A. W. Phillips - Employment, Inflation and Growth

8/14/2019 A. W. Phillips - Employment, Inflation and Growth

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The Suntory and Toyota International Centres for Economics and Related Disciplines

Employment, Inflation and GrowthAuthor(s): A. W. PhillipsSource: Economica, New Series, Vol. 29, No. 113 (Feb., 1962), pp. 1-16Published by: Blackwell Publishing on behalf of The London School of Economics and PoliticalScience and The Suntory and Toyota International Centres for Economics and Related

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1962]

Employment,Inflation and Growth'By A. W. PHILLIPS1. INTRODUCTION

Sincethe end of the secondworldwar economicpolicy and con-troversy n Britainhavebeen directed o ways of attaininga numberof related objectives,prominentamong which are the maintenanceof a high and stablelevel of employment, easonable tabilityof theaverage evel of finalproductprices,a fairly rapidrate of economicgrowth,a satisfactory alanceof foreign radeandreasonable tabilityof foreignexchangerates. It can hardlybe claimedthat there hasbeen completesuccess in the attainmentof these objectives. It istruethatemployment as beenmaintained t an extremelyhighlevel.The average evel of unemploymentince 1948has been little morethan 1 per cent. of the work force. This is probablya lowerlevelof unemploymenthanthat attained n any single yearin peacetimeduringthe previous century, except perhapsin 1872. Even in theboomyearsof thepre-warradecyclethepercentage f tradeunionistsunemployed arely ell below2 per cent. and over the 53 years from1861to 1913it averaged 2 per cent. The actions taken to improvethe stabilityof the systemhave also had some measureof success.Beforethe firstworld war therewas a fairly regular radecycle withan averageperiod of about eight years, duringwhich trade unionunemploymentluctuatedbetweenabout 2 and 10 per cent. Sincethe second world war the cyclicalmovements n economic activityhave becomemorerapid,with a periodof four or fiveyears,but thefluctuationshave been smaller. Unemployment, ndeed, has onlyfluctuatedbetweenabout 1 per cent. and 21 per cent., that is, over arangeof about 12 per cent., but the percentageluctuationsn grossnationalproductabout the growthtrend have been about five timesas largeas this,2the rangeof the fluctuationsas a percentageof thetrendbeing about 7 or 8 per cent. Between1948 and 1960, grossnationalproductincreasedat an averagerate of about 2i per cent.per annumand productivityper man hour at perhaps1l per cent.perannum. Though hese ratesof increaseprobablycompare avour-ably with those in earlierperiodsof Britishhistory they are lowerthan those of a number of other industrialcountries in the sameperiod. Theaverage ateof rise of the retailpriceindexbetween1948and 1960was 3.7 percent.perannum. Therewould be fairly generalagreementhat this rateof inflations undesirable.It hasundoubtedly

1Inaugural lecture given at the London School of Economics and PoliticalScienceon 28th November,1961.2 See F. W. Paish, " Output,Inflationand Growth", to be published.1 A


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2 ECONOMICA [FEBRUARYbeena majorcauseof thegeneralweaknessof the balanceof paymentsand the foreignreserves,and if continued t would almost certainlymake the presentrate of exchangeuntenable.

It is my belief that one of the main reasonsfor the difficulties hathave been experienced n devising and implementingappropriateeconomic policies is lack of adequate quantitativeknowledge andunderstandingf how the economicsystemworks. Of course, econ-omists do understand,n a generalsort of way, quite a lot about theworkingof the economicsystemand do now havea massof quantita-tive informationabout importanteconomicvariables. But in orderto bringthis knowledge o bear on the problemof formulating ndattaininga consistent et of policyobjectiveswerequirealsoknowledgeof the quantitativeelationsbetweeneconomicvariables.In particularit is necessaryo knowwhatquantitativeelationshold between hoseeconomicvariableswhich are either the objectivesof policy or theinstruments hroughwhichwe attemptto attainthe objectives.Forexample, f some relationholds, in giveninstitutionalconditionsandon averageover a periodof years,betweenthe level of employmentand the speedof inflation,failureto take accountof it may lead tothe adoptionof inconsistentobjectivesand to a type of schizophrenicbehaviouras attemptsare made to attain these inconsistentaims.Knowledgeof the relationwould lead either to modificationof theobjectivesto make them consistentor perhaps,since an economicrelation s onlytheresultof fairlyregularpatternsof humanbehaviour,to some modificationof institutionsor behaviourwhichwould alterthe relation so as to permitsome more desirablecombinationsofconsistentaims. Or again,if at a certaintime unemployments feltto be too high and short-term nterestrates are loweredin ordertoraise the demandfor goods and so for labour, how large will theeffectsbe and when will they occur; will the higherdemand alsoleadto an increasen fixed nvestment ndif so how largean increaseand afterwhatintervalof time; will wageratesand pricesrisemorerapidlyas a result of the higher demand; if internal demandandpricesrise will importsrise and exports fall, and if so when and byhow much? If we are to assessthe effectsof our attemptso influencethe courseof economicaffairswe need answers,numericalanswers,to questions ike these. If we do not have this knowledge he policyadjustmentswill almost certainlybe inappropriaten magnitudeortimingor both andmaywellcause,as I believe heyhaveoftencausedin thepast,unnecessary ndharmful luctuationsn economicactivity.We may obtain tentativeestimatesof a quantitativerelation ineconomicsby making a preliminary ubjectiveanalysis of humanmotivationand behaviourand then carryingout a statisticalanalysisof relevantdata from past records. We also need to investigate hedegreeof error hat theremay be in the estimate, he extent to whichthe relation n successive horttime periods departs rom its averageoverlongerperiodsandwhether here s anyevidence hat the average


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1962] EMPLOYMENT,NFLATIONAND GROWTH 3relationchangesin any systematicway throughtime. On the basisof quantitative stimatesof this sort it is possibleto set up simplifiedmodels of the economic systemand by studyingthe propertiesofdifferentmodels with a varietyof policy relationshipswe can formsome judgementof the likelyeffectsof alternativeypes of economicpolicy. The empirical tudyof economicrelationsandthe quantitativeinvestigationof the behaviourof models of economicprocessesarecomparatively ecent developmentsn our subject. The knowledgeand understandingwhichhave so far beengainedare far from beingadequatefor a firm and detailed appraisalof economic policy. Ithink they do, however,make possiblesome attemptat clarificationof the problemswe face andjustifysome suggestions or methodsofdealingwiththem.2. SOME GENERAL PRINCIPLES OF FLUCTUATIONS AND STABILITY

The firstpolicyobjective shouldlike to consider s that of main-taininga stablelevel of employment;but beforeproceeding o thisit seems desirable o illustrate omegeneralpointsaboutequilibrium,stabilityand fluctuationsn thesimplestpossibleway. Letmethereforeconsidera single commoditywhich is being continuouslyproducedandconsumedand which s tradedon a perfectly ompetitivemarket.Assumethat the rateof productions an increasingunctionof price,the rateof consumptions a decreasingunctionof priceandthat therate of changeof the priceis proportionalo the excessdemand, .e.,to the rate of consumptionminusthe rate of production. This is thesimple ext-bookexampleof supplyand demandn a singlecompetitivemarket. It is frequently tated,and has indeedbeen statedwith someemphasis ysucheminent conomists sWalras,Marshall ndWicksell,that sucha system s necessarilytable, .e., that it alwaystendsto anequilibriumn whichthe price s suchthatthe ratesof productionandconsumption reequal. Thearguments usuallyvery simple. Supposethe system s not in equilibrium; or example,suppose here is excessdemand. Thenthe pricewill rise. Thiswill increaseproductionandreduceconsumption nd so reduce he excessdemand. Sincethe pricecontinues o rise so long as thereis any excessdemandand any risein price reducesthe excess demandthe processwill continueuntilthe excessdemand s eliminated. In brief; the existenceof any dis-crepancybetweenproductionand consumptioncauses a movementin pricewhichtendsto correct he discrepancy.Therefore, he argu-mentruns,the system s stable. Thisarguments, of course, allaciousexcepton the assumption hat the completeresponseof the ratesofproductionand consumption o any changein price occurs instan-taneously. If thereareanytimelagsin anyof theresponseshe systemwillusually luctuate.Whetherhefluctuationswilldieawayorwhethertheywill increasen amplitude ndtendto someregularandsustainedlimitcycledependson the precise ormsof the timelags,on the slopes


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4 ECONOMICA [FEBRUARYof the supplyand demandcurvesand on the speed at which the pricechangeswhenthere is a given excessdemand.The competitivemodel which we have beenconsidering,and otherso-called" self-equilibrating"models of economicprocessesare, infact,examplesof what areknown n other fieldsof study as" negativefeed-backcontrol systems". In order to see intuitivelywhy thesesystemsare often oscillatoryand may well be unstable whichmeansin practice hat they tend to producefairlylarge and regularcyclicalmovements)et us consideragain the competitivemarket. Assumethistimethat somefactorotherthanpricecausessmallcyclicalchangesin productionor consumption, o that excess demandis alternatelypositiveand negative see curvea of Figure1). We shall call this anexogenousmovementof excessdemand and see what furthermove-ments in excess demandwould be induced by price changeswhichdependedonly on this exogenousmovement. In otherwordswe shallfindwhatwouldusuallybe calledthe correctivemovementsn excessdemandwhichresultfromthe pricechanges ausedbytheexogenousmovementsn excess demand. Sincewe areassuming hat the rateofchangeof priceis proportionalo the exogenousmovements n excessdemand, he rateof changeof pricewould havethe sametimepatternas the exogenousmovement. The price itself, however,would lagbehind he rateof changeof priceby a quarterof a cycle (seecurveb)

a. Exogenous movement,and rate of changeof price+

b. Price+

C. nduced movement,with no time lag

+

d. Induced movement, with time lagFigure 1


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1962] EMPLOYMENT, NFLATIONAND GROWTH 5since the pricewould be at its maximumwhen its rate of changewaszero and changing rom positiveto negative,and wouldbe at a mini-mumwhenits rate of changewas zero andchanging rom negative opositive. If the completeresponseof productionand consumption oany changein price was instantaneous, he excess demandinducedby the movementsof pricewouldbe at its minimumwhen price wasat its maximumand vice versa(see curve c). Suppose,however, hatproductionand consumption esponded o changes in price with atime lag equal to one quarterof the period of the cycle. Then theexcessdemandnducedby the pricechangeswouldbe exactly n phasewiththeexogenousmovementsn excessdemand seecurved). Insteadof tending to offset or correct he exogenousmovement, he inducedchangeswould tendto accentuate r amplify he fluctuationsn excessdemandcausedby theexogenousmovement.It is intuitivelyplausible,andcanin fact be proved, hat if, in this case,what areusuallycalledthe equilibrating r corrective orces are strong enoughto make theamplitudeof the inducedmovements n excessdemandgreater hanthe amplitude f the exogenousmovements,he systemwillbe unstable,that is, the fluctuationswill increaseand tend towardsa regularandsustainedimitcycle.

The exogenousmovementsor disturbanceswhich affecteconomicactivityare not usually,of course,of the simpletype assumed n thisexample. Theyare morelikelyto be of a ratherarbitrary r randompatternwhichcanbedescribed nlyintermsof a statistical rstochasticprocess.Suchprocesses an, however,beanalysed,by a methodknownas spectraldensity analysis, into cyclical components with periodsrangingover the wholespectrumromzero to infinity. If disturbancesof this sort operateon themodelwehavebeen considering, ny cyclicalcomponentwhoseperiodis such that the time lag in the responseofexcess demandto priceresults in a lag in the neighbourhoodof aquarterof the cyclical periodwill be amplified,while cyclicalcom-ponentswhoseperiodsare widely different romthis will be reducedin amplitude. If the " correcting orces" are sufficiently trongthecyclicalcomponentswithina particularangeof frequencies r periodswill be amplifiedo such an extentthattheywill dominate he marketmovements,which will then exhibit large and somewhatirregularfluctuations,n which,however, cycleswith this particular angeofperiodicitieswill predominate.There are two more mattersof some importancehat I shouldliketo referto whiledealingwiththe generalprinciples f fluctuations ndstability. The first concernswhatI shallcall the formor distributionof the timelags. Suppose he price n the commoditymarketwe havebeenconsideringwas constant or a long timeand thensuddenlyroseandremained onstantat the newlevel. The rateof productionwouldeventually ncreaseto some higher value, but there are any numberof timepathsthatthisincreasemight ollow. Forexample,productionmight start to rise immediatelyand continueto rise at a gradually


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6 ECONOMICA [FEBRUARYdiminishing ate, or it might remain constant for a while and thenincreasegradually,or it might remainconstantfor a longer time andthen increasevery suddenly see curves a and b and c in Figure 2).Now it can be shown, but by methodswhich I shallnot inflicton youhere,thatthe existenceof a time lag of the first formin the correctiveprocess is much less likely to cause fluctuationsand instability hana lag of the second form, and a lag of the secondform is less likely

Price

cProduction

Figure 2to causethese troublesthan is the thirdform of lag. An importantrule in devisinga corrective ystem is therefore o get the correctiveadjustmenttartedmmediatelyhediscrepancyt is intended o correctbeginsto be observed. Provideda fairproportionof the effect of thecorrectiveaction is obtainedfairly quicklyit does not much matterif the remaining ffectsare delayed; but it does matterverymuchifthe corrective ction itselfor all of its effectsaredelayed.The secondmatterwhichI should ike to dealwith briefly s thatofalternative ypesof corrective ction. It is perhapsbest introducedbyaskingwhat wouldhappenif in the simplecommoditymodelwhichwe considered arlier t wasthe pricerather hanthe rate of changeofpricewhich dependedon the excess demand. We see fromthe curvesthat the pricemovementswould occur a quarterof a cycleearlierasa result of this modification,and the inducedmovements n excessdemandwould no longerbe in phasewiththe exogenousmovements,so that the destabilising ffectsof the induced movementswould bereducedor eliminated. Depending on the form of the time lag, itmightor mightnot be possibleto find a cycle of higher frequency,that is, of shorterperiod,for which the lag in the responseof excessdemand o pricewashalf a cycle insteadof a quarter ycle. If so, anexogenousmovement f thishigher requencywould eadto aninducedmovementn phasewiththeexogenousmovementand if theamplitude


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19621 EMPLOYMENT,NFLATION AND GROWTH 7of the inducedmovementwas sufficientlyarge instabilitycould stilloccur at the higher frequency. But since most forms of time lag arein effect weightedaveragesand tend to producea low amplitudeofresponseto high frequency ycles the likelihoodof cyclical nstabilitywould be reduced. On the otherhand this form of correction,whichis called proportional ontrol,could neverensure hat productionandconsumptionwere brought into equality, since the price would beconstantif excess demandwere constant,even if it were not zero.However, a combinationof proportionalcontrol and the type ofcorrectionused before, which is called integral control, overcomesthis difficulty nd givesbetterperformancehan integralcontrolalone.We may go further n this directionand consider he effect of addingto the correctiveactiona componentbased on the rate of changeofexcessdemand. Since hefluctuationsn therateof changeof a cyclicalvariable ead the fluctuations n the variable tself by a quarterof acycle,this component f corrective ction,knownas derivative ontrol,has a somewhatsimilareffect to that which would be obtained bybasingthe corrective ctionon a forecastof excessdemand. A deriv-ative componentof control s used in combinationwith proportionaland integralcomponentsn most negative eed-backcontrolsystems.By an appropriate ombinationof the threecomponentst is usuallypossible o obtainvery good regulatingperformancef a system,withcorrectiveactions based only on the actual values of the variablesand their rates of change in the immediatepast, and without anyrecourse o predictedvaluesor forecasts.3. FLUCTUATIONS IN EMPLOYMENT AND ECONOMIC ACTIVITYI hopeI havenot boredyou too muchby thisrather ong and some-whattechnicaldigressionon the generalprinciplesof fluctuations ndstability. ButI thinksomeunderstandingf theseprincipless helpfulin a discussionof the stabilityof employmentand economic activity.For the correctiveadjustmentswhichaffectemploymentand activityin the whole economy,whetherthey be inherent n the workingofthe economyor appliedas deliberatenstruments f policy,areagainexamplesof controlby negativefeed-back. The use of forecasts npolicy does not substantially ffectthis statement, incethe forecastsare themselvesargelybasedon observationsof the economyand itsmovementsn the recentpast. Indeed, giventhe presentstateof theart of forecasting believethat better resultsmight be obtainedbybasingsuitablecorrective ctiondirectlyon observations f the econ-omy and its changesrather than on forecastswhich are themselveslargelyderived,perhapsby dubiousprocesses,romthoseobservations.Evenif therewereno specialfeatureswhichmightaccentuatedis-turbancesandfluctuationsn the economyas a whole,it couldnot beassumed that the existence of correctiveadjustments,even quitepowerfulcorrectiveadjustments,would stabilisean economy. If theyoperatewith long time lags, and especially f there are long delays


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8 ECONOMICA [FEBRUARYbefore heycommence o operate, heywill causecyclical luctuations,and the strongerthe corrective orces the more violent will be thefluctuations.But there is fairlygeneralagreement mongeconomiststhat thereare special eaturesof an economicsystem, n particularhemultiplierprocessand adjustmentsn inventoriesand capital equip-ment,whichaccentuate isturbancesnd tendto causecyclical luctua-tions. These features ncrease the need for deliberatestabilisationpolicies, but also make it more difficult o devise suitablepolicies.The problemis best studiedby investigating he propertiesof avarietyof models in which use is made of the limited amount ofquantitative nowledgeat presentavailableabouteconomicrelation-ships. The work involvedin such investigationss greatlyreducedand the rangeof possiblemodels is widened by the use of modernelectronicequipment. The results obtained in this way cannot, ofcourse,be conclusive,but from the investigations have done so farI have considerable onfidencen two simple propositions. The firstis that correctiveaction takenin an attemptto reduce the anmplitudeof the shortcycleof four or fiveyearswhich s typicalof the post-warperiod is not likely to be successfulunless it is based on recentlyobservedrates of changeof economicactivityas well as on the levelof activity. Theother s thateven f the corrective ction s appropriatein this respect t will still be unsuccessfulunlessa fair proportionofits ultimatedirecteffecton demand,say about a quarterof it, occurswithin hreeor fourmonthsof theoccurrence f theerror t is designedto correct,and at least one half of the full effect within about sixmonths.Let us examinesome of the existingmeansof influencingdemandin the light of these requirements. The responseof investmenttochanges n monetaryconditionsand interestratesis almostcertainlydelayedand slow. Thereis probablya delayof somemonthsbeforedecisionsto invest are significantly ffectedand with most types ofinvestmentthere is probablya further long time lag between thedecisionsto invest and the actual productionof capital goods. Ifthis is so, fluctuations re likelyto be intensified atherthan reducedby attempts o correctthem throughoperatingon long-term nterestrates andinvestmentn fixedcapital. This does not meanthatinterestratepolicyis unimportant.I believe t has a vital role to play in thesloweradjustments equiredas a resultof changesin the desire tosaveor invest,andthusin influencinghe averageevel of employmentandtheaverage ateof changeof theprice eveloverfairly ong periods.It is more difficult o judge the effect of operatingon short-termcreditand short interestrates. Adjustmentsn these can be mademorequickly hanin long rates,andto the extentthat theyaffectthedesireor ability to hold inventoriesthey might have a significanteffecton productionwithintwo or three months. But I think muchmoreempiricalwork will be neededbefore one can judge with con-fidence hemagnitude,peedandreliabilityof these effects. I suspect


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1962] EMPLOYMENT,NFLATIONAND GROWTH 9that if fairly large and rapid adjustmentsn short-termcredit con-ditionswere madein response o boththe levelandthe rate of changeof economicactivitythey would help to reducethe amplitudeof theshort cycle. But there is a difficultyn using adjustments f short-termcreditandinterest ates orthispurpose.Shortrates,andperhapsto a lesserextentcredit,arecloselyrelated o bankrate, and the levelof bank rate is often made to dependas much on the state of theforeignreservesas on the internalconditionof the economy. To theextentthatfluctuationsn the foreignreservesaretheresultof fluctua-tions in the balanceof tradetheywill tendto lag behindfluctuationsin the balanceof trade by a quarterof a cycle. Sincethe balanceoftrade moves fairly closely with internalactivity,fluctuations n thereserves end to lag behindinternalactivity,so that changes n bankratetendto be too latefor satisfactoryorrection f economic luctua-tions.My conclusionconcerningmonetarypolicy is thus similarto thatof the Radcliffe Committee;' " . . . monetary measures cannot alonebe relied upon to keep in nice balancean economysubjectto majorstrains romboth without and within. Monetarymeasurescan help,but that is all ". My reasonsfor this conclusionareperhapsa littledifferentromthoseof the Committee.I thinkthatchanges n interestrates and credit conditionsprobablydo have quite powerfuleffectson demand, but that their usefulnessfor correctingshort-periodfluctuationss seriouslyimitedas a resultof the long timelags in theresponseof investment o changes n interestrates,andin the caseofcreditas a resultof the temptationor need to makethe adjustmentsin response o the stateof the foreignreserves ather hanat the timesappropriate o the correctionof fluctuations n internaleconomicactivity. Muchmoreresearchwill have to be done, however,beforethe last word is said on these matters,and I would heartilyendorsethe Committee's statement2 that " . . . it is essential to have muchgreaterand more systematicknowledgeof the factorsthat make upthe financial ystemand of theirrelativemovements".Turningto fiscal methodsof influencingdemand,it is clear thatadjustmentshroughannualbudgetsdo not meet the requirementshavestatedfor the correctionof short-period ycles. Budgetchangeshave probablyplayed some part, togetherwith monetarypolicy, inovercominghe moresevereandlongercyclesof pre-wardays,thoughthis mayhavecomeaboutas muchthrough he confidence f businessmenthatthe budgetcouldand wouldbe usedto averta severeslump,with the consequentgreaterstabilityof their investmentplans, asthrough he actualuseof budgetchanges. Therecent ntroduction fgeneraladjustments f purchase ax as a regulatingdeviceis a morepromisingdevelopment. It suffers,however,from two defects; the

I Reportof the Committeeon the Working f the MonetarySystem,Cmnd. 827,(1959),p. 183.2 Ibid., p. 336.


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10 ECONOMICA rFEBRUARYratherarbitrary nd limitedrangeof goods affected,and the fact thatwhen demandis high there might be expectationsof an increase npurchase ax whichwould lead to a further ncrease n demandandwhendemand s low there might be expectations f a decrease n taxwhichwouldfurtherdiminishdemand.Hire purchasecontrols suffereven more severely rom these defects.None of the fiscal instrumentsat present n use satisfiesthe con-ditions for a satisfactorymeans of correction. If the purchasetaxwere changed nto a generalsalestax and adjustedby small amountsat frequentntervalst would do thejob. But a preferable lternativewould be the introductionof adjustmentsof directtaxes. A fairlysimpleway of adjustingdirecttaxes would be to calculateeverytaxto be paidin exactly he same way as is now done andthento add orsubtracta certainpercentageo the calculated igureas a stabilisationadjustment.In the case of P.A.Y.E., whichis calculatedon the basisof income and allowancescumulated rom the beginningof the taxyear,thefigureaddedor subtractedn eachpay periodas a stabilisationadjustmentwouldbe kept separaterom the figure or the normaltaxand wouldbe neglectedn forming he cumulatedax paid. Thefigurecalculated or the normaltax in each pay periodwould thus not beaffectedby earlierstabilisationadjustments, nd no changewouldbeneededin existingP.A.Y.E. tables or in the methodof using them.The percentageo be addedor subtracted ould be changed f nec-essary at regularintervals; qaarterly ntervals might prove to beshortenough, houghchangesat monthly ntervals houldbe possible.In this case those P.A.Y.E. taxes which are paid quarterly hould beadjustedby the averageof the percentages revailingn the preceedingthree months. Similarlyall annualassessmentsor directtax shouldbe calculatedas at presentand then the averageof the percentageadjustments revailing verthe year applied o this figure. Sufficientlyfine adjustmentwoald probablybe obtainedif the changesin thepercentageo be added or subtractedwere made in steps of 2-. percent., i.e., sixpencen thepound. Theabsolutevalueof the taxadjust-mentwould of coursebe much arger or a personwitha highincomethanfor one witha low income. This has advantagesrom the pointof view bothof equityandof efficacy;thelargeradjustments neededto induce hepersonwiththehigher ncome o changehis expenditure.Therewouldno doubtbe some administrativeifficultiesn introducinga schemeof thissort,but onceit was in operation he additionalworkinvolvedwouldnot be verygreat. I believe hatthe choice ies betweenaccepting he minor inconvenienceof such a schemeand acceptingthe continuationof the fluctuations n employmentand economicactivitywhichwe have experienced ince the war.4. EMPLOYMENTAND INFLATIONI haveso far beendiscussingluctuationsn employment nd econ-omic activitywithoutany referenceo the average evel about which


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1962] EMPLOYMENT, NFLATIONAND GROWTH 1I1employment s fluctuating. Considerationof the average level ofemployment ringsus to the questionof the relationsbetweenemploy-ment, or unemployment, ndinflationandthe rateof growth. In thepast few years a numberof people have carriedout empirical tudiesof the relation between unemployment, r some other index of thedemand or labour, and the rateof changeof wageratesor earnings.Somewhat different methods and hypotheses have been used bydifferentpeople. In my own very crudeattempt o studythisrelation'I assumed hat changes n the cost of living only affectwage changesin years when prices are risingrapidly,usuallyas a result of rapidlyrising import prices. Others2have assumed hat changes n the costof living have a proportionateffecton wageratesin everyyear. Forthe post-war ears his is probablynearer he truth hantheassumptionI used. Butwe mustthen recognise hatchanges n the cost of livingarein turn mainlythe resultof earlierchanges n wageratesand to alesser extent of changes in import prices. If these two behaviourrelationsare fittedto empiricaldata we can proceed o eliminatepricechangesand obtaina singlerelationexpressingwage changes n termsof unemployment nd changesin import prices,or alternativelywemay eliminatewage changesand express price changesin terms ofunemploymentand changesin import prices. These new relationsare not, of course,behaviour elations,but theyarevalidrelations orpredictionpurposes,and areindeed n themostuseful ormforpredic-tion. The relation obtaineds best considered s a prediction elationof this sort. If the otherstudiesare also interpretedn thisway thereis reasonableagreement n the results obtained. It seemsthat if theaverage evel of unemploymentwerekept at a little less than 2-1percent. the averagerate of increase n wages over a period of yearscould be expected o be about2 percent.perannumso thatwiththerate of increaseof productivity xperiencedince the war the averagelevel of priceswouldbe almostconstant. Also, in the rangebetween1-1per cent. and 2-- per cent. unemployment,or every0. 1 per cent.that the averageevelof unemployment asreduced,wagesandpriceswouldrise at about6. 3 percent.per yearfaster. If it is true thatsucha relationholdswe arefacedwitha difficult hoice. Thenwe canonlyreduce nflation, or any givenrateof increaseof productivity, t thecost of higherunemployment.I think such a relationdoeshold now,and unless it can be changedwe shall probablymove towards acompromise olution with a ratherhigheraverage evel of unemploy-mentthan in the pastfewyearsand a lower, thoughnot zero, speed

1" The RelationBetweenUnemploymentandthe Rateof Changeof MoneyWageRates in the United Kingdom, 1861-1957", Economica,vol. xxv (N.S.), (1958).2 SeeL. A. Dicks-Mireauxand J.C. R. Dow, " The Determinantsof WageInfla-tion: United Kingdom, 1946-56", Journalof the Royal Statistical Society, vol.122(1959); L. R. Klein and R. J. Ball," SomeEconometricsof the Determinationof Absolute Prices and Wages", EconomicJournal,vol. LXIX (1959), and R. G.Lipsey," The Relation BetweenUnemploymentand the Rate of Changeof Money

WageRatesin the UnitedKingdom,1862-1957: A FurtherAnalysis", Economica,vol. xxvii (N.S.), (1960).


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12 ECONOMICA [FBRUARYof inflation; perhapsabout 2 per cent. unemploymentwith about1 per cent. per yearrise in prices.To consider whetherthe relation can be modifiedwe must knowwhyit is thatwagescontinue o rise whilethere s significant nemploy-ment. A numberof possiblecausesareoftenmentioned,n particularlack of mobilityof labourand ndustry, esultingnunevengeographicaland occupationaldistributionof unemployment,ompetitivebiddingby employers or the most suitable abour and- radeunion pressure.The mobilityof labour and industrywould be increased f geo-graphicaland occupationalmovements n relativewages were allowedto take place more freely. If wages in areas and occupationswhereunemployments low or excessdemand s high rise more than thosewhereunemployments high or excessdemand s low, therewill be agreater ncentive or labour to move to the areasand occupations nwhich wageshaverisenmost, and for industry o move to the areaswherewageshave risen east,andalsofor industryo adapt ts produc-tion methods o use morelabour n thoseoccupationsn whichwageshaverisenleast.Competitivebidding up of wages in a particularoccupation andarea by employers can easily occur even when some labour inthe same occupationand area is unemployed. The basicreason forthis is the wide rangeof abilitythatexistsamongdifferent ndividualsin the same occupation.Somepeople,evenin a singlenarrowoccupa-tional classification,are worth to an employerconsiderablymorethan the average ateof payin the occupation; othersthrough ndivi-dual defectsof character,ntelligenceor physique,areworthless. Awide awakeemployerwill often find it profitable o pay 5 or 10 percent. abovethe averagerateof wagesfor a particular lass of labourin his locality. In this way he can choosethe bestmenand may wellfinishupwithemployeeswhoseproductivitys 10or 15percent.abovethe average. If a large proportionof employersadopt this practicewages may be bid up quite rapidlyeven when there is a significantamountof unemployment. The best solution would seem to be toallowmoreflexibilityn the wages paidto differentndividualsn thesameoccupation.The fourthpossiblereasonI mentioned or wageratesrisingwhenthere is significantunemploymentwas the power and pressureoftradeunions. I have some doubtswhether his has beenan importantfactor,butif it has,andif the tradeunionsfully understandheresultsof their actions,it can only be counteredat the cost of occasionalmajorstrikes. But have the resultsof an irresponsibleuse of theirpowerbeenmade clearto tradeunionsby Governments If it werewidelyand clearly understoodamongthe membersof tradeunionsthat the full use of theirpowerto forceup money wageswould onlylead, at a givenlevel of unemployment,o a faster rate of inflationand that the Governmentwould have no alternativebut to checkthis higherrate of inflation, n partat least,by loweringdemandand


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1962] EMPLOYMENT, NFLATIONAND GROWTH 13causingsome increasein unemployment,t seems possible that thetradeunions might see wheretheirtrueinterestsay.I am not so naiveas to expectthat the suggestions havemadefortryingto shift the relation betweenemploymentand the rate of riseof wage rates in a way whichwouldmake it possibleto maintainahigher evel of employmentwithany givenspeedof inflationarelikelyto meet with an enthusiasticresponse. Theyare all suggestions ormoreflexiblearrangementshichwouldallowfreerplayto the marketforces of supply and demand. But for at least a centuryand a halfbeforethe secondworld warwage-earnersrequentlyhad a prettyrawdeal from the marketforces of supplyand demand,for in most ofthe yearsof the tradecycle, andespeciallyn thecatastrophicnter-waryears, therewas a deficiencyof aggregatedemand. The traditionsbuilt up over that periodstill persistand will continueto persistforsome yearsyet. But in duecourse t maybe realised hatcontinuouslyrising standardsof living come only from continuouslyrising pro-ductivityand that providedthe Government s not preventedbyinflation rommaintaining highaggregateevelof demand or labourthemarket orcesare no longerharmfulbutplaya vitalpart n helpingadaptationand progress.5. EMPLOYMENTAND GROWTH

I have suggested hat a slightlyhigher average evel of unemploy-mentthanthatwhichwe have hadin thelastfewyears,perhapsa littleover 2 percent.,maybe acceptedas a necessary onditionfor modera-ting the speedof inflation. One often hearsheatedarguments gainstcheckingnflationn thisway,on thegrounds hatif therateof growthof the economy weremore rapidpriceswould not rise so fast, andthat the rate of growth will be reducedby operating he economy ata slightly ower evel of employment.It is true,of course, hat a higherrate of growthwith the samerateof changeof wageswould lead to alower speedof inflation. It is also truethatwhileunemploymentwasactually ncreasing,et us sayfrom 1 per cent. to 2 per cent., outputwould be rising ess rapidly hanit would have beenif unemploymenthad been kept at 1I per cent. But the arguments often phrasedasif the steadyrate of growthof the economywith unemployment on-stant at 2 percent.would be less thanthe steadyrateof growthwithunemploymentonstantat 12 per cent. I doubtwhether his is true.Duringshort-periodyclical luctuations he variations n outputasa percentageof the growthtrendare aboutfive timesas largeas thevariations n the percentageunemployment.The difference s largelyaccountedfor by variations n short-timeand overtime; by somepeople, mainlymarriedwomen,movinginto and out of the labourforce; and by " hoarding" of labour duringa recession which isexpectedto be short. If unemploymentwere to rise by 2 per cent.and stay at the new level, the hoardingof labourand some of theinitial changein short-timeand overtimewould be only temporary


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14 ECONOMICA [FEBRUARYand when the adjustmentswere completed the percentage fall inoutput would be considerablyess than five times the increase n ihepercentage nemployment. f accountwere akenof the value of leisurethe fall in real incomewould be still smaller, ince that part of the fallin output whichwas due to a reduction n overtimeand movementofpeople out of the labour force would be partly compensatedby thevalueto the people concernedof the extra leisure. If an increaseofi per cent. in unemployment auseda decreaseof 12 per cent. in out-put, with equal proportionaldecreases n investmentand non-invest-ment expenditures,nvestmentwould fall by 1 per cent. of its ownvalue, and assuming hat the growthrate was proportional o invest-mentthe growthrate would also decreaseby 1I per cent. of its ownvalue, orexample,rom2.5 per cent.to 2.4625percent.; anextremelysmall decrease. If all the decrease n output resulted rom a decreasein non-investment xpenditure here would be no change in the rateof growth. The main conclusion rom this is that the differencen thesteadystateratesof growthbeforeand after he transitiono thehigherunemploymentwould be extremelysmall if the growth rates wereproportionalo investment. Other influences, uch as possibleextraincentiveor compulsionto investin cost-reducing quipmentmighteasilyoutweighany small difference ueto the slight change n invest-ment.It is sometimesargued that the decrease n demand would slowdown growthby reducing he desireof firmsto invest; but this couldalwaysbe remediedby reducing nterestrates. Indeedsince we areassuming hat a Government ould hold unemployment t the newlevel, investment n the new steady state, as in the earlierone, wouldhave to be brought nto equalitywith savings. It is on the willingnessto save,and the more general nfluencesof educationalmprovement,research, nd so on, that the rate of growthdepends n presentcircum-stances. I do not thinkthat verysmallchanges n aggregatedemandandunemployment avemuch effecton these.6. RATES OF EXCHANGEThe final questionI wish to discuss,very briefly, s that of rates ofexchange.The othermajor rading ountrieshaveproblemsof employ-ment, nflationandgrowthwhichare similar o those of Britain. Thequestionariseswhetherall countriesarelikelyto hold that balanceofinternalobjectiveswhich wouldbe consistentwith the maintenance ffixedexchangerates.ProfessorsSamuelsonand Solowl have considered the relationbetweenunemployment nd the rateof changeof the consumerpriceindex n theUnited States. Theirtentativeconclusion s that assumingcontinuation f the conditionsof the post-warperiodthe priceindexmightbe stableif unemploymentwereheld at 5 to 6 per cent., and

I P. A. Samuel.on and R. M. Solow, " Analytical Aspects of Anti-InflationPolicy ", AmericanEconomicReview,vol. L, no. 2 (1960).


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1962] EMPLOYMENT,NFLATIONAND GROWTH 15might rise at about 2 per cent. per annum if unemploymentwere4 per cent. Some estimateswhichI have made lead me to think thatthe situation n the United States s less favourable han this. I estimatethat 7 to 8 per cent. unemploymentwould be neededto maintain astable price level, and that at 4 per cent. unemployment he pricelevel would rise at about 4 per cent. per annum. Of course effortsto increase he rate of growthandto reducestructural nemploymentmay improvethe relationbetweenunemployment nd pricechanges;but unlessmy estimatesare badlyout or considerable mprovementsare obtained t seems ikelythat if unemployments reduced,as seemsto be hoped,to 4 or 5 per cent., the United States may well have arather faster rate of inflation than Britain would have with 2 percent. unemployment.In Germany imilarproblemsare beginning o appear. Unemploy-ment has fallensteadilyfrom about 10 per cent. in 1950to 1.2 percent. in 1960,and labour costs are now rising rapidly. The growthrate is still highbut some specialfactorswhich contributedo it, suchas reconstructionafter the war and the currencydifficulties,andavailabilityof skilled labourfrom unemployedor from refugees,arepassing. It maywell be thatin Germany oo the problemof choosingbetween nflationand unemploymentwill become acute. These threecountries,and others, may perhapsbe prepared o adjusttheir ownchoicesaboutinternalbalance n orderto make themconsistentwitha regimeof fixedexchanges. But I have some doubts whethertheywill be preparedo do so, or if theyare whether heyin factknow thequantitativeworkingsof theirown and other economieswell enoughto choose the appropriateobjectivesbeforegradualdivergencies nprice levelshavecumulatedo such a degree hat they impose a heavystrainon the internationalmonetary system.If this is so, it mightbe betterto allow a limitedflexibilitynto theexchange ystem,so thatgradualdrifts n relativeprices,whichwouldprobablynotbe at a rateof morethan1orat most2 percent.per year,wouldnot producecumulative isequilibrian balancesof tradewhichmight eventuallynecessitateargeand suddenmovementsof exchangeratesand do seriousdamage o the internationalmonetary ystem. Alimitedflexibilitycould be introducedby an agreement hat the parvalueof any one currency,n termsof gold, couldbe changedat anytimeprovided he totalchange n one directionn any periodof twelvemonthsdidnot exceed1percent. Therewould,I think,be muchmoreconfidencehata countrycouldin factworkwithinthisrulethanthatit could for ever succeedin keepingthe par value constant,so thefear,orhope,of a sudden argechange n therate,with thetremendousspeculativemovements t causes,would be greatlydiminished. Themaximumpermissible ate of changeof the par rate, 1 per cent. peryear, could easily be offset by short-termnterestdifferentials,o itneednot leadto any major ransfers f capital.And thislimiteddegreeof exchange lexibilitywould alloweachcountrytime to findby trial


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16 ECONOMCA [FERUARYand error that compromisebetween ts internalobjectiveswhichwasconsistentwith its exchangerate policy.I said at the beginning f this lecture hat I believedone of the maindifficultiesn devisingand implementingppropriateconomicpoliciesis lack of quantitative nowledgeand understandingf how the econ-omic systemworks. By now I have no doubt amplydemonstrated tany rate my own lack of knowledgeand understanding, nd it onlyremains o apologise o any of you who may have comehere expectingclear and definiteanswers o the problemsI have been discussing. Ihope the nextpersonto face the ordeal of giving an inaugural ectureon electionto the Tooke Chairwill be in a position to explainthesemattersmoreclearly.The London School of Economics.

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A. W. Phillips - Employment, Inflation and Growth