Inflation Planning Reconsidered

Abstract

This chapter discusses two problems that are optimal inflation and optimal growth. As it sets up the inflation problem, the labor supply is taken constant but it shows the monetary policy as stabilizing the capital stock. The variable under fiscal control is taken to be the level of employment through the effect of tax collection on aggregate consumption demand. Equivalently, one may regard the control variable as the rate of inflation as on Phillips' hypothesis, the inflation rate is an increasing function of the employment rate—at given inflationary expectations. The expected rate of inflation becomes the state variable in place of national income in the Ramsey problem. On Cagan's hypothesis of adaptive expectations, the expected inflation rate is rising or falling according to whether the actual inflation rate is currently higher or lower than the expected rate: if the former, unemployment is unnaturally low and if the latter, unemployment is unnaturally high. The equilibrium unemployment rate—the rate at which the actual inflation rate equals the prevailing expected inflation rate—is hypothesized to be independent of the expected inflation rate and is called the natural rate of unemployment.