Transcript The Policy Tradeoff: Unemployment vs. Changes in Inflation

Introduction to Macro
Policy and Models
The Policy Tradeoff:
Unemployment vs.
Changes in Inflation
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Focus Today
Simple Micro: Prices, Demand and Supply
 Simple Dynamics: Disequilibrium Means
Change
 An example central to policy choices:
managing the economy to produce a
desired outcome

Simple 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 Equal
 Supply: More Hours Will Be Supplied by
Individuals the Higher the Real Wage
 Equilibrium: 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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Simple Micro in the Labor Market :
Prices, Demand and Supply
REAL
WAGE
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DEMAND
EQUILIBRIUM
SUPPLY
WORKERS or HOURS DEMANDED AND SUPPLIED
Simple Dynamics: Disequilibrium
Means Change in the Labor Market
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Unemployed Workers:
– Voluntary, as in searching for a job at a
wage higher than they or their peers are
being offered: not a sign of
disequilibrium
– Involuntary: Would accept the
prevailing wage but no offer
forthcoming.
»By definition, Supply greater than
Demand...at the prevailing wage
 Involuntary Unemployment Creates
Pressure for (Real) Wages to Fall

Simple Dynamics: Disequilibrium
Means Change in the Labor Market
REAL
WAGE
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DEMAND
DISEQUILIBRIUM
SUPPLY
INVOLUNTARY
UNEMPLOYMENT
WORKERS / HOURS DEMANDED AND SUPPLIED
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Fluctuations in Unemployment
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2
1
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Job Losers
Reenter
New Entrants
Job Leavers
1967
1971
1975
1979
1983
1987
1991
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Fluctuations in Unemployment
DEMOGRAPHICS AND THE UNEMPLOYMENT RATE
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6.2
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5.8
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5.6
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5.4
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5.2
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"YOUNG ADULT SHARE OF POPULATION'
"NAIRU"
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Fluctuations in Unemployment
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10
8
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2
0
1949 1955 1961 1967 1973 1979 1985 1991 1997
Full Employment Unemployment Rate
Unemployment Rate
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THE APPARENT POLICY OPTIONS
IN THE 1960s
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1969
CPI INFLATION RATE
5
4
3
1965
2
1962
1
1959
0
-
1.0
2.0
3.0
4.0
5.0
UNEMPLOYMENT RATE
6.0
7.0
8.0
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PERCENT
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A LONGER PERSPECTIVE
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2
0
-2
UNEMPLOYMENT RATE
CPI INFLATION RATE
THE LONG-TERM POLICY
CHOICES AREN'T AS OBVIOUS
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1974
1980
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1947
INFLATION
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1959
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1983
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-2
UNEMPLOYMENT
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The Equation
for Wage Inflation
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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
inflation
 plus a constant (A0) for productivity
growth and other factors not defined here
 minus an adjustment for the existence of
involuntarily unemployed workers:total
unemployment (U) - voluntary (U@VOL)
A Companion Equation
for Price Inflation

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If prices are a simple “mark-up” on
wages..
P
=K*W
hence RP = RK + RW

..and this markup falls when the economy
is sluggish
»RK = B0 - B1 * (U-U@VOL)

Then:
RP = B0 - B1 * (U-U@VOL) + RW
The Final Form Model
of Price Inflation

RP = B0 - B1 * (U-U@VOL) + RW

AND, EARLIER,
RW=RP\1+A0-A1*(U-U@VOL)

THUS
RP=(A0+B0)-(A1+B1)*(U-U@VOL)+RP\1

OR RP-RP\1 =
THE CHANGE IN INFLATION=
(A0+B0) - (A1+B1)*(U-U@VOL)
The acceleration in prices is tied to the level of excess demand.
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Real Wages Accelerated As Usual after Q1 1997,
As Unemployment Fell Below 5.5%
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8%
Inflation-Igniting Threshold:
(5.5% unemployment)
Inflation (%)
7%
6%
Unemployment
Rate
5%
4%
3%
Nominal
Wage Inflation
2%
Real Wage Inflation
1%
0%
(1%)
1995
1996
1997
1998
Useful Inflation Rules of Thumb
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(Validated 1959-93)
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.
The Track Record for the CPI Rule
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(The Actual and Predicted Changes in CPI
Inflation)
(Percentage points)
History
Forecast
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4
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-4
-6
1961
1966
1971
Consumer Price
Inflation
1976
1981
1986
Actual
1991
Predicted
1996
The Policy Tradeoff: Unemployment
vs. Changes in Inflation
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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

The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 Two
endogenous variables: RP and U
 In terms of the earlier model, think of U as
varying inversely with GNP, hence the
endogenous variables are RP and GNP
 If 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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The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 The
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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.
The 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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The Policy Tradeoff: Unemployment
vs. Changes in Inflation
 Short-term
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interest rates, managed by
the Fed, reveal Fed sensitivity to
inflation, unemployment. and policy
stability. They also reveal a lack of
complete foresight.
THE FED REACTS PREDICTABLY
TO THE ECONOMY
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16
14
10
8
6
4
2
FEDERAL FUNDS RATE
INFLATION+EMPLOYMENT
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97
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95
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93
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91
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89
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87
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85
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83
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81
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79
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77
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73
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71
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69
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67
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65
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63
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61
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59
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57
0
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55
PERCENT
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