Accelaration theory?

Question

Explain what is accelaration theory of inflation.How does it works?

Answer 1

"A lasting favorable effect on employment might be produced if the State undertook - and succeeded in its undertaking - not merely to make the real demand for labour higher than it would otherwise have been, but to make it progressively higher. The expenditure on public works, the rate of bounty paid to private enterprises, the rates of duties in the protective tariff, or whatever it may be, would have to be raised again and again. If these devices succeeded in expanding progressively the real demand for labor, the time lag that intervenes between the stimulus to and the enforcement of claims to higher wages would enable them to make employment permanently larger than it would otherwise have been."

The reaction to Friedman 's natural rate hypothesis was manifold. Some commentators (e.g. F.H. Hahn, 1971; J. Tobin, 1972), deplored the conception of NAIRU, arguing that it was merely hypothesized that it existed and had no good "microeconomic" foundations. This criticism was soon met by the various "search" theories of unemployment developed in a volume edited by Edmund S. Phelps (1970) (esp. Phelps's introduction and the contributions of Dale T. Mortensen, 1970) and in later work of Robert E. Lucas and Edward C. Prescott (1974) and many others since.

The effort of search theory was to explain not only U* but also the kind of expectations NAIRU theory needs. The basic idea is that at any one time, there is a group of workers who believe that they are able to get a better job elsewhere but before they can get it, they must engage in "job searching". Since gathering information to find the ideal job is a time-consuming endeavor, they "quit" working to make their full-time search. In principle, they are not earning a wage during this time (but may receive unemployment benefits, or take out loans, etc. to keep on living). Thus, they are in a sense, "voluntarily" unemployed - albeit temporarily. At any single point in time, there will always be a given amount of such workers switching jobs - frictional unemployment - that is supposed to form the bulk of U*. Certain things, such as time preference, expectations, the amount of unemployment benefits, access to loans, etc. all affect the decision to search and thus will affect the precise value of U*.

In his presidential address, Milton Friedman  (1968) predicted the empirical break-up of the Phillips Curve and challenged economists to prove that his assertion that b = 1 was wrong. In his presidential address to the American Economic Association, James Tobin (1972) attacked both search theoretic explanations as incomplete and provided a theory of unemployment which retained some amount of "aggregate money illusion" due to sectoral differences. This enabled him to maintain a downward-sloping long run Phillips Curve (i.e. with b < 1) which was policy effective

A series of studies were consequently conducted to prove which of the hypotheses - Friedman's b = 1 or Tobin's b < 1 - was correct. Early studies by George L. Perry (1966, 1970), Robert M. Solow (1968), Robert J. Gordon (1970, 1971) and S.J. Turnovsky and M.L. Wachter (1972) yielded estimates for b which were significantly less than 1. But these results soon began to falter. R.J. Gordon (1972), S.J. Turnovsky (1972), J.M. Parkin (1975) and M.L. Wachter (1976), confirmed that, indeed, they could not reject the hypothesis that b = 1.

At any rate, the very notion of policy-exploitable macromodels were exploded soon after by the famous critiques of Robert E. Lucas (1972, 1976) and Thomas J. Sargent (1971), which relied on the notion of rational expectations. Specifically, they demonstrated that even if b < 1, there is still no exploitable long-run unemployment-inflation trade-off. In other words, if agents have rational expectations, then an anticipated government attempt to exploit that trade-off would lead to a response by agents and thus an adjustment in the parameters of the Phillips Curve that would foil the government's efforts. In short, even if the trade-off existed, it would immediately disappear the moment the government tried to exploit it.

At any rate, the debate soon took a surprising twist with the stricter natural rate hypothesis of the New Classicals, as famously laid out by Robert E. Lucas (1972). When replacing adaptive expectations with rational expectations, then not only was there no long-run trade-off between inflation and unemployment, but that there was not even a short-run trade-off!

The  New Classicals objection was that Friedman's "adaptive expectations" assume that agents are making systematic error. There seems to be no good reason, they argued, for agents to expect next year's inflation to be this year's inflation. Intuitively, suppose we begin at NAIRU with zero inflation and zero inflationary expectations. Suppose there is a freakish and thus completely unexpected drought this year that leads to inflation. By Friedman's adaptive expectations, agents should consequently expect inflation next year to be the same. By why? Are agents expecting another freak drought? If so, then droughts can not really be that "freakish" to begin with but must be commonplace or at least systematically related to past droughts. But if droughts have these systematic features, then agents should have had some expectation of the first drought to begin with and thus inflationary expectations should not have been zero to begin with.

Hence, the New Classical argument goes, in the initial period when agents had zero inflation expectations, either agents are not making full use of what they know (i.e. that droughts are common or systematic) or their extrapolation that this year's drought implies a drought next year is completely irrational. Either case would be inconsistent with rational expectations, introduced by John Muth (1961) and applied to this context by Robert E. Lucas (1972, 1973), Thomas J. Sargent (1973) and T.J. Sargent and Neil Wallace (1975, 1976).

The rational expectations hypothesis argues that agents make full use of their information and do not make persistent, systematic error. In other words, either agents would realize the systemic component of the drought and would have had positive inflation expectations to begin with ("making full use of information") or they would realize that the drought was indeed freakish, in which case they would not expect a drought next year and thus not expect next year's inflation to be equal to this year's inflation ("no systematic error").

For the Phillips Curve context, replace the word "drought" with "accelerationist monetary policy". The argument then as an accelerationist monetary policy is systematic, then workers would have expected there to be accelerating inflation from the outset and would have refused to supply more labor in response to the higher money wages dangled before them. In other words, they would not have moved up the short-run Phillips Curve from the initial position (U = U*, p = 0) in Figure 1 to point a (U = U1, p = p1) but rather would have jumped straight to point b (U = U*, p = p1) on the long-run Phillips Curve. In other words, the government would have been unable to lower unemployment to U1 even temporarily.

This does not mean that unemployment cannot fall below U* from monetary acceleration. But this acceleration would have to happen unsystematically or randomly so that agents would not be able to form expectations. In this case, then inflation expectations could not be properly constructed and agents would indeed move up to point a (U = U1, p = p1). But this is temporary: as soon as they realized what happened, like the regular Monetarist story, they would consequently leave the labor market again and bring unemployment back up to U*. The main point of this story, then, is that only random, unexpected monetary accelerations can lower unemployment temporarily. A systematic accelerationist monetary policy will not lower it at all. In other words, there is no policy-effective short-run Phillips Curve trade-off.

In order to make this conclusion work, several assumptions must be made. The most prominent is that information is generally known. If the government conducts an accelerationist monetary policy in complete secrecy, agents might not know it was systematic and supply more labor. However, as the New Classicals argued, secrecy is never really complete and the workers will soon enough wise up to the fact that the acceleration is systematic. In other words, by perceiving the inflation patterns, etc., they will gradually realize that the government is conducting a systematic acceleration policy, in which case they will incorporate this information and change their expectations accordingly -- and thus foil the government's policy again.

The other necessary assumption is no systematic error. Why should not agents be stupid and irrational and just assume that this year's freakish drought implies a drought next year? The New Classicals admit, indeed, that people can be quite stupid: any particular agent can easily make strange extrapolations and systematic errors. However, they argue that it cannot be that all people make the same systematic error. As we are working with "aggregates", each worker may be make systematic errors and have idiosyncratic errors, but by an intuitive appeal to the law of large numbers, these idiosyncratic errors are washed out in the aggregate. In other words, one agent's peculiar stupidity cancels out another agent's stupidity so that, on average, the "representative agent", the "aggregate", is in fact quite smart - by which we mean, that, on average, workers does not make systematic errors.

As Lucas (1972, 1973), Sargent (1973) and Sargent and Wa