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Inflation in Recession and Recovery

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Inflation in Recession and Recovery ROBERT J. GORDON* Universityof Chicago and the National Bureau of Economic Research In.fl!ation in Recession and Recovery The cruelchoice between two evils, unemploymentand inflation, has becomethe majoreconomic issue of the day.' THE INTERVAL FROM 1969:3 TO 1970:4 qualifiesas a full-fledgedeco- nomic slowdownin whichthe officialunemployment rate increasedby 59 percent.But in the firstyear of everyprevious U.S. postwarrecession, the rate of inflationwas lowerthan it was in the last expansionyear, while the rateof inflationwas more rapid in 1970than during any part of the previous businessexpansion.2 This paper develops wage andprice equations that at- tempt,first, to explainwhy inflation accelerated in 1970rather than slowing as it did duringpast recessions;second, to isolatethe relativerole of prices and wagesin the 1970episode; and third,to form predictionsof wage and pricebehavior during the next ten years.In particular,the paperattempts to predictthe responseof the rate of inflationto alternativepaths of eco- nomicrecovery--that is, to estimatehow much more rapidlyprices would * I am gratefulto Thomas D. Henrion for helping me preparethe computer runs. The paperwas made possible by the contributionsof the National Bureau of Economic Researchfor researchassistance and of the Departmentof Economicsof the Universityof Chicagofor computertime. I wish to acknowledge,besides the help receivedfrom mem- bers of the Brookingspanel, the comments of Milton Friedman,and other membersof the Money and BankingWorkshop at the Universityof Chicago, on an earlier version of this paper. 1. JamesTobin and LeonardRoss, "Livingwith Inflation,"The New YorkReview of Books, Vol. 16 (May 6, 1971), p. 23. 2. During the five expansionaryquarters between 1968:2 and 1969:3, the nonfarm privatedeflator increased at an annual rate of 4.2 percent,while duringthe five quarters between 1969:3 and 1970:4, the deflator increased by 5.2 percent. For comparable figures during previous recessions, see my "Prices in 1970: The Horizontal Phillips Curve?"Brookings Papers on EconomicActivity (3:1970), p. 449. 105 106 Brookings Papers on Economic Activity, 1:1971 increaseif full employmentwere to be attainedswiftly rather than grad- ually. In addition,the short- and long-runtradeoffs between inflation and unemploymentare calculated. The resultsshow that in the long run a given reductionin the unemploymentrate causesa greaterincrease in the rate of inflationthan most previousresearch has suggested;nevertheless, the data do not supportthe "accelerationist"hypothesis that there is no long-run tradeoff. Inflationary1970: Was It a Surprise? The Phillipscurve pictures a widelyaccepted hypothesis that the rate of inflationis inverselydependent on the rate of unemployment.The simplest versionof the hypothesismakes no distinctionbetween long-run and short- run Phillipscurves; the economyis alwayson "the"curve and experiences an immediatereduction in the rate of inflationwhenever, as in 1970,the un- employmentrate rises. A more sophisticatedapproach treats the Phillips curveas a long-runequilibrium relationship from whichthe economycan divergein the shortrun. In particular,if wagesand pricesadjust slowly to changesin economicconditions, an increasein the unemploymentrate is not accompaniedby an immediatereduction in the rate of inflation.Even- tually, however,the rate of inflationwill decline after sufficienttime has passedfor the laggedeffects of the higherunemployment rate to worktheir way throughthe economy. In an earlierpaper, I presentedone versionof a "dynamicPhillips curve" in whichinflation was determinedby the interactionof separatewage and priceequations.3 How surprisingwas 1970when viewedagainst their pre- dictions?Using actualprice changes to help predictwages, the wage equa- tion trackedthe firsthalf of 1970well, but underpredictedthe rate of wage increasein the last two quartersby an averageof 1.0 percentagepoint at an annualrate. Using actualwage changesin the priceequation, it underpre- dicted the annualrate of price increaseby an averageof 1.1 percentage points duringthe last threequarters of the year.Full predictions,based on predictedrather than actualvalues of both variablesin both equations,re- sult in a wideningunderprediction of the rate of priceincrease, reaching 2 percentagepoints in the fourthquarter. 3. Robert J. Gordon, "The Recent Accelerationof Inflationand Its Lessons for the Future," BrookingsPapers on EconomicActivity (1:1970), pp. 8-41. RobertJ. Gordon 107 In short, the continuedacceleration of inflationin 1970 was indeed a "surprise"when comparedwith these predictions.This paperseeks to de- velop refinementsto these earlierwage and price equationsthat will im- proveboth the fit to historicaldata and the explanationof developmentsin 1970. Like most other recent research,the model developedhere postulates that the primaryforce "driving" the rateof inflationis the determinationof wages in the labor market.The price equationis based on the hypothesis that in the long run the relativeshares of wage and nonwageincome are constantand that the pricelevel is thus "tied"to laborcost; the purposeof the priceequation is then to describetemporary deviations of the distribu- tion of incomefrom this long-runconstant relationship. The dominantrole this model assignsto wagesin the inflationprocess justifies the dispropor- tionate emphasisthat it receivesin the followingdiscussion. The Determinationof Wages The theoryof wage determinationused here is similarin its generalfea- tures to the approachtaken by most previouseconometric research. The primarycurrent force that pulls the wage level upward(relative to "stan- dard"productivity) is an excess demandfor labor. When workersare in short supply,firms raise wage rates both to bid workersaway from other firmsand to inducenew entrantsinto the laborforce. Workers do not eval- uate wage offersby employersin a vacuum,however, but measurethem againstthe wage they expectto receiveif they remainin theirpresent jobs and the expectedprice level of the goods they will be ableto buy with them. Thusthe secondmajor force pushing upward on wagerates is the expected rate of increasein pricesand wages.Even without currentexcess demand for labor, the averagewage rate would be pushedup fasterthan the trend increasein productivityif the pricelevel were expectedto rise rapidly.4In 4. For a theoreticallabor marketmodel in which the primary"pushing" force is the expectedincrease in wages, see EdmundS. Phelps, "Money-WageDynamics and Labor- Market Equilibrium,"Journal of Political Economy, Vol. 76 (July/August 1968), pp. 678-711. For a model in which the expectedincrease in pricesplays a dominantrole, see Milton Friedman,"The Role of MonetaryPolicy," AmericanEconomic Review, Vol. 58 (March 1968), pp. 1-14. A hybrid model combining elements of both approachesand several other innovationsis containedin a monographthat I am currentlypreparing for the National Bureauof Economic Research. 108 BrookingsPapers on EconomicActivity, 1:1971 short, the basic variablesin most wage equationsfall into two classes,in- tended to measureeither (1) the "pull" of the labor market, or (2) the "push"of price expectations.Much of the controversyin the field centers on the way to measureexcess labor demandand price expectations;the selectionamong the competingmethods that maketheoretical and intuitive sense dependson the verdictof the empiricaldata. ALTERNATIVE MEASURES OF EXCESS LABOR DEMAND The aggregateunemployment rate, the most widelypublicized measure of labor markettightness, is subjectto severalimportant criticisms that have led GeorgePerry, myself, and othersto suggestalternative measures. The unemploymentinverse (1/U). Frictional and structuralunemploy- mentset a floorto the unemploymentrate, but thereis no upperlimit to the degreeof excessdemand that can accompanythis minimumunemployment rate. Thus the relationshipof excess demandand hence wage increasesto the unemploymentrate is usuallyassumed to be convexto the origin.In an attemptto approximatethis convexity,the inverseof the unemployment ratehas beenthe measureof labormarket pressure most frequentlyused in previousresearch. The vacancyrate (V). Since the major currentdeterminant of wage in- creasesis assumedto be net excess labor demand,the rate of unemploy- ment, which measuresexcess labor supply,should in principlebe supple- mentedby a measureof excesslabor demand.Unfortunately, the absence of a comprehensivevacancy measure for the postwarUnited Stateshas in- hibitedthis approach,but I proposeto use, as a roughapproximation to a vacancyrate, the numberof "nonagriculturaljob openings unfilled"(a seriescollected by the U.S. ManpowerAdministration) divided by the ci- vilianlabor force. The obstacleto using this seriesis its partialcoverage, but a workableassumption is thatthe ratioof "unmeasured"to "measured" vacanciesis constant.If so, the vacancyrate (V) can be multipliedby a con- stant selectedto make the net excess demandmeasure (V - U) equal to zero in a periodwhen labor marketsappear to be "in balance."5 5. I assumed that labor markets were "in balance" in 1965:2, requiringthat the vacancyrate be multipliedby 11.0. This arbitrarychoice servesonly to scale the vacancy rate to the same order of magnitudeas the unemploymentrate, but has no effect on the finalresults, since V, and U, are enteredseparately into the regressionsbelow in orderto allow the com'puterto determine the "true" contribution of each variable to labor markettightness. RobertJ. Gordon 109 The total unemploymentrate
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