BRINNER 1 902mit12.ppt Inflation-Unemployment Tradeoff Lecture 12

BRINNER 2 902mit12.ppt The Equation for Wage Inflation The rate of change of wages (RW) equals u the rate of change in prices (RP) in the past year (“\1”) as a proxy for expected inflation u plus a constant (A0) for productivity growth and other factors not defined here u minus an adjustment for the existence of involuntarily unemployed workers:total unemployment (U) - voluntary

BRINNER 3 902mit12.ppt The Equation for Wage Inflation Dependent Method: Least Squares Date: 03/24/00 Time: 14:16 Sample(adjusted): Included observations: 24 after adjusting endpoints VariableCoefficientStd. Errort-Statistic C (RUC-RUFE)/ R-squared S.E. of regression

BRINNER 4 902mit12.ppt The Equation for Wage Inflation

BRINNER 5 902mit12.ppt A Companion Equation for Price Inflation u If prices are a simple “mark-up” on wages adjusted for productivity “QperH” (wages divided by productivity = unit labor costs).. u P = K * W/QperH u hence RP = RK + R(W/QperH) u..and this markup could fall when the economy is sluggish »RK = B0 - B1 * u Then: RP = B0 - B1 * + R(W/QperH)

BRINNER 6 902mit12.ppt A Companion Equation for Price Inflation Dependent Method: Least Squares Date: 03/24/00 Time: 14:37 Sample(adjusted): Included observations: 23 after adjusting endpoints VariableCoefficientStd. Errort-Statistic R-squared S.E. of regression

BRINNER 7 902mit12.ppt A Companion Equation for Price Inflation

BRINNER 8 902mit12.ppt The Final Form Model of Wage and Price Inflation RP = B0 - B1 * + RW AND, EARLIER, THUS RP= (A0+B0) - OR RP-RP\1 =THE CHANGE IN INFLATION = (A0+B0) + SIMILARLY, THE CHANGE IN WAGE INFLATION CAN BE SHOWN TO BE DRIVEN BY THE LEVEL OF UNEMPLOYMENT: = B0 - B1 * + RW\1 + BRING RW\1 TO THE LEFT (and ignore the difference between U and U\1): RW - RW\1= THE CHANGE IN WAGE INFLATION= =(A0+b0) - ( A1+B1) * (U - I.E. A FUNCTION OF THE ADJUSTED LEVEL OF UNEMPLOYMENT

BRINNER 9 902mit12.ppt The Final Form Model of Wage and Price Inflation RP-RP\1 = (A0+B0) THE CHANGE IN INFLATION = A FUNCTION OF THE ADJUSTED LEVEL OF UNEMPLOYMENT A stable, low rate of inflation is a valuable attribute of an economy: it promotes good decision making because economic life is predictable and unbiased by continually changing prices If inflation is constant, RP = RP\1 and the price level is “non-accelerating”, we can compute the associated “non-accelerating rate of unemployment” or “NAIRU”. For this to hold, 0= (A0+B0) - (A1 + B1) * Hence, U(NAIRU) = + (A0+B0)/(A1+B1) A0 is the excess of wage growth over price growth from the wage equation: this tends to be the long- run productivity growth rate. B0 is the excess of price growth less wage growth in the price equation; this tends to be equal to the negative of the long-run productivity growth rate (i.e. prices only need to rise as rapidly as wage growth minus productivity). Thus A0+B0 = 0, and U(NAIRU) is the

BRINNER mit12.ppt The Link Between Unemployment and Real Output u The unemployment rate reflects the difference between the demand for and the supply of labor. u The demand for labor is the number of employees (E) needed, with a given productivity (GDP/E) to produce a given output (GDP) –or, E = GDP / (GDP/E) u The supply of labor is the number of workers (L) seeking to work at a given real wage u The Potential output they can produce in a “Fully Employed economy” = “an economy operating at the “NAIRU” is called “Potential GDP” FE) (1-NAIRU) * (Productivity) –substituting from above for productivity = L *( 1-NAIRU) * (GDP/E) –hence L = / [ (1-NAIRU)*(GDP/E) ] u Unemployment Rate = U/L = (L-E) /L = 1 - E / L =1- { GDP/ (GDP/E) } / { / [ (1-NAIRU) * (GDP/E) ] } =1- { GDP / } x (1-NAIRU) =(APPROX.) NAIRU + THE % “GDP GAP” VS

BRINNER mit12.ppt The Link Between Unemployment and Real Output A small adjustment to this is required to reflect the short-run increases in productivity that occur during booms, and the symmetric short-run loss during recessions u Specifically, the prior formula indicates the unemployment rate would fall a full 1% for each 1% increase in GDP (for any given u In fact, due to temporary shifts in productivity, the actual change is roughly 1/2 of this –In other words, on a cyclical basis, a 1% boost in output is met by firms with a 1/2% boost in employees and a 1/2% boost in temporary productivity u This relationship is known as Okun’s Law: –the change in Unemployment Rate= about half the growth rate difference between potential and actual GDP growth –or, the level of the Unemployment Rate= about half the % gap between potential and actual GDP

BRINNER mit12.ppt The Full Links Among: Inflation, Unemployment and Real Output The critical relationships are: 1. The change in inflation responds (with a negative derivative) to the unemployment rate 2. The unemployment rate responds (with a negative derivative) to the GDP level, given Therefore, 3. The change in inflation responds (with a positive derivative) to the GDP level, given change in inflation GDP level

BRINNER mit12.ppt The Full Links Among: Inflation, Unemployment and Real Output The change in inflation responds (with a positive derivative) to the GDP level, given A favorable external shock, such as a drop in oil prices or imported goods prices, effective reduces the NAIRU (the unemployment rate required to keep inflation unchanged), and thereby raises change in inflation GDP level with NAIRU (1) with NAIRU (2)

BRINNER mit12.ppt The Determination of Trend Potential GDP expands in predictable ways (see Growth lectures) u GDP requires capital, labor, and technology u If we use a narrow definition of capital as physical capital, then trend GDP growth is the weighted average of capital and labor growth rates, plus the total factor productivity growth created by advancing technology u A broader definition of capital changes the defined labor and capital growth rates and hence the residual left for technology

BRINNER mit12.ppt Recall the Determinants of Labor Productivity u What enables an employee to produce more or less per hour? –The “state of the art” potentially available (the production possibility frontier”). –His/ Her own education and training to absorb the state of the art. –The quantity and quality of available, complementary “tools” such as computers, assembly machines.

BRINNER mit12.ppt The Determinants of Labor Productivity u What “infrastructure” can the nation provide to influence: –the level of output in a workplace? »education, health, attitudes toward work, regulation, taxation –the efficiency of “connections” between workplaces? »communication, transportation, common language, anti-monopoly regulation, global access

BRINNER mit12.ppt The Determinants of Labor Productivity u Economists can refer to almost all of these factors as simply different types of “capital” u “Capital” in this context simply means something that is long-lasting and not used up by the process of production u More narrowly, “capital” sometimes only means tangible goods such as equipment, buildings, highways

BRINNER mit12.ppt The Determinants of Labor Productivity u Types of Capital –Tangible equipment and structures –Human, from brains through brawn –Technological, e.g. accumulated R&D –Infrastructure, i.e. tangible goods not owned by one enterprise