Journal Issue

Inflation and stagflation in the international economy: An analysis of the recent experience

International Monetary Fund. External Relations Dept.
Published Date:
September 1976
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Anne Romanis Braun

Any consideration of the intensification of inflation in recent years needs to start with the large U.S. budget deficits at the time of the Viet-Nam war. Because of the size of the U.S. economy, these deficits represented a major inflationary shock to the whole international system. It must be remembered too that the impact of this shock on prices was delayed because it occurred when the other industrial countries were experiencing an easing of demand, deliberately induced to counter rising inflationary pressures in the mid-1960s. Therefore the immediate effect was to produce a much stronger rise in real output in the other countries in 1968–69 than had been foreseen by the authorities. This resulted in intense pressure on capacity in sectors such as engineering, transport equipment, chemicals, ports, and internal transportation, and sharply rising prices for key strategic materials, such as steel, nonferrous metals, and basic steel.

Other governments could have insulated their economies from the inflationary impact of the U.S. budget deficits—had they realized the need and been determined to do so—by allowing their exchange rates to appreciate. However, such action would have represented a major break with the Bretton Woods system of fixed exchange rates; and it would have posed great uncertainty concerning the future pattern of exchange rates or even the type of exchange rate system that would prevail. Governments did not choose to appreciate, and the effect of very strong demand and sharply rising material costs was to provoke an upward shift in the structure of administered prices, especially in the sectors mentioned.

Wage explosions

Wages, however, lagged under the influence of settlements reached during or immediately after the period of easier demand and increased unemployment. At the same time, the consequences of earlier demand restraint were felt in increasing shortages of low-cost housing, deteriorating urban services, and reduced real expenditures for education, health, and welfare. The political effects of the increasingly apparent widening of income disparities were compounded in some countries by weaknesses of tax systems relying on indirect taxes and direct pay-as-you-earn deductions on wages and salaries. These caused a disproportionate share of the tax burden to be borne by wage and salary earners, while other forms of income from property, self-employment, and fees escaped heavy taxation.

Annual rates of change in wages—1964–1975*
BelgiumCanadaFranceFed. Rep.




Source: IMF Data Fund.

Changes show percentage increases over the preceding year in average hourly remuneration in manufacturing.

Source: IMF Data Fund.

Changes show percentage increases over the preceding year in average hourly remuneration in manufacturing.

In the event there was an upward adjustment of relative costs, not via the exchange rate but via political action and “wage explosions” in several countries (see table). These in turn had the effect of altering the political climate elsewhere and rendering governments less willing, or able, to implement policies of restraint. The wage explosions had delayed repercussions as the effects of large increases worked their way through the economies. One feature common to many countries, including the United Kingdom, France, and Sweden, was unprecedented pressure for wage increases in the public sector: civil servants, teachers, doctors, and local government employees demanded increases to catch up and to compensate for the fact that their pay had been subject to particular restraint during the late 1960s. The granting of very large increases was followed by large price increases for public services such as transportation and utilities, and compounded governments’ difficulties in avoiding budget deficits which fueled the inflation.

While these delayed repercussions of the boom in the late sixties were continuing in the other industrial countries, the U.S. authorities adopted restrictive demand policies in 1970. By limiting U.S. demand for foreign goods and services and increasing U.S. competition with foreign products in export markets, U.S. policies helped to curb the strength of inflationary pressures in the international market for tradable goods and services. They also served to enforce some balance of payments discipline for restraint of aggregate demand in those countries which experienced a worsening of their payments position.

Restrictive policies in the United States strengthened the U.S. balance of payments and lessened the weakness of the dollar. But when in 1971 the U.S. authorities sought to restore a higher level of output and employment by means of much easier monetary policy, while monetary restraint was increasing in the other countries, movements of short-term funds in response to interest differential generated heavy currency speculation against the dollar. In a surprise decision the U.S. authorities ceased supporting the dollar in August. The widespread realignment of currencies under the Smithsonian agreement followed in December 1971.

It would seem that the impact of strong demand conditions in the late sixties in generating faster rates of price and wage increase was felt with an unusually long lag. This delay arose partly because conditions favored heavy international “spillovers” of demand that were largely unforeseen in the recipient countries, and partly because the European recession of the mid-1960s continued to exert a moderating influence on the rates of wage and price increase in a number of countries. The unusually long lag contributed to intensify the so-called stagflation—the coincidence of large wage and price increases with reduced activity—in 1970–71.

Abnormal influences in 1972–75

The years 1972–75 were clearly abnormal in several respects, each liable to cause a higher than usual rate of inflation:

• the after effects of the turbulent wage developments in 1969–70, including unusually marked disturbances in customary wage and salary differentials, and pressure on profit margins;

• the consequences of large changes in exchange rates at the end of 1971 and again in 1973;

• the unusual coincidence of very strong recoveries in the United States and in the rest of the industrial world in 1972–73;

• exceptionally large exogenous increases in world market prices for foodstuffs and petroleum in 1973.

We shall understand the influence of these factors better if we pause to consider the nature of inflation in the international system of market economies subject to national economic polices influencing the level of aggregate demand.

National outputs and capital assets consist in part of goods and services which are readily sold across international boundaries—so-called tradables—the prices of which are mainly determined in the international market. Other goods and services—so-called nontradables—are sold only, or almost exclusively in the national market, at prices mainly determined in the national market.

It is generally helpful to consider the direct services of the labor force as “non-tradable” in most countries. In spite of the possibilities of emigration and immigration, labor is usually relatively immobile, and the labor market is less subject to international influences than markets for outputs of tradable goods and services. Thus, as Assar Lindbeck has noted, “nominal wage rates are determined in the national market, and are influenced by domestic circumstances such as excess demand for labor in the country, domestic price expectations, and the specific circumstances of wage bargaining, which are often closely related to the national political situation.” (From his lecture at the December 1975 meeting of the American Economic Association.)

One must also distinguish between tradables and between nontradables according to the characteristics of the markets in which they are bought and sold. Following Nordhaus’ analysis (in his paper at the December 1975 A.E.A. meeting) we may consider markets as falling into one of two classes: auction markets characterized by flexible prices determined by supply and demand under competitive conditions, and administered markets in which sellers or buyers possess significant “market power” and use that power to restrain price movements in face of changes in supply and demand.

Auction markets usually involve numerous sellers and buyers and easy entry for sellers and buyers. They are typified by unregulated international markets for primary commodities, and simple standardized manufactures; and by national markets for nontradables such as unorganized labor, house rentals, and goods and services supplied by small-scale “family businesses.” Administered markets cover a large part of the total output of tradables and nontradables (as well as most of the labor market) in the advanced economies, and much of the modern industrial sector in less developed economies. The distinction between industrial and primary producing countries is therefore associated with a division between countries whose output of tradables is for the most part characterized by inflexible prices, and those whose output of tradables is largely subject to prices fluctuating with supply and demand.

Now we can see that the overall rate of inflation in an economy, as measured by some general index of prices, will reflect prices in:

• international auction markets for tradables;

• national auction markets for nontradables;

• international administered markets for tradables;

• national administered markets for nontradables.

We can expect prices in international auction markets to be highly sensitive to the aggregate level of world demand which is largely determined by the combination of policies pursued in the major economies. We can expect prices in national auction markets to reflect demand policies within the respective countries. But we must expect the movement of prices and wages in both international and national administered markets to be rather unresponsive to changes in the level of demand and employment; but to be subject to upward adjustment for increases in costs or in the cost of living, at irregular intervals and in varying degrees, which are not easily predicted.

Pricing in administered markets

Output prices in many administered markets tend to be set on the basis of costs, assuming a normal level of output, plus a more or less constant markup. In oligopoly situations, where a few firms dominate the market, price decisions may be keyed to the pricing policy of the “leader,” generally a large, relatively low cost producer. In administered labor markets, unions are concerned to increase, or at least maintain, the real wages of their members, and to maintain their relative position in terms of money earnings vis-à-vis other groups. Consequently the current rate of increase in money wages in the administered sector is influenced both by the rate of increase achieved in earlier wage settlements and by the recent rate of increase in prices in both administered and auction markets. Thus administered markets are characterized by strong “momentum effects” as earlier price and wage increases are reflected in the setting of higher administered prices and in the size of wage increases in other sectors, and these in turn raise costs and prices elsewhere.

Within a national economy, enterprises are subject to broadly similar movements in many costs, influenced by such factors as the general movement of wage rates, the influence of demand on national auction market prices, tax changes, and alterations in the exchange rate. But enterprises in different economies may be subject to widely different movements in costs due to such factors. Hence, it is helpful to treat national industries as single enterprises in an oligopolistic world industry when considering price behavior in international markets that are characterized by inflexible prices. This is commonly the case in markets for differentiated products of large-scale industry. One can then visualize that, in certain circumstances all national industries will be more inclined to raise their prices together, in others less so. This is of some relevance to recent experience.

If we return now to the abnormal influences at work in 1972–75, it should first be emphasized that they tended to reinforce each other’s effect. Because of conditions produced by the wage disturbances of 1969–70, the 1971 changes in exchange rates had more effect in enhancing price movements than might otherwise have been the case. The coincidence of recoveries in most industrial countries in 1972–73 induced a very sharp upward movement in international auction market prices sensitive to the aggregate level of world demand. The rise in auction market prices may have been intensified by an inflationary flight from devaluing currencies (whose purchasing power was expected to decline) into commodities (whose prices were expected to rise). The extremely sharp rise precipitated an upward shift of the whole structure of administered prices, and subsequently led to a widespread increase in wage demands. In the United States, which together with Canada and Japan was more affected than most European countries by the extraordinary rise in world market prices for foodstuffs, the effect of higher food prices was compounded by the ending of wage-price controls in 1974. In many countries, pressures for wage increases in 1974 were intensified by the fact that real wages were perceptibly reduced by the combined effects of the 1973 commodity price boom, the specific very large increases in the prices of foodstuffs and petroleum, and the rise in the cost of imports resulting from depreciation of the exchange rate.

It would appear that the outcome of large changes in exchange rates may be uncertain if oligopoly situations of the kind described above are widespread in international markets. While there is some scope for variations in relative prices (due to such factors as product differences, tariff and transport costs, buyers’ inertia, and nonprice competition), pricing decisions tend to be strongly influenced by the decisions of the national industry that is the effective price leader. National industries with higher unit costs than the leader at going exchange rates have to accept lower markups and smaller profits, and probably lower rates of investment; those with lower costs can, and do, charge somewhat lower prices in order to capture a growing share of the world market. However, producers usually have little incentive to lower their prices, relative to those charged by the leader, by more than is required to capture a gradually growing share of the total market since the scope for expanding their output above its “normal” level is limited by existing capacity. And high markups on the existing output are often the means by which they finance the expansion of capacity. They also do not wish to risk creating a situation in which the leader is driven to retaliate by lowering its profit margins in order to prevent its competitors from securing a much larger share of the market.

A change in exchange rates such as occurred in 1971, which raises the relative level of the leader’s costs in terms of foreign currencies, may result in an upward shift of the whole structure of administered prices if the leader (in this case, the industry of the Federal Republic of Germany or Japan) maintains the same markup and other producers raise their prices more or less in line with the increase in the leader’s prices in foreign exchange. Or the change may be reflected in changes in relative prices, in shares of the market, and in the market power of the various national industries, in favor of those which can secure a marked improvement in their relative cost position.

One may surmise that the 1971 realignment had some effect on the first kind, as enterprises in countries where the effective exchange rate had declined, reducing the relative level of costs in foreign currency, took advantage of the opportunity to restore profit margins that had been squeezed. The devaluations subsequently had the effect of promoting a higher level of real output because of the more favorable profit situation of domestic industry. Countries with relatively high production costs in terms of foreign exchange at previously overvalued exchange rates had in effect been subject both to external price discipline and to restraint of real output growth occasioned by a rising real import balance. Both restraints were now relaxed. Countries with previously undervalued exchange rates had been subject to an external stimulus to output expansion and to external influences making for price and wage increases. Both were now reduced or reversed, the appreciation actually causing the price of international auction market commodities in domestic currency to fall.

These effects on countries, though opposite, were not necessarily offsetting. Most governments were under strong political pressure to adopt expansionary programs to reduce unemployment; and it seems likely that the eventual effect of the 1971 realignment was to encourage a higher rate of output expansion associated with a higher rate of price increase than before 1971. The large and erratic changes that followed the abandonment of fixed rates in 1973 acted as a check on real output by increasing uncertainty, and thus contributed to the unexpectedly severe downturn in 1975.

Restrictive financial policies adopted to curb the very rapid rates of inflation experienced in 1973 and early 1974 were associated with unusually severe declines in output and employment and with little easing of price and wage inflation during 1974–75. The unfavorable outcome of policies was partly due to their being implemented in the context of unusually strong “momentum” effects stemming from price and wage developments during the 1972–73 boom and the exceptional increases in world food and petroleum prices. Another factor was that aggregate demand restraint was, on this occasion, associated with disproportionately sharp reductions in demand in certain administered sectors because of marked shifts in the pattern of expenditure. Very much higher food prices in some countries, higher energy prices and also shortages of gasoline, and the disturbance of established patterns of trade by the erratic changes in exchange rates, sharply curtailed demand or dislocated supply in some industries and resulted in unusually heavy layoffs and concentrated pools of unemployment. Much reduced incomes in some localities and reduced consumer spending prompted by fears of unemployment also contributed to increased unemployment.

Implications of the recent inflation

Economists have tended to view the inflationary experience of the 1970s either as a drastic secular worsening of the tradeoff between the rate of unemployment and the rate of wage and price increase, or as a complete negation of the concept of full employment policy. Lind-beck, for instance, questions whether “full employment policies … could have avoided the acceleration of inflation in the world that followed the continuously higher average level of capacity utilization in the western world from the mid-1950s to the late 1960s and early 1970s.”

The monetarists see recent developments as a vindication of their prophecies that if the national authorities succeed in reducing unemployment while tolerating a certain moderate rate of inflation, they will find that there is no lasting “Philips-curve” tradeoff. Assuming that unemployment is reduced because the rise in prices lowers real wages and this induces employers to expand production and employment, the monetarists argue that eventually, when price expectations have adjusted to the actual rate of inflation and real wages are no longer reduced by inflation, the “natural” rate of unemployment must prevail. While price expectations are being adjusted, the authorities will find that a continually higher rate of monetary expansion and inflation is needed to maintain the same level of unemployment. Monetarists who assume that competitive markets and flexible pricing will prevail in the long run even suggest that the natural rate is full employment so that full employment policies, which interfere with the process of adjustment to that position are literally worse than useless.

In practice, however, as Arthur Okun observes, “the world of mixed administered and auction markets poses serious dilemmas for public policy because it is not a world of intractable “natural” unemployment rates, or a world of costless, fully adjusted inflation” (see Brookings Papers on Economic Activity, 1975, No. 2).

The brief account given here suggests that worsening inflation in the early 1970s and the stagflation of 1975–76 was not the result of a continuous and inevitable process in the world economy, or of gradually changing expectations of inflation, but that it was produced by specific policies, shocks, and combinations of circumstances that could perhaps have been avoided. The picture supports Lindbeck’s conclusion that “we live in an unstable market system, which could and should be stabilized by conscious economic policies of national governments,” and “the most reasonable approach … is to assume that there are instabilities and imperfections in both the market system and the political-administrative system and that these interact in a complex way.”

A major source of uncertainty in economic decisions at all levels, and of instability in the world economy, in the last few years has been unforeseen interreactions between national policy decisions, and the repercussions of the combination of the national policies of major countries upon the international market system. Some prerequisites for more successful management of the world economy appear to be:

• a better understanding of the working of administered and auction markets in the international system and national economies (and the forswearing of economic policy recommendations based on logical deductions from unreal premises concerning the nature of markets);

• closer coordination of national economic decisions—or, at the least, more careful attention to the likely impact of other countries’ policies in framing national policy;

• the fostering of a more critical attitude of electorates to attempts by politicians to buy votes by means of unsustainable expansions or other unsound but popular economic policies.

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