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Background Paper on Inflation and Unemployment

  • Global Economics

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The purpose of this paper is to provide background on the trade-off between inflation and unemployment to assist the Commission of Inquiry on Unemployment Insurance in the preparation of its report. The main issues from the point of view of the Commission are the existence of a trade-off between inflation and unemployment and the effects of Unemployment Insurance on the trade-off. To shed light on these issues, the paper reviews the literature on the relationship between the rate of change of wages and the rate of unemployment. The expectations-augmented Phillips curve paradigm for wage determination is reviewed in the second section of the paper. A full exposition of its theoretical rationale and implications is provided. According to this theory, the rate of increase of wages is a function of the the gap between the actual and non-accelerating inflation rate of unemployment, and of the expected rate of price inflation. Other variables such as catch-up for real wage losses and profitablity have also been included in wage equations. An important implication of the extended Phillips curve model, which is emphasized in the paper, is that there is no long run trade-off between higher inflation and permanently lower unemployment, but only a short-run trade-off between higher inflation and temporarily lower unemployment. The Canadian empirical literature on the relationship between wages on the one hand and unemployment and inflationary expectations (based on the cost of living) on the other is reviewed in the third section of the paper. This review, which focuses on the studies done in the last ten years, includes estimates made using micro-data on wage settlements as well as macro wage equations. The wage sectors of the main Canadian macroeconomic models are also canvassed. Tabular summaries of the key results of the studies are provided. Estimates of the impact of variables other than labour market tightness and inflation expectations such as productivity, catch-up, and profitability, which are included in wage equations, are also presented. Three important findings of the literature search on wage behaviour and unemployment, which are of particular interest and which are summarized in tabular form in the third section of the paper, are empirical estimates of: - the Non-Accelerating Inflation Rate of Unemployment (NAIRU) or natural rate of unemployment that is believed to be consistent with the maintenance of a constant rate of inflation; - the short term trade-off between inflation and unemployment based on the coefficient and lag structure of the unemployment rate in the wage equation; and - the impact of the 1971 and 1979 changes in Unemployment Insurance on the natural (non-accelerating inflation) rate of unemployment. The estimates of the impact of changes in the Unemployment Insurance on the natural rate of unemployment should be of particular value in any consideration of further changes to that program.
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In an earlier paper in this journal, Professor Phillips2 has advanced the hypothesis that the percentage rate of change of money wage rates in the United Kingdom (W) can be explained to a very large extent by: (i) the percentage of the labour force unemployed (U), and (ii) the rate of change of unemployment (U). After an inspection of the data, Phillips concluded not only that there is a clearly observable relation-ship between these variables, but that the form of the relationship has been remarkably stable over a period of almost one hundred years. The purpose of the present paper is to reconsider Phillips' work in some detail. In particular it seemed necessary: (i) to consider the general theoretical model that is being tested; (ii) to quantify Phillips' results, determining, if possible, the proportion of the variance in money wage rates that is associated with the two variables, level of unemployment (U) and rate of change of unemploy-ment (U); (iii) to provide systematic tests of the various subsidiary hypotheses framed by Phillips during the course of his analysis; and (iv) to test hypotheses that follow from possible alternative models. The logical order in which to deal with these topics, in the absence of Phillips' paper, would be, first, to outline the phenomena which require explanation, then to develop a model which will explain the phenomena, and, finally, to test further implications of the model. Given Phillips' paper, however, a slight change of approach seems to be desirable. In the first section of this paper a report is given of the statistical analysis carried out on data for the period 1862-1913. Although the main purpose is to discover what phenomena require explanation, a rather elaborate treatment is required in order to test the hypotheses about these phenomena framed by Phillips.
Ce texte s'inscrit dans la lignée des efforts déployés par de nombreux économistes pour évaluer l'efficacité des politiques de contrôle des prix et des revenus. Les conclusions sont que le programme canadien de contrôles a pu conduire à l'effet désiré. Il aurait réduit les augmentations de salaire nominal de 1.7 point de pourcentage dans le secteur privé de l'économie et de 4.3 points de pourcentage dans le secteur public au cours de la période 1975 III - 1977 I. De plus, l'effet semble avoir été progressif pour chacun des secteurs mais sensiblement plus rapide dans le secteur public. Au niveau théorique, les contrôles peuvent déplacer la relation entre les augmentations de salaire nominal et la demande excédentaire sur le marché du travail ou encore opérer une rotation de cette courbe. Dans lequel cas, les augmentations de salaire nominal pourraient être plus élevées en période de contrôle qu'en leur absence. Cette dernière hypothèse a été rejetée en faveur de la première. /// This paper attempts to assess one dimension of the Canadian wage and price controls program established in November 1975: its impact on the rate of money wage increases in major collective agreements. Our conclusion is that until the second quarter of 1977, it may have attained its desired objective. The rate of money wage increases was estimated to be 1.7 percentage point lower in the private sector while 4.3 percentage points lower in the public sector. The impact was progressive in both sectors, but more rapid in the public sector. At the theoretical level, controls can shift or twist the trade-off between the rate of money wage changes and excess demand in the labour market. In the latter case, wage increases could be higher with controls, but empirical evidence rejects this possibility in favour of the former.
The paper attempts to test one widely accepted corollary of the proposition that the availability of or increases in unemployment benefits have serious disincentive effects: namely, that the seasonality of employment will increase. The results based on an analysis of the dispersion of seasonal factors in employment in Canada, by industry group and region, for 1961 to 1974, are compatible with the 1971 revision of the Unemployment Insurance Act having had such an effect. (This abstract was borrowed from another version of this item.)