BRINNER1The Policy Tradeoff: Unemployment vs. Changes in InflationIntroduction to Macro Policy and ModelsBRINNER2Focus Today Simple Micro: Prices, Demand and Supply Simple Dynamics: Disequilibrium Means Change An example central to policy choices: managing the economy to produce a desired outcomeBRINNER3Simple 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 Equal Supply: More Hours Will Be Supplied by Individuals the Higher the Real Wage Equilibrium: Demand=Supply»All Those Wanting to Work at the Current Real Wage Can Find Work after a Reasonable Period of SearchBRINNER4Simple Micro in the Labor Market : Prices, Demand and SupplyDEMANDSUPPLYREALWAGEWORKERS or HOURS DEMANDED AND SUPPLIEDEQUILIBRIUMBRINNER5Simple Dynamics: DisequilibriumMeans Change in the Labor Market Unemployed 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 wage Involuntary Unemployment Creates Pressure for (Real) Wages to FallBRINNER6Simple Dynamics: DisequilibriumMeans Change in the Labor MarketDEMANDSUPPLYREALWAGEWORKERS / HOURS DEMANDED AND SUPPLIEDDISEQUILIBRIUMINVOLUNTARYUNEMPLOYMENTBRINNER7Fluctuations in Unemployment0123456789101967 1971 1975 1979 1983 1987 1991Job Losers ReenterNew Entrants Job LeaversBRINNER8Fluctuations in UnemploymentDEMOGRAPHICS AND THE UNEMPLOYMENT RATE11131517192123252719501952195419561958196019621964196619681970197219741976197819801982198419861988199019921994199619984.855.25.45.65.866.26.4"YOUNG ADULT SHARE OF POPULATION' "NAIRU"BRINNER9Fluctuations in Unemployment024681012194919551961196719731979198519911997Actual RU NAIRUBRINNER10Changes in Nominal and Real Wages-4-2024681019811984198719901993199619992002Real Wage GrowthEmployment Cost Index GDP Price Deflator (lagged one year) (Annual Change)BRINNER11THE APPARENT POLICY OPTIONSIN THE 1960s0123456- 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0UNEMPLOYMENT RATECPI INFLATION RATE1969196519591962BRINNER12A LONGER PERSPECTIVE-20246810121416194819501952195419561958196019621964196619681970197219741976197819801982198419861988199019921994199619982000UNEMPLOYMENT RATE CPI INFLATION RATEBRINNER13THE LONG-TERM POLICY CHOICES AREN'T AS OBVIOUS-20246810121416024681012UNEMPLOYMENTINFLATION19471959198019831974BRINNER14Changes in Real Wages vs. Unemployment-10123-3 -2 -1 0 1 2Unemployment GapReal Wage Growth1994199119891985BRINNER15The Equation for Wage InflationRW=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 inflation plus a constant (A0) for productivity growth and other factors not defined here minus an adjustment for the existence of involuntarily unemployed workers:total unemployment (U) - voluntary (U@VOL)BRINNER16A Companion Equation for Price Inflation If 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 - RABRINNER17The Final Form Model of Price Inflation RP = - B1 * (U-U@VOL) + RW - RA AND, EARLIER,RW=RP\1+A0-A1*(U-U@VOL) THUSRP=(A0-RA)-(A1+B1)*(U-U@VOL)+RP\1 OR 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 1998Real Wage InflationInflation-Igniting Threshold:(5.5% unemployment)Nominal Wage InflationInflation (%)Unemployment RateReal Wages Accelerated As Usual after Q1 1997, As Unemployment Fell Below 5.5%BRINNER190%1%2%3%4%5%6%7%8%1995 1996 1997 1998 1999 2000Real Wage InflationInflation-Igniting Threshold:(5.5% unemployment)Nominal Wage InflationInflation (%)Unemployment RateBut Surprising Moderation Occurred in 1999-2000BRINNER20Useful Inflation Rules of ThumbConsumer 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-6-4-2024681012141961 1966 1971 1976 1981 1986 1991 1996Consumer Price InflationActualPredictedBRINNER22The 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 RATEBRINNER23The Policy Tradeoff: Unemployment vs. Changes in Inflation Two endogenous variables: RP and U In terms of the earlier model, think of U as varying inversely with GNP, hence the endogenous variables are RP and GNP If 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.BRINNER24The Policy Tradeoff: Unemployment vs. Changes in Inflation 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.BRINNER25The Policy Tradeoff: Unemployment vs. Changes in Inflation 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.– .....BRINNER26The Policy Tradeoff: Unemployment vs. Changes in Inflation Short-term interest rates, managed by the Fed, reveal Fed
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