Selected Essays of Axel Leijonhufvud
Chapter 7: Theories of stagflation
7. Theories of stagﬂation The occurrence of stagﬂation came as a nasty shock to a great many economists. Evidently, the economics profession has gotten so much into the habit of teaching that unemployment and inﬂation are alternating or alternative phenomena that their actual conjuncture seemed at ﬁrst to be a riddle to which received theory might not supply an answer. A few writers of some note indeed went so far as to proclaim that stagﬂation proved the bankruptcy of standard theory. Well, stagﬂation is not a riddle. Far-fetched or ad hoc explanations are not required. Instead, theories of unemployment and theories of inﬂation can be combined in a variety of ways that avoid contradiction. I want to discuss a few of these. It seems easiest to start by considering different theories of unemployment. STAGFLATION I: THE CASE OF THE MISSING MARKET MECHANISM The ﬁrst theory of unemployment that needs to be mentioned is based on the notion that labor markets do not have functioning market mechanisms. Wage rates are not governed by demand for and supply of labor. In particular, an excess supply of labor does not constitute a ‘market force’ that will set in motion adjustments that could result in its own elimination. Wage determination is to be explained by institutional factors, exogenous to the market. A common version of this theory has wage rates independent of the excess demand for labor at all values of employment below full employment, with inﬂation...
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