FRBSF Economic Letter
98-04; February 6, 1998
The New Output-Inflation Trade-off
One of the hallmarks of economic analysis is the recognition that choice
involves trade-offs. Whether it's a consumer deciding if the roominess
of a sports utility vehicle is worth the lower gas mileage, or a firm
deciding whether lower wages of an overseas production facility compensate
for the lower worker productivity, or Congress deciding whether a new
expenditure program justifies the higher taxes needed to finance it, trade-offs
must be faced. The same is true in the conduct of monetary policy. Acting
too slowly to head off inflation may risk an increase in expected inflation
that will make subsequent moves to reduce inflation more costly, while
acting too quickly may run the risk of slowing economic growth prematurely.
During the 1960s and early 1970s, many economists and policymakers believed
a central bank could achieve permanently lower unemployment by accepting
permanently higher inflation. Attempts to exploit such a trade-off to
gain the benefits of lower unemployment were, unfortunately, self-defeating.
As unemployment fell and inflation rose, individuals began to expect that
inflation would be higher. Workers demanded more rapidly rising money
wages to compensate for expected price increases, and firms were willing
to agree to these wage demands as they expected to be able to pass through
their increased costs by raising prices. Rather than remaining stable
at a new higher level, the inflation rate continued to increase as long
as unemployment remained below the economy's natural rate. That experience
has convinced most policymakers that no such trade-off exists. Instead,
most agree that the average level of the unemployment rate and the long-run
rate of real economic growth are determined by such fundamentals as technological
change, population growth, labor market institutions, and the skills of
the work force. These factors are unrelated to the economy's average rate
of inflation, so allowing average inflation to rise brings no long-run
benefit in the form of faster growth or lower average unemployment.
This does not mean, however, that central banks do not face unemployment-inflation
trade-offs as they implement monetary policy. In fact, recent research
in macroeconomics has focused increasingly on an important trade-off involving
output and inflation. Unlike the short-run trade-off between the level
of output or unemployment and the level of the inflation rate that was
a focus of earlier policy debates, the new emphasis is on the choice between
the variability of output and the variability of inflation. The research
on this variability trade-off suggests that attempting to keep inflation
within a very narrow band may increase fluctuations in real output and
employment. Conversely, attempts to smooth business cycle fluctuations
more actively will lead to wider fluctuations in inflation. The nature
of this trade-off, and even whether it really exists, is a subject of
debate among economists. This Letter discusses the new output-inflation
trade-off and its implications for the design of monetary policy.
Today, most economists and central bankers accept the proposition that
there is no long-run trade-off between the rate of inflation and the level
of unemployment. At the same time, many believe that policies designed
to help stabilize inflation do have real consequences. John Taylor (1996)
has summarized current thinking about these issues in the form of two
The first proposition, about which there is now little disagreement,
is that there is no long-run trade-off between the rate of inflation
and the rate of unemployment (p. 186).
The second proposition, and there is more disagreement here,
is that there is a short-run trade-off between inflation and
unemployment. I think that the short-run trade-off is best described in
terms of a trade-off between the variability of inflation and
the variability of unemployment; that is, in terms of the short-run
fluctuations in the variables rather than their levels over time (p. 186).
It is this trade-off between the variability of output and inflation
that represents the new policy trade-off. It is easiest to understand
why such a trade-off might arise by considering the economic impact of
an adverse aggregate shock such as a rise in the price of oil or private
sector expectations about future inflation. The direct result of either
would be an increase in inflation. If policy acts to bring inflation back
on target quickly, inflation will be less variable, but output will fluctuate
more around trend. If policy acts more slowly to bring inflation back
on target, then output will fluctuate less while inflation becomes more
variable. Acting to offset the inflationary impact of supply shocks leads
output and unemployment to fluctuate more in the short run, while stabilizing
output leads actual inflation to fluctuate more.
Much of our knowledge of variability trade-offs comes from simulations
of models designed to mimic the behavior of the major industrialized economies.
These models incorporate realistic inflation and output adjustment so
that they can be used to study the variability trade-off implied by different
rules for conducting monetary policy. Fuhrer (1997) provides an example
of this type of research, employing a model of the U.S. economy. The evidence
from simulations can be used to determine the nature of the volatility
trade-off that arises under a particular policy rule and to evaluate alternative
policy rules. For example, Taylor (1993) has suggested that recent Fed
behavior is characterized by a rule that describes how the federal funds
rate is adjusted in response to movements in inflation and the output
gap. Using such a rule for determining the funds rate, together with particular
values for how much the funds rate is adjusted as inflation and the output
gap change, the implied variability of inflation and output can be determined.
By then changing how much the funds rate is adjusted in response to inflation
and the output gap, a different combination of inflation variability and
output variability will be implied. Linking together the different combinations
of inflation and output variability, a trade-off emerges. In a similar
manner, the frontier associated with a different rule for adjusting the
funds rate, such as one that responds to nominal income movements, can
be derived. In addition, a change in the nature of the underlying economic
disturbances would shift the trade-off frontier; an increase in the volatility
of energy prices, for example, would lead to more inflation and
1 illustrates the output-inflation variability trade-off for two hypothetical
policy rules. The rule that produces the dashed trade-off frontier can
be described as inefficient; for any given output volatility, the policy
rule that produces the solid line results in lower inflation volatility.
Once the efficient trade-off frontier has been found, policymakers then
must weigh the relative costs of output variability versus inflation variability
in choosing a point on the frontier. If inflation variability is viewed
as more costly than output variability, a point such as A might be optimal,
while point B would be optimal if the costs of output variability are
assessed more highly. This two-step approach, finding the efficient frontier
and then deciding which point to pick, is useful in separating two distinct
aspects of policy choice. On the one hand, the structure of the economy
and the nature of economic disturbances that affect it will define the
efficient frontier. On the other hand, the factors that determine which
point on the frontier to choose depend on an assessment of the relative
costs of different forms of economic variability.
The notion that focusing more on limiting fluctuations in real output
will lead to more inflation variability is fairly intuitive. But does
such a variability trade-off actually exist? Simulations of economic models
reveal such a trade-off, but economists disagree about which model best
captures the true behavior of the economy, and these disagreements mean
that there is no consensus about the true trade-off faced by policymakers.
It is also difficult to find evidence of the trade-off in the data from
actual economies. There are several reasons why the empirical evidence
is inconclusive. The chief problem is that each point on the trade-off
frontier is associated with a specific way of conducting monetary policy.
If policy has been conducted in a stable and efficient fashion over several
years, then the observed volatility of output and inflation would provide
an observation on a single point on the trade-off frontier. Evidence on
just a single point does not provide information on the entire trade-off
One way around this problem is to look at the experiences of many different
countries. If countries have similar economic structures, have faced similar
disturbances, and have operated on the efficient frontier, but have differed
in the choices policymakers have made between output and inflation stability,
then historical patterns of different countries would provide evidence
on the output and inflation variability trade-off. Unfortunately, actual
economies have different economic structures, have experienced different
disturbances, and have conducted policy in different ways. Thus, it is
difficult to identify a variability trade-off using the historical experiences
of a cross-section of countries.
Evaluating alternative policies in terms of their implications for the
trade-off between output volatility and inflation volatility offers useful
insights into some recent monetary policy debates. For example, the widely
held consensus that monetary policy cannot have permanent effects on the
level of the unemployment rate or the rate of real economic growth has
led some to advocate that central banks focus only on maintaining low
inflation. As a position about the long run, few economists would disagree.
But, as Taylor's second proposition suggests, many economists would argue
that a single-minded focus on maintaining inflation within a very narrow
band may lead to undesired real economic fluctuations. And conversely,
attempts to smooth real fluctuations too actively will lead to excessively
The variability trade-off is also important for those countries that
have moved to an inflation targeting policy regime since it is critical
for determining the appropriate width of the inflation target. New Zealand,
for example, initially defined its inflation target as 0 - 2% inflation.
In 1997, however, this was widened to 0 - 3%. The Bank of England has
a target inflation band of plus or minus 1% around its target of 2.5%
inflation. The output-inflation variability trade-off is one of the key
factors in determining the effects of changing the width of the inflation
band. If the trade-off frontier is steep, for example, then reducing the
variability of inflation causes little increase in output variability.
In this case, a narrow target inflation band would be appropriate. A recognition
of the variability trade-off shifts the focus from the level of inflation
(which should be low) to questions of how wide the target band should
Realizing that the long-run effects of monetary policy determine average
inflation, not average unemployment or the economy's real rate of growth,
is critical to maintaining a successful policy. However, central banks
still face trade-offs as they balance short-run inflation variability
against short-run output variability, and this also needs to be recognized
when evaluating the contribution of monetary policy to achieving macroeconomic
Carl E. Walsh
Professor of Economics, UC Santa Cruz
and Visiting Scholar, FRBSF
Fuhrer, Jeffrey C. 1997. "Inflation/Output Variance Trade-offs
and Optimal Monetary Policy." Journal of Money, Credit and Banking
29 (May) pp. 214-234.
Taylor, John B. 1996. "How Should Monetary Policy Respond to Shocks
while Maintaining Long-Run Price Stability? -- Conceptual Issues."
In Achieving Price Stability, Federal Reserve Bank of Kansas
City, pp. 181-195.
_______.1993. "Discretion versus Policy Rules in Practice."
Carnegie-Rochester Conference Series on Public Policy 39, pp. 195-214.
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