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F. The impact of unionization on wages-

G. Econometric decomposition of the historical wage record.

Chapter IV. The price equation.

A. The empirical framework.

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FIGURES

1. Wage equation..

2. Price equation___

3. Time paths of the economy_

4. Comparison of one-quarter and four-quarter rates of change in the fixed weight wage index..

6. Steady state characterization: The effect of price inflation on wage inflation__

7. Characterization of guidepost effectiveness_

8. Foreign and domestic inflation.

9. The history of wage and price inflation: Simulated and actual experi

ence..

10. a. Simulated history of wage inflation and its component elements___
b. Simulated history of price inflation and its component elements-
11. Short run Phillips curves.

12. Alternative paths (1971-1975).

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5. Comparison of the four-quarter rates of change of alternative wage indexes..

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13. Flexing the elbow: The steady state options under alternative severity index specifications..

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Chapter I. SUMMARY OF CONCLUSIONS

The last few years have seen the worst combination of unemployment and inflation in modern United States experience. What produced so poor a result? Has the economic structure deteriorated so that the choices open to policy have worsened? Do we have to lower our sights for the 1970's? Or were the troubles due to peculiar factors of our recent history?

This study applies the methods of econometrics to these questions. The competing hypotheses are tested against the statistical record, and some new formulations are developed. Historical relationships for the behavior of prices and wages are combined into a small model which is used for simulation studies.

Our conclusions are, within limits, quite optimistic. The largest part of the poor price-unemployment performance is found to be due to particular historical circumstances: the period of excess demand, the abandonment of incomes policy, and the self-generating speed-up of the wage-price spiral once the fundamental conditions had gone sour. If normal conditions can be restored by the new wage-price program, the trade-off should be little changed from the earlier postwar years. We find that the wage-price mechanism gradually becomes explosive once unemployment falls below a critical level, a level with the current structure of the economy in the range of 4 to 4.5 percent. The initially incomplete and delayed reflection in wage claims of deteriorating price behavior keeps the rate of inflation from moving up quickly. But as inflation persists and the wage claims increasingly respond to the price factor, the wage-price spiral accelerates until it reaches an explosive condition. This condition had been reached at the time of the wageprice freeze. Thus, our findings support an "accelerationist," "momentum" view of the inflationary process if the unemployment rate is kept below its critical level. But at higher levels of unemployment the traditional Phillips Curve analysis remains valid. Thus, there is a similarity in our findings with the monetarist position under conditions of full employment, but a rejection of this view under slack circumstances. We reject the terminology of the "natural" unemployment rate because the rate is not rooted solely in the technological conditions of production or markets. There is little that is "natural" about it.

The factors determining the level of the critical unemployment rate are not yet understood in a quantitative sense. The extent of market power applied to wage and price decisions is one fundamental factor: prices rise in the absence of excess demand, with costs passed forward fully even when there is ample idle productive capacity. Wages rise faster than productivity even when prices are stable and labor markets show an excess of supply. Great disparities in the training and opportunities of different segments of the labor force also make the critical unemployment rate high. It is one of the main tasks of future economic policy to lower the critical unemployment rate.

Our study does not support the recent findings that much of the severity of the inflation can be attributed to any deterioration of the structure of the labor force. While it is true that there is a secular decline in the experienced male worker unemployment rates for any given national rate, this has, at most, been a minor factor in accelerating the rate of wage increase.

Similarly, our study does not attribute the deterioration in the unemployment-price tradeoff to a worsened structure of product markets. While the introduction of import quotas on several major industry product lines has diminished competition, the overall increase of imports strengthened competition generally. We find no change in the response of the price level to cost and demand factors over the period.

The study also finds that the presence of the Viet Nam war, as opposed to other sources of excess demand of the same magnitude, had only a small impact on the development of the inflation. The surge of orders for military procurement in 1965-66 provided an extra impetus to price increases, but beyond that no independent "war effect" can be found in the statistics. Of course the unpopularity of the war was the main factor in the failure to raise taxes at the proper time which helped produce the excess demand. In that deeper sense, the war was a major factor.

Finally, the guidepost policies of the 1960's can be seen to have had at least a modest impact on the rate of wage increase, and a larger impact on the wage-price system as a whole. Until the last 18 months of experience, it was difficult to distinguish between the importance of guidepost effects and changes in the structure of the labor force in accounting for the modest wage increases from 1964 to 1967. But the most recent data discriminate strongly between these competing hypotheses, in favor of the guidepost effect and lagging inflationary expectations. The announced abandonment of incomes policies from January 1969 to August 1971 is therefore found to be an important contributing factor to the severity and acceleration of the wage-price spiral in this period.

Looking ahead, our analysis suggests that inflationary expectations are built on about two years of experience. Therefore, with an effective wage-price program, it should be possible to restore normal expectations in about a two-year span. Without the new economic policies of August 1971, it would have required an unemployment rate maintained at 6 percent until 1975 to clear the system of the adverse effects of the recent inflation: only in 1975 would inflation be reduced to the low level corresponding to such high unemployment in the long

run.

The study also concludes that demand policies should not be determined by looking only one year ahead. The short run Phillips Curve always shows little tradeoff because it takes several years for inflation expectations to catch up with reality. Policy has to look at long term relationships between full employment and price stability if we are to reach our long term goals.

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