Economic Report of the President

As an abrupt increase in the price of an important commoditytranslates into an increase in the cost of living, pressure builds forwage gains to match the new inflation. Some gains take place automaticallywhere wages are linked to prices through cost-of-livingclauses in union contracts. Additional acceleration occurs as new contractsare negotiated. As businesses observe the rising wage-pricespiral, they are likely to expect a higher future level of inflation. Theyare then somewhat more likely to grant larger wage increases, bothin the belief that rising inflation will make it possible to pass throughincreases in higher prices and in order to avoid losing workers.Through this process, a sharp increase in food or oil prices can leadto a rise in the underlying inflation rate.The magnitude of the inflationary process set in motion by an oilpriceincrease or some other supply shock depends on the state ofthe economy. The more prosperous the economy and the lower theunemployment level, the more likely it is that the initial increase inprices will lead to higher wage increases and a higher underlying inflationrate.In addition to their inflationary consequences, supply shocks alsocreate recessionary forces. The very large increases in oil prices in1974 and 1979 not only spurred inflation but simultaneously depressedaggregate demand. They were therefore largely responsiblefor the recessions of 1974-75 and 1980. After paying sharply higherprices for petroleum products, consumers had less to spend on othergoods and services. But those who received the revenues from higheroil prices—foreign and domestic oil producers—increased their demandsfor U.S. exports and investment goods only gradually. On balance,therefore, aggregate demand and spending fell, leading tolower output and reduced employment.Such a simultaneous increase in inflation and unemploymentbrought on by supply shocks creates a dilemma for economic policy.If monetary and fiscal policies produce additional aggregate demandto "compensate" for the recessionary forces set in motion by asupply shock, there is likely to be a large induced rise in inflation. If,on the other hand, no effort is made to compensate, aggregatedemand will fall. But given the relative insensitivity of wage and pricedecisions to moderate slack in the economy, some increase in the underlyinginflation rate is nonetheless likely. Only sharply restrictivemonetary and fiscal policies, which strengthen the forces leading torecession, can prevent an increase in the underlying inflation rate.While recessionary forces came into play in 1974 and 1980, the slackeningof aggregate demand was not sufficient to avoid anotherupward ratcheting of the inflation rate.43