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BPEA Article

Contract Theory and the Moderation of Inflation by Recession and by Controls

Abstract

THE EXTRAORDINARY persistence of price inflation in the face of mild and then severe recession over the last several years has suggested a momentum in wages and prices. Once inflation has become the pattern, it is very hard to eliminate. One view of this momentum is that the historical experience of rising wages and prices creates the expectation of further inflation; and, because firms and workers expect prices and wages to rise, they do rise. Provided monetary-fiscal policy is accommodative, these expectations are fully realized and the inflation continues. Another, and not entirely distinct, view holds that firms set wages and prices relative to other wages and prices. The inflation continues not so much because of expectations, but because firms and workers constantly perceive themselves as just catching up with past inflation.

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