NCPA - National Center for Policy Analysis

Does High Employment Mean Inflation?

October 7, 1996

Economists are debating one another over the role of low unemployment in triggering a higher inflation rate. Historically, economists believed that low rates of unemployment led workers to demand higher wages -- which raised the costs of production. These higher costs were then passed along to consumers in the form of higher prices for goods and services -- producing inflation.

The theory that if unemployment falls below a certain level inflation takes off is termed "Nairu": "nonaccelerating inflation rate of unemployment."

Now a good many economists are questioning the validity of this theory.

  • Most proponents of he theory thought that Nairu was 6 percent.
  • But unemployment has not exceeded 6 percent for the past two years, and now stands at 5.2 percent -- with little sign of inflation, except for food and energy prices.

Northwestern University economist Robert Eisner says it is true that when unemployment raises above that "natural" 6 percent rate, inflation does, indeed, fall. But often when it goes below that rate, inflation also falls. One reason may be that when business is good, firms hesitate to raise prices -- fearful of inviting new competitors into their markets.

Most economists do see signs that wages are now on the rise.

  • Total labor costs rose 2.9 percent in the second quarter of this year, and 2.7 percent in the first quarter -- compared to a year earlier.
  • Although third quarter data are not yet available, figures for average hourly earnings suggest that wages will rise again.

Economist James Coons, of the Huntington National Bank in Columbus, cites some other factors stabilizing costs.

  • Current wage gains, he says, stem from higher productivity and better-paid jobs.
  • Low and predictable inflation forces businesses to control costs.
  • His research shows that in any given year between 1960 and 1994 when the economy exceeded 3 percent real gross domestic product growth, inflation averaged 3.7 percent -- and 4.6 percent the next year.
  • When the economy grew slower than 3 percent, inflation averaged 6 percent -- dropping to 5.1 percent the year after.

First Chicago-NBD Bank economist Diane Swonk says that wage gains are strongest in Western states where jobless rates are much higher than in the Midwest and Plains states -- where jobless rates have been around 4.5 percent for the past 18 months.

Some economists cite factors such as global competition, waning union power, the threat of restructuring and the plunge in computer prices to explain the relative stability of wages.

Source: Anna J. Bray, "Do More Jobs Cause Inflation?" Investor's Business Daily, October 7, 1996.


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