What economists have learned from the post-pandemic business cycle

Sure enough, the recovery from the coronavirus pandemic has given economists a new opportunity to learn from their mistakes. A paper presented at a recent conference of the American Economic Association (AEA) provides clues about a theory that may eventually become the next generation of conventional wisdom.

One such paper takes a closer look at the Phillips curve, which explains the theoretical trade-off between unemployment and inflation. The logic is that when unemployment is low, inflation should be high because competition for workers puts upward pressure on wages. As a result, consumer prices rise. But in the 2010s, this curve seemed to disappear. Unemployment continued to decline, but inflation remained low. And after the pandemic, this relationship suddenly seemed to be active again. Inflation rose just as rapidly as unemployment fell.

At the AEA conference, Gauti Eggertson of Brown University suggested that adding a kink to the (previously smooth) Phillips curve might save the concept. The idea is that at some point, when the last available worker is hired, the relationship between inflation and unemployment suddenly becomes nonlinear. “If we hire everyone, we'll reach a ceiling on employment…there's only one way forward,” he said at the conference, adding that beyond that point, inflation can no longer rise steadily as unemployment declines. Rather, it will rise rapidly.

Mr. Eggertson's twist could explain both the absence of inflation in the 2010s and the sudden rise in inflation in 2021. To understand how inflation has fallen recently without rising unemployment, he suggests looking at how labor market tightness interacts with supply disruptions. Shortages of materials and parts are exacerbating labor shortages. Without additional workers, companies cannot increase production or use labor as a substitute for other inputs. Once the supply shortage eased, this process reversed. As a result, the impact of inflation due to a tight labor market has subsided without leading to a rise in the unemployment rate.

Another paper, published by Stephanie Schmidt Grohe of Columbia University, suggests that part of the confusion surrounding the Phillips curve is due to the Great Inflation looming too large in the minds of economists. is suggested. Friedman's research highlighted the role of inflation expectations in that episode. Workers and businesses no longer trust central bankers to fight against rising prices. After that, a vicious cycle occurred in which soaring inflation fueled expectations for future price increases, which became self-fulfilling.

But the experience of the 1970s was not typical, Ms. Schmidt-Grohe suggests. Going further back, he pointed to frequent instances of American inflation rising suddenly and then falling just as suddenly. One such episode occurred during the Spanish flu pandemic that began in 1918. Annual inflation that year soared to 17%. However, by 1921, deflation had set in and prices had fallen by 11%. The recent demise of inflation is not all that surprising when you consider data from not just the second half of the 20th century, but the entire 20th century. Ms. Schmidt-Grohe suggests that the shocks currently hitting the economy, such as climate change, conflict and pandemics, mean a return to the high volatility of earlier times.

Meanwhile, some companies are trying to improve models for the entire economy. These traditionally represent production that takes place in a single sector of hiring workers, renting capital, and producing output, and is hit by shocks to demand and supply. Ivan Warning of the Massachusetts Institute of Technology suggests instead looking at a range of different sectors, each affected by such shocks in its own way. The challenge for monetary policy is therefore to control inflation without inhibiting the necessary reallocation of labor between sectors.

Warning's model fits well in the post-pandemic economy. It has adapted not only to changes in demand from services to goods, but also to supply chain disruptions, energy shocks, and working from home for employees in some sectors. So inflation travels through the economy like a wave, starting with a few goods and then spreading out. That's not to say monetary and fiscal stimulus didn't also contribute to higher prices, Warning said. Rather, the realignment of the economy acted like a supply shock, raising inflation for a given level of aggregate demand.

new ideas for old books

Many of these ideas are not entirely new. For example, Eggertson said that his experiences over the past few years have drawn him back to “old Keynesian fairy tales” and that his version of the Phillips curve is similar to the original. Warning pointed to a speech by James Tobin. Similar to Warning, Tobin suggests that inflationary pressures can occur when sectors grow and contract at different rates, and when you combine that with the nonlinear Phillips curve, you can see that inflation is rising even when it is not. He claimed that it was possible to imagine that it would begin. Hot labor market.

There is nothing new about crises prompting searches of archives. To understand the Great Depression, Keynes turned to his 19th century economist Thomas Malthus. Friedman's views on the causes of the Great Inflation rely heavily on the quantity theory of money, first mentioned in ancient Chinese texts and popularized in Europe by the 16th century astronomer Nicholas Copernicus. Indeed, science may proceed one funeral at a time. But economics is having a resurgence.

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