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The latest IMF WEO 2013 among other things includes an interesting chapter on recent developments on the link between inflation and unemployment. Compared to past recessions, deflationary pressures have been mild during the Great Recession:

inflation and unemployment

These developments are attributed to the already low inflation (which creates a need for outright wage cuts in order to achieve lower inflation rates or even deflation) and anchoring of inflationary expectations due to monetary policy. Structurally high natural rates of unemployment do not seem to be present. One can then question whether the ‘divine coincidence’ still holds, where (based on the augmented Phillips curve) an inflation targeting central bank can maintain a zero output gap by achieving an inflation rate close to inflationary expectations. Since the Phillips curve appears to have become flatter, a low value for ε (in the APC π – π* = -ε [u -u*]) means that low inflation can coexist with large and persistent (as long as inflationary expectations are anchored) spells of unemployment. As a result, the current macroeconomic environment calls for a rethinking of central bank mandates closer to the Fed doctrine (which targets both unemployment and price stability).

This is quite evident in the case of Euro periphery countries such as Greece, where disinflation is accompanied with very large increases in unemployment. Since I ‘ve already touched upon the fact that the Phillips curve does not take into account firm profit margin changes, I will focus on the relationship between wage inflation and unemployment:

wage unemployment change

Starting in 2010 there’s a definite structural break in the rate of growth of ‘Nominal Compensation per Employee’ with wage increases turning negative and following the change in unemployment rate closely. During the 2006 – 2012 a simple linear trend is:

gw = 2.97 – 1.25Δu with an R²=0.86 while for 2010 – 2012 the trend becomes:

gw = 0.44 – 0.87Δu with an R²=0.90

It is clear that expectations of wage increases are close to zero (the 0.44 intercept) while the curve has become much flatter with the ‘unemployment multiplier’ falling below 1. That means that it will take more than 100bp changel in the unemployment rate to achieve a 1% fall in wages. Internal devaluation can only work through productivity from now on, especially since unemployment rates are moving closer to 30%.

Looking into the final demand deflator contributions one can observe the fact that most of the inflationary pressures since 2010 have been either transitory (import price and indirect tax effects) or the result of an effort by firms to maintain their profits margins (which given the fact that Greece is most probably going through a credit crunch are the only source of funding):

Final Demand Deflator Contributions

Labor and wages are the ones to have incurred most of the recession cost (with nominal ULC contributing a fall of -3.3% during 2012) while any remaining inflationary pressures seem to be the result of import prices and profit margins. The above suggest that a better targeted (and relaxed) monetary policy can be highly effective without fuelling any inflationary pressures since the Phillips curve is much flatter while a relaxation of credit constraints would allow firms to use bank credit again for working capital and investments instead of relying only on their own profits. That would allow them to adopt a pricing policy closer to domestic demand conditions and lower the CPI-based REER without hurting unemployment further.


Since i ‘ve recently had a couple of university professors analyze the expectations augmented Phillips curve, I ‘d like to do a short analysis of the relationship, especially in the context of inflation targeting by central banks. First, it is important to point out that the original Phillips equation reflected a relationship between wage growth and unemployment. The modern Phillips curve assumes constant real wages in order to substitute wage inflation for the inflation rate and come up with:

π = π* – ε(u – u*) where π* is the expected inflation rate and u* is the natural rate of unemployment.

This assumption shows its weakness if one uses another route to come up with a breakdown of inflationary sources. Using the equation of exchange:

PQ = PY (Q: real output, Y: real income)

and noting that income is distributed between wages and profits we can come up with:

PQ = (W + U)

Multiplying and dividing by W:

PQ = (W + U/W) * W

W + U/W is actually the aggregate mark-up of profits to wages, which can be set to m:

PQ = mW

Dividing both parts by L (employment):

P*(Q/L) = m*(W/L)

and renaming Q/L to average labor productivity (APL) and W/L to the money wage and taking natural logs we end up with:

π = m + w – APL

In other words, inflation is created by the excess increase of wages and markups to the growth of productivity. Given that the original Phillips curve focused on wage inflation, we can substitute w with the expectations augmented equation to reach:

π = m + (π* – ε(u – u*)) – APL

and moving inflation expectations to the left:

π – π* = m – APL – ε(u – u*)

Modern central banks follow inflation targeting with a view of minimizing the output gap. Taking that policy as given and assuming it is successful at anchoring actual inflation to the expected it is clear that:

m – APL = ε(u – u*)

As a result, only if the markup growth rate is equal to the increase of labor productivity will the outcome be unemployment close to the natural rate while workers will enjoy constant real wages. If firms manage to increase their markups more than productivity they will be able to earn a larger share of income while leading the economy to an unemployment gap. The increased unemployment will lower labor bargaining power and its ability to achieve wage increases. Consequently, pure inflation targeting will not necessarily lead to an optimal outcome but can allow ‘capitalists’ (used with the classical definition of owners of the means of production) to secure higher shares of income while lowering the labor force negotiating power and increasing the unemployment gap. Coupled with a financial sector willing to provide easy credit, this policy can have long-term redistributional effects.

* The original discussion appeared on heteconomist.