Krugman on the impact of a hot economy

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

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

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

Singapore grew much faster and inflation was much lower.

On the other hand, you could argue that I’m not holding “other things equal”. In fact, I did:

Venezuela (1950-90): Average Growth Rate = 10.7%

Singapore (1963-89): Average Growth Rate = 10.8%

Inflation is chasing too much money too little. Because Singapore has produced much more goods, double-digit money growth has created lower inflation than the similar money growth rate in Venezuela. You might think of rapid RGDP growth as “exploiting” some extra money, which leads to lower inflation. BTW, does not add numbers correctly because the velocity also changes gradually over time. (Return using MV = PY, or m + v = p + y change rate.) But it does not change the basic point. For any given money growth rate, rapid RGDP growth lowers inflation in the long run.

Some may argue that long-term growth in RGDP is not inflationary, but the economic boom in cyclical frequencies is still inflationary.

But even at cyclical frequencies the correlation between growth and inflation is volatile. Rapid growth driven by growth in overall demand is inflationary, while rapid growth driven by growth in overall supply is inflationary. This is the basic AS / AD model. This is why I keep saying “never cause a change in price” and “never cause a change in quantity”. (Compare the hot economy of 2000 and the recession of 1974.)

Paul Krugman Phillips Curve’s various approaches to NYT discuss the relationship between inflation and unemployment. The section begins as follows:

It is a universally acknowledged fact – well, however, a fact acknowledged by everyone who thinks about it – that a hot economy leads to higher wages and prices. When labor demand is strong, workers can and do demand wage increases; When demand for products and services is strong, businesses have the “pricing ability” or the ability to raise prices without losing customers.

But does a hot economy lead to higher prices? Or does it lead to a higher rate of price change, i.e. ongoing inflation? Or maybe even to accelerate inflation, a higher rate of change?

If a hot economy means rapid RGDP growth, I would not agree. But in the second sentence Krugman defines “hot” as strong demand. So I see that he is doing the wrong thing that many others are doing.

But in that case, we should not use inflation as a nominal sum when analyzing Philips curve models. The relationship between inflation and unemployment depends on the cause of inflation. Is high inflation due to high overall demand or low supply? A more useful nominal sum would be something like NGDP growth, which more accurately tracks changes in overall demand and thus clarifies the real problem of the Phillips curve debate. It really is a fact that is universally recognized Nominal The hot economy leads to more inflation. And it led to more jobs (in the short term.) The profession made a serious mistake when it spent decades on macro models where inflation was the core nominal overall rather than NGDP growth. (Both Monetarist and New Kensian are responsible.) The Phillips curve should look at the relationship between NGDP growth and unemployment. Reason from price change over time amount (PY).

Even if we switch to NGDP, we still face the same kind of unresolved issues that Krugman wrestled in his column. Is the level of NGDP important? Or growth rate? Or a change in the growth rate?

The answer is three things. On average, the job market will be stronger with 6% NGDP growth compared to 2% NGDP growth. But it is also true that the job market will be stronger with 4% NGDP growth Level The trend is above 2% of NGDP, compared to 4% of NGDP growth and the level trend of NGDP is below 2%. In a sense, where NGDP is relative compared to expectations. But when are expectations formed? It depends on the amount of wage adhesive. The longer the wages (i.e., the longer the wage agreement period), the more important the NGDP expectations are.

If one defines economic “warming” as a strong nominal demand, the question is whether warming leads to a one-time rise in inflation or a steady rise in inflation. If your demand increases once (NGDP increases) then you will get a one-time increase in inflation. If you have a steady increase in your NGDP growth, your inflation will rise permanently. It depends on the monetary policy (broadly defined to include velocity.)

Some Keynesians want to define overall “demand” as a real concept. I have seen graphs that combine “demand” and real GDP, which makes no sense. Consider the AS / AD model. If the AD curve remains stable and AS moves to the right, then RGDP increases and prices fall. Would you call this “demand” growth because consumers are buying more things? That’s exactly what I’ve seen prominent economists do.

Here’s Krugman’s conclusion, which makes some good points:

The pessimists who insist that we have been plagued by years of high unemployment are essentially claiming that we are back in the inflationary environment of the 1970s and early 1980s, that expectations were inconsistent and that we would have to go through a NAIRU to reduce inflation. Extended period of unemployment above.

I do not agree; When I look at different measurements of mid-term inflation expectations, they still look pretty anchor to me. But I must be wrong – the brief history of the inflation theory that I have just described does not inspire much confidence that none of us have a really strong grip on the relationship between economic heat (or coolness) and price.

However, the point I want to make is that you need a theory. The evidence is fairly irresistible that the U.S. economy is currently running very hot and needs to cool down. But how cool it needs to be is not a question that can be resolved without determining what kind of inflation process you think is currently underway.

HT: Ken Duda

Leave a Reply

Your email address will not be published.