Note: This is a chapter from the First Edition of Price Theory that was eliminated in the second edition.

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### Inflation and Unemployment

[Note: This chapter was dropped in the second edition]

An adequate discussion of the nature, causes, and cures of inflation and unemployment requires not a chapter but a book. My purpose here is to show how the ideas developed in this book would provide the groundwork for that one. I start, in Part 1, by explaining what inflation is, why it occurs, and what its consequences are. Part 2 discusses the nature and causes of unemployment. Part 3 will combine elements of Parts 1 and 2 with ideas from earlier chapters in order to suggest reasons why governments often follow policies that lead to inflation.

#### PART 1--INFLATION

The prices we have discussed so far are relative prices: the price of oranges measured in apples, of houses measured in cookies, and the like. If we are talking about relative prices, it makes not sense to say that "prices in general" are going up. If the price of oranges measured in apples is going up, the price of apples measured in oranges must be going down, since one is the inverse of the other. If a house used to cost a million cookies and now costs two million, the price of houses measured in cookies has doubled--but the price of cookies measured in houses has fallen in half, from one millionth of a house per cookie to one two-millionth.

People who complain about inflation and say that "All prices are going up" are talking about money prices --prices of goods measured in money. During an inflation, the prices of goods measured in other goods may go up, down, or stay the same--but the money prices of most goods are going up.

If the prices of one or two goods, measured in money, go up, the reason may be some special circumstance affecting those goods: a bad apple harvest or a fire that has burned down half the houses in a city. If the money prices of almost all goods are going up, it is far more likely that the cause involves, not the goods, but the money in which their prices are all being measured. One way of describing such a situation is to say that the money prices of apples, oranges, houses, cookies, and many other things are going up. A simpler way is to say that the price of money is going down. If apples used to cost \$.50 and now cost \$1, then the price of a dollar has fallen--from two apples to one. During an inflation, the price of goods is rising in terms of one of the things in which it can be measured--money. The price of money is falling in terms of almost all the things in which it can be measured.

#### The Price of Money

The price of money is determined, like the price of everything else, by supply and demand. The quantity supplied is the amount of currency in circulation; the government can increase the supply of money by printing more of it or decrease the supply by collecting more money than it spends and burning the excess.

Note that in economic language, the "supply of money" is the amount of money in circulation, not the rate at which new money is being produced. If no new money is printed (and none wears out), the supply of money is constant, but not zero.If each year, the government prints one dollar for every ten in circulation, the supply of money increases at 10 percent per year.

What about the demand for money? That too is an amount of money, not a number of dollars per year. Spending a dollar removes it from your pocket, but it does not use it up; someone else gets it. Your demand for money is not the amount you spend but the amount you hold. The total demand for money is the total amount that all of us together hold.

Why do we hold money at all? If I arranged my life so that income and expenditure exactly matched, I would have no need to hold money; as soon as a dollar came in for something I had sold, it would go out again for something I bought. This is not the way I (or you) actually live. It is more convenient to arrange income and expenditure separately in the short run, sometimes taking in more than we spend and sometimes spending more than we take in. When we take in more than we spend, our cash balances go up; when we spend more than we take in, they go back down again. Thus my cash balance functions as a sort of shock absorber.

Demand is not a number but a relationship: quantity demanded as a function of price. The quantity of money demanded--the number of dollars you choose to hold--actually depends on two different prices. First, it depends on the price of money; the higher the price of money--the more it can buy--the less you choose to hold, since the more a dollar can buy, the fewer dollars you require to buy things with. Second, the amount of money you hold depends on the cost of holding money.

Suppose I choose to hold, on average, a cash balance of \$100. What I gain is flexibility in arranging my income and expenditures. What I lose is the interest I would have collected if, instead of holding \$100 as currency, I had lent it out and collected interest on it. So the cost of holding money is the money interest rate--also called the nominal interest rate. The higher that interest rate--the more I could get for each dollar I lent out--the more expensive it is for me to hold currency, hence the less I choose to hold.

The distinction between the price of money and the cost of holding money--what we might also describe as the rent on money--is crucial to understanding how the general price level is determined, and confusion between the two is at the root of many of the more common economic mistakes. The price of money is what you must give up to get money; the higher the general price level (the amount of money you must give up to get something else), the lower the price of money. The cost of holding money (more precisely, the cost of holding money measured in money, the number of dollars per year you give up for each dollar you hold) is the nominal interest rate.

There is one important respect in which the demand for money differs from the demand for almost anything else. Since money is used to buy goods, the usefulness to you of a particular bundle of money depends not on how many dollars it contains but on how much it will buy; if all (money) prices doubled, two dollars after the change would be precisely as useful as one dollar before. Hence your demand is not really for a particular amount of money but for a particular amount of purchasing power. What you want is a certain real cash balance, not a certain nominal cash balance.

#### The Equilibrium Level of Prices

This unusual characteristic of the demand for money turns out to be very useful in understanding how the price of money changes with changes in supply or demand. Suppose demand and supply for currency are initially in equilibrium. The number of dollars individuals want to hold is equal to the total number of dollars available to be held; quantity demanded equals quantity supplied. Suddenly the government decides to double the money supply; the new dollars are printed up and distributed to the populace as a "free gift." What happens?

Everyone has twice as much money as before. Since, before the change, people were already holding as much currency as they wanted to, they now find themselves with more currency than they want to hold. The obvious solution is to spend more than they take in, thus reducing their cash balances and converting the surplus into useful goods.

Oddly enough, this obvious solution cannot work. While each of us individually can reduce his cash balance by spending more than he takes in--buying more than he sells--all of us together cannot. If I buy something, I am buying it from someone else--who is selling it. If I get rid of my surplus currency by giving it to you in exchange for goods, my cash balance falls but yours rises.

What is even odder is that although we cannot reduce our nominal cash balances--the number of dollars we hold--the attempt to do so does reduce our real cash balances. Since we are all trying to buy more than we sell, on net the quantity of goods demanded is greater than the quantity supplied. If quantity demanded is greater than quantity supplied, price rises. The rise in prices of goods (measured in money) corresponds to a fall in the value of money (measured in goods). We have just as many dollars as before, but they are worth less. The process continues until real cash balances are down to their desired level. Everyone has twice as many dollars as before and every dollar buys half as much as before; prices have doubled and nothing else has changed.

Another way of understanding the same process is to think of all markets as money markets. If you are selling goods for money, you are also buying money with goods; if you are buying goods with money, you are also selling money for goods. If actual cash balances are larger than desired cash balances, that means that the supply of money is larger than the demand, so the price of money falls. It continues falling until actual and desired cash balances are equal. In nominal terms, the fall in the price of money raises desired cash balances until they equal actual cash balances. In real terms, the fall in the price of money lowers actual cash balances until they equal desired cash balances.

I have just described how equilibrium is established on the market for money--how quantity supplied and quantity demanded are made equal. In doing so, I have also shown how the general level of (money) prices is determined. The equilibrium price level is that level at which the real value of the existing supply of money is equal to the total desired real cash balances of the population. If prices are higher than that, then individuals are holding less cash (in terms of what it will buy) than they wish. They attempt to increase their cash balances by buying less than they sell; in the process, they drive prices down toward their equilibrium level. If prices are below their equilibrium, the same process works in reverse to drive them back up. This description of how the general price level is determined and how it changes is a somewhat simplified one, mostly because I have not discussed what happens while the system is adjusting and have ignored interactions between prices and interest rates; but it is essentially correct, and it will be sufficient for the purposes of this chapter.

#### Inflation--The Changing Price of Money

Suppose we observe that prices are rising. Since rising prices of goods (in money) correspond to a falling price of money (in goods), rising prices mean that either the supply of money is increasing or the demand for money is decreasing.

A change in prices could be the result of a change in either supply or demand, but, in practice, almost all rapid changes in the price of money (and hence the general level of money prices) are due to changes in supply. A change in the demand for money means that individuals are choosing, on average, to hold larger or smaller cash balances than before--perhaps because of a change in their income, the pattern or predictability of their expenditures, or some other feature of their lives affecting how much money they wish to hold. Such real changes, affecting not merely one individual but the average of a large society, rarely occur very fast; it would be unusual, for instance, if the real income of a society grew by more than 10 percent in a year. Changes in supply can occur much more rapidly. In a paper money system like ours, the government can double the supply of money in a few days, simply by printing a lot of large-denomination bills--and some governments have done so.

Changes in demand can, of course, produce substantial changes in the price level, given enough time. An example is the gradual fall in prices during the final decades of the nineteenth century. Money at the time was not paper but gold; it could not be printed, and not very much of it was being mined, The economies of the countries that used gold as money were growing, and so was the number of such countries. Demand rose faster than supply, so the price of money rose--and the prices of goods fell. The process was eventually ended by the discovery of the South African gold fields and the invention of new technologies for extracting gold from lower grade ores.

Such deflations--periods of falling prices--are much rarer than inflations--changes in the opposite direction. An inflation occurs when the supply of money increases faster than the demand, causing prices to rise. In the U.S., inflation rates of 10 percent or more a year ("double digit inflation") have occurred several times in recent years. In many other countries, inflation rates of 20, 50, or 100 percent per year are common.

#### Consequences of Inflation

The consequences of inflation depend on the degree to which it is anticipated. If everyone in the society knows how prices have been changing, are changing, and are going to change in the future, then everyone can allow for the changing value of the dollar over time in setting future prices, making contracts for future payments, and so on. Under such circumstances, inflation is a nuisance, but not much more. If, on the other hand, individuals incorrectly anticipate inflation, failing to expect inflation that does occur, expecting inflation that does not occur, the results are much more serious. We shall first consider the less serious case of fully anticipated inflation, then go on to consider the problems of unanticipated or incorrectly anticipated inflation.

Anticipated Inflation. Suppose I am lending you money, in a world of constant 10 percent inflation. The interest rate at which I lend it to you will depend on my (and everyone else's) supply of loans and your (and everyone else's) demand for loans, as we saw back in Chapter 11. Both you and I know that when you pay the money back, a year from now, each dollar will buy 10 percent less than it does now. What I ultimately consume is not money but goods. What determines the amount I am willing to lend is how much present consumption I must give up by lending you the money instead of spending it myself and how much I shall be able to buy with the money you will pay me back a year later. So my supply of loans is a function not of the nominal interest rate, the interest rate measured in money, but of the real interest rate, the interest rate measured in goods. Similarly, and for the same reason, your demand for loans depends on the real, not the nominal, interest rate.

I would be equally willing to lend (and you to borrow) at a nominal interest rate of 10 percent in a world of 10 percent per year inflation, 20 percent in a world of 20 percent inflation, or zero percent in a world of zero percent inflation; in each case, the real interest rate is zero, since the money paid back buys the same amount of goods as the money lent. Similarly, nominal interest rates of 25, 20, or 15 percent in a world of 10 percent inflation correspond to real interest rates of 15, 10, and 5 percent--and to nominal rates of 15, 10, and 5 percent in a world of no inflation. The nominal interest rate simply equals the real interest rate plus the inflation rate. Both the supply of loans and the demand for loans depend on the real interest rate, so two economies which are identical except for their inflation rates will have the same real interest rates. Nominal interest rates will be different, with the difference just making up for the different inflation rates.

In the case of loans, high nominal interest rates compensate lenders for the effects of anticipated inflation. The same sort of thing happens with other contracts. Just as in the case of loans, the individuals concerned are ultimately interested in goods, not money; so the supply and demand curves that determine prices are functions of the real, not the nominal, amount of future payments. If you hire me on a five-year contract in an inflationary world, both you and I know that the dollars you pay me will be worth less and less each year. If the real terms we are willing to agree on are, say, \$20,000/year for the next five years, we can and will implement them with an agreement for you to pay me \$20,000 this year, \$22,000 next year, and so on. Similarly, for other contracts that involve payments over time, the number of dollars adjusts to compensate for the anticipated change in their value.

This analysis suggests that the main cost of anticipated inflation is the time and trouble of taking account of it in arranging our lives. If, as in most of this book, we ignore such transaction costs, then anticipated inflation would seem to have no important effects.

Unanticipated Inflation. So far, we have been considering fully anticipated inflation; everyone--lenders and borrowers, employers and employees--knows what is happening and what will happen to prices over time. We shall now drop that assumption and consider the effects of unanticipated inflation. We start with the simple case where everyone expects an inflation rate of zero.

We live in a world where prices have been, and are expected to be, stable. I lend you \$1,000 at an interest rate of 5 percent. During the next year, to our surprise, prices rise 6 percent. At the end of the year, you pay me back \$1,050 -- and I find that it will buy less than the \$1,000 I lent you. The loan we thought we were making was at a real and nominal rate of 5 percent; it turned out to be at a nominal rate of 5 percent but a real rate of -1 percent.

As you can see by this example, an unexpected inflation revises the real terms of loans against creditors and in favor of debtors. The same is true if we expect inflation--but less inflation than we get. If we had both anticipated a 5 percent inflation, we would have agreed to a nominal interest rate of 10 percent. The result, if the actual inflation rate turned out to be 10 percent, would have been a real interest rate of zero instead of the 5 percent you thought you were paying and I thought I was getting.

Unanticipated inflation has a similar effect on other contracts. Suppose I have agreed to work for you for the next five years for \$20,000/year, in the belief that prices will be stable. I am wrong; prices rise--and my real income falls--at 10 percent per year. I have gotten a worse deal than I thought and you have gotten a better one. In this case, it is the employer who gains by inflation and the employee who loses. The same thing would be true if our original agreement made allowance for inflation, but the inflation rate turned out to be higher than we expected. Exactly the opposite would happen if we overestimated future inflation; the increase in nominal wages built into my employment contract would more than compensate me for the inflation that actually occurred.

The effects of unanticipated or misanticipated inflation on debtors, creditors, employers and employees are all special cases of a more general principle: Inflation injures individuals with net nominal assets and benefits individuals with net nominal liabilities.

What do I mean by "net nominal assets"? My house is a real asset; it continues to provide me with the same services, whatever happens to the general price level. A pension of \$10,000/year is a nominal asset; since I am receiving a fixed number of dollars, the real value of my pension--what it can buy--goes up or down with the value of money.

When I lend you \$1,000 at 5 percent, I acquire a nominal asset: a claim against you for \$1,050, payable a year from now. You acquire a nominal liability: your obligation to pay that amount a year from now. If the inflation rate rises unexpectedly, the real value of my asset falls, and so does the real value of your liability--which is bad for me and good for you. Similarly, if I agree to work for you for five years at \$20,000/year, I acquire a nominal asset: \$20,000/year for five years. You acquire a nominal liability: the obligation to pay \$20,000/year for five years.

An individual may have both nominal assets and nominal liabilities--an employment contract that pays him a fixed number of dollars in the future and a mortgage that requires him to pay a fixed number of dollars in the future. If his nominal liabilities are larger than his nominal assets, then on net he has nominal liabilities; if the assets are larger, he has net nominal assets. The comparison is simple if the assets and liabilities all come due in the same year. Otherwise things become more complicated. The same individual may be benefited by one pattern of future inflation, with most of the inflation occurring after he collects on his assets and before he must pay on his liabilities, and injured by a different pattern of inflation.

So the general principle is that inflation injures those who have, on net, nominal assets, and benefits those who have, on net, nominal liabilities. Deflation--a fall in prices--benefits those who have net nominal assets and injures those who have net nominal liabilities.

In separating the effects of inflation or deflation from the effects of unanticipated inflation or deflation, there is a somewhat subtle distinction that must be made. In one sense, inflation injures a creditor whether or not it is anticipated; the higher the inflation rate, the less the value of the dollars paid back to him. Once the loan is made, the higher the inflation rate turns out to be, the worse off the creditor is and the better off the debtor. But creditors are not worse off in a world of (fully anticipated) 10 percent inflation than in a world of (fully anticipated) 0 percent inflation; the higher nominal interest rate in the inflationary world just compensates them for the lower value of the money they get back.

A slightly different way of putting this is to point out that in a world of fully anticipated inflation, creditors only lend money (and debtors only borrow it) if they are better off making (or taking) the loan than not doing so. In a world of incorrectly anticipated inflation, the contract is, in effect, revised after it has been made; so the lender (or borrower) may discover that the deal he actually made, unlike the deal he thought he made, is worse than no deal at all.

Uncertain Inflation. So far, we have considered unanticipated inflation in a situation in which people think they know what is happening to prices and turn out to be wrong. A more realistic situation would be one in which everyone knows that he does not know what the inflation rate is going to be. Every long-term nominal contract is then a gamble. If you borrow or lend, accept a job or offer one, you are agreeing to a contract whose real terms depend on what the inflation rate turns out to be. To some extent, one can compensate for this by designing contracts whose terms depend on what happens to the price level; but the result is still to increase considerably the cost, complication, and uncertainty of doing business.

#### PART 2 -- UNEMPLOYMENT

In analyzing markets, including the market for labor, we have almost always assumed that price adjusts until quantity demanded equals quantity supplied, If your only source of economic information is this book, that may seem like an adequate description of how the economy works. If you also read newspapers, watch television, or listen to radio, you may have wondered how, if quantity of labor demanded is equal to quantity supplied, there can be several million people unemployed.

#### Kinds of Unemployment

The first step in answering that question is to look at what is meant by "unemployment." The unemployment figure reported in the newspapers is an estimate of the number of people who, if asked whether they are looking for a job and do not have one, would answer yes; the figure is calculated by asking that question of some small fraction of the population, and, from their answers, estimating what the result would be of asking everyone. Unemployment is usually given in the form of the unemployment rate, the number of people unemployed as a percentage of the total labor force.

Different reasons why someone might answer yes to that question correspond to different sorts of unemployment. Some of them involve an inequality between quantity of labor supplied and quantity demanded; others do not.

Search Unemployment. You have just resigned--or been fired--from a job as an engineer with a salary of \$40,000/year. You could, if you wished, walk into the neighborhood restaurant and offer to wash dishes; by doing so, you might make as much as a quarter of your old income. You decide instead to look for another job as an engineer.

After a few days spent reading the want ads, you locate a possible job. It requires a long commute and pays only \$30,000. You keep looking. After another two weeks, you find a better job, one that pays \$40,000 and is located reasonably close to where you live. You go in for an interview and are offered the job. You spend a few more days looking around in the hopes of finding something better, then accept.

You spent about three weeks between jobs. During how much of that time were you unemployed? In one sense, all of it; in another sense, none.

At any time during those weeks, you would, if asked, have said that you wanted a job and did not have one; so from the standpoint of the Bureau of Labor Statistics, you were counted as unemployed. But during all of that time, you could have had a job--as a dishwasher--if you had wanted one. The reason you did not work as a dishwasher was that you had a better job. You were employed, by yourself, at the job of looking for a job. You obviously preferred that to the alternative of being a dishwasher--as shown by your choice.

Such "search unemployment" makes up a substantial fraction of reported unemployment. In a market where goods are not identical, such as the housing market, the marriage market, or the labor market, searching is a productive activity, If your search finds you a job close to home instead of one on the other side of the city, a job utilizing all of your skills instead of half of them, or a job working with people you enjoy working with, you have produced something of considerable value while "unemployed."

In the case of search unemployment, the individual who says that he is looking for a job is telling the truth. What is deceptive about calling that "unemployment" is the implication that the supply of labor is greater than the demand. Search unemployment is a normal and desirable feature of the labor market. One could reduce or even eliminate it--by announcing that anyone who was unemployed for more than a week would be shot, for example, or by making it illegal for anyone to quit or be fired unless he already had another job. But the result of such a law would be to make the situation worse, not better, by eliminating a productive activity--spending time producing information necessary to choose the right job.

Fictitious Unemployment. Another source of measured unemployment consists of people who find it in their interest to say they are looking for a job when they are not. A condition for receiving welfare, for many although not all recipients, is that the recipient be looking for a job. Presumably some of the people receiving such welfare would rather be unemployed (or employed covertly) and receive welfare than be employed, at the sort of job they could get, and not receive welfare. If you do not want a job, it is easy enough not to find one. So some reported unemployment consists of people who are pretending to look for a job, would accept a job if a sufficiently attractive one were offered to them, but prefer unemployment to the sort of job that will be offered to them. One study estimated that changes in federal welfare rules that made "looking for work" a prerequisite for welfare produced an increase in the measured unemployment rate of between one and two percentage points. If that result is correct, it suggests that unemployment of this sort may be responsible for about one fourth of total measured unemployment.

Involuntary Unemployment. Consider someone so unproductive that he is worth nothing to any employer. He could get a job only by agreeing to work for nothing or less than nothing. So far as a supply and demand diagram is concerned, the quantity of his labor supplied is equal to the quantity demanded, just as we would expect. Unfortunately, the equilibrium price is zero.

This is an extreme case, but it demonstrates the sense in which even the most involuntary unemployment may be "voluntary" so far as the logic of economics is concerned. In terms of the ordinary meaning of words, someone who can only get a job by agreeing to work for nothing is involuntarily unemployed. Yet it seems odd to say that the market is not working merely because an equilibrium price turns out to be zero.

Individuals who want to work but have an equilibrium wage of zero are probably rare, but there is a similar and even more involuntary type of unemployment which is quite common. Under current minimum wage laws, it is illegal, in most fields, for someone to work for less than the minimum wage. If for some kinds of labor--unskilled teenagers, for example--the wage that equates quantity supplied and quantity demanded is below the minimum, then at the minimum wage the quantity of such labor supplied is greater than the quantity demanded. The excess workers--people who are willing to work for the minimum wage and might be willing to work for less but cannot get jobs at the lowest wage that it is legal for employers to pay them--show up in the statistics as unemployed. Minimum wages produce a surplus of labor just as maximum rents produce a shortage of housing.

Disequilibrium Unemployment. So far, all but one of the sorts of unemployment I have discussed have been consistent with equilibrium on the labor market. The exception is unemployment due to minimum wage laws; in that case, the market cannot reach the equilibrium price because the equilibrium price, for some types of labor, is illegal.

There remains one further category: unemployment due to disequilibrium. Throughout this book, I have limited my discussion of disequilibrium to the demonstration that moving a market out of equilibrium creates forces tending to move it back. Such forces do not operate instantaneously. In a changing and unpredictable society, a price at any instant may be above its equilibrium level, with excess supply tending to push it back down; or it may be below its equilibrium level, with excess demand tending to push it back up. Disequilibrium is particularly likely, and particularly long lived, in markets for inhomogeneous goods, such as labor or spouses. If all units of a good are identical--ounces of pure silver, for example--it is relatively easy to observe price, quantity supplied, and quantity demanded, and adjust accordingly. With a million different "qualities" of labor (and jobs and spouses), the informational problem associated with finding the equilibrium price is far harder. It is harder still when what is being sold is not a day's consumption of the good but a contract for the next several years, as is frequently the case on those markets. In that case, the equilibrium price must take account not only of supply and demand conditions today, but of estimated supply and demand conditions over the entire period of the contract. This is made more difficult by something we discussed earlier in the chapter--the effect of uncertain inflation on long-term contracting.

#### Unemployment and Inflation

In arguing that search unemployment is a desirable activity, I implicitly assumed that the individual had an accurate idea of what sort of jobs were available and would therefore choose to search only if the return was, in some average sense, at least as great as the cost. Suppose this is not true. Suppose the worker has somehow been fooled into thinking that if he only looks a little longer, he can get a job paying \$40,000/year, when in fact there are no such jobs available. He may waste months looking for a nonexistent job before he realizes his mistake.

One possible source of such errors is unanticipated or misanticipated inflation. Consider the effect of an unexpected drop in the inflation rate. Prices have been rising at 10 percent per year for many years; most people expect them to continue doing so. For some reason, the government, which has been producing the inflation with a corresponding increase in the money supply, decides to turn off the printing presses.

Everyone has gotten used to the old level of inflation; in buying or selling goods, in taking jobs or hiring workers, the universal assumption is that a dollar will be worth 10 percent less next year than this year. Initially, after the government stops printing money, things continue as before; producers increase the prices of their goods and workers increase their wage expectations at the usual 10 percent per year.

The number of dollars available to buy those goods and hire those workers, however, is not increasing. Producers find that at the prices they are charging, they cannot sell as much as they have produced; they reduce their prices. Eventually, when everyone has gotten the message, prices fall back to where they were when the government stopped increasing the money supply.

Some people get the message faster than others. Producers are selling their goods every day; they quickly discover that their prices are too high and change them. The individual worker looks for a new job only once every several years, so it takes workers much longer to recognize the change and adjust their expectations. In the meantime, workers expect wages above the actual equilibrium wage--the wage at which supply and demand for labor are equal. Seen from the standpoint of the employer, the real wage at which he can get workers has gone up, so he hires fewer workers. Seen from the standpoint of the worker, he is engaging in search based on an overly optimistic picture of what can be found, so he keeps searching long beyond the point where additional search is worth what it costs.

In the situation I have described, incorrect search leads to an undesirably high level of unemployment. It can also lead to an undesirably low level. Consider the case discussed earlier in the chapter, where prices have been stable for a long time and suddenly begin to rise. A worker has just quit a \$30,000 job in the (correct) belief that he is worth at least \$40,000 elsewhere. The next day, he accepts a job that will pay him \$40,000/year for the next five years. What he does not know--and his employer does--is that the inflation rate has risen from zero to 10 percent. In real terms, he is being offered \$40,000 this year, \$36,364 next year, and \$33,058 the year after. If he had known that, he would have kept on looking.

In this case, the unexpected onset of inflation has reduced the unemployment rate, but it has done so in a way that makes the newly employed people worse off; they have been tricked into accepting a worse job than they could have gotten by looking a little longer. Employers, on the other hand, are better off. Since the amount of labor supplied is based not on what the workers are really getting (adjusted for inflation) but on what they think they are getting, the supply curve for labor has shifted out and the equilibrium real wage has fallen. Profits rise. Eventually the workers realize what is happening, the supply curve for labor shifts back, and profits go back to their normal level; but during the adjustment period, the employers are better off and the workers worse off as a result of the workers' mistake.

#### PART 3 -- WHY INFLATION HAPPENS: A PUBLIC CHOICE PERSPECTIVE

I have given a simple--some may think oversimple--explanation of inflation: Inflation occurs because the government expands the supply of money. This raises an obvious question. All politicians, including the ones who get elected, are against inflation, as one can easily discover by listening to their speeches. If all they have to do to stop it is to stop printing money, why do they not do so? Why does inflation ever occur; and if it does start, why is it not immediately stopped?

There are two possible answers. One is that inflation is a mistake; the politicians controlling monetary policy, in the U.S. and elsewhere, do not recognize the connection between the amount of money they print and the value of that money.

This is, to put it mildly, implausible. Our understanding of inflation goes back at least as far as David Hume, who correctly analyzed the causes of inflation more than 200 years ago. While the details of the relation between the money supply, the price level, and other economic variables are complicated, there is an enormous body of evidence, from many different societies at many different times, showing that a large increase in the money supply almost inevitably results in a large increase in prices, and a large increase in prices almost never occurs without a large increase in the money supply. It is hard to believe that if it were in the interest of politicians to know what causes inflation and to use that knowledge in order to prevent it, they would not yet have managed to do so.

The second and more plausible explanation is that politicians frequently find that inflation benefits them. Their behavior, in campaigning against inflation but not doing anything about it when elected, is then entirely rational. They campaign against inflation because they want the support of voters who are opposed to it. They act for inflation because they benefit from some of its consequences. They trust to the rational ignorance of the voters to conceal the inconsistency between words and deeds.

This brings us to the question of why it may often be in the interest of politicians to create or maintain inflation. There are at least two reasons. The first and simplest is that government itself is often a major beneficiary of inflation. The second and more complicated is that (unanticipated) increases in the inflation rate tend to have benefits that are immediate and visible and costs that are delayed and invisible, while (unanticipated) decreases tend to have visible and immediate costs and invisible and delayed benefits. Because of the public good nature of voting, discussed in Chapter 18, voters act mostly on free information, so costs and benefits that are visible and immediate are much more important, politically speaking, than ones that are not. So it is often in the interest of politicians to increase the inflation rate and against their interest to decrease it.

#### Government as a Beneficiary of Inflation

In my earlier discussion of inflation, I pointed out that it benefits debtors, or, more generally, people with net nominal liabilities, and injures creditors, or, more generally, people with net nominal assets. Governments, as a rule, have lots of nominal liabilities and few nominal assets; hence they are among the largest beneficiaries of inflation.

One very large nominal liability of the present government of the U.S. is the national debt. It owes its creditors--the owners of government bonds--a fixed number of dollars. If all prices double, the real value of what it owes falls in half. This is what has happened over the past several decades. The reason why the national debt, in real terms, was lower in 1980 than in 1945 despite the almost uninterrupted deficits of the intervening years is that much of the debt had been inflated away.

Of course, if the government keeps inflating, it will eventually find that in order to borrow money it must offer higher nominal interest rates to compensate lenders for what they expect to lose through inflation. At that point, if investors correctly anticipate future inflation, the government no longer gains by inflation. Like any other creditor, the government succeeds in getting below-market real interest rates only if inflation is unanticipated.

The government still has an incentive to continue inflating, even in this situation. If it does not, inflation will be below what lenders anticipated, and it will find itself paying a higher real interest rate than either the government or its creditors expected; it will be, in effect, compensating lenders for inflation that is not occurring.

A second large liability of the government is its obligation to make future payments: social security, veterans' benefits, and the like. This is only in part a nominal liability. To the extent that cost-of-living adjustments are built into such obligations, what the government owes is a real, rather than a nominal, quantity, an amount of purchasing power rather than a number of dollars.

Inflation as a Source of Revenue. Inflation not only reduces the real value of the liabilities of the governments of the U.S. and similar countries but may also increase their real income. Under a graduated tax system, the higher your nominal income, the higher the percentage of that income that you must pay as taxes. If all prices and all incomes double, your real income before taxes is the same as before, but your tax rate is higher; so the real value of the taxes the government collects from you is higher. This phenomenon, known as bracket creep (inflation makes your income creep into higher brackets), means that inflation produces an automatic tax increase. Politicians, as a general rule, like to be able to spend more money but do not like to be associated with raising taxes, since expenditures are popular with voters and taxes are not. Inflation provides the (political) benefit without the (political) cost.

At present, this particular device for invisible tax increases no longer exists in the U.S. Changes in the tax law passed in 1981 and coming into effect in 1985 provided for indexing: the automatic adjustment of tax brackets to allow for inflation. Whether that reform will remain in effect or be eventually reversed by congressional action remains to be seen.

Bracket creep is not the only way in which government revenue is increased by inflation. When the money supply is increased by the printing of additional currency, someone gets the new money. If the government prints the new money, the government gets it. Printing money is a way in which a government can generate revenue without any visible tax.

Deficit Spending and Inflation. It is often claimed that deficit spending is a major cause of inflation. The usual arguments for this conclusion are wrong; if the government spends more than it takes in and borrows the difference, the effect is to increase the supply of government bonds, not the supply of money. Of course a government could, and some governments do, finance a deficit by printing money instead of borrowing it, but in that case it is the money creation, not the deficit, that produces the inflation.

There is a different sense, however, in which deficit spending may well be linked to inflation. Deficit spending increases the national debt. The larger the national debt, the larger the benefit the government receives from inflation. So although deficit spending does not cause inflation, it does increase the benefit of inflation to the politicians currently in power and so increases the probability that they will follow inflationary policies.

How to Fool All of the People Some of the Time. In discussing the relation between inflation and unemployment, I showed how an unanticipated increase in the inflation rate results, in the short term, in an increase in profits and a decrease in the unemployment rate. The increased profits are paid for by a decrease in real wages--but at the beginning of the inflation, that is not yet obvious to the workers. The decrease in unemployment represents a net loss, not a net gain, to the newly employed workers, since they are accepting jobs that they would have rejected if they had understood the real as well as the nominal terms of what they were being offered. But since they do not yet know that, they believe they are better off. Employers are happy about their high profits, workers are happy about their low unemployment rate; everyone is (apparently) better off. If it happens to be an election year, the incumbent president is reelected by a landslide.

After a while, people adjust. Unemployment goes back up; profits go back down. Prices rise steadily. The incumbent administration blames the inflation on the unreasonable wage demands of the unions (when giving speeches to the Chamber of Commerce) or the attempt of corporations to extort "obscene profits" from consumers (when giving speeches to the AFL-CIO). After a while, another election comes around. The government buys new printing presses and increases the rate of expansion of the money supply from 10 percent to 20. Profits rise. Unemployment falls. The incumbent administration's ticket is reelected in a landslide. Prices are now rising at 20 percent per year. The administration blames the inflation on OPEC.

While this strategy may work for a while, it has some long-run problems. The effects of inflation on profits and unemployment depend on its being unanticipated. The more experience people have with high and rising inflation rates, the harder they are to fool, hence the greater the increase necessary to produce the effect. High and unpredictable inflation rates produce undesirable and politically unpopular effects. At some point, the administration--or its opponents--may conclude that it is politically desirable to stop increasing the inflation rate, and perhaps even to decrease it.

Doing so can be and generally is politically costly. If people expect the inflation rate to remain at 20 percent per year and the money supply expands at a rate of only 10 percent, actual inflation will be lower than anticipated inflation. If people expect the inflation rate to continue to rise, from 20 percent to 30 percent, then even keeping the rate at 20 percent will make actual inflation lower than anticipated inflation. In either case, the result is the opposite of what happened earlier when actual inflation was higher than anticipated inflation. Profits fall; unemployment rises. The fall of profits is associated with a rise in real wages, but since workers are not yet aware of the change in the inflation rate, they do not know they are better off. The politicians who cut the inflation rate lose the next election.

This suggests the possibility of a political business cycle. The administration starts inflating a few months before election day, thus getting itself elected, and stops after the votes are all cast, thus re-establishing expectations of stable prices--to be taken advantage of with another inflation just before the next election. If the president controlled the process, we would get a four-year business cycle; if the congress controlled it, a two-year cycle.

While this provides an elegant explanation for variations in inflation and unemployment rates, it does not appear to be a correct one; statistical studies so far have not found any clear relation between the pattern of elections and the business cycle. What does seem clear is that actions taken by the government have substantial effects on the inflation and unemployment rates and that those rates, in turn, affect how people vote. The resulting connection between policy and votes provides an incentive influencing the policies that incumbent politicians follow, and one that may explain much of what they do.

#### Two Warnings

Before ending the chapter, I should warn you of two things. The first is that, in my experience, economics students have a tendency to confuse the inflation rate and the interest rate. The best way to avoid doing so is to analyze everything in real rather than nominal terms, thus eliminating money and the price of money from the analysis, That is what I did in Chapter 11, where I first introduced interest rates. One can then go from results in real terms to results in nominal terms by converting all prices and flows of money from "constant dollars" (purchasing power) to "current dollars" and all interest rates from "real interest rates" to "nominal interest rates."

The second warning is that this chapter is a short and sketchy explanation of a difficult and complicated set of ideas and relationships. I believe the sketch is in essence an accurate one, although some competent economists might disagree, but it is in any case only a sketch. If you want a clearer understanding of the causes and nature of inflation and unemployment, and the relation between both and government policy, you should take a course or read a book on what used to be called monetary theory and is now more often described as "macroeconomics." The purpose of this chapter is not to replace such a book but to show you that the study of macroeconomics can and should be based on price theory--usually called, with more symmetry than sense, "microeconomics." This is, in two senses, a micro macro chapter.

#### PRICE INDICES

Relative prices continually change as a result of shifts in demand and supply curves; so during an inflation, money prices increase at different rates for different goods. There may even be goods whose money price falls while most prices are rising--computers and calculators in the 1970s, for example.

So far, I have said nothing about how we define the inflation rate when the money prices of different goods are going up at different rates. The obvious solution is to use a price index, an average of the prices of many different goods. In calculating such an average, we need some way of deciding how much weight each good should have. It does not make much sense to say that if the prices of pins and thumbtacks have gone down 10 percent and the prices of food and housing have gone up 10 percent, "on average" prices have stayed the same.

One obvious solution to this problem, and one that is often used, is to define the general level of prices as a weighted average, using the quantity of each item consumed in a year as the weight. Such a price index measures the money cost of buying the entire bundle of goods and services consumed in a year. It is usually expressed relative to some base year. Suppose the base year is 1980. If the price index for 1981 is 1.10, that means that the entire bundle of goods and services consumed in a year cost 10 percent more in 1981 than in 1980.

This raises a further problem--which year's consumption do we use for our weights? Do we compare what the consumption of 1980 would have cost at the prices of 1981 to what it did cost at the prices of 1980, or do we compare what the consumption of 1981 cost at the prices of 1981 to what it would have cost at the prices of 1980? Since the relative amount of different goods consumed will be different in different years, the two methods of computing the price index can be expected to give at least slightly different results.

In actually calculating price indices, both methods have been used. The Laspeyres index is calculated using quantities in the first year, the Paasche index using quantities in the second year. If we define the true percentage increase in prices between Year 1 and Year 2 as that percentage increase in his income that would make the consumer exactly as well off in Year 2 as he was in year 1, it is possible to show that the Laspeyres index overstates the increase in prices and the Paasche understates it. If the Laspeyres index goes up 10 percent from Year 1 to Year 2, then a consumer whose income also went up 10 percent would be better off in Year 2 than in Year 1--he would be able to buy a bundle of goods that he preferred to what he bought in Year 1. If the Paasche index went up 10 percent, a consumer whose income went up 10 percent would be worse off in the second year. Proving these results will be left as an exercise for the reader, in the form of Problems 11 and 12.

PROBLEMS

1. Throughout this chapter, I have used "inflation" to mean "an increasing level of prices." Some economists prefer to use "inflation" to mean "an increase in the supply of money." Usually a situation is either an inflation in both senses or in neither. Describe some possible exceptions--situations where the money supply is going up and prices are not, or prices are going up and the money supply is not.

2. In discussing the benefits government receives from inflation, I said that by printing money, the government can collect revenue without any visible tax. Precisely what is the invisible tax associated with money creation? Who pays it? (Hint: Consider a situation in which inflation is fully anticipated, so that many of its effects disappear. Find an unavoidable cost borne by someone as a result of inflation which is not balanced by a benefit to anyone else, except the government that is printing the money. This is a hard problem.)

3. In discussing the relation between the money supply and inflation, I said that a large increase in the general price level almost never occurs without a large increase in the money supply. Consider a city under siege. When the siege has lasted long enough so that people start getting hungry, the price of a loaf of bread may be 100 times what it was before the siege. Explain what is happening in terms of the explanation of the relation between money and the price level that was given in the chapter. (Note: You may not use the example given in this question to answer Problem 1.)

4. The only cost of holding money which I have discussed is interest lost by holding money instead of lending it out. Another cost is the possibility that if you have money in your wallet, someone may steal it. Suppose the rate of such crimes increases drastically. What will the effect be on the price level, according to the analysis of this chapter? According to the analysis of Chapter 19? Do the two effects work in the same or opposite directions? Explain. (This is a hard problem.)

5. Suppose the inflation rate is 12 percent and the nominal interest rate is 10 percent. Are real interest rates high or low? Assuming that you expect the inflation to continue, is this a good or bad time to borrow money and buy a house? Discuss.

6. Under current tax law, interest payments are deductible and interest income is taxable. How does this affect the relation between real and nominal interest rates--assuming that real rates are defined after tax rather than before tax? How does it affect your answer to Problem 5?

7. In discussing the effects of an unexpected increase in the inflation rate, I claimed that the resulting decrease in the unemployment rate was a cost not a benefit, since workers were being fooled into inefficiently short searches. Does this imply that the increased unemployment due to an unexpected decrease in the inflation rate is a benefit? Discuss.

8. If, as I argue, minimum wage laws result in unemployment for unskilled workers, who, if anyone, benefits from such laws? You may want to use the ideas of Chapter 13 in answering this. (This is a hard problem.)

9. How might you test the correctness of your answer to Problem 8? You may wish to use ideas from Chapter 18. (This is a hard problem.)

10. Laws setting maximum nominal interest rates are called usury laws . What effect would you expect such laws to have? What relation would you anticipate between inflation and difficulties associated with usury laws?

The following problems refer to the optional section:

11. Assume that all consumers are identical. Consider a single consumer in Year 1 and Year 2. In Year 1, he has income I. He consumes only two goods: quantity x of good X and quantity y of good Y. The prices of X and Y are different in the two years.

a. Use an indifference curve diagram to show that the Laspeyres price index for Year 2 based on Year 1 is greater than the percentage increase in income necessary to make the consumer as well off in Year 2 as he was in Year 1.

b. Use an indifference curve diagram to show that the Paasche price index for Year 2 based on Year 1 is less than the percentage increase in income necessary to make the customer as well off in Year 2 as he was in Year

(Hint: The answers to this problem and Problem 12 are closely related to the explanation of the housing paradox in Chapter 3.)

12. Redo Problem 11 for a consumer consuming many goods, using a verbal analysis rather than an indifference curve diagram.

13. You see the following two advertisements on the same day in the same city:

--"Mrs. Jones went into her local A&P store to do her weekly shopping. After she finished, she duplicated her purchases at the Kroger's down the block. It cost 5 percent more at Kroger's than at A&P. Shop A&P; the P stands for better prices."

--"Mrs. Smith did her weekly shopping at Kroger's then went over to the A&P and bought exactly the same things. It cost her 6 percent less at Kroger's. For better prices, shop Kroger's." Assume that the advertisements are both accurate and both involved the same pair of stores.

a. Explain how the results of the two "experiments" could turn out as reported.

b. Explain why, if prices on average are really about the same in both stores, you would expect the results to turn out as reported.

c. Explain the connection between this problem, Problem 12, and the housing paradox of Chapter 3.