Having Your Cake And Eating It Too

January 19, 2001

Two well-known ideas in modern economics are that there is a trade-off between unemployment and price inflation -- the idea that an economy can have low unemployment or stable prices, but not both -- and that there is a "natural" rate of unemployment. However, recent trends in the United States suggest this is not the case. Since 1992, inflation has been low and stable, between 1.6 percent and 3.2 percent. So has unemployment, ranging from 3.9 percent to 6.8 percent.

A recent study explains how low inflation can occur with low unemployment with the theory that the way people react to inflation at low levels differs from their reaction when the inflation rate is substantial. At low inflation rates of between 1 percent and 4 percent, the study says,

  • Inflation may be ignored when setting wages and prices since computing the effects would be too costly.
  • Inflation is no more important than other considerations in setting wages or prices; so it is averaged in, with little effect on prices.
  • Workers see their paychecks rising but do not see the full impact of inflation on prices, leading to less shirking and higher productivity -- which results in higher employment levels.

However, at rates of 5 percent or more, tracking and analyzing inflation is much more important and easier to do. Inflationary expectations are formed by workers, consumers and producers -- with the result that the equilibrium between inflation and employment shifts.

From their analysis of the 1954-to-1993 period, the study's authors conclude that the lowest sustainable rate of unemployment is 1.5 to 3 percentage points lower than the roughly 6 percent "natural" rate. They conclude that central banks should aim at an inflation rate in the range of 1.5 to 4 percent.

Source: "Editing the Phillips Curve," Economic Intuition, Fall 2000; based on George A. Akerlof, William T. Dickens and George L. Perry, "Near-Rational Wage and Price Setting and the Long-Run Phillips Curve," Brookings Papers on Economic Activity, No. 1, 2000, Brookings Institution, 1775 Massachusetts Avenue, N.W., Washington, D.C. 20036, (202) 797-6000.

 

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