Background Paper on Inflation and Unemployment

The purpose of this paper is to provide background on the trade-off between inflation and unemployment to assist the Commission of Inquiry on Unemployment Insurance in the preparation of its report. The main issues from the point of view of the Commission are the existence of a trade-off between inflation and unemployment and the effects of Unemployment Insurance on the trade-off. To shed light on these issues, the paper reviews the literature on the relationship between the rate of change of wages and the rate of unemployment. The expectations-augmented Phillips curve paradigm for wage determination is reviewed in the second section of the paper. A full exposition of its theoretical rationale and implications is provided. According to this theory, the rate of increase of wages is a function of the the gap between the actual and non-accelerating inflation rate of unemployment, and of the expected rate of price inflation. Other variables such as catch-up for real wage losses and profitablity have also been included in wage equations. An important implication of the extended Phillips curve model, which is emphasized in the paper, is that there is no long run trade-off between higher inflation and permanently lower unemployment, but only a short-run trade-off between higher inflation and temporarily lower unemployment. The Canadian empirical literature on the relationship between wages on the one hand and unemployment and inflationary expectations (based on the cost of living) on the other is reviewed in the third section of the paper. This review, which focuses on the studies done in the last ten years, includes estimates made using micro-data on wage settlements as well as macro wage equations. The wage sectors of the main Canadian macroeconomic models are also canvassed. Tabular summaries of the key results of the studies are provided. Estimates of the impact of variables other than labour market tightness and inflation expectations such as productivity, catch-up, and profitability, which are included in wage equations, are also presented. Three important findings of the literature search on wage behaviour and unemployment, which are of particular interest and which are summarized in tabular form in the third section of the paper, are empirical estimates of: - the Non-Accelerating Inflation Rate of Unemployment (NAIRU) or natural rate of unemployment that is believed to be consistent with the maintenance of a constant rate of inflation; - the short term trade-off between inflation and unemployment based on the coefficient and lag structure of the unemployment rate in the wage equation; and - the impact of the 1971 and 1979 changes in Unemployment Insurance on the natural (non-accelerating inflation) rate of unemployment. The estimates of the impact of changes in the Unemployment Insurance on the natural rate of unemployment should be of particular value in any consideration of further changes to that program.