Homework 5 - Stagflation and the PC Model

Stagflation - Background
Stagflation is the term used to describe the unusual economic phenomenon of rising inflation combined with rising unemployment, accompanied by an economic recession or stagnant growth. Stagflation came to be recognized as a very serious macroeconomic problem in the 1970s, when it afflicted many countries in the developed and developing world. It is unusual because inflation is often wage driven, and wage inflation is usually caused by falling unemployment.

A good example of a period of stagflation and the government's response occurred following the resignation of US President Richard Nixon. Price controls had been in effect for a number of years, but were released due to the range of dislocations that they had caused. The country was in a state of political shock, the economy was stagnant and inflation persisted. The oil crisis had caused such inflationary and recessionary effects that inflation had grown from 2.7% p.a. to 8.2%p.a. (average compound rate) respectively, in the decade up to, and decade after, 1973. In the same periods, unemployment had jumped from 4.6% to 7.4% of the labour force.

Model Portfolio Choice & Stagflation
Prior to the above scenario from the 1970s, the prevailing Keynesian school of macroeconomics assumed that inflation and stagnation were unlikely to occur together. Until that time macroeconomists believed that stagnation could be cured by expansionary monetary or fiscal policies, while inflation could be cured by contractionary monetary or fiscal policies. When both stagnation and inflation occurred at the same time and persisted, this called into question existing macroeconomic theories and also posed a dilemma for the standard policy remedies that had been used to stabilize the economy in the past. This was because any remedy for one part of the problem was seen as adding fuel to the other element.

In economic modelling, stagflation is expected to arise from either a supply shock (such as prices of imported raw materials or oil rocketing), or from inappropriate interest rate / money-supply policies by the central bank. As model PC doesn't have an open economy with imports, we must shock the model by reference to central bank actions on interest rates.

In model PC, households wish to hold a certain portion of their wealth in the form of bills, and the remainder in the form of money. Keynes explained that the portion of wealth held as money was attributable (in part) to the liquidity preference (and was related to the amount of disposable income because of the transactions demand for money to which this gives rise). However as there are only two stocks of wealth, and total wealth is a function of disposable income and propensity to consume, then the amount of cash money held is directly determined by the amount of bills held; and that amount is related to the interest rate. In other words, the amount of liquidity is negatively related to the interest rate.

Hence, shocking the system by decreasing interest rates would have the effect of increasing liquidity, by decreasing the demand for bills. This might be expected to create the inflationary pressures required for stagflation, but under model PC, as consumption is said to be pre-determined by propensity to consume out of disposable income and past wealth, the effect of increased interest rates on households activity will therefore only affect portfolio choice and not consumption? To counter this argument, surely increased liquidity must make transactions more frequent?

Furthermore, in model PC, interest is an income of households, so lower rates therefore lead to lower (disposable) income, and this reduces consumption. This has the effect of reducing consumption by a multiple of the interest rate reduction as we move towards the steady state. (see Figure 4.4 p113 ME G&L for inverse scenario). This shock can therefore simulate the stagnation/recession element of stagflation in model PC, but because of the pre-presumption that consumption is a function of propensity to consume and is not affected by interest rates, this does not stoke inflation.

The solution to simulate inflation with stagnation in model PC would therefore require the interest rate reduction and some other 'outside' agent, such as increased commodity demand. We conclude that stagflation can be simulated more easily using more complex models with more variables and exogenous factors, such as models OPEN, OPENEX, etc.

The U.S. stagflation cycle of the 1970s was generally credited as being defeated by policies effected by then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a "disinflationary scenario." Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation.

It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it ultimately did.


Cititations:

An Encyclopedia of Economics, Snowdon B. & Vane H.R., 2002 Edition

The World Economy, a Millennial Perspective, Maddison A., Paris: OECD 2001

Government Money with Portfolio Choice, Chapter 4 Monetary Economics, Godley W. & Lavoie, M.

www.wikipedia.org (Stagflation, Phillips Curve,