Monetary Policy and Inequality: Target Inflation, Wages, and Unemployment

I should describe the human race
as a strange species of bipeds
who cannot run fast enough
to collect the money
which they owe themselves
—Don Marquis

So I was in class listening to a discussion regarding the natural rate of unemployment this week and I had some serious issues I needed to think through. I wanted to question the methodology for determining unemployment’s so called “natural rate”, specifically the use of the Non-accelerating Inflation Rate of Unemployment (NAIRU) analysis for the natural rate of unemployment and the actual accuracy of the Phillips curve, which states  pi = pi_e - b(U-U_n) + v , . In this model π and πe are the inflation and expected inflation, respectively; b is a positive constant; U is unemployment, and Un is the natural rate of unemployment, or NAIRU; v is unexpected exogenous shocks to the world supply. (*See the end of the post for a note on the old model)

Without going into all the details, there are two crucial assumptions built into the concept of NAIRU: first, that inflation is self-perpetuating; second, that unemployment is inversely related to inflation , so that as unemployment goes down, inflation goes up, and vice versa.

The basic NAIRU analysis assumes that when inflation increases workers and employers account for expectations of higher inflation and create contracts that matches the expected level of price inflation to maintain constant real wages. That is, they expect high inflation and counter up their wages to maintain a constant level of real wages. Thus, to prevent ever increasing wages through contract bargaining due to higher labor demand, the analysis requires accelerating inflation to maintain a targeted unemployment level (hence the central bank target inflation rate).

The implicit assumption is that workers and employers cannot contract to incorporate accelerating inflation into wage expectations. However, there is no explicit justification for assuming that expectations or contract structures are limited in this way, aside from the fact that these wage arrangements are not commonly observed. Given a scenario with low unemployment, i.e. a higher demand for labor, why wouldn’t they adjust their wage expectations to reflect accelerating inflation? Why must the wage contracts lead to runaway wage increases and thus self-perpetuating inflation?

I want to challenge these fundamental assumptions. Why is inflation necessarily self-perpetuating? Why does low unemployment necessitate runaway inflation? Why couldn’t inflation rise initially and level off after these increases in inflation are incorporated into expectations?

My greater question is how the use of the Phillips curve (and the Taylor rule) negatively impacts monetary policy decisions. What is the consequence of a target rate of inflation? What is the impact of high employment on real rages? Does increasing globalization and world competition limit the ability of American firms to raise prices, and prevent workers from pushing for higher wages? Maybe this makes up more competitive globally, but what of the real-wage’s impact on domestic aggregate demand? How can we sustain growth if we can’t afford to buy domestic goods?

When I asked my professor about these questions, specifically regarding the relationship between inflation and unemployment, his answer was less than satisfactory. He responded that, yes, inflation is artificially created by the federal reserve, but the major increases of inflation are due to money supply shocks, such as those created by oil shocks. I continued imploring: If unemployment and inflation are linked, how is it that real-wages have not increased in more than three decades? How is this possible that inflation has persisted, that goods have continued rising in price, and that GDP has continued to grow and increase, yet no one has seen a rise in earnings? What’s happening here that I don’t understand?

More plainly, how the hell does our economy continue growing if prices are increasing, yet peoples wages, their buying power, has not?? How are we buying increasingly expensive goods if we don’t have any more money to buy them with? What is fueling our GDP growth for Christs sake?

But my professor wavered, he went on and on about money supply shocks and what not. I actually don’t think he could see the connection I was making, and given that class had been over for ten minutes and his next class was filing in to fill the seats, I could only express my appreciation to him for entertaining and clarifying my confusion which, in the latter case, he did not.

Of course, my convicted intuition is that debt is how, that people have been living on less and less, that necessary consumption has increased and surplus or luxury consumption has decreased. If you look at inflation, debt, and savings rate data, this is clear as day. In my mind, increasing debt and over leveraging have been sustaining domestic consumption for the past several decades. This is the only explanation for how an economy can maintain rising inflation and stagnating wages, yet increase its GDP. This is ALSO why I suspect we’re struggling as an economy right now, why our unemployment is so high and our demand is so low: after the recent recession there was a collapse in the debt market, specifically involving the housing market, and people experienced a massive shock to their balance sheets when the value of their net assets, like tied up in their homes, essentially dried up overnight. The hardest hit were those with large debt balances. Many people were forced to cut back consumption to pay off the massive debt they accrued for a house that’s significantly less valued than when they bought it. In order to get their finances in order and repair their impaired balance sheets households had to cut back consumption. This resulted in the drop in consumer demand we’re experiencing today. Though it’s all interrelated, this may be a little beside the point.

My main contention is this: monetary policy is ruining our country. The federal reserve is operating on behalf of corporate interests rather than in terms of the well being of the citizens at large.

What is the consequences of a target inflation rate of 2-3% in order to keep unemployment at 4-5%? The higher the unemployment, the lower demand for labor, and the lower the wage bargaining power. People can’t demand higher wages if there’s a surplus of workers desperately pandering for the same job: High supply means low demand. If we never allow for low unemployment, never experience a high demand for labor, wages will not increase because workers possess no wage bargaining power; that is, there’s no demand for hiring additional workers, especially at the wages they request to live on. The result? Wage stagnation (WSJ). Familiar?

I have much more to say, and perhaps I didn’t even say my intuitions too clearly here.

I’ll end by saying that I think financial liberalization, inflationary targets, and institutional bargaining power are the cause of wage inequality, debt, and unemployment. Basically all our problems.

I know there’s the whole international competition thing, but I don’t like the assumptions built into the NAIRU and the Phillips curve. I believe they are plain wrong.

*I’ll elaborate and expand on why is this significant later, specifically regarding the use of coefficients: The older Phillips curve, as the long run expectation equilibrium, states [ gP = [1/(1 − λ)]·(−f(U − U*) + gUMC) ] In this model: gp is the price inflation rate; f() function is assumed to be monotonically increasing; U is unemployment; U* is the NAIRU;  λ represents the degree to which employees can gain money wage increases to keep up with expected inflation, preventing a fall in expected real wage, and is presumed constant during any time periods; gPex is the expected inflation rate).


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