Output Effects of Disinflation with Staggered Price Setting

Abstract

1. Introduction Monetary authorities who choose to reduce their country's rate of inflation, that is, to disinflate, are usually faced with subsequent recessions. A pattern of slower growth in money supply, followed by a lower inflation rate and lower output, can be seen in historical statistics, such as those examined by Friedman and Schwartz (1963). When there was thought to be a permanent Phillips curve trade-off between inflation and unemployment, an important policy question was what combination of inflation and unemployment was most desirable. As economists came to accept idea of a short-run but not a long-- run trade-off between inflation and unemployment, stage was set to ask about how much output is lost as a result of a disinflation. Okun (1978), using results from several econometric models, estimated that an extra 1% unemployment rate for one year would reduce inflation between one-sixth and one-half of 1%. To reduce inflation by 1%, these figures suggested that unemployment rate needed to be higher by 2 to 6% of labor force. If one uses an Okun's law of 2.5% of gross national product (GNP) lost for an unemployment rate higher by 1%, then output lost to reduce inflation by 1% would be between 5 and 15% of GNP. term is now widely understood to mean ratio of cumulated percentage loss of output (at an annual rate) to reduction in trend rate of inflation.1 For disinflation in early 1980s in United States, Fischer (1986) figures sacrifice ratio was about five. Other empirical studies, such as those in (1994b) and Jordan (1997), find a range of estimates around an average sacrifice ratio of about two.2 pattern of slower rates of growth in money supply being followed by recessions has posed a challenge to theorists to develop plausible models that help us understand this phenomenon. existence of staggered price setting is one candidate explanation, and Taylor (1979, 1980) deserves credit for introducing formal analyses of how overlapping wage contracts can lead to a persistence in wages and deviations in output from its natural rate during disinflations. Sargent (1983), in discussing conditions for a successful disinflation without much output loss, characterizes Taylor model as follows: this class of models, in terms of unemployment it is costly to end inflation because firms and workers are now locked into long-term wage contracts that were negotiated on basis of wage and price expectations that prevailed in past. . . . In addition, wage contracting mechanism contributes some momentum of its own to process, so that resulting sluggishness in inflation cannot be completely eliminated or overcome by appropriate changes in monetary and fiscal policies (p. 55). Similarly, Vegh (1992), explaining why ending hyperinflations appears to involve less output loss than ending moderate inflations, writes, The fact that in hyperinflations backward-looking contracts (so prevalent in industrial and chronic-inflation countries) disappears is probably at heart of difference in output costs (p. 656). In a widely used textbook, Romer (1996, p. 273) writes that the Taylor model exhibits price level inertia: price level adjusts fully to a monetary shock only after a sustained departure of output from its normal level. As a result, it is often claimed that Taylor model accounts for inflation inertia. Romer then adds provocative sentence: Ball (1994a) demonstrates, however, that this claim is incorrect. link between discrete-time model presented by Romer and contention attributed to is not immediately evident and needs to be clarified. Beginning with an environment of steady growth in money and prices, (1994a) assumes that a new regime suddenly announces a fully credible continuous linear decline in growth rate of money. …