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NBER WO~G PAPER SERIES MACROECONOMIC POLICY ~ THE PRESENCE OF STRUCTURAL MALADJUSTMENT Robert J. Gordon Working Paper 5739 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 September 1996 This research has been supported by the National Science Foundation. I am grateful to Martin Cohan and Tomonori Ishikawa for help with the data and graphs. This paper is part of NBER’s research program in Economic Fluctuations and Growth. Any opinions expressed are those of the author and not those of the National Bureau of Economic Research. 0 1996 by Robert J. Gordon. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including 0 notice, is given to the source. NBER Working Paper 5739 September 1996 MACROECONOMIC POLICY IN THE PRESENCE OF STRUCTURAL MALADWSTMENT ABSTRACT This paper analyzes two-way interactions between structural reform and macro policy. If structural reforms increase the flexibility of labor markets, they are likely to improve the short-run inflation-unemployment tradeoff, providing an incentive for policymakers to expand aggregate demand. In turn, the promise by policymakers that they will encourage a decline in unemployment in response to good news on inflation can be used to strike a political deal with political interests opposed to the introduction or extension of structural reform. Expansionary monetary policy also provides relief on the fiscal front, directly by bringing the actual budget deficit closer to the structural budget deficit, and indirectly, by encouraging structural reform, potentially reducing the structural budget deficit itself. In 1992-93 several European countries dropped out of the ERM to pursue more expansionary monetary policies. The difference in the performance of these countties and those countries which maintained a peg between their currencies and the Deutsche mark provides an important test case of the consequences of expansionary monetary policy. The depreciating nations by 1995 enjoyed a substantial relative acceleration of nominal GDP and, surprisingly, an even greater deceleration of inflation, so that their growth rate of real GDP accelerated more than their growth rate of nominal GDP in relation to the pegging countries. The continued deceleration of inflation in the depreciating countries provides evidence that their natural unemployment rate has declined and that expansionary monetary policy has interacted beneficially with structural reform. Robert J. Gordon Department of Economics Northwestern University Evanston, IL 60208 and NBER [email protected]. nwu.edu 1. Introduction Perhaps the most important single economic linked to the topic of this paper, macroeconomic Is it possible for Europe monetary subsidies of inefficient are the connections these connections currently policy and structural to pursue the macroeconomic union despite the existence of structural fiscal debt and deficits, performance firms, and overregulated union, monetary programs, state and labor markets? to maintain data on major aspects What reform? Do demand the growth required a fixed exchange reform ? It then turns to a theoretical and supply analysis. on the of macroeconomic between macro policy and structural section maladjustment In this view, the task of macro rate of nominal aggregate demand, while structural can be viewed as an adverse supply shock, and successful structural reform as a beneficial supply shock. between the effects of structural oil price shocks. product tightness required begins by examining in terms of aggregate maladjustment and welfare strife with interest groups resisting structural the interactions policy is to control such as excessive to resolve the conflicts among fiscal stringency in Europe and the United States. that interprets policies needed to achieve maladjustments, state pension maladjustment. suggest any new avenues for policy in countries like France that are rate, and the political The paper underfunded today can be and feedbacks between macro policy and structural struggling route to monetary issue in Europe We shall analyze the similarities and differences maladjustment and adverse supply shocks, such as Macroeconomic The supply shock model forces us to distinguish change of structural to a negative maladjustment. change in the Structural degree Policy, Page 2 between the level and rate of reform may be viewed as analogous of structural maladju~ment. On closer examination some types of structural productivity growth as to raise it. The analysis of demand and supply shocks forces us to distinguish as well between reform are just as likely to reduce the rate of two leading models of aggregate supply — the and the hysteresis model — and a hybrid that combines them. natural rate hypothesis How does the outcome of alternative policy interventions depend on knowing the right model in advance? The next section of the paper examines feedback from reform to macro policy: countries with more flexible markets may have a more favorable short-term unemployment hysteresis achieved tradeoff. hypothesis, This is particularly which important from the perspective implies that a reduction in unemployment at the cost of only a finite increase in the inflation which depends on the slope of the short-run from macro policy to reform: tradeoff inflation- curve. of the may be rate, the amount There is also feedback a policy that leans in the direction of expansion make it possible to create a political deal with interest groups that resist reform. expansionary policy also reduces the impact of transition There is still the need to determine may An costs from reform. Most of our discussion of macro policy revolves around monetary exchange rate policy. of policy and where fiscal policy fits in. Macroeconomic Is there still a role for fiscal policy in managing aggregate the monetary-fiscal policy mix states that monetary demand; fiscal policy mainly influences long-run capital accumulation the real interest demand? mainly Policy, Page 3 The theory of controls aggregate rate and hence the rate of and growth. Should monetary policy be conducted high ratios of public debt to GDP? differently in nations that have relatively When fiscal deficits exceed the level consistent with a stable debt-GDP ratio, the need to run a budget surplus becomes an imperative and requires a stimulative exchange monetary policy to compensate, rate stability may not be consistent with the implication with fiscal convergence. The empirical section of the paper examines data on the experience European experiment countries since the 1992 breakdown of the consequences that of ERM, which of expansionary aggregate of selected provides a controlled demand policy. We examine the behavior of nominal GDP growth, as well as the “split” of nominal GDP growth between inflation and real GDP growth, in those countries major effective exchange rate depreciations those that did not depreciate. We conclude in 1992-93 as compared by developing push toward monetary union. with some of the implications empirical results for future macro policy within Europe and exploring of a continued that experienced of the the desirability Macroeconomic 2. The Primary Puzzles in Macroeconomic 2.1 Inflation, Unemployment, We begin by comparing Behavior and Labor’s Share basic macroeconomic indicators United States, in order to identify the puzzles to be explained. well-known United divergence European roughly Union (labelled 2 percent unemployment in the time series of unemployment In 1995 the unemployment States. for same countries for Europe and the Figure 1 displays the rates in Europe and the rate for the current members 1) was 11.0 percent, in the early of the compared 1960s, The to 1995 rate in the United States was 5.7 percent, exactly the same as in 1963. The upsurge of European primarily “Europe” in Figure the Policy, Page 4 between unemployment relative to U. S. unemployment 1975 and 1985, suggesting should begin with major structural occurred that the search for an explanation changes that occurred within Europe during that decade. The major theories that describe the interrelation and inflation rates are the natural rate hypothesis between the unemployment and the hysteresis Inflation rates for the Unit~~d States and the same set of European displayed in Figure 2. Here we see that the average inflation has been remarkably European behavior hypothesis. countries are of “Europe” similar to that of the United States since the late 1960s, with the inflation rate exceeding that for the United States by one or two percentage points per year in most years. Given the similarity of the inflation performances, the Macroeconomic natural rate hypothesis unemployment but increased is consistent with the data only if the natural was roughly stationary unemployment This leaves the causes of the increase and U. S. unemployment the contrast flexibility in the U. S. shared in common explanation (1980), for the divergence between (1979), and real wage rigidity in Europe Following the early- 1970s slowdown by all industrialized nations, real wage rigidity in Europe prevented wage ~/P) definition By definition, natural The seminal (1985), and real wage of productivity growth in the U, S. in tandem with productivity growth, such a deceleration. by examining data on labor’s labor’s income share (S) is equal to the real divided by output per hour (Q/H). Using lower-case letters for logs, this implies that the growth rate of the real wage is equal to the growth of productivity over of European Bruno-Sachs real wage flexibility It is easy to assess the validity of this hypothesis share in national income. behavior. Sachs allowed the growth of real wages to decelerate while in the European rates was a contrast in labor-market of Branson-Rotemberg emphasized rate in Europe rate unexplained. During the early 1980s a popular work rate of in the United States over the last three decades by roughly as much as the actual unemployment the same period. Policy, Page 5 rate plus the growth rate of labor’s share: Aw-Ap = (Aq-ti) + As (1) Macroeconomic Thus any tendency of the growth rate of real wages (Azu - Ap) to exceed the growth rate of productivity (~). (Aq - Ab) would be reflected In consequence, share in Europe 1975-85, Policy, Page 6 in positive growth in labor’s share the real-wage rigidity hypothesis leads us to expect that labor’s would have increased relative to that in the United States during the period of the rising relative European unemployment rate. As the cost of labor increased relative to its marginal product, profits would have been squeezed, the demand for labor would have decreased, and unemployment would have increased. The real-wage substantial decades, rigidity hypothesis U, S. literature (albeit small) growth growth, According to equation to have been consistent per hour. a In the for the failure of (l), this common substantially. with a 1.0 percent labor’s share should have declined at 1.0 percent instance from 70 percent annual For rate of per year, for in 1973 to 53 percent in 1993. Both the real-wage rigidity hypothesis perception rate of output implies that the U. S. wage share must have declined zero real wage growth productivity has as its counterpart features of U. S. labor markets account real wages to keep pace with productivity. perception Europe on the failure of real wages to grow over the past two despite a positive American view, structural regarding for Europe as well as the common U. S. of stagnant real \/ages appear to be the reverse of the truth, as shown by the display of wage shares ir~ Figure 3. These wage share series, constructed by the Macroeconomic OECD, include in wage income an imputation self-employed. (dominated percent Policy, Page 7 for the labor income earned by the Far from declining rapidly, the wage share series for North America by the U. S. ) has remained in 1973 to 66.5 percent roughly in 1993. constant, falling only from The wage share series for Europe 68 did increase relative to North America during 1974-81, which coincides with the period when the European the European unemployment rate began its relentless descent. But since 1981 wage share has declined much more, from a 1981 value of 69.3 percent to 63.4 percent in 1993. Thus any effect on unemployment of the high European wage share during the late 1970s should have been more than reversed by the declining wage share during the 1980s and unemployment convincing The rate casts doubt is parallel slowdown productivity have slowdown Competing absence now high European countries been rigid-real-wage unemployment. the worldwide in the natural hypothesis as a The difficulty in this post-1973 productivity to the oil price shocks of the 1970s, since completely reversed in real terms, while the has not been reversed in most countries. with the view that the increased natural rate of unemployment in origin is the hysteresis hypothesis, is “state dependent,” of such a reversal on the original to that in linking in the industrialized oil shocks structural 1990s. cause of persistently explanation the early automatically which postulates was that the natural rate following in the path of the-actual unemployment Macroeconomic rate like the tail of a dog.1 actual unemployment unemployment temporary turn, The hysteresis hypothesis in Europe by a combination unemployment hysteresis rate, the natural rate by restrictive followed Because the actual unemployment process, the inflation To reverse the process, some combination natural of rate, especially adverse supply shocks (e.g., higher oil prices and a rate during the transition expansionary can explain the evolution of events that raised the actual increase in labor’s share) accompanied through Policy, Page 8 demand in the demand path of the In actual rate was above the natural rate declined, as shown in Figure 2. of beneficial supply shocks supported policy must bring the actual unemployment rate, i.e., the unemployment policy. gap must become negative, by rate below the in order to “drag down” the natural rate. As we shall see in Fig~re 4, none of the major European having a negative expansionary unemplc yment The consequence is close to of such hypothetical policies would be to raise the inflation rate until the economy stabilizes at a new equilibrium with a lower actual and natural unemployment rapid rate of inflation. is to determine gap. countries A key issue in evaluating the merits of expansionary the tradeoff between inflation and unemployment the new equilibrium. The divergent experiences of the ERM in 1992-93 highlight (1995a), especially that dropped of the tradeoff. his own my policy in the transition of those countries the recent behavior 1. See the recent book edit(;d by Cro~ rate, and a more (Cro~ 1995 b). to out Macroeconomic 2.2 Unemployment Gaps, Structural Deficits, and the Stabilizing Studies are available for many different the natural rate of unemployment, rates of unemployment. countries Deficit Ratio which provide estimates and of the gap between 1995 unemployment Policy, Page 9 of the actual and natural gaps for the G-7 countries, plus Spain and Sweden, are shown in Figure 4. The source is Giorno et. al. (1995), which uses a method developed unemployment by Elmeskov is estimated and MacFarlan by solving an equation wages is related simply to the unemployment rate is equal to the actual unemployment accelerating nor decelerating. (1993). The natural in which the rate of change of gap; thus the natural other extreme percent. the actual The unemployment gaps in Figure act~al real GDP in excess of potential France and Spain, with estimated unemployment The average gap for Europe is about 2 percent, unemployment unemployment rate of 11 percent (Figure 4 are arrayed gap and was real GDP, and at the gaps in excess of 3 and subtracting this from 1) implies that the natural rate for Europe in 1995 was about 9 percent, estimate of 6 percent unemployment rate in any year in which wages are neither between the United States, which in 1995 had a negative unemployment assessed to be producing rate of much higher than the for the United States.* 2. In Gordon (1995a) I ha~~e recently estimated the U. S. natural rate of unemployment as a timevarying parameter and have found it co have decreased gradually from about 6.4 percent in 1981 to about 5.8 percent in 1995. Macroeconomic Using a version of Okun’s between actual and potential law to translate unemployment at potential gaps into gaps Giorno et. al. (1995) also compute output, budget deficits, i.e., the budget deficit that would be incurred operating Policy, Page 10 output instead of at actual output. estimates for the same set of countries structural if the economy was Figure 5 displays the 1995 covered by Figure 4 and shows that most of the fiscal problems of the high-deficit recession-induced. None of the European countries have actual deficits that are more than double their structural deficits. European countries deficits would be correspondingly This provides a link between the hysteresis hypothesis There is the possibility that monetary actual and natural rates of unemployment, without difficult politically depreciation, monetary the acceptance rather than Of course, if the natural rate of unemployment were lower in these countries, the structural Europe. are structural budget-cutting. of additional lower. and the fiscal dilemma facing expansion could pull down both the and thus reduce the structural But this would require inflation, and deficits exchange rate the abandonment of union. The consequence of government of large fiscal deficits is, of course, an increase in the ratio debt to GDP. ranges from 52 percent Currently for the major European for France to 125 percent countries this ratio for Italy, as shown in Figure 6. A standard relation states that stability of the debt-GDP ratio requires that the deficitGDP ratio be equal to the growth rate of nominal GDP times the debt-GDP ratio. Macroeconomic Table 1 compares the actual and structural in Figure 6 with a computed ratio is the current growth rate of nominal ratio from Figure 6, multiplied rate of inflation,3 Table 1, for the U. S., in which nominal deficit-GDP and steady output ratio is 2.3 percent GDP growth growth by the “warranted of 5.0 percent at the potential is consistent rate, the required (.46 times .05 equals .023), a bit above the 1995 on line 5 for the U. S. is -0.5, indicating than the stability value, implying a slight shrinkage while the figure displayed The stability As shown in the first column of actual deficit and exactly equal to the 1995 structural displayed ratio. included GDP, which in turn is set equal to the rate of potential output growth plus the current with steady inflation deficits for the same countries “stability value” of the deficit-GDP debt-GDP Policy, Page 11 deficit. Hence the figure that the actual deficit is smaller in 1995 of the debt/GDP c~n line 7 is 0.0, indicating that the structural ratio, deficit is exactly equal to the stability value. Table 1 includes simil:~r calculations for the other European countries covered by Figures 4-6. Line 5 shows that all but Germany and Italy have actual deficits well in excess of the stability value, implying continued The surprising growth in the debt-GDP ratio. inclusion of Italy in the stability group results from a combination a huge debt/GDP ratio and relatively rapid inflation of (and hence high warranted 3. For countries with positive unemployment gaps in Figure 4, the natural rate hypothesis predicts that inflation is demlerating. Thus the warranted nominal GDP growth rate allows the rate of real GDP growrh to accelerate ~ti -u with the deceleration of inflation until the unemployment gap is eliminated. Macroeconomic nominal GDP growth). The list of countries with structural stability value on line 7 is the same as the list of countries 5, although adopted 2.3 of course the debt/GDP expansionary Policy, Page 12 deficits in excess of the with positive gaps on line ratio would grow more slowly if these countries policies to eliminate their output and unemployment gaps. Exchange Rates, Demand Growth, and Inflation The macroeconomic has been dominated by the Maastricht over the significance effective exchange policy discussion within Europe over the past few years conditions of the breakdown 1987 to 1992, and then the breakdown divergence nominal influence GDP growth rates influenced between countries nominal countries Figure 7 plots the from 1981 to 1995. from 1981 to 1987, the ERM period from period starting in 1992. we will return to the recent period and ask how the post-1992 of exchange four largest of the ERM in 1992. rates of the four largest European The history has three stages: convergence Subsequently for monetary union, and the debate real GDP growth is provided GDP growth, nominal in Figures GDP growth and inflation. 8 and 9. Many and the split of A preview for the different factors and we can focus on several major episodes. The major events that occurred after 1987 were the British boom of 1987-89, the German reunification boom of 1990-91, and the divergence growth from the French rate after 1992. of British nominal demand Italy presents a puzzle, with the appearance Macroeconomic of convergence divergence of nominal GDP growth closer to the French Policy, Page 13 rate rather than after the 1992 Italian exchange rate depreciation. Further puzzles are evident in the behavior of inflation French and German inflation rates were relatively close together for the period of the German reunification and its aftermath, rates in Figure 9, after 1987, except 1991-93. The puzzle is that British and Italian inflation rates were much closer to the French and German inflation rates after implications for demand management 3. Stwctuml We shall return 1992 than before. Maladjustment and Aggregate Demand-Supply to several simple analytical distinction between hysteresis hypothesis, demand and its policy, in section V of the paper. This section links the two main topics of the paper, maladjustment, to this puzzle, macro policy and structural tools and theories. and supply shocks, the natural and the response Analysis of demand-management These include the rate hypothesis, the policy to supply shocks. 3.1 Demand Shocks and the Natural Rate Hypothesis We begin with the familiar expectational which plots the inflation hypothesis rate against the unemployment is valid, the long-run natural unemployment Phillips curve diagram in Figure 10, rate. If the natural rate Phillips curve (LP) is a vertical line rising above the rate (U*). The initial short-run Phillips curve (SPJ is drawn Macroeconomic on the assumption actual inflation Policy, Page 14 that the expected inflation rate is p’. which in turn is equal to the rate (p~, the point in the vertical dimension intersects the vertical LP line. The SP cume shifts whenever expected inflation at which the SP curve there is a change in the The SP curve can also shift upward rate (p’). in the case of an adverse supply shock, and down in the case of a beneficial supply shock. shortly link the concept of structural maladjustment We will to that of supply shocks. The influence of aggregate demand is shown by the DG [for Detnarui Growth) schedule. of nominal The position of the DG schedule is determined GDP growth over potential output by the excess of the rate growth, or “excess nominal growth” (x), as well as the previous period’s unemployment to the inflation rate, then by definition output growth, and the unemployment rate, then actual unemployment output growth actual output gro~h rate is fixed. exceeds rate. GDP When x is equal is equal to potential When x exceeds the inflation potential output growth, and the rate declines.4 Consider the effect of a permanent acceleration of excess nominal GDP growth from XOto xl. The DG line shifts upward as shown, and the economy initially moves to point El. With adaptive expectations and an adjustment coefficient of unity, the 4. When this analysis is done on a diagram with the output gap on the horizontal axis then the DC =hedule is a negative 45 degree line. If the Okun’s law coefficient linking the unemployment gap to the output gap were unity, then the DC schedule in Figure 10 would be a positive 45 degree line. If the Okun’s law coefficient is 2 (an output gap of 2 corresponds to an unemployment gap of 1), then the slope of the DC line is 2, indicating that a shortfall of inflation below x of one percentage point corresponds to an unemployment gap of minus 0.5. Macroeconomic expected inflation subsequent rate is equal to last period’s actual inflation rate. Policy, Page 15 Hence in the period the SP line shifts upward to cross the LP line at a point (marked C) directly to the right of point El. In the subsequent to intersect the long-run period the DG schedule shifts rate of inflation directly above the initial equilibrium (at the point marked A).5 If the rate of excess nominal GDP growth at xl permanently, point is maintained the economy will go through the loop shown by the dashed spiral line. This hypothesis. permanent diagram A permanent acceleration which the inflation Maintaining summarizes of excess nominal of the same amount by the as shown deceleration natural GDP growth rate causes a after a transition rate (UJ below the natural period in equilibrium unemployment value. rate (U*) of excess nominal GDP growth and results in a steady of the inflation rate. and a temporary implied rate oscillates above and below its long-run an unemployment curve is linear, permanent acceleration of inflation requires a steady acceleration acceleration the basic results The process is symmetric in Figure 10. A deceleration if the short-run of inflation Phillips requires a of excess nominal GDP growth, results in oscillating inflation, period of unemployment above the natural rate. 5. Imagine a DGZ line drawn through point A. This indicates that the unemployment rate would be unchanged if the inflation rate at that point (pJ equal led the value of excess nominal GDP growth (xl) at the same point. Policy, Page 16 Macroeconomic 3.2 Supply Shocks and t~ Interpretation of Structural Maladjustment Figure 11 uses the same model to examine the effects of an adverse supply shock. The shock is viewed as shifting the SP schedule upwards without changing its slope. If the shock is an agricultural increase, and the initial SPOschedule will shift upward to SP’. But will temporarily after the cause of the agricultural relative price of farm products beneficial crop failure, the relative price of farm products problem is over and normal conditions will decline. The economy will temporarily shocks of 1974-75 the transition and 1979-81 period back to normal raised the relative prices. The OPEC oil price of oil for a substantial In this case the upward shift of the SP curve to SPYis followed to the initial complete, (SPJ when position the transition ignoring the impact of shifting inflation to the higher by a return relative excess nominal GDP growth remains unchanged the DG schedule economy would unemployment. go remains initially to fixed. point in which with higher supply shock the inflation and higher Even if in tile subsequent period the supply shock goes away, the SP schedule will stay above its initial position previously is at XO,and so for the initial transition Then with an adverse L, price expectations. A central case useful for the analysis of supply shocks is a situation period enjoy a supply shock due to the relative price decline, and the SP curve will shift down to SF’ during period. return, the in Figure 10, reflecting if expectations the response are formed as we assumed of expected inflation to the higher Macroeconomic actual inflation caused by the supply shock. Gradually Policy, Page 17 higher unemployment will push down the inflation rate, and the economy will slide back to the initial position by the route shown by the dashed line. But policymakers supply shock. will be tempted If they accelerate policy of “accommodating” unemployment to fight the unemployment nominal demand growth sufficiently, but at the cost of a permanent increase in inflation. higher rate of excess nominal GDP growth. EOto a point like N provides a realistic description made a transition i.e., pursue a the supply shock, the economy will avoid an increase in will arrive at a point like N, with both actual and expected permanently caused by the The economy inflation equal to the The shift from a point like of the process by which the U. S. from 5 percent inflation in the early 1970s to 10 percent inflation in the late 1970s. The opposite extreme is a policy of “extinguishing” GDP growth is dropped M. Because inflation Eventually, sufficiently the supply shock. Nominal to push the economy rightward does not accelerate, when the initial transition there is no adjustment is completed to a point like of expectations. (i.e., the relative price of oil settles down to its new higher level), the SP curve will shift back to its initial position. However, maintained, subsequent excess nominal GDP growth has been diminished, there will be a permanent transition. reduction In short the policymakers and if this reduction in the rate of inflation is in the face a tradeoff in reacting to supply Macroeconomic shocks, with a neutral temporary increase implying a permanent accommodating experience L) or extinguishing in unemployment, increase and extinguishing European countries until the major monetary Numerous responses. (point The contrast policy between (point did experience restriction Franz-Gordon a ~ the effects of did not rate in the late 1970s, whereas the U. S. and an acceleration of inflation that of the early 1980s began. of supply shocks and demand (1992) show that a change in labor’s share, such as that implied by the real-wage rigidity hypothesis inflation-unemployment implying policies helps to explain why Germany events can be fit into the framework In particular, M) policy but an accommodating of inflation. an increase in its inflation several other persisted (point Policy, Page 18 discussed in Part II, shifts the relation in exactly the same way as a change in the relative price of oil. The SP schedule shifts upward during the period when labor’s share is increasing. Whether of accommodation, Thus far unemployment, or not it returns to its original position if any, and the adjustment the analysis does not depends on the degree of expectations allow for simply because the natural rate hypothesis of inflation. a permanent is maintained not allowed for an increase in the natural rate of unemployment. in two ways. First, the nature of the structural functioning there of the labor market could be a hysteresis sufficiently mechanism maladjustment in and we have This could occur could be to impair the to increase the natural in place which increase automatically rate. Second, translates a Macroeconomic period of high actual unemployment into an increase in the Policy, Page 19 natural rate of unemployment. Krugman (1994) asks whether with a relatively high reservation rise in the natural unemployment generous European wage (or legal minimum wage) could explain the Such policies could explain high rate in Europe. but not rising unemployment, unemployment welfare policies, combined as was observed between 1970s and late 1980s, unless the benefits had increased significantly. welfare states were already generous or if there decreased demand unemployment is a minimum for low-productivity in many European unemployment countries, workers low-wage This hypothesis wages then the into is consistent of young people has increased higher with significantly while in the United States the same demand twist has of the demand twiw, Krugman countries, workers If reservation will be translated emerged in the form of an il lcrease in the inequality explanations workers. wage that does not change, rate than reduced relative wages. the facts that long-term with a twist in the a decrease in the demand for low-productivity and an increase in the demand for high productivity do not change, But European back in the early 1970s when unemployment was relatively low. Instead, he argues that the facts are consistent demand for labor, combining the early of wage rates, rejects international which he argues would change the sectoral In searching for competition from mix of high skill relative to low skill employment. been a generalized Macroeconomic Policy, Page 20 Instead, he favors the explanation that there has skill-biased shift in technology that has affected all industries. Krugman places his emphasis on skill-biased technology evolution that of European no one factor European and American labor markets. appears unemployment than a single cause. of the American and European contrast emerges declining) the increase uses the differing performance to assess the plausibility unemployment natural in causes, rather rate in Europe rate in the United States. labor market diagram in which, following equilibrium occurs at the intersection of in He Layard of a labor demand sloped “wage setting curve” which displays the wage that from the bargaining process factors could have caused the European U. S. wage-setting fully to explain as a criterion causes of a rising natural the Bean (1994) argues that there must be multiple economies centers his analysis on a standard curve with a positively In contrast, (1995), like Krugman, to a stable (and recently et. al. (199 1), short-term enough and concludes Gordon a long list of potential significant shifts by comparing at alternative wage-setting levels of labor input. curve to shift upwards What or the curve to shift downwards? 1. An increase in the tax wedge. Since firms pay pre-tax wages but workers receive after-tax wages, any increase in payroll or income taxes can shift up the wagesetting schedule. The tax wedge in the Europe is both higher and increased more than in the United States between the late 1960s and late 1980s (Bean, 1994, p. 586). Macroeconomic 2. The rigid real wage hypothesis the European labor share between seems consistent Policy, Page 21 with the observed bulge in 1974 and 1982 (Figure 3 above), which coincides with the period of most rapid increase in the natural rate of unemployment. 3. A leading candidate for causing divergent behavior across the Atlantic is the marked decline in U. S. trade union membership, percent from 26.2 percent in 1977 to 15.8 in 1993 (union members as a fraction of wage and salary workers). 4. The real minimum wage has fallen sharply in the United States while rising in some European countries, particularly France. 5. Both legal and illegal immigration added substantially pressure 6. market schedule. r~:gulation in Europe, particularly hours, reduce the demand fot unskilled labor as contrasted emerge with an unregulated product to Krugman’s and provide a convincing set of macroeconomic by the phrase “structural maladjustment.” the evolution maladjustment of productivi~] German to the demand that would phenomena skill-biased demand twist that can be summarized We will return below to the interactions and reform with demand management growth. shop-closing market. These six factors are complementary of structural into the U. S. has to the supply of unskilled labor and plausibly added to downward on the U. S. wage-setting Product of unskilled workers policy and with Macroeconomic 3.3 The Hysteresis Hypthesis The second approach unemployment to explaining is the hysteresis hysteresis hypothesis management revives the original demand-induced rate. Inflation converges It can be shown tradeoff alter the unemployment between recession boosts unemployment, rate. gap as inflation Instead, and unemployment. it A which in turn boosts the natural rate. natural rate In reverse, the hypothesis at the cost of a finite, not ever-accelerating, But, unlike the original stable Phillips tradeoff, increase the tradeoff at any given time depends on all of past history. of high unemployment push the unemployment the policy always is faced with the choice of achieving schedule available to policymakers The experience that that demand- rate. stabilizes at a new lower level when the new higher of unemployment rate of by the change of the unemployment to the new higher actual unemployment in the inflation formally of the natural rate hypothesis permanently implies that demand-management a reduction equation the basic implication Phillips rise in the natural to replacing the level of the unemployment is equivalent policy cannot a permanent hypothesis. the driving variable in the inflation rate.G It contradicts Policy, Page 22 implies that European policymakers cannot rate as low as they could were they taking the same policy actions as fifteen or twenty-five years ago. 6. Our diseuxion here refers to a “linear” version of the hysteresis hypothesis in which the equilibrium unemployment rate “like an elephant” remembers all pastshocks. Cross (1995b, p. 190) distinguishes this from the nonlinear version in which the memory of past shocks is selective. Macroeconomic If hysteresis insider-outsider is present model of wage determination to convert a favorable rather in fact, this calls for a theoretical demand or supply shock into wage increases model goes in the same direction. In addition to total unemployment in addition of real wages or of labor’s income share from target levels. stemming from hysteresis-like deviations The for themselves The target real-wage nominal wage increases are influenced labor’s share responds explanation.’ shows how employed insiders are able than into new jobs for the unemployed. curve approach, Policy, Page 23 bargaining in the Phillips by the deviation If the target level of to its actual level, then any pressure on wages of the actual share from the target share gradually disappears. 3.4 Implications of Structural Maladjustment How can the structural in the diagrammatic possibility and hysteresis hypotheses be interpreted previously introduced? In Figure 12 we consider a in the 1970s and early 1980s, the conjunction adverse supply shock caused by higher oil prices and/or an increase income unemployment workers, framework that might have occurred of a temporary in labor’s maladjustment and Hysteresis share, with a permanent increase in . the natural rate of caused by Krugman’s labor demand twist toward more highly skilled together with some 7. A wide variety of theoretical combination and empirical of my previous list of supply-side papers on hysteresis is found in Cross (1988). Macroeconomic impediments, tax wedge. Policy, Page 24 including an increase in the real minimum wage and an increase in the In Figure 12 the temporary SP curve, and the permanent shock is indicated by the upward shift in the increase in the natural rate by the rightward shift in the LP line. What choices are open to policymakers? relative to potential output growth (x) remains moves to point L, just as in Figure 11. removed the economy initially Once the source of the supply shock is returned 12 there no longer is a positive unemployment than excess nominal natural unchanged, (e.g., the relative price of oil or labor’s share stabilizes at a new level), in Figure 11 inflation and unemployment potential If the growth rate of nominal GDP output, rate. GDP growth, gap at point L. Inflation and so output and the unemployment m~ladjustment must grow more slowly than the disinflationary dashed line in Figure 12, initially experiencing then a partial recovery to the equilibrium a further loop shown One apprcach the validity of the condition effect of the unemployment by the rise in unemployment and level UI *. approach and the hysteresis approach explain the observed increase in Europe’s natural rate of unemployment. be distinguished? is higher rate must rise relative to the new higher The econom]~ goes through Both the structural to their original levels. But in Figure is to estimate wage and price equations can Can they to determine for “pure hysteresis,” namely the absence of a “level” gap. In one such attempt, Franz and Gordon (1992) Macroeconomic Policy, Page 25 found that hysteresis was partial rather than full in both Ge~many and the United States, since both level and rate of change countries. Because the German and U. S. coefficients of unemployment potential effects are highly significant in the two countries are so similar, yet the evolution is so different, there through this route for explaining that evolution. appears properties of a permanent depends The structural gap), it provides since the equilibrium natural rate model only on the level of the unemployment maladjustment approach share had been reversed, aspects of the European gap. as depicted in Figure 12 has the appeal Oil shocks, an increase in labor’s share, and a skill-biased all began to occur in the 1970s. translated in unemployment, of the economy are the same as with a straightforward in which inflation of realism. increase to be little If hysteresis is partial (i.e., inflation depends on both the level and change of the unemployment no explanation in both demand twist, By the time the oil shocks and the increase in labor’s the natural rate of unemployment welfare system that prevented had been increased by the demand twist from being into greater inequality of wages, as it was in the United States and to some extent in the United Kingdom. Macroeconomic 4. Intemctions Responses 4.1 between Macro Policy and Structura! Maladjus~ent of Demand Management We can now discuss interactions management policy. macroeconomic management to Successful Structural Reform between structural reform and macro demand- If the sources of structural policy reform policy respond?s maladjustment line Ieftward. are identified begins to reverse their effects, how should Our previous framework in Figure 13, we assume that successful structural ~ Policy, Page 26 We have relabeled the points demand is easiest to interpret reform instantaneously on the diagram, and if, as shifts the so that the economy’s initial high level of the natural rate is at UO* and moves leftward suddenly to U1*.Because the unemployment gap is now zero at point .E1 there is a new SPI schedule that has shifted to the left at the initial inflation rate and expected inflation rate. However, the econom:r does not move instantly from point EOto El. it moves to point A, which is at the intersection of the new SP1 line with the initial DGO line, which holds fixed the initial rate of excess nominal GDP growth point A inflation has declined output growth. in which inflation remains below XOallow a temporary which in turn allows the actL,al unemployment 8. A detailed evaluation (x~. At below the initial value of x, and this allows actual output growth to rise above the rate of potential point El. An alternative Instead, acceleration Successive periods of output growth, rate to decline to the new equilibrium poiicy could achieve the same output path by temporarily anti chronology of structural reform efforts is provided in OECD (1994 b). Macroeconomic Policy, Page 27 raising excess nominal GDP growth by enough to maintain a constant inflation rate, thus allowing the economy to move straight left from EO to El rather than following the curved dashed path drawn through How can such a policy procedure Reserve Board appears point A. be carried out in practice? to follow a policy procedure targeting the unemployment that could be interpreted rate consistent with steady nonaccelerating adjusting interest rates to keep the actual unemployment the natural immediate unemployment instrument, unemployment rate (U*). forecast of the actual unemployment value of U*. Symmetrically, estimated as inflation, i.e., rate as close as possible to Since the Fed believes that the effects of its the Federal Funds rate, take roughly one year to influence the rate, it leans toward its best forecast The U. S. Federal raising the Federal Funds rate when its best rate one year from now is below its estimated it leans toward of the actual unemployment reducing the Federal Funds rate when rate one year from now is above its value of U*. Although U* may not move around as much as the actual unemployment but it is not immutably carved in stone as a single precise number. turns out to be lower than the value forecast private forecasters, rate, When inflation by the Fed’s staff or a consensus of as in much of 1995, the Fed concludes that U* has declined from the value previously assumed by forecasters. This makes it more likely that the Fed will reduce interest rates and less likely that it will raise them. Accordingly, a low realized value of inflation to lower long-term Macroeconomic Policy, Page 28 or a high realized value of unemployment can both lead interest rates as speculators be to reduce short-term guess that the Fed’s next move will interest rates. The Fed appears to act as if it is operating and it does not appear to adjust its operation movements of the exchange attempt by an individual could of this policy procedure rate of the dollar. It would therefore rate toward Monetary fluctuations Union. sufficiently A policymaker large rate in response to a lower natural (achieved nlicroeconomic reform rates by a successful is turning to stimulate unemployment inflation rate. maintaining appear that an to compromise policy) unemployment would notice the in order economy to push down rate first that and would react by reducing dolnestic the to reduce out to be below forecast, the interest actual The c(:ntral aspect of this policy is taking the good news on to be a signal that stimulative unemployment in response to in Europe attempting the actual unemployment inflation environment, central bank within Europe to emulate the Fed’s procedure lead to exchange movement in a closed economy rate, rather policies should be adopted than just “accommodating” the existing unemployment to reduce the the lower inflation rate by rate. 4.2 Structural Reform and l>roductlvity Growth The analysis of Figurl: 13 did not take into account reform on the growth rate of potential any effect of structural output, which would reduce x (the excess of Macroeconomic nominal GDP growth over potential were to remain unchanged. potential Policy, Page 29 output growth) if actual nominal Uncertainty regarding the effect of structural output growth stems from the conflict between two forces. gains should raise productivity grotih. less expensive to hire, such as the reduction for employers GDP growth reform on Pure efficiency But reforms in labor markets that make labor or elimination of the minimum wage, may raise the demand for labor at a given level of output and reduce productivity. reforms, The same effect would especially a loosening would trade consumer be expected of German convenience of particular regulations product on shop-closing market hours that for an increase in the labor requirements needed to achieve a given total of real retail sales. The interactions between changes in the degree of structural both in an adverse and beneficial direction, evolution of European wage-setting unemployment shocks (e.g., an increase initially raises unemployment are explored is portrayed maladjustment, in Gordon (1995 b). The as resulting from a set of adverse in the real effective minimum northwest up a labor demand curve, also boosts the marginal and average products ‘of labor. This is then followed by a profit squeeze and a period productivity of disinvestment, gain but further increases the unemploymel]t by achieving minimum and, by shifting the economy wage) which a beneficial wage-setting the rate. Reversing this process shock (e.g., a reduction wage) would initially reduce unemployment which eliminates in the real effective and both the marginal and Macroeconomic average products of labor, increase of investment, This would then be followed by a profits boom and an which would offset the initial productivity reduce the unemployment Policy, Page 30 loss and further rate. Feedback from Macro Policy to Structural Reform and Vice Versa The analysis of Figure 13 emphasizes the opportunity in the natural rate of unemployment for macro policy to respond to a reduction reform. A policy response that stabilizes inflation and responds to a reduction natural rate as an opportunity to accelerate achieved by structural nominal demand growth in the differs from a passive policy in which excess nominal GDP growth (x) is stabilized. This policy choice may influence reform. When there reducing the minimum is strong the likelihood and magnitude opposition to such reform political wage and reducing government central bankers and finance ministers to respond authorities measures as subsidies, the willingness of aggressively to successful reforms may make those reforms more likely. There is potential the demand-management of structural for a political deal in which promise to lean toward lower interest rates and faster nominal demand growth, in trade for the willingness of political interest groups to support those reform measures that appear to have the greatest chance of reducing the natural unemployment reduce the transition rate. Demand expansion, by creating costs of reform policies which create temporary through the required restructuring of a particular jobs, may also unemployment industry that, for instance, has been Macroeconomic overstaffed as a result of previous Policy, Page 31 and subsidies state ownership (the “olive-belt” airlines come to mind). Another expansion related feedback is from monetary which reduces the unemployment deficit closer to the structural which demand expansion reducing the themselves. natural policy to fiscal policy. gap brings the actual government deficits displayed in Figure 5. goes hand in hand with structural rate of unemployment and hence Reducing the deficit then raises the potential There is feedback budget A successful deal in reform may succeed in the structural deficits for using the fiscal dividend to reduce tax rates and hence the tax wedge, at least in those countries on an explosive track for the debt-GDP Demand which are not ratio. in the reverse direction as well. Countries with more flexible labor markets may have a more favorable inflation-unemployment tradeoff, i.e., a flatter SP schedule in Figures 10-13. This is particularly from the perspective which of the unemployment hysteresis hypothesis, implies Current States, with its flexible labor market, estimates unemployment that a reduction in may be achieved at the cost of only a finite increase in the inflation rate, the amount of which depends on the slope of the short-run United important show that a one-year rate by one full percentage tradeoff curve. The has a very flat short-run sustained reduction point below the natural of tradeoff. the actual unemployment Macroeconomic rate raises the inflation (Gordon, rate by only 0.35 of a percentage point Policy, Page 32 after one year 1995a, Table 1). 5. Policy Lessons fmm tie 1992-93 ERM Breakdown An important controlled experiment was carried countries, United Kingdom, broke away from the ERM and achieved substantial mark, including European country against the countries France, analysts the Italy, Portugal, in 1992-93 several important of their currencies particularly out in Europe which remained Low Countries, have previously believed is futile, since any transitory output depreciation depreciation to evaporate. be eroded by an gains from the exchange In its most extreme form, t:his view holds that countries p:.st a transition period of a year or two, over their real rates. A pessimistic provided Some by any individual gains soon would of inflation that will soon cause the competitive exchange depreciations and Switzerland. acceleration do not have any control, and the aligned with the Deutsche Austria, that Spain, Sweden, when interpr~:tation by some authors. and Spain. He points of the outcome I )eGrauwe divergence is (1995, p. 9) focusses on the two cases of Italy to tne temporary initially the sharp depreciations of the 1992-93 nature of the competitive gains. While “did not affect inflation very much in these countries (mainly because of the rece:;sion), since 1994 inflation differentials with Germany Macroeconomic have started to increase significantly.” to guide their inflation He concludes that in order for Italy and Spain rates to the differential a new policy of “painful disinflation” prospect Policy, Page 33 would prescribed by the Maastricht have to begin. Treaty, Since he views the of success of such policies as low, he thinks that ‘the door to monetary union will be shut for a long time for these countries.” DeGrauwe’s treatment on two depreciating in those countries countries. than Gemny inflation boom. that depreciated with Germany that country with all countries (not including Switzerland. of inflation high in 1992-93 failing to as a result of would look at them with a set of countries in 1994-95 a misleading makes the inflation indicator other differential of the inflation of any differential of other than Germany. Germany) in Table 2. The five appreciating are Austria, Belgium, France, Netherlands, On average these countries experienced of 10.2 percentage the acceleration The omission of Germany is crucial, because The results of the analysis are summarized countries He focusses only A more balanced appraisal and compare that did not depreciate. reasons. rates only with Germany, rate was temporarily the time path of its disinflation other country their inflation of the reunification a set of countries for numerous He greatly exaggerates by comparing note that the German the aftermath is misleading, a nominal-effective appreciation points, from exchange rate indexes of 99.5 in 1992:Q2 in 1995 :Q2. In contrast the depreciating countries — Italy, Portugal, and to 109.7 Spain, Sweden, Macroeconomic and the United Kingdom — experienced an average depreciation an average index value of 99.1 in 1992:Q2 Policy, Page 34 of 22.2 points, from to 76.9 in 1995 :Q2. All of the average values in Table 2 are weighted across the five countries in each group using SummersHeston 1985 PPP weights. Thus among the appreciating Among the depreciating France is 59 percent. countries, countries, the weight of the respective weights of Italy, Spain, and the U. K. are 36,2, 17.0, and 37,2 percent. Both groups of countries deceleration of inflation, But there the similarity depreciating points. countries enjoyed an acceleration of nominal GDP growth, and thus an even greater acceleration of real GDP growth. stops, GDP growth The acceleration of nominal exceeded that in the appreciating countries a in the by 1.3 percentage Yet none of this was absorbed by inflation; inflation actually decelerated more in the depreciating countries than the appreciating countries.. And as a result the acceleration of real GDP growth in the depreciating depreciating countries It is implausible by 1.7 percentage countries exceeded that in the points. that this favorable outcome for the depreciating countries could continue forever, but the IMF forecasts for 1996 (from the same source as used for Table 2) show no acceleration of five depreciating discovered countries. a “macroeconomic route to macroeconomic of inflation to be predicted for the same average Thus it appears that the depreciating free lunch,” an improvement expansion without inflation. countries in competitiveness The implication have and a is that there Macroeconomic is substantial room for individual nations in Europe to reduce their unemployment gaps and their actual budget deficits through inevitable depreciation depreciation Policy, Page 35 in the nominal expansionary exchange monetary rate will translate in the real exchange rate and an improvement policy. The into a durable in competitiveness. With inflation in Germany at only 2 percent, some of which doubtless reflects the well-known upward lead the remaining nations nominal GDP growth, “split” of additional bias in price indexes, there is ample room for Germany tied to its exchange The experience nominal of the depreciating GDP growth highly favorable under present conditions. of inflation rate into a further between growth and inflation is way, the benign behavior in Europe suggests that the natural rate of unemployment decline, just as the Federal Reserve believes has occurred of nations suggests that the output Stated another expansion to has begun to within the United States, Macroeconomic Policy, Page 36 6. Conclusion The management of demand policy interacts with structural maladjustment, both when maladjustment is getting worse, as in the 1970s and early 1980s, and when successful structural reforms reduce the influence of structural and allow a decrease in the natural (i.e., constant-inflation) In our interpretation of structural a combination maladjustment rate of unemployment. factors, rather than a single “silver bullet”, explains the substantial increase in Europe’s natural unemployment decade 1975-85 and the divergence declining natural during the of that natural rate from the stationary rate in the United States. In the 1970s two-supply shocks, in the form of higher real oil prices and an increase in labor’s share in national pushed European unemployment. economies Reactions in some countries in the direction of higher inflation of central banks varied, with monetary — but not others — leading to a substantial or even income, and higher accommodation divergence of inflation rates in Europe by the early 1980s. These two supply both of which were in the mid- 1980s, combined with influence reversed structural maladjustments shocks, to boost the European natural low single digits in the early 1970s to nearly 10 percent prices and labor’s income share declined subsequently, reflects the role of other longer-lasting temporary more and had their deeply unemployment by 1985. entrenched rate from While real oil the natural rate did not. This maladjustments, especially inflexible real Macroeconomic wages for the unskilled who were harmed by skill-biased inflexibility in turn reflects three dimensions technical Policy, Page 37 change, and this along which Europe (on average if not for every country) differs from the United States – high and rising tax wedges, more powerful unions, and a higher and (in some countries) rising real minimum This account does not place much emphasis on hysteresis. Empirical wage. research does not support the “pure hysteresis” view that requires the absence of level effects of the unemployment gap in dynamic wage and price adjustment most plausible channel by which hysteresis operated other sources of maladjustment capacity utilization natural was through to low capital accumulation, rate, Stated differently, Europe The feedback from the with the result that the rate in Europe has been roughly stationary unemployment equations. despite the rise in the no longer has sufficient capital to employ fully its existing labor force. The paper stresses two-way interactions policy. With flexible labor ]narkets, the short-run is likely to be favorable, providing demand. between structural reform and macro inflation-unemployment an incentive for policymakers The benign effect of the British depreciation to expand aggregate in 1992 on the inflation provides one example of the potential payoff of more flexible labor markets. the promise by policymakers that they will encourage tradeoff rate In turn, a decline in unemployment in response to good news on inflation can be used to strike a political deal with political interests opposed to the introduction or extension of structural reform. Expansionary Macroeconomic monetary policy unemployment also provides relief on the fiscal front, gap and bringing In 1992-93 countries the monetary and those countries Deutsche expansionary mark policies. monetary dropped The difference which maintained provides policy, an important did not depreciate. But, surprisingly, reducing the test the budget deficit itself. out of the ERM to pursue . in the performance of these a peg between their currencies Not surprisingly, acceleration reform, potentially the structural countries enjoyed a substantial inflation, structural rate and therefore several European more expansionary by reducing the actual budget deficit closer to the structural budget deficit, but also, by encouraging natural unemployment both Policy, Page 38 case of the consequences the depreciating and of nations by 1995 of nominal GDP growth relative to the nations that they enjoyed an even greater deceleration so that their growth rate of real GDP accelerated of more than their growth rate of nominal GDP. This augurs well for a favorable outcome may be that the natural unemployment of expansionary rate has begun to decline Europe, and that this explains why inflation has continued which have depreciated countries their exchange creates an environment The set of issues addressed litany of contractionary demand demand policy. to decelerate rates significantly. favorable to continued significantly It in in countries Job creation success in structural in those reform. in this paper seems a long way from the depressing decisions currently being made in numerous Macroeconomic European countries in the name of the Maastricht explosive path for the debt-GDP An important if accompanied a mix of tighter abandoning textbook discussion while maintaining does not adopt by a shift toward easier monetary fiscal policy and easier monetary two ways. First, the Bundesbank Bundesbank are on an of the mix, that a shift toward tighter fiscal policy need not reduce output or raise unemployment to expand Some countries ratio and need to bring their fiscal house in order. lesson can be drawn from the traditional fiscal-monetary shift toward criteria. Policy, Page 39 A policy can occur in could adopt easier policies, allowing other countries a fixed exchange easier policies, rate with Germany. other countries Second, if the have the option the path to monetary union and adopting expansionary of infhition. of monetary policies that would bring down botl~ the actual and natural rates of unemployment minimal acceleration policy. with a Macroeconomic Policy, Page 40 REFERENCES BEAN, CHARLES R. (1994). fionomic “European Unemployment: A Survey,” Journal of Literature, 32 (June), 573-619. BRANSON,WILLIAM H. ANDROTEMBERG,JULIOJ. (1980). “International European Economic kviezu, 13 (May), pp. 309-32. with Wage rigidity,” Economics BRUNO, MICHAEL, AND SACHS, JEFFREY D. (1985). Stagflation (Cambridge CROSS, ROD (ED.) (1988). Hypothesis. (1995a). Oxford MA: Harvard Unemployment, and New York: (Cambridge (1995 b). “Is the Natural of Worldwide University Press). Hysteresis, and the Natural tite Basil Blackwell. The Natural Rate of Unemployment: of the Hypothesis. Adjustment UK: Cambridge Rate Hypothesis Reflections on 25 Years University Press). Consistent with Hysteresis?” in Cross, ed. (1995a), pp. 181-200. DEG~UWE, PAUL(1995). “The Economics of Convergence towards Monetary Union in Europe,n CEPR discussion paper 1213, July. ELMESKOV, JORGEN, AND MACFARLAN, MAITLAND (1993). Persistence,” OECD Economic Studies (no. 21, Winter), “Unemployment pp. 57-88. Macroeconomic FRANA WOLFGANG, ANDGORDON, ROBERTJ. (1993). Germany and America: Differences and Policy, Page 41 “Wage and Price Dynamics in Common Themes,” European Economic Review, 37 (May), pp. 719-54. GIORNO, CLAUDE,RICHARDSON,PETE, ROSEVEARE,DEBOM, pAUL (1995). “Potential Output, Output Gaps, ANDVANDENNOORD, and Structural Budget Balances,” OECD Economic Studies (no. 24), pp. 167-209. GORDON, ROBERTJ, (1995a). paper presented November “Estimating the NAIRU as a Time-varying to Panel of Economic Advisers, Congressional Budget Office, 16. (1995 b). “Is There a Tradeoff between Unemployment Growth?” Parameter,” NBER woiking paper 5081, April. and Productivity Forthcoming in Dennis J. Snower and Guillermc) de 1a Dehesa, eds., Uwmployment Policy: How Should Governments Respond to Unemployment? Cambridge UK: Cambridge University Press for CEPR. KRUGMAN, PAUL (1994). “Past and Prospective Federal Reserve Bank oftinsas Causes of High Unemployment,” City Economic &view (fourth quarter), pp. 21- 43. LAYARD, RICHARD, NICmLL, STEPHEN, AND JACKMAN, RICHARD Unemployment: Macroeconomic Pe+ormance and the bbor Oxford University Press). (1991). Wrket (Oxford: Macroeconomic OECD (1994a). 95. Policy, Page 42 The OECD Jobs Study: Unemployment in the OECD Area, 19sO- (Paris). (1994b). Assessing Structural Reform: SACHS, JEFFREYD. (1979). Comparative 269-319. “Wages, Profits, kssons for the Future. and Macroeconomic (Paris). Adjustment: A Study,” Brookings Papers on Economic Activity, 10 (no. 2), pp. Table 1 Gaps between Actual and Structural Deficit/GDP Ratios and Deficit/GDP Ratio Required to Stabilize Debt/GDP Ratio, 1995, Selected Countries 11. s. -. -. -Fmnce ------ 11.K. -. .- Camlsnv . . . .... .. -Snnin --- Sweden ------- Ttslv ..-. J Debt-GDPRatio 46,0 51.5 52.5 58.8 64.8 81,4 2. Warranted Nominal GDP Growth 5.0 4.1 4.2 5.0 7.9 4.9 7,1 3. Stability Value of Deficit/GDP Ratio 2.3 2.1 2.2 2.9 5.1 4.0 8.9 4. Actual 1.8 5.0 4.7 2.4 6.1 10.2 7.8 -0.5 2.9 2.5 -0.5 1.0 6.2 2,3 3.5 3.1 1.8 4.0 8.2 7.5 0.0 1.4 0.9 -1.1 1.1 4.2 -1.4 1. Deficit 5. Actual Deficit minus Stability Value 6. Structural Deficit 7. Structural Deficit minus Stability Value Soume by line: 1. 2. 3. 4,6 124.9 -1.1 Figure 6. 1995 Potential Output growth from Giomo er. al. (1995), Table 2, plus 1995 rate of change of GDP deflator, from IMF World Economic Outfook, October 1995, Table A-9. Line 1 times line 2, calculated as perunt. Figure 5. Table 2 Change in Effective Exchange Rates, and Growth Rates of Nominal GDP, Real GDP, and GDP Deflator, 1992-95, Five Appreciating Countries and Five Depreciating Countries Appreciating Countries Effective Nominal Exchange Rate 1992:Q2 1995:Q2 1995-1992 Percent Change Nominal GDP 1992 1995 1995-1992 in Percent Change Real GDP 1992 1995 1995-1992 in Percent Change in GDP Deflator 1992 1995 1995-1992 Soume Notes: Depreciating Countries Difference, Depr - Apr 99,5 109.7 10.2 99.1 76.9 -22.2 -0.4 -32.8 -32.4 4.2 4.6 0.4 5.0 6.7 1.7 0.8 2.1 1.3 1.7 2.7 1,0 0.2 2.9 2.7 -1.5 0.2 1.7 2.5 1.9 -0.6 4.8 3.8 -1.0 2.3 1.9 -0.4 Appreciating countries are Austria, Belgium, France, Netherlands, Switzerland. Depreciating muntries are Italy, Portugal, Spain, Sweden, and the United Kingdom. All data are aggregated using 1985 Summers-Heston GDP weights. Nominal and real GDP and GDP deflator growth rates are from IMF Wodd October 1995, Tables A2 and A9. Economic Outlook I . , . . , , / , . . . 1 \ . . . . ‘. ‘. . I 1 I n I t . 0 , , , { 1 In \\ 1- 0 5 w ■ --l \ I . \ \ \ . . / 1 -I I I \ \ t I I 1 I J I I \ I I I 0 m m . “- 1 I 1 1 I I I N ai 1 q 0 m q ‘1 1 I 1 I I I I I I 0 \ / .. ) ““””””’ I \~ / I f \ .:”””” ., ,...’ I I ,# :“ \ ) ...‘“ 4 / ‘... \’ “: \: w a ■ ■ F \ o 0 o CD ““””[)”, ... 4 .- “. .’ “. ~’ ,’ /:” /,”1 ! c .“” ( .:~... ~:” ) ..,. \ “:: n : “> \: . \ .. .. .. .. .. .. ,.” . .. .,”” ,.. !/ .. .. \ . :/ /’ I 1, “. ., .. ..-” .. ..”” .. “:- --- .. --- .. / I > ,% 1 \’ .“ I -. -. --- \ “> ~z- “\ .“ .“ “ ... .. .. -- ‘. #\” I ( .> / ‘, I I . 7 \“’, .’:/~ . ..’”/ .. \,’ ‘ ‘ d ..../\ b \ 3 “= ! , <..’ ../)” ..”> .... ‘< . t ..’ I “. * ‘. #’ t. :. I 1“”.., \ ,:...’”” \ .’ \ I . I * I .) \; .\ .. . ) . ...\ “, “’”\ “~., / “k .. <~ ,.. .. .’ ‘$ ‘.<’ .... # > , # # / . #. ..:, ‘/ # , 9- .’ ● ““““.\R / /“ I / .... ‘\ # I , ...... I ‘1 ... .. ..-” ..”” .. ,,. .,. ..1 ..”” -- .. .. k ..” . ‘.. .. ... ., . . . ..”” . 0 N /“ In o m o Inflation Rate Long-Run Phillips Curve LP I t DG1(X1) P2 -. ...-. ............ DGO(XO) R Po -------- -------- -------- -. 1 1 1 SP1(P?) sPo(p;) 1 1 1 1 1 1 1 1 1 u, u* Figure 10 Unemployment Rate Inflation Rate X L PO ---- I 1 ---------.---- 4---” \ \ u’ Figure 11 M SP- (adverse SPO (no shock) SPU (beneficial shock) Unemployment Rate LPO LPI N \ / L -. -. ! PO -------- . ------- -------- .. -. -.. ... -P’ / --------El -------- -. M \ \ SP’ (adverse shock) \ SPO (no shock) / u; Figure 12 u; Unemployment Rate Inflation Rate LPI LPO DG1(xO) \ Po ------- DGO(XO) / X --------. \ . --- . . . . . . . . . . . . El / x / EO ‘b-. .--”* A \ SPO(F?:) / \ u; u: Figure 13 sP1(py) Unemployment Rate