Advertising Economics Jobs / Economist Jobs Help

<!– /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:”"; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”; mso-fareast-language:EN-US;} p.fly-title, li.fly-title, div.fly-title {mso-style-name:fly-title; mso-margin-top-alt:auto; margin-right:0in; mso-margin-bottom-alt:auto; margin-left:0in; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”;} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.25in 1.0in 1.25in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} –>

Section IV

Whilst many theories have been put forward to explain the persistence of high unemployment in Europe – including Labour market institutions and cultural differences – none to my knowledge have considered that unemployment persistence may be being maintained as a result of a co-ordination failure between agents in the economy. Considering the salience of common information when making decisions, this model proposes that Pareto inefficient equilibrium may be occurring as a result of asymmetries of information between firms, wage bargainers and a central bank pursuing strict inflation targets, such as the ECB. Whilst the ECB strictly does not classify itself as an inflation targeter, its mandate for price stability is considered to be an equivalent.

First, consider an economy with two sectors (Sector 1 and Sector 2), all firms are price setters, and all agents are rational. In addition, the economy has an explicit forward looking inflation target that publishes the expected future inflation path. In this situation workers will be knowledgeable about what nominal wage increases they should be experiencing in the present and near future. In addition, rational wage bargainers are acquainted with the SRPC that is believed to characterise the economy and will respond to falls of unemployment with increasing wage demands. This system can act as a substitute for high unionisation because workers will be conscious of whether they are receiving a relatively fair wage. As a result, the theory of the fairness wage – which hinges on the fact that workers exhibit a high degree of loss aversion – puts pressure on firms to increase wages when other firms do, even in the absence of labour market institutions.

Sector 1 firms face an improvement of productivity, and thus a downward shift of their supply curves. If the information regarding the improvement of productivity does not permeate to the economy and Central Bank then inflation expectations will remain unchanged. In a scenario with perfect information, inflation expectations would be lower given the improved supply schedule of Sector 1.

If inflation expectations remain unchanged then wage growth demands will also remain the same for all sectors. Thus firms in both sectors are faced with higher wage growth demands than if the economy was aware of Sector 1’s productivity improvement. Consequently, output and hiring of new workers will be constrained by the exuberant wage bill, and firms will need to raise prices above what they would have done in a perfect information economy. In effect, the credibility of the inflation expectations is making the inflation self-fulfilling, rather than being determined by the fundamentals of the economy. Thus productivity increases may not be exploited, which provides a mechanism for the NAIRU to be downward-sticky to positive supply shocks.

Conversely, the NAIRU in this situation will be upward-flexible. Consider that Sector 1 faces a slowing of productivity, and the information is not conveyed to the economy. Although inflation expectations and wage growth demands remain the same, Sector 1 firms will be forced to increase prices above inflation expectations in the face of the increasing marginal costs. Thus prices rise in this sector regardless of current expectations, and future expectations will adjust in the wake of this experience. To prevent this from continuing into a wage-price spiral, firms in Sector 1 will have to reduce output and thus raise unemployment in the economy. As a result the NAIRU has increased.

Therefore, efficiency losses may be plausible as a result of the information of productivity improvements not being communicated to the economy. In effect, this is a co-ordination failure between firms, workers and the Central Bank. For this to be feasible there needs to be an incentive for the individual firm to not disclose its marginal cost functions, otherwise the firm would happily communicate its favourable movements in productivity. This is believable because transparency of supply curves would lead to superfluous profits being eroded by wage demands and competitors who find weaknesses in the firm’s business model. The difficult experience of finding true marginal cost curves for internalising externalities underscores this argument, as polluting firms have been inclined to hide their true supply schedule to reduce pollution taxes.

Next in this model consider that a productivity improvement in Sector 1 occurs without the economy knowing, but the Central Bank makes a ‘judgement call’ to maintain the increase in demand in spite of unemployment being at the perceived NAIRU level, in the same way that the US Central Bank held interest rates 1997. Since Sector 2 does not have spare capacity, it will respond to the increase in demand with an increase in prices that will raise inflation. This will disadvantage Sector 1, which has the spare capacity to increase output, since the raised prices in Sector 2 results in an economy wide increase of wage demands which reduce the scope to increase output. Even if there are no price increases from Sector 2, if wage bargainers are near-rational and forming their wage demands on the old NAIRU, the fall of unemployment will be accompanied with a rise of wage demands in line with the SRPC. This denies the potential for a non-inflationary expansion to occur if the productivity improvement is not economy-wide, since the non-benefiting firms or the pernicious wage bargainers will push up prices in the presence of an increase of demand. If the policy is carried out with a high level of credibility, as with the much revered US Central Bank, this will serve to lighten the inflationary response and increase the likelihood of success. With the European Central Bank always reminding the population that inflation is just around the corner on any decrease of unemployment, success is less likely.

Moreover, this same co-ordination failure may occur if the NAIRU has fallen for any other reason that is not perceived by all agents in the economy. Other examples may include an increase of efficiency of job matching, a decrease of union power, or the benefits of e-commerce. Although these may benefit all sectors, if this new potential NAIRU is not perceived then wage bargainers will still raise their demands in the face of a fall of unemployment from the current NAIRU, which will rationally cause illogical inflation.

With tight inflation targeting the economy is given little time for information of productivity changes to permeate through the economy and thus allocative efficiency may not occur. Because “hollow” inflation may be created due to the sectoral differences in spare capacity or pernicious wage bargainers, the adjustment period to a lower unemployment equilibrium will be met by contractionary monetary policy, which will reverse the increase in output. If inflation comfort zones were wider in this case then the economy would be better placed to accommodate the possibility of “hollow” inflation, and minimise the possibility of not exploiting productivity improvements. Clearly the band does not need to be too wide, since both the UK and inferred US policy with a symmetrical 1%-3% target have ostensibly been sufficient for them to benefit from the productivity improvement of the 1990’s. Indeed this criticism is directed specifically at the asymmetric policy of the ECB which wishes to achieve inflation below 2%. As well as criticism regarding the nature of the target being asymmetric – which gives the psychological impression of always fighting inflation – the fact that the target is an average of its member’s rates means that large divergences of member states inflation rates may eliminate the comfort zone for inflation variation. If half the states are running 3% inflation then the other half will be forced to run below 1%, giving neither half the ability to tolerate any hollow inflation. This is made even worse for Euro member states given that they are unable to tailor monetary policy to their individual needs. If their NAIRU value has fallen it is unlikely to have much of an effect for area-wide inflation, and thus it is unlikely to receive an easing of monetary policy that would expediate the move to the new NAIRU. Indeed this easing may never occur if other member states experience a negative supply shock. Therefore, this situation not only calls for a wider target, but an increase of co-ordination between Euro states with regard the reduction of structural unemployment.

As an extension is would be useful to find a method to test this model empirically. Unfortunately there are several aspects that would be difficult to model which include: how signals are perceived by the different agents, how to account for near rationality, how to account for changes in productivity if they are not being communicated. One simple extension would be to test for the existence of “hollow” inflation using the benefit of hindsight with regard unemployment movements.

Conclusion

This study has shown that the short run Phillips’ curve relationship has reduced significantly in the period 1993-2004 vis-à-vis the period 1980-1992 for 13 of the 19 countries studied. Further, testing with the unemployment gap whilst accommodating for movements in the natural rate has been shown to be a poor predictor of inflation movements, and thus this study suggests caution when using the unemployment gap as a policy guide.

Whilst much of this reduction in the sacrifice ratio can be attributed to the changing economic climate – particularly the improvements of productivity and inflation targeting – little mention has been made in the literature of what new opportunities and restrictions have arisen for policy. Utilising a co-ordination failure model this paper proposed that in this new climate of inflation targeting the NAIRU may become downward sticky, and unable to move to a new lower equilibrium. This is the result of imperfect information between agents in the economy with differing incentives and a Central Bank that responds too quickly to inflation movements, presenting a rational sub-optimal unemployment equilibrium given the observable information in the economy.

References

Akerlof, G. (2002). “Behavioral Macroeconomics and Macroeconomic Behavior,” The American Economic Review, Vol. 92, No.3 (Jun.,2002), 411-433

Akerlof, G. and Dickens W. and Perry G. (2000). “Near-Rational Wage and Price Setting and the Long-Run Phillips Curve.” Brookings Papers on Economic Activity (1): 1–44.

Ball, L. and Mankiw, N.G. (2002) “The NAIRU in Theory and Practice”, The Journal of Economic Perspectives, Vol. 16, No. 4. (Autumn, 2002), pp. 115-136.

Bernanke, B., and Lauback, T., and Mishkin, F., and Posen, A. (1999) “Inflation Targeting: Lessons from the International Experience,” Princeton: Princeton University Press

Bomfim, A.N. and Diebold, F.X. (1996). “Bounded Rationality and Strategic Complementarity in a Macroeconomic Model: Policy Effects, Persistence and Multipliers”, NBER Working Paper 5482, National Bureau of Economic Research, Inc

Brayton, F., and Roberts, J.M. and Williams, J.C. (1999). “What’s happened to the Phillips curve?,” Finance and Economics Discussion Series 1999-49, Board of Governors of the Federal Reserve System (U.S.)

Brian Arthur, W. (1994) “Bounded Rationality and Inductive Behavior (the El Farol Problem), American Economic Review, 84,406-411, 1994

Carlstrom, C. and Fuerst, T. (2001)”Monetary Policy and Self-fulfilling Expectations: The Danger of Using Forecasts,” (with Charles Carlstrom), 2001, Federal Reserve Bank of Cleveland Economic Review, 37(1).

Conlisk, J. (1996): “Why Bounded Rationality?”, Journal of Economic Literature 34(2), pp. 669 - 700.

Cooper, R. and John, A. (1988). “Coordinating coordination failures in Keynesian models.” Quarterly Journal of Economics, vol. 53, August, pp. 441-63

Economist, The. “The European Central Bank, Haughty indifference, or masterly inactivity?”. The Economist, Jul.14^th, 2005

Eisner, R. (1995). “Our NAIRU Limit: The Governing Myth of Economic Policy”, The American Prospect

Eisner, R. (1997). “A New View of the NAIRU,” in Paul Davidson and Jan A. Kregel, eds., Improving the Global Economy: Keynesian and the Growth in Output and Employment, Edward Elgar Publishing Cheltenham: UK and Lyme, U.S.

Friedman, M. (1968), “The role of monetary policy”, American Economic Review, 58(1), 1-17.

Galbraith, James K. (1997). “Time to Ditch the NAIRU”, The Journal of Economic Perspectives, Vol. 11, No.1 (Winter, 1997), 93-108

Geanakoplos, J. (1992) “Common Knowledge.” Journal of Economic Perspectives, 6(4), 1992 [30pp]

Hacker, M. (2002) “Are Oil Shocks Inflationary? Asymmetric and Non Linear Specifications versus Changes in Regime,” Journal of Money, Credit, and Banking, pp.540-561

Kahnemann, D., Slovic, P. & Tversky, A. (eds.) (1982): Judgement Under Uncertainty: Heuristics and Biases. Cambridge: Cambridge University Press.

Layard, R. and Nickell, S. and Jackman, R. (1991). Unemployment: Macroeconomic Performance and the Labour Market, Oxford, Oxford University Press

Nickell, S. (1997), ‘Unemployment and Labour Market Rigidities: Europe versus North America’, Journal of Economic Perspectives, 11(3), pp. 55–74.

Pagano, M. (1990). “Imperfect Competition, Underemployment Equilibria and Fiscal Policy”, The Economic Journal, Vol. 100, No. 401 (Jun.,1990), 440-463

Palley, T.I. (1999) “The Structural Unemployment Policy Trap: How NAIRU can Mislead Policymakers,” New Economy, 6 (June 1999), 79-83

Semmler, W. and Zhang W. (2004) “Monetary Policy with Nonlinear Phillips Curve and Endogenous NAIRU”

Staiger, Stock and Watson (1996). “How Precise are Estimates of the Natural Rate of Unemployment?“, NBER Working Papers 5477, National Bureau of Economic Research, Inc

Stiglitz, J. (1997). “Reflections on the Natural Rate Hypothesis”, The Journal of Economic Perspectives, Vol. 11, No. 1. (Winter, 1997), pp. 3-10.

<!– /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:”"; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”; mso-fareast-language:EN-US;} p.MsoFootnoteText, li.MsoFootnoteText, div.MsoFootnoteText {mso-style-noshow:yes; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”; mso-fareast-language:EN-US;} span.MsoFootnoteReference {mso-style-noshow:yes; vertical-align:super;} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.25in 1.0in 1.25in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} –>

Section III.C

Causality Issues

When discussing the differences of coefficients between the periods the main concern is the effect that inflation targeting has had in reducing inflation in these countries. As Table III.4 shows, many of these countries introduced inflation targeting in the 1990’s, and were able to reduce inflation with little change of unemployment simply as a result of the increased credibility. Thus there may be many values which report a fall of inflation even without a change of unemployment which will bias the result. These fortunate results will only occur during the first few years of inflation targeting; as a result it is necessary for more years to pass before it can be confidently said that the Phillips curve relationship has been severely dampened. As an extension it would be useful to introduce some form of dummy or structural break to account for the introduction of targeting in these countries

	Year of adoption	Inflation rate at adoption (%)	Inflation target (%)	Inflation rate in 2005 (%)
New Zealand	1989	7.5	1 to 3	2.7
Canada	1991	7.5	1 to 3	2.2
UK	1992	4.7	1 to 3	2.0
Australia	1993	1.8	2 to 3	2.6
Sweden	1993	4.6	1 to 3	0.8
Israel	1997	9.0	1 to 3	1.2
Eurozone	1999	1.1	0 to 2	2.1
Brazil	1999	4.9	1.25 to 6.25	6.8
Poland	1999	7.3	1.5 to 3.5	2.2
South Korea	2000	4.1	2.5 to 3.5	2.8
Hungary	2001	9.1	2.5 to 4.5	4.0
Mexico	2001	6.4	2 to 4	4.3

Table III.4

Additionally, it may be possible that there is an element of reverse-causality, whereby inflation is affecting unemployment. Although contended, this is mentioned by Akerlof, Dickens and Perry (2000) who posit that there is an optimum level of inflation.

Finally, there is the likely omitted variable bias as a result of the other factors that contribute to inflationary pressures which were mentioned earlier.

Policy Implications

As can be seen the significant differences between the two periods suggest that there has been a flattening of the SRPC relationship. Although it is too early to consider this a lasting relationship, it is useful to postulate what this may mean for policy makers if it continues.

Firstly, as a result of the reduced sacrifice ratio it is now increasingly in the policy maker’s interest to experiment with lowering the unemployment rate, since testing the water can be now be achieved with little cost.

Second, because much of this change can be attributed to the introduction of inflation targeting and central bank independence, is there a need for a different approach to unemployment policy? It may be possible that the unemployed are being denied jobs because policy makers are clinging to old models which have not yet accumulated a record of failure, when a better model or policy may be available. With inflation under control in many of these countries, there is little need for contractionary policy except to keep expectations anchored, and thus policy makers should be able to focus primarily on reducing unemployment, either via eliminating structural factors or facilitating wage decisions and job matching. Furthermore, because this relationship is starting to hold over the medium term there may be implications for fiscal policy, which takes longer to take effect.

Third, given that the U-NAIRU test of Section III.B was outperformed by the unemployment level test, as well as the fact that the NAIRU estimate has a large standard error, it is necessary to question the use of the NAIRU as a signal for monetary policy. Successive over-estimation, as was seen in some countries in the 1990’s, may lead to expansion opportunities not being exploited if the firms in the economy believe that monetary policy will be conducted based on the over-estimated NAIRU value.

Fourth, there may be other factors at play that are keeping inflation low. For example, the increase of global competition and trade has put a ceiling on the wage demands of some low skill labourers, since their employer may outsource or move production abroad. In addition, cheap production abroad has lowered import prices, and puts a ceiling on tradeable items in the domestic economy[1]. Further, the rise of the digital economy has raised productivity, improved the facilitation of commerce and job-matching and introduced new employment opportunities, which may lower the level of structural unemployment.

Whether these favourable conditions will hold is important, a return to protectionism for example may see the Phillips curve relationship strengthening again.

<!– /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:”"; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”; mso-fareast-language:EN-US;} p.MsoFootnoteText, li.MsoFootnoteText, div.MsoFootnoteText {mso-style-noshow:yes; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”; mso-fareast-language:EN-US;} span.MsoFootnoteReference {mso-style-noshow:yes; vertical-align:super;} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.25in 1.0in 1.25in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} –>

Methodology

In order to understand the test it is necessary to briefly explain the concept of the Natural Rate and the SRPC. Originally coined by Friedman (1968) the natural rate concept states that there is a unique rate of equilibrium unemployment where inflation is stable. This is determined by structural supply-side factors in the economy, primarily the intersection of the labour supply and labour demand curves. Even though this concept is derived under a perfectly competitive general equilibrium framework, the labour market does not clear as a result of imperfections. These include job mismatching, the level of benefits, the effect of tax on earnings, the power of wage bargainers, efficiency wages, and the elasticity of product demand for firms.

Since the economy has a positive equilibrium rate of unemployment, the theory postulates that if unemployment falls below this level then inflation will accelerate as long as unemployment is below the natural rate. Conversely if unemployment is above the NAIRU then inflation will decelerate as long as it is above this level. As a result, the relation should be similar to that of Figure II.1, which is the relationship that will be tested for in Section III.A. This is represented by equation 2.1.

Figure II.1

(Equation 2.1) π = α + β(U) + ε

π = Inflation (2 year average)

U = Unemployment level

In accordance with the theory, the value of β should be negative, which will be tested using an OLS regression and the use of t-statistics.

Despite the advancements of information processing and financial markets over the last few decades the consensus[1] still agree with Friedman’s (1972) evidence that because of rigidities in the economy it takes around two years for the full effects to inflation to be felt, with the peak effect taking place after one year. Consequently, in this study the inflation values will be an average of the inflation at the time, the inflation one year after, and the inflation two years after (t, t+1, t+2), in order to accommodate the lag. An average was chosen rather than using separate variables for each year because it was difficult to find significant results when each year was analysed separately.

Although this analysis can be seen as being overly simple, including other factors that contribute to inflationary pressures such as commodity prices and financial indicators (which include exchange rates, interest rate differentials and monetary aggregates) were insignificant the majority of the time, and thus not included in order to increase the already small number degrees of freedom and provide a consistent method for the test. It was surprising to find little relationship between oil prices and inflation, considering the marked correlation of the 1970’s. This can be seen in Figure II.2 which demonstrates how the relationship deteriorates from the mid 1980’s[2].

Figure II.2

For Section III.B the premise is to study in greater detail the unemployment-inflation trade-off, by taking into account the movements of the NAIRU from 1990-2003. Hence the equation regressed will be:

(2.2) π = α + β(U-U_n) + ε

By allowing for the changes in U_n in accordance with the estimate, it is hoped that the unemployment related inflation changes can be tracked with better precision and that a stronger SRPC relation can be extracted from the data. How much this improves the accuracy is difficult to estimate, especially considering the tendency of the natural rate estimates to follow the actual unemployment rate. Palley (1998) carries out a regression of OECD unemployment rates which shows that every 1% increase of the actual rate raises the NAIRU estimate by 0.915%.

This relationship will also be tested by OLS regression, and whether β is significantly negative will be analysed with t-statistics. The inflation values are taken as the average of 8 quarters inflation (t,t+1….t+8)