An Econometric Definition of the Inflation-Unemployment Tradeoff

Abstract

In the coming year 1979, is it possible to achieve a 5 percent unemployment rate and keep annual inflation down to 4 percent? To raise this question in terms of a particular econometric model, we ask whether there exist values of the policy instruments which will give rise to solutions of 5 and 4 percent, respectively, for unemployment and inflation. What is the most favorable tradeoff relationship between inflation and unemployment implicit in an econometric model of a national economy? In this paper, we wish to point out that for many econometric models actually in use, the tradeoff relationship is not rigid, but can be shifted toward the origin (but usually not all the way to the origin!) by suitable government policies. Accordingly, we suggest that the tradeoff relationship implicit in an econometric model be defined as the set of points in the unemployment-inflation diagram which cannot be dominated. We will explain the circumstances under which there exists such a southwestern boundary for the points depicting the unemploymentinflation combinations that are achievable according to a given model. We will propose a systematic way to locate points on this boundary and demonstrate that our algorithm works. Stimulated by and based upon A. W. Phillips' original paper on the relation between unemployment and the rate of change of money wage rates, numerous studies have appeared to refine, respecify, and estimate structural equations explaining the rates of change in the wage rates, the price level, unemployment and related variables. It soon became apparent that these studies, though useful, may not be sufficient for ascertaining the tradeoff relationship between unemployment and inflation. If unemployment and inflation are viewed as two of the many endogenous variables which are jointly determined by a system of simultaneous econometric equations, their relationship has to be derived by solving a whole system using alternative values for the policy variables subject to government control. The approach of deriving the unemployment-inflation tradeoff by varying the policy variables and solving for these two endogenous variables in an econometric model has been adopted by

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