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Abstract

The relationship between unemployment and inflation has become rather elusive from the 1990’s onwards. The results in this paper show that the experience in the 1990’s for OECD countries has been significantly different from that in the 1980’s, specifically that during the 1990’s the trade off between unemployment and inflation has been severely dampened. Consequently the level of the Natural Rate of Unemployment for these countries has become less clear since inflation appears to be less affected by unemployment movements, particularly in an economic climate dominated by inflation targeting. The implications of this trend will be discussed, and a co-ordination failure model is proposed which suggests that countries that maintain an overly strict inflation targeting policy may experience efficiency losses as a result of near-rational expectations.

Introduction

The driving impetus behind this paper has been the unemployment experience of the United States during the 1990’s, whereby the Federal Bank pursued an expansionary policy that took unemployment below what at the time was the perceived Non Accelerating Inflation Rate of Unemployment (NAIRU hereafter) without an increase of inflation, defying conventional wisdom. This experience served to underline what appears so far to be a changing trade-off between unemployment and inflation in the industrialized countries, with many countries exhibiting a far smaller sacrifice ratio in the 1990’s than previous decades. Whilst many of the OECD countries have made a switch to formal or informal inflation targeting during the 1990’s, which has enabled them to keep inflation low and anchored, many countries, particularly European, have been left with a considerable level of unemployment, as shown by Figures 1 and 2. With inflation now largely under control the implications for monetary policy, given what seems to be an increasingly weak short run Phillips curve (SRPC hereafter) relationship, have been relatively unexplored.

Figure 1; Source: OECD

Figure 2; Source: OECD

The first test, comprising Section III.A, will be to analyze whether the experience of the OECD countries in the 1990’s and early 2000’s has been significantly different from the experience in the 1980’s. If true, what does this result mean, is the data sufficient to believe that the SRPC relationship has now changed, and what are the causality issues that may be influencing the result? All of these questions and policy implications will form the discussion in Section III.C. Whilst other studies have touched on this topic, none have covered it with such a large range of countries, or to my knowledge such recent datasets.

Second, using NAIRU data for the 1990’s period Section III.B will attempt to examine this new dynamic in closer detail by comparing inflation changes to the unemployment gap, specifically the Unemployment rate minus the NAIRU level (U-NAIRU), with the aim of disseminating the recently elusive relationship. Utilising the unemployment gap data will hopefully allow the analysis to take into account the changing dynamics of an economy, and examine the SRPC with more precision. Interestingly, since these NAIRU values are considered to be medium to long term, the mere fact that they change suggests the lack of a single long run vertical Phillips curve. Whilst this paper does agree with the theory of the long run Phillips curve – the idea that there is a floor to the level of unemployment with stable inflation is plausible given bargaining power and efficiency wage considerations – the experience of the 1990’s onwards for many countries suggests that few countries have settled on or discovered their long run levels.

This leads to the third part of the paper, making up Section IV, which proposes that some of the countries that are suffering from high unemployment may be doing so unnecessarily as a result of a co-ordination failure between agents in the economy. Without discarding any previous explanations, this theory hopes to show that in light of tight inflation targeting an economy may miss out on opportunities for expansion due to asymmetries of information and near rational expectations. This will be followed by discussion and policy implications.

The paper begins with a review of the relevant literature and ideas that contributed to this project, forming Section II. An explanation of the data and methodology form Section III.