By Dr Frank Shostak
In the late 1960’s Edmund Phelps and Milton Friedman (PF) challenged the popular view that there can be a sustainable trade-off between inflation and unemployment. In fact, over time, according to PF, expansionary central bank policies set the platform for lower economic growth and a higher rate of inflation i.e. stagflation. A famous case of stagflation occurred during the 1974-75 period. In March 1975 industrial production fell by nearly 13% year-on-year whilst the yearly growth rate of the consumer price index (CPI) jumped to around 12%.
PF explanation of stagflation
Starting from a situation of equality between the current and the expected rate of inflation the central bank decides to increase the economic growth rate by raising the growth rate of money supply. As a result, a greater supply of money enters the economy and each individual now has more money at his disposal. According to PF, because of this increase, every individual is of the view that he has become wealthier. This raises the demand for goods and services, which in turn sets in motion an increase in the production of goods and services.
This raises producers demand for workers and subsequently the unemployment rate falls to below the equilibrium rate, which both Phelps and Friedman labelled as the natural rate.
Once the unemployment rate declines to below the natural rate this starts to exert an upward pressure on price inflation. Consequently, individuals start to realize that there was a general loosening in the monetary policy. As a result, individuals are beginning to realize that their previous increase in the purchasing power is actually dwindling. Hence, according to PF people start forming higher inflation expectations.
All this in turn works to weaken the overall demand for goods and services. A weakening in the overall demand in turn slows down the production of goods and services. As a result, the unemployment rate moves higher. Observe that we are now back with respect to the unemployment rate and economic growth to where we were prior to the central bank’s decision to loosen its monetary stance but with a much higher price inflation.
What we have here is a decline in the production of goods and services – a rise in the unemployment rate – and an increase in price inflation i.e. we have here stagflation. From this, PF have concluded that as long as the increase in the money supply growth rate is unexpected the central bank can engineer an increase in the economic growth rate.
Once, however, individuals learn about the increase in the money supply and assess the implications of this increase, they adjust their conduct accordingly. Therefore, the stimulatory effect to the economy because of the increase in the money supply growth rate disappears.
In order to overcome this hurdle and strengthen the economic growth rate, the central bank would have to surprise individuals by means of a much higher growth rate of the monetary pumping. However, after a time lag, individuals are likely to learn about this increase and adjust their conduct accordingly. Hence, the stimulatory effect of the higher growth rate of money supply on the economic growth is likely to vanish again and all that is going to remain is a much higher price inflation.
From this, PF concluded that by means of an expansionary monetary policy the central bank can only temporarily generate economic growth. Over time however, such policies are likely to result in higher price inflation. Hence, according to PF there is no long-term trade-off between inflation and unemployment.
Why expected money growth undermines economic growth?
In a market economy, a producer exchanges his product for money. He then exchanges the received money for the products of other producers. Alternatively, we can say that an exchange of something for something takes place by means of money.
Things are, however, not quite the same once money is generated out of “thin air” because of the expansionary central bank policies. Once money out of “thin air” is employed, it sets in motion an exchange of nothing for something. This amounts to a diversion of resources from wealth generators to the holders of the newly generated money.
In the process, wealth generators are left with fewer resources at their disposal, which in turn weakens their ability to grow the economy.
Note that an exchange of nothing for something, which sets the diversion of resources, is going to take place regardless of whether the increase in money supply is expected or unexpected. This means that contrary to PF, even if the money growth is expected it is going to undermine the economic growth. Now, if unexpected monetary policies can cause economic growth why not constantly surprise individuals and cause economic growth?
What then causes stagflation?
Now, increases in money supply set in motion an exchange of nothing for something. This in turn diverts resources from wealth generators to non-wealth generators. Consequently, this weakens the wealth formation process and in turn weakens the economic growth.
What we have here is a situation whereby increases in money supply undermine the process of wealth generation thus hurting economic growth. At the same time, we have more money per goods. This means that the prices of goods are now higher than before the increase in money supply took place.
Hence, what we have here is the increase in goods prices and a weakening in economic growth. This is branded by popular thinking as stagflation. (Note that the price of a good is the amount of money paid for the good. Also, when money enters a particular market, it means that more money is paid for the good in this market. This means an increase in the price of this good).
We suggest that stagflation emerges because of the increase in the money supply. Hence, whenever the central bank adopts an expansionary monetary stance, it also sets in motion stagflation in the months ahead.
The fact that over time a strengthening in the monetary growth may not always manifest through a visible stagflation does not refute what we have concluded with respect to the consequences of increases in the monetary pumping on economic growth and prices.
What matters for the state of an economy is not the manifestation of stagflation i.e. a weakening in economic growth and a strengthening in the prices of goods and services but increases in the money supply. It is increases in money supply that undermine the process of wealth generation.
The severity of stagflation is dependent upon the state of the pool of savings. If this pool is declining then a visible decline in economic activity is likely to ensue. Moreover, on account of past monetary pumping and the consequent increase in price inflation we will have a visible stagflation.
Conversely, if the pool of savings is still growing economic activity is likely to follow suit. Given the rising momentum of prices, we will have here positive correlation between economic activity and price inflation.
Note that the symptoms of stagflation are not visible here because of a growing pool of savings. We can conclude that if on account of past monetary pumping we do not observe the symptoms of stagflation this raises the likelihood that the pool of savings is still growing. Conversely, if we can observe the symptoms of stagflation then most likely the pool of savings is declining.
Conclusions
Increases in money supply set in motion an exchange of nothing for something. This diverts resources from wealth generators to non-wealth generators. Consequently, this weakens the wealth generation process and in turn the pace of economic activity. Now, when money enters goods markets it means that we have more money per goods. This means that the price of goods has risen. Hence, what we have here is the increase in goods prices and a weakening in economic growth. This is what stagflation is all about. We suggest that the outcome of the monetary pumping is always stagflation. It is not always visible though. As the pool of savings comes under pressure, the phenomenon of stagflation becomes more visible.
