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Chapter 13-2

Chapter 13-2. Institutionalists take on the Monetarist. Institutionalist Theories of Inflation . Supporters of institutional theories of inflation accept much of the quantity theory. While they agree that money and inflation move together, they have different causes and effects.

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Chapter 13-2

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  1. Chapter 13-2 Institutionalists take on the Monetarist

  2. Institutionalist Theories of Inflation • Supporters of institutional theories of inflation accept much of the quantity theory. • While they agree that money and inflation move together, they have different causes and effects.

  3. Institutionalist Theories of Inflation • According to the quantity theory, the direction of causation moves from left to right: MV PQ

  4. Institutionalist Theories of Inflation • Institutional theories see it the other way round. • Increases in prices forces government into positions where it must increase money supply or cause unemployment. MV  PQ

  5. Institutionalist Theories of Inflation • According to the quantity theory, changes in money cause changes in prices. • According to the institutionalists, increases in • prices force the government to increase the • money supply.

  6. Institutionalist Theories of Inflation • According to these theorists, the source of inflation is in the price-setting process of firms. • Firms find it easier to raise prices than to lower them. • Firms do not take into account the effect of their pricing decisions on the overall price level.

  7. Focus on the Price-Setting Decisions of Firms • Any increase in firms’ wages, rents, taxes, and other costs are simply passed on to consumers in the form of higher prices.

  8. Focus on the Price-Setting Decisions of Firms • This works so long as the government increases the money supply so that demand is there to buy the goods at the higher prices.

  9. Focus on the Price-Setting Decisions of Firms • Whether the firm selects this price-raising strategy depends on the state of the labor market. • If the labor market is tight, the firm knows that it will lose workers if it doesn’t raise wages.

  10. Changes in the Money Supply Follow Price-Setting by Firms • Institutional theorists see the nominal wage- and price-setting process as generating inflation.

  11. Changes in the Money Supply Follow Price-Setting by Firms • One group pushes up its nominal wage and/or price, other groups responds by doing the same. • The first group finds its relative wages and/or prices have not increased, so they raise them again. • And the process begins anew.

  12. Changes in the Money Supply Follow Price-Setting by Firms • At this point, government has two options: • Increase money supply, thereby ratifying the inflation. • Refuse to ratify the inflation, thereby causing unemployment to rise.

  13. The Insider/Outsider Model and Inflation • The insider-outsider model is an institutionalist story of inflation where insiders bid up wages and outsiders are unemployed.

  14. The Insider/Outsider Model and Inflation • Insiders are business owners and workers with good jobs with excellent long-run prospects; outsiders are everyone else.

  15. The Insider/Outsider Model and Inflation • If markets were purely competitive, wages, profits, and rents would be pushed down to equilibrium levels.

  16. The Insider/Outsider Model and Inflation • Insiders don’t like this, so they develop sociological and institutional barriers to prevent competition from outsiders. • Barriers include unions, laws restricting the firing of workers, and brand recognition.

  17. The Insider/Outsider Model and Inflation • Outsiders must take dead-end, low-paying jobs or try to undertake marginal businesses that pay little return per hour worked.

  18. The Insider/Outsider Model and Inflation • Outsiders are the first to be fired and their businesses are the first to fail in a recession.

  19. The Insider/Outsider Model and Inflation • The economy is only partially competitive – the invisible hand is thwarted by social and political forces. • Insiders push to raise their nominal wages to protect their real wages while outsiders suffer.

  20. Policy Implications of Institutionalist Theories • The quantity theorists have a simple solution for stopping inflation – just cut the growth of the money supply.

  21. Policy Implications of Institutionalist Theories • The institutional theorists agree with this prescription, but they argue that is not only inefficient but unfair. • It causes unemployment among those least able to handle it.

  22. Policy Implications of Institutionalist Theories • They favor contractionary monetary policies used in combination with incomes policy to directly slow down inflation. • Incomes policy – places direct pressure on individuals and businesses to hold down their nominal wages and prices.

  23. Policy Implications of Institutionalist Theories • Formal incomes policies have been out of favor for a number of years. • Informal incomes policies exist in many European nations.

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