What if Paul Volcker didn't fight inflation?

Warren Raftshol — Tue, 14 Jun 2011 05:37:32 GMT

What if Paul Volcker hadn't tried to squeeze inflation out of the economy by pushing the Fed Funds rate to 20% in the period 1979-83?

How did this effort change history?

The driving force in this simulation is the price level p. It is assumed that inflation starting in 1940 is a constant 4% per year except in the interval 1979-83 where it is assumed that inflation was 0%.

The Volcker period induced considerable volatility in the wage share and %employment curves. A number of significant events caused by or associated with this volatility are indicated above, That this volatility was caused by Volcker's inflation fighting efforts can be seen by comparing with the curve below. The only difference in inputs was the omission of the 0% inflation interval.

Government data for the wage share is shown below. In the Goodwin model, all cost factors are subsumed into the wage share so there is some difference with the government data for which "labour share" is strictly wages. The timing of the bulges matches up fairly well, though the simulation seems to exaggerate the 1992 peak shown in the government data.

Here is a comparison of unemployment between recorded data and the simulation. Again, the timing lines up but the nineties unemployment only reached 8%.

Unemployment 1940-79 averages 5% with little variability, It seems that 5% unemployment is just enough to avoid the Phillips Curve jumps in wages that come with labor shortage. Economists like Milton Friedman have even made a science out of it under the heading of NAIRU. NAIRU is an acronym for Non-Accelerating InflationRate of Unemployment.

Motivation for NAIRU is based on a misconception of why prices rise, shared by Monetarists as well as Keynesians that price rises are wage driven. This is to be contrasted with the Austrian and other classical views that rises in the price level are caused by an overabundance of money caused by too-easy credit.

A further point worth noting is that the 'strength' of a currency relies on the wage share component. The rebound in wage share during the nineties is what caused the dollar to be referred to as strong during this period.

Surely the death of the dollar is the same as the death of the wage share.

Conclusion

The simulation fits the data rather well based on the simplified historical average inflation rate. Volcker's inflation fighting effort caused great volatility in the wage share which led to well known events in recent history.

Economics Questions

What if Paul Volcker didn't fight inflation?