bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

214 MONETARY ECONOMICS
non-accelerating-inflation rate of unemployment). 1
The expectations-augmented Phillips curve was bad news for governments
wishing to control unemployment by managing aggregate demand. It
implied that increases in aggregate demand could reduce unemployment but
only in the short run and only at the expense of accelerating inflation. Each
attempt by the government to lower unemployment below the NAIRU
would ratchet up the rate of inflation. In fact, the news was even worse
since it was also argued that increasing inflation interfered with the operation
of the price mechanism and reduced the efficiency of the economy.
This would cause the NAIRU to rise. This view assumed that higher rates
of inflation meant more volatile inflation and hence an increased chance of
incorrect inflationary expectations.
Pause for thought 8.4:
Is it reasonable to assume that inflation is more volatile at higher average rates of
inflation? Can the rate of inflation also be volatile if the average rate of inflation is
low?
The most prominent explanation of the damage done to the price mechanism
by volatile inflation came from Lucas (1972, 1973). He assumed that
firms know the current price of their own goods but only learn what happens
to prices in other markets with a time lag. When the current price of
its output rises, a firm has to decide whether this reflects a real increase in
demand for its own product or a general increase in prices resulting from
random demand shocks. In the former case, the rational response would be
to increase its output; in the latter case, it should not do so. That is, firms
have to distinguish between absolute and relative prices. The signal that
should be provided to producers by changes in relative prices is being confused
by the possibility of inflation, especially by volatile inflation. Firms
face a signal extraction problem. The greater the variability of the general
price level, the more difficult it is for a producer to extract the correct signal,
and the smaller the supply response is likely to be for any given change
in prices. Far from there being a trade-off between unemployment and
inflation, the accepted theory now suggested that inflation caused unemployment
to increase. To reduce unemployment in the long-run, governments
were required to keep inflation low and to attempt to lower the
NAIRU through supply-side measures.
There was also bad news for those authorities who started with a high
rate of inflation and wished to get it down. Reducing the rate of growth of
the money supply would push inflation down but workers would continue