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feel politically able to adopt, no conclusion follows in favor of increasing

monetary growth again, since doing so would make the stagflation dilemma
worse later on as distortions worsened (see pages 2367 below).
Reference to the withdrawal pangs of trying to end inflation raises the
question of how the impact of restraint on money and spending is split between
prices and real activity. The greater and quicker the impact on the price uptrend,
the less real activity suffers. It is a familiar but inexact remark that slow real
economic growth or actual recession restrains inflation (and, conversely, that
rapid real growth causes inflation). The reverse accords better with the equation
of exchange, as illustrated below. Underlying the remark, presumably, is the
idea that slowed real growth is one consequence and indicator of a slowdown
in the growth of nominal income and the money supply. If this is what it means,
however, the standard formulation is misleading. Imagine trying to gauge the
disinflationary intensity of monetary policy by an unwanted side effect of that
policy, namely, a real slowdown, especially since the equation of exchange
indicates that the side effect competes with the desired price deceleration.
One version of the expectations-augmented Phillips curve implies the
causality mentioned in the inexact remarks above. The following priceadjustment equation depicts that version and is taken from page 211 above:
(1) p = pe + f (output gap), where p is the actual rate of inflation, pe is the
anticipated (expected) rate of inflation, the output gap is actual output minus
potential output, and f' is greater than zero. According to this equation, for a
given anticipated rate of inflation and a given level of potentional output, the
change in the actual rate of inflation is directly related to the change in actual
output. Specifically, greater actual output (higher real economic growth) causes
a greater actual rate of inflation. Conversely, lower actual output (or recession)
causes a lower actual rate of inflation. These invalid propositions repeat the
inexact remarks mentioned above.
To see why equation (1) is invalid, we again appeal to the equation of
exchange, now written as:
(2) % change in M + % change in V = % change in P + % change in Q. The
change in the sum of the components on the left side of the equation must equal
the change in the sum of the components on the right side. That is, a change in
the growth rate of nominal income (MV) is split between a change in the actual
rate of inflation and a change in the growth rate of output. More specifically,
the latter two changes are inversely related for a given change in the growth
rate of nominal income . For example, given an expansionary monetary policy
that raises the growth rate of nominal income, the larger is the increase in the
growth rate of output, the smaller will be the acceleration in the actual rate of
inflation. Conversely, given that a disinflationary monetary policy has reduced
the growth rate of nominal income, the larger is the decrease in the growth rate
of output, the smaller will be the deceleration in the actual rate of inflation. As

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a proposition about reality, equation (1) contradicts these results and therefore
must be wrong. Moreover, our analysis is consistent with the high output growth
and low inflation in the United States during the 1990s.

THE NEW KEYNESIAN PHILLIPS CURVE

On pages 1379 above we present the consensus model of monetary policy,
which consists of three equations. The second, a price-adjustment equation, is
often referred to as the new Keynesian Phillips curve . We write it as:
(3) p = pe + f (output gap), where pe is inflation expected to prevail in the
future. The rest of the equation is already familiar. The different priceadjustment equations that have appeared in this model derive from Calvo
(1983), Rotemberg (1982), and Taylor (1980).
Mankiw (2001b) interprets the new Keynesian Phillips curve as a causal
relation that contradicts the facts for three reasons. First, contrary to reality, a
credible disinflation in this model causes booms as shown by Ball (1994).
Second, Fuhrer and Moore (1995) illustrate that the model cannot account for
the persistence of inflation. Given a change in the money growth rate, the effect
on inflation is immediate. Third, Mankiw (2001b) examines impulse response
functions, which are the dynamic paths of inflation and unemployment in
response to monetary policy shocks. He concludes that model simulations
cannot produce the delayed and gradual effect that in reality a monetary shock
has on inflation.
Most versions of the consensus model ignore the important analogy between
the inertia of an established price level and the inertia of a price uptrend. This
analogy helps illuminate the adjustment process. McCallum (2002, p. 90) notes
the professions poor level of understanding of the precise nature of...price
adjustment relations. However, insistence on quantitative precision overlooks
the fact that changes in the money growth rate are followed by long and
variable lags in changes in the rates of inflation and output growth, and for
very good reasons illuminated by monetary-disequilibrium theory. (Compare
pages 12930 above which address the alleged lack of detail in the monetarist
explanation of the monetary transmission process.) The following section
elaborates on the reasons for the persistence of inflation.

INFLATIONARY MOMENTUM
Price and wage momentum has two main aspects, catching up and expectations (compare Humphrey, 1979b). Both involve complex interrelations and

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time lags. Prices and wages and other costs are determined in piecemeal and
decentralized ways. Some firms selling prices are other firms costs. Only
during hyperinflations do various prices and wage rates rise nearly in step with
each other, month by month and week by week. Only the prices of securities
and standardized commodities traded on organized exchanges respond to supply
and demand from hour to hour and minute to minute. Most individual prices and
wages are adjusted only from time to time. As a result, the structure of relative
prices is constantly undergoing distortions and corrections. At any time, many
prices and wages are temporarily lagging behind others in the inflationary
procession. They still have catching up to do after monetary expansion is
checked. Somehow keeping them from catching up would leave them stuck
away from market-clearing levels, and the distorted structure of relative prices
and costs would interfere with some transactions and so with production and
employment. In abstract theory, these distortions could be corrected by declines
in some prices and wages that averaged out further increases in others. Actually,
the difficulties that impede a mere leveling off of upward trends impede all the
more any cuts of particular prices and wages. Catching up does obstruct any
instant end to inflation.
For these and other reasons, a change in monetary policy and in the flow of
spending on final goods and services has its impact spread over many months.
If monetary policy were to be tightened and an inflationary expansion of demand
checked, much of the adjustment of prices to the earlier demand inflation would
remain to be completed.
Extreme inflation has a possible silver lining. As inflation persists and
becomes faster and more fully expected, people shorten the intervals between
price and wage adjustments. Transmission of higher wages and other costs into
higher prices and of higher prices into higher wages occurs more rapidly (Okun,
1979, p. 2). This shortening of lags means that disinflation policy has less of a
problem of prolonged catching up to contend with. In this respect it may be
easier to stop an extreme inflation than a merely moderate one. (Yeager and
associates, 1981 provide some examples.)
Expectations are the second aspect of inflationary momentum, overlapping
with the catch-up aspect, while the interaction of various costs and prices enters
into both. When prices and wages have been rising conspicuously for several
years, people recognize what is happening, expect it to continue, and make
their own pricing decisions and wage demands accordingly. They do so,
anyway, unless some clear-cut change in circumstances provides a reason for
doing otherwise. With particular adjustments being made not every day but
only from time to time, people take account of the erosion of the purchasing
power of the prices or wages that they receive. In adjusting their own prices or
wage demands, they not only allow for any erosion already experienced since
their last adjustment, but also allow for further erosion expected to come in the

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months ahead. Strong anticipations of inflation can reduce the direct influence
of demand on prices (and also of prices on quantities demanded). Cost increases
are more readily and fully passed along despite weakness in demand if that
weakness is viewed as temporary and prices are expected to continue in an
uptrend. Costs and prices push each other up with less friction (Cagan, 1972,
p. 143). As buyers become accustomed to repeatedly paying increased prices
and find it increasingly difficult to keep abreast of and compare the prices asked
by rival sellers, they become less sensitive to price competition. Sellers become
accustomed to passing actual and even expected cost increases on to their
customers without meeting too much buyer resistance.
Even a seller of some product or type of labor for which demand is currently
deficient a businessperson dissatisfied with his sales or a union leader dissatisfied with his members employment may well forgo cutting or may even
increase his money price anyway. He can reduce his real or relative price in
order to attract buyers simply by keeping its nominal increase smaller than the
general inflation rate. When prices and wages are generally rising, to join in
the procession is not necessarily to push for an increased price in real terms
but simply to avoid an unnecessarily large markdown. Why take less than the
market will bear? Why sacrifice to the advantage of others? Even if a seller
should experience some drop or lag in sales attributable to an excessive nominal
price increase, he could expect the continuing general inflation of costs and
prices to make his price soon competitive and acceptable after all. Why reverse
a slightly premature price increase that customers will soon be willing to pay?
Momentum has its policy aspects. Irresoluteness is one of them. Authorities
have often feared the side effects of discontinuing their accommodation of an
entrenched uptrend. (The old analogy between inflation and an addictive drug
is instructive.) Another policy aspect hinges on the fact that some people do
succeed in adjusting to inflation and would suffer if their adjustments were
rendered no longer appropriate. A vivid example concerns young couples who
buy more expensive houses than would otherwise be prudent, incurring almost
crushing burdens of mortgage payments in relation to income. They do so
because they expect their incomes to rise with inflation, shrinking the payments
relatively. An end to inflation would penalize such people in a double-barreled
way. First, mortgage payments would remain a crushing burden unless they
sold their houses. Second, prices would probably drop because the exceptional
demand for real estate as inflation hedges would have vanished. More generally,
taking inflation and the inflation premium out of interest rates would alter
property values, benefiting some persons and firms and victimizing others
(Warburton, 1974, p. 15). Still more generally, certain activities flourish more
in an inflationary than in a stable environment. Their shriveling would hurt
people who had devoted their money and careers to them. Inflation continuing
and becoming deeply ingrained puts more and more people into such a position.

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Political pressures from them, even if only unorganized pressures, work to keep
inflation going.

CREDIBILITY
The expectational aspect of inflationary momentum makes the credibility of a
disinflation policy crucial to how severe the withdrawal pangs will be.11 If a
program of monetary restraint is not credible if price-setters and wage-negotiators think that the authority will lose their nerve and switch gears at the first
sign of recessionary side effects then people will expect the inflation to
continue and will make their price and wage decisions accordingly. The
unintended consequence will be an unfavorable split between the price and
quantity responses to monetary restraint. If, on the contrary, people are
convinced that the authority will stick to its disinflationary course no matter
how bad the side effects, so that the price and wage inflation is bound to abate,
then everyone should realize that if they nevertheless persist in price or wage
increases at the same old pace, they will find themselves ahead of the stalled
inflationary procession and will lose customers or jobs. People will moderate
their price and wage demands, making the split more favorable to continued
production and employment. It is only superficially paradoxical, then, that in
two alternative situations with objectively the same degree of monetary restraint,
the recessionary side effects will be milder when the authority is believed ready
to tolerate them than when the authority is suspected of irresoluteness.
While a resolute and credible disinflation program could thus conceivably
turn expectations around almost at once, the catch-up aspect of inflationary
momentum appears less tractable. Still, if the turnaround in inflationary expectations were quick and complete enough, relative prices could conceivably be
restored to an approximate equilibrium pattern through declines in previously
leading prices that averaged out catch-up increases in previously lagging
prices. As mentioned above, this is just an extreme benchmark case and not
a practical possibility.
The game-theoretic literature on time inconsistency of policy and
reputation attempts to explain the importance of a credible monetary policy.
Kydland and Prescott (1977) and Barro and Gordon (1983) are the seminal
articles in this literature. When the monetary authority is free to conduct discretionary policy, an incentive supposedly exists for it to announce a
conservative (noninflationary) policy and then renege in order to exploit the
Phillips curve tradeoff and thus lower unemployment. If people believe the
authoritys announcement, then the ensuing inflation will be a surprise and will
increase output. However, people with rational expectations will understand the
authoritys incentive to cheat and will therefore expect it to do so. Consequently,