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ISSN 0007-7011

Federal Reserve Bank of Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106
MAY/JUNE 1987

The CPI Futures Market: The Inflation Hedge That Won't G ro w ................ 3
Brian R. Horrigan
Several new financial instruments designed to hedge the value of investments against a
variety of uncertainties have been introduced into the markets, and many have flourished.
One instrument that has not had much success, however, is the CPI futures—a futures
contract whose value is based solely on the Consumer Price Index, the most widely quoted
measure of inflation in the U.S. Some economists have hailed it as a tool to allow households,
businesses, and investors to shed their inflation risk at low cost; some even have predicted it
could become the largest-volume contract in the country. Yet, the daily volume of contracts
traded so far is minuscule, compared to other futures contracts. When such a good idea fails in
practice, several factors are probably involved, but perhaps the overriding factor is that
inflation risk itself has not been a serious concern in recent years.

Explaining Long-Term Unemployment: A New Piece to An Old Puzzle . . . 15
Robert H. DeFina
According to some theories about labor markets, long-term unemployment simply
shouldn't happen. If the labor market is a typical auction market, people will bid for jobs, and
employers will hire the lowest bidders. Therefore, whoever wants to work should be able to
find a job simply by bidding the lowest wage. A new view suggests that something else is
going on inside labor markets that prevents potential workers from landing employment this
way. The "efficiency wage hypothesis" argues that employers may not find it most profitable
to take the lowest bids on wages. Instead, they may find that by paying higher wages, they may
be getting more productivity, and therefore, more profit, out of their workers.

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The CPI Futures Market:
The Inflation Hedge That Won't Grow
Brian R. Horrigan*
Twenty years of persistent inflation in the
United States have brought many proposals for
coping with inflation. On June 21, 1985, the
Coffee, Sugar, & Cocoa Exchange in New York
offered a new way: a futures contract whose
value is based solely on the Consumer Price
Index (CPI), the most widely quoted measure of

*Brian R. Horrigan, now with Chase Econometrics, prepared
this article while he was a Senior Economist in the Research
Department of the Federal Reserve Bank of Philadelphia.




inflation in the U.S. This newly authorized
futures contract provides investors and busi­
nesses a means of hedging against inflation risk,
that is, the uncertainty caused by inflation. Until
the CPI futures contract was invented, there was
no direct means to hedge against inflation risk.
While some so-called inflation hedges—such as
real estate, precious metals, or stocks—may offer
some long-run, imperfect protection against infla­
tion, they are often highly risky investments in
the short run. But the final value of a CPI futures
contract is determined solely by the actual value
3

BUSINESS REVIEW

of the CPI, which allows investors and businesses
to trade on and hedge against pure inflation risk.
Academic economists have been urging the
creation of a CPI futures market for over a decade,
ever since economists Michael Lovell and Robert
Vogel first proposed the idea in 1973.1 The
benefits of having such a futures market have
been noted by many eminent economists, includ­
ing Milton Friedman, Paul Samuelson, and
Robert Barro. These benefits include giving
households and businesses the means to shed
their inflation risk at low cost, allowing invest­
ment decisions to be made on the basis of
profitability without regard to possible future
inflation, and permitting people to save without
the concern that their savings could be hurt by
inflation.2
But despite the early enthusiasm of econo­
mists, the CPI futures market has had very little
activity. There are probably several reasons for
the low activity. For example, the CPI may be an
inadequate measure of inflation for many house­
holds, while businesses may have other ways to
hedge against inflation risk. Furthermore, the
CPI futures market, unlike other futures markets,
has no underlying asset which is storable or
traded on an active spot market, which reduces
the opportunities for arbitrageurs and specula­
tors to participate in the market. Finally, inflation
risk has become small compared to other types

M. Lovell and R. Vogel, "A CPI-Futures Market," Journal of
Political Economy 81 0uly/A ugust 1973) pp. 1009-1012. A
futures market trading on the CPI was independently pro­
posed by L. Ederington, "Living With Inflation: A Proposal
for New Futures and Options Markets," Financial Analyst
Journal (January/February 1980) pp. 42-48, and Milton
Friedman, "Financial Futures Markets and Tabular Stan­
dards," Journal of Political Economy 92 (February 1983) pp.
165-167.
2These eminent economists gave the CPI futures market
enthusiastic endorsements in: Milton Friedman and Rose
Friedman, Tyranny of the Status Quo, (San Diego, CA:
Harcourt Brace, 1984); Paul Samuelson, Economic Index
Futures: An Introduction to the Concept of Shifting Macroeconomic
Risk, Coffee, Sugar, & Cocoa Exchange, Inc., June 1 4 ,1 9 8 3 ;
and Robert Barro, "Futures Markets and the Fluctuations in
Inflation, M onetary Growth, and Asset Returns," Journal of
Business 59 (April 1986) pp. S21-S38.

4



MAY/JUNE 1987

of price risk for many businesses. So, though it
may be a good idea in theory, in practice the CPI
futures market seems unlikely to attain greater
volume unless inflation risk becomes much more
significant than it is currently.
INFLATION RISK
A typical contract in this country—be it a
financial contract such as a loan, a labor contract
specifying an hourly wage rate, or a standard
business contract requiring payment for work
completed—is written in nominal terms, prom­
ising the payment of cash by one party to another
in the future. Inflation—the increase in the
average level of prices of goods and services—
reduces the purchasing power of money over
time. Businesses or investors who make con­
tracts involving the future payment or receipt of
cash are subject to inflation risk if they cannot
precisely predict the future price level.3 Those
making contracts try to protect themselves against
inflation by negotiating their contracts in light of
their anticipations of future inflation. If everybody
who agrees to a contract correctly anticipates the
inflation, everybody will get what he expected
in real terms. But if the inflation turns out dif­
ferently from what two parties anticipated when
they agreed to a contract, one of the parties loses
wealth in real terms while the other gains.
Consider, for example, a financial arrange­
ment in which someone borrows at a nominal
interest rate of 9 percent, while the inflation rate
is 6 percent. In that case, the real interest rate is 3
percent— 9 percent more dollars buys 3 percent
more goods and services after the price level
rises by 6 percent. The inflation rate might,
however, turn out as high as 10 percent or as low
as 2 percent, even though the lender's best guess
for the inflation rate is 6 percent. If the inflation
rate turns out to be 10 percent, the lender gets a
real interest rate of —1 percent (the 9 percent

3Inflation risk here means not only that the average price
level may rise unexpectedly, but also that it may fall un­
expectedly.

FEDERAL RESERVE BANK OF PHILADELPHIA

The CPI Futures Market

nominal interest rate that the lender contracts
for minus the 10 percent inflation rate.) Alter­
natively, if the inflation rate turns out to be 2
percent, the lender gets a real interest rate of 7
percent (the 9 percent nominal interest rate
minus the 2 percent inflation rate). Even if the
nominal interest rate is certain, an uncertain
inflation rate produces an uncertain real interest
rate.
Unanticipated inflation creates redistributions
of the real wealth of businesses and investors,
and the greater the variance of unanticipated
inflation, the greater the redistributions and the
greater the inflation risk it creates. The newly
developed CPI futures market offers one way
for businesses and investors to cope with infla­
tion risk.
THE BASICS OF THE CPI FUTURES MARKET
The CPI. The CPI, a monthly measure of the
average level of prices of consumer goods and
services, generates the most widely quoted
measure of inflation in the United States. The
CPI is compiled and published by the Bureau of
Labor Statistics (BLS), and measures the monthto-month change in the cost of buying a fixed
market basket of goods and services, such as
food, clothing, shelter, and transportation. In
January 1978, the BLS started publishing two
versions of the CPI, one new and the other a
continuation of the original series which was
started in 1919. The CPI futures market uses the
original CPI— now called the Consumer Price
Index for Urban Wage Earners and Clerical
Workers (CPI-W) —since it is the basis for costof-living adjustments in labor contracts, many
lease agreements, and Social Security benefit
payments.4

4The new version of the CPI, the Consum er Price Index for
All Urban Consum ers ( CPI-U), covers everyone covered by
the CPI-W plus salaried workers, the self-employed, and
those not in the labor force, among others. (In the text, just
"C P I" is used for simplicity to represent the CPI-W.) Both
price series are very highly correlated, so that there is little
significance to the fact that the more narrow definition of the




Brian R. Horrigan

The CPI-W is released at the end of the third
week of each month. The CPI is presented in
index form, with the average level of prices in
1967 set at an index value of 100.0. Each CPI
announcement reveals the average of prices
sampled throughout the preceding month. Once
released, the CPI is never revised. The inflation
rate is calculated as the percentage change in the
CPI. For example, the average CPI-W for 1985
was 323.4 and for 1984 was 312.2, so the inflation
rate in 1985 was about 3.6 percent.
The CPI Futures Contract. A CPI futures
contract is a standardized agreement in which
one party to the contract pays the other an
amount of money determined by the level of the
CPI at the time that the CPI is announced. CPI
futures contracts are traded at the Coffee, Sugar,
& Cocoa Exchange in New York, which sets
certain rules and regulations concerning the
trading of the contracts and which standardizes
the characteristics of the contracts, such as the
size, the method of settlement, minimum price
fluctuations, and so forth.5 (See CPI FUTURES
CONTRACT FEATURES, p.6, for details on the
characteristics of the market.) The Exchange
guarantees the performance of each contract
traded at the Exchange, so that buyers and sellers
need not worry about the creditworthiness of
those on the opposite side of the trade.
A CPI futures contract amounts to a bet
between two people on the future value of the
CPI. A useful way to understand how the market
works is to "walk through" a typical transaction.
Suppose on December 3,1986, you want to buy
a CPI futures contract settling in April 1988. You
contact your broker to discover the current "price"
of that contract. Essentially, the "price" of the
contract represents the market's consensus on

price index is used in the CPI futures market.
For more detailed information about the CPI, see Depart­
ment of Labor, BLS Handbook of Labor Statistics, (June 1985)
and BLS Handbook of Methods, Vol. II (April 1984).
5A good introduction to the subject of futures markets can
be found in R. Kolb, Understanding Futures Markets, (Glenview,
IL: Scott, Foresman, and Company, 1985).

5

BUSINESS REVIEW

MAY/JUNE 1987

CPI Futures Contract Features
Exchange

The Economic Index Market of the Coffee, Sugar, & Cocoa Exchange at 4 World
Trade Center in New York

Regulator

Commodity Futures Trading Commission

Trading Hours

9:30 a.m. to 2:30 p.m., New York time

Trading Unit

The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W ),
with the value of the index equal to 100.0 in 1967

Settlem ent Day

The day that the Bureau of Labor Statistics announces the value of the CPI-W

Settlement Price

$100 times the value of the CPI-W

End of Trading

Trading in the futures contracts ends at the close of trading two business days prior
to the settlement day

Minimum
Fluctuation

Prices are quoted to two decimal places, and the minimum price fluctuation is
.01— one basis point. The dollar value of one basis point is $10.00

Daily Price
Limit

300 basis points ($3,000 per contract) above or below the preceding day's settlement
price for contracts in the same delivery month

Position Limits

The maximum net short or long position is 4,000 contracts

Original Margin
Requirements

$1500 per contract, subject to change

what the value of the announced CPI for March
1988 will be. (The March CPI is announced in
April; the CPI futures contract is settled after the
announcement.) So your broker tells you that
the market collectively predicts that the March
1988 CPI will be, rounded, 346.9.6

6The CPI futures market offers contracts going out as far as
three years, so that inflation risk three years out can be
hedged against. In fact, to the extent that inflation risk more
than three years out is correlated with inflation risk at three
years or less one can, in effect, hedge against inflation risk
more than three years out.


6


The next step is to purchase the contract via
the futures Exchange from somebody who is
willing to sell. Even though your CPI futures
contract is not settled with cash until April 1988,
the Exchange requires that you post $1,500
“margin" when you agree to the contract. The
margin is a “good faith" deposit made with the
broker to guarantee that you comply with the
terms of the futures contract. Since the margin
may earn interest while it is held by the broker,
you do not necessarily sacrifice earnings by
posting it.
In addition to posting margin, you must also
FEDERAL RESERVE BANK OF PHILADELPHIA

The CPI Futures Market

Brian R. Horrigan

Brokerage Fees

Brokerage fees are negotiable, vary from broker to broker, and depend on the
number of futures contracts entered into. The fee for a single "round trip"—
opening and closing a position on one CPI futures contract—is likely to be in the $25
to $75 range currently.

Available
Contract
Months

CPI futures contracts continue for three years at any time. Contracts are traded for
quarterly settlement (January, April, July, and October) during the 12-month period
from the current trading date and for semi-annual settlement (July and January)
during the period beyond 12 months but less than 36 months beyond the current
trading date. For example, a user of the CPI futures market on June 2 3 ,1 9 8 6 would
have the following futures contracts available:
SETTLEMENT MONTH
July 1986
July 1987
July 1988

O ctober 1986

January 1987
January 1988
January 1989

April 1987

The settlement of a CPI futures contract is based on the CPI-W measured in the
previous month.
On the first business day following the expiration of any January or July contract,
trading begins in the relevant January or July contract three years hence. On the first
business day following the expiration of an April or O ctober contract, trading
begins in the relevant April or October contract one year hence.
Extensions

The Coffee, Sugar, & Cocoa Exchange has filed a request to modify the nature of the
CPI futures contract. The Exchange wants a new contract that trades not on the level
of the CPI-W, but on the percentage change (that is, the inflation rate) of the CPI-W.
The underlying value of the contract will be $1,000,000 and prices will be quoted in
thousandths of a percent with the minimum tick being 0.005 percentage points,
with each 0.01 change in the projected inflation rate equaling $25 and each tick
being $12.50 per contract. So if the inflation rate com es in one percentage point
higher than specified in the inflation futures contract, the gain to the buyer is $2,500.
The economics of the proposed contract are identical to the existing contract.

pay your broker a fee for his efforts. The size of
the fee is negotiable and can vary with the size
of the transaction. Currently, broker fees run
between $25 and $75 for entering into and
settling a single CPI futures contract.
Between the time you buy the contract and
the day you settle the contract, the market value
of your contract is likely to change. As new
information about the economy comes to light,
participants in the CPI futures market will revise
their beliefs about the March 1988 CPI. If the
participants come to expect more inflation, they
will expect the March 1988 CPI to be higher than



they previously thought, in which case the mar­
ket value of the April 1988 CPI futures contract
will rise. In that case, you will receive capital
gains on your contract. These gains are added to
your margin account on a daily basis as the
contract is "marked to market," and you are free
to withdraw those gains. But suppose market
participants come to expect less inflation; then
the April 1988 CPI futures contract falls in value.
You consequently suffer capital losses on your
contract, and those losses are subtracted from
your margin. If your margin shrinks below a
specified "maintenance level" (which is 75 per­
7

BUSINESS REVIEW

cent of the initial margin in the CPI futures
market), you must post additional margin to
bring the margin back to its original level. If you
fail to make the margin call, your broker liqui­
dates your position immediately at the going
market price.
Now comes settlement day in April 1988. You
and the seller of the contract must settle with
cash. If the CPI comes in higher than the CPI
specified in the futures contract, you make
money. The person who sold you the contract
pays you the difference between the announced
and contracted value of the CPI, times $1,000.
For example, if the CPI comes in at 343.5 while
the contracted value of the CPI is 341.5, you
receive $2,000, that is, (343.5 — 341.5) X $1,000.
Similarly, if the CPI comes in lower than the
contracted value, you lose money; if the CPI
comes in at, say 338.5, you would have to pay the
seller of the contract $3,000. Thus, your gains
and losses in the CPI futures market depend on
the difference between the announced value of
the CPI and the market's expectations of the CPI
as embodied in a CPI futures contract, not just
on the increase in the CPI.7
Finally, you can liquidate your position in the
CPI futures market before settlement day simply
by taking an offsetting futures position of the
same size. For example, if you bought 20 CPI
futures contracts whose settlement day is in
April 1988, you need only sell 20 CPI contracts
with the same settlement day in order to close
out your position and realize the gain or loss on
that date on your initial investment.
It might seem that the CPI futures market is
simply a gambling pit that belongs in Atlantic
City rather than in New York, and indeed, for
those who take purely speculative positions in
futures markets, the analogy is apt.But the CPI

7The Coffee, Sugar, & Cocoa Exchange has filed a request to
modify the nature of the CPI futures contract. The Exchange
wants a new contract that trades not on the level of the CPIW, but on the percentage change (that is, the inflation rate)
of the CPI-W. The economics of the proposed contract are
identical to the existing contract.


8


MAY/JUNE 1987

futures market also allows investors and busi­
nesses to hedge themselves against pure inflation
risk.
HOW THE CPI FUTURES MARKET
CAN LOCK IN A REAL INTEREST RATE
Trillions of dollars worth of financial contracts
in the United States are written in nominal terms
and hence are subject to inflation risk. The CPI
futures market offers those involved in financial
contracts the opportunity to hedge against that
inflation risk and thereby lock in a real interest
rate on their investments. Some examples indi­
cate how this can be done.
Hedging an Investment With the CPI Futures
Market. Suppose in June 1990, a financial insti­
tution—let's call it the Retirees' Investment Fund
(RIF)—invests $1,000,000 in 1-year Treasury
bills bearing a known, fixed nominal yield of 9
percent, which means RIF receives $1,090,000
in principal and interest in June 1991. Now sup­
pose in June 1990, the CPI has a value of 100.0
and the CPI futures contract selling in June 1990
and settling one year later has a price of 106.0, so
the expected inflation rate implicit in the 1-year
futures contract is 6 percent.8 By buying the
appropriate number of CPI futures contracts,
RIF can lock in a 3 percent real return on its
investments. To find the number of futures con­
tracts RIF must buy, divide the amount of money
subject to inflation risk—in this example,
$1,090,000—by the settlement value of one CPI
futures contract—in this example, $106,000—
covering the month in which the T-bills mature.
So dividing, we get approximately ten contracts.
Since fractions of contracts cannot be purchased,
RIF buys ten contracts.
Table 1 shows how the real yield on RIF invest­
ment is affected by inflation. Suppose that infla­
tion is 6 percent during the 12 months following
June 1990. In that case, RIF neither gains nor

8In the example in the text, the CPI for June 1990 is set at
100.0 for convenience, a number below the current value of
the CPI.

FEDERAL RESERVE BANK OF PHILADELPHIA

The CPI Futures Market

Brian R. Horrigan

Table 1

How RIF Locks in a Real Interest Rate of (Almost) 3 Percent

Investment to Be Hedged: $1,000,000
1-year T-Bills, bought in June 1990

in

Nominal Return on the T-Bills: 9%, yielding
$90,000 in interest in addition to the princi­
pal repayment of $1,000,000 in June 1991
CPI in June 1990:

100.0

Price of a 1-year CPI Futures Contract in June
1990: 106.0, an implicit expected inflation
rate of 6%
Number of CPI Futures Contracts Purchased:

Assumed Brokerage Fee Per Contract:

10

$25

Three Scenarios for Settlement After Announcement of June 1991 CPI

CPI In
Time 1991

June-June
Inflation
Rate

Total
Paymentb

Total
Real
Payment'

Total
Real
Yieldd

$0

$1,089,750

$1,028,066

2.81%

Payment On
CPI Futures2

1. 106.0

6%

2. 110.0

10%

$40,000

$1,129,750

$1,027,046

2.70%

3. 102.0

2%

-$ 4 0 ,0 0 0

$1,049,750

$1,029,167

2.92%

aIf the CPI rises by 6 percent, RIF receives nothing on its futures contracts and gets a real yield of approximately 3
percent on its investment in T-bills. If the CPI rises by 10 percent, RIF receives $4,000 on each CPI futures contract it
bought [$1,000 X (110.0 — 106.0)], for a total of $40,000 on 10 contracts. If the CPI rises by 2 percent, RIF pays $4,000
on each CPI futures contract it bought [$1,000 X (102.0 — 106.0)], for a total payment of $40,000 on the 10
contracts.
bThe total payment is the sum of the payment on the T-bills (which is always $1,090,000) and on the CPI futures
contracts, less the brokerage fee for the 10 futures contracts (which is $250). The payment is rounded to the nearest
dollar. Taxes are not considered here because people have different tax brackets.
cThe real payment is the total payment divided by the CPI, expressing the payment in June 1990 dollar values.
dThe real yield is found by dividing the real payment by $1,000,000— the initial principal— and subtracting 1. The
real yield is always about 3 percent because the payment on the CPI futures contracts almost completely offsets the
gain or loss in purchasing pow er on the T-bills caused by inflation being different from the 6 percent implicit in a
1-year CPI futures contract. The hedge is not perfect because fractions of contracts cannot be purchased.

loses on its futures contracts because the actual
CPI turns out to equal the CPI specified in the
futures contract. RIF gets about a 3 percent real
return on its combined investment in T-bills and
CPI futures. If, instead, the inflation rate is 10



percent, RIF ends up with a real return of —1
percent on its T-bills instead of a 3 percent real
return (—1 percent real interest rate = 9 percent
nominal interest rate minus 10 percent inflation).
But RIF gains on the CPI futures contracts that it
9

BUSINESS REVIEW

bought, and the gain about offsets the real loss
on the T-bills, so that the real return on the Tbills plus the CPI futures contracts is about 3
percent. On the other hand, if there is a 2 percent
inflation rate, then RIF pays on its futures con­
tracts. At the same time, the lower inflation creates
a 7 percent real interest rate on the T-bills (7
percent real interest rate = 9 percent nominal
interest rate minus 2 percent inflation). The loss
on the CPI futures contracts offsets the real gain
RIF makes on its T-bills, so that, once again, the
real return on the T-bills plus the CPI futures
contracts is about 3 percent. By buying the right
number of futures contracts, RIF can insure itself
against inflation risk and lock in a real interest
rate on its T-bills.9
Borrowers Can Hedge As Well. Who is selling
the futures contracts that RIF is buying? If RIF
reduces its inflation risk when it lends money by
also buying CPI futures contracts, do the busi­
nesses that sell the contracts increase their infla­
tion risk? Perhaps, but not necessarily. Consider
a hypothetical corporation selling 1-year dis­
count bonds (that is, bonds which do not bear
coupons) which bear a nominal yield of 9 per­
cent.10 The corporation is in a position similar to
RIF's—it is certain about the nominal interest it
will pay, but it is uncertain about the real interest
it will end up paying because it cannot forecast
the inflation rate perfectly. If inflation comes in
unexpectedly high, the real value of the corpo­

^There is a slight problem with this example. One-year
T-bills bought at the end of June 1990 mature at the end of
June 1991 when the investors receive the face value of the
T-bills. However, a CPI futures contract covering the CPI of
June 1991 does not settle until the end of the third week in
July 1991 when the Bureau of Labor Statistics announces the
value of the June 1991 CPI. Thus, there is a lag between
receiving the cash from the T-bills and receiving (or paying)
cash for the CPI futures contract, so the CPI futures market
cannot provide a perfect hedge against unanticipated infla­
tion. The inability to buy fractions of contracts also prevents
perfect hedging.
10A discussion of coupon bonds is more complex; for details
of hedging coupon bonds, see Todd Petzel and A. Fitzsimons,
Bank Utilization of Inflation Futures, (NY: Economic Index
Market of the Coffee, Sugar, and Cocoa Exchange, 1985).

10



MAY/JUNE 1987

ration's debts is unexpectedly reduced, and if
inflation comes in unexpectedly low, the real
value of the corporation's debts is unexpectedly
increased—the reverse of the position of RIF.
The corporation, like RIF, can shed that inflation
risk in the CPI futures market—but it does so by
selling CPI futures contracts, not buying them as
RIF did.
Borrowers, as well as lenders, can hedge them­
selves in the CPI futures market. In fact, busi­
nesses that both borrow and lend, like insurance
companies and banks, can profitably use the CPI
futures market to lock in a real interest rate on
both their assets and liabilities.11 In addition,
nonfinancial businesses also can protect them­
selves from the inflation risk that arises in
ordinary business operations. For example, a
business that submits a fixed nominal bid to
construct a building is vulnerable to changes in
inflation while construction is underway. Another
example, examined below, concerns a business
that negotiates an indexed labor contract with its
employees.
The CPI Futures Market Assists Indexing.
Consider the case of a hypothetical firm called
the American Steel Company (ASC). Because
the price level grows at an uncertain rate, both
the ASC and its employees, members of the
Steel Union, are subject to risk about the real
value of the long-term labor contract they nego­
tiate. Suppose ASC signs a labor contract with
the union that includes a cost-of-living adjust­
ment (COLA) clause that automatically adjusts
wages proportionately to the CPI. While this
indexation protects workers' real wages, it may

^C urrently, financial institutions can use interest rate
futures to reduce significantly the risk to their cash flow that
comes from unexpected variations in the nominal interest
rate. (See Michael Smirlock, "Hedging Bank Borrowing
Costs With Financial Futures," this Business Review (M ay/
June 1986) pp. 13-23.) However, even if a financial institu­
tion completely immunized its cash flow against nominal
interest rate risk, it would still be exposed to inflation risk
because unexpectedly high inflation would reduce the real
value of its cash flow— a risk that could be shed in the CPI
futures market.

FEDERAL RESERVE BANK OF PHILADELPHIA

The CPI Futures Market

expose ASC to inflation risk if the price of steel is
not highly correlated with the CPI. (For some
firms, the prices of their products can fall as the
CPI rises, as happened in recent years with oil,
some foodstuffs, and industrial metals.)12 What
can ASC do? With the CPI futures market, it can
offer its workers indexed contracts without
increasing its inflation risk.
When ASC signs an indexed contract with its
workers, it can simultaneously buy the appro­
priate number of CPI futures contracts, and
thereby protect its profits against unanticipated
inflation. Suppose the inflation rate implicit in
the CPI futures market is 6 percent. If foreign
competition does not allow ASC to raise its steel
prices by more than 6 percent, then each per­
centage point that inflation rises above 6 percent
increases labor costs (and reduces profits) via
the COLA. But A SC's extra labor costs are offset
by the gains on its CPI futures contracts. And if
inflation comes out unexpectedly low, ASC's
lower labor costs are offset by its losses on the
CPI futures contracts.13
IF CPI FUTURES ARE SUCH A GOOD IDEA,
WHY IS THE VOLUME SO LOW?
Shortly after the CPI futures contract was
introduced, Milton Friedman stated that it could
becom e “the largest-volume contract in the
country."14 Yet, the market's activity has been
small, especially when compared to other fu­
tures markets. For example, on December 2,
1986, the volume of the CPI futures market was
zero, while the coffee and S&P 500 futures
markets, two representative futures markets,
traded 3,800 and 109,749 contracts, respectively.

12Further analysis of the advantages and disadvantages of
indexation can be found in Brian Horrigan, "Indexation: A
Reasonable Response to Inflation," this Business Review,
(Septem ber/O ctober 1981) pp. 3-11.
13The hedge is imperfect because the payroll is paid out
every week, so that complete inflation protection would
involve buying a series of contracts maturing at different
dates through the year.
14Quoted in Institutional Investor, (January 1986) p. 17.




Brian R. Horrigan

And the open interest—the total number of
futures contracts not settled or closed out—on
the same day was 58 on the CPI futures market,
while on the coffee and S&P futures market the
figures were 15,322 and 146,005 contracts,
respectively. These values are typical for other
days, also. Clearly, this market is not catching
on. Why has the market failed in practice, so far,
and under what conditions may it yet succeed?
While no definitive answers are available, sev­
eral factors may play important roles.
The CPI May Not Be a Relevant Measure of
Prices For Many. The CPI measures how the
price of a representative “basket" of goods and
services purchased by American consumers has
changed over time. But many American con­
sumers probably purchase a basket of goods
and services that is very different from that
measured by the CPI. If the prices of different
goods and services rise and fall by very different
amounts, the inflation rate faced by individual
families may be significantly different from the
inflation rate as measured by the change in the
CPI. In that case, protection against unexpected
changes in the CPI would have little value in
stabilizing the cost of living for many families.
Economist Robert Gordon gave an example of
how widely spread price increases are among
different commodities: “Someone who spends
equal shares of his income on rent, TV sets,
telephone calls, eggs, and whiskey, would have
experienced a price increase since 1967 of only
51 percent, or a compounded rate of only 3.2
percent per year. Someone else who spends
equal shares on steak, potatoes, coffee, fuel oil,
and mortgage interest, would have experienced
an increase since 1967 of 321.3 percent, or a
compounded rate of 11.7 percent per year."15
Businesses May Prefer Cross-Hedges. For a
new futures contract to be successful, it is not

15Robert J. Gordon, "The Consumer Price Index: Measuring
Inflation and Causing It," The Public Interest (Spring 1981)
p. 117. Also see Robert P. Hagemann, "The Variability of
Inflation Rates across Household Types," Journal of Money,
Credit, and Banking (November 1982) pp. 494-510.

11

BUSINESS REVIEW

enough that the contract provide an opportunity
for hedging against commodity price risk. A
new futures contract must provide opportunities
for reducing risk that are significantly greater
than the opportunities that already exist in other
futures markets. Consequently, many businesses
"cross-hedge," meaning that they hedge against
price risk for one commodity by buying or selling
futures contracts for a similar commodity that
has an active futures market. For example, one
reason for the failure of the barley futures market
is that grain dealers found that they could hedge
against barley price risk in the corn futures mar­
ket. The hedge is imperfect since barley prices
fluctuate relative to corn prices, but the grain
dealers preferred using the corn futures market
which was far more active and "liquid" than the
barley futures market. An analogous situation
could exist for the CPI futures market, namely,
that businesses reject the perfect CPI hedges
available in the CPI futures market for less per­
fect hedges in more liquid futures markets.
Futures markets in industrial and precious
metals and in financial instruments allow some
hedging against CPI risk, and businesses may
well prefer to work in those familiar and active
futures markets to shed (imperfectly) some of
their inflation risk.16
Reduced Inflation Uncertainty Retards the
CPI Futures Market. Businesses face two differ­
ent types of price risk: inflation risk, in which all
prices rise together, but at an uncertain rate, and
relative price risk, in which different prices rise
and fall relative to each other, even though the
average of all prices may not change at all. Both
types of risk affect the real income of businesses.
To see this, consider the economic situation of a
wheat farmer who is sure about the size of his

16This point about the role of cross-hedging in determining
the success of futures contracts is argued in Deborah G.
Black, "Success and Failure of Futures Contracts: Theory
and Empirical Evidence," Monograph Series in Finance and
Economics 1986-1, Salomon Brothers Center for the Study
of Financial Institutions, Graduate School of Business Admin­
istration, New York University, 1986.


12


MAY/JUNE 1987

wheat crop but is uncertain about prices. The
farmer's real income can be reduced either by a
fall in the price of wheat he sells or by an increase
in the prices of the consumer goods he buys. If
the price of wheat remains very stable while the
CPI rises erratically, the main uncertainty about
the farmer's real income is inflation risk, and the
farmer can reduce that risk in the CPI futures
market. But if the CPI is stable while the price of
wheat is volatile, the farmer can protect his
income by shedding his price risk in the wheat
futures market. Eliminating the risk from wheat
prices would eliminate virtually all of his uncer­
tainty about his real income, so there would be
little reason for the farmer to use the CPI futures
market.
For the CPI futures market to be considered
worth the costs of using it (in time and trouble as
well as in brokerage costs), there must be suffi­
cient uncertainty in the CPI to expose many
people to significant inflation risk. A reduction
in inflation risk compared to relative price risk
could be an important reason for the lack of
interest in the CPI futures market, since the level
of inflation and expectations of inflation dropped
significantly after 1980. Economists have docu­
mented that the level of inflation is positively
correlated with inflation uncertainty both in this
country and in other countries, and some eco­
nomic theories predict that the correlation
between inflation uncertainty and the level of
inflation will persist. Since people expect a lower
inflation rate in the near future, people should
also expect inflation to be more predictable and
inflation risk to be less important.17 As inflation

17See John B. Taylor, "On the Relation Between the Vari­
ability of Inflation and the Average Inflation Rate," CamegieRochester Conference Series on Public Policy, (Autumn 1981)
pp. 57-86. Also see Stanley Fischer, "Relative Shocks, Relative
Price Volatility, and Inflation," Brookings Papers in Economic
Activity, 2 (1981) pp. 381-431, and A. Steven Holland, "Does
Higher Inflation Lead to More Uncertain Inflation?" Federal
Reserve Bank of St. Louis Review (February 1984) pp. 15-26.
Stanley Fischer, Indexing, Inflation, and Economic Policy
(Cambridge, MA; The MIT Press, 1986) pp. 301-320, ob-

FEDERAL RESERVE BANK OF PHILADELPHIA

The CPI Futures Market

and inflation risk have subsided, many, and per­
haps most, businesses are in the same position
as the wheat farmer—they find that the risk to
their real profits comes from the variability of
their own prices relative to the CPI, not from the
variability of the CPI, and they use futures mar­
kets to reduce their relative price risk rather
than to reduce their inflation risk. There have
been other futures markets that have become
inactive because of the low level of price volatility,
such as the one for fresh eggs. The same could
happen, and may already be happening, to the
CPI futures market.
There is no underlying asset for the CPI futures
contract. A futures market cannot succeed unless
it attracts businesses that wish to hedge against
the price risk of the commodity traded in the
futures market. But it is hard for a futures market
to survive by attracting only hedgers. Generally,
it helps a futures market to attract arbitrageurs
and speculators, who add "liquidity" to the futures
market. By buying and selling futures contracts
continually, arbitrageurs make it cheaper for
hedgers to buy or sell futures contracts whenever
they want, which in turn attracts more hedgers
to the futures market. Furthermore, they make
the futures market more "efficient," in the sense
that information is reflected in futures prices
more quickly. A problem for the CPI futures
market may be that there is no underlying asset
for the futures contract, as there is for virtually
every other futures contract traded. This feature
inhibits arbitrageurs and speculators from parti­
cipating in the CPI futures market to the same
extent they participate in other futures contracts.
Consider a commodity like wheat, which is
sold in both spot markets and futures markets. If

serves one measure of the relative importance of inflation
risk and relative price risk can be found by comparing the
variance of the CPI inflation rate with the variance of the
stock market rate of return; the former is smaller than the
latter by a factor of the order of 100. Referring to the intro­
duction of CPI-indexed bonds, he comments that "inflation
uncertainty is relatively trivial and insufficient to make the
introduction of a new financial asset worthwhile." The same
point applies to the use of the CPI futures market.




Brian R. Horrigan

the price of a wheat futures contract is high
enough relative to the spot price of wheat, arbi­
trageurs can make money by buying and storing
wheat and simultaneously selling a wheat futures
contract. On settlement day, the arbitrageur
must deliver the wheat promised in the futures
contract at the price specified in the contract, but
the arbitrageur has already purchased the wheat
destined for delivery. Since the selling price of
the wheat as specified in the futures contract is
above the price at which the arbitrageur pur­
chased the wheat, the arbitrageur makes enough
money to cover the cost of storing the wheat and
still have some profit—a risk-free profit, since
the selling price of wheat is set by contract. What
is true for wheat futures in this regard is also true
for other commodity futures and for interest
rate and stock price futures. Arbitrageurs can
supply futures contracts upon demand without
exposing themselves to significant risk as long
as they can buy the asset that underlies the futures
contract.
But if it were impossible to store wheat for
future delivery, the arbitrageur would take on
the risk of a potentially significant wealth loss
when he sold the wheat futures contracts. An
arbitrageur who sold wheat futures contracts
would have to wait until the futures contract
matured, and buy wheat in the spot market for
delivery to the owner of the wheat futures con­
tract. If the spot price of wheat rose above the
futures price of wheat by settlement day, the
arbitrageur would lose wealth. This risk would
inhibit arbitrageurs from selling wheat futures
contracts and would depress the volume of activ­
ity in the wheat futures market. The ability to
buy and store the asset underlying a futures
market encourages the participation of arbi­
trageurs, which enhances the liquidity of the
market.
Unfortunately for the CPI futures market, it is
impossible to buy and store the basket of goods
and services whose price the CPI measures;
there are hundreds of goods and services in the
CPI basket, some of which (like ice cream) can
be stored only at great cost and others (like
13

BUSINESS REVIEW

haircuts) which cannot be stored at all. Since
arbitrageurs cannot buy and store the CPI basket
while selling the CPI futures contract, they
absorb inflation risk when they sell the contract,
which they may not want to do. Thus, the poten­
tial supply of CPI futures contracts is limited in a
way that other, m ore successful futures markets
are not.
Speculators also prefer futures markets for
which there is an underlying asset. For most of
the commodities or assets traded on futures
markets, there are active spot markets in which
there is constant adjustment of prices as new
information is discovered about the future value
of the commodities and assets. The new infor­
mation about spot prices is useful for speculators
seeking to take a risky position in futures markets.
The CPI market basket is not traded in active
spot markets, so there is no continuous price
data available on the CPI. The CPI is announced
once a month, whereas for many commodities
the prices are announced (on their trading floors)
every minute. The lack of continuous price infor­
mation discourages speculators from entering
the CPI futures market, which further reduces
the liquidity of the market.
There is indirect evidence for the argument
that the absence of an underlying asset explains
why market interest in the CPI futures market is
so low. The New York Futures Exchange now
trades a futures contract that, like the CPI futures
market, is settled on a cash basis and whose
settlement value is determined by a price index.
The price index is the Commodity Research
Bureau's (CRB) index of futures prices for 27
key commodities. There are active futures and
spot markets in each of the 27 commodities in
the CRB's futures price index, so that there are
underlying assets for the new futures contract
introduced by the New York Futures Exchange.
The volume of trading and the open interest in
the CRB index futures contract has been much
higher than that in the CPI futures market. On
December 2,19 8 6 , for example, the volume and
open interest were 225 and 1,380, respectively,

Digitized 14 FRASER
for


MAY/JUNE 1987

in the CRB index futures market, while the vol­
ume and open interest were zero and 58, respec­
tively, in the CPI futures market. The CRB index
futures market has been no more successful
than the CPI futures market in attracting hedgers,
so far. But arbitrageurs and speculators have
been able to use the CRB index futures market
because of the presence of underlying assets
that are actively traded and that may be stored,
and they have been more willing to use the
market because of the greater price volatility,
which may explain why the CRB index futures
market has greater activity than the CPI futures
market.
CONCLUSIONS
The introduction of a futures market trading
contracts based on the value of the Consumer
Price Index—enthusiastically endorsed by promi­
nent economists—has made available to busi­
nesses and investors a means of trading and
hedging against inflation risk. The CPI futures
market has not been a great success, however.
Its volume and open interest have been very
low. The novelty of the contract, the inadequacy
of the CPI for measuring inflation risk, the
existence of cross-hedges for the inflation risk of
many households, and the lack of a storable
underlying asset for the contract are undoubtedly
some of the reasons for the market's low trading
volume. But the most important reason for the
failure of the market to be used in a big way is
probably that current inflation risk is not very
significant relative to all of the other risks that
investors and businesses must manage. Given
the costs of using the CPI futures market, most
investors and businesses probably believe that
their scarce resources are better spent coping
with the more significant risks they face. How­
ever, if inflation becomes higher and more erratic,
as it was in the 1970s, inflation risk will again
become significant, and many investors and
businesses may turn to the CPI futures market
to cope with it.

FEDERAL RESERVE BANK OF PHILADELPHIA

Explaining Long-Term Unemployment:
A New Piece To An Old Puzzle
Robert H. DeFina*
At each stage of the business cycle, there are
individuals of all descriptions who want to work
but who fail to find jobs for weeks or even
months. Indeed, several studies find that this
long-term unemployment accounts for most
measured joblessness.

‘ Robert H. DeFina is a Research Officer and Economist in
the Research Department of the Federal Reserve Bank of
Philadelphia.




Such unemployment has long been a focus of
policymakers, because it raises several especially
nettlesome social concerns. From an economic
perspective, protracted unemployment means
lost output as the skills and efforts of productive
individuals go unused for months at a time.
From a broader social perspective, lengthy un­
employment means a higher incidence of psy­
chological and health problems, not only among
the unemployed but also among the members
of their families. Several studies, for example,
15

BUSINESS REVIEW

have associated increases in the U.S. unemploy­
ment rate with increases in suicides, increases in
homicides and other crime, increases in heart,
kidney, and liver disease, increases in admis­
sions to state mental hospitals, and increases in
the incidence of child abuse.1
In order to address those concerns, policy­
makers need a thorough understanding of why
long-term unemployment exists. Unfortunately,
the underlying causes of persistent joblessness
have remained something of a mystery. Recently,
though, economists have begun to rethink their
traditional notions of how labor markets work.
In the process, they have provided novel insights
into the sources of long-term joblessness. Em­
pirical investigation into this new line of thought,
known generally as the "efficiency wage hypo­
thesis," is still at a relatively early stage. But the
evidence that is available suggests that this new
perspective has some validity.
LONG-TERM UNEMPLOYMENT
PRESENTS A PUZZLE
Economists traditionally describe labor mar­
kets as they do auction markets for any other
commodity, in terms of supply and demand. On
the supply side of the market are individuals
with a set of skills who voluntarily offer their
time in return for the going wage. Economists
generally believe that the number of people
who wish to work falls as the wage does. On the
demand side of the market are firms which need
workers to produce output. In contrast to the
quantity of workers supplied, the quantity of
labor demanded usually rises when the wage
falls, because falling wages make it increasingly
profitable to hire more workers. The interaction
of labor supply and demand determines the
level of wages and employment that are actually
observed.
Lengthy unemployment, where individuals

^ h e figures on the adverse health consequences of un­
employment are cited in Robert J. Gordon, Macroeconomics
(Boston: Little, Brown and Company, 1984) pp. 353-354.

16



MAY/JUNE 1987

go many months without a job, does not fit
easily into that basic market description. If un­
employment arises, the reasoning goes, com­
petitive forces will quickly and automatically
guide the wage to a level at which full employ­
ment prevails, that is, a situation in which every­
one who wants a job has one. Specifically, un­
employment encourages competitive job
seekers to offer to work for less than other similar
workers in an effort to obtain one of the relatively
scarce jobs. Employers readily accept those of­
fers since, in the simple market setting, lower
wages mean higher profits. Thus as wages get
bid down, unemployment declines through two
channels. First, the wage reductions spark some
employers to hire more workers. Second, the
wage reductions lead some job seekers to aban­
don their search. Job seekers will continue to bid
down the wage until all individuals who want a
job have one, that is, until unemployment van­
ishes. At that point no one has an incentive to
undercut the wage offer of another, and all simi­
lar workers will be receiving the same market­
clearing wage.
This scenario permits abbreviated unemploy­
ment due to frictions in the economy, such as
incomplete information about job possibilities,
that prevent instantaneous market adjustment
to changing circumstances. Individuals simply
may need some time to collect and assess their
options before acting. But once that information
is obtained, the competitive bidding process, if
fully operative, should guarantee quick access
to a job and rule out anything like the protracted
unemployment experiences that actually oc­
cur.
No official statistics exist on the length of
individuals' completed episodes of unemploy­
ment, although independent estimates have been
made (see UNEMPLOYMENT CAN BE QUITE
LENGTHY). Those estimates show that even
during periods when real gross national product
(GNP) grows rapidly, such as 1962 to 1968,
1971 to 1973, and 1976 to 1978, a person counted
as unemployed can, on average, remain jobless
for six to eight months. Studies also reveal that
FEDERAL RESERVE BANK OF PHILADELPHIA

Explaining Long-Term Unemployment

Robert H. DeFina

Unemployment Can Be Quite Lengthy
Year

Real GNP Growth3*

Average Total Number of Weeks
That a Currently Unemployed
Person Remains Jobless
Akerlof and Main*5

Siderc

1959
1960
1961

5.8
2.2

28.8
25.6

na
na

2.6

31.2

na

1962

29.4

na

1963

5.3
4.1

28.0

na

1964

5.3

1965
1966
1967
1968

5.8
5.8
2.9
4.1

1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982

26.6
23.6

na
na
na

20.8
17.6
16.8

na
18.2

2.4
-0.3
2.8

15.8
17.4
22.6

20.1
25.1

5.0
5.2

24.0
20.0
19.4

17.4

25.0
20.6

28.2
31.6

21.3
32.7
32.4

4.7
5.3
2.5
-0.2

28.6
26.2

28.3
24.1

na
na

1.9

na
na

23.1
26.4
29.2

-0.5
-1.3
4.9

-2.5

35.9

The above figures represent estimates of the total time a person counted as unemployed in the
indicated year remained jobless, on average. If in 1982, for example, a person had been unemployed for
the preceding 17 weeks when counted, he or she remained without a job during the next 18.9 weeks, on
average, for a total duration of 35.9 weeks.

NOTE: "n a" = not available for the indicated year.
aYear-over-year percent change.
^George A. Akerlof and Brian G. M. Main, "An Experience-Weighted Measure of Employment and Unemploy­
ment Durations," American Economic Review (December 1981) Table 4, pp. 1003-1011.
c Hal Sider, "Unemploym ent Duration and Incidence: 1968-82," American Economic Review (June 1985) Table 3, pp.
461-472.




17

BUSINESS REVIEW

protracted unemployment is fairly pervasive, in
that it is experienced by all demographic groups,
and that it may account for a significant fraction
of measured unemployment. For example, one
estimate that focused on 1974 suggested that
half of all unemployment that year was accounted
for by episodes lasting more than three
months.2
Economists have puzzled over the inconsist­
ency between the short unemployment dura­
tions predicted by the auction market model
and the extended durations that actually occur.
In trying to reconcile the two, they generally
have retained their emphasis on the basic mar­
ket paradigm, while focusing on exogenous—
that is, externally imposed—factors that might
prolong or even prevent complete labor market
adjustment after unemployment arises. Three
commonly cited examples are minimum wage
laws, unions, and unemployment insurance.
Minimum wage laws and unions, it is argued, fix
wages at levels that are too high to clear the labor
market. Unemployment insurance potentially
lengthens the duration of unemployment by
defraying the cost of remaining jobless. But not
only does theory suggest that such explanations
of long-term unemployment are incomplete,
those explanations also lack convincing em­
pirical support. For instance, studies find that
minimum wage laws lead to higher teenage un­
employment, but have little or no impact on
aggregate unemployment.3 At best, those ex­

2Kim B. Clark and Lawrence H. Summers, "Labor Market
Dynamics and Unemployment: A Reconsideration,"
Brookings Papers on Economic Activity (Volume 1 ,1979) pp.1372.
3For a thorough discussion of the theoretical and em­
pirical issues regarding those explanations, see Kim B. Clark
and Lawrence H. Summers, "Labor Market Dynamics..." and
Lester C. Thurow, Dangerous Currents: The State of Economics
(New York: Vintage Books, 1984) chapter 7. For related
discussions, see Charles Brown, Curtis Gilroy, and Andrew
Kohen, "The Effect of the Minimum Wage on Employment
and Unemployment," Journal of Economic Literature (June
1982) pp. 487-528, and Daniel S. Hamermesh, Jobless Pay and
the Economy (Baltimore: The Johns Hopkins University Press,
1977).

18



MAY/JUNE 1987

ogenous factors appear to provide a partial
accounting.
Persistent unemployment is also sometimes
identified with unskilled individuals and people
who are displaced by structural change, such as
former steel workers. But the pervasiveness of
lengthy unemployment suggests that long-term
joblessness cannot be accounted for totally by
the problems of a few particular groups. More­
over, the question remains as to why such struc­
turally unemployed individuals cannot simply
bid down wages in order to get jobs.
This partial accounting has led some econo­
mists to question the usefulness of the basic
market-clearing paradigm as a description of the
labor market, and hence as a basis for under­
standing long-term unemployment. Rather than
looking for an exogenous factor that might be
interfering with an otherwise smooth-working
market, those analysts have asked whether
something inherent in labor markets prevents
their clearing. This inquiry has produced a new
view of the labor market, the "efficiency wage
hypothesis," that affords an alternative expla­
nation of long-term unemployment.
THE EFFICIENCY WAGE HYPOTHESIS:
A NEW PIECE IN THE PUZZLE
The efficiency wage hypothesis concentrates
on the possibility that by increasing a worker's
wage, an employer may increase that worker's
productivity. The basic market model, in con­
trast, ignores this potential side benefit of a pay
raise. Rather, it assumes that a worker's produc­
tivity is fixed by her existing skills; a worker's
productivity helps determine her wages, but
wages do not, in turn, influence a worker's pro­
ductivity.
The efficiency wage view, if accurate, has a
striking implication: a firm might actually in­
crease its profits by paying its workers more.
The reasoning behind that implication is fairly
straightforward. Increases in productivity mean
that each worker produces more output. That is,
as productivity rises, labor costs per unit of out­
put fall. Wage increases, by boosting produc­
FEDERAL RESERVE BANK OF PHILADELPHIA

Explaining Long-Term Unemployment

tivity, thus appear as a two-edged sword for
profits. Higher wages directly raise labor costs
and thereby contribute to lower profits, but they
might also raise productivity, thereby cutting
labor costs and contributing to greater profits. If
the boost to productivity is large enough, profits
will rise.
The potential profitability of wage increases
suggests a possible source of lengthy unem­
ployment. Employers will continue raising
wages if doing so leads to maximum profits. By
raising wages they will induce their existing
workers to becom e more productive, but they
will also induce additional people to enter the
labor force and begin looking for jobs. Depend­
ing on how responsive productivity is to wage
changes, firms could ultimately raise wages so
high that the labor market does not clear, leaving
some workers unemployed. And if they do, any
subsequent unemployment will not quickly and
automatically vanish as it would in the auction
market arrangement, because people will not be
able to bid the wage down to get a job.
Unemployed individuals, whether they have
quit, have been fired, or have entered the labor
force for the first time, might try to get jobs by
bidding down the wages of current workers. But
in contrast to the simple competitive market
situation, firms will not accept those offers. Firms
have already weighed the benefits and costs of
lower wages and decided that keeping wages
high yields them their greatest profit. And be­
cause the unemployed cannot bid their way into
jobs, they must instead wait until new openings
arise from quits, firings, or increases in firms'
demand for workers. They must then hope to be
chosen over other jobless persons. On the whole,
unemployed persons might remain jobless for
quite some time.
The potentially beneficial impact of wage in­
creases on productivity provides a coherent ex­
planation of lengthy unemployment. But the
question of why such an impact on productivity
might arise still remains. Efficiency wage theo­
rists have offered several possibly complemen­
tary answers.4



Robert H. DeFina

Higher Wages Might Reduce Shirking. One
answer stems from the difficulties employers
have monitoring workers' efforts. For a variety
of j obs, individuals participate in groups, such as
when researchers coauthor studies or when
construction crews erect a building. On other
occasions, employees have some discretion over
the pace of work, or work at a location physically
distant from an immediate supervisor. Such is
the case, for example, when employees go on
business trips. Additionally, most jobs allow
workers a certain amount of sick leave and time
away for personal reasons. In those cases, man­
agers typically know only imperfectly either
how hard each person works, or whether an
absence from work was legitimate. Workers, as a
consequence, have some chance to decrease
their efforts without being detected.
According to the "shirking" model, workers
decide whether or not to reduce their efforts by
weighing the costs and benefits of doing so.5
The model presumes that workers are fired if
caught shirking, so the expected cost of shirking
reflects their lost wage less any public or private
assistance they might receive while unemployed,
the length of time they remain unemployed, and
the probability that they will be detected. The
expected benefit of shirking is, of course, the
value of on-the-job leisure the workers receive.
Workers choose to shirk if the expected benefits
exceed the expected costs.
In such a scenario, wage increases boost pro­
ductivity because they reduce workers' incen­

4Accessible surveys of particular variants of the efficiency
wage hypothesis are found in Lawrence F. Katz, "Efficiency
Wage Theories: A Partial Evaluation," National Bureau of
Economic Research Working Paper no. 1906, Cambridge,
MA (April 1986), and Janet Yellen, "Efficiency Wage Models
of Unemployment," American Economic Review (May 1984)
pp. 200-205.
5Formal characterizations of the shirking model are de­
scribed in Carl Shapiro and Joseph E. Stiglitz, "Equilibrium
Unemployment as a Worker Discipline Device," American
Economic Review (June 1984) pp. 433-444, and Samuel
Bowles, "The Production Process in a Competitive Econ­
omy: Walrasian, Neo-Ffobbesian and Marxian Models,"
American Economic Review (March 1985) pp. 16-36.

19

BUSINESS REVIEW

tives to shirk. By raising wages, employers raise
the perceived cost to workers of being fired
when caught shirking. Higher wages might tip
the scale in favor of less shirking and, thus,
greater productivity.
Higher Wages Might Reduce Job Turnover. A
related perspective emphasizes the job turnover
that wage increases might reduce. When indi­
viduals join a firm they rarely commit to stay for
an extended period. At a minimum, they retain a
passive interest in their outside options, and
their curiosity will likely grow if they perceive
that their current employment situation is dete­
riorating. If they feel particularly short-changed,
they might quit and devote all their efforts to
obtaining a new job, convinced they can improve
their current lot.
Quits result in net productivity losses to firms.
When workers quit, firms must operate with a
reduced work force until suitable replacements
are found. In addition, firms must devote pos­
sibly substantial amounts of resources to finding
those replacements, such as time taken to review
applications, to interview candidates, and to de­
cide to whom offers will be made.6 Productivity
will also be lowered during an initial "start-up"
period in which new employees learn the par­
ticulars of their jobs.
A firm might succeed in reducing the quit rate
of its work force, and thus raise productivity, by
increasing wages. An employee's wage repre­
sents an important facet of his or her job, and
probably figures in the decision whether to quit.
By raising employees' salaries, the firm increases
the relative attractiveness of their jobs, which
might reduce the frequency of turnover.7

6Charles L. Schultze, "M icroeconomic Efficiency and
Nominal Wage Stickiness," American Economic Review (March
1985) pp. 1-15, presents some evidence on the magnitude of
turnover costs. He cites a study of Los Angeles firms which
shows that costs of turnover (exit costs plus replacement
costs) averaged $3,600, $2,300, and $10,400 for production,
clerical, and professional and managerial workers, respec­
tively.
7A mathematical exposition of the turnover model can be
found in Steven Salop, "A Model of the Natural Rate of

20



MAY/JUNE 1987

Higher Wages Might Boost Employee Morale.
The productivity of employees can also depend
on how fairly they think their employers treat
them. Most firms understand the importance of
good worker morale and firm loyalty for pro­
ductivity, and often actively strive to promote
internal harmony. A firm's wage structure re­
presents an important concern in this regard.
Workers typically have some notion of what
constitutes a "fair day's work for a fair day's
pay." They have some perception of where they
stand relative to other workers both in their own
firm and in other firms, and also have some
perception of what constitutes an appropriate
pay differential. Those feelings of what is an
appropriate wage are partly molded by observing
the treatment of other workers in positions simi­
lar to theirs.
Although firms might find that "fair wages"
are quite high, paying them is worth their
while.8 Firms might be able to pay lower wages
and still retain their employees, but those em­
ployees might be less productive. Employees
who feel cheated, for instance, will not "go the
extra yard" for the firm, and might spend valu­
able time griping to coworkers. By generally
increasing wages to levels considered fair, or by
raising certain workers' wages to maintain in­
ternal pay relationships that are deemed equita­
ble, firms might enjoy a more satisfied and more
productive work force.
But Other Factors Might Render Higher Wages
Unnecessary. The preceding considerations
make a link between higher wages and greater
productivity appear plausible. Thus, they leave
open the possibility that a wage-productivity
link contributes to persistent unemployment.
But even if such a link exists, firms still might not

Unemployment," American Economic Review (March 1979)
pp. 117-125, and Guillermo Calvo, "Quasi-Walrasian Theo­
ries of Unemployment," American Economic Review (May
1979) pp. 102-107.
8A sociological model is rigorously developed in George
A. Akerlof, "Labor Contracts as Partial Gift Exchange," Quar­
terly Journal of Economics (November 1982) pp. 543-569.

FEDERAL RESERVE BANK OF PHILADELPHIA

Explaining Long-Term Unemployment

use wage increases to raise productivity. Factors
either internal or external to firms might render
higher wages unnecessary, or diminish their
use. If so, the cause of persistent unemployment
lies elsewhere.
An important internal factor is that firms can
use other productivity-enhancing techniques.9
Firms can, for instance, deter shirking in ways
other than by paying higher wages. One strategy
involves raising the chances that workers will be
caught by monitoring them closely. That might
entail hiring supervisors or devising sophisti­
cated accountability schemes. Firms might also
discourage shirking by using piece-rates, tying
pay to demonstrated performance. Firms like­
wise might use approaches other than raising
wages to reduce their turnover costs. As in ap­
prenticeship programs, for example, firms ini­
tially might pay new employees less than they are
“worth" in an effort to defray, partially or totally,
the costs of any needed training.10 Some firms
might find that although wage increases raise
profits, such alternatives increase profits more. If
so, those firms will opt for the alternatives.
Firms might also find that external factors al­
ready reduce shirking, quits, and bad morale to
the point where attempts to reduce these prob­
lems further by any approach are uneconomical.
Quit rates might remain low even without a firm's
intervention because workers have strong per­
sonal attachments to their jobs, or because the
financial costs to workers of searching for another
job and relocating to another area are very high.
Similarly, workers might already have sufficient
incentives not to shirk because of the bad reputa­
tion they acquire if fired for lapses in diligence.
The potential importance of those internal and
external factors cannot be dismissed, at least not

Robert H. DeFina

at the conceptual level. Nor can the possibility
that pay raises simply do not boost productivity
to begin with. Thus, whether or not a wageproductivity link actually plays a significant role in
explaining long-lasting unemployment must be
settled empirically.
EMPIRICAL EVIDENCE SUGGESTS
THE NEW PIECE MIGHT FIT
Empirical evidence on the question is sparse,
often inferential, and reflects a variety of metho­
dologies. Some analysts have directly examined
whether the basic premise of the theory, namely,
that wage increases lead to higher productivity, is
valid. In doing so, they have relied mainly on case
studies of employer and employee behavior in
the workplace. Several other authors have taken a
more indirect approach: they develop the logical
implications of the theory and then test statisti­
cally whether those are borne out by actual labor
market experience.
Support Comes from Case Studies... George
Akerlof has provided perhaps the most direct
evidence. In a series of articles, he reviews socio­
logical and psychological case studies of how
wages influence worker productivity.11* He
notes, for instance, an experiment in which stu­
dents were hired for proofreading. "One group
was told that they were not qualified, but would
be paid the usual rate. Another group was told
that they were qualified and were also paid the
usual rate. Those who were led to believe they
were overpaid produced...more output per
hour...than those who were told they were
qualified..." (p. 82). Akerlof argues that such
studies show that increased job satisfaction re­
sulting from higher wages results in greater
worker effort, as stressed by the sociological
theory. He also discusses studies which he claims
reveal that employers actually use wage in-

9These alternatives have been analyzed at length by vari­
ous authors. Lawrence F. Katz, "Efficiency Wage Theories..."
contains a good summary of those discussions.
10This possibility was suggested in Gary S. Becker, Invest­
ment in Human Capital: A Theoretical and Empirical Analysis,
With Special Reference to Education (New York: National Bureau
of Economic Research, 1964).




11 Those reviews are presented in George A. Akerlof,
"Labor Contracts...," and George A. Akerlof, "Gift Exchange
and Efficiency Wages: Four V iew s"American Economic Review
(May 1984) pp. 79-83.

21

BUSINESS REVIEW

creases to raise morale and achieve productivity
gains.
Jeremy Bulow and Lawrence Summers pre­
sented some evidence that gives credence to the
efficiency wage hypothesis in general, and the
shirking model in particular.12 They focused on
historical accounts of the Ford Motor Company's
pay policy, and found changes implemented in
1914 particularly noteworthy. At that time, the
Ford Motor Company began paying employees
$5 a day, while other manufacturers were paying
their workers between $2 and $3 a day. Bulow
and Summers note that observers of the change
claim that it led to large increases in productivity,
reductions in absenteeism, and fewer discharges
for cause. They cite, for example, a contemporary
engineering study which explains that, "The
high Ford wage does away with all of the inertia
and living force resistance... The workingmen
are absolutely docile, and it is safe to say that
since the last day of 1913, every single day has
seen major reductions in Ford shops [sic] labor
costs" (p. 378).
...And from Formal Statistical Tests. Other,
less direct examinations of the efficiency wage
hypothesis are also available. Those generally
rely on statistical analyses which find that similar
workers persistently receive different compen­
sation solely by virtue of their industry affilia­
tion or occupation.13 The auction view of labor
markets cannot easily explain such differentials;
competition among similar workers for the
higher paying jobs should quickly eliminate dif­
ferences in pay. The efficiency wage hypothesis,
in contrast, permits wage differentials for similar
workers to exist as a result of different industry
and occupational characteristics. One industry
might find turnover to be more costly than

12Jeremy I. Bulow and Lawrence H. Summers," A Theory
of Dual Labor Markets With Application to Industrial Policy,
Discrimination, and Keynesian Unemployment," Journal of
Labor Economics (August 1986) pp. 376-414.
13Lawrence F. Katz, "Efficiency Wage Theories..." pre­
sents a comprehensive survey of empirical studies of the
efficiency wage hypothesis.

22



MAY/JUNE 1987

another industry, and thus might need to keep
wages higher in order to contain the problem.
Similarly, differences across occupations in
shirking problems and the ability to monitor
shirking could also give rise to different wage
levels.
As a test of the efficiency wage hypothesis,
analysts have examined whether those wage
differentials vary consistently with the dictates
o f th e p articu lar e ffic ie n c y w ag e th e o rie s . T h e

turnover view, for instance, argues that em­
ployers use wage differentials to reduce costly,
productivity-reducing quits. In fact, several
studies have found that higher wage premiums
tend to be associated with lower quit rates, both
at the industry and individual level, after con­
trolling for other factors that might influence
quits.14 Further studies reveal that higher wage
differentials coincide with lower absenteeism
rates (again, after controlling for other factors),
which may give some support to the shirking
model.15 Because absenteeism can be monitored
with little difficulty, but the reasons for it cannot,
absenteeism may reflect shirking.
Researchers have also found that when one
occupational group in an industry receives a
sizable wage premium relative to wages paid
similar workers in other industries, it is likely
that all occupational groups in an industry re­
ceive a wage premium.16 This result is consis­
tent with the idea that internal wage structures

14Examples of such studies are Richard B. Freeman, "The
Exit-Voice Tradeoff in the Labor Market, Unionism, Job
Tenure, Quits, and Separations," Quarterly Journal of Eco­
nomics (June 1980) pp. 643-673, and Alan B. Krueger and
Lawrence H. Summers, "Efficiency Wages and the Wage
Structure," National Bureau of Economic Research Working
Paper no. 1952, Cambridge, MA (June 1986).
15Such results are presented in Steven Allen, "Trade
Unions, Absenteeism, and Exit-Voice," Industrial and Labor
Relations Review (April 1984) pp. 331-345, and Alan B. Krueger
and Lawrence H. Summers, "Efficiency Wages and...".
16Evidence on the occupational wage structure can be
found in Lawrence F. Katz, "Efficiency Wage Theories...,"
and William T. Dickens and Lawrence F. Katz, "Industry
Wage Patterns and Theories of Wage Determination," Mimeo,
University of California, Berkeley (March 1986).

FEDERAL RESERVE BANK OF PHILADELPHIA

Explaining Long-Term Unemployment

figure importantly in firms' wage-setting deci­
sions, as emphasized by the sociological
model.
Although case studies and statistical analyses
offer some support for the efficiency wage
hypothesis, the question of its validity is by no
means settled. Case studies, while informative
about particular work settings at particular times,
fail to indicate how widespread the discovered
behavioral patterns are. And while statistical
studies examine behavior across a much wider
cross section of workers and firms, none of them
directly links wage increases to productivity
increases. They find a correlation between
higher wages and their presumed benefits, but
fail to establish either purposeful behavior on
the part of firms or a causal link. Thus, the rela­
tions they uncover could be spurious or could
arise for some other independent reason.
THE PUZZLE IS NOT YET COMPLETE
The efficiency wage hypothesis offers a simple
insight into the operation of labor markets: by
raising a worker's wage, a firm may succeed in
raising a worker's productivity. That idea, while
simple, also appears quite powerful because it
provides a logically coherent explanation for
persistent unemployment. Adding to the idea's
strength is the initial empirical support it re­
ceives.
A potentially important contribution this re­
search can make is the guidance it gives policy­
makers in dealing with unemployment. At pre­
sent, the policy implications of efficiency wage
theories are largely undeveloped. Few conclu­
sions have been drawn, and those often hinge
critically on the particular model studied. None­
theless, the theories do seem to leave some scope
for policies to influence unemployment.
Each model ties persistent unemployment to
structural aspects of labor markets. Thus, poli­
cies that affect those aspects may also affect un­
employment. Some researchers, for example,
have discussed the possible impact of increasing
unemployment insurance in the context of the
shirking model.17 According to their logic, the



Robert H. DeFina

increase in unemployment insurance might in­
duce workers to shirk more, since it reduces the
penalty for being caught. This results in firms
having to raise their wages to reduce the shirking,
which in turn could lead to higher unemploy­
ment because it draws more people into the
labor force. Studies indicate that efficiency wage
theories might have implications for other struc­
tural labor market policies as well, such as man­
power training and regulations regarding job
security.18 For instance, regulations that in­
crease job security can reduce the expected cost
of being caught shirking. Thus, they might in­
duce firms to pay higher wages, which might
increase unemployment.
Efficiency wage theorists have examined the
cyclical behavior of unemployment, in addition
to its structural sources. They have found that,
under certain circumstances, the wage "sticki­
ness" implied by efficiency wage theories allows
variations in aggregate demand to cause swings
in the unemployment rate.19 That suggests a
role for monetary and fiscal stabilization policy
to dampen those fluctuations in unemploy­
ment.
Long-term unemployment obviously repre­
sents a complex issue. And not surprisingly,
many important conceptual and empirical ques­
tions regarding its causes and cures remain un­
answered. But while much work is yet to be
done, the research to date on efficiency wage
theories does seem to have yielded a productive
step toward understanding a major social ill.

17

See, in particular, Joseph E. Stiglitz, "Theories of Wage
Rigidity," National Bureau of Economic Research Working
Paper no. 1442. Jeremy I. Bulow and Lawrence H. Summers,
"A Theory of Dual...," presents a somewhat different analysis,
but arrives at a similar conclusion.
18See Jeremy I. Bulow and Lawrence H. Summers, "A
Theory of Dual...," for a discussion of the implications of
some other structural labor market policies using a variant of
the shirking model.
19Both Joseph E. Stiglitz, "Theories of Wage Rigidity," and
George A. Akerlof and Janet Yellen, "A Near Rational Model
of the Business Cycle, With Wage and Price Inertia," Quarterly
Journal of Economics (August 1985) pp. 823-838, analyze that
possibility.

23

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RESERVE BANK OF
PHILADELPHIA
BUSINESS REVIEW Ten Independence Mall, Philadelphia, PA 19106