Oxford macro professor Stephen Nickell and his co-authors delve into the trade-off between inflation and unemployment in the dual mandate of price stability and maximum employment.

Oxford macro professor Stephen Nickell and his co-authors delve into the trade-off between inflation and unemployment in the dual mandate of price stability and maximum employment.

Richard Layard, Stephen Nickell, and Richard Jackman (2005)

 

Unemployment: macroeconomic performance and the labour market

 

Oxford macrofinance professor Stephen Nickell and his co-authors Richard Layard and Richard Jackman delve into the trade-off between inflation and unemployment in the dual mandate of price stability and maximum employment worldwide. Since the 1980s, high unemployment has been a long prevalent macroeconomic problem in Europe. The natural unemployment rate seems to move over time in mysterious and dramatic ways. High unemployment does not make sense in the conventional analysis of neoclassical labor demand and supply in the market for human capital. Labor market imperfections serve as a major feature at the center of any theory of unemployment due to both sticky prices and efficiency wages. For monopolistically competitive firms under constant returns to labor and constant elasticity demand curves, both Avinash Dixit and Joseph Stiglitz (1977) show that the price level is a markup over the nominal wage. In the broader business context, monopolistically competitive firms enjoy economic rent extraction in the form of price markup. As a result, aggregate labor demand and supply curves cannot meet in equilibrium. This disequilibrium result leads to higher unemployment in the market for human capital accumulation.

As Carl Shapiro and Joseph Stiglitz (1984) suggest, employers often learn to pay higher efficiency wages well above labor market equilibrium real wages in order to avoid shirking on the job. The natural unemployment rate reflects nominal rigidities and price-wage markups. In this particular context, the natural unemployment rate can differ from the actual unemployment rate in practice. The deviations of natural unemployment from the actual unemployment rate often lead to substantive shifts in both price inflation and wage inflation. In this fundamental sense, there can be some mysterious and inexorable trade-off between inflation and unemployment in the dual mandate of price stability and maximum employment worldwide.

Price-wage relations resemble the traditional labor demand and supply curves. In the presence of decreasing returns to labor, price markup can indicate an increase in the general price level for each given real wage as employment changes in due course. Labor demand suggests a negative relation between employment and the real wage. Given the general price level, real wage determination suggests higher nominal wages if unemployment is relatively low. In this case, labor supply reflects a positive relation between employment and the real wage. From this fundamental viewpoint, labor demand and supply curves intersect in theory. Price markups and labor market institutions such as unemployment insurance, employment protection, and product market regulation can contribute to persistent disequilibrium efficiency wages in the labor market. In this light, the natural unemployment rate can become persistently high in some parts of the world (such as Europe and Africa). Changes in productivity growth and the user cost of capital further affect these labor market institutions and product market characteristics. From a fundamental viewpoint, key productivity gains and capital market frictions can tilt the trade-off between inflation and unemployment in the dual mandate of both price stability and full employment on the global scale.

 

Cross-country regression results show that many people respond to incentives in the fundamental sense of significant relations between employment levels and the carrots and sticks for labor market institutions.

Layard, Nickell, and Jackman (2005) regress price-wage markups on measures of labor market institutions. These cross-country regression results show significant relations between domestic employment rates and the carrots and sticks for labor market institutions. Specifically, unemployment benefits often help people endure the brief transition between jobs. Also, collective labor union structures further help secure higher efficiency wages over sufficiently long periods of time. Income taxes can help alter domestic labor force participation and unemployment rates through the real business cycle. In recent decades, socioeconomic benefits such as child care tax credits and baseline income tax credits help boost labor force participation rates for women. This higher labor force participation for women often helps reduce domestic unemployment with better high-skill knowledge-intensive work over time. Some other measures of labor market institutions such as public employment and early retirement cannot cause significant changes in labor force participation and unemployment through the real business cycle.

Nobel Laureate Edmund Phelps (1994) focuses on the role of imperfections in both labor and product markets in pursuit of the trade-off between (wage) inflation and unemployment. Phelps analyzes the economic policy implications of labor market imperfections such as efficiency wages for the labor market as well as firm-specific price markups for the product market for goods and services. In accordance with the seminal contributions of Nobel Laureate Edmund Phelps, the evidence shows a negative non-linear trade-off between wage inflation and unemployment in some European countries such as France, Germany, Greece, Italy, Portugal, and Spain. However, whether the trade-off between inflation and unemployment prevails over the long run remains an open controversy among macrofinancial economists.

 

Since the 1980s, unemployment has remained very high in continental Europe with some substantive differences across countries.

Some of the bigger European countries such as France, Germany, Italy, and Spain continue to have unemployment rates about or above 10% per annum. Many small European countries such as Denmark and the Netherlands tend to experience low unemployment rates. Since the 1980s, natural unemployment has remained quite high in continental Europe with some peculiar differences across countries. Some high-skill workers choose to leave the labor force. Low-skill workers seem to leave the labor force by accident. In light of the real reservation wage, these workers can choose how hard they want to look for new jobs. These workers further choose to trade off hard labor and leisure. As a result of mapping job search theories to facts, the micro data analysis suggests labor market reforms in support of high efficiency wages, collective union bargains, unemployment benefits, child care tax credits, or general income tax reductions etc.

As Layard, Nickell, and Jackman find in their empirical analysis, real wages seem to move much less than what Nash equilibrium suggests in theory. Such real wage rigidities tend to arise from intra-firm efficiency wages, collective union constraints, and menu costs in association with capital investment adjustments etc. Meanwhile, quasi-natural experiments and household surveys show that limiting the duration of unemployment benefits often leads to more active job search, lower duration of unemployment, and lower real reservation wages across many industries. On the other hand, greater employment protection reflects longer unemployment duration, lower labor force participation, and lower high-skill human capital flows in and out of unemployment.

Panel data regression results show a relatively robust set of significant correlations between unemployment and some adverse macro economic shocks in association with labor market institutions. These labor market institutions show unemployment benefit duration, collective union power, real wage coordination, and several other forms of employment protection. From a macroeconomic viewpoint, business cycle fluctuations seem to drive much variation in national unemployment. This evidence calls for fiscal-monetary policy coordination for better macro economic stimulus in due course. Fiscal deficits often help boost government expenditures in health care, education, technology, and infrastructure (insofar as the government follows strict upper bounds on national debt). Monetary policy stimulus manifests in the form of interest rate cuts (and lower bank reserve requirements). Both fiscal and monetary policy stimulus programs help ensure better economic growth and full employment in the dual mandate of both price stability and maximum employment.

MIT PhD macro economist Jordi Gali and his thesis advisor and former IMF chief economist Olivier Blanchard empirically show that the core Taylor interest rate rule of solo price stabilization would be equivalent to minimizing the deviations of both inflation and the economic output gap from their respective target levels. Blanchard and Gali refer to this macroeconomic stabilization policy as the divine coincidence. The divine coincidence cannot take into consideration asset market stabilization in due course.

Nevertheless, the divine coincidence vanishes when the econometrician takes into account wage rigidities and financial market imperfections. In this alternative case, the econometrician can readily identify a clear trade-off between wage inflation and unemployment at least in the cross-section of OECD and non-OECD economies. This canonical trade-off between wage inflation and unemployment is the Phillips curve, and the Phillips curve serves as a crucial foundation for the New Keynesian school of macroeconomists such as Olivier Blanchard, Jordi Gali, Gregory Mankiw, and so forth.

In stark contrast, several real business cycle (RBC) macro economists dismiss this narrow focus on the New Keynesian Phillips Curve (NKPC) for a pair of reasons. First, there is no clear trade-off between core CPI inflation and unemployment, and the Phillips curve becomes the Phillips cloud. In other words, the Phillips curve has become too flat to be true. This empirical result holds even when we consider some alternative metrics of inflation such as the personal consumption expenditure (PCE) deflator and core consumer price index (CPI) inflation less food and energy. Hence, there is no conclusive evidence in support of the downward Phillips curve.

Second, NKPC evidence disappears in the time-series data for each of the OECD countries. This time-series data inconsistency also shows up in Japan, Hong Kong, Singapore, and South Korea. In the long run, the Phillips curve becomes so vertical that the natural rate of unemployment seems independent of inflation. In this rather skeptical light, price stabilization has no impact on real macro economic covariates such as real GDP, consumption, employment, capital investment, and so forth. In summary, the Phillips cloud echoes the RBC monetarist school of economists such as Robert Barro, John Cochrane, Roger Farmer, and Robert King etc.

Overall, the relentless NKPC monetary policy debate appears to be a moot issue. New Keynesian central bankers continue to consider a downward Phillips curve or a tentative trade-off between inflation and unemployment, whereas, real business cycle proponents view alternative macroeconomic behaviors and beliefs and even financial market imperfections as plausible sources of transitional dynamism in real macro economic covariates such as GDP growth, employment, capital investment, and financial intermediary capital. In the meantime, the Phillips curve remains an open controversy.

In U.S. economic history, the Federal Reserve System needs to fulfill the legislative mandate of promoting long-term steady economic growth, price stability, maximum sustainable employment, production, and purchasing power. The core problem for Federal Reserve System has become stopping disinflation from becoming a debt-deflation bust. In the current decade, Federal Reserve interest rate adjustments help constrain money supply growth and hence prevent inflation from becoming a major source of economic disturbance. In recent years, Federal Reserve System has gradually formalized FOMC communication channels and procedures to foster transparency and public acceptance of central bank independence and power over the U.S. real macro economy.

The Federal Reserve System learns from its previous interest rate cycles with fiat-money, legal tender, and monetary policy research that the best policy prescription aims to anchor long-run inflation expectations at a low level if the Federal Reserve System strives to attain the congressional dual mandate of both price stability and maximum sustainable employment. The current adoption of a specific 2% inflation target is the end result of decades of learning from this experience with fiat money and core monetary policy research (from Volcker and Greenspan to Bernanke and Yellen). During the current corona virus crisis of 2020-2021, U.S. core CPI inflation continues to hover in the reasonable range of 2.3% to 4.5%. In order to sustain the current U.S. economic expansion, Federal Reserve Chair Jerome Powell and most FOMC members approve an interim federal funds rate at the zero lower bound in accordance with the massive monetary stimulus of quantitative-easing large-scale asset purchases. Powell reiterates the best FOMC intention that financial market participants cannot misconstrue this interim interest rate adjustment as a one-time rate cut at the zero lower bound. The Powell forward guidance better balances the current interest rate cycle in response to adverse economic shocks that arise from the recent rampant pandemic crisis of 2020-2021.

 

Productivity growth, employment protection, collective coordination, and so on can contribute to maximum sustainable employment despite substantive labor market imperfections and inclusive institutions.

Most European governments tend to move in the right direction (although progress has been quite slow). The prescriptive macro economic consensus view includes better unemployment benefits, generous subsidies on job search, key employment protection, judicial intervention in labor market institutions, and less payroll taxation. To the extent that greater productivity boosts consumption, higher consumption so decreases the marginal utility of consumption with the higher real reservation wage. If high productivity relates to a better economic growth path and both consumption and employment increase proportionally along the same path, the real reservation wage increases instantaneously in response to high productivity with no change in employment. If consumption increases in the short run less than one-for-one with productivity, some increase in productivity growth often causes employment to rise for some time. This consensus view seems to resonate with the real business cycle (RBC) school of macroeconomic thought.

The Okun law suggests a robust relation between (un)employment and the output gap. For every 1% increase in the unemployment rate, OECD GDP often tends to be 2% less than its potential GDP ceteris paribus. This empirical relation between unemployment and real GDP proves to be the heuristic rule of thumb for European and OECD countries. For instance, if the government corrects some labor market imperfections to boost labor force participation and employment by 1%, we would expect real GDP to increase such that the output gap closes by 2% ceteris paribus. So helping promote reductions in unemployment can contribute to better economic performance in Europe and some other parts of the world.

When most firms respond to higher labor costs and efficiency wages by increasing capital intensity and so productivity growth (above the actual rate of technological progress), high-skill workers can respond to higher productivity growth with higher wage demands. A rising tide lifts all boats. In stark contrast, low-skill workers can only afford to accept lower real reservation wages. The labor market cannot clear in due course because labor demand and supply cannot meet in equilibrium. This disequilibrium result persists such that unemployment moves in tandem with real business cycle fluctuations. In practice, this disequilibrium persistence often tends to exacerbate economic inequality or wealth and income concentration in the labor market.

The general level of job flows seems quite similar in America, Britain, Canada, and Europe. In light of natural unemployment, economists need to be careful about the role of labor market institutions such as employment protection and unemployment insurance. High-skill knowledge-intensive workers better react to the re-allocation of goods and services. This particular high-skill human capital accumulation arises from product market deregulation and globalization. The government learns to use both carrots and sticks to offer incentives for many people to transform themselves into high-skill knowledge-intensive workers. This dual transformation helps renew the level of job flows within each country. Macroeconomists often learn to shift their focus from the trade-off between inflation and unemployment to a more informative analysis of labor market institutions.

Nowadays, there is ubiquitous agreement about the optimal design of labor market institutions such as unemployment insurance, employment protection, or negative income taxation. Some European countries such as Denmark and the Netherlands seem to have gone further than others in the right direction and thus have achieved lower unemployment and higher labor force participation. The Dutch employment model represents the standard prototype for labor market reforms in Europe. With more flexible employment contracts such as remote work arrangements and work-from-home facilities, the Dutch employment model proves to be the heuristic rule of thumb for many European countries and some other parts of the world. If France, Germany, Greece, Italy, Portugal, and Spain etc chose to import the Dutch model of both unemployment insurance and employment protection, the bigger European countries would probably converge to the Dutch and Danish natural unemployment rates. This macro convergence can contribute to better mutual trust between social partners (i.e. workers, firms, and regulatory state agencies in the public sector). In a fundamental view, economic actors respond to incentives, and these incentives often manifest in the common form of both carrots and sticks for the labor market. Both macro adverse shocks and labor market institutions reshape the evolution of the natural unemployment rates in different countries.

Oxford macrofinance professor Stephen Nickell and his co-authors Richard Layard and Richard Jackman delve into the trade-off between inflation and unemployment in the dual mandate of price stability and maximum employment worldwide. Since the 1980s, high unemployment has been a long prevalent macroeconomic problem in Europe. The natural unemployment rate seems to move over time in mysterious and dramatic ways. High unemployment does not make sense in the conventional analysis of neoclassical labor demand and supply in the market for human capital. Labor market imperfections serve as a major feature at the center of any theory of unemployment due to both sticky prices and efficiency wages. For monopolistically competitive firms under constant returns to labor and constant elasticity demand curves, both Avinash Dixit and Joseph Stiglitz (1977) show that the price level is a markup over the nominal wage. In the broader business context, monopolistically competitive firms enjoy economic rent extraction in the form of price markup. As a result, aggregate labor demand and supply curves cannot meet in equilibrium. This disequilibrium result leads to higher unemployment in the market for human capital accumulation.

As Carl Shapiro and Joseph Stiglitz (1984) suggest, employers often learn to pay higher efficiency wages well above labor market equilibrium real wages in order to avoid shirking on the job. The natural unemployment rate reflects nominal rigidities and price-wage markups. In this particular context, the natural unemployment rate can differ from the actual unemployment rate in practice. The deviations of natural unemployment from the actual unemployment rate often lead to substantive shifts in both price inflation and wage inflation. In this fundamental sense, there can be some mysterious and inexorable trade-off between inflation and unemployment in the dual mandate of price stability and maximum employment worldwide.

 

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