CEPR - Center for Economic and Policy Research


En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press Economists and Inflation: It's Also Interest Rates, not Just Wages

Economists and Inflation: It's Also Interest Rates, not Just Wages

Wednesday, 04 December 2013 05:36

Binyamin Appelbaum had an interesting post about how many economists would like to see a higher rate of inflation to help recover from the downturn. The piece emphasizes the role of inflation in lowering real wages, with the argument that lower real wages are necessary to increase employment.

While there may be some truth to this point, it is worth fleshing out the argument more fully. At any point in time, there are sectors in which demand is increasing and we would expect to see rising real wages and also sectors where demand is falling and we would expect to see real wages do the same (e.g. Wall Street traders -- okay, that was a dream).

Anyhow, when inflation is very low, the only way to bring about declines in real wages in these sectors is by having lower nominal wages. Since workers resist nominal pay cuts, we end up not having this adjustment and therefore we end up with fewer jobs than would otherwise be the case. However it is an important qualification in this story that it is not about reducing real wages for all workers, only for some subset.

The other important point is that higher inflation promotes growth in other ways. First and foremost it makes investment more profitable by reducing real interest rates. Firms are considering spending money today to sell more output (e.g. software, computers, Twitter derivatives etc.) in the future. If they expect to sell this output for higher prices because of inflation, then they will find it more profitable to invest today. If we can keep interest rates more or less constant and raise the expected rate of inflation, then firms will have much more incentive to invest. This process seems to be working successfully in Japan at the moment.

Finally, inflation reduces debt burdens. Everyone who has debt in nominal dollars, such as homeowners, students, state and local governments, and the national government, will see the real value of its debt fall in response to inflation. This reduces their debt burden and makes it easier to spend. This would likely also be an important source of demand growth from higher inflation.

While many economists do emphasize the wage story, to my mind the other parts are likely more important. And, if higher inflation leads to more employment, this will increase workers' bargaining power and allow them to achieve wage gains that are likely to quickly offset any losses due to inflation -- although the Wall Street traders may not make up the lost ground.



Let me make a quick comment to clear up unnecessary confusion (can't do much about the deliberate confusion). The notion of inflation being a way to lower wages in the U.S. refers to the wages of some workers, not all workers. There are always industries seeing increased demand and some seeing reduced demand. The response to the latter would be lower wages. That is difficult to bring about in a situation of near zero inflation and nominal wage rigidity. By having higher inflation so that real wages can fall in these industries, we can increase employment, output, and real wages more generally. That is the argument. Folks can say why that may not work, but it's really not worth anyone's time to deliberately misrepresent it so you can say it's stupid.

Comments (10)Add Comment
written by foosion, December 04, 2013 5:21
inflation reduces debt burdens. ... and makes it easier to spend

Inflation correspondingly reduces income from holding debt, making it harder to spend. It would seem you have to add that lenders are less likely to spend than borrowers (which appears to be true) or that those who lend are foreigners (reducing their impact on our economy).
The Cost to America for Being Exactly Wrong Instead of Approximately Right
written by Last Mover, December 04, 2013 6:39

Milton Friedman used to claim that Keynesian economics could never work because workers would rebel when they realized the value of real wages were eroded by rising nominal prices.

This thinking went on to become formalized as rational expectations theory that ended up ruling much of macro economic policy for decades, especially during the "great moderation" when severe swings in business cycles were believed to be tamed forever.

Friedman was proven wrong early on. In response to government spending that increased employment and inflation at the same time over a period as long as one year and more, currently employed workers did not withdraw their labor at lower real wages nor demand higher nominal wages to keep up, nor did new workers refuse employment to work at lower real wages. Overall unemployment went down.

Stagflation also appeared on the scene as inflation from the supply side from sources like oil that wasn't supposed to be possible in periods of weak demand.

Nevertheless, Americans have been indoctrinated with ridiculous zero-sum thinking by fearmongers of debt and inflation that presumes an efficient market rules with "individual agents" whirring away with nano-second calculations in response to changes in real economic values that will send the economy even further below the stagnation in growth it's already in - caused by the fearmongers themselves btw - at the slightest attempt to use government spending coupled with intentional mild inflation to recover.

The fearmongers are exactly right about the increase in inflation itself but are exactly wrong about the result. They know they are wrong. They know that moderate intended inflation necessary to create more jobs at the macro level is approximately the right thing to do to achieve that objective.

In emergency medical care a critical priority is always to stop the bleeding first then attend to other problems. Otherwise correcting the other problems exactly right before stopping the bleeding with first-best approximations can be fatal.

The bleeding has gone on for 5 years in the name of being exactly right for the wrong reason. The patient is near death, particularly from the side effects, yet the cure is readily available but remains ignored.

You may be dying America, but at least it won't be from the twin fatal diseases of debt and inflation, which are always avoidable. We did everything we could you know.
Wage Inflation
written by jonny bakho, December 04, 2013 7:16
The columnist is so wrong. The type of inflation we most desperately need is wage inflation. Wages need to be higher, not lower. If production were at or above capacity, higher wages would increase the costs of goods and services. However, in an economy where production is far below capacity, increased demand for goods and services causes more workers to be hired to meet demand.

Wages have stagnated or deflated due to the Great Recession. Too little BigG intervention failed to correct this problem which leads to a low demand, low growth economy. Low wages also cause decreases in investment. Training low wage workers means that competitors can entice them away. Higher productivity does not lead to more sales because demand for goods and services is already below capacity. Thus, investment in training or tools to make workers more productive has negative incentive. Raising the minwage would help, not hurt.
written by dax, December 04, 2013 7:38
So let's see. First we need to depress the real wagers of workers, so that there is less unemployment, so wages will then go up! Unfortunately, there are no quantities here, and (down+up) could be greater than, equal to, or less than 0, with the smart money on a fall in real wages when all is said and done. This Keynesian economics thing thus sounds an awful like classical economics, with just a little more obfuscation to make it seem the Keynesian is really on the side of the worker.

As to the idea that inflation will decrease debt, that is the case only if nominal debt stays constant. Anyone see nominal debt staying constant? Whoops nominal governemnt debt is throught the roof. And while the real value of any particular homeowner's debt will be going down, since home prices are going up (faster than inflation), the total value of *all* homeowner's debt might still be going up. Depends on the churn ratio and such.

Not convinced inflation is what the good doctor really wants to order.
written by skeptonomist, December 04, 2013 9:08
What is going on here is that economists, most notably Krugman but others including Baker, start from the premise that fooling around with interest rates and money supply can control economies. Rather than look at empirical evidence, for example the fact that there is no correlation of inflation with growth, they spin "theoretical" fantasies based on imagining how people would react to interest rates and inflation. On this they again ignore empirical evidence from polls, for example the fact that business people do not consider interest rates, inflation or labor cost important now - they are waiting for demand to pick up.

Cutting short-term interest rates to zero didn't work; massive QE has not had a noticeable effect other than swelling excess bank reserves - what's left other than magically creating inflation by command of the Fed?

Before he was chosen Fed chairman Bernanke had grandiose ideas about what monetary policy could do - he promised "Milton and Anna" that the Fed could handle anything. He has had to face reality now and has repeatedly called on Congress to take action to increase spending, which is what would actually increase inflation by raising wages as well as prices. Are other economists ever going to face reality on the subject of monetary policy?
Akerloff Yellen...
written by pete, December 04, 2013 9:59
This is one of the most cited papers, and has as coauthor our new money czarina. The issue is straightforward Keynesian. Wages are sticky downward, PRICE inflation outpaces wage inflation, driving real wages down, and increasing output. In the Keynesian world, output/employment is the bottom line. Obviously the upshot is increased inequality, but that is not part of the goal, just a byproduct. Look at the post Bretton Woods world of unfettered monetary policy...all the gains go to capital, including the huge transfers from the QEs.

Regarding debt and inflation, of course there are two sides to every loan. Thus, lenders, such as pension funds, insurance companies, etc. which own debt, will suffer, while borrowers (firms, homeowners, US) will gain. Again a transfer in part to capital. 35% of Americans do not own homes...and of course this is the bottom rung...they lose...Hmmm.
uhm, Japan, skepto ...
written by Squeezed Turnip, December 04, 2013 1:15
written by skeptonomist, December 04, 2013 10:08
What is going on here is that economists, most notably Krugman but others including Baker, start from the premise that fooling around with interest rates and money supply can control economies. Rather than look at empirical evidence, for example the fact that there is no correlation of inflation with growth, they spin "theoretical" fantasies based on imagining how people would react to interest rates and inflation. …

The expectation has been that the Fed was/is going to keep inflation stabilized, which was the discipline of the previous 30 years and the insistence of the more conservative members of the FRB. It's a lot harder to break a 30 year expectation than they ("the safe 'responsible' ones") thought. But, skepto, you misunderstand the purpose and reach of QE3, as does pete, in a different way, above. The first arrow QE1 in the quiver failed. So did the second, operation twist. The third has produced some signs of life in the patient, but snow white remains asleep still, because the conservatives on the Fed once again prevented an outright statement of commitment to higher inflation. Not everybody got the big hint Bernanke gave, or at least didn't believe he had the votes to do it. But do fueling expectations of higher inflation work? Japan is (on the way to) showing that it does.

So, cut Baker and Krugman and Romer and Stiglitz et al. some slack.
written by jonny bakho, December 04, 2013 2:27
Investment in increased capacity during slack demand raises inventory and not profit. Much of manufacturing has been transformed into JustInTime. Thus, increase in inventory in response to inflation expectations is limited. The BigAuto overproduction marketShare collapsed in 2008. Many services are ephemeral. Plus who thinks labor will be more expensive into the future. We are staring at high unemployment 5 years out. It is difficult to stimulate the labor market by indirect means.
written by Tom Stickler, December 04, 2013 5:59
Rather than argue that inflation encourages businesses to invest today because of the prospect of being able to sell for higher prices in the future, the mechanism is really "invest today because my dollar will be worth less if I wait to spend it later."
written by Alex Bollinger, December 05, 2013 8:08
Baker's update made me visit the comments, and I wasn't disappointed. He's talking about price ratios adjusting because prices as a whole rise faster, guys!

Also, "wage inflation" does not mean what some people here think it means.

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.


Support this blog, donate
Combined Federal Campaign #79613

About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.