introduction to macro policy and models the policy...
TRANSCRIPT
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The Policy Tradeoff: Unemployment vs.
Changes in Inflation
Introduction to Macro Policy and Models
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Focus Today
Simple Micro: Prices, Demand and Supply Simple Dynamics: Disequilibrium Means ChangeAn example central to policy choices: managing the economy to produce a desired outcome
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BRINNER3Simple Micro in the Labor Market :
Prices, Demand and Supply
Demand: More Workers/Hours Will Be Demanded by Employers the Lower the Real Wage, Other Things EqualSupply: More Hours Will Be Supplied by Individuals the Higher the Real WageEquilibrium: Demand=Supply
»All Those Wanting to Work at the Current Real Wage Can Find Work after a Reasonable Period of Search
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BRINNER4Simple Micro in the Labor Market :
Prices, Demand and Supply
DEMAND
SUPPLY
REALWAGE
WORKERS or HOURS DEMANDED AND SUPPLIED
EQUILIBRIUM
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BRINNER5Simple Dynamics: Disequilibrium
Means Change in the Labor MarketUnemployed Workers:– Voluntary, as in searching for a job at a
wage higher than they or their peers are being offered: not a sign ofdisequilibrium
– Involuntary: Would accept the prevailing wage but no offer forthcoming.»By definition, Supply greater than
Demand...at the prevailing wageInvoluntary Unemployment Creates Pressure for (Real) Wages to Fall
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BRINNER6Simple Dynamics: Disequilibrium
Means Change in the Labor Market
DEMAND
SUPPLY
REALWAGE
WORKERS / HOURS DEMANDED AND SUPPLIED
DISEQUILIBRIUM
INVOLUNTARYUNEMPLOYMENT
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Fluctuations in Unemployment
0123456789
10
1967 1971 1975 1979 1983 1987 1991
Job Losers ReenterNew Entrants Job Leavers
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Fluctuations in Unemployment
DEMOGRAPHICS AND THE UNEMPLOYMENT RATE
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1950
1952
1954
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1958
1960
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1968
1970
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1980
1982
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1990
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1994
1996
1998
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5.2
5.4
5.6
5.8
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6.2
6.4
"YOUNG ADULT SHARE OF POPULATION' "NAIRU"
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Fluctuations in Unemployment
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2
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12
1949
1955
1961
1967
1973
1979
1985
1991
1997
Actual RU NAIRU
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BRINNER10Changes in
Nominal and Real Wages
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-2
0
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8
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1981 1984 1987 1990 1993 1996 1999 2002
Real Wage GrowthEmployment Cost Index GDP Price Deflator (lagged one year)
(Annual Change)
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BRINNER11THE APPARENT POLICY OPTIONS
IN THE 1960s
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- 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0
UNEMPLOYMENT RATE
CPI
INFL
ATIO
N R
ATE
1969
1965
1959
1962
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A LONGER PERSPECTIVE
-2
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194819501952195419561958196019621964196619681970197219741976197819801982198419861988199019921994199619982000
UNEMPLOYMENT RATE CPI INFLATION RATE
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BRINNER13THE LONG-TERM POLICY
CHOICES AREN'T AS OBVIOUS
-2
0
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0 2 4 6 8 10 12
UNEMPLOYMENT
INFL
ATIO
N
1947
1959
1980
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1974
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BRINNER14Changes in
Real Wages vs. Unemployment
-1
0
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-3 -2 -1 0 1 2
Unemployment Gap
Real Wage Growth1994
1991
1989
1985
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The Equation for Wage Inflation
RW=RP\1+A0-A1*(U-U@VOL)The rate of change of wages (RW) equals
the rate of change in prices (RP) in the past year (“\1”) as a proxy for expected inflationplus a constant (A0) for productivity growth and other factors not defined hereminus an adjustment for the existence of involuntarily unemployed workers:total unemployment (U) - voluntary (U@VOL)
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BRINNER16A Companion Equation
for Price InflationIf prices are a simple “mark-up” on unit labor costs, i.e. wages(W) relative to productivity(A)..
P = K * (W/A)hence RP = RK + RW - RA
..and this markup falls when the economy is sluggish
» RK = - B1 * (U-U@VOL)Then:RP = - B1 * (U-U@VOL) + RW - RA
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The Final Form Model of Price Inflation
RP = - B1 * (U-U@VOL) + RW - RAAND, EARLIER,
RW=RP\1+A0-A1*(U-U@VOL)THUS
RP=(A0-RA)-(A1+B1)*(U-U@VOL)+RP\1OR RP-RP\1 =
THE CHANGE IN INFLATION=
(A0-RA) - (A1+B1)*(U-U@VOL)
The acceleration in prices is tied to the level of excess demand.
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(1%)
0%
1%
2%
3%
4%
5%
6%
7%
8%
1995 1996 1997 1998
Real Wage Inflation
Inflation-Igniting Threshold:(5.5% unemployment)
Nominal Wage Inflation
Infla
tion
(%)
Unemployment Rate
Real Wages Accelerated As Usual after Q1 1997, As Unemployment Fell Below 5.5%
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0%
1%
2%
3%
4%
5%
6%
7%
8%
1995 1996 1997 1998 1999 2000
Real Wage Inflation
Inflation-Igniting Threshold:(5.5% unemployment)
Nominal Wage Inflation
Infla
tion
(%)
Unemployment Rate
But Surprising Moderation Occurred in 1999-2000
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Useful Inflation Rules of Thumb
Consumer price inflation will rise...• ...By 0.5 for each percentage point the unemployment rate falls below the full employment norm.• ...By 0.1 for each percentage point increase in wholesale energy prices.
Wholesale price inflation (for finished goods) will rise...• ...By the same 0.4 for each percentage point the unemployment rate falls below the full employment norm.• ...By 0.2 for each percentage point increase in wholesale energy prices.
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BRINNER21The Track Record for the CPI Rule
(The Actual and Predicted Changes in CPI Inflation)(Percentage points)
History Forecast
-6
-4
-2
0
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8
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12
14
1961 1966 1971 1976 1981 1986 1991 1996
Consumer Price Inflation
Actual Predicted
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BRINNER22The Policy Tradeoff: Unemployment
vs. Changes in Inflation
RP-RP\1=THE CHANGE IN INFLATION=-0.5 * (U-U@VOL)
THIS IS THE TRADEOFF FACING ANY POLICY-MAKER WITH TARGETS INVOLVING BOTH THE INFLATION RATE AND THE UNEMPLOYMENT RATE
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BRINNER23The Policy Tradeoff: Unemployment
vs. Changes in Inflation
Two endogenous variables: RP and UIn terms of the earlier model, think of U as varying inversely with GNP, hence the endogenous variables are RP and GNPIf these are the only targets policy-makers care about, then they need only two policy instruments to achieve them...
....if we achieve perfect coordination..
....and have perfect system knowledge.
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BRINNER24The Policy Tradeoff: Unemployment
vs. Changes in Inflation
The first priority of the Federal Reserve, the manager of one instrument--credit policy, is one target--inflation control.– The second priority/target is growth.
The first priority of elected officials, the managers of other instruments--taxes and government spending, is usually unemployment / growth– Their second priority is inflation control.
In practice, they do not collaborate well.
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BRINNER25The Policy Tradeoff: Unemployment
vs. Changes in Inflation
Other problems, beyond lack of collaboration, preventing simple achievement of inflation and growth goals.– Political disagreement on targets.– Scientific disagreement on, or stubborn
refusal to recognize, the “model”– External shocks without adequate
warning.– Desire for policy stability.– .....
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BRINNER26The Policy Tradeoff: Unemployment
vs. Changes in Inflation
Short-term interest rates, managed by the Fed, reveal Fed sensitivity to inflation, unemployment. and policy stability. They also reveal a lack of complete foresight.
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BRINNER27THE FED REACTS PREDICTABLY
TO THE ECONOMY
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FEDERAL FUNDS RATEINFLATION+EMPLOYMENT