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Macroeconomic Effects of Selective Public Employment and Wage

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Macroeconomic Effects of Selective Public Employment and Wage MARTIN NEIL BAILY Yale University JAMES TOBIN Yale University MacroeconomicEffects of Selective Public Employment and Wage Subsidies DIRECT JOB CREATION and selective wage subsidies are policies de- signed to alter the mix of employmentin favor of workerswho, in the normal course of economic events, experiencehigh rates of unemploy- ment. As instrumentsof macroeconomicpolicy, these measuresare in- tendedto mitigatethe conflictbetween society's goals for unemployment and inflation.The hope is to "cheatthe Phillipscurve." For the shortrun, as in the currentcyclical recovery, this meansto diminishthe inflationary consequencesof higherrates of employment.For the long run, it means to diminishthe naturalrate of unemployment-or, to use a more neutral term, the minimal nonaccelerating-inflationrate of unemployment Note: This paper presents the analytical framework for the principal arguments, and some related empirical evidence, underlying a paper, "Direct Job Creation, Infla- tion, and Unemployment,"delivered by the authors at the Conference on Direct Job Creation sponsored by the Brookings Institution and the Institute for Research on Poverty, held in Washingtonin April 1977. The conference paper, as revised, will be published in a Brookings volume devoted to the papers presented at the conference. We would like to thank participantsin the conference for helpful comments, and to acknowledge with gratitude the excellent research assistance of Richard Kolsky, Hiroshi Yoshikawa, and David Coppock. We are grateful also for the financial sup- port provided by the institutions sponsoring the conference and by the National Science Foundation. 511 512 Brookings Papers on Economic Activity, 2:1977 (NAIRU). In general,the purposeis to allow standardfiscal and mone- tary policy to achieve more satisfactoryjoint paths of output, employ- ment, andprices. The basic strategyis simple: Shift labor demandto types of workers who are-because of high unemployment,weak bargainingpower, rigid wages,or other characteristics-on relativelyflat Phillips curves.Let the governmenthire, or induceother employers to hire,workers whose unem- ploymentdoes little or nothing to restrainthe advanceof wage costs in the aggregate.The idea is appealing,and our purpose is to examine it systematically.Most of our discussionconcerns the long run-the possi- bility of reducing the NAIRU-because it is in that context that the strategyis most likelyto encountercomplications and pitfalls. For the strategyto have a chance,selective eligibility is essential.Pub- lic employmentopportunities or wage subsidies must be confined to workers whose supply and demand have relatively little to do with economy-wideinflation. From a macroeconomicviewpoint, this is the reason for eligibilitycriteria whose rationalesmay vary greatly: low in- come, low wage, welfaredependency, previous unemployment, residence in a labor surplusarea, youth. Open-ended"employer of last resort"pro- gramsand generalemployment subsidies would not carryout the macro- economicstrategy to whichour paper is directed. We will presenttwo analysesof the way selectiveemployment policies may work. The firstis an aggregativemodel of frictionalunemployment andits possiblereduction. The secondis an explicitlydisaggregated model of labor markets,in which the power of selective employmentpolicies comes from exploitingdifferences among markets in wage responses. ReducingFrictional Unemployment Excess demandin any labor marketis measuredconceptually by the algebraicexcess of jobs over the labor force, or of job vacanciesover the unemployed.For given excess demand, both vacancies and unemploy- mentmay be high, or they maybe low. Unemploymentmatched by simul- taneousvacancies is frictionalunemployment. It is a reasonableassump- tion that inflationarypressure on wages is proportionalto excess demand, or depends separatelyon its components,vacancies and unemployment. If so, both the inflation-unemploymenttradeoff and the NAIRU can be MartinNeil Baily and James Tobin 513 improvedby reductionsof frictionalunemployment. Some labor-market policies-retraining, relocating,and more efficientexchanges of informa- tion-are specificallydesigned to place unemployedworkers in existing vacancies, or to facilitate job searches and shifts without intervening spells of unemployment. These aimsare not centralfeatures of directjob creation.Nevertheless, such programsmay indirectly diminish frictional unemployment.Job vacanciesconnected with directjob creationshould be minimal,while the programitself could be a channel for routing unemployedworkers to vacanciesin the privatesector as long as the wages and durationof the jobs did not reduceincentives to look for alternatives.Their availability may brakemarket wage increasesnearly as much as if they were actually unemployed. Wage subsidiesper se do not promisethe same reductionsin frictional unemployment.If the subsidyfor employingan eligibleworker is perma- nent and the wage is uncontrolled,search behavior will not be modified. The mechanismby which wage subsidiescould be effectiveis described by the secondmodel below. The firstmodel is as follows:X (1) UL(J x) - L(J, x) + N(J, X)-=O, O < LJ < NJ < 1. Here U is the unemploymentrate; L is the labor force, a functionof the numberof jobs (or slots), J, and of a policy parameter,x; and N is em- ployment,a functionof the sametwo variables. (2) VJ-J + N(J, x)=O. The vacancyrate, V, is measuredrelative to the numberof jobs: (3) W = f(U, V,2x) + WO, fu < O,fv > O. Here, W is the proportionalrate of wage inflation(1/W - dW/dt), and depends on built-in or expected inflation, We, and on the vacancy and unemploymentrates. The NAIRU conditionis (4) f(U, V, x) = 0. 1. This is an elaboration of a model one of us presentedpreviously to serve as an organizing framework for examining ways in which labor-marketpolicies, direct job creation and others, could alter the inflation-unemploymenttradeoff and the NAIRU. See the comment by James Tobin (on Michael Wiseman, "Public Employment as Fiscal Policy") in BPEA, 1:1976, pp. 107-10. 514 Brookings Papers on Economic Activity, 2:1977 For long-runequilibrium the three equations 1, 2, and 4 determine U, V, and J as a functionof the policy variable,x. The numberof jobs, J, is directlyrelated to aggregatereal demand,and thus to monetaryand fiscal policies that affect it. Nevertheless,J is an endogenousvariable in long-runanalysis, in the sense that the monetaryand fiscal policymakers seekthe maximumJ consistentwith nonaccelerating inflation. The solutionof the systemgives the NAIRU, U, and dU () /v =-Nfv[ - V-L( -U)] + L(l -U)fv(l - V-Nj) -fxJ[L(l - U) -N], where A=Lfv(l- V-NJ) + Jfu[Lj(l - U)-Nj]. Assume that, with unchangedpolicy x, increasingJ raises the vacancy rate (1 - V > N.) and decreases the unemployment rate-LJ(1 - U) < NJ. Equation5 showsthat a policy x will tend to reducethe NAIRU if: (a) N, > 0; that is, the policy diminishesthe slippagebetween jobs and employment.This reductionin the vacancy content of jobs works only if f, > 0-that is, if the vacancyrate, as well as the unemployment rate,affects the rateof wageinflation. (b) L, < 0; that is, the policy diminishesthe endogenousresponse of the labor force to the numberof jobs. This also works only if f, > 0. (c) f, < 0; that is, the policy diminisheswage inflationfor a given combinationof vacanciesand unemployment. The short-runPhillips tradeoff is (d WI/dJ)/ (d U/dJ). Using equations 1, 2, and 3, andtaking We as given, (6) dWi/dJ _ fv(l - V- Nr)L +fu. dU/dJ [LJ(1 - U) - N]JJ Policy will make the Phillips curve flatterif (a) it raises NJ, (b) it lowers L relativeto J or reducesL., (c) it lowers fv or the absolutesize of fu or both. These three points correspondto the three points for NAIRU. As in that case, points (a) and (b) applyonly if fv > 0. This model is illustratedin figure 1, in which the numberof jobs J is measuredhorizontally, the labor force L and employmentN, verti- cally. The curve L(J) indicates the dependenceof the labor force on job availability;its positive slope representsthe well-known fact that labor-forceparticipation is responsiveto job opportunities.The curve N(J) representsthe transformationof jobs into actual employment.Be- Martin Neil Baily and James Tobin 515 Figure 1. Effects of Labor-MarketPolicy in Reducing Frictional Unemployment Labor force, L Employment,N 3 / L(J) Numberof joJ(J)2 /~~~~~~~~~~oa,,,zV2 V on -~~~~~~~~~~~~~~O -~~~~~~~~~~~~~~~~~.0~~~~~~NumberJ of jobs, tJnetlploymeNumberate josU Unemploymenrate,U 516 Brookings Papers on Economic Activity, 2:1977 cause of "friction,"the transformationis imperfect.The verticalshortfall of N(J) from the 450 reference line J indicates the number of vacancies. Unemploymentis the vertical distance L - N. In the lower panel, the vacancyrate, relativeto jobs, and the unemploymentrate, relativeto the labor force, are shown. One pair of these rates is consistentwith stable wage inflation,and this determinesthe NAIRU and correspondingjobs, vacancies,employment, and labor force. The dashedlines representsome favorableshifts due to policy actions, perhapsdirect job creation.As indicated,these permit increasesin the long-run equilibriumlevels of jobs and employment,and a reduction in the NAIRU. The gains arise from reducingthe vacancy rate corres- pondingto any given unemploymentrate. The necessaryassumption is that vacancieshave an independentinflationary effect on wages. On this assumption,a policy that will reduce the vacancy slippage in N(J) or reduce the induced labor-supplyresponse in L(J) will
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