On the Costs of Inflation and Unemployment

Abstract

The costs of inflation and unemployment and the related issue of Enemy Number have been a popular topic in the press, particularly in the rhetoric of politicians and central bankers. Rightwing politicians (echoed by supposedly independent central bankers) and journalists have been telling the public that inflation is Public Enemy Number One, and therefore it must be fought to the last drop of blood. Academic economists have also engaged in this debate by presenting theories and econometric estimates of the costs of inflation and unemployment with an obvious dichotomy. Those economists who endorse the proposition that inflation is Public Enemy Number One produce evidence on the costs of inflation. On the other hand, economists who reject this proposition produce evidence on the costs of unemployment. The latter would then compare their results with those of the former to prove their point, although the two sets of results may be based on different countries, sample periods, and methodologies. The objective of this paper is to reexamine this issue and to present some evidence on the costs of inflation and unemployment in terms of their effect on output, using one model applied to the same country (the United States) over a very long period (1890-1987). For this purpose, the structural time-series approach proposed by Harvey (1985, 1989) is used to test the relationship between output, on the one hand, and inflation and unemployment, on the other. One advantage of this approach is that there is implicit adjustment for cyclicality in the underlying variables which, in previous studies, proved to be problematical in the sense that spurious results may be obtained if no adjustment is made to take account of cyclical behavior.