Unemployment and Inflation – Part 14

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. 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:

I am now continuing …. Note this Chapter may be split into several at the editorial stage. For now I am just treating it as a continuous and logical (sequential) flow. The sequence is a mix of history and evolution of related ideas.

Chapter 12 – Unemployment and Inflation


12.X Incomes Policies

Governments facing wage-price spiral and reluctant to introduce a sharp contraction in the economy, which might otherwise discipline the combatants in the distribution struggle, have, from time to time, considered the use of so-called incomes policies.

These policies have been introduced, in various forms, in many countries as a way of reducing supply-side cost pressures and allowing employment to stay at all levels.

Incomes policies, in general, and measures that are aimed to control the rate at which wages and prices rise, typically, as the economy moves towards, or is at full employment.

In the context of the Phillips curve, incomes policies were seen as a way of flattening the Phillips curve and reducing the inflationary impact of a reduction in unemployment.

Many countries have at various times introduced these type of policies.

For example, in 1962 the US government introduced wage-price guideposts, which allowed for an average rate of nominal wage increase equal to the average annual rate of productivity growth in the overall economy. Other nominal incomes, including profits, were to be tied to this rule.

Taken together, it was considered that this rule would stabilise the growth in nominal incomes and reduce any inflationary pressures associated with the maintenance of full employment.

The rule also sought to distribute productivity gains eight across all income earners and thus reduce the distributional conflict, which may instigate a wage-price spiral.

For a time, the guidelines seemed to work. But as the US government expenditure grew as a result of its prosecution of the Vietnam war effort and unemployment fell below four percent, wage increases began to exceed average productivity growth. By 1996, the guidelines provided no discipline on the growth of nominal incomes in the US.

It was clear that the US government was unable to compel employers to follow the guideposts in the wage bargaining process.

Despite the failure of the wage-price guideposts, the Republican administration under Nixon reintroduced an incomes policy in 1971. Initially, this was in the form of a 90-day freeze on wages and other nominal incomes. Later, compulsory growth guidelines were set for wages and prices growth and these were replaced with a voluntary mechanism.

Soon after (in 1973), the government introduced yet another freeze on prices, followed by sector-by sector price rises in line with cost increases with a freeze on profit margins. The experiment ended in April 1974.

It is thought that the same institutional structures that made economies more susceptible to distributional conflict in the late 1960s and early 1970s – for example, highly concentrated industries with large firms exercising significant price-setting how interacting with strong trade unions – also named the operation of incomes policies difficult.

Powerful firms are in a strong position to pass on wage demands in the form of higher prices and governments are reluctant, or are unable constitutionally, to mandate strict wage-price controls in normal times.

The other problem with average productivity rules is that they uncompensate workers in above-average productivity growth sectors and overcompensate workers in below-average sectors.

However, incomes policies have worked more effectively in some European nations, for example, Austria and in Scandinavian countries. Such nations have long records of collective bargaining and are more attuned to tri-partite negotiations than the English-speaking nations.

A good example of a successful income policy approach, where wages and prices growth was driven by productivity growth in certain sectors, is the so-called Scandinavian Model (SM) of inflation.

This model, originally developed for fixed exchange rates, dichotomises the economy into a competitive sector (C-sector) and a sheltered sector (S-sector). The C-sector produces products, which are traded on world markets, and its prices follow the general movements in world prices. The C-sector serves as the leader in wage settlements. The S-sector does not trade its goods externally.

Under fixed exchange rates, the C-sector maintains price competitiveness if the growth in money wages in its sector is equal to the rate of change in its labour productivity (assumed to be superior to S-sector productivity) plus the growth in prices of foreign goods. Price inflation in the C-sector is equal to the foreign inflation rate if the above rule is applied. The wage norm established in the C-sector spills over into wages growth throughout the economy.

The S-sector inflation rate thus equals the wage norm less its own productivity growth rate. Hence, aggregate price inflation is equal to the world inflation rate plus the difference between the productivity growth rates in the C- and S-sectors weighted by the S-sector share in total output. The domestic inflation rate can be higher than the rate of growth in foreign prices without damaging competitiveness, as long as the rate of C-sector inflation is less than or equal to the world inflation rate.

In equilibrium, nominal labour costs in the C-sector will grow at a rate equal to the room (the sum of the growth in world prices and the C-sector productivity). Where non-wage costs are positive (taxes, social security and other benefits extracted from the employers), nominal wages would have to grow at a lower rate. The long-run tendency is for nominal wages to absorb the room provided. However in the short-run, labour costs can diverge from the permitted growth path. This disequilibrium must emanate from domestic factors.

The main features of the SM can be summarised as follows:

  • The domestic currency price of C-sector output is exogenously determined by world market prices and the exchange rate.
  • The surplus available for distribution between profits and wages in the C-sector is thus determined by the world inflation rate, the exchange rate and the productivity performance of industries in the C-sector.
  • The wage outcome in the C-sector is spread to the S-sector industries either by design (solidarity) or through competition.
  • The price of output in the S-sector is determined (usually by a mark-up) by the unit labour costs in that sector. The wage outcome in the C-sector and the productivity performance in the S-sector determine unit labour costs.

An incomes policy would establish wage guidelines which would set national wages growth according to trends in world prices (adjusted for exchange rate changes) and productivity in the C-sector. This would help to maintain a stable level of profits in the C-sector.

Whether this was an equilibrium level depends on the distribution of factor shares prevailing at the time the guidelines were first applied.

Clearly, the outcomes could be different from those suggested by the model if a short-run adjustment in factor shares was required. Once a normal share of profits was achieved the guidelines could be enforced to maintain this distribution.

A major criticism of the SM as a general theory of inflation is that it ignores the demand side. Uncoordinated collective bargaining and/or significant growth in non-wage components of labour costs may push costs above the permitted path. Where domestic pressures create divergences from the equilibrium path of nominal wage and costs there is some rationale for pursuing a consensus based incomes policy.

An incomes policy, by minimising domestic cost fluctuations faced by the exposed sector, could reduce the possibility of a C-sector profit squeeze, help maintain C-sector competitiveness, and avoid employment losses. Significant contributions to the general cost level and hence prices can originate from the actions by government. Payroll taxation, various government charges and the like may in fact be more detrimental to the exposed sector than increased wage demands from the labour market.

Although the SM was originally developed for fixed exchange rates, it can accommodate flexible exchange rates. Exchange rate movements can compensate for world price changes and local price rises. The domestic price level can be completely insulated from the world inflation rate if the exchange rate continuously appreciates (at a rate equal to the sum of the world inflation rate and C-sector productivity growth).

Similarly, if local price rises occur, a stable domestic inflation rate can still be maintained if a corresponding decrease in C-sector prices occur. An appreciating exchange rate discounts the foreign price in domestic currency terms.

What about terms of trade changes? Terms of trade changes, which in the SM justify wage rises, also (in practice) stimulate sympathetic exchange rate changes. This combination locks the economy into an uncompetitive bind because of the relative fixity of nominal wages. Unless the exchange rate depreciates far enough to offset both the price fall and the wage rise, profitability in the C-sector will be squeezed.

It was considered appropriate to ameliorate this problem through an incomes policy. Such a policy could be designed to prevent the destabilising wage movements, which respond to terms of trade improvements. In other words, wage bargaining, consistent with the mechanisms defined by the SM may be detrimental to both the domestic inflation target and the competitiveness of the C-sector, and may need to be supplemented by a formal incomes policy to restore or retain consistency.

By the 1970s, with the rising dominance of Monetarism, which eschewed institutional solutions to distributional conflict in favour of market-based approaches, incomes policies lost favour in most countries.

The Monetarist approach combined the use of persistently high unemployment and increased policy attacks on trade unions in many advanced nations to reduce the bargaining power of workers. This reduced the inflationary tendency because workers were unable to pursue real wages growth and as a result productivity growth outstripped real wages growth. This led to a substantial redistribution of real income towards profits during this period.

The rise of Thatcherism in the UK exemplified this increasing dominance of the Monetarist view in the 1980s.

12.X Raw material price rises

Up until now we have been concentrating on workers pursuing nominal wage increases in order to gain higher real wages and/or firms pushing profit margins up to gain a greater profit share of real income as the main drivers of an inflationary process.

However, raw material price shocks can also trigger of a cost-push inflation. These cost shocks may be imported (for example, an oil-dependent nation might face higher energy prices if world oil prices rise) or domestically-sourced (for example, a nation may experience a drought which increases the costs of food which impact on all food processing industries).

Take for example a price rise for an essential imported resource. The imported resource price shock amounts to a loss of real income for the nation in question. That is, there is less real income to distribute to domestic claimants.

The question then is who will bear this loss? With less real income being available for distribution domestically, the reactions of the claimants is crucial to the way in which the economy responds to the impost.

The loss has to be shared or borne by one of the claimants or another. If local firms pass the raw material cost increases on in the form of high prices, then workers would endure a cut in their real wages.

If workers resist this erosion of their real wages and push for higher nominal wages growth then firms can either accept the squeeze on their profit margin or resist.

You can see that the dynamics of the Conflict Theory of Inflation are triggered by the raw material price rise.

The government can employ a number of strategies when faced with this dynamic. It can maintain the existing nominal demand growth which would be very likely to reinforce the spiral.

Alternatively, it can use a combination of strategies to discipline the inflation process including the tightening of fiscal and monetary policy to create unemployment (the NAIRU strategy); the development of consensual incomes policies and/or the imposition of wage-price guidelines (without consensus).

Ultimately, if the claimants on real income try to pass the raw material price rise onto each other then it is likely that contractionary government policy will be introduced and unemployment will rise.


A cost-push inflation requires certain aggregate demand conditions to continue for a wage-price spiral to lead to an accelerating inflation. In this regard, the concept of a supply-side inflation blurs with the demand-pull inflation although their originating forces might be quite different.

For example, an imported raw material shock means that a nation’s real income that is available for distribution to domestic claimants is lower. This will not be inflationary unless it triggers an on-going distributional conflict as domestic claimants (workers and capital) try to pass the real loss onto each other.

However, that conflict needs “oxygen” in the form of on-going economic activity in sectors where the spiral is robust. In that sense, the conditions that will lead to an accelerating inflation – high levels of economic activity – will also sustain an inflationary spiral emanating from the demand-side.

In the next Chapter we will introduce the concept of buffer stocks in a macroeconomy (employment and unemployment) and analyse how they can be manipulated by policy to maintain price stability.



I do plan to finish this discussion off next week

Saturday Quiz

The Saturday Quiz will be back again tomorrow.

That is enough for today!

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

This Post Has 3 Comments

  1. This is a great series.. thank you.

    “For example, an imported raw material shock means that a nation’s real income that is available for distribution to domestic claimants is lower. This will not be inflationary unless it triggers an on-going distributional conflict as domestic claimants (workers and capital) try to pass the real loss onto each other.”

    Is it assumed that the credit system will always accommodate inflation in this setting, providing employers (or, heaven forbid, workers) with credit to cover their shortfall, accelerating the spiral? I guess this resolves to another government policy setting- the interest rate.

    A material shock episode seems like a good time to pull in the reigns and allow increased costs to settle out among economic actors, rather than accommodating with more credit, inflation, and stagflation. Then the government can attend to the real policy choices- which claimants to favor with legal, regulatory, and fiscal tools.

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