Do We Need Separate Theories of Inflation and Unemployment

Abstract

Lipsey's early attempt to provide some theoretical underpinning to the Phillips curve treated labour markets as markets where prices, i.e., money wage rates, adjust upward or downward to situations of excess demand or supply. (Lipsey, 1960) The adjustment was not assumed to be instantaneous as it would be in a Walrasian general equilibrium world. Instead, Lipsey assumed that the rate of increase or decrease in money wages would be proportionate to the relative amount of excess demand for or supply of labour. What held in one labour market held in all others and for the whole economy. With the aid of a few additional assumptions, Lipsey was able to derive a negative relation between the unemployment rate for the whole economy and the rate of wage inflation (the so-called Phillips curve). The key assumption in this analysis was the role played by wages in response to disequilibria. Wages were assumed to be flexible downwards as well as upwards. Similar models for product markets have filled the undergraduate texts for years. Subsequent developments in inflation and unemployment theory have if anything led to a polarization of views as to the response of wages and prices to excess demand and supply situations; one view positing rapid and sometimes even instantaneous adjustments, the other, none at all. Interestingly enough, both extreme positions conclude that changes in aggregate demand do not simultaneously affect the rate of inflation and the rate of unemployment. On the one hand, adherents of the new macro rational expectations hypothesis are prone to argue that variations in aggregate demand affect the rate of wage and price inflation but have a negligible effect on unemployment. The Phillips curve is vertical. On the other hand, there are the modern-day cost-push theorists who deny that changes in aggregate demand affect the rate of inflation. (Piore, 1979:5-6) Only the unemployment rate is affected as the Phillips curve is horizontal. In both cases, separate theories of inflation and unemployment are required. It is the main thesis of this paper that it is possible to develop a more complete model of inflation, one that can better explain events in a number of capitalist economies in the past decade. Thus, it will be argued that changes in aggregate demand affect the unemployment rate and the rate of wage and price inflation but the impact involves an asymmetry. Increases in aggregate demand may directly increase the rate of wage and price inflation and decrease the rate of unemployment, but decreases in aggregate demand may have little or no direct effect on money wages and prices over the politically feasible range of unemployment rates.