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Last Modified: 2000-5-04
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New Economy Forum Briefing

J. Bradford DeLong
http://www.j-bradford-delong.net/
delong@econ.berkeley.edu

May 2000

 


Consequences of the Computer Revolution for the Business Cycle

  • Remember the Phillips Curve--the relationship between unemployment and inflation?
    • For more than 25 years mainstream economists' forecasts have rested on the idea that should unemployment fall below an unknown (but very real) level called the natural rate of unemployment, then inflation will start to rise.
    • Today, however, the Phillips Curve is missing.
    • No one at the end of the 1980's knew exactly what the natural rate of unemployment was. But even the most optimistic did not think it could be lower than 5.5 percent and even the most pessimistic knew it could be no higher than 6.5 percent.
  • Today, however, the unemployment rate is between 4.0 and 4.5 percent--and any acceleration in inflation is very slow to show itself.
  • Is the favorable inward shift of the Phillips Curve the result of the "new economy"?
  • Perhaps--if workers have not woken up to the greater bargaining power faster real productivity growth gives them...
    • If real wage aspirations are a function not of productivity growth but of the unemployment rate, then an acceleration of productivity growth produces a more favorable inflation-unemployment tradeoff.
    • In the context of the 1960s, 1970s, 1980s, and 1990s, the current natural rate of unemployment does seem to be profoundly affected by current productivity growth.
  • But the chief reason to pin the more favorable inflation-unemployment tradeoff on the "new economy" is a weak, negative one--the absence of alternative theories.
    • With a floating exchange rate it is hard to see how "globalization" can have a big effect on wage and price setting...
    • Demographic shifts have not been large enough...

That's why officials in the Clinton Administration and the Federal
Reserve, as well as independent analysts, bit their fingernails throughout the 1990's as they awaited the return of rising inflation. By 1994 unemployment - at 6.1% - was in the range where inflation had started to accelerate in the late 1980's, so the Fed spoke of undertaking "preemptive strikes" against inflation.

Yet no inflation followed. By 1996 the unemployment rate was as low as it had ever gotten in the 1980's. Yet inflation fell to less than two percent a year. By 1999 unemployment was 4.2%--well below anyone's previous estimate of the natural rate--yet inflation was an even-lower 1.5%.

Where was the Phillips Curve? Until the end of 1997 there was confidence that the Phillips Curve would soon return. Temporary special factors--health care costs, rapid falls in computer prices, and so on--were momentarily retarding the tendency of inflation to rise when unemployment was lower than its natural rate. Such factors couldn't last forever, could they? Of course not. So when their influence came to an end, inflation would begin its rise. But years passed, and inflation did not rise.

So mainstream economists' opinion shifted to the belief that the natural rate of unemployment had fallen, though how far no one really knew. Economists began spinning theories of what had caused the natural rate to fall. Harvard's Jim Medoff began arguing in the early 1990's that technological and organizational changes had led the labor market to do a better job of matching workers needing jobs to vacancies, thus substantially lowering the natural rate. Others pointed to faster productivity growth that allowed higher wage increases to be consistent with relative price stability. Still others pointed to workers' fears for their jobs generated by the memory of the deep recession and high
unemployment of 1981-1983.

At some primal level, all economists still believe in something like a Phillips Curve. All believe that unemployment will fall if demand expands faster than the economy's long-run productive capacity. And all believe that if demand keeps on expanding faster than the economy's long-run productive capacity then, in the long run, inflation will rise.

It was just that the natural rate of unemployment--the signal that
this long run had arrived--had fallen mysteriously far and mysteriously fast.

But, truth be told, the Phillips Curve has not worked well outside
America. Economists Doug Staiger, Mark Watson, and Jim Stock pointed out in the _Journal of Economic Perspectives_ that even in the United States the Phillips Curve relationship was never as strong or as good at forecasting inflation as was taught in intermediate macroeconomics. And only in the United States has there been a relatively stable natural rate of unemployment to serve as a reliable indicator of when demand pressure is about to raise inflation. Elsewhere the causes of rising inflation have
always been too complex to be summarized by simply comparing unemployment to even a semi-stable "natural rate."

Thus perhaps the surprising thing is not that Phillips Curve-based
forecasts of inflation have gone awry in the past half decade. Perhaps the surprising thing is that the complicated economic processes determining changes in inflation could be summarized for so long by such a simple relationship as the standard Phillips Curve. In any event one thing is very clear: the simple theory of the relation between inflation and unemployment that economists have peddled for a quarter century no longer works; if economists are to be of any use, they need to come up with a better - and in all likelihood more sophisticated - approach to understanding why inflation rises.

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Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
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