introduction to macro policy and models the policy...

BRINNER1

The Policy Tradeoff: Unemployment vs.

Changes in Inflation

Introduction to Macro Policy and Models

BRINNER2

Focus Today

Simple Micro: Prices, Demand and Supply Simple Dynamics: Disequilibrium Means ChangeAn example central to policy choices: managing the economy to produce a desired outcome

BRINNER3Simple 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 EqualSupply: More Hours Will Be Supplied by Individuals the Higher the Real WageEquilibrium: Demand=Supply

»All Those Wanting to Work at the Current Real Wage Can Find Work after a Reasonable Period of Search

BRINNER4Simple Micro in the Labor Market :

Prices, Demand and Supply

DEMAND

SUPPLY

REALWAGE

WORKERS or HOURS DEMANDED AND SUPPLIED

EQUILIBRIUM

BRINNER5Simple Dynamics: Disequilibrium

Means Change in the Labor MarketUnemployed Workers:– Voluntary, as in searching for a job at a

wage higher than they or their peers are being offered: not a sign ofdisequilibrium

– Involuntary: Would accept the prevailing wage but no offer forthcoming.»By definition, Supply greater than

Demand...at the prevailing wageInvoluntary Unemployment Creates Pressure for (Real) Wages to Fall

BRINNER6Simple Dynamics: Disequilibrium

Means Change in the Labor Market

DEMAND

SUPPLY

REALWAGE

WORKERS / HOURS DEMANDED AND SUPPLIED

DISEQUILIBRIUM

INVOLUNTARYUNEMPLOYMENT

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Fluctuations in Unemployment

0123456789

10

1967 1971 1975 1979 1983 1987 1991

Job Losers ReenterNew Entrants Job Leavers

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DEMOGRAPHICS AND THE UNEMPLOYMENT RATE

11

13

15

17

19

21

23

25

27

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

4.8

5

5.2

5.4

5.6

5.8

6

6.2

6.4

"YOUNG ADULT SHARE OF POPULATION' "NAIRU"

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0

2

4

6

8

10

12

1949

1955

1961

1967

1973

1979

1985

1991

1997

Actual RU NAIRU

BRINNER10Changes in

Nominal and Real Wages

-4

-2

0

2

4

6

8

10

1981 1984 1987 1990 1993 1996 1999 2002

Real Wage GrowthEmployment Cost Index GDP Price Deflator (lagged one year)

(Annual Change)

BRINNER11THE APPARENT POLICY OPTIONS

IN THE 1960s

0

1

2

3

4

5

6

- 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0

UNEMPLOYMENT RATE

CPI

INFL

ATIO

N R

ATE

1969

1965

1959

1962

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A LONGER PERSPECTIVE

-2

0

2

4

6

8

10

12

14

16

194819501952195419561958196019621964196619681970197219741976197819801982198419861988199019921994199619982000

UNEMPLOYMENT RATE CPI INFLATION RATE

BRINNER13THE LONG-TERM POLICY

CHOICES AREN'T AS OBVIOUS

-2

0

2

4

6

8

10

12

14

16

0 2 4 6 8 10 12

UNEMPLOYMENT

INFL

ATIO

N

1947

1959

1980

1983

1974

BRINNER14Changes in

Real Wages vs. Unemployment

-1

0

1

2

3

-3 -2 -1 0 1 2

Unemployment Gap

Real Wage Growth1994

1991

1989

1985

BRINNER15

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 inflationplus a constant (A0) for productivity growth and other factors not defined hereminus an adjustment for the existence of involuntarily unemployed workers:total unemployment (U) - voluntary (U@VOL)

BRINNER16A Companion Equation

for Price InflationIf prices are a simple “mark-up” on unit labor costs, i.e. wages(W) relative to productivity(A)..

P = K * (W/A)hence RP = RK + RW - RA

..and this markup falls when the economy is sluggish

» RK = - B1 * (U-U@VOL)Then:RP = - B1 * (U-U@VOL) + RW - RA

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The Final Form Model of Price Inflation

RP = - B1 * (U-U@VOL) + RW - RAAND, EARLIER,

RW=RP\1+A0-A1*(U-U@VOL)THUS

RP=(A0-RA)-(A1+B1)*(U-U@VOL)+RP\1OR RP-RP\1 =

THE CHANGE IN INFLATION=

(A0-RA) - (A1+B1)*(U-U@VOL)

The acceleration in prices is tied to the level of excess demand.

BRINNER18

(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%

BRINNER19

0%

1%

2%

3%

4%

5%

6%

7%

8%

1995 1996 1997 1998 1999 2000

Real Wage Inflation

Inflation-Igniting Threshold:(5.5% unemployment)

Nominal Wage Inflation

Infla

tion

(%)

Unemployment Rate

But Surprising Moderation Occurred in 1999-2000

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Useful Inflation Rules of Thumb

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.

BRINNER21The Track Record for the CPI Rule

(The Actual and Predicted Changes in CPI Inflation)(Percentage points)

History Forecast

-6

-4

-2

0

2

4

6

8

10

12

14

1961 1966 1971 1976 1981 1986 1991 1996

Consumer Price Inflation

Actual Predicted

BRINNER22The 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



Two endogenous variables: RP and UIn terms of the earlier model, think of U as varying inversely with GNP, hence the endogenous variables are RP and GNPIf 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.



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.



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.– .....



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.

BRINNER27THE FED REACTS PREDICTABLY

TO THE ECONOMY

0

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1999

FEDERAL FUNDS RATEINFLATION+EMPLOYMENT

introduction to macro policy and models the policy...

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