January 31, 2021

Is a rise in the inflation rate in the offing? Two of the most popular arguments favoring a higher inflation are based on well-established economic views. The Philipps Curve posits a tradeoff between the unemployment rate and the inflation rate. Hence as the economy recovers, according to the Phillips curve, the lower unemployment rate results in higher inflationary pressures. The other view argues that inflation is a monetary phenomenon reflecting too much money chasing too few goods. Both hypotheses yield empirically testable implications. Yet, the data does not seem to support either hypothesis. Contrary to the Phillips Curve views, as the economy approached the 5% unemployment rate, our proxy for full employment , the inflation rate did not accelerate. Also, the economy has experienced large swings in the monetary base and MZM growth rates without a corresponding swing in the underlying inflation rate. The inability to explain the recent inflation rate by either view raises some questions about their usefulness in forecasting the inflation rate. Next, we show that it is possible to simultaneously explain the failure of the two views to explain the relationship between while retaining the view that inflation is a monetary phenomenon.

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