Reappraisal of the Phillips Curve and Direct Effects of Money Supply on Inflation

Abstract

This chapter attempts to provide some evidence on two closely related issues. The first is the question of how well or how badly a typical nonmonetarist econometric structure can account for the dynamic pattern of wages and prices in the United States from the 1960s to the 1980s. The second is whether an econometric structure such as this can be successful in fully capturing the effects of the quantity of money on movements of the price level. The second issue is in turn closely related to the question of whether a significant increase in the money supply, regardless of other conditions such as the level of the unemployment rate, is inflationary.

In discussions of macroeconomic theory and policy since the mid-1970s, it is often taken for granted that conventional macroeconometric models have failed in some fundamental way to account for the actual development of the U.S. economy and that the prime culprit in this failure is the Phillips curve (Lucas and Sargent, 1978, 1981). For those who have followed the performance of the modified Phillips curve and associated equations through the 1970s and most of the 1980s, the widespread perception of the complete failure of these equations to "explain" movements of prices and wages during this period has been a complete puzzle, since these equations have been more stable and more reliable over time than most other empirical macroeconomic relationships during the period in question, at least in the United States.

In this chapter we first attempt to exhibit the stability of these empirical relationships and their ability to predict movements of prices and wages during the period in question. For this purpose we will utilize the set of equations embedded in the current structure of the MPS econometric model of the United States, and we also refer to its early predecessors (Brayton and Mauskopf, 1985; deMenil and Enzler, 1971). However, most of our results do not depend on the performance of the rest of the MPS model.

We also present evidence that this set of equations can account for most of the effects of money supply movements on the general price level. The most judicious interpretation of the evidence is that there remains a small direct effect of the money supply on the price level not captured by the MPS equations. The pattern of evidence, however, is rather mixed, and we have not been able to come up with any indication suggesting a specific mechanism generating this direct effect of the money supply. This issue appears to be very important in affecting our understanding of the dynamic characteristics of the whole economy, as discussed briefly at the end of this chapter.