Inflation and unemployment revisited, or where is the deflation?

Ryan Avent has a good blog post, and an associated column, and a post from two days ago, related to an issue I have been discussing, namely if the negative AD shock is so primary and so terrible why have we seen so much price stability and even some mild inflation?  He covers so much ground it is hard to excerpt, so do read the whole thing, here is one summary bit:

The question is: if unemployment and disinflation typically go together, and if central banks effectively prevented disinflation, then why is there still so much unemployment?

I like what Ryan says but would stress some points which he does not relate.  Here you will find Krugman and Martin Wolf on the same topic, again many good points but I don’t think they are addressing the crux of the problem.

The key problem is not how to reconcile observed rates of unemployment and inflation (although that is an interesting issue), rather the key problem is how to reconcile observed rates of inflation with repeated claims made about the relative importance of negative AD shocks as the initial sin.  That’s the elephant in the room.

Again, wage stickiness might explain why “pressures for five percent deflation” might be translated into no more than “actual two percent deflation.”  It will not explain why deflationary pressures are translated into say “1.6% price inflation.”

My take would be this.  Let’s start with a simple AS-AD model and assume the AS and AD curves both shift back to the left.  It’s then easy to get a fall in output and employment without much if any deflationary pressures.

There is no need for “did they forget how to make ice cubes?” jokes or “was the Great Depression caused by soup kitchens?” kind of unperceptive remarks.  Two simple candidates for the AS shocks are increases in the risk premium and credit contraction; I would add TGS-related ideas as well.

For a bit more detail, consider a credit collapse, as we’ve been seeing for instance in Spain.  Due to a evaluation of expectations about the future of Spain and the security of euros in Spanish banks, credit dries up and some small and medium-sized businesses go under or cannot expand.  Sometimes the credit collapse is driven by deposit flight, other times by the need to recapitalize banks, other times by the greater riskiness of the real economy.  A credit collapse is both a negative AD shock and a negative AS shock together.

After all this, you can toss in inflation targeting, if need be, to help explain why so many countries are in the 0-2 percent inflation range.  But in any case the net deflationary pressures are not so strong in the first place.

Krugman, by the way, recently considered the view that both demand-side and supply-side forces might be at work, but his response is hardly an argument at all:

Oh, and one more thing: no, you can’t say “Well, there may be truth to both views”. Either the economy is supply-constrained or it’s demand-constrained. Of course even the most ardent demand-siders will admit that there are supply constraints in there somewhere, that if we had an economic boom we would, after some period of time, enter a regime where printing money is inflationary and government borrowing drive up interest rates. But not here, not now.

There is not much here, other than “Either the economy is supply-constrained or it’s demand-constrained.”  But that’s oddly non-marginalist.  The supply and demand sides interact like Marshallian scissors.  It’s not that one or the other has to be some kind of immoveable wall, or vertical curve, beyond which the other cannot budge.  A few seconds looking at shifts of AD and AS curves, as mentioned above, can establish this.

In sum, there is no big puzzle once we recognize that significant AD and AS shocks have been at work.


Man, Krugman, Avent, Wolf - it would be hard to narrow the debate more than this.

Two issues with Krugman's piece:

(1) I'm not sure his characterization of the Austrian view is correct. I don't think there's a labor market problem of too high (aggregate) wages. It's something like: there's a structure to the labor market. That structure has collapsed. It needs to be rebuilt, entrepreneur by entrepreneur, worker by worker. You can't take a short-cut by trying to raise the tide. Further, it's not clear you can raise the tide without upsetting the boats. After all, you can only open faucets.

(2) I don't understand the quote "What my side of the debate would call for, instead, is a reduction in the real interest rate, if possible, by raising expected inflation." I admit I don't understand interest rates very well. But I thought PK and other new Keynesians now believe that the real rate of interest is structural. And the CB shouldn't raise or lower it. Instead, they should raise the *nominal rate* with expected inflation, so it rises above the zero bound. Can someone clarify?

I still don't understand the problem you have with this argument?

Prices are not sticky the way wages are, for one thing. Plus it has been going on for years, we are outside of the "short run" now. Note also that real median wages *have* been falling, more than seven percent since the end of the recession, the observed upswing in average wages is coming from the top of the distribution.

Just as people sometimes use the 'structure' of the labor market to justify or explain high unemployment in the face of destitute workers willing to work for nearly any salary, I think one ought to consider the structure of the firms - with or without pricing power.


1- some firms might have to cut their prices to defend volumes but not all. My hunch has been that oligopolies have been on the rise and many firms, especially big ones, can afford to be price insensitive ('might be worth looking at sectors. Autos is an oligopoly but seem competitive. What about, say, Healthcare? Finance? Food & Beverages? etc)

2- some firms seem willing to forgo volumes in order to maintain margin i.e. they may not be recruiting or investing in new capacity because they do not foresee top line growth but they are, at the same time, unwilling to maintain top line growth if it comes at the expense of their profitability... They prefer to focus on cost reduction to defend their margins... And that might be the logical choice if, in a world where everyone has been trying hard to crush labor costs, it is not obvious that lower prices would necessarily generate more demand. Consumers would take the lower priced bargain and save the difference with the previously higher price rather than increase consumption?

What do you think?

Are short and long run not sufficiently abstract for us not to be sure where exactly we are? For one, time between recessions has probably increased quite a bit from the historical norm.

So basically: inflation/deflation/whatever -- the important issue is that economies are shrinking?

Shorter answers to TC's questions: central banks have created sticky prices, by not letting them fall. As there's no Philips curve, the net effect is higher-than-warranted prices and a drop in quantity. As TC says, the AS, AD curves have shifted to the left, so AS', AD' intersect to give a lower Q but because of QE by central banks, a more rightward shifted AD curve than warranted (AD should be even less sans easing), hence P is higher than expected. All this is bad as Austrians/Austerians would argue since the economy has no incentive to realign itself better.

This may not be reflected in mainstream macro dogma, but there is something to this.
Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity.

And then, there is the Greenbacker critique that basically goes that the only way that aggregate money can pay back aggregate debt is for velocity to increase.

Tyler, you could have made the exact same argument in the great depression after industrial production and gdp bottomed and the economy started to grow. There was price inflation despite extremely high unemployment. So right now, we have the economy growing slowly due to the Fed providing demand support and we have some moderate inflation, despite higher unemployment than usual. Not that big of a mystery. (Either PK or Scott Sumner has made this point before referencing inflationary behavior after the bottom in GDP in the GD.)

Hmmm... the CPI was at 17.2 in December 1929 and 14.0 in December 1939. That's a cumulative average of -2.0% per year.

Also, unemployment in the 1930s was at least twice current levels.

So, I'm not seeing the exact same argument.

I think an additional factor contributing to the "why is there 1.6% inflation" question is the following: The "right" wage offer for each individual worker varies from worker to worker. The distribution of wage offers gets trimmed at zero. So even a distribution that would have a mean below zero in a non-rigidity world can have a positive mean if the distribution gets trimmed at zero. It's another zero lower bound at work in the labor market!

I'm not sure what you're preferred measure of the price level is, but I'm looking at monthly CPI-U data and seeing deflation through most of 2009. I'm guessing then that your argument isn't "why wasn't there any deflation?" but rather, "why wasn't there more and why didn't it continue given unemployment?"

I think your AS-AD argument is entirely fine. Just to throw idea out there though, what if some of it is measurement error?

CPI has problems. A Laspeyres price index will systematically overstate inflation. Chained measures fix some of that, but I think you'd have to weed through the raw data, factor in increased demand for cheaper substitutes, how quality changes were factored in, think hard about exogenous shocks to markets for certain items like energy and commodities, etc. and not just look at the "official" headline inflation level.

There are also reports that many people switched to underground/informal labor markets that don't show up in the CPS or the Establishment Survey during the recession and many have stayed there.

Maybe the official measure of the price level is overstated and the official count of how many people do work for money is understated.

I doubt that explains that much of the puzzle, but it may make the puzzle a bit less puzzling. This isn't my preferred explanation, just throwing out food for thought.

If my Chicago Plan View is useful, then we would need to see Long Term Bond Rates rising to provide the necessary Evidence and Incentives for Employment to rev up. If that's not happening, it's because the Underlying Causes of the Crisis have not been seen to be properly addressed. That's why the Chicago Plan was so wide-ranging, including Banking Reform.

I thought this was a good post; in particular I like the insight that a credit collapse is a shock to both AS and AD. The one thing I find lacking is a discussion of the policy implications, since after all that is the reason for having the demand-side/supply-side debate in the first place. My view is that the supply-side issues should be addressed but that will take a long time, whereas monetary expansion can address the demand-side issues relatively quickly, and we can tolerate some short- or medium-term inflation if it means alleviating the problems of long-term unemployment.

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But in real terms is the economy smaller? Has Q not recovered to pre-recession levels? (or is that question all about just what inflation rate to apply?)

Okay -- probably did this backwards. Checking out FRED, looks like real GDP is about where it was in 2005 ([1][id]=USARGDPC)

The employment population ratio looks very interesting compared to real GDP ( (Wonder how well technical analysis works on economic charts -- nice head and shoulder pattern before the drop.)

In terms or median and mean income (national, all levels) we're a bit behind where we were in 2005, looks like it's about where it was in 1997 or 1998.

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My name's Damian Merritt and I'd get into this more deeply.

Tyler, a theory, using the Australian economy to illustrate:

Australia has had a thirty year credit binge, with current account deficits funding investment, and consumption spending (particularly on housing. House prices are exhorbitant). We've also had, generally, a rising nominal exchange rate. But domestic, non-tradable prices have been ok, rising at just below 4% for the last decade or so. How is inflation so benign? - we've had incredible growth in demand and money supply after all. Answer may be that we have increased our consumption of imports, where we are price takers. We've had a rising nominal exchange rate, easing imported inflation. I'd guess that for a while there, China's export goods were falling in price. We've also spent up big on houses, fuelled by easy credit and supply-side restrictions. So, its as if a fair portion of the demand that should have been causing CPI inflation has instead been used for spending on housing - causing house price appreciation - and spending on imports - which, with a rising nominal exchange rate, and being a price taker, has meant tradable goods prices have effectively eased our CPI figure. Our CPI is 60% based on non-tradable prices, and 40% on tradable. Therefore, our increased spending on imports has acted as not only a safety valve for all this demand, but is has also meant our measured inflation has been fairly benign, at just below 3% (I think) for the last 2 or so decades.

The US is probably quite similar I'd imagine... The US's exchange rate has depreciated, meaning imported prices rise and there's more dollars floating around, which, due to income and substitution effects, people are more likely to spend domestically. This may have been causing inflation to occur despite such subdued conditions...?

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for the, why is there no deflation question. Could the robust extension in ue benefits, disability program and other safety net like measures contribute to higher than expected inflation while unemployment remains fairly high? I beleive there has been some research that I cannot recall that did an analysis on various instances throughout history that suggested that as governments handouts make up a great % of income, higher inlflation results, especially if they are borrowing the money.

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