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Section I

Literature Review

Given that the topic of the project has to my knowledge not been explicitly explored what follows is a brief summary of literature that have contributed ideas and formed the base. The cohesive theory is that near rational expectations result in suboptimal unemployment equilibrium.

First, consider the phenomenon of high unemployment, with special reference to the post 1979 oil shock experience of Europe vis-à-vis the United States. As Figure I.1 shows these regions suffered a reversal of fortune, with the unemployment of the United States decreasing after the shock and undercutting a previously successful Europe, where unemployment continued to rise and plateau at a high level. Labour market institutions have received the thick of accusations, but as Nickell (1997, p.65) notes “…roughly speaking, the labour market institutions were the same. So how can the labour market institutions have anything to do with unemployment?”. Clearly other explanations are required.

Figure I.1; Source: OECD Economic Outlook

Second, various economists point to the negative externalities of high unemployment. Layard, Nickell and Jackman (1991) suggest that persistent high unemployment decreases the work and job search skills of the unemployed and that the employed closely guard their wage at the expense of expanding employment. Additionally Eisner (1995) notes that the rise in wages that can accompany a fall in unemployment may cause a substitution of capital for labour which would curb inflation. As a result, Stiglitz (1997) suggests that reducing unemployment can cause a reduction of the NAIRU via a positive feedback effect and thus the economy faces a moving target, which is argued empirically by Semmler and Zhang (2004). Considering that these effects take time the economy may experience a little inflation along the way. Galbraith (1997) highlights the asymmetrical problem this presents for policymakers by suggesting that if a higher NAIRU accompanies higher unemployment in response to a negative shock to the economy, the obsession with the NAIRU as a long term target and fear of inflation prevent a major positive shock or policy move from correcting this; thus the economy may become stuck at a higher unemployment equilibria.

Third, various studies including Blanchard (2003) suggest that the NAIRU may vary over time and can be affected by the inflation rate and monetary policy. Additionally, the presence of imperfect competition, information asymmetries and price rigidity may give rise to multiple equilibria. Bomfim and Diebold (1996) demonstrate that the combination of bounded rationality and strategic complementarity can lead to strong policy effects and output persistence, whereby rational agents anticipate the behaviour of suboptimal agents and strategically imitate. Cooper and John (1988) and Pagano (1990) suggest that such coordination failures lead to multiple unemployment equilibria and that well constructed and strong policy intervention may be necessary to prevent getting stuck at high unemployment.

Fourth, the previous points give cause for policy experimentation. This is typically frowned upon because of the theorised convex and risk-averse nature of the short run Phillips curve produces unfavourable rising inflation with falls of unemployment. However, CEA empirical studies cited in Stiglitz (1997) suggest that the best fit for the US economy was concave during the 1990’s, while separate studies by Eisner (1996) and Galbraith (1997) point to the lack of correlation between low unemployment and accelerating inflation. Therefore even risk-averse policy makers should find reason to experiment, considering the economy can always reverse course without cost. This study hopes to investigate this relationship for the European countries.

Fifth, Galbraith (1997) contests that the US experience shows little evidence for a vertical long run Phillips curve, as demonstrated by Figure I.2. Akerlof, Dickens and Perry (2000) postulate that the long run Phillips curve is not vertical but bowed inward and then forward bending, suggesting that there is an optimum positive inflation rate, which greases the wheels of the economy. Consequently overly strict inflation targeting may bring efficiency losses for the economy

Figure I.2; Source Galbraith (1997)

Sixth, research in the field of behavioural economics is substantial and growing, Akerlof (2002) cites many important studies in the field; potentially relevant findings for near rational expectations are listed below. Conlisk (1996) and Kahnemann et al. (1982) have shown that the physiological limits of human cognition exhibit what has come to be known as bounded rationality, which has proven important in economics. Systematic errors are evident in decision experiments, consumer behaviour and expectations, suggesting that actors are not rational. Interestingly, studies so far have concentrated on financial issues such as asset prices and inflation expectations have not yet been considered. Geanakoplos (1992) highlights the salience of common knowledge between agents in decision making when more than one agent is involved, an example could be policy makers and the public. Brian Arthur (1994) notes that the inductive reasoning process of humans results in a built-in hysteresis; because expectational models are tested by their previous accuracy of tracking the economy, a switch to a better model will occur only once the previous model has accumulated a record of failure.

Seventh, Carlstrom and Fuerst (2001) have provided an interesting critique of forward-looking inflation targets. Because “policy depends on expected inflation and expected inflation, in turn, depends on policy” decision making leads to an “infinite regress” whereby the public and central bank continue to affect each other. This leaves the economy vulnerable to self-fulfilling expectations, and sunspots can occur where extraneous information can be self fulfilled by changes in behaviour by either agent. The Economist (2005) intuitively picks up on this suggesting that because the ECB constantly gives the impression that policy needs to be tight to protect from the ever-present threat of inflation, the public believe nothing can be done to improve growth, presenting a vicious circle. Mismatches between the public, firms and policymakers need not be particularly complicated to cause disruption; Ball and Mankiw (2002) cite the role of the aspiration wage and how wage setters perniciously sustain real wage increases when productivity falls.

Eighth, Staiger, Stock and Watson (1996) point to the lack of precision when calculating the NAIRU (for example the 95% confidence interval in the US was 5.1% to 7.7% for 1990). Not only does this suggest caution when utilising the NAIRU as a guide for policy, but it also serves as caution for any subsequent results this project obtains.