The pre- and postwar price-output paradox revisited.

AuthorTaylor, Jason E.
  1. Introduction

    Past studies relating changes in the overall price level to changes in real output show a positive correlation between these variables in the years before World War II (WWII) and a negative correlation in the years since the war. The empirical implications of these findings on the efficacy of price stability are unclear. Prima facie, it would appear this analysis shows that certain price level movements may be helpful sometimes and harmful other times. In their international study of the historical properties of business cycles, Backus and Kehoe (1992, p. 880) assert that, "Changes ... in the sign of the correlation between price and output fluctuations are the most striking differences between periods in the variables we have studied."

    Interestingly, the pre-WWII period consisted largely of deflation, whereas the postwar era has consisted almost exclusively of inflation. In the United States, for example, in only one postwar year, 1949, did the price level fall, and this drop was under 1%. Conversely, the price level in 1913 was 16% below its 1869 level and the price level in 1940 was 32% below its 1920 level. Many other countries underwent relatively similar price movement experiences prior to and after WWII. Taking these price level movements into account, past studies on the price-output correlation suggest that, on average, the less prices fell in the deflationary period before 1940, the higher the growth in real output (a positive price-output relationship), and that the less prices have risen in the inflationary postwar era, again, the higher the growth in real output (a negative price-output relationship). Taken together, this implies that any change in the price level, regardless of the direction, is negatively correlated with the growth in real output: A stable empirical relationship may exist between these variables after all.

    We use an international data set to see whether the price-output correlation disparity before and after WWII can be reconciled empirically by looking at the absolute value of changes in the price level. We find that the conflicting pre- and postwar findings can be resolved: Any change in the price level, positive or negative, has historically been associated with slower growth in real output. Our empirical findings support theories espousing the economic benefits of price stability.

  2. Past Studies of the Price-Output Correlation

    Many studies have examined the historical relationship between the rates of change in the price level and real output, both in the United States and across countries. International analyses such as Kormendi and Meguire (1985), Fischer (1991), DeGregario (1992), Gomme (1993), Wynne (1993), Bruno and Easterly (1998), Haslag (1998), and others consistently find a negative relationship between inflation rates and rates of output growth. (1) These analyses are, however, restricted to postwar years, which have been almost exclusively inflationary for the sampled countries. This implies that the less price levels have risen in the postwar era, the higher the rate of economic growth.

    Whereas most international data sets contain 20 to 40 years of recent data for each country, price-output correlation studies of the United States have been able to take advantage of the availability of data to expand samples back to 1870. For example, Cooley and Ohanian (1991) estimate, among other relationships, the correlation between the rate of inflation and the rate of output growth and find that whereas this relationship is negative between 1949 and 1975, it is positive between 1870 and 1900.

    Fortunately, the United States is not the only country for which significant amounts of pre-war data are available. Backus and Kehoe (1992) compile an international data set of 10 countries, including the United States, for which at least a century of data is available. Among other things, they analyze the relationship between percentage changes in the price level and percentage changes in output and find, consistent with the aforementioned postwar international studies, a negative price--output relationship in each of the 10 sampled countries after WWII. On the contrary, however, the pre- and interwar eras reveal a positive price-output relationship for the majority of countries observed. The authors speculate briefly on a few potential sources of these conflicting findings. One possibility, they note, is that a structural change has taken place in the way prices and real output have interacted since WWII. Another is that business cycle movements were driven by demand shocks before and supply shocks after the war. Additionally, there have been major differences in monetary policy with and without the gold standard, which has been largely abandoned in the postwar era. (2)

    The purpose...

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