by N. Gregory Mankiw
Fortune, December 8, 1997
Life is full of tradeoffs. Consumers trade off spending today against
saving for tomorrow. Congress trades off tax cuts against deficit
reduction. And the Federal Reserve trades off inflation against
unemployment.
But wait: The U.S. is now enjoying low inflation and low unemployment.
Doesn't this refute the old theory of an inflation-unemployment tradeoff?
Not at all, and Alan Greenspan knows it. The Fed has a single policy
lever, and this lever pushes inflation and unemployment in opposite
directions.
When the Fed wants to reduce
unemployment, it reduces interest rates by
increasing the money supply. Lower
interest rates stimulate spending on goods
and services, and this encourages firms to
hire more workers. But with more dollars
circulating in the economy, over time each
dollar becomes worth less. The result is
higher inflation.
Conversely, when the Fed wants to fight
inflation, it reduces growth in the money supply. Yet this causes a rise
in
interest rates, which depresses spending and increases unemployment.
How, then, does the U.S. economy now find itself enjoying both the
lowest inflation and the lowest unemployment in decades? The answer is
that while the Fed always faces an inflation-unemployment tradeoff, the
tradeoff does not stay the same from year to year.
Consider an analogy. As a consumer, you face a tradeoff between
spending and saving. The more you spend, the less you save. Of course,
if your income rises, you can both spend more and save more. And if
your income falls, you might choose to both spend less and save less.
But this in no way denies the tradeoff between spending and saving that
you face every day.
What, then, can alter the short-run tradeoff between inflation and
unemployment? There are three answers--inflation expectations, supply
shocks, and labor-market conditions--and each is important for
understanding the economic environment the Fed now faces.
Inflation Expectations: When expected inflation is high, workers
demand larger wage increases. Employers acquiesce, expecting that
they can pass higher costs on to consumers. As a result, high expected
inflation leads to rapid cost escalation, which in turn leads to high actual
inflation. Economist Robert Solow put the point succinctly during the
high inflation of the 1970s: "Why is our money ever less valuable?
Perhaps it is simply that we have inflation because we expect inflation,
and we expect inflation because we've had it."
Just the opposite is true today. Now we have low inflation because we
expect low inflation, and we expect low inflation because we've had it.
Greenspan has bought for himself a favorable tradeoff between inflation
and unemployment by giving the public many years of low inflation.
Supply Shocks: Sometimes outside events affect the prices at which
firms supply their goods and services. The classic inflationary supply
shocks were the OPEC oil price increases of the 1970s. As the cost of
all oil-related products rose, the Fed had to cope with a less favorable
tradeoff between inflation and unemployment. Greenspan has been more
fortunate. Shortly before he was appointed Fed chairman in 1987, world
oil prices plummeted, improving the inflation-unemployment tradeoff.
Over the past two years, the foreign-exchange market has provided a
similar benefit. The rise in the exchange rate from 90 to 120 yen per
dollar has put downward pressure on the prices of imports and
import-competing goods. And because wages respond to consumer
prices, the strong dollar has also kept down growth in labor costs.
Labor-Market Conditions:
Monetary policy is only one
determinant of the
unemployment rate. More
important, especially in the long
run, is how well the labor
market matches workers and
jobs. In many European
countries, unemployment
remains high because welfare
policies give unskilled workers
little incentive to find jobs. The
U.S. is less generous, and one
result is a more favorable
tradeoff between inflation and
unemployment.
The declining unemployment rate over the past several years has led
some economists to wonder whether the U.S. labor market is getting
better at matching workers and jobs. Why might that be? The increasing
role of temporary-help agencies is one possible explanation.
Because so many variables can shift the inflation-unemployment
tradeoff, the Fed tries to keep track of it all. Many economists
summarize the answer with a number called the NAIRU, standing for
"non-accelerating inflation rate of unemployment." When unemployment
rises above the NAIRU, inflation tends to fall below rates experienced
in
the recent past. When unemployment falls below the NAIRU, inflation
tends to rise.
But here's the rub: Estimates of the NAIRU are notoriously imprecise.
This uncertainty makes the task facing the Fed chairman and his
colleagues all the more difficult. But it should not delude us into thinking
that the Fed can push unemployment lower without risking higher
inflation. Indeed, unless Greenspan's good luck continues, there is reason
to fear that higher inflation may be around the corner.
N. Gregory Mankiw is a Harvard economics professor and author of
Principles of Economics.