Models of Inflation

Inflation was too high in the 1970s and early 1980s because mainstream economists had a poor understanding of when inflation is beneficial and when it is harmful and of how to control it.  Today inflation is too low because mainstream economists have a poor understanding of the costs and benefits of inflation and how to control it.  In some ways, we are in the mirror image of the problems of the 1970s. 
Lowering inflation is simple.  Just restrict the money supply and communicate expectations clearly.  Raising inflation is also simple.  Just expand the money supply and communicate expectations clearly.  The important think in both cases is for the central bank to clearly communicate that it will keep doing whatever it takes to bring inflation to the approximate level that it wants.  Today it seems amazing that economists did not understand this in the 1970s and someday it will seem amazing that many prominent economists do not understand this today. 

Supply Shocks

Moneybox explains why Casey Mulligan is wrong about the current recession being due to a supply shock:

Casey Mulligan thinks the recession wasn't caused by a demand shock but is instead a "redistribution recession" caused by the fact that shifts in labor market incentives have made it less worthwhile to work. John Quiggin says we can no this is wrong by looking at the international data, since there's a curious coincidence in timing of the fall in employment in the United States, Iceland, Estonia, United Kingdom, Japan, etc. that seems hard to explain by Barack Obama's Medicaid policies.

But I think there's an easier way to tell that it's wrong, and that's by looking at the inflation data above.

Imagine we passed a law putting the top federal income tax rate up to 75 percent and lowering the threshold for the top bracket to $100,000 for a single person and $200,000 for a married couple and used the revenue to finance a progam that pays you a cash grant of $10,000 a year if you don't have a job but gives you nothing if you're employed. It's pretty obvious that a policy along these lines really would cause some affluent people to downshift their careers and would cause some low wage workers to just quit and live off a combination of the 10 grand and under the table earnings. But in response you'd also see inflation. With some affluent professionals working shorter hours or quitting their jobs to launch the cupcake factories of their dreams, the price of hiring the services of the remaining affluent professionals would be bid up. Similarly, many minimum wage employers would have to raise nominal wages to compete with the increased appeal of not working.

In other words you'd see exactly what you'd see from any other kind of supply shock—a reduction in real output (fewer willing workers) combined with an acceleration in the price level (scarcity) rather than what we actually saw (see above) which is a collapse in the price level at the exact same time as the collapse in output.

Something to recall is that although "supply-side economics" came to just be code for "let's cut taxes" there's an actual reason that phrase came into currency in the late-1970s namely that we were precisely facing a combination of high unemployment and high inflation. That high inflation was an excellent indicator that boosting demand would not be effective in boosting output. So even if you think the specific proposed supply-side remedy was cranky, it was smart to seize the "supply side" label.

But that's not the situation we've been facing.

 

Krugman expounds on this theme:

Mulligan’s ...claim that increased use of the social safety net is a cause rather than a result of the depressed economy [is wrong]. As one of his commenters points out, this amounts to the claim that soup kitchens caused the Great Depression. Quiggin [link] does an admirable job of refuting this claim. I would, however, add one more point. If you really believe that the problem is that excessive generosity to the downtrodden is reducing the incentive to work, so that what we really have is a supply problem rather than a demand problem, you should expect to see upward pressure on wages.
What we actually see:

 The textbook AS-AD model and labor supply models support the analysis that we are not in a supply shock.  In real terms, wages are declining. 


Note that the austerians and their fellow travellers (like Cochrine) have completely forgotten their ideology when it comes to analysis of the “fiscal cliff”.  This is a only problem under a purely Keynesian analysis.  The cliff is the idea that the government will suddenly almost balance its budget!  Everyone is scared that this dramatic Keynesian shock will plunge the nation into recession, but if austerians were consistent, they would be proclaiming it is exactly what is needed to restore confidence.