Saturday, September 29, 2012

PSA: Brief but Substantial Inflation is Expected in a Recovery

I've been thinking on the Kocherlakota turn-around and the recent hubbub over the increased TIPS spread, and I'd like to say a piece on inflation in recoveries.

My outlook on inflation in recoveries is informed mostly by John Maynard Keynes in his General Theory of Employment Interest and Money. In one of the final chapters Keynes lays out dynamics of the price level in a slump and in a recovery with regard to the price-output split. Basically, as aggregate demand increases, some of that demand manifests itself as more real output and some as inflation; the amount of each is determined by the slope of the short-run aggregate supply curve. If all workers and capital goods were perfectly fungible, no factors of production would be in a position to demand higher nominal compensation while some resources were still idle. So any increase in nominal demand would be met purely with an increase in real GDP while real GDP was below its potential. Once real GDP was at its potential, however, any increase in demand would merely add more inflation with no increase in output. No inflation while the economy is depressed, soley inflation once the economy is recovered.

In reality, however, workers and capital goods are far from perfectly fungible. This means that as aggregate demand increases, some factors of production find themselves fully employed before others and before real GDP is at its potential, so that they can demand higher rates of remuneration while the economy recovers but before it has fully. So in a normal recovery, we should expect to see a spurt of increased inflation as employment and prodction recovers, and for this inflation to tapper off once recovery has been achieved. There is no long-tradeoff between inflation and unemployment; but the two should reverse correlate during a healthy recovery.
Note how inflation rises and falls with the utilization rate of manufacturing capacity; the price level is determined by aggregate demand AND supply. 

No comments:

Post a Comment