Inflation (Finance) ; Monetary policy - United States

William G. Dewald

English

Research Papers in Economics

October 24,1981 
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How Fast Could Inflation Be-Eliminated? 
The inflation rate, measured by the GNP 
deflator, decelerated from a 10.7  -percent 
annual rate in the fourth quarter of 1980 to a 
6.6-percent rate in the second quarter of 
1981. How long would it take, with a 
non-inflationary monetary policy, to 
eliminate inflation altogether? Simulation 
results based on a small econometric model 
of  the U.S. economy the author has 
developed in recent years suggest that the 
task could be accomplished essentially 
within two years' time, and completely 
within four years' time. But the task could be 
complicated by shifts that take place in 
inflation expectations-and most probably 
would be accompanied by a recession. 
Episodes of slowing inflation 
Two major decelerations in inflation have 
occurred during the past 30 years. In the most 
recent case, the inflation rate dropped from 
1.1.3 percent to 10.2 percent between the 
fourth quarter of 1974 and the first quarter of 
1975, and then fell gradually to a low of 3.6 
percent in the first half of 1976 (see chart). 
The inflation rate thus fell by more than half in 
a year and a half, and might have fallen even 
further if fiscal and monetary policymakers 
had not adopted new stimulative measures in 
1977. Special circumstances, such as the 
Arab oil embargo and other supply factors, 
also temporarily affected the inflation rate 
during this episode. 
Tlie other major geceleration followed the 
12-percent Korean War inflation peak in the 
first quarter of 1951. After U.S. military forces 
became involved in that action, consumers 
bought everything in sight in anticipation of 
World War II-type shortages. But businesses 
soon restocked their depleted inventories, 
and the government increased taxes and 
imposed credit controls to hold demand 
growth to a non-inflationary rate. As a result, 
inflation was eliminated almost immediately. 
Historically, in several foreign countries, 
governments have brought hyperinflations to 
a screeching halt by instituting reforms that 
succeeded in strictly limiting government 
budget deficits and paper-money issuance. 
Inflationary expectations 
The speed of reducing inflation depends on 
the speed of adjustment of  inflation 
expectations. In 1975-76, high inflationary 
expectations were built into the system. The 
public was understandably dubious after 
years of observing anti-inflation rhetoric 
coupled with the actuality of accelerating 
inflation. Consequently the adjustment was 
slow and costly. In 1952, in contrast, inflation 
expectations weren't built in. People 
expected that wartime inflation would be 
followed by deflation as they had observed 
previously. Hence, once they had refilled 
their larders in 1952, they didn't  expect more 
inflation; and the price adjustment came to 
an end. The record is clear. If the public 
accepts anti-inflationary policies on faith, 
inflationary expectations and the inflation 
rate adjust rapidly. On the contrary, if a lot of 
Doubting Thomases have to see inflation fall 
to believe it, the adjustment is slow and costly 
in terms of unemployment and recession. 
Sustainable inflation 
To understand the role of expectations, we 
should consider the sustainable inflation 
rate-the rate that would be sustained if 
actual and expected inflation were the same. 
Actual inflation (P) by definition equals total 
GNP growth in dollar terms (Y)  le2.S real GNP 
growth (X). Sustainable inflation (P) by 
definition thus equals sp~ding  growth less 
sustainable real growth (X). 
We hypothesize that the public forms 
inflationary expectations on the basis of 
certain identifiable factors influencing 
spending growth and sustainable real growth. 
Since the latter is strictly limited by the 
availability of productive factors, inflation is 
largely a consequence of  too much spending. 
Though the annual real-growth rate fell a fu II Opinions expressed in this newsletter do not 
necessarilv refleel  the  vie\:v~~ (}f the rnanagemenl 
of the Federal Reserve Bank of San  francIsco, 
nr of the Board of Covernors of the Federal 
Reserve Svslern. 
percentage point in the 1970's, the inflation 
rate increased to 1  0 percent as a 
consequence of rising spending growth. 
Nevertheless changes in real growth have 
sometimes caused inflation. The Plague 
killed a third of the European population in 
the 14th Century and caused a decline in 
output and a substantial rise in prices. That 
case would not by typical, however. In the 
1970's, the observed one-percentage-point 
reduction in average real growth represented 
all the supply-side factors contributing to 
inflation: drought, pestilence, oil cartels, tax 
rates, environmental-protection regu lations, 
labor and business monopolies, labor-force 
composition, etc. 
Factors influencing spending growth 
In our model, monetary growth and trend 
spending growth together accounted for 6.9 
percentage points of the 7.2-percent average 
spending growth of the 1953-80 period. 
High-em  p I  oyment govern  ment spend i  ng had 
a significant impact, although it washed out 
ina I  ittle over a year, and exports had a small 
residual effect on total spending. Though 
only half the variation in spending growth 
could be explained statistically, monetary 
growth was the most important identifiable 
factor with a systematic effect on spending 
growth -and thus on inflation. 
Over the 1953-80 period, spending 
increased 7.2 percent annually which in itself 
would sustain a like rate of inflation. 
High-employment real growth increased 3.3 
percent annually, which would reduce 
inflation by a like amount. Together, spending 
and real growth thus explained nearly all of 
the 4.1-percent average inflation rate (see 
table). The small residual is accountable to 
two factors. (1) Rising import prices had 
important supply effects in 1974-75 and 
again in 1980, but on the average contributed 
only 0.1  percentage points to average 
inflation. (2) Demand pressure-the gap 
between the levels of total demand and 
supply-varied in both directions over the 
business cycle, but on the average also 
contributed only 0.1  percentage points 
to inflation. 
2 
In the framework of our table, sustainable 
inflation represents the inflation rate that 
would persist on the basis of the underlying 
inflation determinants other than the cyclical 
effects of demand pressure. And as the chart 
shows, inflationary pressure existed 
whenever sustainable inflation exceeded 
actual inflation. Persistent inflationary 
pressure was associated with accelerating 
actual·inflation (for example, 1961-66 and 
1971-75), whereas negative inflation 
pressure. was associated with decelerating 
inflation (for example, 1956-58 and 
1975-76). These effects were not always 
immediate. Despite negative inflationary 
pressure, inflation increased for a full year in 
1956-57 before turning down. Also, because 
of wage-price controls, inflationary pressure 
existed alongside stable or falling actual' 
inflation in 1971-72 -but  the inflation lid 
blew off when the controls expi red 
in 1973-74. 
Despite innumerable special factors-
wage-price controls, strikes, crop failures, oil 
embargoes, and the like-a systematic and 
significant relationship existed over the 
1953-80 period between monetary growth 
and spending growth, and in turn between 
spending growth and inflation. Our research 
illustrates that association, and shows the 
timing of adjustment of actual inflation to 
sustainable inflation. The estimated 
adjustment reflects the time required for the 
economy to ad just expectations and prices to 
the underlying factors systematically 
associated with inflation. 
What would happen now if  monetary growth 
were reduced enough to eliminate inflation 
permanently? According to the author's 
model it would be necessary to hold M 1  B 
growth at an annual rate of zero to 3 percent, 
.which is about the range of M1 B growth in 
recent months. The adjustment would not be 
instantaneous, requiring four years 
altogether. But the inflation rate could be 
reduced by more than half in one year, and by 
nearly four-fifths in two years. In other words, 
the inflation rate would be 2 percent or less 
~fter two years' time-in contrast to the 7.3-percent figure forecast by the 
Administration for 1982. 
In our analysis, we have simply evaluated 
how soon inflation could be eliminated if  the 
authorities set monetary growth at a 
noninflationary rate and left it there. We 
found that, with the same response as in the 
past, inflation could be cut in half in one year 
and eradicated in four years. However, the 
cost could be a recession of about a year's 
duration-similar to those experienced by 
the U.S. economy in earlier periods of 
decelerating inflation. Thatthe U.s. economy 
has survived the anti-inflationary 
decompression chamber before is somewhat 
reassuring. That it might again require a 
disquieting case. of the recession bends is 
not a cheerful prospect-but then, neither 
is inflation. 
William G. Dewald 
Underlying Causes of Inflation 
(1953-1980) 
Average  Estimated  Contribution 
Weight  to Average 
Inflation 
(Percent)  (Percent) 
Trend Spending Growth  1  2.426  2.4 
M 1-B Monetary Growth  4.3  1.039  4.5 
High Employment Government Spending Growth  7.69  -0.003  0.0 
Growth  10.56  0.024  0.3 
Spending Growth  7.24  1.000  7.2 
High Employment Output Growth  3.33  -1.000  -3.3 
Price Inflation  4.74  0.027  .1 
High Employment Output Growth Adjusted for Import 
Price deflation  -3.2 
Demand Pressure (Level)*  1.59  0.034  .1 
Inflation  4.1 
* Demand pressure is defined as the difference between the level of estimated real demand and 
high employment  output, both in logarithms. The level and growth rate of  high employment output 
were adjusted to incorporate effects of factors estimated to offset inflation autonomously such as 
import prices. About four-fifths of the variation in inflation was accountable to these underlying 
factors. 
Inflation  pressure  .... 
2 
o 
1955  1960  1965  1970  1975 
3 RANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
Large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total# 
Commercial and .industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total# 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total # 
Individuals, part. & corp. 
(Large negotiable CD's) 
Amount 
Outstanding 
10/7/81 
153,707 
132,725 
40,275 
54,655 
23,136 
1,787 
5,682 
15,300 
42,028 
29,194 
29,774 
86,201 
78,287 
34,204 
Change 
from 
9/30/81 
413 
330 
44 
80 
- 75 
255 
9 
74 
- 349 
564 
248 
1,001 
995 
346 
-
-
-
-
-
Weekly Averages  Weekended  Weekended 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (+ )/Deficiency (  - ) 
Borrowings 
Net free reserves (  + )/Net borrowed( -) 
* Excludes trading account securities. 
#  Includes items not shown separately. 
10/7/81  9/30/81 
85  222 
3  99 
82  123 
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~  \ill~m~J1w:<dI~cm ~;;]J1W:~~~CQI 
C::hangefrom 
year ago 
Dollar  Percent 
11,648  8.2 
12,640  10.5 
5,273  15.1 
6,007  12.3 
830  3.5 
802  81.4 
824  - 12.7 
1.64  - 1.1 
4,370  9.4 
5,045  14.7 
232  - 0.8 
21,107  32.4 
21,844  38.7 
9,734  39.8 
Comparable 
year-ago period 
90 
38 
52 
Editorial comments may be addressed to the editor (William Burke) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Infonnation Section; 
Federal Reserve Bank of San FrancisCo, P.O. Box 7702, San Francisco94.120. Phone (415) 544-2184. 

How fast could inflation be eliminated?

http://www.frbsf.org/publications/economics/letter/1981/el81-43.pdf

How fast could inflation be eliminated?

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