MMT Textbook Name Here
X
Unemployment
and Inflation
Chapter Outline
In this Chapter, we will introduce the concept of inflation and discuss various approaches that seek to explain it.
We will differentiate between inflationary pressures that arise from nominal demand (spending) growth
outstripping the real capacity of the economy to react to it with output responses and, inflation that may arise
from supply shocks – such as a rise in an imported raw material (for example, oil).
The first type of inflation has been termed demand-pull because excess nominal demand (relative to real output
capacity) pulls up the price level. Sometimes you will encounter the expression “too much money chasing to
few goods” as a crude simplification of this type of inflation.
The public debate about whether expansionary fiscal policy causes inflation, which we will deal with
specifically in Chapters 13 and 19, are also predicated on the claims that fiscal stimulus runs the danger of
causing the economy to overheat.
The second type of inflation is termed cost-push inflation because it originates from the costs of production
increasing and pushing up the price level. We will learn that the mechanisms through which the supply shocks
manifest as inflation are different to those that operate under demand-pull inflation.
However, both forms of inflation can be understood within a general framework whereby different claimants on
real GDP and national income struggle to assert their aspirations. In this sense, we cast inflation within the
general distributional struggle or conflict, that is elemental in capitalist economies, between workers seeking to
maintain and achieve a higher real wage and firms seeking to maintain and expand their profit rate.
In other words, we situate the problem of inflation as being intrinsic to the conflicting relations between workers
and capital, which are mediated by government. This mediation varies over the course of history and in more
recent times has been biased towards protecting the interests of capital, particularly financial capital, at the
expense of workers’ real wage aspirations. We will consider the consequences of that policy stance in this
Chapter.
In the pre-Keynesian era the concept of full employment only allowed for voluntary unemployment:
employment was determined at the intersection of labour demand and supply which was the outcome of
maximising, rational and voluntary decision making by workers and firms.
However, in the immediate Post World War II Keynesian era, the concept of full employment was recast and the
emphasis became one of providing enough jobs to match the work preferences of the available labour force.
Any remaining unemployment (frictions aside) was considered involuntary and due to the failure of the
monetary economy to generate demand sufficient to meet the saving preferences of the private sector. The
notion of involuntary unemployment was at the heart of this conception of full employment. That is, full
employment coincided with zero involuntary unemployment.
This Post World War II consensus was steadily eroded away over the next 40 odd years. By the early to mid1970s, mainstream macroeconomics reverted back to the pre-Keynesian notions of voluntary unemployment and
effectively abandoned the concept of true full employment.
However, the process of abandonment began in the 1950s when the discussion turned to inflation and the tradeoff between the twin evils of unemployment and inflation. This was the era in which the Phillips curve
literature emerged, named after the New Zealand economist Bill Phillips who “discovered” what was then
considered to be a statistically reliable, inverse relationship between unemployment and inflation – the so-called
trade-off between unemployment and inflation.
For the concept of true full employment, however, it was the subsequent Monetarist and New Classical
1
MMT Textbook Name Here
reinterpretation of the trade-off that was devastating. The Classical (pre-Keynesian) notions of a natural
unemployment rate (understood as being equivalent to full employment) was revived and this led economic
theory to reject demand management policies which aimed to limit unemployment to its frictional component.
In this Chapter, we will explore the evolution of the Phillips Curve and the way in which the idea that there
might be a trade-off between the twin-evils of unemployment and inflation has changed as ideological
dominance has shifted from those who see a profound role for government to play in maintaining low levels of
unemployment and those, of neo-liberal persuasion, who eschew the intervention of government and consider
the “market” will generate full employment without government.
We will see how more recent developments in history, such as the augmentation of the Phillips curve with
inflationary expectations and the so-called “natural rate of unemployment” models, which have sought to
resurrect the Classical theory believe that the free market delivers optimal outcomes and were discredited during
the Great Depression (see Chapter 11 Keynes and the Classics), are paradigmatically different to the original
conception of the Phillips curve.
The more recent literature has sought to deny the existence of a stable trade-off between unemployment and
inflation and can be traced back to the American economist Irving Fisher who was a prominent and influential
exponent in the last century of the Neoclassical approach.
In this Chapter we are building on the analysis presented in Chapter 11 where we outlined the debate between
Keynes and the Classics. We will draw on your understanding of the standard Classical labour market and the
conclusion that is drawn from that body of theory, that unemployment arises when the real wage is excessive.
We will also extend the discussion of the Keynesian view on unemployment and the fundamental distinction
between voluntary and involuntary unemployment. We have seen that the latter is caused by deficient aggregate
demand which can be solved by demand policies.
A thorough understanding of the debate between Keynes and the Classics allows for more deeper understanding
of the so-called Phillips curve, which came to prominence in the late 1950s, but which, in fact, had been
conceived by economists earlier than this.
The focus of this discussion on the question as to whether there is a trade-off between inflation and
unemployment and whether governments can use expansionary fiscal policy to reduce unemployment to some
irreducible (frictional) minimum.
[Note: the Chapter order has been a juggled a little. This was formerly going to be Chapter 11 but
we will probably take the Keynes and the Classics material out of this chapter and run it as a standalone Chapter 11 or even 10 - decisions are still to be taken]
2
MMT Textbook Name Here
X.1
What is Inflation?
There are many misconceptions as to what inflation actually is. Many media commentators, for example, think
that a pay rise for workers constitutes inflation. Others (of perhaps a different political persuasion) think that
when companies increase the price of a good or service they are offering that this is inflation.
Some people think inflation occurs, when following an exchange rate depreciation the local price of imported
goods and services rise. A depreciating exchange rate means that the local currency becomes less valuable in
relation to other currencies and foreign-sourced goods and services typically become more expensive to local
buyers. But is this inflationary?
Similarly, some commentators think inflation occurs when the government increases a particular tax (say, a
value-added tax on goods and services or GST) by x per cent and this is passed on by firms in the form of higher
prices for goods and services.
None of these examples constitute inflation. Given they all involve a rise in prices, each example would
constitute what we would call a necessary condition for an inflationary episode. But none of these examples
represent a sufficient condition. Observing a price rise alone will not be sufficient to justify the conclusion that
one is observing as being an inflationary episode.
Inflation is the continuous rise in the price level. That is, the price level has to be rising each period that
you observe it.
If the price level rises by 10 per cent every month, for example, then we would be observing an inflationary
episode. In this case, the inflation rate would be considered stable – a constant or proportionate increase in the
price level per period.
If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in
month three and so on, then we would be observing an accelerating inflation. Alternatively, if the price level
was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating
inflation.
If the price level starts to continuously fall then we call that a deflationary episode. The term hyper-inflation is
reserved for inflationary episodes, which rapidly exponentiate. There have been few instances of this problem in
recorded history.
Thus, a price rise can become inflation if it is repeating, but a once-off price rise is not considered to be an
inflationary episode.
We might also define a normal price level as being the prices firms are willing to supply at when they are
operating at normal capacity. This is the price that satisfies the desired mark-up, which aims to generate a profit
rate that will satisfy the strategic aspirations of the firms. Refresh your memory of the discussion of mark-up
pricing in Chapter 9 if you are uncertain of the way in which firms relate their pricing to other targets.
However, the economic (business) cycle fluctuates around these “normal” levels of capacity utilisation and
firms not only adjust to the flux and uncertainty of aggregate demand by adjusting output, but in some cases,
will vary prices. This is particularly the case during a recession.
When there are very depressed levels of activity, firms might offer discounts or sales in order to increase
capacity utilisation. They thus temporarily suppress their profit margins as a means of maintaining their market
share. As demand conditions become more favourable, the firms start withdrawing the discounts and the
frequency of sales decrease and prices return to those levels that offer the desired rate of return to firms at
normal levels of capacity utilisation.
We would not consider these cyclical adjustments in prices, where they occur to constitute inflation.
3
MMT Textbook Name Here
X.2
Inflation in Practice
SHORT EMPIRICAL ANALYSIS OF THE RECENT HISTORY OF INFLATION WILL APPEAR HERE. GRAPHS,
TABLES ETC.
4
MMT Textbook Name Here
X.3
Early Historical Views About Inflation and Unemployment
The early English classical economists considered the relationship between inflation and unemployment within
the context of the convertibility of the currency note issue into gold. Such convertibility was suspended in 1794
at the outset of the Napoleonic War and did not resume until 1819-1821.
The intervening period of inconvertible paper was initially marked by rampant inflation. Subsequently, in the
period between 1814 and 1816, many country banks in England failed and this led to a destruction of countrybank paper (a form of money) and a sharp contraction in the money supply.
The deflation that resulted imposed harsh effects on the unemployed and members of the working class which
became worse with the resumption of cash payments (at the gold parity, which existed prior to the suspension).
Somewhat earlier (1752), the Scottish economist, David Hume wrote an essay entitled – Of Money – and
outlined a theory that is very reminiscent of what we later called the Phillips curve relationship – the trade-off
between inflation and unemployment.
Hume said that the expansionary effect of an increase in money supply begins via a rise in cash balances in the
economy. There is a presumption that the economy is at less than full employment and, with excess capacity in
the labour market, the higher spending leads to firms increasing output. The expansion lowers unemployment
but eventually the excess demand for labour forces up production costs (via money wage increases) and prices
rise as a result.
There was thus a very clear argument being set forth linking monetary developments (increased money supply)
to the improvement in the real economy. Several other English economists supported this view at the time,
including Henry Thornton and Thomas Attwood.
Attwood, in particular, based his theory of inflation on his real world observations of the consequences for the
working class of the deflationary strategies of the Bank of England after the Napoleonic Wars. He observed that
the attempts by the Bank of England to bring the currency notes back to parity with gold – that is, the sharp
reduction in the money stock – came at the expense of economic activity and caused unemployment to rise.
The harsh deflationary policies adopted by the Bank of England in 1815 and 1816 – as it tried to bring the
currency notes back to parity with gold (that is, sharply reduce the money stock) – saw many brass and iron
workers in the Birmingham area, who were largely occupied in the armaments industry, lose their employment.
Economic activity collapsed in England during this period of monetary contraction.
Attwood also opposed the view that an unfettered labour market would maintain full employment by real wage
adjustments, which became the central idea of Classical employment theory.
These early views were strongly opposed by the Classical economists who came after them. In particular, the
evolution of Classical employment theory, which Keynes opposed in the 1930s, denied the existence of a tradeoff between inflation and unemployment.
5
MMT Textbook Name Here
X.4
The Quantity Theory of Money
Posted on Friday, February 8, 2013 by bill
The Classical theory of employment, that we analysed in detail in Chapter 11, was based on the view that the
real variables in the economy – output, productivity, real wages, and employment – were determined by the
equilibrium outcome in the labour market.
The real wage was considered to be determined in the labour market, that is, exclusively by labour demand and
labour supply. Labour demand was inversely related to the real wage because they asserted that marginal
productivity was subject to diminishing returns and the supply of labour was positively related to the real wage
because workers would prefer to work more hours as the price of leisure (the real wage) rose.
The real wage is construed in this theory as being the price of leisure in the sense that it represents the other
goods and services foregone (via lost income) of an hour of non-work (leisure). The real wage is thus a relative
price – of leisure relative to other goods and services.
As we have learned in Chapter 11, the important Classical result is that the interaction between the labour
demand and supply functions determines the real level of the economy at any point in time. Aggregate supply of
goods and services is determined by the level of employment and the prevailing technology, which maps how
much output is forthcoming for a given level of employment. The more productive is labour the higher will the
output supply be at each level of employment.
Say’s Law, which follows from the loanable funds doctrine, is then invoked to assume away any problems in
matching aggregate demand with this supply of goods and services. The loanable funds doctrine posits that
saving and investment will always be brought into balance by movements in the interest rate, which is construed
as being the price of today’s consumption relative to future consumption.
The theory thus assumes that two relative prices – the real wage in the labour market and the interest rate in the
loans market – ensure that full employment occurs (with zero involuntary unemployment). Knowledge of the
general price level was thus irrelevant to explaining the real side of the economy.
This separation between the explanation for the determination of the real economic outcomes and the theory of
the general price level is referred to as the classical dichotomy, for obvious reasons. The later Classical
economists believed that if the supply of money was, for example, doubled, that there would be no impact on
the real performance of the economy. All that would happen is that the price level would double.
The classical dichotomy that emerged in the C19th stands in contradistinction to the earlier ideas developed by
economists such as David Hume that there was a trade-off between unemployment and inflation that could be
manipulated (in policy terms) by the central bank varying the money supply.
It is of no surprise that the Classical employment model relied, in part, on the notion of a classical dichotomy for
its conclusions. It origins were based on a barter model where there is an absence of money and owner
producers trade real products. Clearly, this conception of an economy has no application to the monetary
economy we live in.
The development of Classical monetary theory was only intended to explain the level and change in the general
price level. The main attention of the Classical economists was in trying to understand the supply of output and
the accumulation of productive capital (and hence economic growth).
The theory of the general price level that emerged from the classical dichotomy was called the Quantity Theory
of Money. The Quantity Theory of Money, had its origins in the work of French economists in the sixteenth
century, in particular, Jean Bodin.
Why would we be interested in something a French economist conceived in the sixteenth century? The answer is
that in the same way that the main ideas of Classical employment theory still resonate in the public debate (for
example, the denial that mass unemployment is the result of a deficiency of aggregate demand), the theory of
inflation that arises from the Quantity Theory of Money is still influential and forms the core of what became
known as Monetarism in the 1970s.
Economics is not a unified discipline and different schools of thought advance conflicting policy frameworks.
Monetarism and its more modern expressions form one such school of thought in macroeconomics and relies on
the Quantity Theory of Money for its inflation theory.
6
MMT Textbook Name Here
We will also see that the crude theory of inflation that emerges from the Quantity Theory of Money has intuitive
appeal and is not very different to what we might expect the average lay person would believe – that growth in
the money supply causes its value to decline (that is, causes inflation).
The Quantity Theory of Money was very influential in the nineteenth century. The theory begins with what was
known as the equation of exchange, which is, at first blush, an accounting identity.
We write the equation as:
(X.1)
MV = PY
PY is the nominal value of total output (which you will relate to as the definition of nominal GDP in the
national accounts) given P is the price level and Y is real output. Consistent with that definition you will
understand that PQ is a flow of output and expenditure.
M is the quantity of money in circulation (the money supply) and V is called the velocity of circulation, which is
the average circulation of the money stock. V is thus the turnover of the quantity of money per period in making
transactions.
To understand velocity, think about the following example. Assume the total stock of money is $100, which is
held by the two people that make up this economy. In the current period (say a year), Person A buys goods and
services from Person B for $100. In turn, Person B buys goods and services from Person A for $100.
The total transactions equal $200 yet there is only $100 in the economy. Each dollar has thus be used “twice”
over the course of the year. So the velocity in this economy is 2.
The money supply is a stock (so many dollars at a point in time). Any given stock of money might turnover
several times in any given period in the course of all the myriad of transactions that are made using money.
As we learned in Chapter 4 when we considered stocks and flows, flows add to or subtract from related stocks.
But it makes no sense to say that a stock of say $100 is equal to a flow of $100. They are incommensurate
concepts in this regard.
The velocity of circulation converts the stock of money into a flow of money and renders the left-hand side of
Equation (X.1) commensurate with the right-hand side.
As it stands, Equation (X.1) is a self-evident truth because it is an accounting statement. It is obvious that the
total value of spending (MV) will have to equal to the total nominal value of output (PY). In other words, there
is no theoretical content in the relationship as it stands.
We thus need to introduce some behavioural elements into Equation (X.1) in order to use it as a theory of the
general price level.
In this regard, it is important to see the Quantity Theory of Money and Say’s Law as being mutually reinforcing
planks of the Classical theory. The latter was proposed to justify the presumption that full employment output
would be continuously supplied and sold, which meant that the former would ensure that changes in the stock of
money would only impact on the price level.
As Keynes observed, price level changes did not necessarily correlate with changes in the money supply, which
led to his rejection of the Quantity Theory of Money.
In turn, his understanding of how the price level could change without a change in the money supply was
informed by his rejection of Say’s Law – that is, his recognition that total employment was determined by
effective demand and the capitalist monetary economy could easily fall into a state where effective demand was
deficient.
But the Classical theorists considered that a flexible real wage would ensure that full employment was attained –
at least as a normal state where competition prevailed and there were no “artificial” real wage rigidities
imposed.
As a result, they considered Y to be fixed at the full employment output level.
Additionally, they considered V to be constant given that it was determined by customs and payment habits. For
example, people are paid on a weekly or fortnightly basis and shop, say, once a week for their needs. These
habits were considered to underpin a relative constancy of V.
Figure X.1 depicts the resulting causality that defines the Quantity Theory of Money is explanation of the
general price level. The horizontal bars above the V and Y indicate they are assumed to be constant. It follows
that changes in M will directly and only impact on P.
7
MMT Textbook Name Here
Figure X.1
The Quantity Theory of Money
To understand this theory more deeply it is important to note that the Classical economists considered the role of
money to be confined to acting as a medium of exchange to free people from the tyranny of a double
coincidence of wants in barter. That is, to overcome the problem that a farmer who had carrots to offer but
wanted some plumbing done could not find a plumber desiring any carrots.
Money was seen as lubricating the process of real exchange of goods and services and there was no other reason
why a person would wish to hold it.
The underlying view was that if individuals found they had more money than in the past then they would try to
spend it. Logically, it followed that they considered a rising stock of money to be associated with higher growth
in aggregate demand (spending).
As Figure X.1 shows, monetary growth (and the assumed extra spending) would directly lead to price rises
because the economy was already assumed to be producing at its maximum productive capacity and the habits
underpinning velocity were stable.
In Chapter 14, we will consider the evolution of monetary theory and see that one of the central ideas that
Keynes used to discredit the Classical theory of prices related to the role of money as a store of value, which
allowed individuals to manage uncertainty about asset prices by holding their wealth in its most liquid form.
For now it is worth noting two empirical facts. First, capitalist economies are rarely at full employment. The fact
that economies typically operate with spare productive capacity and often with persistently high rates of
unemployment means that it is hard to maintain the view that there is no scope for firms to expand real output
when there is an increase in nominal aggregate demand growth.
Thus, if there was an increase in availability of credit and borrowers used the deposits that were created by the
loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing real
output to maintain market share rather than pushing up prices.
Second, the empirical behaviour of the velocity of circulation demonstrates that the assumption that it is
constant is not plausible. Figure X.2 uses US data provided by the US Federal Reserve Bank and shows the
velocity of circulation, constructed as the ratio of nominal GDP to the M2 measure of the money supply.
The US Federal Reserve says that this measure:
… can be thought of as the rate of turnover in the money supply–that is, the number of times one
dollar is used to purchase final goods and services included in GDP.
8
MMT Textbook Name Here
Figure X.2
Velocity of M2 Money Stock (M2V), US, 1950-2012
2.2
2.1
Ratio
2.0
1.9
1.8
1.7
1.6
1.5
1950
1960
1970
1980
1990
Data
source:
US
Federal
Reserve
Bank,
St
http://research.stlouisfed.org/fred2/series/M2V.
NB: Shaded areas indicate US recessions 2013 research.stlouisfed.org
2000
Louis
2010
FRED2
2020
database
The conclusion we draw is that the evidence does not support the basic causality that the Quantity Theory of
Money offers. The situation is much more complicated than the claim that there is a simple proportionate
relationship between increases in the money supply and rises in the general price level.
However, there are major problems with the theory of money that underpins the Quantity Theory of Money and
we will explore those issues more fully in Chapter 14.
We now turn to considering the role of the Phillips curve in macroeconomics.
9
MMT Textbook Name Here
X.5
The Phillips Curve
In Chapter 9, we derived what we termed to be a General Aggregate Supply Function (Figure 9.5) and the
reverse L shape. The horizontal segment was explained by the price mark-up rule and the assumption of
constant unit costs. In other words, firms in aggregate are assumed to supply as much real output (goods and
services) as is demanded at the current price level set up to some capacity limit.
Figure 9.5 became vertical after full employment because beyond that point the economy exhausts its capacity
to expand short-run output due to shortages of labour and capital equipment. At that point, firms will be trying
to outbid each other for the already fully employed labour resources and in doing so would drive money wages
up.
Under normal circumstances, the economy will rarely approach the output level (Y*) which means that for
normally encountered utilisation rates the economy faces constant costs.
We acknowledged in Chapter 9, however, that rising costs might be encountered given that all firms are
unlikely to hit full capacity simultaneously. Ww noted that the reverse L shape simplifies the analysis somewhat
by assuming that the capacity constraint is reached by all firms in all sectors at the same time.
In reality, bottlenecks in production are likely to occur in some sectors before others and so cost pressures will
begin to mount before the overall full capacity output is reached.
This recognition leads us to consider the so-called Phillips curve, which was originally constructed in the work
of A.W. Phillips published in 1958, as a relationship between the percentage growth in money wages and the
unemployment rate. Later, economists constructed the relationship as being between the general inflation rate
and the unemployment rate.
In the pre-Keynesian era, unemployment was considered to be a voluntary state and full employment was thus
defined in terms of the employment level determined by the intersection of labour demand and labour supply.
So by construction, full employment reflected the optimal outcome of maximising, rational and voluntary
decision making by workers and firms. At the so-called full employment real wage, any worker wanting work
could find an employer willing to offer the desired hours of employment and any employer could fill their
desired offer of hours from the services of willing employees.
In the Section 12.4, we discussed the fact that the trade-off between inflation and unemployment had been a
subject of discussion since the time of the Classical economists, but it never had a prominent place in the debate
and was dominated by the evolution of the Quantity Theory of Money.
In the 1950s, this changed and the Phillips curve became a centrepiece of macroeconomic analysis. In 1958,
New Zealand economist Bill Phillips published a statistical study, which showed the relationship between the
unemployment rate and the proportionate rate of change in money-wage rates for the United Kingdom. He
studied that relationship for the period 1861 to 1957.
Phillips believed that given that money wage costs represent a high proportion of total costs that movements in
money wage rates will drive movements in the general price level.
The Phillips curve has been used by macroeconomists to link the level of economic activity to the movement in
the price level. In the Phillips curve framework, the level of economic activity is represented by the
unemployment rate. The presumption is that when the unemployment rate rises above some irreducible
minimum then economic activity is declining and as the unemployment rate moves towards that irreducible
minimum the economy moves closer to full capacity and full employment.
We will see in a later section that the Phillips curve and Okun’s Law, which links changes in the unemployment
rate to output gaps (the difference between potential output and actual output) coexist comfortably in
macroeconomic theory. The latter provides the extra link between unemployment and output.
In some textbooks you will find inflation models that conflate the two concepts (Phillips curve and Okuns’ Law)
and directly relate the inflation rate to the output gap. We prefer for reasons that will be obvious not to take that
approach in this text book.
Figure X.3 shows a stylised Phillips curve.
Figure X 3
A Stylised Phillips Curve
10
MMT Textbook Name Here
15th Feb Blog
Early Keynesian Empirical Work on Inflation and Unemployment
In the 1930s, Dutch economist Jan Tinbergen published the first econometric study of the trade-off between
inflation and unemployment in 1936. Tinbergen became famous for his 1939 League of Nations project which
attempted to provide empirical justification for the emerging Keynesian view that governments should intervene
to stabilise business cycle fluctuations (Tinbergen, 1939).
Tinbergens’ was the first Phillips curve if we take that to mean a model with causality running from excess
demand in the labour market to wage changes. The model was thus based on price adjustment reacting to
quantity disequilibrium in the labour market with no presumption of full employment. Given that excess
demand is not directly observable, Tinbergen used employment relative to its trend level as the excess demand
proxy.
Tinbergen also included a price change term on the right-hand side of his equation explaining money wage
changes which was lagged one period. This was to represent catch-up behaviour or cost of living adjustments to
nominal wages. In other words, Tinbergen had a model of wage inflation dependent on excess labour market
demand and a shift parameter (in his case the lagged inflation term). The estimated model clearly implied a
trade-off between wage inflation and the state of the labour market.
In the 1940s and 1950s, the US Cowles Commission were the first to construct large-scale macroeconometric
models, which were designed to aid policy makers in determining the potential consequences of their fiscal
policy choices. A key figure in this work was American economist Lawrence Klein, who acknowledged the
influence of Jan Tinbergen in designing models of wage inflation.
Klein’s wage inflation equation used unemployment as the (inverse) proxy for excess demand for labour and
included price change variables on the right hand side to capture real wage aspirations of workers. So workers
would try to gain money wage increases to match inflation but unemployment would temper their capacity to
succeed in their bargaining aims. (Klein (1985).
From an historical perspective, the work of the Cowles Commission in developing models of inflation (Phillips
curve) and the relationship between unemployment and GDP gaps (Okun’s Law) was the foundation stone for
the 1960s Keynesians and became the centrepiece of macroeconomic orthodoxy during this period in place of
the Quantity Theory of Money which had been thoroughly discredited by Keynes himself and subsequent
empirical research.
It is important to acknowledge that the work of Klein and his team showed they knew that the economy could
undergo nominal wage inflation independent of the state of the labour market if bargaining agents formed
expectations that the inflation rate was rising.
They considered workers formed expectations of future inflation which influenced the way they bargained for
wage rises with their employers. They explicitly modelled the change in money wages as a function of lagged
inflation because they considered it took time for real wage aspirations to feed into bargained outcomes.
As we will see later, the Monetarists in the late 1960s claimed that it was Milton Friedman and Edmund Phelps
who showed that government aims to reduce the unemployment rate using expansionary fiscal and monetary
policy would be futile because of the role of expectations of inflation. The reality is that the economists long
before Friedman and Phelps clearly understood that workers would consider expected inflation when bargaining
for money wages.
The point to understand is that following the publication of the General Theory in 1936, Klein and his cohort
advanced the Keynesian paradigm by giving it empirical authority. Their efforts in estimating the inflationunemployment nexus was empirically based and they did not provide a strong theoretical basis for their models.
Arthur Brown’s ‘The Great Inflation’
In the 1950s, the Phillips curve became a centrepiece of macroeconomic analysis. The first major contribution
(prior to Phillips’ own 1958 publication) was provided by the English economist Arthur Brown in his book –
The Great Inflation, 1939-51.
There was an interesting obituary written by Tony Thirlwall on the event of Arthur Brown’s death in 2003.
Thirlwall wrote that Arthur Brown:
11
MMT Textbook Name Here
… precisely anticipated the Phillips curve, which plots the inverse relation between wage and
price inflation and the rate of unemployment.
He never received the credit he deserved for this empirical finding; strictly speaking, the Phillips
curve should be called the Brown curve.
Brown, who was firmly in the Keynesian mould, provided an account of the role of expectations and real wages
in the determination of the trade-off between inflation and unemployment, thus adding theoretical substance to
the empirical work of Tinbergen and Klein et al.
Brown was also the first theorist to investigate the question of the instability of the wage change-unemployment
relationship, a subject that was at the centre of the Monetarist attack on the Keynesian orthodoxy in the late
1960, the legacy of which has influenced macroeconomic theory and policy design ever since.
Brown’s work also outlined the relationship between the price-wage spiral mechanism, which can drive inflation
and the distributional struggle between labour and capital over the available real income. In this sense, he
anticipated a competing claims explanation of inflation, which became popular in the 1970s among PostKeynesians and Marxists. We will discuss these conceptions of inflation later in this Chapter.
His aim was to explain the underlying causes of the inflation and he said that merely characterising this as
(Brown, 1955: 16):
… a propensity of the community to spend more than its current income … does not throw much
light upon the causes of inflation.
He believed that the “reason for this propensity” (Brown, 1955: 17):
… may go deep into the market institutions and the social and political structures of the
communities concerned …
Thus, he was not satisfied with an approach that was ahistorical such as the Quantity Theory of Money. To
understand the inflationary process, Brown thought it was essential to understand social, economic and political
factors and their interactions.
Brown assumes an open economy where firms have price setting power is used and fixed nominal contracts
between workers and employers are common. Thus he was not convinced that the competitive models of firm
behaviour that neo-classical economics promoted were of any use in explaining what happens in a capitalist
economy where firms’ market power exists.
He also recognised that firms do not adjust prices in response to changes in demand for their goods and services
because there are significant costs of price adjustment. He wrote (Brown, 1955: 80) that prices are:
… fixed by producers in relation to costs of production (which depend on factor prices), and for
wages to be fixed either automatically or by bargaining in relation to the prices of consumers’
goods.
In other words, there is a wage-price dependency, which underpins the inflation mechanism.
Brown (1955: 100-101) produced two “Phillips curve” scatter plots using UK data which showed the
relationship between the rate of unemployment (on the horizontal axis) and the percentage change in wage rates
(on the vertical axis), in one case, and the percentage change in hourly earnings (1920-51), in the second
diagram (1920-1948).
Figure X.4 depicts a stylised version of the relationship between unemployment and money wage inflation that
was posited by Brown.
12
MMT Textbook Name Here
The Basic Phillips Curve
Change in money wages (%)
Figure X.4
Unemployment Rate (%)
The causality underlying the scatter plots was Keynesian such that the business cycle was driven by fluctuations
in effective demand. In times of strong growth, the labour market disequilibrium (excess demand for labour)
increases bargaining power of unions and reduces unemployment and this leads to an increase in the rate of
money wages growth. Conversely, when the expansion ceases and unemployment starts to rise again, the rate of
growth in money wages declines.
Brown also thought the relationship between wage changes and the unemployment rate was non-linear. Thus,
wage changes are larger when the unemployment rate is low than when the unemployment rate is high. The
curve implied is very flat at high unemployment rates and then becomes very steep, if not vertical, at low
unemployment rates.
Brown considered that attitudes to the distribution of real income between wages and profits were also
influential in the bargaining process. Workers will resist attempts by firms to increase profit margins and cut
real wages through price rises. Firms, also use their price setting power to try to gain a greater share of real
income. They also try to pass on the burden of rising raw material prices to workers.
The conflict over the distribution of real income can thus lead to a wage-price spiral developing where the
respective bargaining strengths of labour and capital perpetuate an inflationary process as each defend their real
claims on income.
13
MMT Textbook Name Here
Brown (1955: 105) wrote that the development of a wage-price spiral is dependent on the:
… aims of the two parties who are competing for the real income of the country or their success in
achieving those aims.
This idea became the centrepiece of what we now refer to as the “competing claims” theories of inflation, which
depict the inflation process as resulting from incompatible claims on total nominal income by workers and
firms, which exceed the total available.
Workers negotiate real wage targets via money wage demands on firms, who in turn pursue some target markup
(as a vehicle for a desired rate of return). Prices may be slow to adjust in a time of rising costs due to the costs of
price adjustment. If the sum of the claims exceeds national income, either or both parties may use their pricesetting power to achieve their targets. Inflation is the outcome of the distributional conflict.
It is thus important to acknowledge that while Brown considered the inflationary process was conditioned by the
state of the economy, he also explicitly recognised that inflationary expectations could drive the wage-price
spiral independently of excess demand.
Once prices have been given a sufficiently strong upward push by any cause whatever, it is possible that further
increases may be expected, and the automatic fulfilment of this expectation, in advance of the time at which the
further increase was anticipated, may then cause a further upward revision of prices expected to rule in the
future. A mechanism of this kind can, clearly, produce an indefinitely accelerating price increase, provided that
certain requirements are met.
The conditions outlined by Brown (1955: 5-6) whereby expectations of inflation can drive price increases
independent of excess demand factors are:

Prices have to be flexible enough to change when expectations change.

Money supply growth must be sufficient to match price inflation or else real demand falls.
The speed of adjustment of price changes to changes in price expectations does not rely on perfect flexibility. It
can take some time for expectations to work their way through the price change process without negating their
influence.
A final point relating to Brown’s work relates to his recognition that the relationship between wage changes and
the unemployment rate was not stable. He argued convincingly that the relationship went through several
discrete periods – Pre World War I, between the wars, then Post World War II.
He considered historical epochs to offer quite different bargaining conditions and price setting power. His
contribution teaches us that universal models of economic behaviour always have to be tempered by a
contextual and historical understanding.
The work that followed Brown, however, downplayed the recognition that the relationship between wage
changes and unemployment might not be stable over time. As we will see, this shift in emphasis had significant
historical ramifications in the development of thinking about inflation and unemployment and subsequent policy
design.
Paul Sultan (1957) – “I discovered the Phillips curve!”
While Arthur Brown went within one stroke of producing the graphical Phillips curve of the type depicted in
Figure X.3, it was the American text-book writer, Paul Sultan who published the first textbook version of what
is now known widely as the Phillips curve (that is, Figure X.3).
Sultan’s graph showed the annual percentage change in the price level on the vertical axis and the rate of
unemployment on the horizontal axis. Importantly, this was not the relationship that Phillips published in 1958.
His was in terms of money wage changes rather than price inflation.
Sultan wrote (1957: 555) that:
… the line relating unemployment to inflation … [reference to his Figure 24] … is strictly
hypothetical, but it suggests that the tighter the employment situation the greater the hazard of
inflation. …Assuming that a fairly precise functional relationship exists between inflation and the
level of employment, it is possible to determine the ‘safe’ degree of full employment. In our
hypothetical case, we are assuming that when unemployment is less than 2 per cent of the work
force, we face the dangers of inflation. And when unemployment is larger than 6 per cent, we face
the problem of serious deflation.
14
MMT Textbook Name Here
Sultan did not consider the role of expectations and the question of stability.
Phillips Work on Inflation
In 1958, New Zealand economist Bill Phillips published a statistical study, which showed the relationship
between the unemployment rate and the proportionate rate of change in money-wage rates for the United
Kingdom. He studied that relationship for the period 1861 to 1957.
He had earlier written a paper in 1954 which can be considered a precursor to his 1958 empirical study.
Phillips believed that given that money wage costs represent a high proportion of total costs that movements in
money wage rates will drive movements in the general price level.
The Phillips curve has been used by macroeconomists to link the level of economic activity to the movement in
the price level. In the Phillips curve framework, the level of economic activity is represented by the
unemployment rate. The presumption is that when the unemployment rate rises above some irreducible
minimum then economic activity is declining and as the unemployment rate moves towards that irreducible
minimum, the economy moves closer to full capacity and full employment.
We will see in a later section that the Phillips curve and Okun’s Law, which links changes in the unemployment
rate to output gaps (the difference between potential output and actual output) coexist comfortably in
macroeconomic theory. The latter provides the extra link between unemployment and output.
In some textbooks you will find inflation models that conflate the two concepts (Phillips curve and Okuns’ Law)
and directly relate the inflation rate to the output gap. We prefer for reasons that will be obvious not to take that
approach in this text book.
15
MMT Textbook Name Here
Thursday, February 21, 2013 by bill
I am now continuing Section 12.6 on the Phillips Curve …
MATERIAL HERE NOT REPEATED.
Phillips Own Version of The Phillips Curve
The Phillips curve has been used by macroeconomists to link the level of economic activity to the movement in
the price level. In the Phillips curve framework, the level of economic activity is represented by the
unemployment rate. The presumption is that when the unemployment rate rises above some irreducible
minimum then economic activity is declining, and as the unemployment rate moves towards that irreducible
minimum, the economy moves closer to full capacity and full employment.
We will see in a later section that the Phillips curve and Okun’s Law, which links changes in the unemployment
rate to output gaps (the difference between potential output and actual output) coexist comfortably in
macroeconomic theory. The latter provides the extra link between unemployment and output.
In some textbooks you will find inflation models that conflate the two concepts (Phillips curve and Okuns’ Law)
and directly relate the inflation rate to the output gap. We prefer for reasons that will be obvious not to take that
approach in this text book.
In 1958, New Zealand economist Bill Phillips published a statistical study, which showed the relationship
between the unemployment rate and the proportionate rate of change in money-wage rates for the United
Kingdom. He studied that relationship for the period 1861 to 1957.
Phillips believed that given that money wage costs represent a high proportion of total costs that movements in
money wage rates will drive movements in the general price level.
He had earlier written a paper in 1954 which can be considered a precursor to his 1958 empirical study, which
serious students should read in conjunction with his 1958 study.
One of the graphs he produced in his 1958 article is reproduced as Figure X.5. It shows two separate periods of
data. First, the curve fitted with statistical methods to fit the data for the period 1861-1913. Second, the scatter
plot of the data for the period 1913-1948. Phillips produced a number of graphs like this to show how he built
up his overall curve for the entire period 1861 to 1957. The detail of his method is not relevant here but for those
interested in the early efforts using regression techniques a thorough reading of his article is recommended.
16
MMT Textbook Name Here
Figure X.5
Phillips 1958 Figure 9 – Unemployment and Money Wage Inflation, 1913-1948
How did Phillips explain this relationship? In his 1958 article (Page 283) he provided a basic theory to add
behavioural meaning to the empirical relationship he found that linked the unemployment rate to the growth of
money wage rates.
He wrote:
When the demand for a commodity or service is high relatively to the supply of it we expect the
price to rise, the rate of rise being greater the greater the excess demand. Conversely when the
demand is low relatively to the supply we expect the price to fall, the rate of fall being greater the
greater the deficiency of demand. It seems plausible that this principle should operate as one of
the factors determining the rate of change of money wage rates, which are the price of labour
services. When the demand for labour is high and there are very few unemployed we should
expect employers to bid wage rates up quite rapidly, each firm and each industry being
continually tempted to offer a little above the prevailing rates to attract the most suitable labour
from other firms and industries. On the other hand it appears that workers are reluctant to offer
their services at less than the prevailing rates when the demand for labour is low and
unemployment is high so that wage rates fall only very slowly. The relation between
unemployment and the rate of change of wage rates is therefore likely to be highly non-linear.
Phillips also buttressed this excess demand for labour explanation with two other factors which could influence
the rate of change of money wage rates. First, he noted (Page 283) that the “rate of change of the demand for
labour, and so of unemployment” (emphasis added) was important to consider.
When business activity was rising:
17
MMT Textbook Name Here
… employers would be bidding more vigorously for the services of labour than they would in a
year during with the average percentage unemployment was the same but the demand for labour
was not increasing.
Similarly, when business activity was falling:
… employers will be less inclined to grant wage increases, and workers will be in a weaker
position to press for them, than they would be in a year during which the average percentage
unemployment was the same but the demand for labour was not decreasing.
He thus recognised that in the context of wage bargaining between employers and workers, the direction of
change in the economy was a factor that had to be considered quite apart from the level the economy was
currently at.
The other factor Phillips thought was essential to consider was the “rate of change of retail prices”, which could
drive the growth in money wage rates “through cost of living adjustments” (Page 283). He thought this impact
would be of less importance unless there was a “very rapid rise in import prices” (Page 284).
But in recognising that the movement in retail prices is intrinsic to understanding the movement in real wages
and that this link worked through adjustments in the money wage rates, Phillips was reinforcing the arguments
made by Keynes that the real wage was not determined in the labour market and that workers could not directly
manipulate the real wage prevailing at any time.
Soon after Phillips had published his work on the UK, the American economists Paul Samuelson and Robert
Solow published an article in 1960, which produced a Phillips curve-type relationship using US data over the
period 1934 to 1958.
Building on the recognition that money wage costs represent a high proportion of total costs that movements in
money wage rates will drive movements in the general price level, Samuelson and Solow’s “Phillips curve” was
a relationship between the rate of growth in the general price level (that is, price inflation) and the
unemployment rate.
Samuelson and Solow also defined the Phillips Curve as a policy tool, which the government could use to
lessen the burden of unemployment.
The timing of the Samuelson-Solow contribution is important. Between 1960-61, the US economy was mired in
a deep recession and the unemployment rate was rising. The work of Samuelson and Solow was designed to be
a major intervention into the policy debate and provide policy makers with a new framework for understanding
the consequences of policies designed to reduce the unemployment rate.
Figure X.6 replicates Figure 2 from Samuelson and Solow (1960) which they call their “price-level modification
of the Phillips curve” (Page 192). Note the sub-text – a “menu of choice”, implying that policy makers could
choose points along their estimated Phillips curve to reach preferred combinations of inflation and
unemployment.
This introduced the idea of a policy trade-off between unemployment and inflation. If the government wanted to
sustain lower unemployment rates then the cost of that policy decision would be higher inflation.
18
MMT Textbook Name Here
The Samuelson-Solow “Modified” Phillips Curve for The US Economy
Figure X.6
11
10
9
Average Price Rise (per annum) %
8
7
6
5
B
4
3
2
1
A
0
0
-1
1
2
3
4
5
6
7
8
9
Unemployment Rate %
Source: Samuelson and Solow (1960) Figure 2, “Modified Phillips Curve for U.S.”
This shows the menu of choice between different degrees of unemployment and price stability as roughly
estimated from last twenty-five years of American data. [text from original source].
They interpreted their Phillips curve in the following way (Page 192):
1. In order to have wages increase at no more than 21/2 percent per annum characteristics of our
productivity growth, the American economy would seem on the basis of twentieth-century and
postwar experience to have to undergo something like 5 to 6 per cent of the civilian labor force’s
being unemployed. That much unemployment would appear to be the cost of price stability in the
years immediately ahead.
2. In order to achieve the nonperfectionist’s goal of high enough output to give us no more than 3
per cent unemployment, the price index might have to rise by as much as 4 to 5 per cent per year.
That much price rise would seem to be the necessary cost of high employment and production in
the years ahead.
Relating these assessments to the graph (Figure X.6), price stability (no inflation) is defined at Point A (where
the unemployment rate was estimated to be 5.5 per cent) and Point B is where a 3 per cent unemployment rate
corresponds to an inflation rate of 4.5 per cent per annum.
Samuelson and Solow qualified their work in this way (Page 193):
Aside from the usual warning that these are simply our best guesses we must give another caution.
All of our discussion has been phrased in short-run terms, dealing with what might happen in the
next few years. It would be wrong, though, to think that our Figure 2 menu that relates obtainable
19
MMT Textbook Name Here
price and unemployment behavior will maintain its same shape in the longer run. What we do in a
policy way during the next few years might cause it to shift in a definite way.
In other words, the “trade-off” they proposed between inflation and unemployment might shift in the longer run
in response to policy makers exploiting it in the short-run. As we will see this warning was very prescient.
However, despite this warning, the Phillips curve “trade-off” became conventional wisdom among mainstream
economists profession and policy makers and the latter proceeded to design policy as if the choice was stable
over time.
It is also significant, that the work of Phillips and Samuelson and Solow and some other economists at the time,
shifted the debate about what constitutes full employment. Whereas the Keynesian orthodoxy in the 1940s and
1950s defined full employment in terms of a number of jobs – that is, there had to be at least as many of vacant
jobs available as there were persons seeking employment – the introduction of the Phillips curve and its
emphasis on unemployment changed that focus.
Initially, this change in focus involved a debate about what constituted the irreducible minimum rate of
unemployment. The work of Bancroft (1950), Dunlop (1950) and Slichter (1950) were important contributions
to this shift in emphasis.
But soon the debate became tangled up in models of unemployment and inflation after the work of Phillips and,
then, Samuelson and Solow were published. The debate shifted from considering how many jobs were required
to be generated to achieve full employment to consideration of the existence and nature of a trade-off between
nominal (inflation) and real (unemployment) outcomes.
The Keynesian orthodoxy considered real output (income) and employment as being demand-determined in the
short-run, with price inflation being explained by a negatively sloped Phillip’s curve (in both the short-run and
the long-run). Policy-makers believed they could manipulate demand and exploit this trade-off to achieve a
socially optimal level of unemployment and inflation. Significantly, the concept of full employment gave way to
the rate of unemployment that was politically acceptable in the light of some accompanying inflation rate. Full
employment was no longer debated in terms of a number of jobs.
20
MMT Textbook Name Here
Friday, February 22, 2013 by bill
I am now continuing Section 12.6 on the Phillips Curve …
To see how the Samuelson and Solow (1960) price inflation Phillips curve can be rationalised, we go back to
Chapter 9, where we introduced a model of mark-up pricing where firms price by adding a percentage margin to
unit costs, which reflects their desired revenue. This, in turn, is consistent with their desired rate of return on
capital.
The simplified price mark-up model we introduced in Chapter 9 was:
(X.2) P = (1 + m)WN/Y
where P is the price of output, m is the per unit mark-up on unit labour costs, W is the money wage, N is total
employment and Y is total output. WN is the total wage bill.
We also learned that N/Y is the inverse of labour productivity (Y/N), which means that we could express the
mark-up model as:
(X.3) P = (1 + m)W/LP
If we expressed this in rates of change we would be able to say that the inflation rate will be stable if the markup is constant and the growth in money wages is exactly offset by the growth in labour productivity.
In other words, growth in labour productivity provides the economy with non-inflationary room to expand
money wages (and real wages). As long as money wages grow in proportion with labour productivity growth,
unit labour costs (W/LP) will be constant and our simplified mark-up model would predict that prices would be
stable.
Consider Figure X.7, which plots two Phillips curves. Note on the vertical axis we are measuring both the rate
of change of money wages and the rate of price inflation. In that sense, we are combining the Phillips (1958)
curve, which related money wage inflation to the unemployment rate and the modified Phillips curve outlined in
Samuelson and Solow (1960), who related price inflation to the unemployment rate.
The curve denoted Phillips (1958) shows that money wage inflation per annum is zero when the unemployment
rate is 8 per cent. When the unemployment rate is at 2 per cent, the state of the labour market is such that money
wage inflation rises to 3 per cent (per annum).
The Samuelson and Solow (1960) curve is the price inflation modified Phillips curve. It cuts the horizontal axis
at an unemployment rate of 2 per cent, which means that the rate of price inflation is zero, whereas the rate of
money wage inflation is 3 per cent.
The vertical difference between the two curves – measured by the distance AB – is the current rate of
productivity growth (which in this case would be 3 per cent per annum).
In other words, in this example, the unemployment rate that is consistent with zero (stable) inflation is 2 per
cent.
21
MMT Textbook Name Here
Figure X.7
Wage and Price Phillips Curves
Change in money wages and inflation (%)
Phillips (1958)
S&S
(1960)
A
3
0
9
2
Unemployment Rate (%)
9
A more complex and realistic price mark-up model would take into account non-labour costs such as raw
material and energy costs (denoted rm). We might define total unit costs to be the sum of labour and non-labour
costs per unit of output produced and the resulting mark-up equation would be:
(X.4) P = (1 + m)[W/LP + rm/Y]
This means that with a constant mark-up (m), firms will increase their prices if there is a raw material price
shock even if unit labour costs are constant.
We will return to the role of so-called supply shocks (for example, raw material price rises) later when we
discuss theories of inflation and the way in which an external price shock can complicate the conflict that
workers and capital have over the distribution of national income, which plays out in efforts to defend real
wages and mark-ups.
The price inflation Phillips curve was accepted by policy makers in the 1960s and into the 1970s as an integral
part of their macroeconomic tool box. By assuming it was stable over the policy setting horizon and would not
shift in response to policy changes (that is, they assumed it was not an endogenous relationship), the Phillips
curve immediately defined attainable and unattainable combinations of unemployment and inflation.
Consider Figure X.8 which shows a price inflation Phillips curve (price inflation on the vertical axis). Policy
makers considered any point along an estimated Phillips curve to be feasible given the dynamics of the labour
22
MMT Textbook Name Here
market. So it could choose to target a lower unemployment rate, for example, Point A, knowing that in relation
to say, Point B the policy choice would lead to higher inflation than before.
From any particular point on the curve, the slope of the curve (denoted here at Point A by the red line) would
tell the government how much inflation they would have to bear for a given reduction in the unemployment rate.
The slope of the Phillips curve is thus the magnitude of the trade-off between inflation and unemployment.
Another way of thinking about this is that the slope told the government the percentage point rise in the
unemployment rate for every percentage point reduction in the inflation rate. So they could use the Phillips
curve to calculate the real impacts of a contractionary fiscal and/or monetary policy strategy designed to reduce
inflation.
Furthermore, it is obvious that any combination of inflation and unemployment “inside” the Phillips curve (the
shaded area in Figure X.8) are unattainable. The trade-off forced on the government by the dynamics of the
pricing process and the way that firms responded to rises or falls in excess demand for labour dictated the
possible outcomes.
The Unemployment-Inflation Choice Set
Inflation Rate (%)
Figure X.8
A
Slope of Phillips curve denotes
the trade off available.
B
0
Unemployment Rate (%)
What would be the best choice for government? Ultimately that became a political matter and governments tried
to assess what the socially acceptable combination of the twin evils – inflation and unemployment – might be.
Depending on the ideological preferences of the voters, some nations might choose Point B on Figure X.8 while
other nations would be more comfortable with Point A and the higher inflation that accompanied the lower
unemployment rate at that level of economic activity.
23
MMT Textbook Name Here
The problem for government that the Phillips trade-off presented is that the combinations of inflation and
unemployment that were considered to be socially acceptable might not have been possible in terms of the
available trade-offs. For example, voters might be very averse to both inflation and unemployment and only
hold preferences that fell in the shaded area.
[NOTE - RUN OUT OF TIME TODAY - WE ARE HEADING INTO A DISCUSSIONS OF POLICIES THAT
MIGHT SHIFT THE PHILLIPS CURVE PRIOR TO ADDING EXPECTATIONS TO IT]
24
MMT Textbook Name Here
Unemployment and inflation – Part 6
Posted on Friday, March 1, 2013 by bill
Advanced Material:
The Phillips Curve Algebra
We have discussed the original Phillips curve (Phillips, 1958), which was a relationship between the growth in
money wages and the unemployment rate. We have also seen, how a price mark-up model allows this
relationship to be expressed as one between the growth in the price level (that is, inflation) and the
unemployment rate (Samuelson and Solow, 1960).
The simplest linearised form of the price Phillips curve relationship is given as:
(X.5) Ṗ α + βU-1
where 𝑃̇ is the rate of inflation (the dot above the P symbolising a rate of change), α is a constant, β is a
coefficient which tells us how price inflation responds to the excess demand variable, U -1.
U-1 is the inverse of the unemployment rate to capture the non-linear shape of the Phillips curve as hypothesised
by Phillips himself and later Samuelson and Solow.
What interpretation can we give to the coefficient, α? Referring back to the price mark-up model (Figure X.1),
we know that W.(N/Y) represents unit labour costs. N/Y is the inverse of labour productivity. We noted in the
discussion above that when money wages grow in line with labour productivity there will be no inflationary
pressures coming from the labour market.
The term βU-1 measures the impact of the state of the labour market on inflation via money wages growth. It
follows then that the coefficient, α measures the impact of productivity growth, which will be a negative factor.
In other words, price inflation (holding other cost factors constant) will be equal to the growth in money wages
minus labour productivity growth.
The Instability of the Phillips Curve
The standard price Phillips curve model that evolved in the 1960s was supported of the dominant view of
inflation at the time based on Keynes notion of an inflation gap.
In his 1940 pamphlet - How to pay for the war: a radical plan for the chancellor of the exchequer, John Maynard
Keynes outlined his concept of the inflationary gap.
He aimed to apply the notion of effective demand that he developed in the - General Theory - to help understand
how an under-full employment equilibrium could arise in a monetary economy - to a fully employed war-time
economy.
With the onset of World War 2, the large-scale war spending funded by debt-issuance pushed capacity in the
British economy to its limit. Keynes argued that even if money wage rates were constant, the rising household
incomes, as employment rose, would strain the available consumption goods, which would cause inflation to
accelerate.
He rejected the view of the Treasury at the time that by issuing new debentures to finance the War effort, the
Government would be drawing on private "voluntary saving" and creating the non-inflationary "room" for its
own spending. That idea was a hang-over of the loanable funds doctrine and failed to see that rising budget
deficits also increase the flow of saving in the economy because they stimulate increases in national income.
Keynes argued that even when nominal effective demand was growing in excess of the capacity of the economy
to respond in real terms (by increasing output), total saving still increased. As a result, the Treasury view that by
drawing on "voluntary saving" flows the war could be financed without risking inflation was rejected by
Keynes. He argued that financing the war through debt-issuance could only be non-inflationary if the
government spending was equivalent to the full-employment level of saving.
In “How to Pay for the War”, Keynes (1940) defined the inflationary gap as an excess of planned expenditure
over the available output at pre-inflation or base prices (GET EXACT PAGE). The pre-inflation benchmark was
the full employment level. Thus, if an economy can meet the growth in nominal expected demand by expanding
the capacity to produce goods and services, the inflationary gap would not open.
25
MMT Textbook Name Here
This idea was distilled into the demand-pull theory of inflation. Once full employment was reached then
nominal demand growth beyond that level would be inflationary.
The Phillips curve was clearly consistent with this view of inflation. The simple theory underpinning the first
Phillips curve analysis argued that as nominal demand growth pushed the unemployment rate towards its
irreducible minimum (frictional unemployment), wage and price inflation would start to rise. In other words, the
economy would be "pulled" into the inflationary gap by excess aggregate demand growth.
The Phillips curve demonstrated to policy makers how much inflation would arise as the economy was pulled by
nominal demand growth beyond its real capacity to produce goods and services.
It is interesting to note than in the pamphlet - How to Pay for the War - Keynes also suggested that inflation
could arise due to cost push factors (also called "sellers' inflation). There had been a long line of authors who
had identified inflation emerging as a result of distributional struggle over the available real income being
produced.
For example, in the Marxian tradition, authors such as Michal Kalecki had advanced what became known as
cost-push theories of inflation.
Within the Keynesian tradition, in Chapter 14 of Abba Lerner's 1951 book - Economics of Employment there is
a coherent discussion of how distributional struggle may lead to a wage-price spiral and generalised inflation.
With a mark-up pricing model assumed, an economy that approaches full employment will gradually eat into the
"reserve army of unemployed", which gives workers more bargaining power relative to when unemployment
was higher. The workers via their trade unions were more likely to demand higher money wages. Firms might
fear prolonged strikes and concede to the workers' demands but then, in turn, defend their real profits by
increasing prices (via the mark-up).
This dynamic could easily lead to a series of wage and price rises as each party sought to defend their real stake
in production. As a result, inflation becomes the product of distributional struggle reflecting the relative
bargaining strengths of workers and employers.
Lerner was intent on showing that the dynamic for this wage-price spiral need not come from trade unions
becoming emboldened by falling unemployment. He argued that capital might seek to expand its real share by
pushing up the mark-up on unit costs. Such a strategy could only be successful if workers conceded the real
wage cut implied by the rising prices. Firms would be more likely to attempt this strategy when they perceived
the bargaining power of workers to be weak - that is, when unemployment was higher.
In this way, Lerner recognised that inflation and high unemployment could co-exist - that is, he foreshadowed
the possibility of stagflation. We will return to discuss this concept later in the Chapter because it has
paramount importance to the way the discussion of the Phillips curve evolved in the 1970s.
For now, it is enough to recognise that the Phillips curve could subsume the "cost-push" theories of inflation
given that they also proposed a negative relationship between unemployment and inflation. You will note
though that the idea of stagflation that Lerner advanced in the early 1950s would also help understand the
empirical instability in the Phillips curve that began to manifest in the late 1960s, which led to a major shift in
macroeconomic thinking.
As the US government prosecuted the Vietnam War effort through the 1960s, the inflation rate began to rise. In
the late 1960s and early 1070s, the demand-pull pressures of the spending associated with the war effort
combined with sharp rises in oil prices courtesy of the formation of the cartel, the Organisation of Petroleum
Exporting Countries (OPEC). Oil prices under OPEC quadrupled in 1973, generated huge cost shocks to oildependent economies such as the US and Japan.
Consider Figure X.9, which shows the combinations of the unemployment rate and the annual inflation for the
US economy from 1948 to 1980. The blue diamonds show the observations for the period 1948 to 1969, and the
black curve is the logarithmic regression between the inflation rate and the unemployment rate. So it shows a
simple price Phillips curve of the type depicted in Equation X.5. The curve fits the data quite well and shows the
typical trade-off between unemployment and inflation, that was considered to be fit for exploitation by policy
makers, intent on keeping unemployment close to full employment.
However, consider the observations depicted by the red squares, which cover the period from 1970 to 1980.
Those observations are clearly inconsistent with the stable Phillips curve representation and seem to suggest a
positively sloping relationship.
This apparent shift in the Phillips curve was cast as a "collapse" in the relationship and led to accusations that
the underlying conceptualisation of the Keynesian Phillips curve was flawed.
26
MMT Textbook Name Here
Figure X.9
The Shifting US Phillips Curve - 1948-1980
Source: US Bureau of Labor Statistics. The unemployment rate series begins in 1948. The inflation rate is
measured as the annual rise in the Consumer Price Index.
[NOTE - RUN OUT OF TIME TODAY - WE ARE HEADING INTO THE SHIFT IN THE PHILLIPS CURVE PRIOR
TO ADDING EXPECTATIONS TO IT]
27
MMT Textbook Name Here
Unemployment and Inflation – Part 7
Posted on Friday, March 8, 2013 by bill
Consider Figure X.10, which shows the relationship between the US unemployment rate (horizontal axis) and
the annual inflation rate for the period 1948 to 2012, subdivided into three periods: 1948-1969; 1970-1980; and
1981-2012. As before the lines depict the logarithmic regression between the inflation rate and the
unemployment rate for the three sub-periods.
What was considered to be a relatively stable relationship in the 1950s and 1960s, became unstable in the 1970s
and suggested a positive relationship between inflation and unemployment. By the 1980s, as inflation
moderated, it became hard to determine any relationship between inflation and unemployment in the US
economy.
From an empirical perspective, then, the faith that the Phillips curve was a stable relationship that could be
exploited in some predictable fashion by policy makers to maintain low unemployment became highly
questionable.
Figure X.10
The Shifting US Phillips Curve – 1948-2012
Source: see Figure X.9
We always have to be very careful when we visualise data in this way. The observations between 1970 and
1980, may in fact be signifying a shifting Phillips curve relationship and the regression line is just picking up the
shifting function. In other words, the relationship is unstable over time although it may permit a short-run tradeoff between the inflation rate and the unemployment rate.
That conjecture is represented in Figure X.11, which shows stylised Phillips Curve for the US data from 19482012. Please note that these are not actual estimated Phillips curves. They just demonstrate that there might be a
family of such curves and each one might remain in place for a short-period, which would provide policy
makers with a false sense of security. At some point the curve might shift out to a new loci and inflation would
accelerate.
28
MMT Textbook Name Here
Figure X.11
A Family of Phillips Curves
Source: see Figure X.9
It should be clear from our earlier discussion of the work of A.J. Brown that the assumption that the Phillips
curve was stable was always problematic.
It was known that the Phillips curve was susceptible to sudden and/or large increases in inflation. The
econometrically-estimated consumption functions in the large macroeconomic policy models, which were
popular in the 1960s also became unstable in the 1970s. Some economists successfully showed that the failure
of the large-scale econometric models to forecast variables such as savings and consumption in the early 1970s
could be traced to the misspecification of the structural consumption function. Most of these models ignored the
possibility that rising inflation would influence consumption (for example, if consumers expect prices to rise
quickly in the future they may bring forward consumption decisions).
The breakdown of the Phillips curve in the late 1960s was another “econometric” function that was misspecified
because it also ignored the possibility that rising inflation might become self-fulfilling as workers and firms
sought to protect their real wages and real profit margins.
Another consideration as to why the discussions about instability were largely ignored is that the “textbook”
model of the Phillips curve was very attractive in its simplicity. Textbooks typically stylise discussions and
eschew complicated stories for the sake of pedagogy. You will be aware that we have not taken this approach in
this text. We consider a rich treatment of institutions and history to be an important part of the learning process
in macroeconomics.
The work of A.J. Brown and others was insightful and probably too deeply grounded in the institutional
literature to be acceptable for the way textbook writers chose to advance their pedagogy at the time.
It is probable that had Brown’s work on instability and the way changes in the institutions of wage and price
determination (for example, wage bargaining and real wage resistance) change the trade-off between inflation
and unemployment been more recognised, the subsequent history of the Phillips curve, which we discuss next,
might have been very different.
It is a fact that the mainstream Keynesian consensus in the 1960s abstracted from the potential instability that
was rooted in the institutional nature of wage and price setting. Instead, policy makers pursued the attractive
notion that they could permanently maintain low unemployment rates as long as they ensured effective demand
was sufficient relative to the non-government sector’s saving plans and any demand leakages from net exports.
However, the legacy of the Keynes and Classics debate persisted through the 1950s and 1960s. The neoclassical school was unwilling to accept the basic insights provided by Keynes that effective demand drove
output and national income and that the capitalist monetary system was susceptible to crises of over-production.
29
MMT Textbook Name Here
In the late 1960s, this on-going debate about the effectiveness of fiscal and monetary policy in counterstabilising the economic cycle was rehearsed within the Phillips curve framework.
A group of economists, centred at the University of Chicago were opposed to government attempts to maintain
full employment. Their argument largely reflected their belief that a self-regulating free market would generate
optimal outcomes. In other words, they were adherents of the competitive neo-classical model and considered
most government intervention to be problematic.
This opposition at the microeconomic level manifested in demands for widespread deregulation in product,
labour and financial markets and a major retrenchment in the size of government.
At the macroeconomic level, the Phillips curve became the “battleground”. Policy makers during the “stable”
Phillips curve policy era assumed they could permanently target a low unemployment rate and incur some finite
inflation rate as a consequence. The extent to which inflation rose was determined by the steepness of the
Phillips curve, which was considered to be relatively flat.
The emerging Monetarists, who eschewed government intervention, challenged that view and asserted that
there was no permanent (long-run) trade-off between inflation and unemployment. They claimed that, ultimately
the market would ensure the unemployment rate was stable around its so-called natural rate and attempts by
government to push it below this rate would lead to accelerating inflation.
Chicago economist Milton Friedman was the most vocal Monetarist and in a famous article in 1968 outlined
what became known as the accelerationist hypothesis.
30
MMT Textbook Name Here
X.6
The Accelerationist Hypothesis and the Expectations-Augmented
Phillips Curve
The empirical instability in the relationship between unemployment and inflation opened the way for what
became known as the Monetarist paradigm in macroeconomics to gain ascendancy.
The Monetarists reinterpreted the trade-off by adding the role of inflationary expectations, and in doing so,
revived the Classical (pre-Keynesian) notion of a natural unemployment rate (defined as equivalent to full
employment). The devastating consequence of this assertion was the rejection of a role for demand management
policies to limit unemployment to its frictional component.
The Phillips curve also became a tool in the hands of the Monetarists to regain the ground they had lost to the
Keynesians. With the support of the textbooks, the model endured even though the original model was lost in
the process.
Despite the rich Keynesian history discussed earlier, it was easy for Friedman and others to hijack the debate.
The Keynesians were operating in a dichotomised framework – at the macroeconomic level they had adopted
the Phillips curve, yet they had developed very little theory to underpin it. They were particularly tense and
uneasy about what were referred to as the microeconomic foundations of the relation.
There were attempts by the Keynesians to justify the Phillips curve as a competitive adjustment process, such
that if there was growing demand for labour, wages rose as unemployment fell.
But the Monetarists claimed that in a competitive market, workers cared about real wages rather than nominal
wages and so the basic Phillips curve which only focused on the relationship between percentage change in
money wages and the unemployment rate was defective.
The accelerationist hypothesis was advanced in 1968 by Milton Friedman before the empirical breakdown of the
relationship between inflation and unemployment emerged in the early 1970s.
So while the Phillips curve presented the Monetarists with the opportunity to debate the failings of the
mainstream Keynesian analysis, it was the empirical havoc created by the 1970s oil price shocks which added
weight to their (flawed) arguments.
It is important to note, that nothing had really changed in the modern statement of Monetarism that had not
already been shown to be deficient, albeit in different terms, by Keynes and others.
As noted above, the Phillips curve was just one of a number of macroeconomic equations in the large policy
models that ignored inflationary expectations. The misspecification was not significant while inflation was
negligible. Once inflation rates soared throughout the world with the oil price rises of the early 1970s, all these
misspecified relations broke down.
The Monetarists used that empirical chaos to cast the theoretical ideas of Keynesianism into disrepute.
Monetarist thought emerged from this wreckage as being eminently plausible. It was a serendipitous period for
the Neoclassical economists because they managed to reassert the issue of real wage bargaining before the
empirical relations broke down.
Although in the mid-1960s, the Monetarist theoretical structure had undergone harsh criticism from economists
like Robert Clower and Axel Leijonhufvud, the empirical shift in the Phillips curve in the early 1970s was
interpreted as a validation of the Monetarist concept of a natural rate of unemployment and the negative
connotations for aggregate demand management that this concept invoked.
There were two basic propositions that Friedman asserted in his attack on the Phillips curve.
SECTION HERE REPLACED BY 13 MARCH TEXT
31
MMT Textbook Name Here
Unemployment and Inflation – Part 8
Posted on Wednesday, March 13, 2013 by bill
First, he asserted that there is a natural rate of unemployment, which is determined by the underlying structure
of the labour market and the rate of capital formation and productivity growth. He believed that the economy
always tends back to that level of unemployment even if the government attempts to use fiscal and monetary
policy expansion to reduce unemployment.
Friedman (1968: Page 8 ) wrote:
At any moment of time there is some level of unemployment which has the property that it is
consistent with equilibrium in the structure of real wages. At that level of unemployment, real
wage rates are tending on average to rise at a ”normal” secular rate, i.e., at a rate that can be
indefinitely maintained so long as capital formation, technological improvements, etc., remain on
their long-run trends. A lower level of unemployment is an indication that there is excess demand
for labor that will produce upward pressure on real wage rates…. The “natural rate of
unemployment”, in other words, is the level that would be ground out by the Walrasian system of
general equilibrium equations, provided there is imbedded in them the actual structural
characteristics of the labor and commodity markets, including market imperfections, stochastic
variability in demand and supplies, the cost of gathering information about job vacancies and
labor availabilities, the costs of mobility, and so on.
He later noted (Friedman, 1968: 9) that the natural rate of unemployment is not “immutable and unchangeable”
but is insensitive to monetary (aggregate demand) forces. That is, he considered increasing nominal aggregate
demand would not reduce the natural rate.
He also considered that the natural rate was, in part, “man-made and policy-made”. For example, Monetarists
argued that imposing minimum wages and providing unemployment benefits would increase the natural rate.
The basic idea of the “natural rate of unemployment” that Friedman developed follows straightforwardly from
the Classical labour market that we developed in Chapter 11. The Monetarist approach was an attempt to
promote ideas that Keynes demolished in the 1930s. Friedman asserted that real wages were the relevant object
of concern from the perspective of firms and workers rather than money wages. Workers supplied labour based
on the price of leisure, which in that model is the real wage.
Similarly, firms employed labour to advance their profit-maximisation aims, and that required that they set the
real wage equal to the marginal product of the last worker employed.
In that context, it was considered that real wages would adjust to ensure the labour market cleared at the “natural
rate” level of unemployment. While there might be temporary deviations around that rate, for reasons we will
explore next, over time, the economy would always be tending back to the natural rate.
The natural rate was thus conceived as being the level of unemployment that arose as a result of natural frictions
in the labour market and had no cyclical component. In other words, it did not arise as a result of a deficiency in
aggregate demand. Friedman considered that these frictions could include the distortions arising from policy
noted above.
But the natural rate of unemployment was considered invariant to aggregate demand changes, which meant that
governments could not reduce it through an aggregate demand expansion.
Second, that the Phillips curve is, at best, a short-run relationship that can only be exploited as long as workers
suffer from money illusion and confuse money wage rises with real wage rises. In other words, any given shortrun Phillips curve is dependent on workers assuming that price inflation is stable. Under that assumption, there
is no role for price expectations in the Phillips curve.
However, Friedman and others argued that eventually workers would realise that their real wage was being
eroded as price inflation outstripped money wages growth. In doing so, they would start to form expectations of
continuing inflation.
As a consequence, workers would build these inflationary expectations into their future outlook and pursue real
wage increases, which reflected not only the state of the labour market (relative strength of demand and supply)
but also how much they expected prices to rise in the period governed by the wage bargain.
32
MMT Textbook Name Here
The Monetarists argued that if the government attempted to reduce unemployment below the natural rate, then
as the inflation rate rose, workers would demand even higher money wages growth to achieve their desired real
wage levels. Ultimately, all that would result was an accelerating price level.
THIS SECTION WAS REPLACED BY 15 MARCH TEXT
33
MMT Textbook Name Here
Unemployment and Inflation – Part 9
Posted on Friday, March 15, 2013 by bill
Figure X.12 captures the accelerationist hypothesis. The short-run Phillips curves are shown conditional on a
specific expectation of inflation held by the workers. The superscript e denotes “expected” inflation. We use the
terminology, expectations are realised to denote a state where the expectations formed are equal to the actual
outcome.
Figure X.12
The Expectations-Augmented Long-Run Phillips Curve]
Inflation Rate (%)
Long-Run Vertical PC
D
𝑃̇ 3
E
𝑃̇ 2
C
B
SRPC 𝑃̇
𝑃̇ 1
A
𝑒
SRPC 𝑃̇
2
SRPC 𝑃̇
UT
𝑒
3
𝑒
1
U*
Unemployment Rate (%)
Start at Point A, where the inflation rate is Ṗ1 and the unemployment rate is at its so-called “natural rate” (U*).
At this point, the inflationary expectations held by workers (Ṗ1) are consistent with the actual inflation rate
Pdot1. According to Friedman, the labour market will be operating at the natural rate of unemployment,
whenever inflationary expectations are realised.
To see how the accelerationist hypothesis plays out, we assume that the government is under political pressure
and forms the view that U* unemployment rate is too high. It believes it can use expansionary fiscal and
monetary policy to achieve a lower target rate of unemployment, U T. They also think they can exploit the
34
MMT Textbook Name Here
Phillips Curve trade-off and move the economy to Point B, with an inflation rate of Ṗ2 as the “cost” of the lower
unemployment rate.
As a consequence government stimulates nominal aggregate demand to push the economy to point B. The
increased demand for labour pushes up the inflation rate (to Ṗ2) and money wage rates also rise in the labour
market. The accelerationist hypothesis assumes that the price level accelerates more quickly than money wages
and as a consequence the real wage falls.
The Monetarists resurrected the Classical labour market and placed it at the centre of their attack on Keynesian
macroeconomics. Accordingly, firms will offer more employment because the real wage has now fallen and
they can still profit maximise at the lower level of marginal productivity.
Why would workers supply more labour if the real wage was falling? In the Classical labour market it is
assumed that labour supply is a positive function of the real wage so workers will withdraw labour if the real
wage falls.
The Monetarist approach overcomes that seeming problem by imposing asymmetric expectations on the workers
and firms. The firms were assumed to have complete price and wage information at all times so they knew what
the actual real wage was doing at any point in time.
However, the workers were assumed to gather information about the inflation rate in a lagged or adaptive
fashion and thus could be fooled into believing that the real wage was rising when, in fact, it was falling.
Thus, workers are assumed to be initially oblivious to the rising inflation – that is, their inflationary expectations
do not adjust to the actual inflation rate immediately. As a consequence they mistake the rising nominal wages
for an increasing real wage and willingly supply more labour even though the real wage has actually fallen.
The central proposition of the Classical labour market is that workers care about real wages not money wages.
The accelerationist hypothesis added the idea that workers form adaptive expectations of inflation, which
means that it takes some time for them to differentiate between movements in money wages and movements in
real wages.
Monetarists asserted that Point B is unstable and can only persist as long as workers are fooled into believing the
money wage increases they received were equivalent to real wage increases.
But inflationary expectations adapt to the actual higher inflation rate after a time. Once the workers increase
their inflationary expectations to 𝑃̇ 2 then the SRPC shifts out and the labour market settles at Point C when the
new expectations catch up with the higher inflation rate (Ṗ2).
The path the labour market takes as inflationary expectations adjust to the actual inflation rate and the short-run
Phillips curve shift (that is, from Point B to Point C or Point D to Point E) is an empirical matter. But for
Monetarists, once inflationary expectations have fully adjusted to the current inflation rate (at Points C and E,
for example), the economy will return to the natural rate of unemployment (U*), irrespective of government
attempts to target the lower unemployment rate.
For Friedman, the short-run dynamics of the labour market were driven by the capacity of the government to
“fool” workers into believing the inflation rate was lower than the actual inflation rate. As long as some of the
inflation rate is unanticipated by workers, the government can maintain the unemployment rate below the
natural rate but at a costs of rising inflation.
This narrative seeks to explain mass unemployment in the same way. The Friedman story is that mass
unemployment occurs when workers refuse to accept money wage offers that they think generate a real wage
below the actual real wage consistent with these offers. Workers think the real wage implied by the wage offers
is too low because they wrongly believe that inflation is higher than it is. That is, their inflationary expectations
exceed the actual inflation rate.
As a consequence, they start quitting their jobs and/or refuse to take new job offers thinking it is better to search
for higher real wage paying positions. Once they realise they have mistakenly thought inflation was higher than
it actually is, they start to accept the job offers at the current money wage levels and increase their labour
supply.
Friedman was thus forced to explain changes in unemployment in terms of swings in the supply of labour,
driven by misconceptions of what the actual inflation rate was. And at the empirical level this theory predicts
that quits will fall as employment
The simplest fact then, which would give support to this notion of supply-side shifts, is whether the quit rate is,
indeed, counter-cyclical – as the theory predicts. The empirical evidence is that quit rates are pro-cyclical, which
35
MMT Textbook Name Here
means they rise when the labour market is strong and workers feel confident about their job chances and fall
when the labour market is weak and workers fear unemployment. This is exactly the opposite to what would be
required to substantiate Friedman’s natural rate theory.
American economist, Lester Thurow summarised this issue succinctly:
… why do quits rise in booms and fall in recessions? If recessions are due to informational
mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the
real world.
In the Advanced Material Box – The Expectations-Augmented Phillips Curve, we present a more analytical
version of the Friedman natural rate hypothesis.
Advanced Material – The Expectations-Augmented Phillips Curve
The original Phillips curve related the growth of money wages to the unemployment rate. In linear form we
would write this as:
(X.6) Ẇ t = βUt
β<0
where U is the unemployment rate, the subscript t denotes the current period, and β is the slope of the Phillips
curve or the sensitivity of the growth of money wages to changes in the unemployment rate. The simple Phillips
curve depicts a negative relationship between the growth of money wage rates and movements in the
unemployment rate. You should recall from Chapter 4 that the convention is to typically use positive signs for
all terms and then specify the hypothesis about the direction of the sign of the coefficient separately. So β < 0
tells us that the impact of the changes in the unemployment rate on money wages growth is negative.
As we saw earlier in the Chapter, in the price-mark up framework we have developed, the rate of price inflation
(Ṗ) is equal to the growth in money wages (Ẇ) less the growth in productivity (ġ):
(X.7) Ṗ t = Ẇ t - ġ t
If we substitute, the simple Phillips curve (X.6) into the price inflation relationship (X.7) we find the price
Phillips curve relationship:
(X.8) Ṗ t = βUt - ġ t
This tells us that the rate of general price inflation will be higher the lower is the unemployment rate and the
lower is the productivity growth.
Friedman claimed that the simple version of the Phillips curve, whether specified in its original form or in the
price inflation form, overlooked the fact that workers would be concerned about the growth in real wages. That
is, in considering the state of the labour market (captured by the unemployment rate), they would set their
money wage demands after considering what the inflation rate was likely to be.
In other words, the rate of money wages growth would be influenced by the expected inflation rate
independently of the unemployment rate.
This conjecture led Friedman to modify the simple Phillips curve to include the influence of inflationary
expectations in the wage bargaining process:
𝑒
(X.9) Ẇ t = βUt + ∅𝑃̇
𝑡
0 ≤ ∅ ≤1
The additional term 𝑃̇ e represents inflationary expectations that are formed by workers, which condition the
wage bargaining process. We assume that the coefficient φ lies between 0 and 1. If φ = 0, then the Expectations
Augmented Phillips Curve collapses back into the price Phillips curve (X.7). If φ = 1, then any change in
inflationary expectations is passed on fully to wages growth.
The subscripts might be confusing here. We assume that workers form expectations of the inflation in period t,
in the prior period and then bargain for wages growth in the current period based on what they think the
inflation rate will be.
Adding this term to the Phillips curve led to the development of the Expectations-Augmented Phillips Curve
(EAPC):
36
MMT Textbook Name Here
𝑒
(X.10) Ṗ t = 𝛼 + βUt + ∅𝑃̇
𝑡
Here we have assumed that productivity growth is constant and captured by the term α (< 0).
In terms of Figure X.12, the inflationary expectations term on the right hand side of Equation (X.10) shifts the
short-run Phillips curve, denoted by the remaining right-hand side terms.
If workers' inflationary expectations increase, then the short-run Phillips curve shifts out and vice-versa.
After the EAPC replaced the simple price Phillips curve as the main framework for considering the relationship
between inflation and unemployment, economists began to focus on the value of φ. Many econometric studies
were conducted to estimate the value.
Why does the value of ∅ matter? What would happen if ∅ = 1?
Friedman defined the long-run steady-state (stable inflation) to occur when the actual rate of inflation was equal
to the expected rate of inflation. That is, workers finally caught up with the actual inflation rate and their
inflationary expectations captured that knowledge. At this point, he claimed the economy would be operating at
the natural rate of unemployment.
In that case, the EAPC would collapse to what is referred to as the long-run steady-state Phillips curve:
e
(X.11) Ṗ t = α + βUt + ∅Ṗ
t
Ṗ t = α + βUt + ∅Ṗt
Ṗ t (1 - ∅) = α + βUt
α
β
Ṗ t = (1−∅)
+ (1−∅)
Ut
Examine this relationship carefully because it looks similar to the short-run Phillips curve (X.8), except the
β
coefficients are now divided by the term (1 – ∅). The slope of this long-run Phillips curve,
is steeper than
(1−∅)
the slope of the short-run Phillips curve, β and the closer ∅ is to one, the steeper is the slope of the long-run
Phillips curve. Once ∅ equals one, the slope becomes vertical and there is no longer any relationship between
inflation and the unemployment rate. In other words, the trade-off vanishes.
Figure X.13 depicts the two cases. There is a family of short-run Phillips curves (SRPC) (two are shown). The
first long-run Phillips curve drawn on the assumption that 0 < ∅ < 1, is steeper than the short-run curves but
non-vertical. It means that in the long-run there is still a trade-off between the inflation rate and the
unemployment rate but it is a steeper trade-off than occurs in the short-run before inflationary expectations
adjust upwards to the new inflation rate.
The second long-run Phillips curve assumes that ∅ = 1 and is vertical as a consequence, which means there is no
long-run trade off between inflation and the unemployment rate that can be exploited by the government. Under
these assumptions, the economy always tends back to the natural rate of unemployment U* once inflationary
expectations adjust to the actual inflation rate.
37
MMT Textbook Name Here
Figure X.13
Short- and Long-Run Phillips Curves
Inflation Rate (%)
Long-run PC ∅ = 1
SRPC
SRPC
U*
Unemployment Rate (%)
Long-run PC 0 < ∅ < 1
You can now see why economists who became captive of this framework were interested in the value of ∅. For
Keynesians, a value of ∅ less than one maintained their policy position that the government could use
expansionary fiscal and monetary policy to reduce the unemployment rate should they consider the current rate
to be too high.
For Monetarists, a value of ∅ = 1, was consistent with their claims that the Keynesian aggregate demand
management framework was flawed and would only cause inflation should the government try to push the
unemployment rate below the natural rate, which was established when inflationary expectations were equal to
the actual inflation rate.
Thus, at the time, the focus of the macroeconomic debate was on the value of ∅.
To see the way the natural rate of unemployment emerges out of this framework, we can solve Equation (X.11)
for the long-run unemployment rate. After the relevant algebraic manipulation we get:
(X.12) U* = Ṗ (1−∅)
- αβ
β
Which shows there is still a trade-off in the long-run between unemployment and inflation as long as ∅ ≠ 1.
Once, ∅ = 1, the long-run unemployment rate becomes Friedman’s natural rate and the equation representing
that case is written as:
38
MMT Textbook Name Here
(X.13) U* = −
α
β
This means that in the Friedman natural rate hypothesis, there are only two factors which influence the long-run
or natural rate of unemployment: (a) the rate of growth of productivity captured in the α term; and (b) the shortrun responsiveness of wage inflation to movements in the unemployment rate (β). Note that given β is assumed
to be negative, the sign on the term -(α/β) is positive.
As a result, the higher is the growth in productivity, other things equal, the lower will be the natural rate. The
Monetarists assumed that productivity growth was a structural phenomenon and invariant to aggregate demand
policies.
It is clear, that in the Expectations-Augmented Phillips Curve framework, the government could only achieve
temporary reductions in the unemployment rate below the natural rate as long as it could drive a wedge between
the expected inflation rate and the actual inflation rate, Once the workers’ inflationary expectations adjusted,
then the trade-off disappeared and the economy would return to the natural rate of unemployment, albeit with
higher inflation.
Continued attempts at driving down the unemployment rate below the natural rate would, according to the
Monetarists, just result in accelerating inflation.
The introduction of the role of inflationary expectations in the Phillips curve focused attention on how such
expectations were formed. What behavioural models could be invoked to capture expectations. There were two
main theories advanced by economists: (a) adaptive expectations, and later; (b) rational expectations.
Both theories considered the formation of expectations to be endogenous to the economic system. That is,
developments within the system conditioned the way in which workers (and firms) formed views about the
future course of inflation.
We consider the implications of these two theories in the Advanced material box – Inflationary Expectations.
Advanced Material – The Adaptive Expectations Hypothesis
The assumption that workers formed their expectations of inflation in an adaptive manner allowed the
Monetarists to conclude the government attempts to reduce the unemployment rate would only cause
accelerating inflation and that the economy would always tend back to the natural rate of unemployment.
The only way the government could sustain an unemployment rate below the natural rate using aggregate
demand stimulus would be if they continually drove the price level ahead of the money wage level and forced
the workers to continually misperceive the true inflation rate.
The Adaptive Expectations hypothesis is expressed in terms of the past history of the inflation rate. The
assertion is that the workers adapt their expectations of inflation as a result of learning from their past
forecasting errors.
The following model expresses this idea:
(X.14) 𝑃𝑒𝑡+1 = 𝑃̇ t + λ(𝑃̇t - 𝑃𝑒𝑡 ) 0 < λ < 1
The left-hand side of Equation 12A is the expected inflation rate in the next period (t + 1) formed by workers in
period t. Equation 12A has to components on the right-hand side. First, 𝑃̇ t is the actual inflation rate in the
current period. Thus, workers use the current inflation rate as a baseline to what they think the inflation rate in
the next period will be.
Second, the term λ(𝑃̇ t – 𝑃𝑡𝑒 ) captures the forecast error from the previous period. 𝑃𝑡𝑒 was the inflation
expectation that workers formed in period t-1 of inflation in period t. The difference between that expectation
and the actual rate than occurred is the size of their forecast error. The coefficient λ measures the strength of
adaption to error. The higher is λ, the more responsive workers will be to actual conditions.
MORE LATER HERE
39
MMT Textbook Name Here
40
MMT Textbook Name Here
Unemployment and Inflation – Part 10
Posted on Friday, March 22, 2013 by bill
Advanced Material – The Rational Expectations Hypothesis
An extreme form of Monetarism, which became known as New Classical Economics posits that no policy
intervention from government can be successful because so-called economic agents (for example, household
and firms) form expectations in a rational manner.
This literature, which evolved in the late 1970s claimed that government policy attempts to stimulate aggregate
demand would be ineffective in real terms but highly inflationary.
The theory claimed that as economic agents formed their expectations rationally, they were able to anticipate
any government policy action and its intended outcome and change their behaviour accordingly, which would
undermine the policy impact.
For example, individuals might anticipate a rise in government spending and predict that taxes would rise in the
future to pay back the deficit. As a result the private individuals will reduce their own spending to save for the
higher taxes and that action thwarts the expansionary impact o the public spending increase.
Recall that under adaptive expectations, economic agents are playing catch-up all the time. They adopt to their
past forecasting errors by revising their current expectations of inflation accordingly.
In this context, Monetarists like Milton Friedman claimed that the government could exploit a short-run Phillips
curve for a time with expansionary policy by tricking workers into thinking their real wages had risen when in
fact their money wage increases were lagging behind the inflation rate.
But Monetarists considered the unanticipated inflation would induce the workers to supply a higher quantity of
labour than would be forthcoming at the so-called natural rate of output (defined in terms of a natural rate of
unemployment).
Under adaptive expectations, the workers take some time to catch up with the actual inflation rate. Once they
adjust to the actual inflation rate and realise that their real wage has actually fallen, they withdraw their labour
back to the natural level.
The use of adaptive expectations to represent the way workers adjusted to changing circumstances was criticised
because it implied an irrationality that could not be explained or appear reasonable. In a period of continually
rising prices, workers would never catch up. Why wouldn’t they realise after a few periods of errors that they
were under-forecasting and seek to compensate by overshooting the next period?
The theory of rational expectations was developed, in part, to meet these objections. Economic agents, when
forming their expectations were considered to act in a rational manner consistent with the assumptions in
mainstream microeconomics pertaining to Homus Economicus.
This required that economic agents used all the information that was available and relevant at the time when
forming their views of the future.
What information do they possess? The rational expectations (RATEX) hypothesis claims that individuals
essentially know the true economic model that is driving economic outcomes and make accurate predictions of
these outcomes. Any forecasting errors are random. The proponents of RATEX said that predictions derived
from rational expectations are on average accurate.
Proponents of the rational expectations (RATEX) hypothesis assumed that all people understood the economic
model that policy makers use to formulate their policy interventions. The most uneducated person is assumed to
command highly sophisticated knowledge of the structural specification of the economy that treasury and
central banks deploy in their policy-making processes.
Further, people are assumed to be able to perfectly predict how policy makers will respond (in both direction
and quantum) to past policy forecast errors. According the RATEX hypothesis, people are able to anticipate
both policy changes and their impacts.
As a result, any “pre-announced” policy expansions or contractions will have no effect on the real economy. For
example, if the government announces it will be expanding the deficit and adding new high powered money, we
will also assume immediately that it will be inflationary and will not alter our real demands or supply (so real
outcomes remain fixed). Our response will be to simply increase the value of all nominal contracts and thus
41
MMT Textbook Name Here
generate the inflation we predict via our expectations.
The government can thus never trick the private sector. The introduction of rational expectations into the debate,
thus, went a step further than the Monetarists who conceded that governments could shift the economy from the
“natural level” by introducing unanticipated policy changes.
The New Classical Economics denied that governments could alter the course of the real economy at all. In
other words, there was not even the possibility of a short-run trade-off between inflation and the unemployment
rate. Workers would always know the future inflation rate and build it fully into each round of money wage
bargaining.
The economy would thus always stay on the long-run Phillips curve.
While there are some very sophisticated theoretical critiques of the RATEX hypothesis (for example, the
Sonnenschein-Mantel-Debreu theorem) which extend the notion of the fallacy of composition where what might
be valid at the individual level will not hold at the aggregate level, some simple reflection suggests that the
informational requirements necessary for the hypothesis to be valid are beyond the scope of individuals.
A relatively new field of study called behavioural economics has attempted to examine how people make
decisions and form views about the future. The starting point is that individuals have what are known as
cognitive biases which constrain our capacity to make rational decisions.
RATEX-based models have failed to account for even the most elemental macroeconomic outcomes over the
last several decades. They categorically fail to predict movements in financial, currency and commodity
markets.
The 2008-09 Global Financial Crisis was not the first time that models employing rational expectations
categorically failed to predict major events.
Rational expectations imposes a mechanical forecasting rule on to individual decision-making when, in fact,
these individuals exist in an environment of endemic uncertainty where the future is unknowable.
As we will see in later Chapters, endemic uncertainty is a major problem facing decision-makers at all levels
and of all types in a capitalist monetary economy. The existence of uncertainty gives money, the most liquid of
all assets, a special capacity to span the uncertainty of time.
In the real world, people have imperfect knowledge of what information is necessary for forecasting and even
less knowledge of how this choice of information will impact on future outcomes. We also do not know how we
will react to changing circumstances until we are confronted with them. The nature of endemic uncertainty is
that we cannot know the full range of options that might be presented to us at some time in the future.
42
MMT Textbook Name Here
X.7
Hysteresis and The Phillips Curve Trade-Off
While the focus of economists was on trying to estimate how fast individual expectations responded to rising
inflation and the role that inflationary expectations played in wage and price formation, a new strand of
literature emerged which challenged the Monetarist contention that there was no long-run trade-off between
inflation and the unemployment rate.
At the empirical level it was noted that the estimates of the unobserved natural rate (sometimes called the NonAccelerating Inflation Rate of Unemployment (NAIRU)) derived from econometric models seemed to track the
actual unemployment rate with a lag.
At the time that Monetarism became influential in economic policy making, unemployment rates rose after the
major oil price rises in the early and mid-1970s. We will examine this period separately later.
The estimates of the natural rate seemed to rise to. For example, consider Figure X.14 which shows the
Australian Treasury estimate of the NAIRU from 1959 to 1976, the latter part of this period being highly
turbulent and marked the end of the post-War full employment era where unemployment rates were usually
below 2 per cent.
You can clearly see that the estimated NAIRU tracks the actual unemployment rate.
Figure X.14
Australian Unemployment Rates and Treasury NAIRU Estimates
These observations led economists to question the idea that there was a cyclically-invariant natural rate of
unemployment. It appeared that the best estimates of the unemployment rate that was consistent with stable
inflation at any point in time were highly cyclical.
A new theory emerged to explain the apparent cyclical relationship between the equilibrium unemployment rate
and the actual unemployment rate. It was called the hysteresis hypothesis.
The early work in this field showed that the increasing NAIRU estimates (based on econometric models) merely
reflected the decade or more of high actual unemployment rates and restrictive fiscal and monetary policies, and
hence, were not indicative of increasing structural impediments in the labour market.
It was also shown that there was no credibility in the claims that major increases in unemployment are due to the
structural changes like demographic changes or welfare payment distortions.
The hysteresis effect describes the interaction between the actual and equilibrium unemployment rates. The
significance of hysteresis is that the unemployment rate associated with stable prices, at any point in time should
not be conceived of as a rigid non-inflationary constraint on expansionary macro policy. The equilibrium rate
itself can be reduced by policies, which reduce the actual unemployment rate.
43
MMT Textbook Name Here
The importance of hysteresis is that a long-run inflation-unemployment rate trade-off can still be exploited by
the government and one of the major planks of Monetarism would be invalid.
One way to explain this is to focus on the way in which the labour market adjusts to cyclical changes in
economic activity.
Recessions cause unemployment to rise and due to their prolonged nature the short-term joblessness becomes
entrenched in long-term unemployment. The unemployment rate behaves asymmetrically with respect to the
business cycle which means that it jumps up quickly but takes a long time to fall again.
The non-wage labour market adjustment that accompanies a low-pressure economy, which could lead to
hysteresis, are well documented. Training opportunities are provided with entry-level jobs and so the (average)
skill of the labour force declines as vacancies fall.
New entrants are denied relevant skills (and socialisation associated with stable work patterns) and redundant
workers face skill obsolescence.
Both groups need jobs in order to update and/or acquire relevant skills. Skill (experience) upgrading also occurs
through mobility, which is restricted during a downturn.
The idea is that structural imbalance increases in a recession due to the cyclical labour market adjustments
commonly observed in downturns, and decreases at higher levels of demand as the adjustments are reserved.
Structural imbalance refers to the inability of the actual unemployed to present themselves as an effective excess
supply.
[MORE COMING HERE]
Advanced Material – Hysteresis and The Phillips Curve
In this box, we will learn that if there is hysteresis present in the labour market, then a long-run trade-off
between inflation and the unemployment rate is possible even if the coefficient on the augmented term in the
Phillips curve (the coefficient on the inflationary expectations term) is equal to unity.
This result was shown in Mitchell, W.F. (1987) ‘NAIRU, Structural Imbalance and the Macroequilibrium
Unemployment Rate’, Australian Economic Papers, 26(48), June, 101-118.
At any point in time there might be an equilibrium unemployment rate, which is associated with price stability,
in that it temporarily constrains the wage demands of the employed and balances the competing distributional
claims on output. We might call this unemployment rate the macroequilibrium unemployment rate (MRU).
The interaction between the actual and equilibrium unemployment rates has been termed the hysteresis effect.
The significance of hysteresis, if it exists, is that the unemployment rate associated with stable prices, at any
point in time should not be conceived of as a rigid non-inflationary constraint on expansionary macro policy.
The equilibrium rate itself can be reduced by policies, which reduce the actual unemployment rate. Thus, we use
the term MRU, as the non-inflationary unemployment rate, as distinct from the Monetarist concept of the
NAIRU, to highlight the hysteresis mechanism.
The idea is that structural imbalance increases in a recession due to the cyclical labour market adjustments
commonly observed in downturns, and decreases at higher levels of demand as the adjustments are reserved.
Structural imbalance refers to the inability of the actual unemployed to present themselves as an effective excess
supply.
In this sense, the MRU is distinguished from Friedman’s natural rate of unemployment, which was considered
to be invariant to the economic cycle.
To see how hysteresis alters the Phillips curve, we start with a standard wage inflation equation such as:
∗
e
(X.15) Ẇt = α – β( u -u ) + ∅Ṗ
t
t t
which suggests that the rate of growth in money wages in time t (W)̇ is equal to some constant (α) which
captures productivity growth and other influences, less the deviation of the unemployment rate from its steady∗
state value. The gap (( u -u ) is just a different way of capturing the excess demand in the labour market. If
t
t
the gap is positive then the actual unemployment is above the MRU and there should be downward pressure on
money wage demands, other things equal.
44
MMT Textbook Name Here
If the gap is negative then the actual unemployment is below the MRU and there should be upward pressure on
money wage demands, other things equal.
We have made the sign on β negative to be explicit in our understanding of how the state of the labour market
impacts on money wages growth. This is, of-course entirely consistent with the original Phillips depiction.
The additional term captures inflationary expectations as explained in our derivation of the EAPC.
The hysteresis effect, that is, the tracking of the actual unemployment rate by the equilibrium rate of
unemployment could be represented in a number of ways. In this example, we follow Mitchell (1987) who
represented U* as a weighted average of the actual unemployment rate and the equilibrium rate in the last
period.
The following model shows that the MRU adjusts to the actual unemployment with a lag:
∗
∗
∗
(X.16) u − u
= λ (u
-u
)
t
t−1
t
−
1
t−1
∗
∗
This says that the current MRU (u ) is equal to its value last period (u
) plus some fraction of the gap
t
t−1
between the actual and MRU last period.
The value of λ measures the sensitivity of MRU to the state of activity. The higher is λ, other things equal, the
greater the capacity of aggregate policy to permanently reduce unemployment without ever-accelerating
inflation.
[TO BE CONTINUED]
45
MMT Textbook Name Here
Unemployment and Inflation – Part 11
Posted on Friday, March 29, 2013 by bill
[PICKING UP FROM HERE]
X.8
Underemployment and The Phillips Curve
As we saw in Chapter 10, underemployment has become an increasingly significant component of labour
underutilisation in many nations over the last two decades. In some nations, such as Australia, the rise in
underemployment has outstripped the fall in official unemployment. National statistical agencies have
responded to these trends by publishing more regular updates of underemployment. They have also constructed
new data series to provide broader measures of labour wastage (for example, the Australia Bureau of Statistics
Broad Labour Underutilisation series, which is published on a quarterly basis).
After the major recession that beset many nations in the early 1990s, unemployment fell as growth gathered
pace. At the same time, inflation also moderated and this led economists to increasingly question the practical
utility of the concept of the natural rate for policy purposes, quite apart from the conceptual disagreements.
This scepticism was reinforced because various agencies produced estimates of the natural rate of
unemployment that declined steadily throughout the 1990s as the unemployment rate fell. As the unemployment
rate went below an existing natural rate estimate (and inflation continued to fall) new estimates of the natural
rate were produced, which showed it had fallen.
This led to the obvious conclusion that the concept had no predictive capacity in relation to the relationship
between movements in the unemployment rate and the inflation rate.
For example, in the US, the Congressional Budget Office recently (February 5, 2013) made their estimates of
natural rate available – Estimates of Potential GDP and the Related Unemployment Rate, January 1991 to
February 2013 which can be found here: http://www.cbo.gov/publication/43903.
The dataset provides estimates of the natural rate of unemployment in the US as computed in each January from
1991 to 1999. The estimates are back- and forward-cast, with the January 1991 estimates ending in the
December-quarter 1996 and the January 1999 estimates ending in the fourth-quarter 2009
Figure X.15 shows the various estimates (in two-yearly intervals) for the period 1980Q1 to the end of each
estimated sample. There are two characteristics of the time series. First, the CBO arbitrarily pushed the
estimated natural rate of unemployment between 1991 and 1995. Second, for each of the time-series estimates
the natural rate was falling, particularly in the 1990s.
46
MMT Textbook Name Here
Figure X.15
Congressional Budget Office Estimates of The Natural Rate of Unemployment
6.4
6.2
Per Cent
6.0
5.8
5.6
5.4
5.2
1980Q1
1981Q1
1982Q1
1983Q1
1984Q1
1985Q1
1986Q1
1987Q1
1988Q1
1989Q1
1990Q1
1991Q1
1992Q1
1993Q1
1994Q1
1995Q1
1996Q1
1997Q1
1998Q1
1999Q1
2000Q1
2001Q1
2002Q1
2003Q1
2004Q1
2005Q1
2006Q1
2007Q1
2008Q1
2009Q1
5.0
CBO Estimates of the Natural Rate of Unemployment
1991 Estimates
1993 Estimates
1997 Estimates
1999 Estimates
1995 Estimates
Source: CBO, Estimates of Potential GDP and the Related Unemployment Rate, January 1991 to February
2013, February 5, 2013.
While there are various explanations that have been offered to rationalise the way the estimated natural rates of
unemployment fell over the 1990s (for example, demographic changes in the labour market with youth falling in
proportion), one plausible explanation is that there is no separate informational content in these estimates and
they just reflect in some lagged fashion the dynamics of the unemployment rate – that is, the hysteresis
hypothesis.
The question then arises as to why the unemployment rate and the inflation rate both fell in many nations during
the 1990s. What does this mean for the Phillips curve?
To understand this more fully, economists started to focus on the concept of the excess supply of labour, which
is a key variable constraining wage and price changes in the Phillips curve framework.
The standard Phillips curve approach predicts a statistically significant, negative coefficient on the official
unemployment rate (a proxy for excess demand). However, the hysteresis model suggests that state dependence
is positively related to unemployment duration and at some point the long-term unemployed cease to exert any
threat to those currently employed.
Consequently, they do not discipline the wage demands of those in work and do not influence inflation. The
hidden unemployed are even more distant from the wage setting process. So we might expect that the short-term
unemployment is a better excess demand proxy in the inflation adjustment function.
While the short-term unemployed may be proximate enough to the wage setting process to influence price
movements, there is another significant and even more proximate source of surplus labour available to
employees to condition wage bargaining – the underemployed.
The underemployed represent an untapped pool of potential working hours that can be clearly redistributed
among a smaller pool of persons in a relatively costless fashion if employers wish.
It is thus reasonable to hypothesise that the underemployed pose a viable threat to those in full-time work who
might be better placed to set the wage norms in the economy.
This argument is consistent with research in the institutionalist literature that shows that wage determination is
dominated by insiders (the employed) who set up barriers to isolate themselves from the threat of
47
MMT Textbook Name Here
unemployment. Phillips curve studies have found that within-firm excess demand for labour variables (like the
rate of capacity utilisation or rate of overtime) to be more significant in disciplining the wage determination
process than external excess demand proxies such as the unemployment rate.
It is plausible that while the short-term unemployed may still pose a more latent threat than the long-term
unemployed, the underemployed are also likely to be considered an effective surplus labour pool. In that case
we might expect downward pressure on price inflation to emerge from both sources of excess labour.
Figure X.16 shows the relationship between the unemployment rate and inflation in Australia between 1978 and
2012. The sample is split into three sub-samples. The first from March 1978 to September 1983 is defined by
the starting point of the most recent consistent Labour Force data (February 1978) and the peak unemployment
rate from the 1982 recession (September 1983).
The second period December 1983 to September 1993 depicts the recovery phase in the 1980s and then the
period to the unemployment peak that followed the 1991 recession. The final period goes from December 1993
to December 2012.
The solid lines are simple linear trend regressions.
Figure X.16
Inflation and Unemployment, Australia, 1978-2013
14
Annual Inflation Rate (%)
12
10
8
6
4
2
0
-2
0
2
4
6
8
10
12
Unemployment Rate (%)
Mar 1978 - Sep 1983
Dec 1983 - Sep 1993
Dec 1993 - Dec 2012
Source: Australian Bureau of Statistics, Consumer Price Index and Labour Force.
The relationship between the annual inflation rate and the unemployment rate clearly shifted after the 1991
recession. The graph shows three particular points (September 1995, September 1996, and September 1997) as
the Phillips curve was flattening and moving inwards. So over these years, the unemployment rate was stuck due
to a lack of aggregate demand growth but the inflation rate was falling.
48
MMT Textbook Name Here
This has been explained, in part, by the fall in inflationary expectations. The 1991 recession was particularly
severe and led to a sharp drop in the annual inflation rate and with it a decline in survey-based inflationary
expectations.
The other major labour market development that arose during the 1991 recession was the sharp increase and
then persistence of high underemployment as firms shed full-time jobs, and as the recovery got underway, began
to replace the full-time jobs that were shed with part-time opportunities. Even though employment growth
gathered pace in the late 1990s, a majority of those jobs in Australia were part-time. Further, the part-time jobs
were increasingly of a casual nature.
Figure X.17 shows the relationship between unemployment and inflation from 1978 to 2012. It also shows the
relationship between the underemployment estimates provided by the Australian Bureau of Statistics and annual
inflation for the same period.
The equations shown are the simple regressions depicted graphically by the solid lines. The graph suggests the
negative relationship between inflation and underemployment is stronger than the relationship between inflation
and unemployment. More detailed econometric analysis confirms this to be the case.
Figure X.17
Inflation and Unemployment and Underemployment, Australia, 1978-2013
Source: Australian Bureau of Statistics, Consumer Price Index and Labour Force.
The inclusion of underemployment in the Phillips curve specification helps explain why low rates of
unemployment have not been inflationary in the period leading up to the Global Financial Crisis. It suggests that
shifts in the way the labour market operates – with more casualised work and underemployment – have been
significant in explaining the impact of the labour market on wage inflation and general price level inflation.
49
MMT Textbook Name Here
Unemployment and Inflation – Part 12
Posted on Friday, April 5, 2013 by bill
[PICKING UP FROM HERE]
X.9
Demand-Pull and Cost-Push Inflation
Economists distinguish between cost-push and demand-pull inflation although, as we will see, the demarcation
between the two types of inflation is not as clear cut as one might think.
Demand-pull inflation refers to the situation where prices start accelerating continuously because nominal
aggregate demand growth outstrips the capacity of the economy to respond by expanding real output.
Gross Domestic Product (GDP) is the market value of final goods and services produced in some period. We
represent that as the product of total real output (Y) and the general price level (P), that is, GDP = PY.
We have learned from the National Accounts, that aggregate demand is always equal to GDP or PY. It is clear
that if there is growth in nominal spending that cannot be met by an increase in real output (Y) then the general
price level (P) has to rise.
Keynes outlined the notion of an inflationary gap in his famous 1940 article – How to Pay for the War: A radical
plan for the Chancellor of the Exchequer.
While this plan was devised in the context of war-time spending when faced by tight supply constraints (that is,
a restricted ability to expand real output), the concept of the inflationary gap has been generalised to describe
situations of excess demand, where aggregate demand is growing faster than the aggregate supply capacity can
absorb it.
When there is excess capacity (supply potential) rising nominal aggregate demand growth will typically impact
on real output growth first as firms fight for market share and access idle labour resources and unused capacity
without facing rising input costs.
There are also extensive costs incurred by firms when they change prices, which leads to a “catalogue” approach
where firms will forecast their expected costs over some future period and set prices according to their desired
return. They then signal those prices in their catalogues and advertising to consumers and stand ready to supply
whatever is demanded at that price (up to exhaustion of capacity). In other words, they do not frequently alter
their prices to reflect changing demand conditions. Only periodically will firms typically revise their price
catalogues.
Further, the economy is also marked by social relations that reflect trust and reliability. Firms, for example, seek
to build relationships with their customers that will ensure product loyalty. In this context, firms will not seek to
vary prices once they are notified to consumers.
Firms also resist cutting prices when demand falls because they want to avoid so-called adverse selection
problems, where they gain a reputation only as a bargain priced supplier. Firms value “repeat sales” and thus
foster consumer good will.
The situation changes somewhat, when the economy approaches full productive capacity. Then the mix between
real output growth and price rises becomes more likely to be biased toward price rises (depending on
bottlenecks in specific areas of productive activity). At full capacity, GDP can only grow via inflation (that is,
nominal values increase only). At this point the inflationary gap is breached.
An alternative source of inflationary pressure can arise from the supply-side. Cost-push inflation (sometimes
called “sellers inflation”) is generally explained in the context of “product markets” where firms have price
setting power and set prices by applying some form of profit mark-up to costs.
We learned in Chapter 9, that generally, firms are considered to have target profit rates which they render
operational by applying a mark-up on their unit costs. Unit costs are driven largely by wage costs, productivity
movements and raw material prices.
Take the case of an increase in wage costs with productivity and other unit costs constant. In this situation, unit
costs will rise and prices will rise unless firms accept a squeeze on their mark-up. In other words, either prices
rise and deflate the nominal wage (leading to a real wage cut) or the firms accept a real cut in their per unit
returns.
50
MMT Textbook Name Here
This concept then led to economists asking the question – under what circumstances will firms and/or workers
accept such a real wage cut? This, in turn, broadened the enquiry to include considerations of social relations,
power and conflict.
Workers have various motivations depending on the theory but most accept that real wages growth (increasing
the capacity of the nominal or money wage to command real goods and services) is a primary aim of most wage
bargaining.
Firms have an incentive to resist real wages growth that is not underpinned by productivity growth because they
would have to “pay” for it by reducing their real margins.
The capacity of workers to realise nominal wage gains is considered to be pro-cyclical – that is, when the
economy is operating at “high pressure” (high levels of capacity utilisation) workers are more able to succeed in
gaining money wage gains. This is especially the case if they are organised into coherent trade unions, which
function as a countervailing force to offset the power of the employer.
When the employer is dealing with workers individually they are seen to have more power than when they are
dealing with one bargaining unit (trade unit), which represents all workers in the workplace.
The pro-cyclical nature of the bargaining power held by workers arises because unemployment is seen as
disciplining the capacity of workers to gain wages growth – in line with Marx’s reserve army of labour.
In this context, a so-called “battle of the mark-ups” can arise where workers try to get a higher share of real
output for themselves by pushing for higher money wages and firms then resist the squeeze on their profits by
passing on the rising costs – that is, increasing prices with the mark-up constant.
At that point there is no inflation – just a once-off rise in prices and no change to the distribution of national
income in real terms.
It is here that the concept of real wage resistance becomes relevant. If the economy is operating at high
pressure, workers may resist the attempt by firms to maintain their real profit margin. They may seek to
maintain their previous real wage and will thus respond to the increasing price level by imposing further
nominal wage demands. If their bargaining power is strong (which from the firm’s perspective is usually in
terms of how much damage the workers can inflict via industrial action on output and hence profits) then they
are likely to be successful. If not, they may have to accept the real wage cut imposed on them by the increasing
price level.
At that point there is still no inflation. But if firms are not willing to absorb the squeeze on their real output
claims then they will raise prices again and the beginnings of a wage-price spiral begins. If this process
continues then a cost-push inflation is the result.
The causality may come from firms pushing for a higher mark-up and trying to squeeze workers’ real wages. In
this case, we might refer to the unfolding inflationary process as a price-wage spiral.
The dynamic that drives a cost-push inflation is seen to arise from the underlying social relations in the
economy. It is here that we can consider a general theory of inflation, which recognises that the two sides of the
labour market are likely to have conflicting aims and seek to fulfil those aims by imposing real costs on the
other party.
NB: Original conflict theory of inflation (from blog 5 April) removed as superseded in blog 12 April
51
MMT Textbook Name Here
Unemployment and Inflation – Part 13
Posted on Friday, April 12, 2013 by bill
X.10 The Conflict Theory of Inflation
The Conflict Theory of Inflation beds the analytical approach in the power relations within the capitalist
system. It brings together social, political and economic considerations into a generalised view of the inflation
cycle.
The conflict theory derives directly from cost-push theories referred to above. Conflict theory recognises that
the money supply is endogenous, which is in contradistinction to the Monetarist’s Quantity Theory of Money
that erroneously considers that the money supply is exogenously controlled by the central bank.
The conflict theory assumes that firms and trade unions have some degree of market power (that is, they can
influence prices and wage outcomes) without much correspondence to the state of the economy. They are
assumed to both desire some targeted real output share and use their capacity to influence nominal prices and
wages to extract that real share.
In each period, the economy produces a given real output (real GDP), which is shared between the groups with
distributional claims in the form of wages, profits, taxes etc. In the following discussion, we assume away the
other claimants and concentrate only on the split between wages and profits. Later, we will introduce a change
in an exogenous claimant in the form of a rise in a significant raw material price.
If the desired real output shares of the workers and firms is consistent with the available real output produced
then there is no incompatibility and there will be no inflationary pressures. The available real output is
distributed each period in the form of wages and profits, which satisfy the respective claimants.
The problem arises when the sum of the distributional claims (expressed in nominal terms – money wage
demands and mark-ups) are greater than the real output available. In those circumstances, inflation can occur via
the wage-price or price-wage spiral mechanisms noted above.
The wage-price spiral might also become a wage-wage-price spiral as one section of the workforce seeks to
restore relativities after another group of workers succeed in their nominal wage demands.
The role of government is also implicated. While it is the distributional conflict over available real output which
initiates the inflationary spiral, government policy has to be compliant for the nascent inflation to persist.
Business firms will typically access credit (for example, overdrafts) to “finance” their working capital needs in
advance of realisation via sales. In an inflationary spiral, as workers seek higher nominal wages, firms will
judge whether the costs of industrial action in the form of lost output and sales are higher than the costs of
accessing credit to fund the higher wages bill. Typically, the latter option will be cheaper.
If credit conditions become tighter and loans become more expensive then firms will be less able to pay the
higher money wages demanded by workers. The impact of the higher interest rates may thus lead to a squeeze
on real wages with the consequent negative impact on consumption spending. Firms will also be less willing to
invest in new projects given the cost of funds is higher.
As a consequence, if monetary policy becomes tighter there will be some point where real production growth
declines and the workers who are in weaker bargaining positions are laid off. The rising unemployment, in turn,
eventually discourages the workers from pursuing their on-going demand for wage increases and ultimately the
inflationary process is choked off.
The Conflict Theory of Inflation thus hypothesises a trade-off between inflation and unemployment.
The alternative policy stance is for the central bank to accommodate the inflationary struggle by leaving its
monetary policy settings (interest rates) unchanged. This accommodation would also likely see the fiscal
authorities maintaining existing tax rates and spending growth.
From an operational perspective, the commercial banks would be extending loans and, in the process, creating
deposits in the accounts of its business clients. The central bank would then ensure that there were sufficient
reserves in the banking system to maintain stability in the payments system. The nominal wage-price spiral
would thus fuel the demand for more loans with little disciplining forces.
There are also strong alignments between the conflict theory of inflation and Hyman Minksy’s financial
instability notion. Both theories consider that behavioural dynamics are variable across the business cycle.
52
MMT Textbook Name Here
When economic activity is strong, the risk-averseness of banks declines and they become more willing to extend
credit to marginal borrowers. Equally, firms will be more willing to pass on nominal wage demands because it
becomes harder to find labour and the costs of an industrial dispute in terms of lost sales and profits are high.
Workers also have more bargaining power due to the buoyant conditions.
At low levels of economic activity, the rising unemployment and falling sales militates against wage demands
and profit push. It also is associated with higher loan delinquency rates and banks become more conservative in
their lending practices.
Conflict Theory of Inflation and Inflationary Biases
There was a series of articles in the journal Marxism Today in 1974 which advanced the notion of inflation
being the result of a distributional conflict between workers and capital.
As an aside, you can view an limited archive of Marxism Today since 1977 here
http://www.amielandmelburn.org.uk/collections/mt/index_frame.htm , which is a very valuable resource.
-
The article by – introduced the notion that inflation was a structural construct. He said (Devine, 1974: 80):
The phenomenon in need of explanation is not inflation in the abstract but inflation in the world of
state monopoly capitalism in the period since the second world war. Two questions arise. First,
throughout this period inflation has been chronic in all the major capitalist countries; why has it
replaced depression as the principle “economic” problem confronting the capitalist system as a
whole? Second, within this overall framework, why has the rate of inflation varied between
countries and at different times?
He argued that the increased bargaining power of workers (that accompanied the long period of full employment
in the post Second World War period) and the declining productivity in the early 1970s imparted a structural
bias towards inflation which manifested in the inflation breakout in the mid-1970s which he says “ended the
golden age”.
In this context, the “relatively full employment” has meant that (Devine, 1974: 80):
… money wages (earnings) have risen continuously, although at varying rates, for a prolonged
period unprecedented in the history of capitalism. This has had far reaching effects on the
functioning of the capitalist system. Faced with rising money wages, capitalists have sought to
contain the increase in real wages and fend off pressure on profits by increasing prices.
On the industry side, large, oligopolistic firms with price-setting power competed against each other in nonprice forms (for example, product quality, etc). The firms, however, were interdependent because market share
was sensitive to their pricing strategies. When a firm was faced with nominal wage demands, the management
knew that its rivals would be similarly pressured and their competitive positions would not depend on the
absolute price level. Rather, a firm could lose market share if they increased prices, while other firms
maintained lower prices.
But in an environment where the firms considered that the government would continue to ensure that effective
demand was sufficient to maintain full employment there was no reason to assume that rising prices would
damage their sales.
As a result, firms had little incentive to resist the wage demands of their workers and strong incentives to protect
their market share and profits by passing on the demands in the form of higher prices.
This structural depiction of inflation – embedded in the class dynamics of capital and labour, both of which had
increasing capacity to set prices and defend their real shares of production – implicates Keynesian-style
approaches to full employment.
There was also an international component to the structural theory. It was argued that the Bretton Woods system
imparted deflationary forces on economies that were experiencing strong domestic demand growth. As national
income rose and imports increased, central banks were obliged to tighten monetary policy to maintain the agreed
exchange rate parity and the constraints on monetary growth acted to choke off incompatible nominal claims on
the available real income.
However, when the Bretton Woods system of convertible currencies and fixed exchange rates collapsed in 1971
the structural biases towards inflation came to the fore.
Devine (1974: 86) argued that:
53
MMT Textbook Name Here
… floating exchange rates have been used as an additional weapon available to the state. Given
domestic inflation, floating rates provide a degree of flexibility in dealing with the resultant
pressure on the external payments position. However, if a float is to be effective in stabilising a
payments imbalance it is likely to involve lower real incomes at home. If a reduction in real wages
(or their rate of growth) is not acquiesced in there will then be additional pressure for higher
money wages and if this cannot be contained the rate of inflation will increase and there will be
further depreciation.
The structuralist view also noted that the mid-1970s crisis – which marked the end of the Keynesian period –
was not only marked by rising inflation but also by an on-going profit squeeze due to declining productivity and
increasing external competition for market share. The profit squeeze led to firms reducing their rate of
investment (which reduced aggregate demand growth) which combined with harsh contractions in monetary and
fiscal policy created the stagflation that bedevilled the world in the second half of the 1970s.
The resolution to the “structural bias” proposed by economists depended on their ideological persuasion. On the
one hand, those who identified themselves as Keynesians proposed incomes policies as a way of mediating the
distributional struggle and rendering nominal income claims compatible with real output.
On the other hand, the emerging Monetarists considered the problem to be an abuse of market power by the
trade unions and this motivated demands for policy makers to legislate to reduce the bargaining power of
workers. The rising unemployment was also not opposed by capital because it was seen as a vehicle for
undermining the capacity of the trade unions to make wage demands.
[NOTE: A SMALL DISCUSSION ON INCOMES POLICIES WILL BE HERE - NEXT WEEK]
From the mid-1970s, the combined weight of persistently high unemployment and increased policy attacks on
trade unions in many advanced nations reduced the inflation spiral as workers were unable to pursue real wages
growth and productivity growth outstripped real wages growth. As a result, there was a substantial redistribution
of real income towards profits during this period.
The rise of Thatcherism in the UK exemplified this increasing dominance of the Monetarist view in the 1980s.
54
MMT Textbook Name Here
Unemployment and Inflation – Part 14
Posted on Friday, April 19, 2013 by bill
X.11 Incomes Policies
Governments facing wage-price spiral and reluctant to introduce a sharp contraction in the economy, which
might otherwise discipline the combatants in the distribution struggle, have, from time to time, considered the
use of so-called incomes policies.
These policies have been introduced, in various forms, in many countries as a way of reducing supply-side cost
pressures and allowing employment to stay at all levels.
Incomes policies, in general, are measures that are aimed to control the rate at which wages and prices rise,
typically as the economy moves towards, or is at full employment.
In the context of the Phillips curve, incomes policies were seen as a way of flattening the Phillips curve and
reducing the inflationary impact of a reduction in unemployment.
Many countries have at various times introduced these type of policies.
For example, in 1962 the US government introduced wage-price guideposts, which allowed for an average rate
of nominal wage increase equal to the average annual rate of productivity growth in the overall economy. Other
nominal incomes, including profits, were to be tied to this rule.
Taken together, it was considered that this rule would stabilise the growth in nominal incomes and reduce any
inflationary pressures associated with the maintenance of full employment.
The rule also sought to distribute productivity gains across all income earners and thus reduce the distributional
conflict, which may instigate a wage-price spiral.
For a time, the guidelines seemed to work. But as the US government expenditure grew as a result of its
prosecution of the Vietnam war effort and unemployment fell below four percent, wage increases began to
exceed average productivity growth. By 1996, the guidelines provided no discipline on the growth of nominal
incomes in the US.
It was clear that the US government was unable to compel employers to follow the guideposts in the wage
bargaining process.
Despite the failure of the wage-price guideposts, the Republican administration under Nixon reintroduced an
incomes policy in 1971. Initially, this was in the form of a 90-day freeze on wages and other nominal incomes.
Later, compulsory growth guidelines were set for wages and prices growth and these were replaced with a
voluntary mechanism.
Soon after (in 1973), the government introduced yet another freeze on prices, followed by sector-by sector price
rises in line with cost increases with a freeze on profit margins. The experiment ended in April 1974.
It is thought that the same institutional structures that made economies more susceptible to distributional conflict
in the late 1960s and early 1970s – for example, highly concentrated industries with large firms exercising
significant price-setting how interacting with strong trade unions – also named the operation of incomes policies
difficult.
Powerful firms are in a strong position to pass on wage demands in the form of higher prices and governments
are reluctant, or are unable constitutionally, to mandate strict wage-price controls in normal times.
The other problem with average productivity rules is that they undercompensate workers in above-average
productivity growth sectors and overcompensate workers in below-average sectors.
However, incomes policies have worked more effectively in some European nations, for example, Austria and
in Scandinavian countries. Such nations have long records of collective bargaining and are more attuned to tripartite negotiations than the English-speaking nations.
A good example of a successful income policy approach, where wages and prices growth was driven by
productivity growth in certain sectors, is the so-called Scandinavian Model (SM) of inflation.
This model, originally developed for fixed exchange rates, dichotomises the economy into a competitive sector
(C-sector) and a sheltered sector (S-sector). The C-sector produces products, which are traded on world markets,
55
MMT Textbook Name Here
and its prices follow the general movements in world prices. The C-sector serves as the leader in wage
settlements. The S-sector does not trade its goods externally.
Under fixed exchange rates, the C-sector maintains price competitiveness if the growth in money wages in its
sector is equal to the rate of change in its labour productivity (assumed to be superior to S-sector productivity)
plus the growth in prices of foreign goods. Price inflation in the C-sector is equal to the foreign inflation rate if
the above rule is applied. The wage norm established in the C-sector spills over into wages growth throughout
the economy.
The S-sector inflation rate thus equals the wage norm less its own productivity growth rate. Hence, aggregate
price inflation is equal to the world inflation rate plus the difference between the productivity growth rates in the
C- and S-sectors weighted by the S-sector share in total output. The domestic inflation rate can be higher than
the rate of growth in foreign prices without damaging competitiveness, as long as the rate of C-sector inflation is
less than or equal to the world inflation rate.
In equilibrium, nominal labour costs in the C-sector will grow at a rate equal to the room (the sum of the growth
in world prices and the C-sector productivity). Where non-wage costs are positive (taxes, social security and
other benefits extracted from the employers), nominal wages would have to grow at a lower rate. The long-run
tendency is for nominal wages to absorb the room provided. However in the short-run, labour costs can diverge
from the permitted growth path. This disequilibrium must emanate from domestic factors.
The main features of the SM can be summarised as follows:

The domestic currency price of C-sector output is exogenously determined by world market
prices and the exchange rate.

The surplus available for distribution between profits and wages in the C-sector is thus
determined by the world inflation rate, the exchange rate and the productivity performance of
industries in the C-sector.

The wage outcome in the C-sector is spread to the S-sector industries either by design
(solidarity) or through competition.

The price of output in the S-sector is determined (usually by a mark-up) by the unit labour
costs in that sector. The wage outcome in the C-sector and the productivity performance in the
S-sector determine unit labour costs.
An incomes policy would establish wage guidelines which would set national wages growth according to trends
in world prices (adjusted for exchange rate changes) and productivity in the C-sector. This would help to
maintain a stable level of profits in the C-sector.
Whether this was an equilibrium level depends on the distribution of factor shares prevailing at the time the
guidelines were first applied.
Clearly, the outcomes could be different from those suggested by the model if a short-run adjustment in factor
shares was required. Once a normal share of profits was achieved the guidelines could be enforced to maintain
this distribution.
A major criticism of the SM as a general theory of inflation is that it ignores the demand side. Uncoordinated
collective bargaining and/or significant growth in non-wage components of labour costs may push costs above
the permitted path. Where domestic pressures create divergences from the equilibrium path of nominal wage
and costs there is some rationale for pursuing a consensus based incomes policy.
An incomes policy, by minimising domestic cost fluctuations faced by the exposed sector, could reduce the
possibility of a C-sector profit squeeze, help maintain C-sector competitiveness, and avoid employment losses.
Significant contributions to the general cost level and hence prices can originate from the actions by
government. Payroll taxation, various government charges and the like may in fact be more detrimental to the
exposed sector than increased wage demands from the labour market.
Although the SM was originally developed for fixed exchange rates, it can accommodate flexible exchange
rates. Exchange rate movements can compensate for world price changes and local price rises. The domestic
price level can be completely insulated from the world inflation rate if the exchange rate continuously
appreciates (at a rate equal to the sum of the world inflation rate and C-sector productivity growth).
Similarly, if local price rises occur, a stable domestic inflation rate can still be maintained if a corresponding
decrease in C-sector prices occur. An appreciating exchange rate discounts the foreign price in domestic
currency terms.
56
MMT Textbook Name Here
What about terms of trade changes? Terms of trade changes, which in the SM justify wage rises, also (in
practice) stimulate sympathetic exchange rate changes. This combination locks the economy into an
uncompetitive bind because of the relative fixity of nominal wages. Unless the exchange rate depreciates far
enough to offset both the price fall and the wage rise, profitability in the C-sector will be squeezed.
It was considered appropriate to ameliorate this problem through an incomes policy. Such a policy could be
designed to prevent the destabilising wage movements, which respond to terms of trade improvements. In other
words, wage bargaining, consistent with the mechanisms defined by the SM may be detrimental to both the
domestic inflation target and the competitiveness of the C-sector, and may need to be supplemented by a formal
incomes policy to restore or retain consistency.
By the 1970s, with the rising dominance of Monetarism, which eschewed institutional solutions to distributional
conflict in favour of market-based approaches, incomes policies lost favour in most countries.
The Monetarist approach combined the use of persistently high unemployment and increased policy attacks on
trade unions in many advanced nations to reduce the bargaining power of workers. This reduced the inflationary
tendency because workers were unable to pursue real wages growth and as a result productivity growth
outstripped real wages growth. This led to a substantial redistribution of real income towards profits during this
period.
The rise of Thatcherism in the UK exemplified this increasing dominance of the Monetarist view in the 1980s.
X.12 Raw Material Price Rises
Up until now we have been concentrating on workers pursuing nominal wage increases in order to gain higher
real wages and/or firms pushing profit margins up to gain a greater profit share of real income as the main
drivers of an inflationary process.
However, raw material price shocks can also trigger off a cost-push inflation. These cost shocks may be
imported (for example, an oil-dependent nation might face higher energy prices if world oil prices rise) or
domestically-sourced (for example, a nation may experience a drought which increases the costs of food which
impact on all food processing industries).
Take for example a price rise for an essential imported resource. The imported resource price shock amounts to
a loss of real income for the nation in question. That is, there is less real income to distribute to domestic
claimants.
The question then is who will bear this loss? With less real income being available for distribution domestically,
the reactions of the claimants is crucial to the way in which the economy responds to the impost.
The loss has to be shared or borne by one of the claimants or another. If local firms pass the raw material cost
increases on in the form of high prices, then workers would endure a cut in their real wages.
If workers resist this erosion of their real wages and push for higher nominal wages growth then firms can either
accept the squeeze on their profit margin or resist.
You can see that the dynamics of the Conflict Theory of Inflation are triggered by the raw material price rise.
The government can employ a number of strategies when faced with this dynamic. It can maintain the existing
nominal demand growth which would be very likely to reinforce the spiral.
Alternatively, it can use a combination of strategies to discipline the inflation process including the tightening of
fiscal and monetary policy to create unemployment (the NAIRU strategy); the development of consensual
incomes policies and/or the imposition of wage-price guidelines (without consensus).
Ultimately, if the claimants on real income try to pass the raw material price rise onto each other then it is likely
that contractionary government policy will be introduced and unemployment will rise.
Summary
A cost-push inflation requires certain aggregate demand conditions to continue for a wage-price spiral to lead to
an accelerating inflation. In this regard, the concept of a supply-side inflation blurs with the demand-pull
inflation although their originating forces might be quite different.
57
MMT Textbook Name Here
For example, an imported raw material shock means that a nation’s real income that is available for distribution
to domestic claimants is lower. This will not be inflationary unless it triggers an on-going distributional conflict
as domestic claimants (workers and capital) try to pass the real loss onto each other.
However, that conflict needs “oxygen” in the form of on-going economic activity in sectors where the spiral is
robust. In that sense, the conditions that will lead to an accelerating inflation – high levels of economic activity –
will also sustain an inflationary spiral emanating from the demand-side.
In the next Chapter we will introduce the concept of buffer stocks in a macroeconomy (employment and
unemployment) and analyse how they can be manipulated by policy to maintain price stability.
58
MMT Textbook Name Here
References
Bancroft, G. (1950) 'The Census Bureau Estimates of Unemployment'”, The Review of Economics and
Statistics, February, pp. 59-65.
Brown, A.J (1955) The Great Inflation, 1939-51, Oxford University Press: Oxford
Devine, P. (1974) ‘Inflation and Marxist Theory’, Marxism Today, March, 79–92, available at:
https://docs.google.com/viewer?url=http://64.62.200.70/PERIODICAL/PDF/MarxismToday-1974mar/17-31/.
Dunlop, J.T (1950) 'Estimates of Unemployment: Some Unresolved Problems', Review of Economics and
Statistics, February, pp. 77-79.
Friedman, M. (1968) 'The Role of Monetary Policy', The American Economic Review, 58(10), March, 1-17
Hume, D. (1752), ‘Of Money’ – MORE DETAILS NEEDED HERE – LINK HAS ARTICLE ONLY NOT
WHERE IT APPEARED.
Keynes, J.M. (1940) How to Pay for the War: A radical plan for the Chancellor of the Exchequer, London,
Macmillan]
Keynes, J.M. (General Theory – CHECK OTHER CHAPTERS FOR THIS)
Klein, L. (1985)
Abba Lerner's 1951 book - Economics of Employment
Mitchell, W.F. (1987) ‘NAIRU, Structural Imbalance and the Macroequilibrium Unemployment Rate’,
Australian Economic Papers, 26(48), June, 101-118.
Phillips, A.W. (1958) 'The Relation between Unemployment and the Rate of Change of Money Wage Rates in
the United Kingdom, 1861-1957', Economica, 25(100), 283-299.
Samuelson, P.A. and Solow, R.M. (1960) 'Analytical Aspects of Anti-Inflation Policy', American Economic
Review, 50(2), Papers and Proceedings of the Seventy-second Annual Meeting of the American Economic
Association, May, 177-194.
Slichter, S. (1950) 'Comment on the Papers on Employment and Unemployment', Review of Economics and
Statistics, February, pp. 74-77.]
Sultan, P. (1957) – MORE DETTAILS NEEDED HERE
Thirlwall, T. (2003)
Thurow, L. (1983) Dangerous Currents, Oxford University Press; First Edition.
Tinbergen, J. (1939)
59