5.5.2 The real costs of disinflation
The second main policy implication of the new classical approach concerns
the output–employment costs of reducing inflation. New classical economists
share the monetarist view that inflation is essentially a monetary phenomenon
propagated by excessive monetary growth. However, substantial disagreement
exists between economists over the real costs of disinflation. Here we
will compare the new classical view with that of Keynesians and monetarists.
The amount of lost output that an economy endures in order to reduce
inflation is known as the ‘sacrifice ratio’. In Keynesian models the sacrifice
ratio tends to be large, even if agents have rational expectations, owing to the
sluggish response of prices and wages to reductions in aggregate demand.
Given gradual price adjustment, a deflationary impulse will inevitably lead to
significant real losses which can be prolonged by hysteresis effects, that is,
where a recession causes the natural rate of unemployment to increase (see
Cross, 1988; Gordon, 1988; and Chapter 7). Some Keynesians have advocated
the temporary use of incomes policy as a supplementary policy measure
to accompany monetary restraint as a way of increasing the efficiency of
disinflation policies (see, for example, Lipsey, 1981). It should also be noted
that Post Keynesian economists regard incomes policy as a crucial permanent
anti-inflationary weapon. Monetary disinflation alone will tend to produce a
permanently higher level of unemployment in Post Keynesian models (see
Cornwall, 1984).
The orthodox monetarist view, discussed in Chapter 4, section 4.3.2, is that
unemployment will rise following monetary contraction, the extent and duration
of which depend on the degree of monetary contraction, the extent of
institutional adaptations and how quickly people adjust downwards their
expectations of future rates of inflation. The critical factor here is the responsiveness
of expectations to the change of monetary regime and this in turn
implies that the credibility and reputation of the monetary authority will play
a crucial role in determining the sacrifice ratio.
In contrast to both the Keynesian and monetarist models, the new classical
approach implies that announced/anticipated changes in monetary policy will
have no effect on the level of output and employment even in the short run,
provided the policy is credible. An announced monetary contraction which is
believed will cause rational agents immediately to revise downwards their
inflation expectations. The monetary authorities can in principle reduce the
rate of inflation without the associated output and employment costs predicted
by Keynesian and monetarist analysis; that is, the sacriflce ratio is
zero! As one critic has noted, ‘in a Sargent–Wallace world the Fed could
eliminate inflation simply by announcing that henceforth it would expand the
money supply at a rate compatible with price stability’ (Gordon, 1978, p. 338).
In terms of Figure 4.6, the rate of inflation could be reduced from A to D
without any increase in unemployment. In such circumstances there is no
necessity to follow a policy of gradual monetary contraction advocated by
orthodox monetarists. Given the absence of output–employment costs, new
classicists argue that the authorities might just as well announce a dramatic
reduction in the rate of monetary expansion to reduce inflation to their preferred
target rate.
With respect to the output–employment costs of reducing inflation, it is
interesting to note briefly the prima facie evidence provided by the Reagan
(USA) and Thatcher (UK) deflations in the early 1980s. Following the restrictive
monetary policy pursued in both economies during this period, both
the US economy (1981–2) and the UK economy (1980–81) experienced deep
recessions. Between 1979 and 1983, inflation fell from 11.2 per cent to 3.2
per cent in the US economy and from 13.4 per cent to 4.6 per cent in the UK
economy, while over the same period unemployment rose from 5.8 per cent
to 9.6 per cent in the USA and from 4.7 to 11.1 per cent in the UK (see Tables
1.4 and 1.5). In commenting on the UK experience, Matthews and Minford
(1987) attribute the severity of the recession in this period primarily to
adverse external and supply-side shocks. However, the monetary disinflation
initiated by the Thatcher government was also a factor. This disinflation was
unintentionally severe and as a result ‘expectations were quite unprepared for
it’. Because initially the Thatcher government had a credibility problem, the
‘accidental shock treatment’ produced painful effects on output and employment.
An important influence on credibility in new classical models is the
growth path of government debt. New classical economists insist that in order
to engineer a disinflation without experiencing a severe sacrifice ratio, a fiscal
strategy is required which is compatible with the announced monetary policy,
otherwise agents with rational expectations will expect a policy reversal (‘Uturn’)
in the future. As Matthews and Minford (1987) point out, ‘A key
feature of the Thatcher anti-inflation strategy was a parallel reduction in
government budget deficits.’ This ‘Medium Term Financial Strategy’ was
aimed at creating long-run credibility (see also Minford et al., 1980; Sargent
and Wallace, 1981; Sargent, 1993, 1999) .
In the USA a ‘monetary policy experiment’ was conducted between October
1979 and the summer of 1982. This Volcker disinflation was also associated
with a severe recession, although the influence of the second oil shock must
also have been a contributory factor. In commenting on this case, Milton
Friedman (1984) has argued that the relevant economic agents did not have
any widespread belief in the new disinflationary policy announced by the Fed
in October 1979. In a similar vein, Poole (1988) has observed that ‘a recession
may be necessary to provide the evidence that the central bank is serious’.
For a discussion of the US ‘monetarist experiment’, the reader is referred to
Brimmer (1983) and B. Friedman (1988). Useful surveys relating to the issue
of disinflation are provided by Dalziel (1991), Ball (1991, 1994) and Chadha
et al. (1992).
From the above discussion it is clear that, for painless disinflation to occur,
the public must believe that the monetary authority is prepared to carry
through its announced monetary contraction. If policy announcements lack
credibility, inflationary expectations will not fall sufficiently to prevent the
economy from experiencing output–employment costs. Initially the arguments
relating to the importance of credibility were forcefully presented by
Fellner (1976, 1979). A second line of argument, closely related to the need
for policy credibility, is that associated with the problem of dynamic time
inconsistency. This matter was first raised in the seminal paper of Kydland
and Prescott (1977) and we next examine the policy implications of this
influential theory.
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