Krugman on the effects of a hot economy

People often suggest that a fast growing economy is inflationary. I would say the exact opposite is true. Consider this data for Venezuela and Singapore from an old textbook by Robert Barro:

Venezuela (1950-90): Average GDP growth = 4.4% Average inflation = 8.0%

Singapore (1963-89): Average GDP growth = 8.1% Average inflation = 3.6%

Singapore has experienced much faster growth and much lower inflation.

On the other hand, you could say that I don’t consider “all other things being equal”. In fact, I did:

Venezuela (1950-90): average monetary growth rate (base) = 10.7%

Singapore (1963-89): Average monetary growth rate (base) = 10.8%

Inflation is too much money for too few goods. Because Singapore was producing far more goods, the double-digit money growth created less inflation than a similar rate of money growth in Venezuela. You might think that the faster GDPR growth “sucks up” some of the extra money, leading to lower inflation. BTW, the numbers don’t add up precisely because the speed also changes gradually over time. (Remember MV=PY, or m + v = p + y using rates of change.) But that doesn’t change the basis point. For a given rate of money growth, faster GDP growth leads to lower inflation in the long run.

Some might argue that long-term GDPR increases are not inflationary, but at cyclical frequencies, an economic boom is still inflationary.

But even at cyclical frequencies, the correlation between growth and inflation is unstable. Rapid growth induced by an increase in aggregate demand is inflationary, while rapid growth induced by an increase in aggregate supply is deflationary. This is the basic AS/AD model. That’s why I keep saying “never reason from a change in price” and “never reason from a change in quantity”. (Compare inflation in the hot economy of 2000 and the recession of 1974.)

Paul Krugmann has an article in the NYT discussing various approaches to the Philips curve – the relationship between inflation and unemployment. The piece begins like this:

It’s a universally recognized truth – well, anyway, a truth recognized by everyone I know who thinks about it – that a hot economy leads to higher wages and prices. When the demand for labor is strong, workers can and do demand wage increases; when demand for goods and services is strong, firms have “pricing power,” that is, the ability to raise prices without losing customers.

But does a hot economy lead to a higher price level? Or does it lead to a higher rate of price change, ie continued inflation? Or maybe even accelerating inflation, a higher rate of change in the rate of change?

If a hot economy meant rapid GDPR growth, then I would disagree. But in the second sentence, Krugman defines “hot” as high demand. He therefore does not make the mistake that so many others make.

But in this case, maybe we shouldn’t even use inflation as a nominal aggregate when analyzing Philips Curve models. The relationship between inflation and unemployment depends on the cause of inflation. Is higher inflation due to more aggregate demand or less supply? A more useful nominal aggregate would be something like NGDP growth, which tracks changes in aggregate demand much more accurately, and thus clarifies the real issue in the Philips curve debate. It is truly a universally recognized truth that a nominally hot economy leads to more inflation. And it also leads to more jobs (in the short term). The profession made a big mistake when it spent decades on macroeconomic models where inflation was the key nominal aggregate, instead of NGDP growth. (Monetarists and neo-Keynesians are to blame.) The Phillips curve should examine the relationship between NGDP growth and unemployment. Reason from a change in price multiplied by quantity (PY).

Even as we move to the NGDP, we still face the same kind of unresolved issues that Krugman grapples with in his column. Is it the level of NGDP that counts? Or the growth rate? Or the change in the growth rate?

The answer is that all three count. On average, the labor market will be stronger with NGDP growth of 6% than with NGDP growth of 2%. But it is also true that the labor market will be stronger with GDP growth of 4% and the level NGDP 2% above trend, than with NGDP growth of 4% and the NGDP level 2% below trend. In a sense, it all depends on where the NGDP stands in relation to expectations. But when did expectations form? It depends on the extent of wage rigidity. The longer the wage stickiness (i.e. the longer the duration of wage contracts), the longer the period over which NGDP expectations matter.

If we define economic “heat” as high nominal demand, then the question of whether heat leads to a one-time rise in inflation or a permanent rise in inflation is actually quite straightforward. If you have a one-time increase in demand (NGDP growth), you get a one-time increase in inflation. If you have a permanent increase in NGDP growth, you have a permanent increase in inflation. It depends on monetary policy (broadly defined to include velocity).

Some Keynesians want to define aggregate “demand” as a real concept. I’ve seen charts that confuse “demand” with real GDP, which doesn’t make sense. Take the AS/AD model. If the AD curve is stable and AS is moving to the right, then GDPR is rising and prices are falling. Do you want to call this an increase in “demand” just because consumers are buying more products? I have seen leading economists do just that.

Here is Krugman’s conclusion, which brings out some good points:

The pessimists who insist that we are doomed to years of high unemployment are essentially saying that we have returned to the inflationary environment of the 1970s and early 1980s, that expectations are no longer anchored and that to reduce the inflation, we will have to go through a long spell of unemployment well above the NAIRU.

I do not agree; when I look at various measures of medium-term inflation expectations, they still seem pretty entrenched. But I could, of course, be wrong – the brief history of the theory of inflation that I have just told does not inspire much confidence that any of us has a really solid grasp on the relationship between the economic heat (or coldness) and prices.

What I mean, however, is that you need a theory. The evidence is quite overwhelming that the US economy is currently too hot and needs to cool down. But how much cooling it needs is not a matter that can be settled without deciding what kind of inflation process you think is currently going on.

TH: Ken Duda

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