George L. Perry

The Macroeconomics of Low Inflation

THE CONCEPT of a natural unemployment rate has been central to most modern models of inflation and stabilization. According to these models, inflation will accelerate or decelerate depending on whether unemployment is below or above the natural rate, while any existing rate of inflation will continue if unemployment is at the natural rate. The natural rate is thus the minimum, and only, sustainable rate of unemployment, but the inflation rate is left as a choice variable for policymakers. Since complete price stability has attractive features, many economists and policymakers who accept the natural rate hypothesis believe that central banks should target zero inflation. We question the standard version of the natural rate model and each of these implications. Central to our analysis is the effect of downward nominal wage rigidity in an economy in which individual firms experience stochastic shocks in the demand for their output. We embed these features in a model that otherwise resembles a standard natural rate model and show there is no unique natural unemployment rate. Rather, the rate of unemployment that is consistent with steady inflation

Near-Rational Wage and Price Setting and the Long-Run Phillips Curve

OVER THIRTY YEARS ago, in his presidential address to the American Economic Association, Milton Friedman asserted that in the long run the Phillips curve was vertical at a natural rate of unemployment that could be identified by the behavior of inflation.(1) Unemployment below the natural rate would generate accelerating inflation, and unemployment above it, accelerating deflation. Five years later the New Classical economists posed a further challenge to the stabilization orthodoxy of the day. In their models with rational expectations, not only was monetary policy unable to alter the long-term level of unemployment, it could not even contribute to stabilization around the natural rate.(2) The New Keynesian economics has shown that, even with rational expectations, small amounts of wage and price stickiness permit a stabilizing monetary policy.(3) But the idea of a natural unemployment rate that is invariant to inflation still characterizes macroeconomic modeling and informs policymaking. The familiar empirical counterpart to the theoretical natural rate is the nonaccelerating-inflation rate of unemployment, or NAIRU. Phillips curves embodying a NAIRU are estimated using lagged inflation as a proxy for inflationary expectations. NAIRU models appear in most textbooks, and estimates of the NAIRU--which is assumed to be relatively constant--are widely used by economic forecasters, policy analysts, and policymakers. However, the inadequacy of such models has been demonstrated forcefully in recent years, as low and stable rates of inflation have coexisted with a wide range of unemployment rates. If there were a single, relatively constant natural rate, we should have seen inflation slowing significantly when unemployment was above that rate, and rising when it was below. Instead, the inflation rate has remained fairly steady, with annual inflation as measured by the urban consumer price index (CPI-U) ranging from 1.6 to 3.0 percent since 1992, while the unemployment rate has ranged from 6.8 to 3.9 percent. In this paper we present a model that can accommodate relatively constant inflation over a wide range of unemployment rates. Another motivation is a recent finding by William Brainard and George Perry.(4) Estimating a Phillips curve in which all the parameters are allowed to vary over time, they find that the coefficient on the proxy for expected inflation in the Phillips curve has changed considerably, while other parameters of that model have been relatively constant. In particular, Brainard and Perry found that the coefficient on expected inflation was initially low in the 1950s and 1960s, grew in the 1970s, and has fallen since then. The model we present can explain both why the coefficient on expected inflation might be expected to change over time and, to some extent, the time pattern of changes observed by Brainard and Perry. Our paper also allows an interpretation of the findings of Robert King arm Mark Watson and of Ray Fair.(5) Both find a long-run trade-off between inflation and unemployment. In addition, King and Watson find that the amount of inflation that must be tolerated to obtain a given reduction of unemployment rose considerably after 1970. Our model allows a trade-off, but only at low rates of inflation such as those that prevailed in the 1950s, 1960s, and 1990s. At higher rates of inflation, the trade-off is reduced, and at high enough rates of inflation, it disappears. Much of the empirical controversy surrounding the relationship between inflation and unemployment has focused on how people form expectations. This may be neither the most important theoretical nor the most important empirical issue. Instead, this paper suggests that it is not how people form expectations but how they use them--and even whether they use them at all--that is the issue. Economists typically assume that economic agents make the best possible use of the information available to them. But psychologists who study how people make decisions have a different view. …

Changing Labor Markets and Inflation

WHAT RATES OF INFLATION will accompany various unemployment rates? This question is the central concern of stabilization policy today and also a major source of uncertainty for economic forecasting. Whether the approach was made through informed judgment or rigorous research, investigators have sought the answer to this question in the historic relation between unemployment rates, on the one hand, and rates of wage increase on the other, with wage increases then used to explain inflation. With many variations and refinements, this concept of a trade-off between wage changes and the aggregate unemployment rate has been the framework for most discussions of inflation during the past decade. In this view of the inflationary process, the aggregate unemployment rate has served as a proxy for the tightness of labor markets. But significant changes have been taking place in the composition of the labor forcenotably an increase in the proportion of teenagers and women-and in the unemployment experience of different age-sex groups. As a result, the aggregate unemployment rate in recent years has been an increasingly misleading proxy for comparing the current labor market with earlier ones. A given unemployment rate is associated with a tighter overall labor market today than it was ten or twenty years ago. And this means that the trade-off between inflation and the aggregate unemployment rate has shifted: To-

Inflation in Theory and Practice

THE ECONOMIC EXPERIENCE of the past decade has confirmed the limitations of stabilization policy for slowing inflation. The two recessions of the decade revealed how costly it is to stop an entrenched inflation by creating economic slack. Two episodes of massive increase in energy prices exposed the vulnerability of the average price level to exogenous supply shocks. And the economys performance throughout the decade frustrated attempts to combine price stability with goals for high employment hat are conventionally accepted and that are based on observations of the labor market. The failure to stop inflation during the past ten years contrasts starkly with the success achieved in reducing unemployment during the 1960s. As a consequence, professional macroeconomics has been in ferment throughout the past decade. In contrast to the broad consensus that existed ten years ago about stabilization, today there is substantial disagreement about how to deal with inflation and about the costs of alternative strategies for slowing it. The predominant way of thinking about this problem is based on an economy with quantity-adjusting markets and involuntary cyclical unemployment. Within this neo-Keynesian model of the macroeconomy, a Phillips curve represents the short-run response of wage inflation to cyclical variations in unemployment. Most prices are largely determined by the costs of inputs, the most important of which is labor. But the response of the average price level to cyclical fluctuations is magnified by the movement of volatile raw materials prices and by a

Productivity and Real Wages: Is There a Puzzle?

IN RECENT PUBLIC DISCUSSION of labor income in the United States, considerable concern has been voiced that real wages are not keeping up with productivity growth (or are declining), that sharply rising fringe benefit costs are undermining gains in take-home pay, and that workers in other countries are enjoying better pay increases than U.S. workers. Two frequently cited measures published by the Bureau of Labor Statistics (BLS), which are shown in figure 1, highlight some of these concerns. The first measure-the growth in real hourly compensation in the nonfarm business sector-has slowed to 0.4 percent a year from 2.4 percent a year over the 1960-73 period. Meanwhile, hourly output per worker has grown at 0.9 percent a year-noticeably faster than hourly compensation, although down considerably from its 1960-73 annual growth rate of 2.5 percent. In an economy where real wage growth has paralleled the rise in productivity over the long run, this apparent divergence implies that the benefits of increased productivity have not been distributed in the expected way over the past two decades. The second BLS measure-real hourly earnings of nonsupervisory employees-excludes employer payments for pension, health care, employment taxes, and other nonwage costs that are counted in real hourly

Slowing the Wage-Price Spiral: The Macroeconomic View

OVER A DECADE has passed since the standard remedy of demand restraint was first urged to combat inflation. By the mid-1960s, many economists, including those at the Council of Economic Advisers, believed war expenditures were pushing the economy into the inflationary, excess-demand zone and recommended tax increases to help restrain aggregate demand. We cannot know how different subsequent economic performance would have been if that advice had been heeded. But it was not. Unemployment continued to decline into 1969, and the inflation rate in consumer prices rose above 5 percent. Inflation, by then, had become firmly entrenched in economic decisionmaking. When demand finally fell and unemployment rose in the recession of 1970, the inflation rate scarcely budged. Both average hourly earnings and the private nonfarm price deflator rose faster during 1970-71 than in any year of the 1960s. Many observers concluded that a recession deeper than that of 1970 would be needed to stop inflation. In summer 1971, the Nixon administration tried a different cure, imposing wage and price controls that lasted in modified form until April 1974. These controls slowed the inflation rate for most wages and prices. But by the time the controls expired, higher prices for food and fuel, which were largely unrelated to the state of demand, and for industrial raw materials, which reflected strong world demand and speculative buying, had created double-digit rates of overall

What Have We Learned about Disinflation

U.S. MONETARY POLICY since 1979 has been geared to stopping inflation. It has had considerable success in doing so, but at a great cost in lost output and high unemployment, not only in the United States, but throughout the world. In Europe unemployment rose steadily from 1979 to 1982 and is expected to rise further in 1983. In the United States, unemployment rose to 10.7 percent at the trough of the recession in the fourth quarter of 1982, more than I1/2 points above the previous postwar record reached at the worst point of the severe 1975 recession. The duration of economic weakness in the present disinflation period distinguishes it from previous postwar recessions even more than the amount by which unemployment rose and the level that unemployment reached. If the brief bounce-back in economic activity after mid-1980 is ignored, the recent U.S. recession lasted twelve quarters. The previous postwar record was the five-quarter recession of 1974-75. All other postwar recessions had lasted less than a year. By the end of 1983 the cumulative excess of unemployment over its 1979 level will be about 11 percentage point-years, corresponding to an estimated

Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?

700 billion to

Papers on Economic Activity

900 billion of forgone GNP in todays prices. This severe recession has been accompanied by a dramatic slowing in the rate of inflation. Table 1 summarizes several measures of inflation that reflect that slowdown, including widely used measures of actual inflation rates, which are affected by many special developments not closely associated with the underlying inflation problem, and some alternative measures of the underlying inflation rate. During the 1978-

Making Policy in a Changing World

Brookings Institution. In addition, GEORGE AKERLOF is Professor of Economics at University of California, Berkeley; WILLIAM DICKENS is a Research Associate at the National Bureau of Economic Research; and GEORGE PERRY is Editor of the Brookings Papers. 1992 consumer price inflation has not been higher than 3 percent a year a lower rate than at any time since the mid-1960s. In fact, worries about price increases apparently have fallen completely off the publics radar screen. In a recent poll, only 1 percent of respondents listed inflation or the cost of living as one of the most important problems facing the country today. But inflation is still on the screen