At lunch today, I decided to make a foolish claim (on other occasions they just emerge spontaneously). Specifically, that inflation is not a problem. Why? Consider the budget constraint of the consumer. Inflation scales up the left and right hand side of the budget constraint by the same amount leaving it unchanged. Mark Satterthwaite pointed out that I was assuming that prices an income would adjust all at once. I was, he noted, ignoring the fact that many contracts were denominated in nominal dollars rather than inflation adjusted dollars. Ok, but this raises the question of why we write contracts in this way. Why not contracts based on inflation adjusted dollars? Luciano de Castro piped in that such contracts were normal in Brazil. In fact, salaries were paid the same way. Jonathan Weinstein said that this makes the method by which one computes inflation very important. In particular, it has to be immune to manipulation (he also observed that making a switch to inflated adjusted contracts would be like printing money…..but once). OK, but this means that inflation is not the issue but rather the absence of a reliable index of it. Then, Sasa Pekec and Uri Weiss argued that inflation allowed governments to break promises made earlier, so why would Governments agree to doing away with it? Didn’t get to the bottom of it as we had to break up.
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11 comments
May 2, 2012 at 6:37 pm
fmb
Many important contracts are formally not long-term, but roll periodically. Think “employee at will” or “one year lease” — both are frequently renewed. Somehow we manage to do this without undue pain renegotiating over surplus. Renewal terms are often pretty anchored by the previous terms even though there is likely a lot of hoped-for-and-now-demonstrated value in continuing the relationship and both sides could potentially hold out for a bigger cut.
However we got there, nominal wage rigidity seems like a useful part of how we achieve this: the expectation of a bad reaction is so strong that employers rarely attempt nominal wage cuts.
In that context, a wedge between this focal point and *real* wage growth is useful. If real wages need to shrink a little in order for markets to clear, that normally works out okay.
In a world where inflation is high and/or variable, more indexing would happen, and this wedge might be reduced or go away. If we converge on a focal point where real wages rarely go down (instead of rarely going down more than ~2% pa), labor markets will fail to clear more often.
I think this is basically a story of how a wedge between inflation and an acceptable default “renewal wage” keeps transaction costs low. Lower inflation might interfere with that in an obvious way, but so might higher inflation accompanied by indexing.
May 4, 2012 at 11:19 am
rvohra
Dear fmb
If we take as given the taboo against dropping wages then, I agree with the claim that inflation is useful in this regard. But, why the taboo? Ok, a hard question that even Truman Bewley had trouble answering. One reason maybe be to provide incentives over time and so inflation adjusted wages would help the firms’s commitment power in this regard. Along these lines, wouldn’t we expect to see variation between workers. Those with monopoly power could demand inflation adjusted wages and those without take it in nominal $’s?
May 4, 2012 at 11:58 am
fmb
I think we do see variation: in some sectors wages are even now outpacing inflation.
My answer (i.e. speculation) about the “taboo” is that it’s not a taboo, but something more strategic with a focal point element. Let’s say I renegotiate wages annually, but don’t know exactly how much surplus my employer gets from continuing our relationship. Then I have a tricky negotiation problem. Intransigence about a nominal wage cut might get me a bigger slice of the pie. If, in fact, employer surplus is slightly negative at that price, we may feel to clear when we should, but that’s an unavoidable cost of information asymmetry.
The fact that nominal wage cuts are a taboo for some makes me more credible: my employer doesn’t know whether I actually view it as a taboo, but might reasonably fear that I do. In contrast, insisting that I’ll walk if my wages don’t go up .05% seems much less likely to be taken seriously.
If inflation is high, strategic refusal to take a nominal pay cut becomes less useful, but there’s no strong focal point any more. This potentially makes adjusting real wages to clear markets harder.
May 9, 2012 at 9:22 am
rvohra
Dear fmb
What I still don’t see is why this argument applies for all the contracts the employer writes. In some it is the buyer (as in the employer-employee relationship) and in others it is the supplier.
May 3, 2012 at 8:42 am
anonymous
I travelled to Argentina last month. It striked me that items in the shop were not marked with their prices. This makes it very costly to choose your preferred item. Plus, it makes it difficult to compare what is expensive. Suppose you buy a piece of computer hardware every now and then. You enter the shop and you see the price…if inflation is high how can you know whether that price is high? you should remember not only the previous price you saw but the date and the inflation rate! It seems to me that price dispersion would be much higher under high inflation and that would increase search costs and reduce competition.
May 4, 2012 at 10:54 am
rvohra
Dear Anon:
You suggested that under inflation there would be greater price dispersion. I don’t see immediately why this should be the case. In a world of unlimited capacity, no differentiation, full information about costs and prices being charged, I would argue that prices would be driven to marginal cost (independent of inflation).
Rakesh
May 5, 2012 at 6:55 pm
Michael
Maybe our world isn’t one of “unlimited capacity, no differentiation, full information about costs and prices being charged”.
May 7, 2012 at 10:05 am
rvohra
Dear Michael
not so fast…..the point of that hypothetical was to show that there was a scenario where inflation could not generate price dispersion. That means, for inflation generate price dispersion, one of the restraints I imposed (unlimited capacity etc) has to give. Limited and varying capacity, would, by itself generate price dispersion (in a suitable setting). In this case, how would you distinguish between variation induced by this as opposed to inflation?
Rakesh
May 7, 2012 at 10:49 am
Michael
Dear Rakesh,
Robert Lucas created a theory of buisness cycles based on producers being unable to differentiate between real increases in demand and increases in the money supply. This theory suffers of course from the obvious problem that monetary policy is usually not a secret.
So suppose you have a standard consumer search model with price dispersion and consumers who cannot return to previously visited shops. If there is an ever present risk of unforseeable increases in the price level, a consumer might be willing to pay more than she would if she knew that no general increase in the price level happened. In that case price disperion might actually increase (say, the support of the distribution of prices in a symmetric equilibrium becomes larger). I’m not sure thi must be the case without seeing a model, but I don’t see immediately why it shouldn’t be the case.
Michael
May 9, 2012 at 9:28 am
rvohra
Michael
Thanks, did not know about the Lucas paper (an obvious danger when one speculates about matters outside one’s specialty and well studied by others!). if I follow, this story would suggest transparency on prices would be crucial in ensuring that inflation is not a problem.
May 8, 2012 at 9:15 pm
saberprivateer
If the government breaks enough promises then inflation is an issue because the feedback loop to producers would be to not enter contracts with the government. If there was a reliable index (unlikely given so much debate about things like the % jobless rate) then producers would adjust prices and governments wouldn’t benefit from inflation.
Since in either case inflation does not benefit the government in the long run they should stop printing money and let the market decide. =)