commodity market on wages can be represented by a pair of proxies for excess demand: (1) the gap between actual and potential output and (2) the first difference in the gap. A dynamic simulation of the wage and price equations, which allows for the effects of wages on prices and prices on wages, provides an assessment of the inflationary implications of alternative paths of economic recovery and of the required duration of a stable prices at any cost policy that prevents recovery and maintains the output gap. Policy simulations with a two-equation wage-price model have both disadvantages and advantages as compared to simulations using the large-scale forecasting models.

This article analyzes the policy issues posed by an inflation initiated by commodity shortages in the U.S. during the 1970s. For any given supply of farm products, an increase in nonfarm output raises the demand for farm products, and hence the relative price, by an amount that depends positively on the income elasticity and negatively on the price elasticity. The relative price depends, in part, on the level of nonfarm output, except in the special case of a zero income elasticity. Nonfarm output is assumed to be produced with labor and some other fixed factor, like capital. If a lower real wage causes workers to reduce their labor input, either by withdrawing from the labor force or by working fewer hours per week a crop failure must reduce nonfarm output. Whether or not the labor supply shrinks in the flexible-price case, the welfare of nonfarm workers is reduced. Not only does a crop failure reduce total real output, but also, as long as the demand for farm products id price inelastic, it transfers income from workers to farmers, who enjoy a windfall. In the case of perfect price flexibility, nonfarm output is either fixed or determined by workers' decisions about labor policy, leaving the nonfarm price level to be determined by stabilization policy. If, on the other hand, the nonfarm wage rate is rigid and nonfarm prices are marked up over the wage rate by a constant fraction, then nonfarm prices are fixed and nonfarm real output is determined by stabilization policy.

This section presents several comments about a paper by Robert E. Hall published in this same issue of Brookings Papers on Economic Activity, which analyzes how labor market conditions determine the evolution of the wage level and hence the rate of wage inflation. Hall's paper makes a major contribution with its theoretical analysis of the role of turnover and quality adjustments in the process of wage setting. But it is seriously deficient when viewed as an attempt at comprehensive analysis of the inflation process. The major problem is the failure to assign any role to prices in the setting of wages; indeed, scarcely anywhere in this entire paper on the inflation process does the word prices appear. Although Hall's paper makes an important contribution to the theory of labor markets, it is not as general as one might wish. Hall adds variations in labor quality to wage changes as a second instrument of employer policy. Hall shows how the marginal and average effective wages can diverge. This is a novel and interesting idea: new workers may be paid more than old ones in the sense that they provide labor services of lower quality for the same wage, and yet old workers may not quit if their wage rate contains a premium for the specific human capital that their employer has invested in them.

Presents a paper on the response of wages and prices to the first two years on controls initiated by President Richard Nixon. Intent to study the changes in prices and wages behavior. Methodological preliminaries and econometric models; Alternative counterfactual simulations for 1971-73; Untangling the effects of import prices; Conclusion that the inflation of 1973 needs reconsideration; Discussion of the paper by the panel.

While the Consumer Price Index (CPI) is the best measure currently available, it is not a true cost-of-living index. It suffers from a variety of conceptual and practical problems as the vehicle for measuring changes in the cost of living. Despite import updates and improvements, it is likely that changes in the CPI have substantially overstated the actual rate of price inflation. Moreover, revisions have not been carried out in a way that can provide an internally consistent series on the cost of living over an extended span of time. More importantly, changes in the CPI are likely to continue to overstate the change in the true cost of living for the foreseeable future. This overstatement will have important unintended consequences, including overindexing government outlays and tax brackets and increasing the federal deficit and debt. The analytical and econometric research clone over recent decades has heightened economists' understanding of these issues. The time has come for governments in the United States and elsewhere to recognize these problems and act accordingly. That involves providing enhanced support for the statistical agencies to improve the price statistics with all deliberate speed in a non-politicized manner.

The persistence of high unemployment in Europe during late 1980s poses many puzzles for macroeconomic analysis, both theoretical and empirical. Numerous macroeconomic doctrines may be called, and have been called into question by the European experience. The article discusses the particular theory addressed by researcher Milton Friedman's 1968 Natural Rate Hypothesis, which implies that, because inflation in Europe has stabilized and is no longer decelerating, Europe must today be operating at close to its natural rate of unemployment, often called the "nonaccelerating inflation rate of unemployment" (NAIRU). Two principal interpretations of the rising European NAIRU have been offered in the article. The "structuralist" view advances specific supply-side impediments, including high real wages and government regulations, as the cause of the rising NAIRU and reaches the pessimistic conclusion that NAIRU cannot decline until these impediments are removed. A weakness of this interpretation is the absence of convincing quantitative evidence capable of explaining why European NAIRU should have increased from 2 percent in 1960s to 10 percent in 1980s.

The article focuses on the role of wages in the inflation process. Traditionally wage equations of the Phillips curve variety are the central element explaining inflation in large-scale Keynesian econometric models. Price changes are specified as determined by a "markup" price equation and have little life of their own, mainly mimicking wage changes. Such a view of the inflation process is rejected by this paper. A relatively unrestricted equation for price change can be converted into a form in which wage changes enter only in the form of lagged changes in labor's share. When the labor's share variable is statistically insignificant, wage behavior becomes irrelevant for inflation. Differences in the behavior of labor cost and inflation imply changes in labor's income share which alter the profit share of income in the opposite direction. The paper also concludes that price changes are irrelevant for wage changes, that is, that both prices and labor costs live a life of their own. No evidence is provided on the causes of such a new regime in wage behavior in which labor's share has fallen, nor indeed on the causes of the old regime in which labor's share rose from 1965 to 1978.

The high variance and continued acceleration of inflation during the 1970's pose new challenges to the time-series econometrician. The theme of this article is that inflation in the decade of nineteen seventies has depended not only on the level of aggregate demand and the role of inertia but also on a number of different supply shocks. Two of these, the increase in the relative price of oil and decline in the rate of productivity growth, have been outside of the direct control of the government, particularly in the short run. But both the variance and acceleration of inflation have been aggravated by three measures within the purview of government policy-makers: increases in the effective Social Security tax, increases in the minimum wage rate, and episodes of direct government intervention in the price-setting process. Because of their futility, these intervention episodes can be regarded as "self-inflicted wounds," like the tax and minimum wage changes that normally are described by this term.

The article analyzes the theory of domestic inflation. Changes in the adjusted growth rate of money are thus isolated as a necessary concomitant of long-run changes in the inflation rate. The Application of Rational Expectations to Economic Policy (AREEP) constitutes a radical contribution to the theory of the short-run determinants of unemployment and inflation. The same downward inertia of price adjustment which vitiates the conclusions of AREEP poses obstacles for policymakers. An economy inheriting a substantial fully anticipated inflation and operating at the natural unemployment rate has two problems--how to achieve price stability and how to reduce natural unemployment to allow the creation of jobs for disadvantaged groups suffering from high employment rates. The direct remedy for inflation is the creation of a recession. Another remedy is the direct control of wages and prices. Finally, the ongoing inflation can be accepted rather than resisted by allowing for the full indexing of financial assets, labor and product contracts, and all nominal dollar amounts (tax brackets, maxima, minima) written into private and government regulations.

The author responds to comments made by Karl Brunner regarding the author's paper in the December 1975 issue of 'The Journal of Law and Economics,' on economic and political factors influencing inflation rates. Brunner's critique is divided into a rejection of the long-run Bailey analysis as irrelevant to the short-run political process, criticism of the cost-push framework for ignoring long-run constraints and skepticism regarding the relevance of the short-term Phillips curve. In his concentration on the postwar persistence of inflation as the sole phenomenon to be explained, Brunner ignores the contribution of the Bailey analysis to the understanding of episodic wartime inflations. Brunner also ignores the contribution of the Phillips Curve slope to an explanation of the persistence of postwar inflation.

The analysis of the political economy of inflation can be divided into two major sub-topics, namely, the demand for and supply of inflation. Pressures for the government to pursue or not to pursue a more inflationary policy emanates from entities such as taxpayers who resist tax increases made necessary by increases in expenditures, beneficiaries of government programs who resist expenditure reductions and groups attempting to obtain an increase in their share of national income. The main alternatives to the two-sided demand-supply approach to inflation theory are the hard-line monetarist and hard-line cost-push frameworks. Theoretical and empirical support for the political business cycle, or the deliberate generation by vote-buying politicians of election-synchronized economic expansion, is found as one of several determinants of the supply of inflation.

The article presents information on consumer prices, the consumer price index and the cost of living. Accurately measuring prices and their rate of change, inflation, is central to almost every economic issue. There is virtually no other issue that is so endemic to every field of economics. Some examples include aggregate growth and productivity, industry prices and productivity, government taxes and spending programs that are indexed to inflation, budget deficits and debt, monetary policy, real financial returns, real wages, real median incomes and poverty rates and the comparative performance of economies. While the Consumer Price Index (CPI) is the best measure currently available, it is not a cost-of-living index and it suffers from a variety of conceptual and practical problems. Despite important updates and improvements over time, the change in the CPI has substantially overstated the actual rate of inflation, and is likely to continue to overstate the change in the cost of living for the foreseeable future. This overstatement will have important unintended consequences, including over indexing government outlays and tax brackets and increasing the federal deficit and debt. Moreover, such revisions as have occurred have not been carried out in a way that can provide an internally consistent series on the cost of living over an extended span of time.

The article performs a statistical appraisal of the impact of the wage-price controls in the U.S. The condition of the U.S. economy improved in almost every respect after the initiation of the wage-price control program on August 15, I971. Real gross national product grew rapidly, unemployment finally began to decline, and the rate of inflation moderated. But the coincidence of timing does not necessarily mean that controls are an essential condition for prosperity, or that the August 1971 message was the key that unlocked the floodgates behind which real aggregate demand had been restrained. The determination of the four basic macroeconomic magnitudes--nominal (current dollar) income, real output, prices, and unemployment--is usefully separated into three subproblems: (1) the determination of nominal income, (2) the division of that nominal income between real output and prices, and (3) the relationship between real output and unemployment. Before the achievement of the control program can be evaluated, a criterion for its success should be established. By my standard, controls can be judged successful if the value to society of the reduction in inflation they achieve relative to that which would have occurred without them is greater than the direct and indirect costs imposed by the control program.

This article argues that the institutions of the U.S. economy do adapt to inflation, once it becomes fairly steady, and thus automatically offer protection against the costs associated with accelerating inflation. Full employment and price stability do not deserve equal primacy as stabilization goals. Most of the evils commonly associated with inflation occur only when the actual inflation rate deviates from that which is expected, that is, when the inflation is a surprise. The welfare costs of a fully anticipated inflation, although a popular subject in economics journals and graduate theory exams, are not widely discussed or understood elsewhere. The article first discusses the cost of maintaining a steady inflation at a rate similar to the 5 percent annual average that has obtained in the U.S. since the beginning of 1968. This analysis does not depend on the existence of a long-run tradeoff between the expected rate of inflation and the unemployment rate. The accelerationist position that no long-run tradeoff exists is relevant for the choice of the optimal unemployment rate, not the inflation rate: In the absence of a long-run tradeoff, steady inflation can be maintained only at a single natural rate of unemployment, whereas a negatively sloped long-run tradeoff allows the choice among many alternative unemployment rates.

This paper attempts to predict the response of the rate of inflation to alternative paths of economic recovery--that is, to estimate how much more rapidly prices would increase if full employment were to be attained swiftly rather than gradually. The model developed postulates that the primary force driving the rate of inflation is the determination of wages in the labor market. The dominant role this model assigns to wages in the inflation process justifies the disproportionate emphasis that it receives in the following discussion. The theory of wage determination used is similar in its general features to the approach taken by most previous econometric research. The determination of price expectations has become an increasingly popular subject for research in recent years as the accelerating pace of U.S. inflation has made the topic more relevant. The rate of inflation is increased permanently when labor market tightness increases to a new higher level. The rate of inflation at any given time also depends crucially on the expected rate of inflation inherited from the past. Factors that contribute to temporary increases in the rate of inflation are increases in social security or personal income tax rates, a sudden acceleration of the demand for commodities and a sudden deceleration of output, which causes a decline in the ratio of actual to standard productivity because of lags in hiring and firing.

Reports on the acceleration of inflation in the U.S. in 1969. Annual rates of change for selected price indicators; Quarterly pattern of inflation in nonfarm private deflator from 1964 to 1969; Standard and actual unit labor costs; Ratio of new orders to shipments.

This article suggests that the U.S. federal government should attach some urgency to the task of constructing government investment and capital accounts. The demand by economists for government capital data has not been very high in the past, because the absence of meaningful government output figures has precluded productivity studies of the government sector. But the article suggests that many government assets are important inputs in the private sector. Much of the apparent decline in the U.S. private capital-output ratio may have been due to the gradual replacement of privately owned railroad assets by government-owned highways and airports. The existence of a substantial stock of government financed assets used by private firms, particularly in manufacturing, suggests a number of interesting topics for further research. For instance, the rate of return on corporate assets in manufacturing during and immediately after World War II was considerably higher than in the 1950s and 1960s. While this was partly due to high utilization rates and the inflation of sales prices relative to asset values, a further factor may have been the substantial profits earned with government financed assets which did not enter into the capital base on which the rate of return was calculated.

This article presents comments by the author on an article titled "Understanding Inflation in the 1980s," by Robert Gordon and published in the January 1985 issue of the journal Brookings papers on Economic Activity. According to the author, the only part of the theory called into question by recent experience is markup pricing, which seems to fail in the case of imports. U.S. prices have fallen less than predicted by a simple model in which the U.S. price of imported goods is a simple markup over the foreign price restated in dollars at the prevailing exchange rate. The U.S. pricing of imports seems to be quite sensitive to conditions in U.S. markets, less sensitive to costs of production. That makes good economic sense, but it goes against the spirit of the markup hypothesis, in which costs are the predominant determinant of price. The heart of Gordon's paper is a set of regressions of the rate of price inflation on various determinants. It is a good idea to ask what, in principle, can be learned from these regressions. In general, a regression of one endogenous variable on another tells nothing about the structural relations of the two variables.