New Evidence on the Output Cost of Fighting Inflation

By Filardo, Andrew J. | Economic Review - Federal Reserve Bank of Kansas City, Third Quarter 1998 | Go to article overview

New Evidence on the Output Cost of Fighting Inflation


Filardo, Andrew J., Economic Review - Federal Reserve Bank of Kansas City


The Federal Reserve has made significant progress toward price stability over the last two decades. The annual inflation rate has declined from 13 percent in the early 1980s to roughly 2 percent today. The current environment of low and stable inflation has fostered superior economic performance. Lower inflation has led to lower interest rates, which in turn have helped spur investment, foster more affordable housing, and, arguably, support the current solid expansion and strength of the stock market.

To be sure, the current low-inflation environment has come at a price. One key cost of achieving low inflation is the output loss that generally accompanies a permanent decline in inflation. Particularly stark examples of this output cost were seen in the early 1980s and early 1990s. In the early 1980s, disinflation was associated with one ofthe largest recessions ofthe postwar era. A recession, though somewhat milder, also accompanied the disinflation of the early 1990s. Another more subtle output cost of fighting inflation is the cost of preventing inflation from rising. As incipient inflation pressures build, tighter monetary policy can slow the economy and thereby preemptively forestall the rise in actual inflation. The slower output growth is the cost of resisting inflation pressures. Together, these two output costs of fighting inflation play important roles in determining how to seek further disinflation toward price stability and how best to maintain low inflation.1

A significant factor determining the output cost of fighting inflation is the tradeoff between inflation and output, often referred to as the Phillips curve. Traditionally, estimates of this relationship assume the shape of this curve is linear. This implies that the slope of the Phillips curve is constant and, therefore, independent of the stage of the business cycle, the speed of the disinflation, and how aggressively incipient inflation pressures are fought. Recent research, however, has begun to question whether the slope is constant. In other words, assessing the output cost of fighting inflation may be more complicated than traditionally assumed.

This article investigates the shape of the Phillips curve and the associated output cost of fighting inflation. The first section discusses how the output cost of inflation is linked to the shape of the Phillips curve and reviews the current debate about the shape. The second section offers new empirical evidence on the nonlinear shape of the Phillips curve and on the output cost of fighting inflation. The third section draws policy implications from the new evidence. The article concludes that, while the Phillips curve traditionally has been thought of as approximately linear, closer examination of the inflation-output relationship reveals important nonlinearities. This new evidence and its implications for the output cost of fighting inflation may require new policy strategies.

RECENT CHALLENGE TO THE TRADITIONAL VIEW OF THE OUTPUT COST OF FIGHTING INFLATION

Strategies for fighting inflation depend on careful consideration of all the costs and benefits of achieving and maintaining a low-inflation environment. The potential benefits of low inflation include faster economic growth, higher productivity, a more stable economic environment, and fewer tax distortions. The costs of achieving and maintaining low inflation include lost output, higher unemployment, and related social ills. This article focuses on the output cost of fighting inflation by examining how to accurately measure the output losses. Only with accurate measures can the net benefits of fighting inflation reliably be assessed.2

Traditionally, the output cost of fighting inflation has been summarized in a single number using the "sacrifice ratio" concept. The sacrifice ratio is a well-known economic concept that can distill complex economic phenomena into a fairly simple, yet informative, cost measure. …

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