Power & Market

Inflationary Fed Policies: Why They Think They Should Do It, and Why It Doesn't Really Work

Demand Side economists, like Paul Krugman, claim that officials can use changes in the inflation rate and in public debt to “manage the economy”. Higher inflation rates supposedly act as a stimulus to increase GDP, and to lower the unemployment rate. How is this supposed to work? In the original form of this argument workers are fooled by inflation. That is, workers don't perceive the effect that inflation has on the purchasing power of their wages. Employers do perceive cheaper real wages, so they pick up some bargains by hiring some additional workers. These marginal workers have lower productivity, but since wages have gone down, they are well worth hiring. In many modern versions of the demand side theory, some businesses are slow to raise their prices in response to a general increase in prices. Hence, total demand for goods may increase. The idea that higher inflation leads to lower unemployment is known as the “Phillips Curve”.

Modern economists all agree that the stimulative effects of inflation, if any, must be temporary. Markets will adjust to inflation over time, and these adjustments will shift aggregate supply so as to nullify any prior increase in aggregate demand.

Statistical data suggests that workers respond to inflation promptly and aggressively. The graph just below shows that unit labor costs increase during inflationary booms. When the Federal Reserve increases the money supply this increases total spending, and many prices begin to rise.

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There is in fact some evidence of inflation reducing unemployment rates, temporarily. However, workers react to tight labor markets by pressing for higher wages and by not working as hard. The trendline in the above graph represents the immediate effect of inflation on unit labor costs, there is no lag in this regression. If there was a long lag in the effect of inflation on labor market conditions, then Federal Reserve officials would have some room to manipulate labor markets. It takes some time for Federal Reserve policy to affect the rate of inflation, but very little time for workers to nullify the effect of inflation. Furthermore, the effectiveness of inflationary policies depends on the strength, not just the timing, of our responses to these policies. Changes in unit labor costs have a 27.5% correlation with inflation rates. Only a few of the data points above are exactly on the trend line, most are either well above or below. This means that the specific response to Federal Reserve policies and labor markets does vary in each case. Worse still, this effect seems to shift during severe crises (e.g the Subprime and C- 19 crises). Hence, the task of crafting optimal inflationary policies is a guessing game. In other words, Federal Reserve officials face the worst combination of conditions for using inflationary monetary policy to achieve lower unemployment.

The evidence in the above graph directly contradicts the original version of the Phillips Curve . This data also poses difficulties for contemporary proponents of the Phillips Curve. The data presented above also indicates that the recent wave of inflation was unnecessary. The Federal Reserve created a wave of inflation in order to deal with the Covid-19 crisis. The benefits of the aforesaid inflationary policy were doubtful from the outset, and reducing inflation will likely cause a recession in 2024.

[This article first appeared at "On the Other Hand..."]

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