The Conquest of American Inflation.

• Author: Bomberger, William A.
• Position: Review

By Thomas J. Sargent. Princeton, NJ: Princeton University Press, 1999; Pp. xiv, 148. $29.95.

During 1960, consumer prices rose 1.6% as they did in 1998. A modern-day Rip Van Winkle waking from a 38-year sleep last year would find much that amazed him. Low inflation would not be among them. If Rip were an economist, he would find his training out of date. He fell asleep familiar with the newly minted "Phillips Curve" (PC):

[y.sub.t] = [b.sub.0] + [b.sub.1][u.sub.t] + [a.sub.1][y.sub.t-1] + [a.sub.2][y.sub.t-2] + . . . + [e.sub.t]

(where y is inflation, u is unemployment, e is an error, and [a.sub.1] = [a.sub.2] = . . . = 0 in the original).

There is a permanent trade-off between inflation and unemployment in PC. This implies that an optimal monetary policy is one that produces a positive inflation rate and an unemployment rate lower than the one which would accompany price stability.

Rip awakened during the reign of the "natural rate" model (NR):

[y.sub.t] = [b.sub.0]+ [b.sub.1][u.sub.t] + [x.sub.t] + [e.sub.t]

(where x is the expected inflation rate). According to NR, any sustained inflation rate, once it comes to be expected (y = x), will coexist with the same "natural" unemployment rate (u = -[b.sub.0]/[b.sub.1]). Thus, an optimal policy would be one that yields zero inflation. With such a model available to policy makers, Rip might wonder how the U.S. managed to allow inflation to reach double-digit levels on more than one occasion before getting the genie (apparently) back in the bottle before Rip awakened.

Thomas Sargent wonders too. It is the purpose of his compact book (about 130 pages of text) to explain these 40 years of oscillating inflation. To Sargent, the question is: Why did Federal Reserve Board (Fed) policy produce 20 years of accelerating inflation, followed by deceleration, culminating in price stability? He focuses exclusively on two alternative explanations of imperfect monetary policy. Rip would need to look elsewhere to learn of oil shocks, price controls, and so on.

Sargent's first alternative is a simple one. The Fed initially thought the world was described by the PC above and acted accordingly. This produced poor results in a world actually described by NR. Eventually, the Fed learned its mistake, accepted NR, and succeeded in ratcheting inflation down without permanently increasing unemployment. Sargent labels this the "triumph of the natural rate theory" story. But this story is not truly simple. NR is often cast...