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902mit02.ppt

The Policy Tradeoff: Unemployment vs.

Changes in Inflation

Introduction to Macro Policy and Models

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902mit02.ppt

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

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902mit02.pptSimple 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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902mit02.pptSimple Micro in the Labor Market : Prices, Demand and Supply

DEMAND

SUPPLY

REALWAGE

WORKERS or HOURS DEMANDED AND SUPPLIED

EQUILIBRIUM

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902mit02.ppt Simple Dynamics: Disequilibrium Means Change in the Labor Market

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

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902mit02.pptSimple Dynamics: Disequilibrium Means Change in the Labor Market

DEMAND

SUPPLY

REALWAGE

WORKERS / HOURS DEMANDED AND SUPPLIED

DISEQUILIBRIUM

INVOLUNTARYUNEMPLOYMENT

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902mit02.ppt

Fluctuations in Unemployment

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10

1967 1971 1975 1979 1983 1987 1991

Job Losers

Reenter

New Entrants

Job Leavers

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902mit02.ppt

Fluctuations in Unemployment

DEMOGRAPHICS AND THE UNEMPLOYMENT RATE

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1998

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6.4

"YOUNG ADULT SHARE OF POPULATION' "NAIRU"

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902mit02.ppt

Fluctuations in Unemployment

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1949 1955 1961 1967 1973 1979 1985 1991 1997Unemployment Rate Full Employment Unemployment Rate

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902mit02.pptTHE 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

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TE

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902mit02.ppt

A LONGER PERSPECTIVE

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UNEMPLOYMENT RATE CPI INFLATION RATE

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902mit02.pptTHE LONG-TERM POLICY

CHOICES AREN'T AS OBVIOUS

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UNEMPLOYMENT

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902mit02.ppt

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 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)

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902mit02.ppt

A Companion Equation for Price Inflation

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

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902mit02.ppt

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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(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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902mit02.ppt

Useful Inflation Rules of Thumb (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.

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902mit02.pptThe Track Record for the CPI Rule

(The Actual and Predicted Changes in CPI Inflation)

(Percentage points)

History Forecast

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1961 1966 1971 1976 1981 1986 1991 1996

Consumer Price Inflation

Actual Predicted

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902mit02.pptThe 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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902mit02.pptThe 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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902mit02.pptThe 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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902mit02.pptThe 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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902mit02.pptThe 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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902mit02.pptTHE FED REACTS PREDICTABLY

TO THE ECONOMY

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FEDERAL FUNDS RATE INFLATION+EMPLOYMENT