World Inflation and Monetary Accommodation in Eight Countries

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ROBERT J. GORDON Northwestern University

World Inlation and Monetary Accommodation in Eight Countries

The "monetarist"view of ... the accelerationof inflationsince 1965 [is] that it has been the ultimateconsequence of an increasein the rate of world monetary expansion, an increase attributableprimarily to the excessively expansionary monetary policy pursued by the United States in recent years.-Harry G. Johnson' I find the alternativeexplanation ... which regardsthe basic cause as increased trade-unionmilitancy ... moreplausible.-Nicholas Kaldor2 There is little doubt, then, that the wage-inflationidea does not apply to the inflationaryexperiences we have seen in the real world.... Only when the macroeconomic implicationsof the wage-inflationhypothesis are traced through and confronted with the facts does it become apparentthat it cannot be sus- tained.-Arnold C. Harberger3

Note: This research has been supported by the National Science Foundation. I am gratefulto my colleague John Bilson for aiding me in the acquisitionof data from the InternationalMonetary Fund, and to my research assistant James Glassman for an absolutely outstanding job. Also helpful were the suggestions of Victor Argy, Jacques Artus, Jacob Frenkel, Hans Genberg, John Helliwell, Paul Krugman,David Laidler, Michael Parkin, Richard Sweeney, George Zis, and members of the Brook- ings panel. Of special value were a number of discussions with ChristopherSims. 1. Harry G. Johnson, "Inflation: A 'Monetarist' View," in Harry G. Johnson, Further Essays in Monetary Economics (Allen & Unwin, 1972), p. 335. 2. Nicholas Kaldor, "Inflationand Recession in the World Economy," Economic Journal,vol. 86 (December 1976), p. 710. 3. Arnold C. Harberger,"Inflation," in John Van Doren, ed., Symposium on the Emerging World Economy (Great Ideas Today series) (Encyclopaedia Britannica Educational Corporation, 1976), pp. 94-106. 409 410 Brookings Papers on Economic Activity, 2:1977

WHILE"SUPPLY SHOCKS" in oil and food are widely agreed to have ag- gravatedinflation in many countriesin 1973-75, no consensushas yet emergedto explain the accelerationof inflationbetween the mid-1960s and 1970-72 in the majorindustrialized nations outside of North Amer- ica. Instead,two majorschools of thought,the "internationalmonetarist" and the "wage push," have developed alternativeexplanations having radically differentpolicy implications. The first group views inflation within a conventionalmacroeconomic framework as an "international monetaryphenomenon" and identifiesits fundamentalcause as an excess demandfor commoditiesgenerated by governmentactions. Any attempt to bringin other factors, particularlythose of the wage-pushvariety, is dismissed.Adherents of the wage-pushor "sociological"school of thought disagree, pointing to the allegedly spontaneouswage explosions that occurredin a numberof Europeancountries in 1968 and 1970 as evidence of the specialnoneconomic character of the recentinflation. Wage claims are viewed as part of a continuingconflict over income shares among competingsocial groups, and the events of the 1968-70 period reflectedlabor's "long-smouldering resentment and dissatisfaction."4

Aims of the Paper

The sourcesof inflationin the mainindustrialized nations in the period of fixed exchangerates have not yet been adequatelyestablished. Both the international-monetaristand wage-pusharguments are unsatisfactory and incomplete. The accelerationof wages and pricesin 1969-70 in the majornations outside of the UnitedStates followed a continuingdecelera- tion of their rates of monetarygrowth between 1963 and 1969. For the "world"-the United States plus seven other importantindustrial na-

4. Kaldor, "Inflation and Recession," p. 710. In his more eclectic analysis of wages, George L. Perry considerswage push, closely associated with a dissatisfaction with shares, an important part of the wage explosions of the 1968-70 period, and consequently one of the factors that brought the average rate of wage inflation in the 1970s to a new, higher, plateau. See his "Determinantsof Wage Inflation around the World," BPEA, 2:1975, pp. 403-35. Earlier, William D. Nordhaus had rejected a related explanation labeled "frustrationtheories" in "The Worldwide Wage Ex- plosion,"BPEA, 2:1972, pp. 431-64. RobertJ. Gordon 411 tions5-the 1969-70 accelerationof wage rates preceded by almost a year the 1971 explosionof money and internationalreserves, in apparent conflict with the international-monetaristexplanation. Wage-push pro- ponentshave not made their case either, because autonomouswage in- creasesdo not automaticallypass into the pricelevel. This paperaccepts from the outset the propositionthat world inflation must in the long run be a world monetaryphenomenon. Confirmation of a connectionbetween the rates of growthof world money and prices, as in severalrecent studies, is viewedas only the firststep in the development of a fuller understandingof the inflationprocess, because the sourcesof changes in world money are left unexplained.6A correlationbetween worldprices and money does not rule out wage push as a sourceof world monetarygrowth. Instead of viewing internationalmonetary and wage- push factorsas competitiveexplanations of inflation,a more comprehensive theoretical frameworkis presented which incorporatesthese two ingredientsas possible explanationsof the behavior of the monetary authorities,together with fiscal deficits, supply shocks, and a countercyclicalmonetary reaction function. Since a time-seriescorrelation between inflation and monetarygrowth is consistentwith several sources of monetarygrowth, a more discrimi- nating empirical methodology is required. An impirical study of the United Statesand seven other majorindustrial nations attempts to determine whetherthe data are consistentwith an effect of any or all of the possible sourcesof monetaryaccommodation. Among the majorquestions to be answeredare the following: If U.S. monetarygrowth is to be blamedfor the accelerationof inflationin other countries,by what channelswas this impulsetransmitted? Did patternsof causationdiffer among countries?Were some countriesbetter able than othersto pursuecountercyclical rather than procyclical monetary policies? Did differencesacross countries in the degreeof accommodationto supply shocks in 1974 correspondwith the degree of accommodationto wage

5. The "Other Seven" countries are Canada, France, West Germany, Italy, Japan, Sweden, and the United Kingdom. 6. See, for instance, David I. Meiselman, "WorldwideInflation: A Monetarist View," in Meiselman and Arthur B. Laffer, eds., The Phenomenon of Worldwide Inflation (American EnterpriseInstitute, 1975), pp. 69-112. See also Hans Genberg and Alexander K. Swoboda, "Causes and Origins of the Current Worldwide Infla- tion," discussion paper (Geneva: Graduate Institute of International Studies, November 1975; processed). 412 Brookings Papers on Economic Activity, 2:1977 push or reserveinflows in the earlierperiod? Do episodesof wage push identifiedby othersappear to have been genuinelyexogenous or were they precededby episodes of monetaryaccommodation? Can the breakdown of the BrettonWoods systembe treatedultimately as anothercasualty of the VietnamWar, or did domesticevents in othercountries play a role? Answersto these questionsare useful not only for an understandingof history, but for future policymaking:Is control of the money supply eithernecessary or sufficientfor a nationto controlits inflationrate? Is it likely that monetaryauthorities will be able in the futureto insulatethe inflationrate from the tendenciesto wage push, or are incomes policies requiredas a cure? Finally,the paperraises a methodologicalquestion of interestto many economistscaught in the middle without any particularallegiance to an international-monetaristor wage-pushview of the world: Can econometric techniquesuncover systematic tendencies toward procyclical accom- modationor countercyclicalactivism on the part of centralbanks, or do shiftingtargets and prioritiesdefy statisticalgeneralizations and call instead for a moredescriptive and anecdotalapproach to monetaryhistory?

International-MonetaristApproach

The international-monetaristapproach begins from the proposition that underfixed exchangerates the world inflationrate is determinedpri- marily by previous changes in the rate of growth of the world money supply. This follows from two basic propositionswhich previouslyhad been emphasizedby U.S. monetaristsaddressing issues of a closed economy: the stabilityof the demand-for-moneyfunction, and the lack of any long-run tradeoff between inflation and unemployment.Both of these elements have been tested by international-monetaristeconomists who have estimated structural equations describing the behavior of the demand-for-moneyfunction and the expectationalPhillips curve for the "world"(usually the Group of Ten).7 Further,reduced-form tests have

7. See M. R. Gray, R. Ward, and G. Zis, "The World Demand for Money Func- tion: Some PreliminaryResults," and Nigel Duck and others, "The Determinationof the Rate of Change of Wages and Prices in the Fixed Exchange Rate World Econ- omy, 1956-71," both in Michael Parkin and George Zis, eds., Inflation in the World Economy (Manchester University Press and University of Toronto Press, 1976), pp. 151-78 and 113-43, respectively. RobertJ. Gordon 413 found that changesin the world rate of monetarygrowth have preceded changesin the world inflationrate.8 The behaviorof individualcountries is characterizednot only by stable national demand-for-moneyfunctions and vertical long-run Phillips curves, but by two additionalfeatures. First, capital is mobile among nations,so that internationalreserves tend to flow in or out as necessary to set a nation's money supply equal to its demand for money, which dependsprimarily on its price level, real output, and interestrate.9 Sec- ond, commodityarbitrage maintains the tradable-goodsportion of the domesticprice level fairlyclose to the worldprice level of tradablegoods, while labor mobility communicateschanges in prices of tradablegoods to the nontradablessector.10 Thus any event that raises the foreignprice level tends to push up both the domestic price level and the domestic money supply, irrespectiveof the reaction of the domestic monetary authorities. The international-monetaristapproach traces the accelerationof inflation outsidethe United Statesin the late 1960s back to U.S. fiscal deficits incurredto pay for Vietnamexpenditures, which inducedan acceleration in the growthrate of the U.S. money supplyand pricelevel. Inflationthen spreadfrom the United Statesto othercountries by four main channelsof transmission."First, the "directprice influence"working through commodity arbitrageraised the prices of tradablegoods everywhere.This then pushedup the marginalvalue productof labor and of other factors of productionand hence domesticcosts, raisingthe pricesof nontradable

8. See Genbergand Swoboda, "Causesand Origins." 9. See Robert A. Mundell, International Economics (Macmillan, 1968), chap. 18; also Harry G. Johnson, "The Monetary Approach to Balance-of-Payments Theory,"in Johnson, FurtherEssays in MonetaryEconomics, pp. 229-49. 10. Rudiger Dornbusch, "Devaluation, Money, and Nontraded Goods," Ameri- can Economic Review, vol. 63 (December 1973), pp. 871-80. The Dornbusch model is extended to the case of imperfectly flexible prices in Robert J. Gordon, "Interrela- tions Between Domestic and International Theories of Inflation," in Robert Z. Aliber, ed., The Political Economy of Monetary Reform (Macmillan, 1977), pp. 126-54. 11. An excellent general discussion of the channels through which inflation is transmittedcan be found in Walter S. Salant, "InternationalTransmission of Infla- tion," in LawrenceB. Krause and Walter S. Salant, eds., WorldwideInflation: Theory and Recent Experience (Brookings Institution, 1977), pp. 167-227. See also Alex- ander K. Swoboda, "Monetary Approaches to Worldwide Inflation," in the same volume, especially pp. 3 3-44. 414 Brookings Papers on Economic Activity, 2:1977 goods.'2Second, the tradesurpluses of other nationsinduced by the fact that U.S. income growthwas higher than their own, as well as by de- terioratingU.S. price competitiveness,boosted foreignlevels of produc- tion and income throughthe conventional"Keynesian demand-pressure mechanism."Third, the "BrettonWoods monetizationchannel" allowed U.S. balance-of-paymentsdeficits to be paid for by the creationof U.S. dollar liabilitieswhich expandedthe monetarybase of many nationsand furtherfueled their own domesticinflation rates. Fourth, an acceleration of U.S. inflationcould have raised domesticexpectations of inflationdi- rectly, leading to higher wage and price increases.The channels were connected, since the direct effects of higher prices for tradablegoods, higherreal output,and higherexpected prices for nontradablegoods, all raised a nation'stransaction demand for money and, with freely mobile capital,attracted the internationalreserves needed to bringthe domestic moneysupply into equalitywith higher money demand. In the long rununder fixed exchangerates, then, policymakers in small countries should regard inflation as part of the external environment ratherthan under their own control. Domestic "wage push" by unions cannot contributeto domestic inflation;worker groups that achieve a highernominal wage when the price level is determinedabroad can raise theirown incomesonly at the expenseof unemploymentand lowerprofits, particularlyin the tradable-goodssector. Incomes policies designed to controlwage push may be able to influencethe unemploymentrate or the distributionof income,but not the inflationrate. But the internationalmonetarist's denial of a role for an autonomous wage push in the worldinflation process is not totallyconvincing, because the symmetrybetween tradable-goodsprices and domestic wages is ig- nored. Both are determinantsof domesticprices and the transactionde- mand for money. An autonomouswage push could raise the demand for money and, with perfectcapital mobility, suck in the reservesneeded to provide the base for a higher domesticmoney supply. If commodity arbitrageis perfect, the profitsof firmsin the tradable-goodssector will be squeezed,but there is some evidencethat commodityarbitrage is not 12. This is the primary channel of international transmission in the "Scandi- navian" model of inflation. See Gbsta Edgren, Karl-Olof Faxen, and Clas-Erik Odhner, "Wages, Growth and the Distribution of Income," Swedish Journal of Economics, vol. 71 (September 1969), pp. 133-60. Also Odd Aukrust, "Inflationin the Open Economy: A Norwegian Model," in Krause and Salant, eds., Worldwide Inflation,pp. 107-53. RobertJ. Gordon 415 perfect, at least in the short run.'3 The increase in domestic monetary growth would contribute to an acceleration in world monetary growth and in the world rate of inflation, particularly if an autonomous wage push were to occur in several countries simultaneously.

The Wage-Push, or "Sociological," Explanation

In its most extreme form, proponents of the wage-push view argue that the inflation rate depends entirely on the aggressiveness of labor unions in pressing wage demands. Peter Wiles has claimed, for instance, that "we have moved from wage claims based on the actual situation in the trade ... to claims picked out of the air...."14 The underlying source of wage push is viewed variously as a conflict over the fairness of the income distribution and wage structure; as the result of the rise of the tactics of the New Left and the decline of authority; and as a consequence of a communications revolution that increased awareness of foreign wage claims. The independent influence of money and aggregate demand is often viewed as negligible.'5 While money is sometimes rejected as a cause of wage behavior, changes in money are viewed as a consequence of wage push in many discussions. Sooner or later the central bank will have to raise the money supply in order to accommodate the higher transaction demand for money created by higher wages. Richard Cooper has made this point succinctly: The wage level in the modern economy is indeterminantbecause in the final analysisthe monetaryauthorities must-for political reasons-provide a money supply adequateto ratify any given level of money wages, no matter how it was reached,in orderto avoid excessiveunemployment.'6

13. See Irving B. Kravis and Robert E. Lipsey, "Export Prices and the Trans- mission of Inflation," American Economic Review, vol. 67 (February 1977), pp. 155-63. Also see Rudiger Dornbusch and Paul Krugman, "Flexible Exchange Rates in the Short Run,"BPEA, 3:1976, especially pp. 559-68. 14. Peter Wiles, "Cost Inflation and the State of Economic Theory," Economic Journal,vol. 83 (June 1973), p. 378. 15. A clear statement emphasizing the fairness issue is contained in John Hicks, The Crisis in KeynesianEconomics (Basic Books, 1974), chap. 3. 16. Richard N. Cooper, statement in "Commentaries"on paper by Thomas D. Willet, "The EurocurrencyMarket, Exchange-RateSystems, and National Financial Policies," in Carl H. Stem, John H. Makin, and Dennis E. Logue, eds., Eurocur- rencies and the International Monetary System (American Enterprise Institute, 1976), p. 252. 416 Brookings Papers on Economic Activity, 2:1977 Some British commentatorsadmit the monetaryconnection.'7 But this acknowledgmentis by no meansuniversal.'8 Severalinvestigators have found that wage equationsfor majorEuro- pean countriesrequire the use of dummyvariables to explainparticular episodes of sudden accelerationin the rate of wage change.'"While a significantpositive coefficienton a dummyvariable indicates only that somethingis happeningthat cannot be otherwiseexplained, the timing of the wage accelerationscorrespond to widely recognizedincidents of aggressivelabor behavior,particularly the Frenchgeneral strike of May 1968, andthe Italian"hot autumn" of 1969. The wage-pushexplanation has been universallycondemned by proponents of the international-monetaristview, but empiricalcritiques by internationalmonetarists have involved tests of unnecessarilyrestrictive versions of the sociological approach.For instance, any influence on wages of excess commodityor labor demandor proxies for inflationary expectationsis cited as negative evidence, implicitlyruling out a more eclectic frameworkin which both the aggressivenessof workers and conventionaleconomic variablesmight be influential.Further, tests by internationalmonetarists have measuredwage-push effects by including variablesrepresenting time lost in strikesrather than the dummyvariables cited earlier.To the extentthat workers achieve their wage aimsby threats of strikes that are not actually carriedout, wage push could exist but neverthelessbe uncorrelatedwith strike variables.20Unfortunately, this 17. Wiles, "Cost Inflation,"p. 385; Stephen Marris, "Panel Discussion: World Inflation,"in Claassen and Salin, eds., StabilizationPolicies in InterdependentEcon- omies, p. 303. 18. Aubrey Jones, for instance, argues that "a tightening of the supply of money is not, therefore, .. . a solution to the problem of rising prices," in The New Inflation:The Politics oj Prices and Incomes (London: Andre Deutsch, and Penguin, 1973),p. 39. 19. See in particular George L. Perry, "Determinantsof Wage Inflation,"especially table 4, p. 424, in which significant coefficients are found for a dummy for 1968 in France and for 1970 in Italy, West Germany, Sweden, and the United King- dom (a 1968 dummy for Japan is only marginally significant). A similar approach was followed by Erich Spitaller, who found significantdummy coefficientsin various periods for France, West Germany, and the United Kingdom; see "Semi-Annual Wage Equations for the ManufacturingSectors in Six Major Industrial Countries," Review of WorldEconomics, no. 2 (1976), pp. 300-37. 20. The most comprehensive tests of strike variables are presented in David Laidler, "Inflation-Alternative Explanations and Policies: Tests on Data Drawn from Six Countries," in Karl Brunner and Allan H. Meltzer, Institutions, Policies and Economic Performance (Amsterdam: North-Holland, 1976), pp. 251-306. RobertJ. Gordon 417 problemmakes it difficultto link puzzlingepisodes identifiedby significant coefficientson dummyvariables to any quantifiableproxy for labor militancy.

The Demandfor and Supplyof MonetaryAccommodation

Internationalmonetary effects and wage push are only two of the possible sources of inflation. A useful frameworkfor analysis of the sources of inflationis to distinguishfactors that create pressureon the centralbank to "accommodate"-that is, to react by raisingthe money supply-and factorsthat help to explainwhy the centralbank reacts as it does to these pressures.A "demandfor monetaly accommodation"is createdby domesticdemand shifts, domesticcost push, and demandand supply shocks from abroad.The "supplyof monetaryaccommodation" by the centralbank dependson the weightsin its countercyclicalreaction function, its own degree of independencefrom the government,and the extentof the government'sattempts to influenceits chancesfor reelection by manipulatingthe economy.21

THE DEMAND FOR MONETARY ACCOMMODATION When the real money supplyis held constant,an increasein domestic expenditureswill tend to alterinterest rates, whether its sourceis a change in consumer attitudes,business expectations,government spending, or tax rates. An increasein spendingshifts the "IS curve"of intermediate macroeconomictheory to the rightup a fixed"LM curve," and the central bankis forcedto raisethe moneysupply if it desiresto offsetpart or all of the increasein interestrates that would otherwiseoccur. Central banks may be under pressure not only from autonomous shiftsin demand,but also from autonomousincreases in wages and prices negotiatedin the privatesector, and from externalsupply shocks. At first glancethe motivationfor wage push may seem elusive,at least in a closed

Laidler has pointed out to me that strike variables were first used by British cost- push proponents,not by internationalmonetarists who were seeking to test the cost- push hypothesis. 21. A more formal and extended presentationof this framework is developed in Robert J. Gordon, "The Demand for and Supply of Inflation,"Journal of Law and Economics, vol. 18 (December 1975), pp. 807-36. 418 Brookings Papers on Economic Activity, 2:1977 economy, since prices are likely to be markedup over any autonomous wage increasesachieved by workers,leaving real wages unchanged.But workerswho "push"may achievean increasein theirreal incomerelative to holdersof assetswith returns fixed in nominalterms, workers who have less marketpower, and profitsof firmsin the tradable-goodssector. Sup- ply shocks-for example, crop failures or the formationof commodity cartels-are like any other type of cost push in creatingproblems for the monetaryauthorities, because a failureto accommodatewill createunem- ployment, while accommodationmay unleash an inflationaryspiral if workersattempt to maintaintheir original real wage levels intact. Internationalcapital mobility may emboldenworkers and otherscon- sideringan autonomouspush, since theirown actionscan directlyinduce a rise in the money supply by pulling in internationalreserves. In this case the push is automaticallyaccommodated. Only when capitalis less than perfectlymobile can the central bank attempt to sterilize part of the reserveinflow by open-marketsales of its domesticassets, a restrictive rediscountpolicy, or an increase in the reserve requirementsof com- mercialbanks.

THE SUPPLY OF MONETARY ACCOMMODATION AND THE MONETARY REACTION FUNCTION The mere existenceof pressureon the centralbank does not implythat it will act either to accommodateor to resist. A central bank following Friedman'srule of a constantgrowth rate for the money supply would ignore such pressuresentirely. More likely, a central bank will attempt to vary the growthof the money supply,or some other monetaryinstru- ment over which it believes it has more direct control, with the aim of maximizinga social-welfarefunction. Higher unemploymentand inflation, andlower foreign-exchange reserves, are all evils thatmay be resisted by countervailingshifts in monetarypolicy. Two sets of conflicts constrainthe reaction of policymakers.First, even an idealisticattempt to maximizesociety's welfare collides with the incompatibilityof short-run improvementsin unemploymentand in inflation,or in unemploymentand in the foreignbalance. Wage push and supply shocks allow no easy solutions, for a centralbank must choose whetherto resisttheir stimulusto inflationby contractingor to resistun- employmentby expanding. RobertJ. Gordon 419 Second,"idealistic" weights on targetvariables derived from economic theory may conflict with "popularity"weights motivated by political expediency.Evidence of a substantiallag of inflationbehind changesin unemploymentintroduces a distinction,stressed by Lindbeck,between short-runtargets, which maximizevotes for an incumbentgovernment's reelection,and long-run targets, which maximize economic welfare.22

A Frameworkfor EmpiricalTesting

The generalframework developed in the precedingsection identifies a large number of variablesupon which the behavior of the domestic money supplymay depend-private and governmentexpenditures, wage push, foreignprices, international reserves, domestic unemployment, and inflation.23The aim of the empiricalsection is to determinewhether any of the componenthypotheses can be confirmedor denied,for the United States, for the "OtherSeven" (the aggregateof seven major industrial countriesbesides the United States), or for any of the seven countries individually.

CHAINS OF CAUSATION The central task of the empiricalwork is to estimate an equationin whichthe growthrate of the moneysupply is the dependentvariable, and the set of independentvariables includes those claimed above to be possible determinantsof central-bankbehavior. In addition to the money equation,equations with the growthrates of wages and prices as alternative dependentvariables are estimated,in order to assess the role of autonomouswage push as a source of inflation.Table 1 lays out the expectedpattern of signs on coefficientsin equationsexplaining the behaviorof the money supplyand domesticwages, accordingto the various subhypotheses.

22. Assar Lindbeck, "StabilizationPolicy in Open Economies with Endogenous Politicians," American Economic Review, vol. 66 (May 1976), pp. 1-19. See also William D. Nordhaus, "The Political Business Cycle," Review of Economic Studies, vol. 42 (April 1975), pp. 169-90. 23. Another factor, emphasized by Nordhaus, Lindbeck, and others, is the timing of elections. Although political dummy variables are included in the money equations estimated below, space limitations require that a full consideration of the political hypothesisbe postponed for another paper. o b 0 +~-H +

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-.-C4 Cf 4 ~ 6.6 RobertJ. Gordon 421 For instance,the first column lists the patternof signs in the money equation predictedby the international-monetaristview. Consider the responseof the economy to a foreign demand shock, the type of event that the international-monetaristapproach blames for the worldwide accelerationof inflationin the late 1960s and early 1970s. Higherforeign demand stimulatesboth higher domestic output and higher tradablegoods prices. The simultaneousincrease in reserves is partly a direct result of the trade surplus, and partly an indirect result of the higher demand for money induced by both the price and output effects. A money-supplyequation should exhibit positive signs on currentor lagged determinantsof money demand,particularly domestic prices and output. Because of the focus here on the aftereffectsof autonomouswage movements, the domesticprice index is proxiedin table 1 by the combination of tradable-goodsprices and domestic wages. The role of international reservesis to identifythe effect on money-supplygrowth of shifts in the demand for money caused by factors other than tradable-goodsprices and domesticoutput and wages. The absenceof a positive sign on internationalreserves in the money equationsuggests the possibilitythat central banks succeed in varyingtheir domesticassets to offset reserveflows and thus manageto sterilizesome shifts in the demandfor money. This wouldtend to deny that the supplyof moneyis determinedexclusively by the demandfor money. A positive sign on internationalreserves is consistentnot only with the international-monetaristapproach, but also with the countercyclical-ac- tivist view that an inflow of reservesallows a centralbank to pursueits domestic price and output objectivesin a more expansionarydirection than would be possible if reserveswere being lost. The countercyclical activists(column 5) would also expectthat an increasein the growthrate of real outputshould lead to a reductionin the growthrate of the money supply.As for the variablesreflecting nominal wages and tradable-goods prices, the coefficientin the money-growthequation can be positive but shouldbe significantlysmaller than unity (so that a wage or priceacceler- ation is allowedto cut the level of real balances). Some interpreters,particularly those identifiedwith the international- monetaristcamp, have tested a restrictiveversion of the wage-pushapproach which requireswage behaviorto be entirelyindependent of any macroeconomicvariables. A broaderview is that autonomousforces are capable of shiftingthe rate of wage change, given domestic and world 422 Brookings Papers on Economic Activity, 2:1977 prices, domestic output, and monetary growth. Two versions of this broaderwage-push approach are listed in separatecolumns in table 1: a wage push that is subsequentlyaccommodated by the central bank (column7), and a wagepush that is not accommodated(column 8). The positive signs on line 7 in columns7 and 8 representthe crucialautono- mouswage-push effect. Since this autonomousinfluence is deniedby most adherentsto the international-monetaristview, a zero coefficientis entered in column6 on line 7. But evidenceof an autonomouswage push, in the form of significant positive coefficientson appropriatedummy variables in the wage equation, is not sufficientto validate the wage-pushapproach as a theory of inflation.First, the higher level of wage rates may cause a squeeze on profitsrather than an increasein prices. This possibilitymay be greatest for a small, open economy and may result if the centralbank does not providethe money to accommodatethe wage increase.It is treatedas a separatesubhypothesis regarding the money equationin table 1 in the columnreflecting wage push without monetary accommodation (compare columns2 and 3). Not only is the coefficienton wage ratesin the money equation equal to zero (line 2), but for consistencythe money supply shouldnot respondto increasesin tradable-goodsprices either (line 4).24 Shiftsin domesticdemand may lead to monetaryaccommodation if the centralbank is attemptingto stabilizeinterest rates. While private shifts in the IS curve are difficultto measureempirically, it is possible to include an estimateof the full-employmentfiscal deficitas an additionalvariable in the money equation,with a sign expectedto be positiveif deficitfinanc- ing has contributedto episodesof monetaryacceleration, as in column4. The overviewin table 1 suggeststhat distinguishingthe international- monetaristview from the subhypothesisof wage-pushwith monetaryac- commodationmay be ratherdifficult. Joint feedbackbetween money and wage rates is admissibleunder eitherapproach, as indicatedby the positive coefficientson wages in the money equationand money in the wage equation.Nevertheless, the signson coefficientsin table 1 indicatethat the frameworkcan still yield interestingconclusions: 1. Zero coefficientson internationalreserves in the money equation would tend to raisethe probabilitythat centralbanks were able to sterilize

24. Since consistency is not a necessary feature of the policies of columns 2 and 3, the entries on traded-goodsprices in those columns are enclosed in parentheses. RobertJ. Gordon 423 changesin the demandfor money that attractedreserves, suggesting ex- ceptions to the international-monetaristassumption that the domestic money supplyis determinedexclusively by the demandfor money. 2. Zero coefficientson dummyvariables in wage equationsin periods when wage push is allegedto have occurredwould tend to deny the rele- vance of the wage-pushhypothesis and to confirmthe negativeverdict of previousempirical tests of that view producedby the international-monetaristcamp. 3. Nonpositive coefficients on wage rates in the money equation, togetherwith positivewage-push dummy coefficients, would tend to indicate that any episodesof wage push were not accommodated,a view that is consistentwith columns3 and 8 of table 1. 4. Negativecoefficients in the money equationon domesticoutput, or positive coefficientsbelow unity on wages and tradable-goodsprices, would tend to confirmthe countercyclical-reactionapproach and provide evidenceagainst destabilizing accommodation. 5. Positive coefficientson the full-employmentdeficit would tend to confirm the deficit-financesubhypothesis without denying any of the others. The patternof signs in table 1 can be viewedfrom a broaderperspec- tive. First, the money equationprovides a test of whetherchanges in the money supply are truly exogenous,dependent only on the fixed aims of the centralbank, or the centralbank reactssystematically to eventsin the economy (in which case econometricequations that treatthe money supply as exogenousyield biasedcoefficients). Both internationalmonetarists and wage-pushproponents expect that the monetaryauthorities will behave passively,allowing an accelerationin monetarygrowth in response to a higherdemand for money,whereas those who view the authoritiesas a centralcomponent of an activiststabilization policy hope that negative coefficientswill emergeon the outputratio and zero or small positiveco- efficientswill be attachedto changesin nominalwages and tradable-goods prices.

TESTS FOR EXOGENEITY AND FEEDBACK Empiricaltesting requires attention both to the signsof coefficientsand to timingrelationships. In an influentialarticle Christopher Sims proposed testingfor patternsof feedbackbetween a pair of variablesby running 424 Brookings Papers on Economic Activity, 2:1977 two regressions,with each as dependentvariable and both leading and lagged values of the other as independentvariables.25 Significant coeff- cients on the leading values of a right-handvariable indicate that it is endogenous,influenced by feedbackfrom the left-handvariable. A second method, which was originally proposed by Granger and which Sims has recently implementedfor the United States and West Germany,also involvesestimation of a separateequation for each endogenous variablebut substituteslagged values of the dependentvariable for leadingvalues of the independentvariables.26 Now a dependentvariable is identifiedas exogenousif the coefficientson all the currentand lagged values of the independentvariables in its equation are zero. A separateequation is estimatedfor each variableof interest.For instance, the hypothesisthat the money supply is truly exogenous, and not determinedby feedbackfrom any of the economicvariables listed in table 1, would requirethat all of the coefficientson currentand lagged values of those variablesbe insignificantlydifferent from zero in an equation with money as the dependentvariable. Because all variablesof interest are includedon the right-handside of each equation,some are bound to be endogenous.Once it is determinedthat a variable,say money, is sub- ject to feedbackbecause some right-handcoefficients in its equationare nonzero,it then becomespossible that the coefficientson money in other equationsare biased. This limitationmust be recognizedin interpretations of individualcoefficients in the regressionresults presented below. Severalfactors lead to the choice of the second methodin this paper. First,the inclusionof laggeddependent variables allows serialcorrelation to be purged,in contrastto the disadvantagesof the arbitrary"prefilter- ing" performedby Sims in his oft-cited use of the first method. Second, the first method is extremelyclumsy to use in multivariateapplications, since both leading and lagging terms must be included for each independentvariable; as a result, degrees of freedom are rapidlyexhausted. Third,equations with leading variables cannot be subjectedto postsample extrapolationexperiments, which are often of interestto determinehow well a given set of currentand lagged right-handvariables account for

25. ChristopherA. Sims, "Money, Income, and Causality,"American Economic Review, vol. 62 (September 1972), pp. 540-52. 26. See C. W. J. Granger, "InvestigatingCausal Relations by Econometric Mod- els and Cross-SpectralMethods," Econometrica, vol. 37 (July 1969), pp. 424-38. Sims'recent work is not yet available for distribution. RobertJ. Gordon 425 movementsof a dependentvariable after the end of a given sample period.27 To controlits length, the paper containsequations for only three dependentvariables for each country,the nominalmoney supply, wage rates, and the deflatorfor gross nationalproduct (or gross domesticproduct), all expressedas quarterlyrates of change. Primaryemphasis is placed on the money and wage equations.A price equationis estimatedonly to examinethe extent to which domestic prices respondedduring alleged episodesof wagepush.28

DETAILED SPECIFICATIONS The equationspecifications have severalimportant features.29 1. In light of recent evidence that U.S. wage behavior can be explained as well by the gap between actual (Q) and potential (Q*) real GNP as byvariousunemployment concepts, I decidedto use a singlevari- able, the "outputratio" (Q/Q*), as a proxyfor the effectsof real output and labor-marketconditions in the money, wage, and price equations.-0 Because the level of money should be related to the level of Q/Q*, the equationfor the rate of changeof money uses as an independentvariable the rate of changeof Q/Q*. On the other hand, the traditionalPhillips- curvehypothesis postulates that the rate of changeof wage rates depends on the level of excess labordemand, so the level of Q/Q* was used in the equationsfor the wagerate and the pricedeflator. 2. There is no reason that an "automaticstabilizer" increase in the fiscal deficit caused by a recessionshould put pressureon the monetary authority.Thus as a proxy for the full-employmentdeficit, the fiscal-

27. I am grateful to Robert Hall for urging me to switch to the second method after a preliminarybout with the leading-variabletechnique. 28. The price equation includes two sets of current and lagged wage variables: (1) the contribution of the dummy variables in the wage equation, and (2) wage change minus the dummy contribution. If the two sets of coefficients are identical, then all wage changes alter prices in the same way, whereas a zero coefficient on the dummy contributionwould indicate that the autonomous wage movements identified by the dummy variablesdid not influenceprice change at all. 29. Readers are referred to the data appendix, available from the author on request, for a detailed account of the construction of the data file developed for this project. 30. Robert J. Gordon, "Can the Inflation of the 1970s Be Explained?" BPEA, 1:1977, pp. 253-77. 426 BrookingsPape-s on Economic Activity, 2:1977 deficit variablethat is enteredinto the money equationsis the residual from a separateequation (not exhibitedbelow) that explainsthe actual fiscal deficitas a functionof a constant,seasonal dummies,and current and laggedreal GNP. 3. The "basic equations"are uniformly estimated for the sample period 1958:3 to 1973:1. The first quarteris determinedby the need to includelagged variables and by the 1957:1 startingdate of the data file. The last quartermarks the initiationof the system of flexible exchange rates. Interestingfeatures of the 1973-76 intervalare identifiedboth by examinationof the residualsof a postsampleextrapolation, and by reesti- mationof an auxiliaryequation for the full 1958:3-1976:4 period.Shifts in coefficientsbetween the basic and auxiliaryequations can be examined for evidenceof changesin structurein the periodof flexiblerates. 4. The auxiliaryequations for the rate of changeof the money supply all include as an additionalvariable the rate of change of the exchange rate betweeneach countryand the U.S. dollar, enteredin the form of a multiplicativedummy equal to zero through 1973:1 and to itself there- after. 5. Four lagged dependentand independentvariables are includedin the wage and price equations, and three lagged dependentand independentvariables are included in the moneyequations. 6. For most countriesthe dependentvariable in the money equation is M1.Early investigationspointed to massiveshifts between demand and time deposits in Canadaand France in 1967-68 as a result of banking reforms,and so M2was usedfor thesetwo countries. 7. Preliminaryresults indicated that the coefficienton internationalre- servesin the money equationshould be allowedto shift at least once during the sampleperiod. Thus separatecoefficients on reservesare estimated in the money equationsfor 1958:3-1965:4 and 1966:1-1973:1, as well as for 1973:2-1976:4 in the auxiliaryequations. The breaksfor Canada are 1962:2 and 1970:2, correspondingto the end of the firstexperiment with flexiblerates and the beginningof the second.

THE ROLE OF DUMMY VARIABLES The use of dummyvariables in the empiricalresults may requirejusti- fication. The practice is generally accepted as legitimatewhen some a priorireason suggeststreating a particularperiod as unique. But it can RobertJ. Gordon 427 be questionedwhen the choice of time periodsis arbitraryor based on a preliminary"peek" at the data. By this criterion the use of seasonal dummyvariables in all equationsqualifies on the a priori criterion,but the wage-pushdummies cannot enter any such plea of innocence.Even if particularevents that mighthave causeda wage push can be identified- for example,the Italian "hot autumn"of 1969-there is no a prioricri- terion to determinehow long the effect on wage rates mighthave lasted. With simultaneous,centralized, nationwide bargaining, the entire effect might occur in one quarter.With other bargainingmechanisms, it could be spreadover severalquarters. Because the precise timing of the wage-pushdummies in some cases was of necessitydetermined by "peeking"at the data,separate versions of the wage equationswith and without the wage-pushdummies are exhibited. Although some readers might have preferredthat the use of wage-pushdummies be replacedby a detailedexamination and discussion of individualresiduals, this approachwas rejectedin orderto avoid bias- ing other coefficientsin an equationin which "true"specification involves dummies.In fact, the inclusionof dummyvariables does generallyalter the coefficientson othervariables in the wage equationspresented below.

STRIKING FEATURES OF THE BASIC DATA Figure 1 displaysfour-quarter overlapping rates of changeof money, wage rates, and the price deflatorfor the United States, for a weighted averageof the OtherSeven, and for the World,consisting of the United Statesand the OtherSeven.31 The most strikingaspect of the figureis the differencebetween the international-monetaristparable and the actual behaviorof the averagefor the World and for the Other Seven. There appearsto be only a very loose relationbetween World wage and monetary changesbetween 1958 and the end of 1972. The rate of wage change was essentiallyconstant between 1960 and 1966, and showedno response to the temporaryacceleration of money in 1963-66. Further,monetary behaviorappears able to explainlittle of the doubling of wage changebe- tween late 1967 and mid-1970, since the averagerate of money growth during 1967-69 (7.1 percent) differedlittle from that in 1963-66 (6.8 percent). On the otherhand, the lead of wage changerelative to the monetaryacceleration of 1970-71 suggeststhat at least partof the behaviorof 31. The weights are currentshares of real GNP in U.S. dollars. 0~~~~~~~~~~~~~~~. 0

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ch) do~~~~~~) * V. (.~~~~~~ 0 . 2~~~~~V C4~~~~~~~~~~~~~~~~~~~~~~~4 430 Brookings Papers on Economic Activity, 2:1977 Table 2. Coefficientsand t Statisticsfrom Two-WayRegressions on WorldMoney and Wages, and on WorldMoney and Pricesa Independentvariable Lag on independent Money in Money in Wagein Price in variableand wage price money money regressionstatistic equation equation equation equation (1) (2) (3) (4) Lag Currentperiod -0.043 0.016 -0.371 0.197 (-0.87) (0.38) (-0.87) (0.38) One period -0.034 0.050 -0.331 -0.875 (-0.68) (1.36) (-0.71) (-1.60) Two period 0.009 0.043 0.770 -0.647 (0.16) (1.06) (1.58) (-1.35) Three period 0.001 0.006 1.683 0.588 (0.01) (0.15) (3.52) (1.12) Four period -0.036 0.055 -0.876 1.834 (-0.85) (1.48) (-1.66) (3.47) Regressionzstatistic Sum of coefficients -0.103 0.170 0.873 1.097 (-0.98) (1.95) (0.82) (0.95) Standarderror (percent) 0.266 0.229 0.777 0.808 Sources: See discussion in text. a. All variables are one-quarterpercent changes. All equations include in addition a constant term, three seasonal dunmuyvariables, and four lagged values of the dependent variable. The sample period for all regressions in this table is 1958:3-1973:1.

money in this period might be explainedby passive accommodationto wagechange. Althoughthe primaryfocus of this studyis on chainsof causationand timing relationshipsbetween money and wages in the eight individual countries,table 2 displaysthe resultsof simpleregressions relating wage, price,and monetary rates of change.As in all regressionsestimated in this paper, four lagged values of the dependentvariable are included,so the dependentvariable is consideredexogenous and influencedonly by its own past values if the coefficientson all of the independentvariables are zero. Table2 exploresthe international-monetaristcontention that the world inflationrate dependson previousvalues of world monetarygrowth. In fact, only in the price equation (column 2) is the sum of money coeffi- cientsstatistically significant, although the sum of coefficientsis muchtoo small to be consistentwith the long-run neutralityof world monetary change.But the resultsin column 1 do not appearat all consistentwith a RobertJ. Gordon 431 monetaryexplanation of wage behavior.Moreover, although the sum of coefficientson wages and prices in the two money equationsis insignificant in columns3 and 4, it is quitelarge, and one coefficientin each equation is very stronglypositive. Thus the exogeneityof the world rate of monetarygrowth is not strongly supported,and the possibilityis suggested that exogenous wage movements generated passive monetary accommodation. Anotherinteresting feature of figure 1 is the divergenceof monetary- growthrates in the United Statesand the OtherSeven. While the growth rate of money acceleratedin the United States between 1962 and early 1969, that in the Other Seven deceleratedbetween late 1963 and early 1970. And thoughthe explosiveperiod of monetarygrowth in the Other Seven betweenlate 1970 and early 1973 does correspondto a period of relativelyrapid U.S. monetarygrowth, the previousperiod of acceleration in the United Statesduring 1967-69 was accompaniedby relatively low monetarygrowth rates in the OtherSeven. Again this patternis consistentwith the hypothesisthat the United Stateswas not the sole engine of world monetarygrowth, and that domesticwage behaviorwithin the OtherSeven played some role in the 1970-71 monetaryacceleration.

Summaryof Basic Results

The signs and significanceof several of the more interestingcoeffi- cients in wage and money equations for individual countries and the aggregatefor the OtherSeven are listed in table 3. The tablestarts with the United States and the weighted average of the Other Seven, and con- tinues with the results for each of the Other Seven countries.The signs (+, 0, or -) referto the sumsof coefficientsof the independentvariables, and the superscriptsa and b indicatestatistical significance (using a one- tailedtest) at the 10 percentand 5 percentlevel, respectively.A signwith- out a superscriptstands at only the bare marginof significance,the 20 percentconfidence level.

WAGE-PUSH, INTERNATIONAL RESERVES, AND MONETARY ACCOMMODATION The basic messageof the resultsis that, while no simplesubhypothesis accuratelydescribes the behavior of money and inflationin all of the V-4

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0, 't) Ca ed Ck..z.-u ;I1%100 cr 0 0 - C %O 0 O - PC . . - I ., -1 .0 6 z C's c4 E 0 0 I Do (L) El Cd 41 g -g s k. re E C .0 ,* - B: Do cd 0 - 5 0 0 0 ::1 CTJ 0 lz . :s cn'CA Zo : cd .6 C; -6 'd as .6 0 0 Aq w 'i ji j or. .6 4sZ cli cli & RobertJ. Gordon 433 eight countries,nevertheless the internationalmonetarists fare betterthan the wage-pushgroup. The coefficienton internationalreserves in the secondhalf of the sampleperiod in the moneyequation (1966:1-1973: 1) is stronglypositive in three of the importantcountries, West Germany, Japan, and the United Kingdom,indicating that central banks in these countrieswere unable completely to sterilize shifts in money demand. Furthermore,in each of these three countries (as well as in the United Statesand France) money has a positiveinfluence on the behaviorof the wage rate.The explosionof growthin worldreserves during the 1970-72 intervalthus appearsto have contributedto an accelerationof growthin the moneysupply and indirectlyto an accelerationof wagegrowth. The wage-pushhypothesis appears to be alive and well as an explanation of wage rates,but not as a theoryof inflationor of monetarygrowth. Largepositive coefficientson wage-pushdummy variables emerge in the price equation for various periods in the Other Seven average, and in France, West Germany,Italy, Sweden, and the United Kingdomtaken separately.The inflationaryimpact of the autonomouswage movements is measuredin a price equationthat containstwo wage variables(each entered as a currentvalue and four lags): first,the actualrate of changeof wages minus the contributionof the dummyvariables in the wage equation, and second, the contributionof the dummyvariables themselves. For the OtherSeven as a group,the coefficienton the dummycontribution is close to zero, as comparedwith a coefficienton "normal"wage changes of close to unity. Only in the United Kingdomis the coefficienton the dummycontribution not only as large as the normalcoefficient, but also statisticallysignificant. In France,West Germany,Italy, and Sweden,the coefficienton the dummycontribution is largerthan the normalone. How can the generallysmall values of the sum of wage coefficients in the money equationsbe reconciledwith the appearanceof feedback from wages to money in the equationfor the world as a whole (table 2, column 3)? The world responselies between the small response of the OtherSeven and the large sum of coefficientsfor the United States.Thus passive monetary accommodationin the world appears to have been centeredin the very countrythat exhibitsno sign whatsoeverof autonomous wage push. Only in the United Kingdomdo the results display all of the ingredientsrequired for wage push to be a valid theorynot only of wages but also of continuinginflation; but, as discussedbelow, even this "victory"for wage push is temperedby the findingthat the 1970 wage 434 Brookings Papers on Economic Activity, 2:1977 push in the United Kingdomwas not autonomousat all, but ratherap- pearsto havebeen a postcontrolsrebound. In general,the behaviorof monetaryauthorities in differentcountries has little in common, and no single subhypothesisreceives strong confirmation.The Japaneseappear to be inconsistent,pursuing a counter- cyclicalpolicy relativeto the outputbusiness cycle while simultaneously accommodatingfiscal deficits.The Japanesemoney supplyreacted posi- tivelyto inflowsof reserves,a resultconsistent with both the internationalmonetarist and countercyclical-activistapproaches. Sweden exhibits countercyclicalbehavior, while money in Italy and Britain appearsto fluctuateprocyclically. Both the Germansand the Canadiansare inconsistent, resistinghigher prices of traded goods but allowing the growth rate of the money supplyto rise in responseto higherwage rates.A positive coefficient on a nominal variable does not indicate destabilizing behaviorin the money equationunless its value exceeds unity; by this criteriononly the United Statesand Sweden (and the United Kingdomin the extendedsample period) exhibita destabilizingresponse of moneyto wagechange. In several countriesthe intemational-monetaristcase is bolsteredby the significantlypositive coefficientson moneyin the wage equation.Yet the resultssummarized in table 3 understatethe monetaryeffect, because some of the procyclicalcorrelation of money and wages is soaked up by the output-ratiovariable. When the output ratio is omitted from the basic wage equation, the money coefficientsbecome larger in several countries.2 This result denies the extreme wage-pushview that wage

32. The money coefficients and t ratios (in parentheses), with and without the output-ratiovariable, are as follows: With output Withoutoutput United States 0.258 (3.04) 0.327 (4.15) Other Seven 0.209 (1.58) 0.156 (1.11) Canada -0.049(-0.43) 0.019 (0.17) France 0.593 (2.61) 0.526 (2.48) West Germany 0.430 (1.36) 0.702 (2.52) Italy 0.179 (0.77) 0.212 (0.94) Japan 0.172 (1.12) 0.171 (1.00) Sweden -0.260(-1.99) -0.024(-0.22) United Kingdom 0.652 (2.89) 0.706 (3.55) The decline in the coefficientfor the Other Seven is puzzling, in light of the increase in the average coefficientof the seven individualcountries from 0.25 to 0.33. RobertJ. Gordon 435 claims are "pickedout of the air" and are totally independentof market forces, but is consistentwith a more eclecticview that both marketforces and autonomous"push" episodes matter for wagebehavior.

DetailedResults by Country

Tables4 through12, groupedtogether at the end of the paperfor easy reference,present the detailed empiricalresults. There is one table for each country,and one for the aggregateof the OtherSeven. The firsttwo columns of each table present equationsin which the quarterlyrate of change in the money supply is the dependentvariable, with the shorter sample period through 1973:1 in column 1 and the extended period through1976:4 in column 2. The next three columnspresent wage-rate equations,with the short sample period in column 3, and with control and wage-pushdummy variables added in column4 for the shortperiod, and in column 5 for the extendedperiod. Finally, a single equationfor price change is presented in column 6.

THE UNITED STATES A vast amount of empiricalwork on "St. Louis equations"in the United States has treated the rate of growth of the money supply as exogenous in equations explainingthe growth of nominal GNP. Sims' paper confirmsthe exogeneity of money in a simple bivariatetest on the money supply and nominal income.34This result appearsto be re- peated in column 1 of table 4 for the United States,in the sense that no sum of coefficientson any independentvariable is significant,even at the 10 percentlevel. On the other hand, the sum of coefficientson the wage rate is very large, and one of the individualcoefficients has a t ratio of 3.6. A Tinbergenanalysis indicates that the wage variable does contribute almost all of the explanationof the accelerationof monetary growthin 1964-68.35It is the zigzagplus-minus pattern of the wagecoeffi- cients that reducesthe significanceof the sum of coefficients,suggesting

33. The set-up of table 6, for Canada, is slightly differentbecause no wage equations with dummy variables for the 1958-73 period were estimated for that country. 34. Sims, "Money,Income, and Causality,"p. 547. 35. The contributionof the wage terms rises from an average of 1.23 percent per quarterin 1964 to 3.73 percent in 1968. 436 Brookings Papers on Economic Activity, 2:1977 that monetarygrowth respondedin this period to the accelerationof wage growth, and less to the rate of growth of wages by itself.86 The most interestingfeatures of the U.S. wage equationsare the strong role of moneyand of dummyvariables for guidepostand restraint periods. The significantnegative coefficientson the guidepost dummiesconfirm earlierresults, of Perry and others, and so does the patternof the other dummyvariables in general.When the effects of all three dummiesfor the 1971-75 periodin the extendedwage equationin column5 are cumu- lated, the sum of 0.18 percent indicates that the rebound more than canceledthe mild restraininginfluence of the controls.The bottom line in the table lists the postsamplecumulative extrapolation errors for three of the equations.These errorsare remarkablysmall, both relativeto my previouswork on "structural"wage and price equations,and compared to the resultsfor some of the other countries.

THE OTHER SEVEN The moneysupply in the OtherSeven appears to have been exogenous, with no significantsum of coefficients on any independentvariable. Despite the positive coefficientson internationalreserves in the money equationsof several importantcountries, the money equation for the OtherSeven bases its explanationof the 1970-73 money explosion (see figure 1 ) on a lagged response to changes in wage rates and tradablegoods prices. This in turn leads to horrendouspostsample extrapolation errors,as the equationpredicts huge rates of monetarygrowth, of 25 to 30 percentin 1974-75, in responseto the 1974 accelerationin wage rates and tradable-goodsprices. The large positive coefficienton the fiscal deficitalso leads to an expectationof rapidmonetary growth, in contrast to the decelerationthat actuallyoccurred. The wage and price equationsin the OtherSeven are more reasonable andinteresting. As in the UnitedStates, money and dummyvariables play a relativelystrong role, althoughhere most of the significantdummy variables have positive coefficientswhich supportthe wage-pushsubhypo- thesis, ratherthan the predominantlynegative coefficientsobserved for the United States. It is importantto note that the significanceof money 36. The coefficienton the fourth lag is strongly negative. The sum of coefficients on the currentvalue and first three lags is 3.87 with a I ratio of 2.53. Figure 1 reveals the lead of wages relative to money in late 1965, and the contemporaneous movements in late 1968, mid-1970, and early 1971. RobertJ. Gordon 437 in the wage equationfor both the United States and the Other Seven evaporatesif the dummy variables are omitted (column 3). Thus one cannotclaim both that dummy variables are unimportant or inappropriate and that money is an importantdeterminant of wage change. The tradi- tional Phillips-curveeffect, in the form of a positiverelation between the rate of changeof wages and the level of the outputratio, shows up more strongly for the Other Seven than for the United States in column 4. Traded-goodsprices also are more important,as would be expected. The wage-pushdummy variables are chosen for the same periods as in the majorindividual countries and are significanton lines 10c and 10d. But this lends little supportto the wage-pushhypothesis, because there appearsto have been no significantpositive impactof these autonomous episodesof wage changeon the price deflator,or of wage ratesin general on the money supply. The relatively strong positive impact of moneysupply growthon wages supportsthe internationalmonetarists. But the directeffect of moneyon pricesis negative.Combining the estimatedrole of money in the wage and price equationsfor the OtherSeven indicates that morethan half of the impactof money on wage changedoes not feed throughto pricechange.

CANADA The Canadianmoney equationsdiffer from the othersby splittingthe reserves variable accordingto the dates when Canada terminatedand reinstatedfloating exchange rates, and also by includingthe exchange rate as a variablethroughout the sampleperiod. Further,in light of previous resultsand the overalldomination of the Canadianeconomy by the United States, each Canadianequation includes as an independentvariable the correspondingquantity in the United States.87The resultsyield few significantcoefficients that would deny the exogeneityof the Canadian money supply. The influenceof the U.S. money supply is surprisingly weak in light of the commonperiods of monetaryrestriction in the two countriesm 1959-60, 1969-70, and 1974. No dummy variables are included in the basic Canadianwage and price equations.U.S. wages and priceshave relativelyweak effectsin the expecteddirection. In the extendedwage equationthrough 1976 (column 37. See, for instance, Spitiller, "Semi-AnnualWage Equations for the Manufac- turingSectors." 438 Brookings Papers on Economic Activity, 2:1977 4), a dummyvariable is includedfor the Canadianpolicy of wage and price restraintsannounced in October 1975. The equation,which relies on the U.S. wage andtraded-goods prices for almostall of its explanation of Canadianwage behavior,attaches a stronglypositive coefficient to this dummyvariable. This perverse result apparently identifies the acceleration of wages in Canadarelative to the United States that promptedthe re- straintprogram rather than the positive effects, if any, that the program had.

FRANCE France appearsto have pursueda relativelycountercyclical monetary policy. The negativesums of coefficientson the outputratio and traded- goods prices tend to confirmthe OECD narrativeof phases of French monetarypolicy which attributesrestrictive measures introduced in 1963 andlate 1968 to a reactionto the accelerationof inflationin those periods. Partiallyoffsetting this verdict is a relativelylarge, albeit insignificant, sum of coefficientson wage rates.An inspectionof the data indicatesthat the mid-1968 episode of autonomouswage increasewas initiallyaccom- modated,but that within six months monetarypolicy had shifted to a stanceof restriction. Another interesting feature of the French money equation is the absenceof any accommodationof reserveinflows. The expectedpositive correlationbetween money and international reserves in 1971-72 is offset by a dramaticnegative correlation in 1968-70, when the initialmonetary accommodationof the 1968 wage push causedmassive reserve outflows, followedby a devaluationin August 1969, a periodof tight money, and a reserveinflow. Another factor breakingthe positive correlationbetween reservesand money was the mild restrictionand a decelerationin monetary growth achievedby the French in late 1971, the period of maxi- mumaccumulation of reserves.38 The wage equationof column 4 introducestwo dummyvariables, the secondof whichreduces the standarderror of the equation.The restraint dummyrefers to the eight quartersof 1964 and 1965, when a mild form of incomes policy was in effect.39The wage-pushdummy is in effect in 38. This restrictivereaction to the capital inflow is noted in Organisationfor Eco- nomic Co-operationand Development, Monetary Policy in France, Monetary Studies Series (Paris: OECD, 1974), p. 46. 39. Lloyd Ulman and Robert J. Flanagan, Wage Restraint:A Study of Incomes Policies in Western Europe (University of California Press, 1971), pp. 161-63. RobertJ. Gordon 439 1968:2 and 1968:3 and reflectsthe impactof the June 1968 Protocole de Grenellewhich resultedin a nominalwage increaseof 11 to 13 percent in manufacturingin the aftermathof the May generalstrike. The price equationtends to supportthe wage-pushapproach, since the contributionof the dummy-variablecoefficients to price changewas even greaterthan that of "normal"wage increases.But the wage-push episodedid not lead to a continuinginflation because the final ingredient requiredfor that development-a continuing accommodationby the centralbank-was not present. By early 1969 the net influenceof the countercyclicalcoefficients in the money equation-not just the negative coefficientson traded-goodsprices and the outputratio, but also the positive coefficienton reserves-had swampedthe influenceof the positive coefficienton wages.

WEST GERMANY The standardexplanation of the explosionin Germanmonetary growth between 1970:4 and 1973:1 is the flood of dollar reserves into the Bundesbankbeginning in early 1970; and the adventof the flexible-rate systemis usuallycited as the factor that allowedthe Germansto "regain control"of their money supplyin early 1973. Indeed, the statisticalsig- nificanceof the second reservesvariable is greaterin the Germanmoney equation(table 8, column 1, line 8b) thanit is for any othercountry. But an inspectionof the other coefficientssuggests that the story of German monetarymovements is more complex than the simple international- monetariststory about a helplessly passive central banker drowningin dollars.Explaining the total accelerationin the four-quarterrate of change of money from 5.77 percentin 1970:3 to 13.41 percentin 1971:3, the equationassigns almost as much responsibilityto the 1969-70 wage ac- celerationas to the 1970-71 inflow of reserves.40This single episode of monetaryaccommodation stands in sharp contrastto the evidencethat duringmost of the rest of the sample period the centralbank operated accordingto a simple countercyclicalreaction function, inauguratinga restrictivepolicy whenthe inflationrate began to accelerate.The equation picks up this countercyclicalbehavior by assigninga large negative co- efficientto the changein traded-goodsprices, which makes a substantial 40. Over the same period the contributionof the wage terms to the four-quarter rate of change of money rises by 5.23 percent, and of the reserve terms by 6.72 percent. Since this overexplainsthe actual acceleration, the contributionof the other terms decreases. 440 Brookings Papers on Economic Activity, 2:1977 negativecontribution in each of the phaseslabeled as "restrictive"by the OECD (1959-60, 1965-66, and 1969-70).4' The large underpredictionin the postsampleextrapolation of the Ger- man money equationis a less extremeversion of the Canadianproblem; when a negative coefficientis assignedto the change in tradable-goods prices, a large negativegrowth rate of money is predictedin 1974. The extendedmoney equationexhibits substantialshifts in coefficientsas it strugglesto explain the 1974 experience,providing evidence of a structural shift in Germanmonetary policy when the era of flexibleexchange ratesbegan in early 1973. Two dummy variables are included in the Germanwage and price equations.A restraintdummy is in effect in 1967-69, a period during whichunion leaders are claimedto have agreedto modestwage increases in the interestsof economic stabilization.42Then a "reentry,"or wage- push, dummy covers the three quarters1969:4-1970:2. The restraint dummy is insignificant,but the wage-pushdummy is very large, con- tributinga cumulativewage increase of almost 6 percent in column 4 andmore than that in column5. Did the 1969-70 episode contributeto a continuingacceleration of inflation?The coefficienton the wage-dummycontribution in the price equationis relativelylarge, but at a very low level of significance.More importantmay have been the positive effect of the wage increases on monetarygrowth, and of money growthon price behavior.Overall, the resultsseem to suggestthat the inflowof dollar reserveswas not the sole cause of the Germanmonetary explosion of 1970-72, and that at least some of the responsibilityrests with domestic wage developments.

ITALY Althoughsignificance levels are low, most variablesin the basic Italian money equation are positive, indicatingan accommodativerather than 41. OECD, Monetary Policy in Germany, Monetary Studies Series (Paris: OECD, December 1973), pp. 43-50. 42. Ulman and Flanagan, Wage Restraint, pp. 186-91. See also Gerhard Fels, "Inflationin Germany,"in Krause and Salant, eds., WorldwideInflation, pp. 619-20. Herbert Giersch dates the voluntary restraintback to a meeting between the German Council of Economic Advisers and representativesof the trade unions and the em- ployers' associations on June 17, 1965, in A Discussion with Herbert Giersch: Cur- rent Problems of the West German Economy, 1976-1977 (American Enterprise Institute, 1977), p. 6. RobertJ. Gordon 441 countercyclicalmonetary policy. An accelerationof the risein wages,output, and traded-goodsprices, and a largerfiscal deficitall appearto have stimulatedmonetary growth. In contrastto WestGermany there is no accommodationof reserve inflows in 1971; quarterlyrates of monetary growthin Italywere lower in everyquarter of 1971 thanin the corresponding quarterof the preceding"wage-push" year, 1970. A structuralchange appearsto have occurredin 1973, since the equationpredicts more than double the monetarygrowth that actuallytook place afterthe end of the sampleperiod. The large and significantcoefficients on the dummy variablesin the Italian wage equations suggest that the Italian data are congenialto a wage-pushinterpretation. The firstdummy variable applies to the period in the early 1960s often describedby the term "wage explosion."48The second applies to the single quarterwhen the wage increasesfollowing the "hotautumn" of 1969 took effect. But, althoughwage push helps explain wages in Italy, the wage-push hypothesissuffers in the priceequation, since wageincreases had no influence at all on price increases.Nor did wage growth have a substantial impact on the monetaryauthorities. The Italian centralbank appearsto have behavedin a destabilizingprocyclical manner, but morein response to domesticoutput than to wage rates. The absenceof price responseto the 1970 wage push is confirmedby an inspectionof the data: the deflatorfor the ItalianGNP exhibitsa rate of increasein the firstthree quarters of 1970 that is almost identicalto that of the same period in 1969. Perhapsthe most surprisingaspect of the Italian inflationperformance was the absence of any accelerationduring the entire 1969-72 period. Economic recoverybetween 1966 and 1969 had alreadycaused a sub- stantialacceleration in wage and price changebefore the "hot autumn." Since 1973, Italianwage increaseshave been considerablymore rapid than can be explainedby the coefficientsin the 1958-73 wage equation. A comparisonof columns4 and 5 of table 9 indicatesthat the coefficient on traded-goodsprices has become larger and much more significant. More than those in most other countries,workers in Italy have foughtto preservetheir real wages in the face of a spiral in traded-goodsprices causedby the food and oil supplyshocks of 1973-74, and by the depreci- ation of the lira beginningin mid-1975. But the high positive coefficient 43. Ulman and Flanagan, Wage Restraint, pp. 202-03, include the interval 1961:3-1963:2 in their descriptionof the "wageexplosion." 442 Brookings Papers on Economic Activity, 2:1977 on monetarygrowth in the wage equationwhen it is extendedthrough 1976 suggeststhat the centralbank may have considerableleverage over the behaviorof wage ratesgiven changesin traded-goodsprices.

JAPAN Japanseems to be the model case in which monetarypolicy responded primarilyto the growthrate of internationalreserves. Most analysesof Japanesepostwar monetary policy cite deteriorationsin the balance of paymentsas the single factor behind episodes of monetaryrestriction.44 The basic money equationin table 10, column 1, is consistentwith this overall interpretation,with the largestpositive sum of coefficientson re- servesof any country. But there seems to be more to an explanationof monetarybehavior than a simple reserveseffect. Beyond that, the money supply appearsto have respondedstrongly in a countercyclicaldirection to outputfluctua- tions. In fact, the accommodationof reserveinflows in 1971 might not have been so extremehad the economynot been experiencinga growth recessionin that year, with the trough of the output ratio occurringin 1971:4. Accounts of Japanesewage and price behaviorappear unanimous in denying any role for wage push.45Perry's test for autonomouswage change in 1968 yielded a positive coefficienton a dummyvariable for that year but at a low level of significance.46Perry's conclusion is con- firmedin table 10, where dummyvariables for 1968 and for 1970 are positive but insignificant.Further, the absenceof any positive impact of wage change on monetarygrowth argues against any lasting effect of autonomouswage movements on the inflationrate. The patternof postsampleextrapolation errors is consistentwith that in other countriesand can be interDretedin light of shifts in coefficients 44. OECD, Monetary Policy in Japan, Monetary Studies Series (Paris: OECD, December 1972), p. 58. See also Gardner Ackley with collaboration of Hiromitsu Ishi, "Fiscal, Monetary, and Related Policies," in Hugh Patrick and Henry Rosovsky, eds., Asia's New Giant: How the Japanese Economy Works (Brookings Institution, 1976), pp. 169-71. Ackley and Ishi argue that it was the balance of payments alone, not domestic overheatingof inflation,that guided the timing of the monetary authorities. 45. See ibid., p. 176. Also Ryutaro Komiya and Yoshio Suzuki, "Inflation in Japan,"in Krauseand Salant, eds., WorldwideInflation, pp. 303-48. 46. Perry, "Determinantsof Wage Inflation around the World," table 6, p. 427. RobertJ. Gordon 443 when the sampleperiod is extended.The huge overpredictionof monetary growthafter 1973 is accountedfor largelyby the positive coefficient on traded-goodsprices, which suggests erroneouslythat the oil shock wouldbe accommodatedrather than resisted. Further, the countercyclical behaviorduring 1958-73 leads to the expectationthat the centralbank woulddo morethan it actuallydid to counteractthe unprecedented1973- 75 dropin the outputratio.

SWEDEN The main featureof the Swedishmonetary equation is a countercyclical outputeffect, similar to but largerin size thanthat in the corresponding Japaneseequation. The recent problemsof the Swedisheconomy, leading to the August 1977 devaluation,may dateback to the uniqueSwedish responseto the 1974 supplyshocks and worldwiderecession. In contrast to most countries,which failed to pursuevigorous monetary policies to counterthe recession,the four-quarterrate of changeof moneyin Sweden reached postwar peaks, around a 30 percent annual rate of growth, throughoutthe 1974:3 to 1975:2 interval.47As in the case of Canadaand Germany,a negative coefficienton traded-goodsprices in the sample period 1958-73 causes a postsampleprediction of a drop in the money supply, in contrast to the accelerationthat actually occurred and that shifts the coefficienton traded-goodsprices to a positivevalue in the extendedmoney equation. Appropriatelyenough, Swedish wage behavior appears to adhereto the Scandinavianmodel of the internationaltransmission of inflation.48The elasticityof wage changeto changesin world pricesis very largein all of the wage equations.A set of three dummyvariables was introducedinto the wageequations. First, following Perry's lead, a wage-pushdummy was introducedfor 1970. Second, a dummywas includedfor the subsequent year, to determinewhether price restrainthad any effect on wage behavior.49Finally, a "reentry"dummy was entered to test whether any restrainingeffect in 1971 was offsetin 1972. 47. This statement is equally valid for Ml and M2. The four-quarter rate of change of M1 peaked at 27.2 percent in 1974:3 and that for M2 at 34.0 percent in the same quarter. 48. Edgren and others, "Wages, Growth and the Distribution of Income," and Aukrust, "Inflationin the Open Economy." 49. Lars Calmfors, "Inflationin Sweden,"in Krause and Salant, eds., Worldwide Inflation,p. 530. 444 Brookings Papers on Economic Activity, 2:1977 The signs are positiveon all three dummyvariables in the wage equations, and significantin the case of the firstand third,indicating that wage change was faster than otherwisewould have been expectedduring the entire1970-72 period.The unsatisfactoryforecasting performance of the 1958-73 wage equationsis a consequenceof the implausiblyhigh coefficient on traded-goodsprices, which leads to the predictionof muchfaster wage increasesin 1973-75 than actuallyoccurred. The coefficientdrops to a much more reasonablelevel in the extendedequation in column 5. All wage equationsexhibit the same negativecoefficients on money and the outputratio, perhaps justifying the skepticismof Scandinavianecono- mistsabout the monetaristapproach, but suggestinga puzzlethat requires furtherresearch.

UNITED KINGDOM The resultsfor the UnitedKingdom are perhapsthe most interestingof all, and offer so manypositive and significantcoefficients that both international monetaristsand wage-push proponents will be pleased that their approachis vindicated,but dismayedthat the oppositeframework is validatedas well! The basic money equationindicates significant accommodationof both output changesand inflowsof reserves.The monetary authorityappears to have behavedin a destabilizingmanner, increasing the amplitudeof the output businesscycle until forced by a balance-of- paymentsconstraint to shiftto a restrictivepolicy. The selectionof dummyvariables for the wage and price equationsis designed to test whether alleged episodes of wage push actually represented a reboundin the aftermathof the variousperiods of wage freeze and restraint.Periods of applicabilityof the variousdummy variables are those selectedby the Economist as subjectto a wage "freeze,""restraint," or "reentry."50In addition,a specialdummy is includedfor the 1970 episode that has made wage push a byword amongBritish economists.In- deed, autonomousmovements during control and reentryperiods appear to be importantin explainingBritish wage behavior. Further, the behavior

50. "Faith, Five Hopes, and Cassandra,"Economist (July 23, 1977), p. 75. The freeze dummy is in effect in 1961:3-1961:4; 1966:3-1966:4; 1972:4-1973:1. The restraint dummy is in effect in 1962:1-1963:1; 1967:1-1969:4; 1973:2-1974:1; 1975:2-1976:4. The reentry dummy is in effect in 1963:2-1964: 1; 1970:1-1970:4; 1974:2-1975:1. RobertJ. Gordon 445 of pricesappears to have correspondedto that of wages,in contrastto the absenceof price responseto wage dummyvariables in most other countries. And as final icing to the wage-pushcake, the coefficienton wages in the money equationis positive and extremelylarge in the extended sampleperiod. But internationalmonetarists might respond that though the icing may be impressivethe cake withinis cardboard.Somewhat remarkably in light of the antimonetaristorientation of manyBritish economists, the influence of money on wage behavior is strongerthan it is in any other country.Moreover, the 1970 wage-pushepisode does not appearto repre- sent any profound sociological phenomenon,but simply an attemptto catchup for losses in real incomeduring the precedingperiod of restraint. Becausethe restraintdummy is in effectfor so many quarters(line lOb), the cumulativeeffect of all the dummyvariables taken together is strongly negative,implying that total wage changeduring 1958-73 was 26 percent less thanwould have been expectedon the basis of the contributionof the othercoefficients.5' As furthersupport for the monetaristcase, the equationsfor the United Kingdomclearly indict the Bank of Englandas the major culpritin the 1974-76 British wage explosion. Like workers in all other countries except the United States and West Germany,British workers tried to maintaintheir real wages in the face of the 1973-74 increasesin traded- goods prices. The centralbank then respondedby accommodatingthese wageincreases, and this monetaryacceleration fueled a furtherincrease in the rateof wage growth.

Conclusion

Despite the length of this paper, it should be viewed as a preliminary effort. The episodes of autonomous wage changes captured here by dummyvariables may be attributablepartially to factors uniqueto each country-tax changes, increases in the minimumwage, or changes in 51. Another serious defect in the wage-push argument is evident if account is taken of changes in the tax rate, a variable not included in this study. Large tax increases in 1967-69 would have justified a wage push by British workers even if wage restrainthad not been in effect. See H. A. Turner and Frank Wilkinson, "Real Net Incomes and the Wage Explosion," New Society, vol. 17 (February 25, 1971), pp. 309-10. 446 Brookings Papers on Economic Activity, 2:1977 unemploymentcompensation systems. Moreover, the results may be sensitiveto the particularwage seriesused in each country,and to errors in measuringwages. The attemptto fit a single money equationto the period 1958-73 overlooks the likelihood that monetary regimes may change. Furtherexplorations into the behavior of monetaryauthorities will requireexperiments to revealsuch changes,and shouldbe conducted on a varietyof monetaryaggregates and bases. Nevertheless,several interestingconclusions do emergefrom the resultspresented here. The paperbegan with three quotationssetting out the conflictbetween the international-monetaristand wage-pushexplanations of the acceleration of world inflationduring the latterpart of the era of fixed exchange rates.Which of the quotationssurvives the confrontationwith the data? HarryJohnson attributed the accelerationof worldinflation ultimately to U.S. monetaryexpansion. Table 2 confirmsthat world inflationis sig- nificantlyinfluenced by the world rate of monetarygrowth, to which the United States contributesabout half. U.S. monetarygrowth appearsto have had a significantinfluence on the growthrate of U.S. wages, and U.S. prices then respondedto wage changes with an elasticityof unity. The rate of wage growthin the OtherSeven appearsto have accelerated in 1969-70, well before the 1970-71 accelerationin monetarygrowth there,but this does not rule out a causalrole for U.S. monetarybehavior. The statisticalresults attribute about two-thirds of this wage acceleration in the OtherSeven to the influenceof a high outputlevel and an acceleration in the rise of world prices of tradablegoods, both of which were caused partlyby the prior U.S. monetaryacceleration. As in the case of the United States, these wage increases in the Other Seven were then passedon as domesticprice increases,and the domesticprice level in the OtherSeven was also pushedup directlyby higherworld prices of tradable goods. NicholasKaldor prefers to attributethe accelerationof worldinflation to a wage push causedby trade-unionmilitancy. The resultshere provide little supportfor this wage-pushinterpretation. About one-thirdof the 1967-70 accelerationin wage growthin the OtherSeven is attributableto the contributionof the dummy variablesin the wage equation for the OtherSeven. But, as the Harbergerquotation points out, the othermacro- economic effects requiredfor wage push to be a source of a continuing inflationwere absent.The portionof the wage accelerationcontributed by the wage-pushdummy variables in the OtherSeven did not feed through RobertJ. Gordon 447 into pricechange.52 Further, there is no signof the passiveaccommodation of wage changeby monetaryauthorities required if an inflationinitiated by wage push is to continue.A positive effect of wages on monetarybe- havioris close to statisticalsignificance only in the United States, where there was no sign of any autonomouswage push. It is fitting that the wage-push hypothesis comes closest to fulfilling its macroeconomic requirementsin the United Kingdom,where it has received such wide- spread attention;but even so the autonomousupsurge of wage change in 1969-70 appearsto have representeda reboundin the aftermathof wagecontrols and restraint rather than a spontaneousevent. Is control of the money supply sufficientto control inflation?Money growthhas a significantlypositive impact on wage growthin four major countriesmaking up 72 percentof the 1976 GNP of the eight countries consideredhere.53 Not only does this tend to deny the contentionof some wage-pushproponents that wage claims are numbers"picked out of thin air,"but it also supportsthe international-monetaristposition that control of worldmonetary growth is a crucialrequirement in the determinationof the worldinflation rate. A qualificationis thatin the remainingfour countriesthe effectof moneyon wagesis weak or nonexistent.A furtherquali- ficationis that the estimatedelasticity of wages with respectto money is small, and that of prices with respect to money is smallerstill. Finally, this effect of money on prices apparentlyoperates in conjunctionwith the effectof moneyon output. The results indicate that the major competitorto the international- monetaristapproach as an explanationof world monetarygrowth is not the wage-pushhypothesis, but ratherthe countercyclical-reactionfunc- tion. It does not appearto be true, as proponentsof the international- monetaristview contend, that the money supply in these countries is automaticallyset equal to the demandfor money by internationalmove- mentsof capital.Instead, in the moneyequations for most countriesthere are negative coefficientson either tradable-goodsprices or the domestic output ratio, two importantpositive determinantsof the demand for money. Further,the positive coefficientson internationalreserves in the

52. For the Other Seven the dummy contribution had essentially a zero sign in the price equation, and in all countries other than the United Kingdom its coefficient was insignificantlydifferent from zero. 53. The four countries are the United States, France, West Germany, and the United Kingdom. See note 32, which presents estimates of the money coefficients in the wage equation when the output-ratiovariable is omitted. 448 Brookings Papers on Economic Activity, 2:1977 money equationsfor several countriesare consistentwith the countercyclical-reactionapproach as well as the international-monetaristview. Almost all countriesexperienced periods of monetaryrestriction as central banksresponded to some combinationof buoyantgrowth in output, importedinflation, and reserve outflows. The studyreveals differences among countries in the behaviorof money andwage rates that are as interestingas theirsimilarities. Today's dichot- omy between"healthy" nations like West Germanyand Japan,caught in a virtuouscircle of appreciationand deceleratinginflation, and "sick" nationslike Italy and the UnitedKingdom (pre-1977), caught in a vicious circle of depreciationand persistentinflation, shows up in differencesin behaviorbefore the advent of flexible exchangerates in 1973. Growth cycles in the money supply in Germanyand Japan appearto have followed a countercyclical-reactionpattern, whereas accommodationwas therule in Italy andthe UnitedKingdom. The resultsprovide little supportfor the idea that centralbanks indi- rectly cause wage push through prior episodes of accommodation.In fact, the largestcoefficient on wages in a money equationoccurs in the case of the United States,which exhibitsno evidenceof wage push at all. On the other hand, one can apparentlypick today's healthy and sick nationsreasonably well by the response of wage rates to traded-goods prices.54This in turn may reflectin part a guess by trade unions in the sicknations that any attemptto maintainreal wages in the face of the 1974 supplyshocks would be accommodatedby centralbanks. The paperprovides ample support for Lucas'criticism of econometric modelsas forecastingdevices.55 Policy regimeshave changedin the face 54. Compare the traded-goods coefficients in the extended wage equation in each of the tables. The size of the coefficientsappears to be a rather accurate inverse indicatorof the currenteconomic health of the major economies: Italy 0.753 Sweden 0.682 United Kingdom 0.404 France 0.323 Canada 0.282 Japan 0.179 United States 0.029 West Germany 0.025 55. Robert E. Lucas, Jr., "EconometricPolicy Evaluation: A Critique,"in Karl Brunner and Allan H. Meltzer, eds., The Phillips Curve and Labor Markets (North-Holland,1976), pp. 19-46. RobertJ. Gordon 449 of novel events like the 1974 supply shock. In the case of almost every country,money equations estimated for the 1958-73 intervalmake huge forecastingerrors during 1973-76; it appearsthat the response of the monetaryauthorities to changesin traded-goodsprices shifted in the face of the strikingprice increases of 1974. Further,the dramaticcontrast between the volatilityof changesin the wage rate in some of the Other Seven countriesand the sluggishchanges exhibited by the United States remindsus thatwe all take for grantedcharacteristics of the U.S. economy that depend ultimatelyon its labor-marketinstitutions and that would change dramaticallyif those institutionsresembled the ones in Europe andJapan.

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Notes to Tables 4 through 12

Unless otherwise indicated, all variables are one-quarterrates of changein percent.The numbersin parenthesesare t ratios. All coefficientsand t ratiosrepresent the sum of a series of freely estimated coefficients.The numberof individualcoefficients is as follows: All equations-lagged dependentvariable, four coefficients.Money equation-wage variable, current and four lagged coefficients;other independentvariables, current and three lagged coefficients.Wage and price equations-all independent variables, current and four lagged coefficients. The money conceptis M1for all countriesexcept Canadaand France, for which it is M2. In additionto the coefficientslisted in the tables,each equationincludes as additionalindependent variables a constantterm and three seasonal dummyvariables. The money equationscontain political dummyvariables set equal to unity in the quarterof each national election and the three preceding quarters,with one politicaldummy coefficient per election. In cases wherethe sum of coefficientsis not statisticallysignificant, one or moreindividual lagged coefficients nevertheless may be significant.The superscriptsindicate significanceat the 5 percentlevel (one-tailedtest) of one or more positiveindividual coefficients (*); one or more negative coefficients(* * ); and one or more coefficientsof both signs (t). Standarderrors, cumulative extrapolation errors, and coefficientson dummyvariables are listedas percentages. Cumulativeerrors in line 12 do not includethe effect of any dummies that are applicableonly in the periodafter 1973: 1-for example,the U.S. reentrydummy in table4, line 9d. A detaileddata appendixis availablefrom the authoron request. Commentsand Discussion

RobertE. Hal: The two most interestinghypotheses investigated in Gor- don's paper are, first,the propositionthat monetaryexpansion and little else drivesinflation; and second,the contraryproposition that wageinflation rises or falls of its own accord, independentof money or other determinantsof demand. To keep my discussion simple, I will focus on wage ratherthan price inflation.The wage-pushhypothesis is supported by any evidencethat wages behave in a way that is not predictablefrom the behaviorof money and other determinantsof demand.The extreme wage-pushhypothesis requires, moreover, that demandhave no role in predictingwages. The believerin wage push is hoping for a wage equation with large unexplainedresiduals and low coefficientsfor money and the real outputgap. Obviously,Gordon's research cannot fail to turnup some evidencein favor of wage push. Everyonegrants the wage equation some residuals. Just the opposite evidence would supportthe monetaristhypothesis. Wagesshould be highlypredictable and money shouldhave an important role in the prediction.The monetaristhopes that the wage equationwill fit well and that demandwill matter.It is noteworthythat, from the per- spectiveof this paper,much of Gordon'spast researchhas been devoted to establishinga monetaristproposition-namely, the successof the Phil- lips curve. Still, there is an evidentbias in the procedureof this paperin favor of the wage-pushhypothesis-every user of econometricsknows how easyit is to rununsuccessful regressions. The interpretationof Gordon'sresults for wages presentssome chal- lenges. For the purposesof my discussion,equation 3 in the individualcountry regressionsis the relevantone. There is wide variationamong countriesin the standarderrors of the regression.The U.S. equationis by 469 470 Brookings Papers on Economic Activity, 2:1977 far the best, with a standarderror of 0.18 (implying a typical forecast error of wages one quarterahead of 0.18 percent). Worst are those for the United Kingdom (1.20), Sweden (1.32), and Italy (1.42). But much of the success of the U.S. wage equation arises from the lagged rates of wage inflation.This findingof persistentwage inflationis no sur- prise: every modernPhillips curve has some kind of "expectation"term of this kind. Whatis surprisingis the unimportanceof laggedwage inflation in many other countries.This is a kind of confirmationof the wage- push hypothesis: there are isolated large surprisesin the inflationrate that make the serialcorrelation of wage changeslow or even negative.In any case, the unpredictabilityof wage inflationoutside the United States is confirmedby theseresults. Money and other demandvariables are not withoutinfluence in some countries, accordingto Gordon. The wage-pushhypothesis is not uni- versally true in its extremeform. Still, quite apart from the subsidiary questionof why monetarygrowth has fluctuated,these resultsmake clear that nowhere is there a close correlationbetween monetaryexpansion and wage inflationthat operateswith only a brief lag. My own view that money has a quick and strongeffect on real outputbut that its effect on wages and pricestakes much longer is not changedby theseresults. My principalmisgivings about Gordon'sresults relate to their sensi- tivityto measurementerror. Nothing in the procedurecan distinguishbe- tweena wage push and a blunderby the nationalstatistical agency. Errors in measuringmoney and other right-handvariables would also explain theirweakness in Gordon'sregressions. It seemsunlikely that a tightrela- tionshipbetween money and wages lurks in his data, concealedby mea- surementerrors, but some part of the findingsthat are favorableto wage pushare probably artifacts of these errors. A basic point of the paperis that the wage equationhas largeresiduals in every countrybut the United States. Gordon chooses to express this findingby puttingin dummyvariables for majorepisodes of unexplained wage inflationand then noting the large coefficientsof these variables. Since fishingaround for good dummiesis a notoriouspractice of certain schools of econometrics,it seemsto me that the use of dummies,to which I have no serious objectionshere, can only detractfrom the paper. It would be much betterjust to show the readerthe residuals.Certainly the readerlearns nothing from the coefficientsof other variablesin regres- RobertJ. Gordon 471 sions in whichdummies make up for the conspicuousfailure of the vari- ablesto explainmajor episodes of wageinflation.

Michael Parkin: Internationalmonetarism is a body of analysis that seeks to explain world inflationunder a regimeof fixed exchangerates. Wage push is a view of the causes of inflationat the national level. In view of this fundamentaldifference in the phenomenathat they seek to explain,it is difficultto discriminatebetween these two viewsof the world. Gordonattempts to do so by examininginflation at both the world aggregate and national levels. At the level of world aggregates,international monetarismlooks convincing.However, at the nationallevel many puz- zles remain,including in severalcases a completelack of significanceof monetaryfactors in the inflationprocess. A fundamentalspecification problem could be at the source of this. Whilethe internationalmonetarist views worldinflation as determinedby a standardmacromonetary process, he emphasizesthat at the national level, price movementscontain important relative-price adjustments, the nationalinflation rate being equal to the worldinflation rate adjustedfor that nation'srelative-price movements. The source of national relativeprice movementsemphasized by internationalmonetarists is the differ- ence between ( 1) an individualcountry's differential growth rate of pro- ductivityin its traded-and nontraded-goodssectors, and (2) the average differentialin the rest of the world.'A countrywhose rate of productivity growthin its traded-goodssector exceeds that in its nontraded-goodssector by an amountgreater than that which on averageis occurringin the rest of the world will, under fixed exchange rates, experience a rate of increase in its domestic price index higher than the world average. This considerationdetermines the trenddeviation of a national"inflation" rate from world inflation.In addition,there is room for cyclical devia- tions of the national "inflation"rate from world inflation,again arising from changesin internationalrelative prices as betweentraded and nontradedgoods. A countrythat is generatingan excessiverate of expansion of domestic credit will at the same time be experiencinga current-account deficit. This will be associatedwith a rise in the price of its nontraded goods relative to the world price of traded goods since, as the 1. See Michael Parkin, "WorldInflation, International Relative Prices and Mone- tary EquilibriumUnder Fixed Exchange Rates," in Robert Z. Aliber, ed., The Politi- cal Economy of Monetary Reform (London: Macmillan, 1977), pp. 220-42. 472 BrookingsPapers on Economic Activity, 2:1977 countryattempts to raiseits expenditurelevel relativeto its incomelevel, it will substitutetoward domestic nontraded goods, satisfyingits excess demandfor tradedgoods from foreign sources. This substitutionin the productionprocess will be associatedwith a more rapidlyrising price of nontradedgoods. Thus the rate of inflationof domesticprices will deviate from the world inflationrate both for trend reasons (due to underlying differentialsin productivitygrowth) and for reasonsdue to cycles in the ratesof domesticcredit expansion and the nationalbalance of payments.2 The above remarksconcerning the nationalprice index also hold for the wage index and thereforesuggest that Gordon'sformulation of the determinantsof nationalwage changesdo not accordwith the predictions of the international-monetaristschool. He focuseson whatmight be called closed-economymonetarism with the ad hoc additionof an international relativeprice-namely, the price of the country'sactual traded goods (a simple averageof export and importprices for each country). His wage equationfor the international-monetaristview has domesticmoney, domesticoutput, traded-goods prices, and internationalreserves as explanatory variables.For the internationalmonetarist, the wage equationfor an individualcountry (in reducedform) would containthe rate of growthof the world money supply,the differencebetween the productivitygrowth ratesin the tradablesand nontradablessectors in the countryin question relative to that differencefor the rest of the world. No other variables would appearin an internationalmonetarist's reduced-form equation for domesticwage (or price) inflation. Gordonpresents a full and fair accountof the wage-pushview put in perhapsits best light.However, his empiricalformulation of the approach seemsto me to miss the centralproposition that that school has soughtto advance.It also raises the oft-asked question: What is the explanatory variable(or set of explanatoryvariables) that the wage-pushschool views as generatinginflation? First, recall that the centralfact that the wage- push school soughtto explainwas the widespreadtendency for the short- run relationshipbetween inflation and unemploymentto drift upward following 1966. This, more than anythingelse, was what gave rise to dis- satisfactionwith the previously conventionallyaccepted Phillips-curve

2. Michael Parkin, "Inflation, the Balance of Payments, Domestic Credit Ex- pansion and Exchange Rate Adjustments,"in Robert Z. Aliber, ed., National Mone- tary Policies and the International Financial System (University of Chicago Press, 1974), pp. 49-63. RobertJ. Gordon 473 hypothesisand to the widespreadpopularity of the invocationof wage- push "sociological"sources of the "newinflation." Gordon's formulation, at least in the way it is implemented,is incapableof addressingthis feature of the wage-pushschool. His procedureof "peeking"at the data and then dummyingout the largeresiduals amounts in effectto restrictingthe wage- push hypothesisto one about "blips"in the evolution of wages. Many previous wage studies have suggested that, apart from some sizable randommovements, no mysteryattends the overallmovement of money wages,given the developmentof otherstandard macroeconomic variables that are widely alleged to affectwages. However,the wage-pushpropo- nent could still argue that his position has not really been tested. He would see the broadtrend of monetarypolicy, ratherthan its quarter-by- quartervariation, as the factor respondingto whateverunderlying social pressuresare generatinginflation. In otherwords, the wage-pushview (as I understandit) is a theory of broad trends in inflationrather than of minutemovements from quarterto quarteror year to year. Thatbroader formulationis not addressedin Gordon'spaper, even thoughthat paper goes much furtherthan any previousstudy in tryingto do justice to the wage-pushviews. The wage-pushadvocate would probably argue that the same factors that cause wages to rise also cause monetarygrowth. In other words, it is not that wages "cause"money but that social forces (somewhat ill-defined) cause both rising wages and accommodating money. Causalitytests thereforewould requirethe explicitidentification of the exogenoussocial variables. Of the batteryof coefficientsestimated and reportedby Gordon,only two emergeas crucialfor discriminatingbetween the wage-pushand international-monetaristhypotheses. The firstis the coefficienton wagesin the money equation.This needs to be significantlypositive for the wage-push view to be correct, implyingthat money accommodatesprevious wage movements.Zero coefficients on wagesin the moneyequation would indicate that wages do not "cause"money (that is, are not accommodated). On this test internationalmonetarism scores eight and wage-pushzero. The second importantcoefficient, at least in the Gordonframework, is that of the wage-pushdummy variables in the wage equations.The international-monetaristposition requiresthat these be zero while the wage- push view requiresthem to be significantlypositive. On this competition, wage push wins five to three.However, the rules of the game-"peeking" at the data and then simplyusing a dummyvariable to pick up the effects 474 BrookingsPapers on Economic Activity, 2:1977 of any previouslyobserved large movements in wages-virtually guaran- tee a victoryfor the wage-pushview. RobertHall said enoughabout the difficultiesand problemswith using dummy variables in this way.As con- ceived by Gordon,the international-monetaristhypothesis requires that money appear significantlypositive in the wage equations.This result occurs only in the case of the United States, France, and the United Kingdomwith any strength,and in the case of West Germanywith less strength.For Swedenthere is a significantlyperverse effect and for Can- ada and Italy no measurableeffect at all. It may appearthat this indicates a defeat for the international-monetaristposition. However, as indicated above in the remarksconcerning the appropriatespecification of that view, there is no stronglypredicted relationship between national money supplyand nationalwages unless relative-wagechanges arising from differentialsin internationalproductivity growth are also allowedfor. Fur- thermore,collinearity may be present, arisingfrom the inclusionof the outputratio as well as moneyin these wage equations.In view of the mis- specificationof the international-monetaristhypothesis concerning movements of national wages and nationalprices, no strong inferenceabout the appropriatenessof that set of hypothesescan be drawnfrom the esti- mationof the particularwage equations included in thispaper. Despite its weaknesses,this massive study by Gordon does seem to containsome elementsof policy conclusion.They are that, insofaras one can drawinferences from this body of work,monetary policy has to bear the brunt of the fight on inflation,and, while direct controls can have some marginalimpact, they do not appearto be capable of moving the broad trend of inflationaway from where the monetaryaggregates are takingit. Much moreimportant, however, than the policy conclusionsare those concerningan agendafor research.Gordon does not spell out such an agenda,but in manyways one is implicitin whathe has done. The first questionthat arisesconcerns the identificationof the exogenouscauses of wage push. Not until such variableshave been specifiedcan propercau- sality tests be undertakenthat are capable of rejecting(or confirming) the wage-pushview. Second, when the specificationis changedso as to characterizeinternational monetarism and the wage-pushview morepre- cisely, how robust are the empiricalfindings? This is the minimumre- searchtask that must be undertakenbefore the questionsraised here are finallylaid to rest. RobertJ. Gordon 475

RobertJ. Gordon:Let me respondto Parkin'scomment by defendingthe paper'sinclusion of domesticmoney in the wage equation.Parkin's own accountof IM associatesa domesticcredit expansion with an increasein prices of domesticnontraded goods, which must be accompaniedby ( 1 ) an increasein domesticwages, and (2) an increasein the domesticmoney supply (unless reserveflows totally offset the domesticcredit expansion, an extreme position rejected by previous empiricalwork). The basic DornbuschIM paper (see text note 10 above) is centeredon the connec- tion betweendomestic wages and money. Parkin'sremarks on wage push centeron the distinctionbetween epi- sodic "blips"and "broadtrends." A basic point of the paperis that indi- vidualepisodes of wage accelerationcannot be a sourceof a "broadtrend" towardmore inflation unless (1) the higherwages raise prices rather than squeezingprofits, and (2) the money supply accommodatesthe wage increases. Parkin asks that "social forces"rather than wages be linked to monetarygrowth, but it is hardto see how these forces could be a source of inflationwithout raising wages as well as money, and this relationship shouldbe revealedin positivecoefficients on currentor past wages in the money equationor both. RobertHall's distaste for dummyvariables is understandable,but there is no available altemativeto test for the presenceof autonomouswage movements.The paperintroduced dummies in the wage equationnot to soak up every extremeresidual, but only for use in episodes previously identifiedby othersas cases of wage explosionor acceleration.The "peeking" involved only determiningthe exact durationof each episode, not the choice of the episodesthemselves. Omission of the dummyvariables would have biased the coefficientson the other independentvariables in the wage equation,as is evidentin a comparisonof columns3 and 4 of tables4 through12. In particular,the impactof moneyon wagesis appre- ciablystronger when the dummyvariables are included.

GeneralDiscussion

Several participantsfelt that Gordon had not provided an adequate test of the wage-pushhypothesis. Thomas Juster cautioned that the diffl- culty of testingfor phenomenasuch as "theeffect of improvedcommuni- 476 Brookings Papers on Economic Activity, 2:1977 cations on wage aspirations"did not mean that they could be ignoredin seriousexplanations of wage behavior.Charles Holt noted that some success has been obtainedby Dicks-Mireauxin using proxiesfor union ag- gressivenessin wage equations,and suggestedthat Gordon might have modeled such processesmore effectively.Michael Wachterargued that since some versionsof wage push implied that relative-wagechanges in particularsectors trigger inflation, disaggregated wage equationswould be neededto test the wage-pushhypothesis. Gardner Ackley pointedout that in testingfor wage push, Gordonhad ignoredthe role of the wage-deter- minationprocess in regularsecular movementsof wages and prices. A persistentinflationary push arisingfrom wage-settinginstitutions would not be identifiedby Gordon'stests. Several commentswere made about Gordon's results. John Shoven observedthat the equationswere largelyunsuccessful and confirmedno hypothesis,except possibly an extremeversion of wage push such as Hall had in mind.Money could not be said to cause wage or pricemovements and wages could not be said to cause changesin money.Edmund Phelps was dissatisfiedbecause Gordon's equations implied that a 1 percent change in both the money supply and traded-goodsprices would not, asymptotically,imply anything like a 1 percentchange in wages.Together with MartinBaily, Phelps also objectedthat Gordonhad overlookedthe numerouschanges in exchangerates that had been madeunder the fixed- exchange-rateregime as well as the interventionthat has gone on under the system of "flexible"rates. Baily cautionedthat the exogeneitytests Gordonrelied on appliedonly asymptoticallyfor largesamples, and were not reliablefor smallsamples. James Duesenberryand Ackley both found Gordon's modeling of policy decisions too simplistic.Duesenberry pointed out that monetary policy did not conformto a single pattern.At some times policymakers will accommodatedemand shifts; at others they will pursue a counter- cyclicalcourse. And even if they mightinitially have a restrictivereaction to an inflationaryshock, over a longer horizon,if the inflationpersisted, they mightwell accommodatethe highertrack in wages and prices.Due- senberryfurther reasoned that the trendin wages would help determine the trend in money, but that this connectionmight well be lost in equations such as Gordon's.Ackley stressedthe complexityof policymakers' behavior. Policy might be wrong, and then changed as participants learned;reactions might be nonlinear,different for small than for large RobertJ. Gordon 477 changes. The evidence suggestedthat policy is exogenous.Attempts to endogenizepolicy have not been fruitfuland one did not learn as much from the statisticalsummaries represented by Gordon'sequations as one would by simplyexamining policy episodesdirectly. Pentti Kouri noted that the coefficienton the reservesvariable in the money-supplyequations contained a downwardbias and might incor- rectly indicatethat the money supplywas exogenouswhen in fact it was moved by reserves.There are, potentially,two distinctrelations between reserves and the money supply, one positive and one negative. There wouldbe a positiverelationship to the extentthat authoritiesdid not fully sterilizea reserve inflow; there would be a negative relationshipto the extent that expansionof the domesticmoney base led to some decline in foreignreserves. These effectsshould be isolated, with only the firstone relevantto Gordon'sinquiry. Gordon was sympatheticwith the reservationsof Duesenberryand Ackley. Reactionsof policymakerswere complex, and coefficientsin reaction functionsmight vary. If fixed coefficientsin the money equation turnedout to be insignificantin the paper,indicating exogeneity of money, this did not rule out the possibilitythat endogenouspolicy reactionsmight be identifiedby furtherresearch with nonlinearor variablecoefficients. Nevertheless,several strongresults emergedfrom the money equations, includingthe failure of Japan and Germanyto sterilizereserve inflows and the sensitivityof Japanto both the balanceof paymentsand the do- mesticbusiness cycle. Gordondisagreed with Shoven'sremark that the resultsdid not exhibit strongeffects of moneyon wages.Although this was truein the aggregate, the significant,if small,coefficients on moneyin most of the countryequa- tions providedevidence that centralbanks may have more influenceover wage determinationthan they realize. In particular,the strongfeedback between money and wages in the extended equationsfor Italy and the United Kingdomshed light on a sourceof theirproblems in the 1974-76 interval.