Can the Inflation of the 1970s be Explained?

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.