Download Nairu

Tnflation
The
Logic
of
807
Wage-Price Arithmetic
aionship between prices, wages. and productvity can be 1ormalized as tolows: The fact that
a r e based on average labor costs per unit or output implies that Pis always proportional to WLIQ,
ee Pis the price level. i
the wage rate. i s labor-hours, and Q is output Assume that average
ioductivity (Q/L) is growing smootnly at 1 percent per year. Hence, if wages are growing a
4 percet annually, prices will grow at 3 percent annually (
gowth in prouuciy.
ore
a
4 percent growth in wages1 percent
generalyX
Rate of intation= rale of
wage growth
-rale of
productivily growth
Ths shows the relatonship between price nlation and wage inftalion.
We can ilusrate ow ciosey ths relationship holds with actual numbors for a high-inlation period
nd for a low-iniation period. The following table shows the major long-run determinants of inilation to be
wage growth and productivily change. From the lirst to the second period. inflation rose because wage
g h reased s I y whe producviy fellsharpy In the third period, infiation was low because
*age growin was restrained white productivity growih rebounded.
Rate of
cPiRateof wage productivit
inttation%grOwth )rowth (5)
1958-19733
1973
-1995
56
1995-2007
ource:
ne
59
26
26
43
Bureau od labot Saisics data
on
the beusineu wtor,
at mwk
g
Nonaccelerating Inflation Rate of Unemployment
Faun
loked carefully at inflationary periods noticed that the simple two-variable Phik
M
in Figure 30-8 was unstable. On the basis of theoretical work ot kamuna e p s
odem
an, along with statistical tests of the actual history, macrocconomists developed
wrd
o
hitlipsc
g
ination, which distinguishes between the long run aund the sliot run. Ihe
hillips curve of Figure 30-8 holds only in the short un. In the long run, the
not
rtical,
downward-sloping. This approach implies that in the longrun there
mployment rate that is consistent wih steady intlation. 1his is the nonacelerating
is
tunimum
Maon
le of unemployment or NAIRU
(pronounceu
te
consisten
and vage in
M
be
(or NAIRU) s that
unemply ment
of unemployment
ng inllation raterate.
price
Ar the NAIRU, upuard and dousmaard Jorces
onstant inflation
The NAIRU is the
to
on
n
balance,
so
thae is
no
tendency Jor anflation
changr.
e n t rate that can be sustained without upuard presure on njlatun.
idea behind
n d thhe NAIRU is that the state of the economy can be divided into three situations:
the
Ghee ets wl
s
NAIRU1
tem e l m e s be encountered. The ornginal arhe lur tie AIRU Was the "natural rate of
atinlactory lecause ihete
nothing
natural about
the
NATRU,
nemploy
808
Economics
Excess demand. \When markets are extremey tught, with low unemployment and high utilization of
capacity, then prices and wages wll be subyect to demand-pull inflation.
Excess supply. In recessionary situations, with high unemployment and idled factories, firms tend
to sell at discounts and workers Push less agsressively 1or wage increases. Wage and price infla
tion tend to moderate.
Neutral pressurs. Sometimes the economy is Operating in neutral." The upward wage pressures
from job vacancies just match the downward wage pressures from unemployment. There are no
supply shocks from oil or other exogenous sources. Here, the cconomy is at the NAIRU, and
intlation neither rises nor falls.
From Short Run to Long Run
How does the economy move from the short run to the long run? The basic idea is that when price
changes are unanticipated, the short-run Philips curve tends to shift up or down. This point is illus
trated by a series of steps in a "boom cyele
here and in Figure 30-9:
Period 1. In the first period, unemployment is at the NAIRU. There are no demand or supply
surprises, and the economy is at point A on the lower short-run Phillips curve (SRPC) in Figure
30-9.
SAPC
Long-run
Phalps curve
Inflation
E periods 2 and 3
Short-run Phiips
C u e ro pOTOd
int.ation in
perioa
Short-run Philips curve for
Deriods
U
1 and 2
NAIRU
Unemploynent rate
FIGURE 30-9. The Shiting Phillips Curve
This figure shows how economicexpansion leads to an inflationary surprise and an upward shit in the Sh
hillips curve. The steps in the shift are explained by the bullets in the tex. Nole t h a
5, and C, the shiting curve produces a cockwise loop.
y o u connece p o
Intiation
809
Prind 2. Next,supposethere an comic expansion which lowers the umemployment rate. As
mployment declines, firms recruit workers more vigorously, giving larger wage increases than
formerly. As outpiit u p c h e s tgicuy, price markups tie. Wages and prices begin to acceler
ate. In terms of our Phillips ure, the eronomy moes up and to the left to point Bon its short
run Phillips curve (aleng
n
Figure 309) As shown in the figure, intlation expectations
have not yet changed, s0 the economy stays on the original Phillips cune, on SRPC. The lower
unemployment rate raises inlation during the second period.
Paiod3. Because iniliatuon as ien, rms and workers are surpised, and they revise upward
their intlationary expectations. 1hey begin to incorporate the higher expected inlation into
their wage and price decisions, The result is a shift in the short- un Phillips curnr. We can see the
new curve as C
in Figure 0-9. The new short-run Phillips curne lies above the original Phik
lips curne, rellecting the higher expected rate of inflation. We have drawn the curve so that the
newexpectedntlation rate tor perioxl Scquas the actual in lation rate in period2.Ifa slowdowm
in cconomicactivity brings the unemployment rate back to the NAIRU in period 3, the economy
mones to point C. Even tho1gh the unemployment rate is the same as it was in period 1, actual
nilation will be higher, rellecting the upward shilt in the short-run Phillips curve.
Note the surprising outcome. Because the expected intlation rate has increased, the rate of
inlation is higher in period 3 than during period I even though the unemploynent rate is the
satme. The economy in period 3will have the same rraland
GDP and unemployment rate as it did in
growing
Pod
.even though the nominal magnitudes (prices nominal GDP)
piully than they did before the expansion raised the expected rate of intlation.
are now
more
ne can aso tracka "recession cycle that occurs when unemployment rises and the actual intlaa l e lals below its expected rate. The expected rate of inllation declines in recesions, and the
o m y enoys a lower inllation rate when it retums to the NAIRU. This painful cycle ol austerity
uTed during the Carter-Volcker-Reagan wars against inflation during 1979-1984.
he Vertical Long-Run Phillips Curve
the
unemployment rate departs from the NAIRU, the intlation rate will tend to change.What
Pensif the gap between the actual unemployment rate and the NAIRU Persists? For example, say
e
NAIRU is 5 percent while the actual unemplovment rate s 3 percent. Because ot the Bp.
inftation will tend to rise from year to year. Inflation might be 3percent in the firs ear percent in
ear, 5
Ould this
letenty
ong
lo
percent in the third year-and might
irl
slop?
it
continue
slops only when unemploynent
to move
upward thereafter. When
moves back to
the NAIRU. Put dif.
as unemployment is below the MAIRE, Wage inilaton will tend lo increae.
Nte behavior will
nemployment
be
seen at
high
unemployiment.
In that c a e ,
intlation will tend
is above the R
to
fall
will the shifts of supNAIRU will inlalion stabilze; only then
eh unenployment is ut the
ply an
will
intlaton-at
whatever is its
be
balance; oniy the
and in different labor markets n
iterti
l t e n d neither to increase nor to deciea
tor economic
policy. It implies that
has important implicalions
here iern theory of inflation
the long run. If the
an cconony can enjO
ninum level of unemploynent
tCopo
luhis will ignite an upward spiral of
output and employnent,
pished to very high levels of
age
also provides a lormula
cur bing intlauon. When the inflaP i c e inflation. This theory
raise the
atecessiaon,
tgsct
unemploynent1 rate
a country
mey,
ighien
can
O
high,
oveUhe NAIRU, and thereby redue inllation.
Only
in
hat
tor
810
Economics
The NAIRU defines the neutral zone betueen excesive tightness/nsing inflation and
high unem
ployment/falling inflation. In the short run, inflation can be reduced by aising unemployment
abone the NAIRU, but in the long run, the NAIRU is the louwest sustainable rate of unemployment.
Quantitative Estimates
Although the NAIRU is a crucial macroeconomic concept. precise mumerical estimates of the NAIRU
have proved elusive. Many macroeconomists have used advanced
techniques to estimate the NARU
For this text, we have adopted the estimates prepared by the CongressionalBudget Otfice (CRO)
According to the CBO, the NAIRU rose grad1ually from the 1950s, peaked at 6.3 percent of the labo
force around 1980, and declined to 4.8 percent by 2008. CBO estimates, along with the actual unem
ployment rate through the end of 2008, are shown in Figure 30-10.
Doubts about the NAIRU
The concept of the nonaccelerating intlation rate of unemploynent, along with its output twin o
is crucial for understanding inflation and the connection
the short run and
potenial
GDI,
between
the long un in maCTOeconomics. But the mainstream view remains controversial.
Actual unamployment rate
NAIRU
1960
1990
1970
2000
2010
Year
a d e d areas are NEER recessions
FIGURE 30-10. Actual Unenmployment Rate and NAIRU for the Uniled Stales
TheNAIRU is the unemployment rate at which upward and downward lorces atting on inilation are in balance
weCE; Axtual unempament tate toen Bareau of labor Sutistio NAIRU fron esümates of the Camgiesswnal Badget Oftice
Inflation811
whether the NAIRU is a stable and reliable concept. he intlatiom experiene
States has led econonsts
qeson ietner tetes tCt stable NATRU for the
aited
o t h e r question is whetheran extended pertod ot g h unemionient will lead to a dete
n
to
o f job skills,
not
Might
ueteyto a higher NAIRU.
anng
expetece,
ot otne
Teal
cotunliy with diminished capileave
DTeuce nestnent
1nllation
with
rates
of
not that
ane
anoa
to loss
growth
slow
a
and
capacity shortage protce
a
the
unemployment
even
Nng
ae the NAIKUT
colirms some of these worries (recall o u r discus
the last t w o
decdes
Esperience in Europe over
he
In the early 1960s,
en ot the previous chapter).with
puzle A
on of the European unemployien
Germany,
Brtan appeared to be inol equilibrn and unemployment
France, andlate
Lhor markets
1 9 s , alter a decale
stagnation
slow job growth,
ratesbetweenI and 2 percent. By the
in
Libe market equnilibriun seemed to be in balance with unemployment raiesin the t
pereent
ege. On the basis of recent European experience, many nacroeconomists are looking for a s i
cpuin the instability of the NAIRU and its dependence upon actual tunemploymernt as well as labor
Earket institutions.
Review
he mujor points to understand are the tollowing:
In the short nun, an increase in aggregate demand which lowers the unemployment rale below
tent to
NAIRU will tend to increase the inflation rate. Recessions
high
the
and
unempovnent
line inflaticon. In the short run, there is a tradeoff between inflation and unemploynent.
e n nlation is higher or lower than what people expect, intlation expectatons adjut
craged inflation expectations will generally shift the short-run Philips curve up or d o n
e
ong-run Phillips curve is vertical at the nonaccelerating intlation rate of unemploynen
above (below) the NAIRU will tend to lower (inerease) the rate ot
AIRU). Unemployment
EifLation.
CDILEMMAS OF ANTI-INFLATION POLICY
e
econony evohes in resprn
designed
On inflati *
uw
Long
The NA
Ssues
Hke
Our
change.
political forces and technological
also alapt.
must
inllauon and unemplovmet,
he
the
length
Phillips
cune is
vertical
that
decade T
oher
g
It
Cost to Reduce
that
nation
can
estsunemployment.
a
long run. Just
agustuent
ntlation
l a k e s at
ol
llation by
expected
the
policynakets may wAnt ta knoW Just
reduce
But
to adjust
is the
how longshock
lully
3
to
long
is
a
not
or
ieast yats petlups
labor
for
to adjust, Tor
espectations
takes yeaIs
d for all thhese eilects to percoiate nrous
lul
dca
o0om
Does
in the
of time that it takes the econouy
Kecent studies suggest
it
n e Teason
4
O n lor the
the long delay is that
her lo.
*"
E e n contracts to be renegoated,
analysis
and
In this tinal sec
Long Run:
yholds that
n with
Much
theo
economic
cony, we discuss the pressing isuues that arise in combating inflaticon.
Is the
for this
to
rate
temporarily reducing
hOW much it costs to