Inflation dynamics.

• Author: Ball, Laurence M.

Policy toward inflation is a continual struggle. The Federal Reserve can reduce inflation by slowing money growth, but at a large cost: when inflation falls, as in the early 1980s, output falls as well. Recently, fears of a deeper recession have prevented the Fed from pushing toward zero inflation. In addition, even when the Fed pays the price of disinflation, the gains may not be permanent. Inflation rises again when there is an adverse macroeconomic shock, such as wartime spending (in the late 1960s) or a rise in oil prices (in the 1970s and, to some degree, in 1990). Finally, inflation is often unstable: periods of high average inflation exhibit considerable variability. The resulting uncertainty adds to the economic costs of inflation.

Could policymakers keep inflation low and stable without large output losses? It is difficult to address this question, because economists do not agree on the behavior of inflation. Indeed, many economic models suggest that this behavior should not occur--for example, disinflations should not cause the recessions that we observe in actual experience. This article describes research that seeks a better understanding of inflation, with the ultimate goal of designing better policies.

The Costs of Disinflation

Classical economics postulates that money is neutral: changes in nominal variables, such as inflation, do not affect real output. Unfortunately, this idea is refuted by history: Romer and Romer show that efforts to reduce inflation almost inevitably produce recessions.(1) The conventional explanation for this fact centers on slow adjustment of nominal wages and prices. In particular, following Taylor's influential work,(2) "New Keynesians" argue that the staggered timing of price adjustments across firms creates inertia in the price level, Since prices adjust slowly to a monetary contraction, the effects fall largely on output.

I argue that this view is incorrect.(3) In particular, it confuses levels with growth rates. Taylor shows that, with staggered adjustment, the price level adjusts slowly to a decrease in the money stock. (Intuitively, no group of firms wants to go first in substantially cutting its prices.) In modern economies, however, a monetary contraction is a slowdown in the growth of money, not an absolute decrease in the level of the money stock. I show that staggered adjustment in theory should not impede the response of inflation to such a policy. If disinflation is "credible"--if it is...