Unemployment and inflation – Part 4

Today I have had a major report to complete on “efficiency dividends” in government budgets (for a union), have a lot of travel ahead, and also want to progress my macroeconomics. Report complete except for summary, which I will finish on the plane tonight. So until then I am progressing the Modern Monetary Theory (MMT) text-book, which I am writing in liaison with my colleague and friend, Randy Wray. We are trying to get it completed for use in second-semester 2013 and so I am spending more time on it to meet that expectation. Today, I continue to develop the material on unemployment and inflation. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

This is the continuation of the Chapter on unemployment and inflation – the series so far is:

• Unemployment and inflation – Part 1
• Unemployment and inflation – Part 2
• Unemployment and inflation – Part 3

I am now continuing Section 12.6 on the Phillips Curve …

Chapter 12 – Unemployment and Inflation

MATERIAL HERE NOT REPEATED.

Phillips own version of the Phillips curve

The Phillips curve has been used by macroeconomists to link the level of economic activity to the movement in the price level. In the Phillips curve framework, the level of economic activity is represented by the unemployment rate. The presumption is that when the unemployment rate rises above some irreducible minimum then economic activity is declining and as the unemployment rate moves towards that irreducible minimum the economy moves closer to full capacity and full employment.

We will see in a later section that the Phillips curve and Okun’s Law, which links changes in the unemployment rate to output gaps (the difference between potential output and actual output) coexist comfortably in macroeconomic theory. The latter provides the extra link between unemployment and output.

In some textbooks you will find inflation models that conflate the two concepts (Phillips curve and Okuns’ Law) and directly relate the inflation rate to the output gap. We prefer for reasons that will be obvious not to take that approach in this text book.

In 1958, New Zealand economist Bill Phillips published a statistical study, which showed the relationship between the unemployment rate and the proportionate rate of change in money-wage rates for the United Kingdom. He studied that relationship for the period 1861 to 1957.

Phillips believed that given that money wage costs represent a high proportion of total costs that movements in money wage rates will drive movements in the general price level.

He had earlier written a paper in 1954 which can be considered a precursor to his 1958 empirical study, which serious students should read in conjunction with his 1958 study.

[REFERENCE: Phillips, A.W. (1958) ‘The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957’, Economica, 25(100), 283-299. The link is if you have a subscription at your library to JSTOR.]

One of the graphs he produced in his 1958 article is reproduced as Figure 11.4. It shows two separate periods of data. First, the curve fitted with statistical methods to fit the data for the period 1861-1913. Second, the scatter plot of the data for the period 1913-1948. Phillips produced a number of graphs like this to show how he built up his overall curve for the entire period 1861 to 1957. The detail of his method is not relevant here but for those interested in the early efforts using regression techniques a thorough reading of his article is recommended.

Figure 11.5 Phillips 1958 Figure 9 – unemployment and money wage inflation, 1913-1948

How did Phillips explain this relationship? In his 1958 article (Page 283) he provided a basic theory to add behavioural meaning to the empirical relationship he found that linked the unemployment rate to the growth of money wage rates.

He wrote:

When the demand for a commodity or service is high relatively to the supply of it we expect the price to rise, the rate of rise being greater the greater the excess demand. Conversely when the demand is low relatively to the supply we expect the price to fall, the rate of fall being greater the greater the deficiency of demand. It seems plausible that this principle should operate as one of the factors determining the rate of change of money wage rates,which are the price of labour services. When the demand for labour is high and there are very few unemployed we should expect employers to bid wage rates up quite rapidly,each firm and each industry being continually tempted to offer a little above the prevailing rates to attract the most suitable labour from other firms and industries. On the other hand it appears that workers are reluctant to offer their services at less than the prevailing rates when the demand for labour is low and unemployment is high so that wage rates fall only very slowly. The relation between unemployment and the rate of change of wage rates is therefore likely to be highly non-linear.

Phillips also buttressed this excess demand for labour explanation with two other factors which could influence the rate of change of money wage rates. First, he noted (Page 283) that the “rate of change of the demand for labour, and so of unemployment” (emphasis added) was important to consider.

When business activity was rising:

… employers would be bidding more vigorously for the services of labour than they would in a year during with the average percentage unemployment was the same but the demand for labour was not increasing.

Similarly, when business activity was falling:

… employers will be less inclined to grant wage increases,and workers will be in a weaker position to press for them, than they would be in a year during which the average percentage unemployment was the same but the demand for labour was not decreasing.

He thus recognised that in the context of wage bargaining between employers and workers, the direction of change in the economy was a factor that had to be considered quite apart from the level the economy was currently at.

The other factor Phillips thought was essential to consider was the “rate of change of retail prices”, which could drive the growth in money wage rates “through cost of living adjustments” (Page 283). He thought this impact would be of less importance unless there was a “very rapid rise in import prices” (Page 284).

But in recognising that the movement in retail prices is intrinsic to understanding the movement in real wages and that this link worked through adjustments in the money wage rates, Phillips was reinforcing the arguments made by Keynes that the real wage was not determined in the labour market and that workers could not directly manipulate the real wage prevailing at any time.

Soon after Phillips had published his work on the UK, the American economists Paul Samuelson and Robert Solow published an article in 1960, which produced a Phillips curve-type relationship using US data over the period 1934 to 1958.

[Reference: Samuelson, P.A. and Solow, R.M. (1960) ‘Analytical Aspects of Anti-Inflation Policy’, American Economic Review, 50(2), Papers and Proceedings of the Seventy-second Annual Meeting of the American Economic Association, May, 177-194. You can download a JSTOR copy outside of the JSTOR restrictions – HERE.]

Building on the recognition that money wage costs represent a high proportion of total costs that movements in money wage rates will drive movements in the general price level, Samuelson and Solow’s “Phillips curve” was a relationship between the rate of growth in the general price level (that is, price inflation) and the unemployment rate.

Samuelson and Solow also defined the Phillips Curve as a policy tool, which the government could use to lessen the burden of unemployment.

The timing of the Samuelson-Solow contribution is important. Between 1960-61, the US economy was mired in a deep recession and the unemployment rate was rising. The work of Samuelson and Solow was designed to be a major intervention into the policy debate and provide policy makers with a new framework for understanding the consequences of policies designed to reduce the unemployment rate.

Figure 11.5 replicates Figure 2 from Samuelson and Solow (1960) which they call their “price-level modification of the Phillips curve” (Page 192). Note the sub-text – a “menu of choice”, implying that policy makers could choose points along their estimated Phillips curve to reach preferred combinations of inflation and unemployment.

This introduced the idea of a policy trade-off between unemployment and inflation. If the government wanted to sustain lower unemployment rates then the cost of that policy decision would be higher inflation.

Figure 11.5 The Samuelson-Solow “Modified” Phillips curve for the US economy

They interpreted their Phillips curve in the following way (Page 192):

1. In order to have wages increase at no more than 21/2 percent per annum characteristics of our productivity growth, the American economy would seem on the basis of twentieth-century and postwar experience to have to undergo something like 5 to 6 per cent of the civilian labor force’s being unemployed. That much unemployment would appear to be the cost of price stability in the years immediately ahead.

2. In order to achieve the nonperfectionist’s goal of high enough output to give us no more than 3 per cent unemployment, the price index might have to rise by as much as 4 to 5 per cent per year. That much price rise would seem to be the necessary cost of high employment and production in the years ahead.

Relating these assessments to the graph (Figure 11.5), price stability (no inflation) is defined at Point A (where the unemployment rate was estimated to be 5.5 per cent) and Point B is where a 3 per cent unemployment rate corresponds to an inflation rate of 4.5 per cent per annum.

Samuelson and Solow qualified their work in this way (Page 193):

Aside from the usual warning that these are simply our best guesses we must give another caution. All of our discussion has been phrased in short-run terms, dealing with what might happen in the next few years. It would be wrong, though, to think that our Figure 2 menu that relates obtainable price and unemployment behavior will maintain its same shape in the longer run. What we do in a policy way during the next few years might cause it to shift in a definite way.

In other words, the “trade-off” they proposed between inflation and unemployment might shift in the longer run in response to policy makers exploiting it in the short-run. As we will see this warning was very prescient.

However, despite this warning, the Phillips curve “trade-off” became conventional wisdom among mainstream economists profession and policy makers and the latter proceeded to design policy as if the choice was stable over time.

It is also significant, that the work of Phillips and Samuelson and Solow and some other economists at the time, shifted the debate about what constitutes full employment. Whereas the Keynesian orthodoxy in the 1940s and 1950s defined full employment in terms of a number of jobs – that is, there had to be at least as many of vacant jobs available as there were persons seeking employment – the introduction of the Phillips curve and its emphasis on unemployment changed that focus.

Initially, this change in focus involved a debate about what constituted the irreducible minimum rate of unemployment. The work of Bancroft (1950), Dunlop (1950) and Slichter (1950) were important contributions to this shift in emphasis.

But soon the debate became tangled up in models of unemployment and inflation after the work of Phillips and, then, Samuelson and Solow were published. The debate shifted from considering how many jobs were required to be generated to achieve full employment to consideration of the existence and nature of a trade-off between nominal (inflation) and real (unemployment) outcomes.

The Keynesian orthodoxy considered real output (income) and employment as being demand-determined in the short-run, with price inflation being explained by a negatively sloped Phillip’s curve (in both the short-run and the long-run). Policy-makers believed they could manipulate demand and exploit this trade-off to achieve a socially optimal level of unemployment and inflation. Significantly, the concept of full employment gave way to the rate of unemployment that was politically acceptable in the light of some accompanying inflation rate. Full employment was no longer debated in terms of a number of jobs.

[References: Bancroft, G. (1950) ‘The Census Bureau Estimates of Unemployment'”, The Review of Economics and Statistics, February, pp. 59-65.

Dunlop, J.T (1950) ‘Estimates of Unemployment: Some Unresolved Problems’, Review of Economics and Statistics, February, pp. 77-79.

Slichter, S. (1950) ‘Comment on the Papers on Employment and Unemployment’, Review of Economics and Statistics, February, pp. 74-77.]

TO BE CONTINUED

Conclusion

NEXT TIME I WILL FINISH THE ORIGINAL PHILLIPS CURVE AND CONSIDER THE RESPONSES TO IT LEADING UP TO THE EVOLUTION OF THE NATURAL RATE OF UNEMPLOYMENT APPROACH WHICH STILL DOMINATES.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.