Effects of Monetary Policy on the Labor Market

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increases in the aggregate price level): it is not unusual to see hyperinflation and high rates of unemployment go hand-in-hand. It should also be emphasized that nothing in this analysis suggests that any one-time increase in the price level must necessarily be followed by persistent inflation at a fixed rate that will eventually turn into accelerating inflation. The accelerating inflation described by Friedman and Phelps is created by design in order to surprise economic agents. It will not result from forces beyond the control of the policymakers, and it will not be produced by policymakers that implement a stable monetary policy—even if that policy involves a high money growth rate.

The NIRU (aka NAIRU): A Response to the Monetarists. Although the introduction to this article focused on the NAIRU, the analysis presented so far has concentrated on the Phillips curve. The reason for this attention is that the Phillips curve is a key element of the theory of the inflation-unemployment relationship that includes the NAIRU.

As the discussion has shown, during the 1960s Keynesian theorists came to regard the inverse (downward- sloping) empirical relationship between inflation and unemployment—the Phillips curve relationship—as a stable menu of options from which policymakers could choose. The apparent concreteness of this menu helped produce widespread confidence in the potential effec- tiveness of Keynesian-inspired countercyclical demand management. To Keynesians, the job of macroeconomists was to design demand-management policies that would strike the right balance between the competing problems of unemployment and inflation. Monetarists did not share the Keynesians’ faith in the effectiveness of demand man- agement, and during the 1960s and the 1970s there were fierce debates between the two schools. These debates sometimes took the form of disputes about the slope of the Phillips curve. Keynesians believed that the Phillips curve was quite flat, particularly at high unemployment rates. It followed that when unemployment was high, the unemployment rate could be reduced at little cost in terms of increased inflation. Monetarists, on the other hand, believed the curve was quite steep, so expansionary demand management was likely to produce a significant amount of inflation without providing much benefit in terms of lower unemployment. The monetarist challenge to Keynesian ideas about the Phillips curve culminated in the Friedman-Phelps hypothesis that the curve was verti- cal in the long run.

During the severe recession of 1974-75 both the inflation rate and the unemployment rate reached some

of the highest levels in postwar U.S. history. This experi- ence shook public faith in Keynesianism and played a key role in shaping the subsequent debate about inflation. The warnings of Milton Friedman and other monetarists that attempts to “ride the Phillips curve” might lead to accelerating inflation began to be heeded by more and more people, both inside and outside the ranks of profes- sional economists. The credibility of the monetarist alter- native to Keynesian theory was greatly strengthened.

Despite the credibility gains of the monetarists, how- ever, the events of the mid-1970s did not result in the demise of Keynesian macroeconomics or even of analysis based on the Phillips curve. Many economists continued to use the Phillips curve as the basis for forecasting and policy advice. As Okun recalls, “It was hard to cast aside a tool that had traced the United States record so well from 1954 through the late sixties. And it was easy to ignore the Friedman and Phelps attack on the stability of the short-run Phillips curve, and their prophetic warning (issued at a time when the Phillips curve was still per- forming admirably) that the curve would come unstuck in a prolonged period of excess demand. Unfortunately, most of the profession (including me) took too long to recognize that” (1980, 166).

Some Keynesians reacted to the events of 1974-75 by attempting to reinterpret the Phillips curve in a way that reconciled the Keynesian and monetarist views of the inflation-unemployment relation but preserved consider- able scope for activist demand management. To do so was necessary to acknowledge that there might indeed be limits to the exploitability of the Phillips curve rela- tion: in particular, attempts to use it to keep the unem- ployment rate below a threshold level might indeed result in accelerating inflation. As early as 1975, for example, Keynesians Franco Modigliani and Lucas Papademos asserted that “the existence of NIRU [the noninflationary rate of unemployment] is implied by both the ‘vertical’ and the ‘nonvertical’ schools of the Phillips curve” (1975, 142).8

What exactly was the NIRU? In the now-conventional Phillips curve diagram, which has the unemployment rate on the horizontal axis and the inflation rate on the verti- cal axis, the NIRU was the unemployment rate at which the Keynesians’ downward-sloping Phillips curve inter- sected a vertical line at Friedman’s natural rate of unem- ployment. Thus, the NIRU was equal to the natural rate. But while monetarists believed that the existence of a natural rate implied that there was no useful trade-off between inflation and unemployment, Modigliani and Papademos interpreted the NIRU as a constraint on the

8. The NIRU was later renamed the NAIRU, or nonaccelerating inflation rate of unemployment. This name makes it clear that sufficiently low unemployment rates are believed to be associated with accelerating inflation, not just higher fixed rates of inflation.

12 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 1997

ability of policymakers to exploit a trade-off that remained both available and helpful in the short run.

Perhaps the most striking thing about the Modigliani-Papademos argument is that while it incorpo- rated many aspects of Friedman’s critique of Keynesian theory, it stood Friedman’s principal policy recommenda- tion on its head: Friedman was strongly opposed to activist monetary policy. One of the reasons that was pos- sible was that most expositions of the monetarist view of the inflation-unemployment relationship—including Friedman’s—did not seem to resolve the question of the strength or persistence of the short-run effects of mone- tary policy. After all, Friedman’s inflation-acceleration theory did seem to suggest that monetary policy could produce temporary reductions in the level of unemploy- ment—but these reductions could be sustained only at the price of continually increasing inflation rates.

The remaining difference between the Keynesians and the monetarists was actually quite fundamental: it involved the direction of the causal relationship between inflation and unemployment. This difference continued to allow members of the two schools to hold contrasting views about the sensitivity of the unemployment rate to changes in the inflation rate (or vice versa) and thus about whether the short-run Phillips curve trade-off was potentially useful to policymakers.

Monetarists saw the level of unemployment as deter- mined largely through the process of labor market clear- ing. The economy, in their view, was never far from the full-employment equilibrium of the classical model. Monetarists believed that monetary policy had a direct and powerful influence on the price level and the infla- tion rate. While the channels through which it obtained

this influence might involve the goods and labor markets, these markets adjusted and cleared so quickly that poli- cy changes had little effect on them. In particular, mone- tary policy could affect the level of unemployment only marginally and only by producing inflation surprises whose impact would decrease rapidly over time. Since unexpected changes in the inflation rate could produce only small changes in the level of unemployment, the Phillips curve was quite steep even in the short run. The rate of unemployment could never stray far from the nat- ural rate, and continued efforts to keep it below the nat- ural rate would result mostly in accelerating inflation.

Keynesians, on the other hand, continued to believe that the economy could and often did operate at “equilib- rium” positions in which aggregate demand was defi- cient—positions in which there was massive excess supply of labor and large-scale involuntary unemploy- ment. The level of unemployment, they believed, deter- mined the rate of inflation by determining the growth rate of nominal wages (see above). Thus, changes in unemployment caused changes in inflation, rather than the reverse.

It was their belief that the level of aggregate demand could be and often was deficient that allowed Keynesians to believe that policies that influenced its level could play an important role in determining the current level of employment. As long as there was “slack” (unemployed labor and other resources) in the economy, monetary ease, for example, would not start a wage-price spiral because the initial round of goods-price increases it pro- duced (see above) would not place substantial upward pressure on nominal wage rates. Thus, Keynesians believed that the economy spent most of its time in a range of unemployment rates well to the right of the nat- ural rate/NIRU—a range within which the Phillips curve was very flat. If demand stimulus pushed the unemploy- ment rate too low, however, then labor market tightness would put persistent upward pressure on the inflation rate. This was the range where the short-run Phillips curve was steep; it was also the range within which the long-run increases in the inflation rate predicted by Friedman were a serious potential problem. Thus Modigliani and Papademos wrote that “unemployment rates left of the shaded area [the area displaying the cur- rent range of NIRU estimates] imply a high probability that inflation will accelerate” (1975, 147) (see Chart 3).

Despite the fundamental differences between the monetarists and the Keynesians, the NIRU was seen by many contemporary economists as helping build a con- sensus about the nature of the inflation-unemployment relationship. According to James Tobin, the “consensus macroeconomic framework, vintage 1970” held that “the nonagricultural business sector plays a key role in deter- mining the economy’s rate of inflation. . . . According to the standard ‘augmented Phillips curve’ view, rates of

C H A R T 3 The Natural Rate

Keynesians believed that the economy spent most of its time in a range of unemployment rates well to the right of the natural rate and that unemployment rates to the left of the shaded area implied that inflation was likely to accelerate.

N R U n e m p l o y m e n t R a t e