Most economists do not look upon wage-price controls with favor, for two reasons:
1. Complementary monetary and fiscal policy are required. Most empirical evidence suggests that control policies do not work, even if, as was done by Diocletian during the Roman Empire, the death penalty is imposed for violation. This evidence, however, comes from situations in which the control policies could not have been expected to be successful. In figure 12.4, if the rate of growth of the money supply were not reduced from 5 percent to 3 percent, it would be impossible for a policy of wage-price controls to be successful. Some evidence, such as the 1975-78 Canadian experience, suggests that control policies can be of benefit if they are complemented by appropriate monetary and fiscal policies a crucial proviso to the adoption of wage-price control policies.
2. Costs and benefits should be compared. There are high costs associated with controls. The most important costs result from the constraints that controls place upon the operation of the price system, hindering its job of allocating and distributing goods and services in an efficient fashion. These costs could be considerable, but can be alleviated somewhat by designing some flexibilities into the controls program. For example, the controls rules could permit extra wage or price increases in markets experiencing obvious shortages. In any event, a decision to adopt or reject a guidelines or controls program should be made by comparing its costs and benefits.
12.5 Explaining Stagflation
The Phillips curve can be used to create some explanations for stagflation, which can be defined as high inflation combined with high unemployment, or as rising inflation in conjunction with rising unemployment. In the world of the original Phillips curve, both such phenomena were impossible.
Consider first stagflation defined as high inflation combined with high unemployment. High inflation can be created by a high money-supply growth rate. There are three basic ways in which high unemployment can accompany this high inflation:
1. High NRU. The natural rate of unemployment may itself be high, owing to factors affecting frictional or structural unemployment, or for institutional reasons such as generous unemployment insurance benefits.
2. A current fight against inflation: The government may be in the process of fighting an inflation by creating a recession, so that the economy is temporarily lodged near a point like E in figure 12.3.
3. Real wage overhang. A permanent negative supply shock may have occurred, and workers may refuse to allow their real wage to fall. If they have sufficient power or a wage indexation policy to hold their real wage up, unemployment beyond the natural rate will develop.
