It is a well-known belief that by means of monetary policy, the central bank can influence the rate of real economic expansion. It is also held that this influence however, carries a price, which manifests itself in terms of inflation.
For instance, if the goal is to reach a faster economic growth rate and a lower unemployment rate then citizens should be ready to pay a price for this in terms of a higher rate of inflation.
It is held that there is a trade-off between inflation and unemployment, which is depicted by the Phillips curve. (William Phillips described a historical relationship between the rates of unemployment and the corresponding rates of rises in wages in the United Kingdom,1861-1957, published in the quarterly journal of Economica,1958).
The inverse correlation between the rate of inflation and the unemployment rate has become an important element in the theory of price inflation. The lower the unemployment rate the higher the inflation rate. Conversely, the higher the unemployment rate the lower the inflation rate is going to be.
The events of the 1970’s came as a shock for most economists. Their theories based on the supposed existing trade-off suddenly became useless. During the 1974-75 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labelled as stagflation.
In March 1975, US industrial production fell by nearly 13% while the yearly growth rate of the consumer price index (CPI) jumped to around 12%.
Likewise, a large fall in economic activity and galloping price inflation was observed during 1979. By December of that year, the yearly growth rate of industrial production stood close to nil while the growth rate of the CPI stood at over 13%.
Again the stagflation of 1970’s was a big surprise to most mainstream economists who held that a fall in real economic growth and a rise in the unemployment rate should be accompanied by a fall in the inflation rate and not an increase.
Some economists such as Milton Friedman and Edmund Phelps were questioning the popular view arguing that there cannot be trade-off between economic growth and inflation in the long-term. They were suggesting that this could only occur in the short term. Based on this way of thinking they have formulated the stagflation theory.
The Friedman-Phelps (FP) Explanation of Stagflation
Starting from a situation of equality between the current and the expected inflation rate the central bank decides to lift the rate of economic growth by lifting the growth rate of money supply.
As a result, a greater supply of money enters the economy and each individual now has more money at his disposal. Because of this increase, every individual is of the view that he has become wealthier.
This raises the demand for goods and services, which in turn sets in motion an increase in the production of goods and services. All this in turn lifts producers demand for workers and consequently the unemployment rate falls to below the equilibrium rate, which both Friedman and Phelps labeled as the natural rate.1
According to FP, the increase in people’s overall demand for goods and services and the ensuing increase in the production of goods and services is of a temporary nature. Once the unemployment rate falls below the equilibrium rate this starts to put upward pressure on the rate of price inflation.2
Because of this, individuals begin to realize that there was a general loosening in the monetary policy. In respond to this realization, they start forming higher inflation expectations.
Individuals are now realizing that their previous increase in the purchasing power is starting to dwindle. Consequently, all this works to weaken the overall demand for goods and services.
A weakening in the overall demand in turn slows down the production of goods and services while the unemployment goes up – an economic slowdown emerges.
Observe that we are now back with respect to unemployment and real economic growth to where we were prior to the central bank’s decision to loosen its monetary stance but with a much higher inflation rate.
What we have here is a fall in the production of goods and services – a rise in the unemployment rate – and an increase in price inflation i.e. we have stagflation.
From this, Friedman and Phelps have concluded that as long as the increase in the money supply growth rate is unexpected the central bank can engineer an increase in the economic growth rate.
Once, however, people learn about the increase in the money supply and assess the implications of this increase they adjust their conduct accordingly. Consequently, the boost to the real economy from the increase in the money supply growth rate disappears.
In order to overcome this hurdle and strengthen the economic growth rate the central bank would have to surprise individuals through a much higher pace of monetary pumping.
However, after some time lag people will learn about this increase and adjust their conduct accordingly. Consequently, the effect of the higher growth rate of money supply on the real economy is likely to vanish again and all that will remain is a much higher rate of inflation.
From this, Friedman and Phelps have concluded that by means of loose monetary policies the central bank can only temporarily create real economic growth. Over time however, such policies will only result in higher price inflation. Hence, according to Friedman and Phelps there is no long-term trade-off between inflation and economic growth and unemployment.
Can Money Grow the Economy?
We have seen that according to FP loose monetary policy can only grow the economy in the short-term but not in the long-term. In this way of thinking, because of the increase in the money supply growth rate a greater supply of money enters the economy and each individual now has more money at his disposal. This is, however, not a tenable proposition.
When money is injected, there must always be somebody who gets the money first and somebody who gets the new money last. Money moves from one individual to another individual and from one market to another market.
The beneficiaries of this increase are the first recipients of money. With more money in their possession, (assuming that demand for money stays unchanged) and for a given amount of goods available, they can now divert to themselves a bigger portion of the pool of available goods than before the increase in money supply took place. This means that less goods are now available to those individuals who have not received the new money as yet (late recipients of money).
This of course means that the effective demand of the late recipients of money must fall since fewer goods are now available to them. Observe that because of the fact that people are not identical, even if their respective money holdings have risen by the same percentage, as implied by Friedman-Phelps analysis, their response to this will not be identical. This in turn means that those individuals who spent the new money first benefit at the expense of those who spend the new money later on.3
Hence an increase in money supply cannot cause a general increase in overall effective demand for goods. Only through an increase in the production of goods this can be achieved. The more goods an individual produces the more of other goods he can secure for himself. This means that an individual’s effective demand is constrained by his production of goods, all other things being equal. Demand therefore, cannot stand by itself and be independent – it is limited by production, which serves as the mean of securing various goods and services.
Increases in Money Supply Actually Weaken Economic Growth
Money permits the product of one specialist to be exchanged for the product of another specialist. Alternatively, we can say that an exchange of something for something takes place by means of money. Things are, however, not quite the same once money is generated out of “thin air” because of loose central bank policies and fractional reserve banking. Once money is created out of “thin air” and employed in the economy it sets in motion an exchange of nothing for something. This amounts to a diversion of real wealth from wealth generators to the holders of newly created money. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy. So contrary to Friedman-Phelps way of thinking, money cannot grow the economy even in the short-run. On the contrary, an increase in money only undermines real economic growth .
What Causes Stagflation?
We have seen that an increase in the money supply out of “thin air” results in an exchange of nothing for something. As a result, the process of real wealth formation weakens and this in turn undermines the economic growth rate. The increase in the money supply growth rate, coupled with the slowdown in the growth rate of goods produced results in the increase in price inflation. (Note that a price is the amount of money paid for a unit of a good). Observe that what we have here is a faster increase in price inflation and a decline in the growth rate in the production of goods. However, this is exactly what stagflation is all about i.e. an increase in price inflation and a fall in real economic growth. Stagflation is the natural outcome of monetary pumping which weakens the pace of economic growth and at the same time raises the rate of increase of the prices of goods and services.
The fact that a strengthening in monetary growth may not always manifest itself as visible stagflation does not refute what we have concluded with respect to the consequences of increases in the rate of monetary pumping on economic growth and prices.
Consider the following situation. On account of past increases in the growth rate of money supply and the consequent softening in the growth rate of goods produced the rate of price inflation is going up.
Now, because the underlying bottom line of the economy is still strong notwithstanding the damage inflicted by a stronger money supply growth rate, the growth rate of the production of goods only weakens slightly. Within such a situation, the unemployment rate could continue falling. What we have here is an increase in price inflation and a fall in the unemployment rate.
Any theory, which concludes from this inverse correlation that there is a trade-off between inflation and unemployment, will be false since it ignores the true consequences of increases in the money supply growth rate. Hence, we can conclude that the Phillips curve cannot be a basis for a sound theory of inflation.
The events of 1970’s have unsettled the view that there can be a trade-off between inflation and unemployment.
During the 1974-79 period, a situation emerged where the growth momentum of prices strengthened while at the same time the pace of real economic activity had been declining. This unexpected event was labeled as stagflation.
Milton Friedman and Edmund Phelps have shown that a trade-off between inflation and unemployment can exist in the short term but not in the long-term. By Friedman and Phelps the phenomena of stagflation depicts the lack of the long-term trade-off.
Given the fact that monetary pumping undermines the process of real wealth formation, however, it is not possible to have trade-off neither in the long term nor in the short term. Hence, we can conclude that the Phillips curve cannot be a basis for a sound theory of what sets in motion price inflation.
This article originally posted here.