About This Issue
Last year our Annual Report contained an article that
characterized the "rational expectations" approach to macroeconomics
as a challenge to established views of policymaking. The
preface of that article stated that the theory of rational
expectations had profound implications for the conduct of
During the last year, while serving as a voting member
of the Federal Open Market Committee. I have tried to apply
the theory of rational expectations to policy-making. In
participating in the debate on how best to eliminate inflation
in the United States I have argued that the cost of fighting
inflation through the use of tighter macroeconomic policies
has been greatly overstated by forecasts from traditional
models. These models assume that decision makers are irrational
-- i.e., that they can be fooled for long periods of time
by changes in policy. But if in fact decision makers are
rational then restrictive policy actions when implemented
properly can lower inflation without severely disrupting
the economy. The efficiency with which decision makers process
information ultimately determines the costs of fighting
inflation with tighter macroeconomic policies.
The following article extends the 1977 Annual Report.
After providing an analysis of the policies previously used
to cope with inflation, policies we believe were seriously
flawed, we propose that the monetary and fiscal authorities
continue the efforts they began last fall to decrease the
rate of growth of money and government debt gradually but
steadily. Given the much underestimated ability of the public
to adjust to such actions, we believe that this policy can
eventually eliminate inflation in the United States without
high costs in terms of output and unemployment.
Most economic analysts believe that inflation could be fought
by lowering the rate of growth of money and cutting the federal
budget deficit. They feel that this would slow real economic
growth and in turn ease inflation by lowering capacity utilization
rates in plants and factories and by causing higher -- perhaps
significantly higher -- unemployment.
Some analysts argue in favor of such an anti-inflation plan
because they feel it's necessary even if it causes more unemployment.
Others think that higher unemployment is so undesirable that
the government should fight inflation by imposing economic controls
on wages, prices, or credit.
In the last two decades, inflation in the United States has
been fought with abrupt cuts in money and debt growth that reduced
real economic activity. Inflation slowed in response to these
policies, but because unemployment rose substantially these
policies were soon abandoned. In order to achieve a permanent
reduction in inflation, policymakers must avoid politically
intolerable rises in unemployment. To do this in today's political
and economic environment, cuts in money and debt growth must
be gradual and announced well in advance.
What policymakers must do to fight inflation effectively,
in other words, is to eliminate, whenever possible, surprises
in monetary and fiscal policies. They must build a set of policies
that the public has faith in and will take into account when
forming expectations of future inflation and spending. In short,
policy must be credible. And the only way to make policy credible
is to announce it, implement it faithfully, and avoid shifting
Why Policy Surprises Are Costly
The concept of a policy surprise is important because policies
affect real economic activity principally through surprises.
This point can be illustrated most easily with an example that
ignores some of the complexities of the world we live in. Although
this example is simplified, making it more complex or more like
the real world would not change the conclusions. Suppose that
existing wages and their rate of growth were established in
contract negotiations between firms and workers, negotiations
that were undertaken in the belief that the inflation rate would
remain constant because the monetary authority would keep the
growth of money unchanged. Putting aside uncertainties from
sources other than the government, labor contracts would allow
wages to grow at a rate equal to the rate of productivity growth
plus the expected rate of inflation.
Now suppose that the monetary authority considers the inflation
rate too high and unexpectedly decides to reduce the growth
of money. This lowers the growth rate of aggregate demand, and
businesses, in order to maximize profits, must raise prices
more slowly than they had expected. They soon find it in their
best interests to lay off some workers, because each worker
produces the expected amount of goods, but the goods now have
lower market value than expected and bring in less revenue than
was expected when wage rates were established. In effect, marginal
workers are priced out of their jobs.
As a result of the surprise policy change, the economy has
achieved a lower inflation rate. But production, employment,
personal income, and profits are also lower. [See boxed material
below for a more formal discussion of the effect of policy surprises
on output and prices.)
Once the policy change is recognized, an adjustment process
begins. Since there are workers without jobs and since the inflation
rate is lower than previously expected, newly negotiated labor
contracts specify slower wage growth. Marginal workers, who
had been laid off, return to their jobs as their wages no longer
outstrip the value of their output. Aggregate output then returns
to its original level. That is, after the policy change is recognized,
the system adjusts. It regains its initial level of economic
activity and real income, but price and wage increases become
How Policy Surprises Affect Output and Prices
Adjustment to a policy surprise is illustrated in the chart
below. The curve D0, the aggregate demand curve, represents
the output demanded by consumers, investors, and government
at each price level before the surprise policy change. The curve
S0 the aggregate supply curve, represents the output supplied
by all producers at each price level before the surprise policy
change. The price level is P0 and output is equal to Q0.
Before the surprise policy change, private decision makers were
expecting aggregate demand to rise to De1. Wage contracts were settled
that called for wage increases just sufficient to maintain real
purchasing power, that is to push the aggregate supply curveor
what is the same thing, the economy's cost curveto S1. If
the surprise policy change did not occur, prices would rise to Pe1
and output would remain at Q0.
But when the surprise policy comes and the slower growth of
money takes effect, aggregate demand rises less than expected,
to D1. Prices, as a result, rise more slowly than expected,
reaching P1 instead of Pe1. This slower growth in prices, however,
lowers the value of the output of workers. In fact, for all
workers the value of output is less than expected when wage
contract settlements were reached. And for many marginal workers,
this value is below their wage costs. Some workers are laid
off and output falls to Q1.
If firms and laborers were able to anticipate the monetary
authority's decision to reduce the rate of money growth, inflation
would slow without higher unemployment or lower output. The
temporary rise in unemployment and shortfall in output could
be avoided if the monetary authority announced well in advance
that money growth was going to be reduced and if people believed
this announcement. Firms and workers could then negotiate appropriate
wage contracts. They could agree to clauses that permit money
wages to be adjusted in order to keep real wages constant. Or
they could negotiate the growth in their money wages, taking
into account the new and lower money supply growth and the new
rate of inflation. It is in their own best interests to do this.
If they don't, they make their labor too expensive and encourage
firms to lay them off.
Fighting Inflation with Surprise Policy Changes: The Last
The theory that surprise policy changes affect the economy quite
differently than well announced, well understood policy changes
does much to explain the accelerating inflation in the United
States during the last 15 years. During this period, as Figure
1 shows, there have been three times when inflation was considered
rapid enough to call for restrictive monetary and fiscal policies.
The first was in 1966, the second in 1968-69, and the third
in 1973- 74(1). But as the figure also shows, these actions
were abruptly initiated and abruptly discontinued.
Perhaps because they were so abrupt, these actions seemed to be
surprises. In the spring of 1969, for instance, a leading forecasting
service commented that the restraints considered by government policymakers
(retention of the 1968 tax surcharge, strict monetary policy, repeal
of the investment tax credit, increases in Social Security taxes,
and cuts in expenditures) were "highly unlikely." But what was judged
unlikely turned out to be what happened. Again, at the beginning
of 1974, a time when the economy was at a standstill as the result
of past restrictive policies and the OPEC oil shock, many forecasters
expected the Fed to permit faster growth of money, which in turn
would allow short-term interest rates to edge down. As before, this
assessment of how policymakers would behave was off the markmoney
growth was further slowed and interest rates rose to record highs
at midyear. If these policy changes were surprises, as seems likely,
then they contributed to the losses in employment and production
that subsequently developed.
The attempts of 1968-69 and 1973-74 to abruptly check the
growth of aggregate spending and thereby lower inflation were
partially successful. Rates of inflation, responding after a
lag to the restrictive policies, declined as desired. Almost
simultaneously, however, production slipped lower and unemployment
rose. These effects were sufficiently prolonged and extensive
for the periods December 1969 through November 1970 and November
1973 through March 1975 to be designated recessions.
Reacting to the high unemployment that preceded these recessions,
policymakers changed direction again. They tried to stimulate
spending with expansive policies. As Figure 1 indicates, they
did this just before or, at the latest, just after the recessions.
The changes in policy reflected their concern over declines
in production and employment, but ironically their previous
policy changes had contributed to these declines, at least to
the extent that the changes were surprises.
The surprise reversals of policyfrom checking to stimulating
aggregate demandhelped to revive production and make the economy
grow. Each time policy became expansive, however, it did so before
inflation could drop to its preceding cyclical low, as shown in
Figure 2. In no case did inflation return to its starting level,
even when monetary and fiscal policies were supplemented with wage
and price controls in 1971. With each cycle the economy moved further
from the goal of price stability.
The behavior of prices was, of course, a concern at other
times, including 1971 when mandatory price and wage controls
were set in place. However, it was only in these periods that
government policies were attempting purposively to curb aggregate
demand in order to slow the rise in prices. All three periods
were preceded by years in which policy had been expansionary.
And in 1973-74, the inflation stemming from past expansionary
policy was aggravated by the release of mandatory controls,
permitting increases in previously suppressed wages and prices,
and by the quadrupling of oil prices by OPEC.
A Fundamental Fallacy
Virtually all economists would agree that tighter macroeconomic
policies can lower inflation. (See page 5 for a discussion of
the relationship between money, government debt, and inflation.)
But based on past experience, many believe that even a modest
cut in the government budget deficit or in money growth would
cause massive unemployment or long periods of slow economic
growth and high unemployment. Such beliefs are based on a confusion.
Because labor markets often have not adjusted immediately to
surprise policy actions, some observers believe that any policy
action aimed at cutting money growth and the federal budget
deficit will produce high unemployment, no matter how it is
implemented. They seem to assume that labor markets adjust very
slowly, if at all, to changes in policy.
If restrictive policies were pursued and were somehow kept
as surprises, it would take many years of high unemployment
to bring the inflation rate down to zero. But this is not very
plausible. A new permanent policy can be a surprise year after
year only if people can be fooled for very long periods of time
and if their expectations of future inflation are based exclusively
on the policies and economic circumstances of an earlier period.(2)
In reality, when policy changes, decision makers' expectations
change. Their expectations are based not just on past inflation
rates but on all available information, including information on
new policies or new anti-inflation programs. Their expectations
must change when policy changes if people do indeed behave as economists
for the last 200 years have said they behavein their own best
interests. When people believe that money growth or inflation rates
have changed, they will not be acting in their own best interests
to ignore this when negotiating wage contracts. A firm could lose
money if it ignored a new economic policy, because the policy affects
the wages it must pay its workers and the prices it can charge for
its products. Workers could price themselves out of their jobs if
they assume that inflation is going to be higher than it turns out
to be and bargain for high wage settlements. On the other hand,
if workers assume that inflation is going to be lower than it turns
out to be and bargain for low wage settlements, they could find
that their incomes, when adjusted for inflation, are falling.
The data suggest that people are not naive about permanent
policy changes. In the United States from 1960 to 1978, as Figure
3 shows, there appears to be no trade-off between inflation
and unemployment. This is consistent with the theory that people
are not fooled for long periods by changes in policy. Indeed,
the relationship between inflation and unemployment appears
to be the opposite of what many people have claimed. Higher
inflation tends to be associated with higher, not lower, unemployment.
Apparent trade-offs have existed only for short periods of time,
as might be expected if people temporarily failed to perceive
a shift in the course of macroeconomic policy.
As shown in the figure, increases in inflation were generally
associated with a decline in unemployment during the first half
of 1960. During the 1960s money growth accelerated and a sizable
budget deficit began to emerge. After the many years of virtual
price stability in the 1950s, this shift in policy probably
came as a surprise to most market participants and helped to
boost output and lower unemployment. But after a short while,
when the basic policy change was presumably recognized, wage
demands began to adjust. Thus, in the late 1960s and early 1970s
when inflation rose, unemployment generally rose.(3)
The correlation of inflation and unemployment over the last
two decades suggests that labor markets do, in fact, react to
basic changes in macroeconomic policies. According to Figure
3, once a change in policy and the resulting inflationary consequences
are understood, labor markets adjust. If history is any guide,
this means that if more stimulative policies are expected, then
we should get more inflation and more unemployment. Conversely,
if tighter policies are expected, we should get less of each.
Gains can thus be made against inflation without incurring the
high costs of increased unemployment.
Growth in Money and Government Debt Fuel Inflation
Economic policymakers have repeatedly lauded the twin goals
of high employment and stable prices mandated by the Employment
Act of 1946. But macroeconomic policies, particularly during
the last 15 years or so, have produced a steady acceleration
in the rate of inflation in the United States. As shown in the
chart below, this surge in inflation has generally been accompanied
by an increase in the rate of growth of money (M1, or currency
plus demand deposits) and in the outstanding stock of U.S. government
During the past two decades a heated and sometimes divisive
debate has taken place between different schools of economists
on whether and how much money matters in the economic system.
Economists now generally agree that monetary growth is a key
determinant of the rate of inflation. They continue to disagree
about how rapidly an increase in money works to increase prices
and on the channels through which it works, but not about its
importance to the behavior of prices.
In addition to money growth, deficit financing by the federal
government can also increase aggregate spending and drive prices
higher. Whether or not it does depends in part on whether the
debt is retired in the future. If it is, then taxes will have
to be increased to pay the interest and repay the principal.
Rational individuals, taking account of these future tax obligations,
will alter their consumption and savings plans enough to retire
the debt. In this case, aggregate demand will be unaffected
by the temporarily increased deficit.
But the case is quite different when the new government debt is
not to be retiredwhen it is a permanent addition to the outstanding
stock of securities. The only worry for individual taxpayers then
is interest on the debt. But interest payments simply transfer purchasing
power from taxpayers to bondholders; they do not change aggregate
demand. Thus, if the debt is not expected to be retired, aggregate
spending will rise. This will push prices higher.
This point has significance for our current problems. Since
fiscal 1960 the federal government has operated with a budget
surplus (unified basis) in only one year, 1969. The surplus
amounted to a little over $3 billion. However, the cumulative
sum of deficits in the other years since 1960 comes to over
$350 billion. Under current budget plans, there is no prospect
of a surplus until fiscal 1982. In view of this, it is conceivable
that much of the increase in federal debt in recent years has
been viewed as having a low probability of retirement and has
thus made a direct contribution to the nation's inflation problem.
Needed: A Credible Macroeconomic Policy
A policy of gradually slowing money growth and reducing the
federal budget deficit can lower and, ultimately, eliminate
inflation in the United States. (See discussion on page 7.)
There are compelling political or psychological reasons that
the steps should be gradual. In the years since World War II,
macroeconomic policy has been characterized by stop-and-go actions
and by many surprises. On the basis of this experience, many
observers doubt that government has the will to change and to
persist patiently in a sequence of announced, gradual steps
to achieve price stability. To these skeptics, as well as others
who may not fully understand the new policy approach and its
implications, the change in approach will come as a surprise.
If it does surprise some people, then real costs will arise,
at least during the early steps of the new approach. In fact,
large changes could shock the economy and cause a recession.
A serious recession could lead, as in the past, to the abandonment
of attempts to bring inflation under control. For this reason,
it is essential that the initial steps be small. Of course,
if people for some reason believed that the government was going
to take the monetary and fiscal steps necessary to control inflation
and if they were not restricted by previous contracts, then
even the initial steps could be made large without causing a
shock or a recession.
Once the program of gradually slowing growth in aggregate
demand has begun and the government has unambiguously demonstrated
its determination to carry it out, the costs of the program
will decline. When the new approach is well known and understood,
then even large steps will not lead to higher unemployment.
As surprises gradually disappear, so will the high costs of
fighting inflation with macroeconomic policies.
Inflation Can Be Eliminated Without Creating High Unemployment
A gradualist policy scenario is illustrated in the accompanying
chart, where Uf represents the "full employment" unemployment
rate. The economy is initially at point P0, experiencing inflation
equal to io and an unemployment rate equal to Uf.
Then a small contractionary change of policy occurs. When this
first step is takenmoney supply growth is cut or the deficit
is reduced or boththe economy moves to the point P1. Unemployment
rises because the public does not anticipate the change in policy.
But after the policy change occurs, at least some of the public
are persuaded that future announcements of tighter policy ought
to be taken more seriously. Once workers recognize and act upon
the new policy steps, then inflation and unemployment can be reduced
When the second stepa further gradual tightening of policyis
announced and then implemented, workers begin to lower their demands
for wage increases. When they do this, they are acting in their
own best interests. If they do not lower their wage demands, they
will make labor too expensive and workers will be laid off. The
anticipated tightening of policy thus lowers not only inflation
but unemployment, since firms can afford to hire more workers when
wages are rising less rapidly.
Subsequent steps to tighten policy result in further decreases
in inflation and unemployment as labor market participants adjust
their wage demands to reflect the lower rate of inflation. Fewer
and fewer workers are now priced out of their jobs. Eventually,
the point P4 is achieved. At this point, the economy once again
has full employment but at a much lower rate of inflation. Because
an ever-growing share of the labor market comes to recognize
the consequences of the new policy, the cost of significantly
lowering inflation is modest and short-lived.
Alternatively, if labor markets do not adjust at all, the
sequence of policy steps described above will produce the series
of points P1, Q1. Q2. and Q3. This is the process that critics
of tighter macroeconomic policies have in mind when they argue
that it is too expensive to fight inflation with these policies.
However, all the evidence indicates that firms and workers
will recognize the implications of a policy change for their
own markets. They will learn and they will adjust. Even skeptics
will find it in their best interests to modify their economic
behavior to reflect the changed environment. Adjustments in
wage demands will occur, and the mistakes made by the public
that can be attributed to a misperception of government policy
will become less and less important. As a result, the later
policy steps in the sequence do not involve substantial unemployment,
since the steps are properly anticipated by decision makers.
Nineteen hundred and seventy-eight was a year of exemplary operating
performance for the Federal Reserve System in general and the Federal
Reserve Bank of Minneapolis in particular. Ninth District 1978 operating
expense of $28.1 million represents a 2.1% reduction from 1977 levels the first time in our history that we have experienced an actual
year-to-year expense reduction. This decrease in expenses was accomplished
in spite of a 7.3% increase in measurable outputs (e.g., checks,
currency and coin, and securities processing), expansion of supervision
and regulation activities, expanded legislated responsibilities
in the area of consumer affairs, and general price level increases.
The accompanying charts illustrate some of the factors which
contributed to this performance. As the charts indicate, 1978
did not really represent an exception but rather a continuation
of favorable trends in expenses, productivity and unit costs
over the past five years. The first two charts (charts 1 and
2) deal with expense and measurable output trends since 1973.
Over this time period, total expenses in the Ninth District
increased by an average of 6.8% per year while measurable output
increased 6.0% per year. For the Federal Reserve System as a
whole, total expenses have increased on average by 8.6% per
year while measurable output has increased 6.4% per year.
Unit cost performance (chart 3) has been even more favorable.
Approximately 80% of System expenditures are incurred in areas
where there are measurable outputs. Expense growth in these
areas has been even less than total expense growth, averaging
5.4% per year for the Ninth District and 8.4% for the System.
This coupled with the growth in output, has resulted in Ninth
District 1978 weighted average unit costs being 2.3% below 1973
levels for an average decline of 0.6% per year. Although showing
a decline for 1978, average unit costs for the System have increased
at the rate of 1.9% per year since 1973. Since the GNP price
deflator has increased at an average rate of 7.9% per year real
dollar unit costs have decreased by approximately 33% for the
Ninth District and 25% for the System over the period 1973 through
Increases in productivity (chart 4) have been a prime contributor
to unit cost performance. Output per manhour has increased 37.8%
since 1974 for the Federal Reserve Bank of Minneapolis and 41.5%
for the System. This compares with a productivity gain of 7.4% over
the same time period for the nonfarm private business sector. Decreases
in total employment in each of the last four years (chart 5) have
resulted in 1978 employment levels falling below 1973 levels for
both the Ninth District and the System.
(2) For example, Paul A. Anderson of the Federal Reserve Bank of
Minneapolis used a prominent econometric model to simulate what
would happen if the money growth rate doubled permanently. He then
asked the model to compare price expectations used in the model
over a three-year period with the actual performance of prices over
that same period. In the model, expectations were way of. For the
three year period, according to the model, people would not even
begin to respond accurately to the increased inflation. Their estimates
of inflation would stray further and further from the actual performance
of prices and would begin to improve only in the fourth year. See
"Rational Expectations". How Important for Econometric Policy Analysis?" Quarterly Review. Federal Reserve Bank of Minneapolis (Fall
(3) Part of the reason for this relationship is that average unemployment
rates have risen during the last two decades as the labor participation
rates of women and teenagers, who have traditionally experienced
higher than average unemployment rates, have risen. Also, the liberalization
of income maintenance programs has tended to raise average unemployment
rates. The 1974-75 points are especially high because they were
influenced by the OPEC price hike and the dismantling of price controls.