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The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by
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I.
Introduction and Summary
3
II.
The "New" Theory of the Business Cycle:
Larry Butler
Are Recessions Just Random?
6
III. Inflation and the Business Cycle
Herbert Runyon
IV. The Outlook for Inflation Based on Cost-Push
Yvonne Levy
and Capacity Factors
V.
Labor Force Participation and Unemployment
Insurance- A Time Series Study
Rose McElhattan
VI. Unemployment, Unused Capacity
and the Business Cycle
Larry Butler
Fashions come and go in economic analysisa prime example being business-cycle analysis,
which has received relatively little attention in
recent years. This was not true a generation ago;
for several decades following the Great Depression, a steady stream of books and articles on the
subject flowed from the presses. For example, a
standard text like Alvin Hansen's Business Cycles and National Income (1951) contained 262
items in its bibliography. But as time passed and
14
22
35
46
the long-awaited Great Postwar Depression
failed to arrive, interest dwindled and finally
almost ceased. In the midst of the long expansion
of the 1960's, many observers proclaimed that
the business cycle had been tamed, only to be
proven wrong in the tumultuous 1970's.
Interest in business-cycle analysis might have
remained fairly mild were it not for the 1974-75
recession-a severe downturn which differed
considerably in character from the fairly typical
3
(and generally mild) downturns which had occurred at irregular intervals over the preceding
several decades. The contrast between the recent
recession (and recovery) and previous cyclical
movements is a major theme of this issue. In
searching for explanations for that phenomenon, in several cases we again recur to a theme
which has dominated earlier issues of this
Review-the increased risk and uncertainty re~
suIting from the serious inflation of the 1970's,
which has created severe problems for the real
economy as well as for financial markets and
institutions.
But first, there is the theoretical question of
how cycles actually develop, a question addressed by Larry Butler in the opening article.
Butler analyzes the six full cycles of the postWorld War II period and notes certain common
features, such as regularity of movement of GNP
components, consistency of income shares, and
highly irregular timing of cyclical turning-points.
He turns for an explanation to the "rational
expectations" literature. In such models, rational
transactors equipped with complete (or nearly
complete) information act in ways which reduce
observed errors in prices and quantities to uncorrelated random noise. A pure rational expectations approach would not generate cycles if the
errors were random. Obviously there are cycles
in the real world. By introducing limitations on
the information available to transactors, one can
develop a model where output varies cyclically
on the basis of a sequence of random shocks to
the economy even when expectations are assumed to be rational. Butler uses a simplifed
version of such a rational-expectations model to
generate business-cycle fluctuations similar to
the ones experienced in the postwar period.
The principal achievement of this "new" cycle
model is an accurate description of cyclical
timing. In the context of Butler's simple model,
there is no problem explaining why recessions
are short, sharp and irregular in timing. "The
timing factor suggests that the economy is subject to random shocks from a variety of sources,
and that these will sometimes be severe enough
to generate recessions. Further, if the shocks are
in fact random, the recessions we observe will be
short and sharp."
Herbert Runyon turns to the current scene to
examine the impact of inflation on risk-taking
and thereby on the dimensions of the cycle. He
argues that a high and unanticipated rate of
inflation significantly altered the profile of the
latest cycle, causing it to differ from the average
of other recent cycles. This was clearly apparent
from an examination of consumption spending,
which normally dominates recovery movements,
and inventory investment, which dominates
most recession movements.
"Consumers, faced with much greater than
expected inflation in the early 1970's, became
uncertain and reacted by spending less and
saving more, even before real output and employment had started to decline. Businessmen,
on the other hand, continued to add to their
inventories after output and consumption had
turned down, accumulating stocks in anticipation of continued materials price increases." In
Runyon's view, the same inflation that caused
the consumer to restrict his spending induced the
businessman to expand his buying, but in response to inflation rather than demonstrated
final demand. And since this severe and unexpected inflation contributed to the distortion of
the most recent cycle, we cannot rule out further
cyclical episodes of this type as long as inflation
remains a threat.
The first two articles look at the business cycle
from the point of view of movements in output,
that is, the markets for goods and services. The
last three look at these movements as reflected in
the factor markets-the markets for capital and
labor.
Yvonne Levy carries further the notion of
cyclical comparability, in analyzing the role of
costs and capacity utilization rates in the industrial pricing process. Her study indicates that the
major cost-push elements have followed the
usual cyclical pattern during the recent recovery
period. Typically, total costs per unit ofproduction rise at a relatively slow rate early in the
recovery, when output is rising relatively rapidly,
and at a faster pace as the recovery matures. But
at that advanced stage of the expansion, excess
demand pressures relative to available supply
cause widespread capacity bottlenecks in the
basic materials industries, exerting strong upward pressure on industrial prices.
Yet, in attempting to forecast the direction of
4
prices in 1977, Levy concludes that such pressures are not yet on the horizon, and that the
increase in industrial prices will not be much
higher than last year's 6.3-percent rise. Her
analysis is based on the 1976 and projected 1977
behavior of labor, material and energy costs, as
well as the expected level of capacity-utilization
rates in manufacturing. She adds that the favorable late-year supply outlook for most agricultural products, modified by the effects of recent
weather problems, suggests a one-percentagepoint greater increase than last year in farm and
food prices.
Rose McElhattan introduces several variables
which determine cyclical behavior in labor supply, with emphasis upon the influence of
unemployment-insurance (VI) benefits. Her
findings indicate that the payment of VI benefits
has weakened the "discouraged worker" effect,
so that when jobs become difficult to find, less
workers leave the worker force (or are discouraged from entering) than would be the case if no
payments were provided for the unemployed.
McElhattan claims that if the discouragedworker effect is weaker than originally thought,
the unemployment rate should have greater
amplitude and conform more closely with cyclical changes in aggregate output. However, other
economic conditions could be offsetting, including the tendency for increases in unemployment
benefits to add to the labor-participation rate.
"For example, an increase in VI benefits during
an economic downturn acts to increase the labor
supply, and thereby to increase the unemployment rate more than would be justified by
aggregate-demand conditions alone. This behavior helps to explain the unusual and largely
unexpected increases in the labor-force participation rate observed during last year's economic
'pause.''' According to McElhattan's calculations, the large increase in the ratio between VI
benefits and weekly spendable earnings between
1976.1 and 1976.3 may have added about
145,000 workers to the labor force and about.14
percentage points to the unemployment rate in
the third quarter of 1976.
In the final paper, Larry Butler argues that the
unemployment anomalies discussed by McElhattan have disappeared over long periods of
time in the past because of market-induced
changes in the real wage and in the capital-labor
ratio. He then notes, in analyzing the cyclical
relationship between unemployment and capacity utilization, that the two bore a stable relationship to one another until 1974, but that subsequently, unemployment has been increasingly
higher than would have been predicted on the
basis of past cyclical relationships. In contrast,
unused capacity has behaved in the recent recession and in the present recovery just as it has in
previous cycles. "This observation leads to the
conclusion that unused capacity is still a good
measure of overall factor-market tightness while
unemployment is not. The economy is thus likely
to enter a period with available capacity constraining output but with the unemployment rate
still well above 6 percent."
Butler argues that the reproducibility of capital helps keep the average level of unused capacity stable over time, as manufacturers adjust their
investment demand to keep their capital stock in
line with the long-run demand they expect for
their output. A portion of any needed adjustment can be accomplished fairly quickly by
cutting investment sharply. The fall in fixed
investment in 1974-75 was in fact quite sharp,
and investment has remained sluggish since, thus
accounting for the "normal" behavior of unused
capacity despite the continuing low level of
income relative to past trends. But he adds that
the labor force does not have the same kind of
self-adjusting capacity, so the severity of the
1974-75 recession has left us with substantial
unemployment two full years after the recession
trough.
5
Larry Butler*
occur when they do-which is probably the least
understood feature of the cycle. In fact, both
regularities and erratic timing have been so
pronounced as to require an explanation of
observed cycles, that is, a theory of the cycle.
According to the "new" theory of the cycle
analyzed here, cyclical events can be seen as
arising from random shocks to the economy. In
this paper, we will discuss how such shocks can
generate cycles, and more importantly, why we
should expect them to do so in market economies.
Our analysis shows, first, that the renewal of
interest in "shock" theories of the cycle stems
from the recent development of the "rational
expectations" literature in economics. According to that view, the public forms expectations,
particularly of prices, which incorporate knowledge of both the economic structure and of the
behavior of policymakers, and may offset the
actions of policymakers. In this context, the
business cycle can only be explained as the
economy's response to "outside" shocks. The
rational explanations approach is closely related
to much of the pre-Keynesian theoretical tradition. As this development has proceeded, however, the new expectational models have become
difficult to distinguish from older Keynesian
models, which attempted to explain cycles in
terms of the failure of certain prices to adjust
quickly enough to clear markets (especially the
labor market). The new cycle models provide
important insights, the most important being the
view of the cycle as a sequence of random shocks
to the economy. We use a simplified version of
such a model to generate business-cycle fluctuations similar to the ones experienced in the
postwar period.
Despite the challenge of finding a common
explanation for observed cycles and price move-
Business cycles are features of all marketoriented economies. In the United States, there
have been six recessions since the end of World
War II, separated by generally long-lived periods
of expansion. Measured from trough to trough,
these cycles have varied in length from just under
three years to ten full years. The associated
downturns have varied greatly in severity. Until
the most recent recession, whose trough was
reached in early 1975, it was possible to argue
that government stabilization efforts had become increasingly successful, judging by the
reduction in observed movements in income. But
the last recession, the most severe of the postwar
period, destroyed any thoughts that we had in
fact learned to control the cycle.
Despite the varying depth and duration of
these business cycles, they have displayed striking similarities both in the U.S. and in other
market-oriented economies. In each cycle, for
example,
I. the major components of output have
moved together;
2. the output of producer goods and consumer durable goods have fluctuated much
more than the output of non-durable
goods and services; and
3. both wages and profits have moved with
output, although with a greater variability
in the profits share of income. Thus income
and its components have displayed a highly
consistent relationship to each otheL l
The principal features of the expansions we
have experienced include the consistency of
income shares and the highly irregular timing of
cyclical turning points. In this article we attempt
to explain the feature of timing-why recessions
*Senior Economist, Federal Reserve Bank of San Francisco
6
ments, little work on such a theory was done
from the mid-1930's until quite recently. The
reasons for this hiatus are outlined in Section 1
below. Section 2 describes the recent development of the rational expectations literature,
which has been the source of the recent renewal
of interest in "shock" cycle theory. Section 3
provides a discussion of the principles governing
the new "random shocks" cycle model. Finally,
Section 4 provides a description of a very simple
"new" cycle model.
I. From Classical to Keynesian Theory
Classical economic theory is based on the
assumption that all prices can move to levels
which equate supply and demand in each market. In such a world, people offer labor and
capital as long as they find it to be profitable, and
wages and interest adjust automatically to clear
the labor and capital markets. There are no
unused resources in this world, and in particular
no involuntary unemployment, for the real wage
adjusts to equate the supply of and the demand
for labor. Though this classical approach provides an elegant way of showing how relative
prices are determined, it essentially assumes
away the business cycle and thus does not further
our understanding of the rather large observed
short-term movements in output and employment.
During the early 1930's and even before
theorists were aware of the need for some devic~
which would allow the integration of classical
value theory with the harsh facts about income
and employment fluctuations which characterized business cycles. A large business-eycle literature existed, much of it focusing on the role of
monetary factors in the cycle. The literature
often emphasized the role of institutional rigidities in keeping the economic system away from
classical equilibrium, and thus tended to favor
removing such obstacles in order to dampen the
cycle. Much of this work sounds quite modern,
especially in its description of how external
shocks initiate cycles. As a statement of what the
"new" cycle theory is about, it would be hard to
improve on this passage from Gottfried Haberler
(1937):
endogenous and exogenous factors. The structure of the
chair is responsible for the fact that irregular shocks are
transformed into fairly regular swings. An ordinary chair
would .ordinarily respond quite differently, although
some kmds of impulse are thinkable (regular pushes and
pulls) which would make it move in regular swings. 2
Classical business cycles thus consisted of a
sequence of shocks to an economy which, in
most respects, was able to produce a fairly quick
return to full relative-price equilibrium and thus
full employment.
The Keynesian alternative to this analysis was
developed in the middle and late 1930's, with the
main tools of Keynesian theory in place in l.R.
Hicks' Value and Capital (1939). This disequilibrium approach, which drops the classical assumption that all markets clear simultaneously,
has come to characterize almost all macroeconomic work since Keynes. Specifically, Keynes
assumed that wages are inflexible downward in
the short run when output is below its fullemployment level, so that a fall in prices leads to
a rise in real wages and a fall in the demand for
labor. This produces an underemployment equilibrium, which can be eliminated only by aggregate stimulus, in the form ofexpansive fiscal and
monetary policy.
The distinction between the Keynesian and
classical cycle models is illustrated in Chart l.
The curves describe aggregate supply and demand for output as functions of the price level.
The principal difference between the two models
lies in the supply curves. The vertical classical
supply curve (lower panel) embodies the assumption that prices can always adjust to produce fullemployment output. In contrast, the Keynesian
aggregate supply curves (upper panel) assume
the presence of a rigid wage rate W 0' which may
yield a less-than-full-employment level of output
Yu' Expansive policy will shift the demand
schedule to the right and eventually produce full
employment at the level Yf. In the bottom panel,
We can compare the economic system with a pendulum
or with a rocking-chair. A rocking-chair may be made to
perform fairly regular swings by quite irregular impulses
(shocks) from outside. (Besides, it may have a mechanism
installed which makes it swing without outside forces
operating on it.) In the explanation of the movement of
the chair we must now distinguish two factors: the
structure of the chair and the impulses from the outside-
7
Chart 1
serving to allocate scarce labor and capital and
also to determine the mix of output. Yet the old
question of integrating such a price mechanism
with a cycle-generating mechanism failed to
surface until the late 1960's, thirty years after the
Keynesian revolution.
There is a cogent theoretical reason for this
anomaly. Once one accepts the key role of
underemployment disequilibrium in the Keynesian short-term apparatus, it becomes clear that
there is no necessary contradiction between a
Keynesian short run and a classical long run. The
former is characterized by disequilibrium in at
least some markets, the latter by full equilibrium.
In particular, it is easy to devise models in which
an increase in, say, money supply increases real
incomes in the short run but affects only prices in
the long. Out of equilibrium, both price and
output respond to a shock; on return to equilibrium, only prices are affected by the shock. 3
Keynesian theorists, in developing a way of
describing the behavior of economic units which
are not in equilibrium, did not see a clear need for
a separate cycle theory. Their cycle theory was
one of aggregate demand disequilibrium, with
only a limited role for and no explanation of
price movements.
The disequilibrium-equilibrium dichotomy is
best exemplified in the natural rate hypothesis
(NRH), first presented by Milton Friedman in
1968. 4 Suppose the economy is in equilibrium at
some unemployment rate, level of income, and
inflation rate. The NRH says that if there is no
difference between the actual and expected rate
of inflation, unemployment will be at some fixed
level, which we define as its natural rate. If the
economy is shocked by, let us say, a permanent
increase in the growth of money, the unemployment rate will be at its old NRH level when the
economy returns to equilibrium, and all of the
increase in money growth will be translated into
an increase in the rate of inflation. Friedman's
proposition follows entirely from the properties
of the classical model. In the absence of changes
in taste or technology, the new equilibrium must
be at the same level of real income, and thus at
the same level of unemployment, as the old, and
all ofthe increased money growth must appear as
an increase in inflation. It is only in the "short
run" that increased money supply will increase
KEYNESIAN RECOVERIES FROM RECESSION
Prices
Supply
Demand (wo)
L-
---..:.
.,;...-
Yu
Output
Yf
CLASSICAL RECOVERIES FROM RECESSION
Prices
Supply (wo )
'1
Demand
Output
Yu
Yf
recession comes instead from a classical shock to
supply, which reduces output to Y u. Given the
vertical aggregate supply curve, which reflects
the assumption offlexible prices, the price effects
of the shock work through the economy, and the
supply curve shifts back to full employment at
the output level Y[The Keynesian revolution replaced the quite
sophisticated relative-price mechanism of the
classical model, where wages adjust to clear the
labor market, with the simple assumption that
nominal wages are determined "outside of the
model." There was an advantage to such a shiftreal income is no longer 'always at the full
employment level-but this advantage was purchased at some cost. The relative-price mechanism, with flexible wages playing a major adjustment role, is the heart of the classical model,
8
output, and thus employment.
The NRH makes no direct statement about the
way people form expectations; it just assumes
that people do form them, and are correct in the
long run. The NRH can thus be considered a
direct application of Keynesian disequilibrium
theory, early versions of which date from the late
1930's. The NRH, or something very like it,
should thus have long been part of the Keynesian
macroeconomic tradition. But until the late
1960's none of the main macro-models used any
version of the NRH. Most instead contained a
Phillips curve, which traces a relation between
the rate of inflation and the rate of unemployment. The principle here differs from the NRH,
which traces a relation between the difference
between the actual and expected rates of inflation and the rate of unemployment. The NRH
thus allows for an accelerating inflation, while
the Phillips curve does not.
The importance of the distinction between
what people expect to occur and what does occur
cannot be overemphasized. In a pure classical
model, the distinction does not matter, because
people have perfect foresight. But if they do not
have perfect foresight, they must have some
means of forming exnectations about their future incomes and prices. The major Keynesian
macromodels assume that these expectations are
formed as weighted sums of past values of the
variables themselves. This device has the virtue
of greatly limiting the amount of information
which is relevant to the explanation of anyone
variable, and therefore makes the specification
and estimation of particular equations relatively
easy.
II. Rational Expectations
order for them to affect individual behavior, for
if they were not, the information would be built
into the next set of expectations. Because these
shocks are random, there can be no possibility
that a shortfall of demand in the current period
will increase the probability ofa further shortfall
next quarter. In this world, the mere process of
forming expectations prevents business cycles.
The essence of the cycle is a close relation
between successive movements in output, and a
model whose response to a shock is an immediate
return to equilibrium might not seem to be the
best vehicle for analyzing such cyclical movements. However, that would ignore a key assumption in the analysis, which is that information is costless. It is possible to devise models
where all individuals have rational expectations,
but do not adjust fully to new information
because the cost of acquiring that information is
too high to be worthwhile. This approach could
lead to an integrated value and cycle theory,
where everyone responds rationally to available
price and output data, and yet where short-term
output movements are not necessarily random.
That Keynesian approach has a drawback,
however, in that it is not based on any notion of
how rational people form expectations. But the
problem can be dealt with by assuming that
people have the ability, based on all currently
available information, to form unbiased estimates offuture quantities and prices. Most of the
economic theory based on this "rational expectations" model is close in spirit to the classical
model.
Suppose someone believes that a certain set of
prices will prevail, and sets his demands accordingly. Then in terms of expected prices, he will be
in a classical world. He can be induced to move
away from his equilibrium set of demands for
goods only when actual prices turn out to be
different from his expected price set. If actual
prices are different, he immediately incorporates
this new information in his expectations and
moves to a new set of equilibrium demands.
Except for random shocks to his demands
caused by unexpected price movements, he is
always in equilibrium. Moreover, the random
shocks must be unrelated to earlier shocks in
9
m.
Random Shocks Model
ment, despite the rationality of expectations of
both prices and quantities, there is no preSumption that adjustment to a new classical equilibrium will be instantaneous. It is hardto.tell this
world from Keynes' (or, more properlY,Hicks')
on any matter of principle, except that the
rational-expectations literature would. add one
requirement: that the model. used should itself
generate the expectations of the variables in
question. Though such a model need notcontain
the simple, uncorrelated errors of the pure rational expectations model, we could interpret (as
that literature does) the observed errors in the
model as a sequence of random shocks to the
economy.
As has been known for some time, random
events in time series can generate cyclical movements which have a close resemblance to economic cycles. Also, a great portion of the movement in most economic time series can be
explained by the series' past history. Because the
logic behind the rational-expectations approach
involves the ability of transactors to reduce
errors in observed price and output forecasts to
randomness, the main contribution of this approach may be its ability to explain these correlated error processes and at the same time provide a reasonably good explanation of the
business cycle. Yet we cannot be sure that this
approach will provide an adequate description of
cyclical movements. The difficulty of providing a
reasonable expectational interpretation of a
model increases enormously with the number of
separate errors we must consider, as does also the
difficulty of estimating very general lag structures. A general 12-variable model of output
with 10 lags on each variable would require the
estimation of 12x10= 120 parameters, and thus
would exhaust the available quarterly postwar
data. The basic approach, then, must consist of
capturing as much movement as possible in a
small number of variables, as we attempt to do in
the following model, which contains only one
relevant random error.
A basic way of introducing non-random errors
is to place some limitation on the amount of
information people have at their disposal. Suppose, for instance, that my information set does
not include the price of natural gas in New York.
If a shortage ofgas develops in New York and the
price goes up there, I should in principle respond
to the increase immediately. But ifI do not know
of the shortage, or if I do not know how it will
affect California prices, I will have no response
until the New York price increase spills over to
the California market. The aggregate response
will be a relatively slow adjustment in both price
and quantity, as information about a shock in
one segment of the economy slowly becomes
reflected in prices in all segments. Shocks will
affect output over a span of time, and movements in output will be a moving sum of a
number of successive shocks and will be related.
That is, a cycle will be possible. Placing arbitrary
limits on the information sets available to transactors is not elegant theoretically, but it does
yield the real world's highly correlated errors.
Edmund Phelps' labor-market theory, utilizing the natural rate hypothesis,s indicates how
the arbitrariness in this problem of information
content can be eliminated. Unlike Friedman,
Phelps and his followers have emphasized the
short-run, rather than the long-run, properties of
the NRH. In Phelps' approach, most of the
emphasis has been on the role of search and other
costs of finding employment, which implies that
people bargain about their incomes rather than
about their wages. For example, a construction
worker with a high probability of being laid off
during bad weather is likely to insist on a higher
wage rate than a factory worker with the same
skills, to compensate for working fewer hours.
Thus, there is a conscious tradeoff between the
wage rate and the probability of being laid off.
This result implies that expectations primarily
concern quantities rather than price. For what
people do is to maximize the value of the stream
of their future wages, taking into account any
future loss from unemployment. In this environ-
10
IV. A Simple Model
Suppose the path of real income through time
can be described entirely by its past history, as
follows:
The effect on income of any such shock will
dissipate only slowly. It will be felt first through
its direct impact, then in the following quarter
throughits effect on the y-1 term, in the quarter
after that through its effect on both y -I and y-2,
and so on, with the equation used as a forecaster
of longer and longer periods ahead. The results
of such a forecast sequence are given in the table
below. This model is compatible with short-term
restoration of price equilibrium to the economy,
as in the pure rational-expectations model, but it
is not compatible with short-term quantity equilibrium.
Effect of Shock
Quarter
eO on Real
Ahead
Income in Quarter K
(I)y = .09y* + lAY_l - A9Y_2 + e, where
y is real income,
y* is the trend level of real income at a
3\;2-percent annual trend growth,
y-l and y-2 are past values of this realincome deviation from trend, and
e is random error, uncorrelated with its
own past values. 6
We may ask two questions:
a. Is there a plausible world where this model
holds?
b. How well does the model explain observed
business cycles?
The answer is yes to the first question. Suppose the world to be a place where the citizenry
fixes its real consumption expenditure as a
percentage "a" of its expected income.? Then
rational expectations would indicate that
o
1
2
3
4
5
6
7
8
c =aye =a(.09y* + lAy -1 - A9y -2)
If we next assume that the rest of income is i,
equal to investment plus government expenditure, then
i = y-c = (I-a) (.09y* + 1.4Y_l - A9Y_2) + e
This simple model is compatible with both
classical theory and certain empirical observations on the business cycle. First, real income is
independent of nominal magnitudes in the long
run, and even in the short run is randomly
shocked by those magnitudes only through their
impact on the error term. In the long run (say, 20
quarters ahead), the expected value of real income is y*, the trend level of real income. This
fact is compatible with Keynesian and classical
theory, and also with the natural rate hypothesis.
But the model also says that a rise in nominal
magnitudes, such as monetary or fiscal policy
variables, will exert a single-period shock effect
on the real economy, through its potential effect
on the random error term. The model incorporates fiscal or monetary influences into this error
term by assuming that the size of these effects is
too small to be distinguishable from random
noise.
eO
1AOeO
1. 47e O
1. 37e O
1.20eO
1.0leO
.82e O
.66e O
.52e O
12
.18eO
16
.06eO
20
.02eO
The model is also compatible with one of the
broader cyclical generalizations-the much
greater amplitude of movements in investment
than of movements in consumption. In the short
run, the impact of any shock to income falls
entirely on investment, because consumption is a
fixed function of past income. As the model
transmits shocks, they appear initially as unanticipated investment, and are then built into
consumption over a span of time. Two consecutive large negative shocks to real income-a
recession, by the normal definition-will produce a large decline in real investment and only a
small movement in consumption.
How well does this simple model describe the
cyclical movements of the past several decades?
The standard error of the above equation, fitted
11
one, has been followed by about six quarters of
extremely high economic growth. The model
simply failed to pick up these fluctuations. The
model predicts relatively slow turnarounds in
real growth rates, so that (for example) a twoquarter recession followed by three quarters of
very high real growth would be marginally less
probable than a recession of five quarters. And
as the table indicates, the model predicts no such
lengthY recessions.
The explanation has to do with the nature of
simple autoregressive schemes. Whatever their
virtues, such schemes tend to say that a variable's
level next quarter will be quite similar to its level
this quarter. In rate-of-growth terms, our equation says that this quarter's expected growth rate
for GNP will equal 60 percent of the trend
growth of 3Y2 percent plus 40 percent of last
quarter's actual growth, plus a small weight
moving the level of income back toward its trend
line.9 So in a fundamental way, the equation does
not have the capacity to produce large quarterto-quarter swings in the level of income, though
the relatively high standard error suggests the
occurrence of large unsystematic swings in
growth rates. Thus the model reproduces the
observed short, sharp pattern of recessionary
decline with more precision than it does the long,
high growth pattern of early recovery.
We have argued that even this simple randomshocks model-a type favored in the "new" cycle
theory-can be used to generate behavior which
is strongly reminiscent of some of the main
characteristics of the observed business cycle. It
does so imperfectly, and in particular somewhat
understates the duration of the typical downturn
and the strength of the ensuing early recovery.
But this model assumes a single-source random
event, which must thus incorporate every aspect
of random influence on the economy from the
ordinary monetary and fiscal shocks to world
commodity-price booms. Because of the frequent difference in character of these different
influences, it should be possible to improve on
the single-shock model by providing a better
explanation of the sources of shocks.
to quarterly U.S. data for the 1952-75 period (96
quarters), is 4.0 percent of GNP, with an annual
trend growth in income of 3.5 percent of GNP.
These figures may be used to indicate how well
the model describes actual cycles. Based on the
relation between trend growth and standard
error, the probability of anyone observation
showing an actual decline in income is .19,8 and
thus 18 quarters ofdecline (.19 x96) should occur
in the period of fit. There actually were 18
quarters of decline in the observation period, but
this is true almost by definition. The method of
fit was designed to produce empirically uncorrelated errors, with high and low errors in roughly
the frequency predicted by the bell-shaped curve
of the normal statistical distribution.
More interesting is how well the equation
predicts a second decline following the firstthat is, the actual occurrence of a recession,
defined as two quarters of consecutive decline in
real GNP. Because the equation's lagged GNP
terms make for a very sluggish GNP response to
the first decline, the second decline is considerably more likely than the first, with a probability
of .38. The probability of two consecutive declines is thus .19x. 38 = .073. The equation thus
"predicts" .073 x 96 = 7 recessions in the period, in
contrast to the 5 recessions which actually occurred.
Where the equation begins to slip is in predicting longer recessions. Similar, though somewhat
more involved, calculations of the type used
above yield for the 1952-75 period:
Actual
Predicted
Number
Length of Recession Number
(Quarters)
7
5
2 or more
3 or more
3
4
1
2
4 or more
2
5
o
Thus the relation tends to slightly understate the
frequency of long recessions, and to overstate the
frequency of short recessions.
The real problem, though, lies in the prediction of recovery periods. Each of the 5 recessions
in the 1952-75 period, including the most recent
12
V. Summary and Conclusions
Interest in a "new" business-cycle model began
with the development of rational-expectations
models in the late 1960's. In these models, it was
found that with complete (or nearly complete)
information, rational transactors would act in a
way which would reduce observed errors in both
prices and quantities to uncorrelated random
noise. In the case of non-random errors, transactors would incorporate their information in
succeeding price forecasts. No cycle, in the ordinary sense, would be possible. The next step in
developing a cyclical model involved the attempt, by now largely successful, to provide
limitations on the information available to transactors, which would allow for serially correlated
observations in quantities and perhaps prices as
well.
We argued initially that, in light of this development, it has become much harder to tell these
models apart from the much older (and numerous) Keynesian disequilibrium models. Models
which embody both rational expectations and
slow adjustment are clearly feasible. In the work
of Phelps and others, quantity disequilibrium in
the labor market results from discontinuous
search and transactions costs of various kindsfactors which tend to limit the information
available to transactors in that market. And in
the rational-expectations model with correlated
errors, quantities at least do not fully adjust to
shocks instantly, so that this model fits into the
Hicksian dichotomy between short-term disequilibrium and long-term equilibrium. Moreover, Phelps' argument is essentially that people
bargain over their incomes and not their wages,
trading future layoffs against wage increases.
Thus the formation of rational quantity (and
price) expectations adds one requirement to the
usual disequilibrium model, that the model itself
generate expectations. In that event, it will be
possible to interpret observed errors as they are
interpreted in the "new" cycle theory (and in our
simple model), as a sequence of random shocks
to the economy.
The principal achievement of the "new" cycle
model is an accurate description of cyclical
timing. In the context of our very simple model,
there is no problem in explaining why recessions
are short, sharp, and irregular in timing. The
timing factor suggests that the economy is subject to random shocks from a variety of sources,
and that these will sometimes be severe enough
to generate recessions. Further, if the shocks are
in fact random, the recessions we observe will in
fact be short and sharp. The major thing missing
from our simple model is an adequate description of Haberler's "rocking chair": the perception of the economy embodied in the model is too
simple to explain how the economy works itself
out of recession.
FOOTNOTES
permanent-income hypothesis. For a more detailed expianation of the relation between permanent income and rationalexpectations hypothesis, see Kurt Dew, "Market Response to
Economic Policies," this Review, Fall 1976, pp. 20-30.
8. This calculation assumes normally distributed errors with a
mean of 3.5 percent and a standard error of 4.0 percent. Zero
growth in the calculation is .88 standard errors below the mean,
and 19 percent of the normal distribution is more than .88
standard errors less than the mean.
9. This small weight is what gives the model its long-run
classical properties.
1. The consistency of these similarities is documented by
Herbert Runyon in this issue of the Review.
2. Gottfried Haberler, Prosperity and Depression, Geneva,
League of Nations, 1939. His book is perhaps the culmination of
the classical cycle-theory tradition. With its late date, it contains
an extensive discussion of Keynesian theory, but little referencetotheformal disequilibrium theory which was then emerging.
3. This statement summarizes what Samuelson calls the "neoclassical synthesis" of Keynesian and classical theory.
4. Milton Friedman, "The Role of Monetary Policy," American
Economic Review, 1968, pp. 1-17.
5. Edmund Phelps, "Money-wage Dynamics and Labor-Market
Equilibrium," Journal of Political Economy, 1968, pp. 678-711.
Friedman and Phelps are given credit for simultaneous authorship of the NRH. It is of course a feature of the older classical
model as well.
6. This relation is in fact the best description of real income
solely in terms of its past values and a random error, as fitted by
Box-Jenkins methods to real GNP data for the 1952-75 period.
7. This formulation is a very simple version of the standard
behavioral explanation of movements in consumption, the
FURTHER REFERENCES
R.J. Barro, "Rational Expectations and the Role of Monetary
Policy," Journal of Monetary Economics 1976, pp. 1-32.
R.J. Gordon, "Recent Developments in the Theory of Inflation
and Unemployment," Journal of Monetary Economics 1976, pp.
185-220.
R.E. Lucas, "An Equilibrium Model of the Business Cycle,"
Journal of Political Economy 1975, pp. 1113-44.
R.E. Lucas, "Understanding Business Cycles," prepared forthe
Kiel Conference on Growth Without Inflation, 1976.
T.J. Sargent, "A Classical Macroeconometric Model for the
United States," Journal of Political Economy 1976, pp. 207-37.
13
Herbert Runyon*
two decades. The recessions have been short in
length, while the recoveries have shown considerable regularity in their pattern of growth-but
not their duration, which has varied substantially over time.
Our central thesis is that consumption spending and inventory investment were distorted
from their usual pattern of behavior in the 197375 period, as the high rate of inflation altered the
expectations and responses of consumers and
businessmen in the recession phase of the cycle.
Consumers reacted to the uncertainty introduced by a large and unanticipated inflation rate
by restraining expenditures and increasing savings, despite continued increases in income and
employment prior to the cyclical peak. Conversely, businessmen reacted to accelerating
price increases of materials by increasing their
stocks of such goods, despite the decline in real
output.
This paper examines the characteristics of the
five post-Korean War business cycles. We emphasize particularly the most recent recession,
which was the severest of the group and was
distinguished from the others by a high-and
largely unanticipated-rate of inflation. Indeed,
there is reason to believe that inflation contributed significantly to the severity of the 1973-75
recession. The magnitude and unexpectedness of
this price upsurge led to changes in behavior that
were most evident in consumption spending and
inventory investment.
Our basic approach is to analyze the contribution of the major sectors of the economy to
fluctuations in real output, as measured by gross
national product in 1972 dollars. I Essentially, we
analyze the cycle by identifying the sectors that
contribute to cyclical turning points. Additionally, we note the common characteristics of the
observed recessions and recoveries of the past
I. Characteristics of Recoveries
National Bureau of Economic Research. The
current recovery has been at or close to the top of
the growth range for its first eight quarters. It
should be remembered, however, that that recovery was preceded by the most severe postKorean recession-and that rapid recovery does
not always imply a sustainable recovery.
In all cyclical recovery periods, personal consumption expenditures have constituted the largest share of the increase in total output, varying
between 48 percent and 65 percent in individual
cycles (Table 1). This magnitude is to be expected, since consumption expenditures generally
account for nearly two-thirds of total spending
in the economy. Yet despite its size, consumption
spending is not the most active sector in promoting the expansion of total output. Consumption
The similarities of the five post-Korean cyclical recoveries can be seen by comparing the
cumulative growth of real output for each of
those periods (Chart 1). Eight quarters after the
cyclical trough, the average annual growth rates
ranged between roughly 5 and 6 percent. (For
those recoveries which lasted at least twelve
quarters, the growth range narrowed somewhat,
to about 4 to 5 percent.)
Strong early growth is no particular guarantee
of the longevity of recovery (and vice versa),
since the first two years of the great 1961-69
expansion represented one of the weakest of all
recoveries. Yet that recovery became the longest
cyclical expansion in the 123-year annals of the
*Research Officer, Federal Reserve Bank of San Francisco
14
spending is constrained by income, which in turn
equals the total value of the components of
output, as described in the usual definitional
equation of income determination.
Y = C+I+X+G
when
Y = income (i.e., market value of output)
C = consumption spending
I = investment spending
X = net exports
G = government spending
Thus, all of the major sectors of the economy
contribute to total income, varying in degree
from recovery to recovery. But the relation of
consumption to income is a special one, with its
level determined by the level of income. This
relationship-the consumption function-is us-
ually .defined as
C = f(YD)
where Y D is disposable (after tax) income. The
relationship is highly stable in the long run but
less so in the short run. Changes in fiscal policy
may alter after-tax income and hence consumption. Individuals may choose to save rather than
consume. Yet short-term shifts in the savings rate
are compatible with a stable long-term savings
rate in the context of permanent income. 2 (Permanent income is a theoretical concept wherein
the individual is regarded as allocating his income over his lifetime rather than limiting its
disposition to the year in which it is earned. That
is to say, this year's consumption or saving
decisions are usually made with an eye to lifetime
income.)
Chart 1
CUMULATIVE CHANGE IN REAL OUTPUT IN CYCLICAL RECOVERIES
Cumulative
Change(%)
50
45
r
20
15
10
~~.1-_~-~_.1-_~-~-~--!-8-......L9--1~O--1~1--1~2--I.13--I.14-/.~5
Quarters after trough
15
Table 1
Cumulative Changes in Major GNP Sectors in
Five Recovery Periods
(Percent of Change in Real GNP)
Recovery Period
1954.21956.2
Cumulative change
Real GNP
Consumption
Residential Construction
Business Fixed Invest.
Inventory Invest.
Net Exports
Government
Addendum:
Change in Real GNP
(Billions of 1972 dollars)
1958.11960.1
1960.41962.4
1970.41972.4
1975.11977.1
Average
100.0
100.0
100.0
100.0
100.0
100.0
61.1
48.3
49.7
64.9
64.6
57.7
4.9
12.3
7.3
15.6
12.2
10.5
16.8
7.1
8.3
12.9
5.5
10.1
15.5
26.3
11.7
5.7
18.7
15.6
Share
4.0
~0.5
~3.4
~1.3
~5.9
-1.4
~2.3
6.5
26.4
2.2
4.9
7.5
61.9
77.3
73.9
130.8
135.7
95.9
II. Characteristics of Recessions
A common characteristic of recessions is their
relatively short duration-from two to five quarters (Chart 2). And unlike the situation in recoveries, the paths of contraction of real output
tend to diverge as recessions continue. The brief
1957-58 recession was the most severe for any
two-quarter period. The two longest
recessions~thoseof 1969-70 and 1973-75-were
respectively the least and most severe in overall
terms of the period covered. Yet each of these
lengthy recessions was marked by some unique
features. In 1969-70, the recession tended to be
prolonged by the General Motors strike of late
1970. In 1973-75, the initially mild downturn
culminated after a year in a steep two-quarter
decline reminiscent of 1957-58.
Inventory investment stands out as far and
away the major factor in the cumulative recession declines in real output (Table 2). The sole
exception was 1953-54, when a massive reduction iIi. government spending occurred in the
wake of the Korean War demobilization. In
contrast, consumption spending has generally
contributed least to cyclical downturns, declining only in the 1957-58 and 1973-75 recessions. In
both instances, this was due to a fall in durablegoods purchases-chiefly autos, the most volatile portion of consumer spending. In each of
these cases, the decline in consumer spending
followed a period of exceptionally strong auto
sales.
Chart 2
CUMULATIVE CHANGE IN REAL OUTPUT
IN CYCLICAL RECESSIONS
Cumulative
Change(%)
o
1970.4
-2
1954.2
-4
-6
1975.1
-8 ' - - _ - . L_ _....L.._ _L...-_-.L_---J
o
16
123
Quarters after peak
4
5
Consumption spending holds up in a recession
because the so-called automatic stabilizerssuch as unemployment insurance and reduced
tax liabilities-cushion the decline in disposable
income. But consumption spending, although
not declining, does slow down, and the effect is
seen in an accumulation of business inventories
in excess of their desired levels. In consequence,
businessmen do not re-order goods until stocks
are reduced and brought into line with their
current expectations of sales. This effect is pervasive, for inventories must be reduced at all levels
from retailers' shelves to manufacturers' warehouses. As new orders are reduced, production
falls and unemployment rises.
This response of inventory investment to
changes in consumer spending-the "acceleration principle"-is expressed in functional terms
as
61 t = f(5 t - 5 t -l)
where current inventory investment (61 t) is
governed by sales in the current period (5 t)
relative to sales in the previous period (S t-l)'
Even when consumption spending is growing, if
it grows more slowly than in the past, the change
in inventories (61 t) will decline. 3 And it is
important to remember, it is the change (not the
level) of inventories which enters the GNP accounts. The acceleration principle is symmetrical; in the typical recovery, inventory investment
is second only to consumption in contributing to
the overall expansion of output (Table 1), and as
noted above it accounts for the bulk of recession
declines. In recessions, as businessmen's anticipations of rising sales become disappointed,
inventory accumulation becomes involuntary,
and forces businessmen to reduce stocks.
In the typical recession, a decline in business
fixed investment ranks second only to inventory
liquidation as a contributor to declining output.
The acceleration principle applies to business
capital spending as it does to inventory investment, though the time horizon of anticipated
sales must be extended. Inventory adjustment is
a function of current sales, while capacityexpanding investment in plant and equipment is
a function of expected future sales. The expansion of capacity takes time, perhaps as long as a
year after funds have been appropriated. 4 However, when excess capacity exists (or increases),
expansion plans will be shelved or projects
stretched out until the sales outlook improves.
The result is a significant reduction in business
capital spending.
Largely because of differences in reaction
time, consumption spending-not investmenttends to be the leader in each recovery. Consumption decisions may be constrained by income, but investment decisions are conditioned
by businessmen's assessment of future demand
and the facilities required to meet that demand.
Thus, businessmen may not react as quickly as
consumers to recovery prospects at the bottom
of a recession.
Table 2
Cumulative Changes in Major GNP Sectors in
Five Recession Periods
(Percent of Change in Real GNP)
Recession Period
1953.21954.2
Cumulative change
Real GNP
Personal Consumption
Residential Construction
Business Fixed Invest.
Inventory Invest.
Net Exports
Government
Addendum:
Change in Real GNP
(Billions of 1972 dollars)
1957.31958.1
1960.11960.4
1969.31970.4
1973.41975.1
Average
-100.0
-100.0
-100.0
-100.0
-100.0
-100.0
+
8.7
- 18.8
+ 57.6
+ 93.3
+
4.4
2.7
+ 4.2
13.9
- 22.8
- 14.7
- 76.7
22.1
- 29.5
83.3
- 56.3
- 86.8
Share
+ 25.4
4.9
- 26.5
56.5
- 17.6
45.1
47.1
-202.3
+ 13.6
21.1
+ 45.9
+
7.5
+
8.8
+ 10.9
- 76.7
+ 16.2
+ 72.9
- 45.0
+
6.3
-
- 20.6
22.3
8.5
- 12.0
- 81.5
17
-
5.3
- 29.0
m.
The Different Recession
Business cycles vary because of contemporary
forces which determine the length and vigor of
expansion and the severity of recessions. Nonetheless, all of the cycles before the 1973-75
recession had certain common elements. Inventory liquidation occurred early in each recession
and increased most in each recovery. But the
1973-75 recession was different; inventory liquidation came late in the downturn and consumption spending declined even before the 1973 peak
was reached.
This recession was not only the most severe of
the post-World War II period, but the inflation
which accompanied (and preceded) it was unparalleled since the price upsurge of 1946-47, caused
by the unleashing of pent-up wartime demand
and the easing of price controls. Prices generally
remained stable through most of the next two
decades, and then the inflation rate edged up to
the range of 4Y2-5 percent from 1968-1972. In
1973, the U.S. experienced the world-wide inflation that was raging and which peaked domestically at nearly 14 percent late in 1974. As a result,
consumers were doubly punished during the
recession, by an inflation-caused reduction in
real income and then by increasing unemployment.
Consumption spending, which had been a firm
source of support in the expansion that began in
1971, faltered in mid-1973 (Chart 3). It levelled
off in the late stages of the expansion, and
peaked in the third quarter of the year-one
quarter ahead of real output. It was not until
Chart 3
REAL GNP AND CONSUMPTION SPENDING
$ Billions
(1972 Dollars)
Recession
1300r
-.011(
$ Billions
(1972 Dollars)
1900
Real
GNP.....".
1150
750
1100
1050 T~--'----'--~P
1971
1972
1973
1974
1976
1975.3, eight quarters later, that the 1973.3 level
of real consumer spending was again reached
and surpassed. As in the 1953-54 and 1957-58
cycles, consumer spending for goods (not services) bore the brunt of the decline in spending. 5
IV. Consumption: Inflation and Savings
In making their consumption and saving decisions, consumers were at least as sensitive to the
inflation rate as they were to changes in real
income during the 1971-76 period (Chart 4). In
reviewing this period, Joseph Bisignano has
noted that individuals tend to react to unanticipated inflation by increasing their rate of saving. 6 Savings generally declined in 1971-72 as
inflation decelerated, and then rose in 1972-73 as
inflation accelerated. The parallel was not exact;
in fact, the savings rate dipped in 1974 when the
inflation rate peaked, as the decline in real
disposable income indicated that there are limits
to the displacement of consumption by saving.
But then the relationship was re-established in
1975, as the inflation rate and the savings rate
declined together.
The general consumer response to inflation of
the unanticipated magnitude of 1973-75 was an
evident decision to reduce spending and increase
saving. Even in 1973, despite rising employment
and disposable income, real consumption recorded a slight decline. Moreover, consumers
responded, then and later, to the differential
impact of inflation on different sectors of consumption. From peak to trough, real purchases
18
in food expenditures. The demand for food as
such is highly inelastic at some point, since it is
necessary to sustain life. Yet real expenditures
for food declined early in 1973 in the face of a 12
percent (annual rate) rise in food prices, and
spending remained depressed for three years
(Chart 5). Consumers were quick to adjust the
contents of their market baskets on the basis of
relative prices, reducing their consumption of
meat and processed foods and increasing their
consumption of fresh fruits and vegetables.? In
contrast, there was less possibility for substitution in housing, because of market rigidities and
transaction costs, such as leases and costs of
search and moving.
Chart 4
INCOME, INFLATION and the SAVINGS RATE
$ Billions
(1972 Dollars)
900
Percent
25
Disposable
Income ""
20
--
Chart 5
15
REAL FOOD EXPENDITURES
AND
CHANGES IN FOOD PRICES
10
$ Billions
(1972 Dollars)
165
Recession
CIlllnge (%)'
25
160
P
1972
1973
Change
in
..
Food
Prices
T
1974
1975
1976
of durable goods declined by more than 15
percent, while purchases of nondurable goods
fell more than 3 percent. At the same time,
despite sharply rising prices of services, expenditures in that category rose 4Y2 percent, with
housing services rising by 9\;1 percent.
This pattern reflects the ability of consumers
to seek and respond to possible substitutes.
Durable goods by their nature are deferrable. In
addition, there is a high degree of substitutability
155
15
150
10
145
140 T _..L-_....I-_....J
........
'Ii
1971
1972
• Annual rate
19
1976
V. Inventories: Inflation Factor
Unlike consumers, businessmen in the 1973~75
period generally did not .restrict theiLexpendi~
tures and increase their savings in the face of
inflation. Inventory investment, which typically
tumsdown early in each recession, did not do so
in this case until real output bottomed out, and
liquidation of stocks continued through the first
three quarters of the recovery (Chart 6). Quite
atypically, the inventory sector eased the rate of
decline in real output in 1974, and then held
down the rate of growth in the early stages of
recovery. The continued inventory build~up of
1974, in the face of declining consumption and
real output, might be explained in terms of such
factors as involuntary accumulation of stocks.
However, special mention should be made of the
inflation expectations of businessmen engendiered by a rapid run-up in materials prices.
The sharp rise in wholesale prices in 1974 helps
explain much of the hehavior of inventories at
that time, reflecting the fact that changes in
stocks of materials and work in progress are
three times as volatile as changes in stocks of
finished durable goods. 8 Durable goods producers responded to the inflationary rise in the
wholesale prices of materials-which reached
rates 0[30-40 percent inlate 1974-by increasing
their inventories of materials relative to stocks of
finished goods, possibly in anticipation of further price increases (Chart 7). This took place a
year after consumer demand had softened and
while total real output was already declining.
Thus, expectations of price inflation apparently
had a more significant impact than business sales
expectations upon inventory investment policy
in the most recent cycle.
Chart 6
REAL GNP AND
CHANGES IN INVENTORY INVESTMENT
$ Billions
(1972 Dollars)
1300
Recession
$ Billions
(1972 Dollars)
30
Chart 7
CHANGES IN MATERIALS PRICES
AND RELATIONSHIP OF INVENTORIES
TO FINISHED GOODS INVENTORIES
20
1250
Percent
50
10
40
o
11501---+----
1100
1971
1972
-J...-'-_---' -
Percent
150
Inventories of
Durable Materiais
& Supplies/lnvento
of Finished
Durable Goods
140
--
130
20
120
10
-20
1000 L . - - - ' - - - - ' - - - :
T
y
30
-10
1050
Recession
110
30
: - - - ' - _.... 100
1972
1976
20
1976
VI. Summary and Conclusions
A high and unanticipated rate of inflation
significantly altered the profile of the most recent
business cycle, causing it to differ from the
average of other recent cycles. This is clearly
apparent from an examination of consumption
spending, which normally dominates most recession movements.
The recent behavior of consumers suggests
that they may exert a considerable amount of
autonomous control over their aggregate level of
spending in the short run. This is not inconsistent
with the view that consumption in the long run is
endogenous to the system and is a stable function
of income. However, the mood of the
consumer-whether optimistic, cautious, or just
plain uncertain-can generate major changes in
the savings rate.
Consumers, faced with much greater than
expected inflation in the early 1970's, became
uncertain and reacted by spending less and
saving more, even before real output and employment had started to decline. Businessmen,
on the other hand, continued to add to their
inventories after output and consumption had
turned down, accumulating stocks in anticipa-
tion of continued materials price increases. To
some extent, then, the inflation that caused the
consumer to pull in his horns and restrict his
spending also induced the businessman to spend
more, in response to inflation rather than demonstrated final demand.
The principal lesson Jor the future is that
inflation cannot be lightly regarded as a factor in
the business cycle, particularly when that inflation is unanticipated. Because of inflation, the
profile of the last cycle was substantially altered
from the typical cycle sequence. Reduced consumer spending reduced the rate of growth prior
to the cyclical peak. Conversely, continued inventory investment during most of the recession
cushioned the decline in real output. However,
when the inventory adjustment came, it was swift
and severe. In the ensuing recovery, inventory
policy has been fairly conservative while the
consumer savings rate has receded, reflecting the
reduced rate of inflation. Yet, since the severe
and unexpected inflation of the 1973-74 period
apparently contributed to the distortions evident
in the most recent cycle, future episodes of this
type should not be ruled out.
FOOTNOTES
1. The reference cycle turning points are determined by the
4. Shirley Almon, "Lags Between Investment Decisions and
their Causes," Review of Economics and Statistics, vol. 50,
National Bureau on the basis of the behavior of economic
indicators representing all sectors of the economy, such as
1968, pp. 193-206.
5. Economic Report of the President, 1955, p. 15; 1959, p. 12.
employment, prices, costs and profits and other measures that
range beyond production and income as represented by real
6. J.R. Bisignano, "The Effect of Inflation on Savings Behavgross national product. Many of these series are monthly series,
ior," Economic Review, Federal Reserve Bank of San Francisco,
and the reference turning points are designated on a monthly
December 1975, pp. 25-26.
7. Agricultural Statistics 1976. U.S. Department of Agriculture,
basis. Suppose that a series which coincides with cyclical
movements, such asthe index of industrial production, bottoms
U.S. Government Printing Office, Washington: 1976, p. 561.
out in April and then starts to rise. April may then be the
8. Feldstein and Auerbach have recently taken issue with the
"conventional wisdom" regarding inventory policy. Heretofore,
reference trough date, but since output will be rising in Mayand
inventory changes-especially in durable-goods manufacturJune, real GNP may rise in the second quarter, making the first
quarter the trough for real GNP.
ing-have been considered to be a lagged response to corpoSee Victor Zarnowitz and Charlotte Boschan, "Cyclical Indirate sales expectations, as expressed in new orders or unfilled
cators: An Evaluation and New Leading Indexes," Business
orders. According to this reasoning, if sales expectations are
Cycle Digest, U.S. Department of Commerce, May 1975, pp. vdisappointed, the increase in finished-goods inventories reflects both the shortfall in sales and the original intended
xiv; Cyclical Analysis of Time Series; Selected Procedures in
Computer Programs, Gerhard Bry and Charlolle Boschan,
increase in inventories. Feldstein and Auerbach question this
theory of lagged response; they contend that the adjustment
Technical Paper 20, National Bureau of Economic Research,
New York: 1971, Chapter 3.
process is much more immediate, taking place largely within
2. Albert Ando and Franco Modigliani, "The Life Cycle Hythe current quarter, but also incorporating a longer-term period
of adjustment to a "desired" level of inventories. The short lags
pothesis of Saving: Aggregate Implications and Tests," American Economic Review, LIlI, March 1963, pp. 79-80. The authors
in this model would lead us to expect a prompt response to
state that when income declines, the savings rate will also fall.
inflation of the 1973-74 type. Martin Feldstein and Alan AuerThis happened in recessions prior to 1969-70 and 1973-75; in
bach, "Inventory Behavior in Durable-Goods Manufacturing:
which the savings rate rose in the recession. See also Bert G.
The Target-Adjustment Model," Brookings Papers on Economic Activity, 1976, pp. 351-392. D.A. Belsley, Industrial ProducHickman, Growth and Stability in the Postwar Economy,
Brookings Institution, Washington: 1960, pp. 259-261.
tion Behavior: The Order-Stock Distinction, North-Holland
3. Michael K. Evans, Macroeconomic Activity, Harper & Row,
Publishing Company, Amsterdam, 1969, pp. 18-27, pp. 43-47.
New York: 1969, pp. 373-375.
21
Yvonne Levy*
also for factor inputs. It is in this sense, with
regard to their role in transmitting inflation, that
it is useful to study the underlying "cost-push"
elements at work in the inflationary process.
This article attempts to study the role of costs
and capacity-utilization rates in the industrial
pricing process, and to formulate an inflation
forecast for 1977 based on a consideration of
those factors as well as the expected behavior of
farm and food prices. The first section describes
the cost-plus pricing methods most manufacturing firms follow in setting their prices, and the
variables that affect the various elements of cost.
The second and third sections compare the
behavior of the various cost elements during the
current recovery in U.S. economic activity with
that of previous post-war economic recoveries.
The fourth section examines the behavior of
costs and prices during 1976 in more detail, as a
prelude toward developing an inflation forecast.
Finally, in the last section we analyze what all
these considerations imply for the overall rate of
inflation in 1977.
Cost-push influences frequently have been
cited as the cause of short-term increases in the
overall price level. But there is general agreement
among economists that, over the long run, inflation is a demand-related rather than a supplyrelated phenomenon. Neither strong unions nor
oligopolistic manufacturing firms, through their
market power, can independently generate a
sustained upward movement in prices. Unless
wage increases are validated or supported by
increased demand for labor, rising unemployment eventually will halt the wage-push. Similarly, the efforts of sellers to widen their profit
margins, without regard to the strength of demand, eventually will be frustrated by heavy
discounting from list prices.
The monetarists go a step further and argue
that inflation is always a purely monetary phenomenon, that apparent cost-push influences
(even in the short run) are lagged reactions to
past excesses in monetary growth. But even the
monetarists agree that a short-run acceleration
in the rate of money growth initially stimulates
the demand not only for goods and services but
I. Cost-Price Determination Process
the basis of average costs of production (for
labor, materials, energy and capital) plus a
margin of profit based on some predetermined
target rate of return on investment. I Prices per
unit therefore change primarily in response to
changes in unit costs, or profit margins, rather
than in response to short-term shifts in the
demand for goods. Of course, demand influences
may be felt through variations in the profit
margin, since firms frequently increase their
markups during booms and shade their list prices
during recessions and other periods of demandsupply imbalance.
Unit labor costs, the largest cost factor, de-
Most manufacturing firms in the United
States operate in imperfectly competitive markets, where individual producers have some
control over the price of their output in the shortrun. They do not passively accept as a "given" the
price established by the freely operating forces of
supply and demand. Rather, empirical studies
have shown that most firms set their product
prices in accordance with some version of the
cost-plus principle. The central tenet of this
doctrine-also known as mark-up pricing-is
that prices per unit of output are set primarily on
*Economist,
Federal Reserve Bank of San Francisco.
22
pend upon the hourly compensation paid workers and their productivity, i.e., output per hour.
Wage-rate changes in turn depend primarily
upon the unemployment rate and the past rate of
inflation in consumer prices.2 Under the traditional Phillips Curve concept, the rate of increase
in wages bears an inverse relationship to the rate
of unemployment, which serves as a measure of
tightness in labor markets. 3 For the recovery
stage of the business cycle, with unemployment
declining, the Phillips analysis thus implies an
accelerated rate of increase in compensation.
Past inflation influences wages in two ways: I)
automatically, through the operation of cost-ofliving adjustment (COLA) clauses in labor contracts and 2) through the collective-bargaining
process, as organized workers seek also to increase their real wages. Because labor contracts
normally extend over several years' time, wages
are affected not only by past price behavior but
also by the expected behavior of prices during
the term of new contracts.
The second major determinant of unit labor
costs is productivity.4 Changes in labor productivity reflect two distinct forces: I) the long-term
trend in technology as reflected in the capi-
tal! output ratio and 2) short-term cyclical fluctuations in output and the capacity-utilization
rate. s
Other direct costs of production include the
costs of materials and energy. The costs of
industrial raw materials-such as cotton, hides,
natural rubber, and metal scrap-depend largely
upon prices determined in highly competitive
markets, where changes in demand lead to quick
adjustments. Consequently, their prices tend to
show a higher degree of cyclical volatility than
prices for products at later stages of the production process. Highly processed materials, such as
steel and aluminum, in contrast are priced in
oligopolistic markets in accordance with the
cost-plus principles outlined here. Higher prices
for these products affect the costs incurred by
manufacturers of finished products such as automobiles and appliances, encouraging them to
raise their product prices. The costs of energy,
which have risen sharply (both absolutely and
relatively) in recent years, are determined primarily by OPEC cartel's actions in setting the
world price of oil and by the Federal Power
Commission's actions in regulating interstate
natural-gas prices.
II. Cost Behavior During Previous
Recoveries
How do these cost elements behave during the
recovery phase of the typical business cycle? A
review of five cyclical recoveries (prior to the
1973-75 period) shows that hourlycompensation growth typically increases gradually as the recovery progresses, presumably in
response to both a decline in the rate of unemployment and a speed-up in the rate of inflation
(Chart I-A). Output per labor-hour typically
rises sharply during the early stages of the recovery, when capital and labor are both underutilized and output can be expanded without
commensurate growth in aggregate hours by
fuller resource utilization (Chart I-B).6 In contrast, output per labor-hour normally slows
during the more advanced stages of the business
recovery, as plant capacity becomes more fully
utilized and output expansion becomes difficult
even with increased inputs of labor.
The rapid rise of productivity early in the
expansion, combined with a relatively moderate
rate of increase in compensation, typically causes
unit labor costs to stabilize or even decline
(Chart I-C). Later in the recovery, with slowing
productivity and accelerating compensation,
unit labor costs tend to rise at a more rapid rate.
On the raw material side, industrial rawmaterial prices typically begin to turn upward
about a quarter before the cyclical low in general
business activity, as manufacturers begin to
rebuild their materials inventories in preparation
for increased production. These prices tend to
rise slowly, then more rapidly, and then more
slowly again in response to a slower growth of
production and inventory accumulation. Finally, late in the expansion period, the rate of
increase in prices begins to accelerate again as
buyers begin to react to expectations of shortages (Chart 2-A). 7 Reflecting these price movements, raw material costs per unit of output tend
to fluctuate in the same manner over the course
of each cyclical expansion. Energy prices (and
23
essedmaterials such as steel, aluminum, and
paper----.,tend to be the first to experience capacity
bottlenecks as the recovery matures. Demand for
these materials is bolstered not only by increased
consumption but also by inventory accumulation (as a hedge against possible shortages and
energy unit costs) in contrast remain relatively
stable until the later stages of the typical recovery
(Chart 2-B)-although not of course in the most
recent recovery.
Those manufacturing industries producing
industrial materials-particularly highly-proc-
Chart 1
CYCLICAL BEHAVIOR OF LABOR AND OVERHEAD COSTS
B. Output per hour
A. Compensation per hour
Change (%)*
Change (%)*
25
25
20
20
15
15
-~_~
\
10
Current recovery
\~,.
",-/
I~current recovery
10
~-~
,J>
I
Avg. of five'"
previous recoveries
01-------....:.-------
r
I
5
5
Avg. of five
previous recoveries
t
01-:...----+---++--.:0:::;;;.-+--:1----
-5
-1 0
-1 0 L....J.--'---L.-..J.-..L....JI.-l--'---L.-...L..L....Ji.......I.--'-....J
-4
T
+4
Quarters to trough
L....I-..L-L.-I-..L-.L-J-.L--'--I-..L-.L-Ji.......I......J
-4
+8
C. Unit labor costs
T
+4
Quarters to trough
+8
D. Unit overhead costs
Change (%)*
Change (%)*
25
25
recovery
Current recovery
y
5
01---+------"------"'".....::;:...:1,--.::...".'-
..
\
Avg. of five
previous recoveries
T
+4
Quarters to trough
T
+4
+8
Quarters to trough
*From previous quarter at annual rate
24
+8
higher prices), so that their output typically tends
to rise faster than the production of finished
products such as automobiles. Thus, at any given
stage of the expansion, the capacity-utilization
rate in the basic material (primary processing)
industries tends to be higher than for the manufacturing sector as a whole (Chart 3).8
This survey of pre-1973 business cycles indicates that total costs per unit of production
generally rise at a relatively slow fate early in the
recovery, when output is rising relatively rapidly,
and ata faster rate as the recovery matures. But
at that advanced stage of the expansion, excess
demand pressures relative to available supply
cause widespread capacity bottlenecks in the
basic material industries, exerting strong upward
pressure on industrial prices.
III. Cost Behavior During the Current
Recovery
Unit labor costs, the dominant cost element,
have followed the typical pattern during the
recovery from the severe 1973-75 recession
(Chart I-A). During the first two quarters of the
recovery, unit labor costs in the nonfarm business sector actually declined sharply, and thus
offset much of the increase in costs that has since
occurred. Meanwhile, the rate of increase in
hourly compensation slowed during the first two
quarters of the recovery, accelerated in early
1976 and then settled back again. This suggests
that the rising unemployment rate during the
first half of 1975 and the latter half of 1976 acted
to moderate the rate of increase in wages during
those periods.
Productivity also has followed the expected
cyclical pattern (Chart I-B), growing fastest
during the early stages of the recovery and then
Chart 2
CYCLICAL BEHAVIOR OF RAW MATERIAL
AND ENERGY COSTS
A. Industrial Raw Materials Prices
B. Fuels and Related Products Prices
Change (%)*
Change (%)*
50
90
40
80
.. Current
recovery
30
70
50
40
30
-20
~
Current
recovery
20
Avg. of five
previous recoveries
-30
Avg. of five
previous
recoveries
10
-40
-50 1.-l--L-L.--I-...l-.L-L.-l--L-L.....L-..1.-.L...J1......J
-4
T
+4
Quarters to trough
+8
T
+4
Quarters to trough
* From previous quarter at annual rate
25
+8
recession than during the recovery (Chart 2-13).
This rise in energy prices undoubtedly acted to
offset some ofthe benefits of the early-recovery
decline in unit Jabor costs.
Total unit costs consequently rose at a relatively modest rate during the early stages of the
recovery, when labor costs were declining. Total
costs then followed roughly the same pattern
during the first half of 1976, before accelerating
because of rapidly rising labor and energy costs.
Despite this gradual acceleration, costs still rose
far less on an annual basis in 1976 than in 1975,
due to the very large increase recorded during the
late-recession period of early 1975.
Industrial prices have generally paralleled the
cyclical movements in costs during this recovery,
but the overall increase in prices has been greater
than the rise in unit labor costs (Charts l-C and
4). This pattern suggests that manufacturing
firms have been attempting to restore their profit
margins to more acceptable levels after seeing
those margins narrow during the preceding receSSlOn.
rising at a more moderate rate. But throughout
most of the current recovery, the growth of
productivity has been above average for comparable stages of the business cycle, due to the
comparatively low capacity-utilization rates prevailing during this business upswing. Gains in
productivity thus have provided a larger than
normal offset to rises in compensation, moderating the upward pressure on industrial prices
stemming from rising unit labor costs. In fact,
the exceptional growth of productivity during
the first two quarters of the recovery actually
acted, along with the deceleration in the growth
of hourly compensation, to reduce unit labor
costs.
Raw material prices also have tended to follow
the expected pattern-rising relatively slowly
and then more rapidly until the "pause" of mid1976, which reduced the demand for industrial
raw materials and moderated their prices (Chart
2-A). Energy prices, on the other hand, failed to
follow the typical pattern, since OPEC actions
caused a greater rate of increase during the
Chart 3
CYCLICAL BEHAVIOR OF CAPACITY UTILIZATION RATE
A.
All
B.
Manufacturing
Percent
85
Processing
95
95
90
Primary
Percent
Avg. of five
previous recoveries
90
Avg. of five
previous recoveries
.,
y
85
80
80
75
75
recovery
recovery
70
70
65
65
60 1..-L--'--'--'-...L-.L.-J'---L-.L--L.---1-...L-.L.--........
T
+4
+8
-4
60 L....JL-.J.--L-.L-'--'--'--...I--.L.-.......'---L--L--L.-'
-4
Quarters to trough
T
+4
Quarters to trough
26
+8
IV. A Closer look at 1976
Prices rose at a slower pace in 1976 than at any
time since 1972, when wage and price controls
hid the actual cost pressures underlying the
economy. The GNP deflator, the broadestmeasure of price change, rose at an average annual
rate of 5.1 percent-about one-half the rate
reached during the peak inflationary period of
1974 (Table I). Actually, the inflation rate accelerated during the course of the year, but the lateyear increase was at least partly due to the impact
of a Federal pay increase.
Food and energy were largely responsible for
the 1976 price improvement, but prices for manufactured products also rose at a more moderate
pace. The food component of the consumer price
index rose by only 3.3 percent-the smallest gain
since 1971. Energy prices at first declined as a
result of a legislated rollback of domestic oil
prices, but they later accelerated again; still, the
7.I-percent annual increase in household energy
prices was only a fraction of the 1974 peak figure.
The wholesale price index also decelerated in
1976 (Table I). The farm and processed-food
component actually declined slightly, acting to
moderate the upward pressure on retail food
prices. Industrial commodities, which account
for more than three-fourths of the total index,
rose 6.3 percent for the year-again, only a
fraction of the earlier peak rate. Slower rates of
increase were widespread among most major
categories, including not only fuels but also
metals, chemicals, and paper. Inflation speeded
up again in late 1976, but slack demand conditions, especially for highly processed basic materials, led to widespread discounting from published list prices. Thus, the acceleration in
realized prices was less than for the posted prices
which make up the industrial price index.
Moderate labor pressures
Reductions in labor cost pressures helped
account for the deceleration in industrial prices.
In 1976, unit labor costs in the private nonfarm
business sector rose by only 3.6 percent-again
only a fraction of the earlier peak (Table 2).
When 1976 opened, it was expected that hourly
compensation would rise by at least 10 percent,
or slightly more than in 1975, as organized labor
sought to compensate for the prior decline in its
real wages attributable to sharply rising living
costs. Most of the contracts expiring had been
negotiated in 1973, when wage and price controls
were still in effect.
Although the settlements in the automobile,
electrical equipment, trucking and rubber industries turned out to be relatively high, the average
first-year increase in compensation amounted to
a relatively low 8.3 percent for all new major
contracts with COLA provisions. Moreover, the
wages of nonunion workers rose at an even
slower rate, so that the increase in hourly compensation for all workers in the nonfarm business sector (including cost-of-living adjustments)
averaged 7.4 percent.
Even more important in moderating labor cost
pressures was the solid growth in productivity.
Output per labor-hour increased in the nonfarm
business sector by a healthy 3.7 percent after
declining in 1974 and rising only slowly in 1975,
Chart 4
CYCLICAL BEHAVIOR OF INDUSTRIAL PRICES
Change ('10)*
40
30
25
20
15
10
recovery
5
o1---"~---:,..e.------"'>4~'---
-5
Avg. of five
previous recoveries
-1 0 L...JI--l--l.--'--'--'--'--'--'---'--L...JI--l--l.-J
T
+4
+8
-4
Quarters to trough
*From previous quarter at annual rate
27
Table 1
Behavior of Major PriceJndice$, 1970-77
(Percent change, at seasonally adjusted annual rates)
GNP Deflator Consumer Price Index
Wholesale Price Index
Farm Products &
All Items
All Items
Processed Foods
Industrial
Commodities
1970
1971
1972
1973
1974
1975
1976
1975
5.4
5.1
4.3
5.8
10.0
9.3
5.1
5.9
4.3
3.3
6.2
11.0
9.1
5.8
3.7
3.2
4.6
13.1
18.9
9.2
4.6
3.4
2.0
7.6
30.0
11.5
3.8
-0.6
6.8
22.2
11.5
6.3
I
8.5
4.3
7.0
7.1
8.3
6.2
8.3
6.5
-2.1
3.3
7.9
9.2
-19.3
7.6
14.1
3.9
5.8
1.7
5.3
11.5
IV
3.2
5.2
4.4
5.8
4.7
4.5
3.6
4.4
-0.7
4.5
3.6
7.6
-16.2
11.6
-7.7
-0.7
4.9
3.3
7.5
10.2
I
5.8
8.6
8.5
16.5
6.6
II
III
IV
1976
1
II
III
3.8
3.6
3.4
1977
Source: GNP deflator: U.S. Department of Commerce, Bureau of Economic Analysis; consumer and wholesale price indexes:
U.S. Department of Labor, Bureau of Labor Statistics.
Table 2
Changes in Productivity, labor Costs and Industrial Prices, 1974-77
(Percent change, at seasonally adjusted annual rate)
Compensation
per hour·
Output
I
II
III
IV
1976
1
II
III
IV
Unit
Labor costs·
Industrial
Prices··
9.3
9.5
7.4
1974
1975
1976
1975
per hour·
-3.5
1.6
3.7
13.2
7.7
3.6
22.2
11.5
6.3
11.6
7.1
6.4
5.8
1.l
lOA
5.8
11.8
8.9
-2.8
-4.2
-2.3
8.9
5.3
11.5
5.4
4.9
3.3
7.5
10.2
6.6
9.0
7.7
7.1
7.0
-1.2
3.4
3.2
4.3
8.3
10.2
2.6
7.3
404
2.7
1.7
1977
I
*Private nonfarm business sector.
**Industrial commodity component, wholesale price index.
Source: U.S. Department of Labor, Bureau of Labor Statistics.
28
and thus helped account for the modest 3.6percent increase in unit labor costs. Productivity
growth weakened as the recovery progressed in
1976, and actually declined slightly during the
final quarter, but that sluggishness was attributable not to capacity restraint but to a temporary
slowdown in industrial production.
In retrospect, it is clear that wage increases in
1976 were moderated by the 1975 slowdown in
inflation, which held down newly negotiated
wage demands-and by the further price slowdown that occurred in 1976, which held down the
increases granted all workers under contracts
with COLA provisions. Slower wage increases,
in combination with above-average productivity
gains, then helped dampen the increase in unit
labor costs in a way that helped cool the inflation
rate even more. Similarly, the slower rate of
increase in energy prices and unit energy costs
helped to moderate the increase in industrial
prices.
Moderate capacity pressures
Capacity restraints posed little threat to the
overall price level in 1976. According to newly
revised Federal Reserve statistics, the rate of
capacity utilization in manufacturing reached 81
percent by the final quarter of 1976. This figure,
although substantially above the cyclical low of
71 percent, was still about 7 percentage points
below the 1973 peak, when shortages and production delays generated intense upward price
measures. 9 In the materials industries, where
shortages had been most intense, the 80-percent
operating rate of late 1976 was a full 13 percentage points below the 1973 peak. Only the chemical, energy and paper industries-with capacity
utilization rates ranging from 83 to 88 percentwere operating at above-average rates.
In raising prices last year, manufacturers attempted not only to recover increased costs but
also to achieve the higher rate of return required
to finance necessary expansion in plant and
Table 3
Profits Per Dollar of Sales, by Industry, 1974-76
(Cents)
1974
All Manufacturing Corporations
Durable Manufacturing Corporations
Basic Material Industries
Primary metal industries
Iron & steel
Nonferrous metals
Fabricated metal products
Stone, clay & glass products
Other Durable Manufacturing
Nondurable Manufacturing Corporations
Petroleum & Coal Products
Basic Material Industries
Industrial chemicals
Textile mill products
Paper & allied products
Rubber & plastic products
Other Nondurable Manufacturing
1975
1976
5.5
4.7
5.5
6.6
6.4
7.0
4.6
4.5
4.3
6.4
12.8
5.9
8.4
2.5
7.0
5.0
4.1
4.6
4.1
4.2
4.3
5.0
3.1
4.2
3.7
4.1
5.1
7.7
4.2
6.9
1.5
5.6
3.1
4.4
5.3
5.2
4.4
3.9
4.1
3.6
4.8
5.0
5.5
5.5
8.5
5.0
6.9
2.4
5.8
3.8
4.5
II
(After taxes)
I
5.2
4.8
3.4
3.5
3.8
3.1
4.8
2.3
5.2
5.6
8.7
5.6
7.8
3.0
6.1
3.9
3.9
5.9
5.8
5.2
4.8
4.8
4.7
5.3
6.2
6.1
5.9
9.0
5.7
7.6
2.9
6.7
4.5
4.8
1976
III
5.3
5.0
4.7
3.9
3.9
3.7
4.9
6.2
5.1
5.6
8.3
4.7
6.7
2.0
5.7
2.8
5.2
IV
5.0
5.0
3.9
3.5
3.8
2.9
4.1
4.6
5.5
5.0
8.0
4.1
5.5
1.6
4.7
4.0
4.1
Source: Federal Trade Commission, "Quarterly Financial Report for Manufacturing, Mining and Trade Corporations."
29
equipment. Many firms. were still tryingtQovercome financial problems generated by therecessiqn. .M!etals and other basic materialsilldustries
had been especially hard hit, because the demand
fort4eir products was adverselyaffectedIlot
only by. the consumption slowdown ibut also by
the . inventory liquidation which continued to
depressoTders even after consuming industries
had begun to recover. For example, steel-mill
ProdlCH:;tshipments dropped 28. percent during
1975, and nonferrous metals experienced similar
declines.
'These industries thus were unable to pass on
all of their higher costs in 1975, and as a result,
PfQfitmargins and rates of return on investment
dropped sharply. For some, the slippage even
continued into 1976 (Tables 3 and 4). During
tl1efirstquarter of lQ76,after-taxprofits per
dQl1ar Qfsales in the primary metals industries
amounted to only. 3.5. cents~lessthanone ...half
themid...19741evel and less than the 5.2-percent
averagereturn earned currently by all mallufactl1ringfirms.• Similarly, their return on stOck...
holders' equity was only 7.1 percent--abol1toIlethird of the mid-1974 figure and far below the
13.3-percent average return earned currently by
all IllaIlllfacturing firms. Their rates Qfretl1rn
rose sharply during the second quarter when
demand.conditions improved, but margins erodedsomewhat. again during the last half· of the
year, despite a spate of published price increases,
as weak demand conditions reduced sales and
undermined list prices.
Table 4
Annual Rates of Return on Stockholders' Equity, by Industry, 1974-76
(Percent)
1976
1974
1975
1976
I
II
III
IV
13.7
12.9
11.8
8.1
8.7
7.0
15.8
16.1
13.4
14.4
14.0
11.4
13.5
6.6
13.6
7.6
16.6
13.1
13.3
9.5
7.1
7.9
5.5
12.9
11.1
14.9
12.9
13.9
9.0
11.0
5.3
10.9
11.4
13.8
(After taxes)
All Manufacturing Corporations
Durable Manufacturing Corporations
Basic Material Industries
Primary metal industries
Iron & steel
Nonferrous metals
Fabricated metal products
Stone, clay & glass products
Other Durable Manufacturing
Nondurable Manufacturing Corporations
Petroleum & Coal Products
Basic Material Industries
Industrial chemicals
Textile mill products
Paper & allied products
Rubber & plastic products
Other Nondurable Manufacturing
14.9
12.6
15.2
16.5
17.0
15.7
16.0
10.6
11.4
17.1
21.1
15.0
17.6
7.9
17.7
14.4
15.0
11.6
10.3
9.9
8.6
10.9
4.9
13.2
8.5
10.5
12.9
12.5
9.7
11.0
4.3
12.6
8.0
15.2
13.9
13.6
11.0
8.2
9.0
6.8
15.3
12.0
14.8
14.2
14.3
12.5
14.2
8.0
13.7
10.8
15.3
13.3
12.3
7.1
7.1
8.1
5.3
15.0
4.8
13.7
14.3
14.7
13.7
16.2
10.0
14.5
10.6
14.3
15.7
16.0
13.6
10.7
11.3
9.5
17.7
15.5
17.1
15.5
14.8
14.7
16.3
10.1
16.3
13.4
16.4
Source: Federal Trade Commission, "Quarterly Financial Report for Manufacturing, Mining and Trade Corporations."
30
V.Higher Inflation in 19771
In 1977, as demand conditions improve suffiThe early-1977 price upsurge would suggest
ciently to support higher prices, producers of
upward pressure on wage negotiations from the
some basic materials such as steel undoubtedly
recent price escalation,. hut little of this was
will raise their posted prices in a further effort to
evident in the steel agreement, which was settled
offset rising costs and improve profit margins.
about as expected with an 8.3-percent first-year
increase and an average 5-percent annual inThe higher cost of these products in turn will lead
to higher prices for many manufactured goods in
crease over the life of the contract. Again, the
which those materials are utilized. This does not
significant improvement in the unemployment
rate would suggest further upward pressure on
mean, however, that wholesale industrial prices
will rise significantly above the 6.3-percent figure
labor compensation-except for the fact that the
registered in 1976. Based on the expected growth
jobless rate, presently hovering around 7.3 perof. demand, bottleneck pressures are likely to
cent, is still abnormally high for this stage of the
develop in only a few manufacturing industries
recovery. In 1977 also, fewer workers will be
over the course of the year, while near-term
involved in negotiations who are not already
prospects for unit labor costs and energy costs do
covered by cost-of-living adjustment provisions.
not appear as worrisome as they did during the
In fact, two-thirds of the workers covered by
weather-caused supply problems of early 1977.
expiring contracts have been protected by
Similarly, the prospect ofample supplies of most
COLA provisions, and thus from at least some of
farm products points to only about a one
the effects of inflation, during the past three
years.
percentage-point increase in food-price inflaProductivity growth in the nonfarm business
tion, despite recent problems caused by the
sector probably will drop below the 1975 figure
Eastern freeze and the Western drought. Altogether, these factors suggest a moderate acceleraof 3.7 percent, reflecting the tendency for planttion in the overall inflation rate in 1977 as a
utilization rates to increase in the later stages ofa
whole.
business recovery. However, productivity
growth may remain above normal, because there
Moderate increase in labor pressures
is still less pressure on capacity-utilization rates
Unit labor costs in the private nonfarm busithan at the same point of previous recoveries.
ness sector may rise about 4 or 5 percent this
The relatively strong first quarter peryear, compared to the 3.6-percent increase of
formance-a 2.6-percent rate of increase in
1976. An increase of that magnitude seems likely
output per labor-hour in the nonfarm business
on the basis of a modest 2-to-3 percent increase
sector-in the face of severe weather problems
in labor productivity, along with a 7-percent rise
suggests grounds for optimism in this regard. In
in hourly compensation. Normally, labor
any event, if productivity grows by 2 to 3 percent
compensation would rise at a faster rate at this
and labor compensation rises at a 7-percent rate,
stage of a mature expansion, but the increase
the increase in unit labor costs could be held to 4
could be dampened by the improvement in the
or 5 percent.
inflation rate that already occurred in 1976.
Shortages posed by capacity restraints do not
appear to be a major threat. If industrial producThis year, as in 1976, the collective bargaining
calendar is extremely heavy.1O Major contracts
tion rises (as expected) by 6 percent this year, and
if manufacturing capacity increases by 3 percent
covering nearly 5 million workers are expiring in
a number of important industries-including
(in line with past plant-equipment spending
trends), the capacity-utilization rate in manufaccoal, petroleum refining, steel, aluminum and
turing will rise only gradually from 81 to 84
construction. On the basis of the agreement
recently reached in the first of those industriespercent-still quite low in comparison with the
steel-it seems likely that the overall increase in
peak operating rates reached in 1973. Thus the
compensation for all workers in nonfarm busisupply situation generally should be quite easy,
with only a few exceptions such as paper. In fact,
ness will be close to the 7.4-percent increase
with the continuation of present trends in prorecorded in 1976.
31
duction and capacity growth, bottlenecks would
not be likely to hamper production until well into
Fatnriand food prices
I'lleQverall rate pf inflation this year will of
course reflectCllanges in farm and food prices as
well as the changes in industrial prices discussed
above.·iPrior to the advent of the recent drought
alldfreeze, food prices were not expected to bea
major source of inflationary pressure. Indeed,
theD.S. Department of Agriculture early this
year was predicting a 3- to 4-percent rise in the
foodcomp.onentofthe CPI, not much more than
in 1976.'2 But the USDA later raised theforecast
to flle 4- to 6-percent range, as a result of the
sharp increase in fruit and vegetables prices
caused.. by California's drought and Florida's
freeze. 13 .yet with only few exceptions, the supply
prospects for most major products remain quite
favorable.
In the case of meat (particularly beef), the
supply conditions that led to lower prices last
year are unlikely to persist throughout 1977.
Favorable ratios of livestock to feed prices in
1975 resulted in large increases in meat production in 1976. The resulting addition to supplies
helped depress prices, but the ensuing reduction
in cattle numbers then set the stage for higher
beef prices in the latter part of this year. But
continued large supplies of pork and poultry are
expected to dampen the overall increase in retail
meat prices.
Most observers predict significantly higher
prices for fresh fruits and vegetables-and of
course sharply higher prices fOf coffee. Indeed,
most of the acceleration in the inflation in farm
and food prices during the first quarter was
attributable to these products. But prices for
fresh vegetables already have begun to decline,
so that the annual increase in fresh fruit and
vegetable prices should be less than in the first
quarter. Moreover, prices of cereal products
should remain relatively stable on an annual
basis because of ample supplies of the principal
foodgr<lins, wheat and rice. Indeed, heavy U.S.
output of these crops in 1976 allowed substantial
rebuilding of stocks. Similarly, milk production
is expected to continue at high levels, creating the
possibility of some weakness in prices.
1978.
Energy and raw material inputs
J:tnergy prices are likely to rise at a somewhat
faster rate than .had been expected before severe
we<lther conditions abnormally increased the
winter demand for heating fuels. Prior to the
onsetpfthefreeze, energy experts were predicting a 6- to 7-percent rise in prices of fuels and
rela.ted products about the same rate as in
1976. 11 These estimates took into account the
OPEC-imposed increase in the price of imported
crude oil at the beginning of the year.
These forecasts are now considered to be a
little low. To help alleviate the natural-gas shortage in freeze-affected areas, Congress passed
legislation calling for the removal of price controls (through July) on emergency sales of natural gas in interstate markets. However, the
amount of gas involved in these "emergency"
sales is only a small percentage of the total
market, so that little additional price pressure
should result. Altogether, energy prices may not
rise more than 7Yz percent this year, assuming
some pressure from that source and from the
initial implementation of the Administration's
energy program. Still, an increase of that magnitude would raise energy costs per unit of output
in manufacturing-and the overall rate of
inflation-by rather modest amounts.
Industrial raw-material prices accelerated during the first quarter of 1977, reaching a point 15
percent higher than a year earlier. Some increase
in prices is normal for this stage of the recovery,
but the recent upsurge has been aggravated by
this spring's "snap back" in industrial production, which followed the late 1976 pause and
subsequent weather-induced slowdown. As production returns to its normal growth trend,
industrial raw-material prices should rise at a
slower rate, and, as a result, the rise in unit rawmaterial costs may parallel last year's increase.
32
VI. Summary and Conclusions
costs, and the expected lev~l of capacityutilization rates in manufacturing. Meanwhile,
the favorable supply outlook for most agricultural products, in conjunction with the effects of
recent weather problems, suggests a onepercentage point greater increase than last year
in farm and food prices. Our overall analysis of
the expected behavior of manufacturing costs
and farm and food prices, together with its
implications for the expected behavior of the
wholesale and consumer price indexes, sugg~sts
that the GNP deflator will increase about 5.5-6.0
percent in 1977, only moderately faster than the
5.I-percent rate recorded last year.
In this article, we examined the typical cyclical
behavior of industrial prices, and presented
projections of future price behavior based on
cost-push and capacity factors. Industrial commodities not· only account for three-quarters of
the weight of the wholesale-price index, but their
prices are also the major determinant of prices
for nonfood items sold at the retail level. To
round out the inflation outlook, we also analyzed the expected behavior of farm and food
prices at the wholesale and retail levels.
Our analysis suggests that the increase in
industrial prices will not be much higher than last
year's 6.3-percent figure, judging from the ex~
pected behavior of labor, material and energy
FOOTNOTES
1. Actual costs per unit usually vary greatly with the rate of
operation. To overcome this variability in cost, most manufacturing firms use a "standard" rate of operation for estimating
unit costs rather than the actual operating rate. The standard
rate may be the actual average rate of operation experienced
over a period of years, e.g., 75 or 80 percent of plant capacity.
The use of a standard operating rate makes for less frequent
price changes than would actual unit cost pricing, because it
makes prices respond to changes in labor, material and energy
prices rather than operating rates (unless the standard rate is
changed). Standard unit labor costs typically are calculated on
the basis of the trend rate of growth in productivity. Similarly,
under target return pricing, profit margins are determined not
on the basis of actual operating rates but on an assumed or
long-run average rate of. plant utilization. In effect, this procedure is designed to prevent short-run changes in volume from
unduly affecting prices, with the expectation that the averaging
of fluctuations in cost and demand over the business cycle will
produce the desired rate of return on investment. Under standard cost procedures, prices at any given time may not necessarily reflect actual unit costs of production, although over longer
periods prices must reflect actual unit costs for firms to remain
in business.
For a description of the pricing practices of large industrial
corporations in the United States, see A.D.H. Caplan, Joel B.
Dirlam and Robert F. Lanzillotti, Pricing in Big Business: A Case
Approach (Washington, D.C.: The Brookings Institution, 1958).
An example of the target pricing calculus and its implications
also appears in Gardner G. Means, Pricing Power and the
Public interest (New York: Harper and Brothers Publishing
Company, 1962), pp. 232-248. For an analysis of the properties
of various econometric price determination models incorporating these micro-economic pricing practices, see William D.
Nordhaus, "Recent Developments in Price Dynamics," The
Econometrics of Price Determination, Conference sponsored
by the Board of Governors of the Federal Reserve System and
Social Science Research Council, October 30-31,1970, Washington, D.C., pp. 16-49.
2. There have been numerous empirical studies utilizing these
two variables as determinants of changes in money wages. See
for example, Otto Eckstein and Thomas A. Wilson, "The Determination of Money Wages in Amel ican Industry," Quarterly
Journal of Economics, LXXVI, Number 3 (August 1962), pp.
379-414. For a more recent version of that approach, see Otto
Eckstein and Roger Brinner, The Inflation Process in the United
States, Congressional Joint Economic Committee, 92nd Congress, 2nd Session (Washington, D.C.: U.S. Government Printing Office, 1976), pp. 3-46. Also, Paul A. Samuelson and Robert
M. Solow, "Analytical Aspects of Anti-Inflation Policy," Ameri·
can Economic Review, Papers and Proceedings, L, Number 2
(May 1960), pp. 177-194. This article also contains an excellent
discussion of the difficulties of disentangling "demand-pull"
and "cost-push" sources of inflation from ex-post statistical
data.
3. A.w. Phillips, "The Relation Between Unemployment and
the Rate of Change in Money Wage Rates in the United Kingdom, 1951-1957," Economica, N.S., XXV, Number 100 (November 1958), pp. 283-299. For an analysis of later modifications in
the original Phillips Curve concept, see Thomas M. Humphrey,
"Changing Views of the Phillips Curve," Monthly Review, Federal Reserve Bank of Richmond, L1X, Number 7 (July 1973), pp.
3-13.
4. Unit labor cost is computed as the ratio of compensation per
hour/output per hour. In determining the increase in unit labor
costs during any given period, increases in output per hour, Le.,
prOductivity, provide a direct offset to increases in compensation per hour. For example, in 1976, unit labor costs in the
private nonfarm business sector rose by 3.6 percent, reflecting
a 7.4-percent increase in compensation per hour and a 3.7percent increase in productivity. For a more complete explanation of the manner in which unit labor cost is measured, as well
as the inverse relationship between unit labor cost and productivity, see J. Randolph Norsworthy and Lawrence J. Fulco,
"Productivity and Costs in the Third Quarter," Monthly Labor
Review, XLVI, Number 2 (February 1976), pp. 38-39.
5. See, for example, Thor Hultgren, Changes in Labor Cost
During Cycles in Production and Business, National Bureau of
Economic Research, Occasional Paper No. 74, 1960; Edwin
Kuh, "Profits, Profit Markups and Productivity," Study Paper
No. 15, Congressional Joint Economic Committee, Study of
Employment, Growth and Price Levels (Washington, D.C.: U.S.
Government Printing Office, 1959). Also, Thomas A. Wilson and
Otto Eckstein, "Short-Run Productivity Behavior in U.S. Manufacturing," Review of Economics and Statistics, XLVI, Number 1
33
l"I'Iat~riil-lsllerieS,$l3e "New Elltimatell of Capacity Utilization:
Manufacturing and Materials," Federal Reserve Bulletin, LXII,
Number II (November 1976), pp.892·905.
~·JnJ",te 1976,the fElderaIResElrvElB9q,rdintroducedil- major
revisioniin its manUfacturing capacity-utilization series dating
Pack to 1946. i The revised figures .showed that the capacity
utHizationratein recent periods tended tobemuch higherthan
earlierestimates. The overall capacity.utilizationratElinmanuf~9tl.lrin!,l.('jl.lringtheihirdquarterof 1976, ·forexample,was
estimated to be 80.8 percent, in contrast to the figure of 73.6
percent reported earlier. The differential Petween current oper.
atingrates and the peak rates attain.ed in 1973thus was cQnsiderably smaller than originally calcUlated-although substantial
nonetheless. For a discullsionofthe methodology, refertolbld.
10, .For a discussion of 1977 labor negotiations andthecolJec.
tiye p",rgaining environment, see !-ena w. Bolton, "Bargaining
Calendar to be Heavy in 1977," Monthlyl.lIbor ~evl~w,!-XLlX,
Number 12 (December 1976), pages 14-24. Also,Douglas
LeRoy, Schedule Wage Increases and Escalator Provisions in
1977," Monthly l.aborReview, C, Number 1 (January 1977), pp.
20-26.
11. economic Report oflhe President, 1977 (Washington, D.C.:
U.s. Government Printing Office, January 1977), page 44.
12. U.S. Department of AgriCUlture, Economic Research Service, Agricultural Outlook, AO-16 (Washington, D.C.: U.S. Government Printing Office, November 1976), pp. 1-11. Also, "Food
Prices Expected to Rise Little in 1977; Boon to the Economy?"
Wall Street Journal, December 28,1976, page 1.
13.
AgriCUltural Outlook, AO-19 (Washington,
D.C.: U.S. Government Printing Office, March 1977), page 7.
(February 1964), pp. 41.54.
6. These results, which were developed independently, conform with the findings of the authors mentioned in footnote 5
above.
7.The upsurge in •industrial. raw. material prices during the
Korean War period helped to push UP this average during the
firstseveral quartersafterthetrough,but this hadlittleeflect on
the typical cyclical pattern. The Bureau of Economic Analysis,
U..S.Departmentol Commerce, classifies th~Bureil-u of Labor
StatisticS'spotmarket price index for 13 industrial raw materialsasa leading indicator of cyclical troughs-but not ofcyclical
peil-ks.because of its inconsistent behavior near the peak.
8. in June 1976, the Federal Reserve Board introduced a new
capacity utilization series .for the industrial materials industries
as<a replacement Jorthe old series for "major materials." The
new series ismuch broader in scope than the old seriell, since it
inclu.des all the materials industries contained. in the industrial
production index. But unlike the old series, it extends only back
to 1967. For the cyclical comparisons used in Chart III-B, it
therefore was necessary to use the FRB capacity utilization
series for primary-processing industries as a proxy for capacity
utilization in the materials industries. The primary-processing
index incorporates many of the same manufacturing industries
that are represented in the industrial-materials indexincluding textiles, lumber, paper, industrial chemicals, petroleum refining, rubber and plastics, stone, clay and glass and
primary and fabricated metals-and has moved in close correspondence with the materials index during the 1967-76 period.
For a discussion of the methodology involved, and of the
relationship between the primary-processing and industrial-
34
Rose McElhattan*
young children (5 and under) as a percentage of
the adult population. The increase in the latter
factor has helped account for the increasing
participation rate of females, which in turn has
been the major reason for the rising trend in the
aggregate labor-force participation rate in the
postwar period.
Our analysis indicates that U1 payments to
individuals have acted to increase the supply of
labor over time and to weaken the familiar
"discouraged worker" effect. According to the
latter hypothesis, an increase in unemployment
signals an increase in the difficulty and cost of
finding a suitable job, causing some unemployed workers to become discouraged and withdraw
from the labor force-and to await a time when
jobs are more plentiful and the cost of finding
work is reduced. However, the payment of
unemployment-insurance benefits may actually
keep unemployed workers in the labor force. Our
analysis suggests that, considering both the cost
of finding a job and the payments of jobless
benefits, there is far less responsiveness of labor
as a group to changes in unemployment rates
than previous estimates of the discouragedworker effect have suggested.
In addition, the statistical results indicate that
since the late 1960's there has been a change in
the net response of labor to cyclical changes in
the average real wage rate. From the late 1940's
and into the 1960's, labor-force participation
generally declined whenever current real wage
rates were perceived as temporarily high, implying a diminished need for additional family
members to supplement income as the pay ofthe
main earner rose. However, this negative laborsupply response to transitory wage changes has
diminished over time, and has even become
slightly positive since 1967. Some labor market
observers have suggested that the growth in
The need to ask for unemployment-insurance
benefits is an unhappy prospect for some unemployed Americans, yet it is a necessity for many
and may be a way of life for others who (deliberately or not) have a long wait between jobs.
Benefit payments, aside from providing income
maintenance for the unemployed, may also have
helped increase the supply of labor over time.
Some individuals who lose their jobs might
otherwise leave the labor force, were it not for
benefit payments which reduce the cost of
searching for another suitable job. Certain unemployed persons, on the other hand, may
report job search in order to receive jobless
benefits (and be counted in the labor force)
although no attempt is made to secure employment. Other individuals might search for seasonal or intermittent employment in order to be
eligible for benefits, when the income from such
employment alone would not be sufficient to
warrant labor-force participation.
This article analyzes the economic factors
which have contributed to cyclical variations in
labor-force participation rates since 1950. Our
primary purpose is to measure the impact, if any,
of the unemployment-insurance (Ul) program
upon the aggregate labor-force participation
rate. Certain simplifying assumptions are made
about the growth of population and labor-force
participation. For example, we estimate the
supply of labor from given population measures, and account for the secular behavior in
labor force participation with a simple time trend
and with a series which measures the number of
*Economist, Federal Reserve Bank of San Francisco.
The author wishes to acknowledge the editorial assistance of
Ken Froewiss and Jack Beebe along with the research
assistance of David McKinnis.
35
labor supply will slow down as real wages rise in
the current recovery, since the increased family
income implied by the higher wage rate will
permit supplementary household workers to
return to nonmarket pursuits. Our results indicate that this is not likely to happen. The tendency of some individuals to leave the labor force as
real wages rise appears to have been offset since
1967 by the behavior of others who want to take
aQvantage of the higher real wages. Section I
provides the conceptual framework for our
labor-force participation model, and Section II
provides the estimated results of that model.
J. A Model of Labor Force ParticipationConceptuai Framework
The underlying notions of the labor-supply
model in this paper come from the established
economic theory of consumer behavioL I According to this theory, individual choices with
regard to labor supply concern the division of
time between market activity and nonmarket
activity-the former including both working and
looking for a job, and the latter including all
other activities, such as child care, cooking,
eating, housework and leisure time in general.
The individual's allocation of time will be influenced by the net real income (that is, dollars of
constant purchasing power) which his or her
services can command in the marketplace. Three
elements are considered in this paper to enter
into the calculation of that net income: the real
wage rate, the cost of finding a suitable job, and
the payment of unemployment insurance benefits.
their labor activity to coincide with periods when
the current actual wage is high relative to their
perception of some "normal" or "permanent"
wage. This hypothesis implies that if current
wages (W) are rising relative to normal real
wages (W*)-that is, if the ratio W/ w* is
increasing-more labor will be supplied.
An alternative hypothesis is the relative wage
effect, described in the works of Richard Easterlin and Michael WachteL3 According to this
hypothesis, the ratio (W / W*) represents a relative standard-of-living variable; that is, it measures today's standard of living, which is represented by current wages (W), in relation to the
expected standard (W*). When current standards of living are rising relative to those expected
on the basis of past experience-that is, when
W/W* is increasing-workers may choose more
nonmarket activity rather than work in the
market. This choice may show up, for example,
in the withdrawal of supplementary family workers from the labor market when the wage of the
main family earner increases. Conversely, when
the current standard of living falls relative to the
expected standard, secondary workers may be
induced to sacrifice nonmarket activity to enter
the labor market to supplement the family income. The impact of an increase in the ratio of
CUrrent to permanent wages upon the labor-force
participation rate thus may be either positive or
negative, depending on whichever is the dominant influence-the permanent-wage effect or
the standard-of-living effect.
Real wages
In the first instance, an increase in the real
wage rate which an individual expects to receive
in the market increases the cost to him of spending time in nonmarket pursuits. Normally, a
change in the real wage rate will alter the allocation of an individual's time, so that different
quantities of labor services will be offered on the
market at different real wage rates.
The individual's reaction to a change in real
wages, however, will depend upon how permanent the change is expected to be. Put differently,
any change in real wage rates may be considered
as made up of "permanent" and short-lived,
"transitory" components. Two separate hypotheses can be used to explain labor's reaction to
wage changes. The first is the permanent wage
effect, analyzed in the work of Milton Friedman. 2 According to this effect, workers will plan
Cost of search and unemployment benefits
Ordinarily, an individual making a labor-force"
decision will have to spend some time and effort
searching for a suitable job. We may infer that
the individual, in offering labor services, has
36
insurance program as being a self-financing
matter. Although the program was intended to
be self-financing, it has not been so for the past
several years of high unemployment. 6
In addition, most state laws create a rather
loose relationship between the benefits received
by an unemployed worker and the payments
made on his behalf. Consequently, as the average
covered wage increases, the maximum weekly
benefit also increases. In such a case, however,
revenues to finance the system do not increase
proportionately, because the taxable wage base
increases much more slowly than average wages.
For these reasons, benefit payments in their own
right tend to affect labor-force participation
decisions.
Our argument thus suggests that changes in
the aggregate labor-force participation rate depend upon changes (both permanent and temporary) in real wage rates, the cost of job search,
and unemployment-insurance benefits. An increase in the cost of job search would tend to
reduce the participation rate, while an increase in
UI payments would tend to increase the labor
supply. The wage effect upon labor supply is less
certain, depending upon the relative importance
of the permanent or relative wage effect. If the
latter is dominant, changes in the supply of
labor-in response to temporary changes in
wages-may be the result of supplementary
family members moving in and out of the labor
force in an effort to maintain the family's accustomed standard of living. On the other hand, the
growing importance of women in the labor
force-particularly married women whose work
experience indicates an increased attachment to
full-year participationS-detracts from the importance of the relative wage hypothesis. Since
the two hypotheses we have considered imply
different signs on the wage coefficients, we can
test in our model to see which effect is dominant.
considered both the cost of looking for ajob and
the expected market wage from a prospective
job. We may also infer that the net benefits of
market activity to the individual are at least
equal to the benefits he would obtain by staying
at home-or, more precisely, engaging in nonmarket activity. An increase in the cost of searching for a job reduces the expected net benefits
from market activity, and could thus lead to a
decline in labor-force participation.
The availability of unemployment-insurance
(UI) benefits also enters into the calculations of
an individual's expected cost of job search.
Unemployed workers may consider UI benefits
as an offsetting payment to the direct cost of job
search. By reducing the individual's search costs,
UI payments increase the net benefits expected
from market activity. An increase in UI payments, therefore, tends to offset the discouragedworker effect and to strengthen labor-force participation. 4
Some individuals also may be attracted into
the labor force by the prospect of receiving
benefits after a short period of employment. UI
payments may encourage seasonal or other intermittent employment when the wages available
from employment alone are not sufficient to
warrant labor-force participation. For this reason too, we may expect the labor-force participation rate to increase when jobless benefits are
increased. 5
We could reason that, to the extent the program is self-financing, UI payments should not
impact upon the labor supply. According to this
argument, the payments have already been in~
corporated into the individual's expected wages.
Although benefits are paid by the employer, they
are considered the same as other employee benefits which are deducted from the employee's total
wage. At least in the short run, however, individuals may not consider their contribution to the
II. Estimation of Labor Supply Model
It is seldom an easy matter to proceed from a
general theoretical framework to a specific regression which can be estimated from available
historical data. The model described above needs
several adjustments before empirical estimation
can proceed. The discussion of those refinements
is followed by the estimation results (including
forecast results) and a summary of their implications.
From theory to testing
There are no historical data which directly
measure the cost of job search. In general,
37
changes in the unemployment rate have been
used in labor supply studies to signaLchanges in
the number of jobs available, with an increase in
unemployment,forexample, indicating an increase in the cost and difficulty of finding a job.
In this paper, the unemployment rate of prime
age males (25-54) is used to represent the cost of
finding a job since this rate, more than any other,
reflects cyclical changes in job opportunities and
in the overall demand for labor. This is because
the supply of prime age males (from a given
population) is relatively insensitive to cyclical
economic conditions so that changes in their
unemployment rate basically reflect changes in
job opportunities and in the demand for labor in
generaI.9
Our model attempts to explain the aggregate
behavior of different population groups. Demographic changes in the population, in particular changes in the agel sex distribution, may well
affect labor participation behavior over time in
ways not captured by the model. To handle this
aggregation problem we have used the share of
prime age males (25-54) in the population (MIX)
to measure the impact of changes in population
composition upon participation decisions in the
estimation period, 1950.1 to 1974.4. In particular, we have permitted the variable MIXtoaffect
both the relative-wage and unemployment-rate
effects on the. labor-force participation rate,
entering those two explanatory variables with
coefficients of the form (a + b MIX) where a and
b are estimated constants. IO
In addition, we have
unemployment-insurance benefits variable
(UIB) in the labor-supply equation as a measure
affecting the unemployment rate's impact upon
the labor supply. We would expect a rise in UIB
to keep more people in the labor force to the
extent the unemployment rate increases; that is,
the greater are the number of individuals faced
with the work-nonmarket activity decision.
Thus, to account for the effects of both MIX and
VIB, the unemployment rate (R U) is written in
the form RU'=(a + bMIX +cUIB)RU, where a, b
and c are estimated constant coefficients. In
other words, the unemployment impact upon the
labor-force participation rate will vary over time
Chart 1
UNEMPLOYMENT INSURANCE BENEFITS
(Maximum
Percent
weekly UIB payments as a percentage of weekly spendable wages)
1948.1-1976.3
10
60
38
time = 13 in 1950.1 and 119 in 1976.3). This time
trend was the most statistically significant of the
several considered, and it has the desirable longrun property of approaching a value of zero as
time progresses. This is a desirable property; the
participation rate has a maximum value of one
and a time trend without a limitation on the
values it can assume would imply a participation
rate with possible values greater than one.
FinCllly, we have assumed that the supply of
labor from a given population responds to both
current and past changes in the economic determinants included in the equation. The time
adjustment model which proved most statistically significant was one in which the supply of
labor responds to past changes in the different
economic determinants with the same distributed lag pattern. In the conventional way, we have
incorporated this behavior by entering the
lagged dependent variable on the righthand side
of the equation. 14
with changes in the population (MIX) and
changes in unemployment benefits (UIB).
The actual value of UI payments in the estimated regression is an index of the relative size of
benefits. Specifically, the variable VIB is the
maximum average weekly benefit, stated as a
percentage of the average weekly spendable
wages of a worker with three dependents in the
nonfarm private business sector (Chart I).!!
Unemployment benefits have increased from
about 50.5 percent of spendable earnings in 1950
to 69.4 percent in 1976.3, but the rise has accelerated in recent years. The increase from 1973.1 to
1976.3 was by far the greatest for any four-year
period since 1948. 12
To estimate permanent wages (W*), we have
assumed that the permanent real wage rate in a
given period is eq ual to a percentage of the trend
level of labor productivity. That percentage is
equal to labor's share in total output produceda relatively constant measure over time. The
details of the procedure used to calculate W* are
given in the appendix.
Although we are concerned with short-term or
business cycle variations in the labor-force participation rate, the labor-supply data incorporate
both trend and short-term movements, which
means we must devise some way of adjusting for
trend. The rise in the aggregate labor-force
participation rate in the postwar period reflects
the dramatic increase in the female participation
rate. 13 Women's labor-force participation tends
to be associated with the number of small children in the family, so to pick up that factor, we
have included in the regression model the number of children 5 years old and under as a
percentage of the adult population. That percentage, which began to decline sharply in the mid1960's, apparently accounts for a significant
amount of change in the aggregate participation
rate. Also, that percentage apparently serves as a
useful proxy for several other related influences
which have had an important influence upon
female labor supply-such as the trend toward
later marriages and the rise in female-education
levels-but which we have not attempted to
estimate separately.
To capture additional secular forces influencing the aggregate participation rate, we have
chosen a nonlinear time trend (1/ time, where
Empirical Results
The following least-squares equation, estimated over the 1950.1-1974.4 period, appears to
explain the movements in the labor-force participation rate quite well. The adjusted coefficient of
determination (R2) of .95 means that about 95
percent of the variation in the aggregate laborforce participation rate can be accounted for by
the model. The standard error of .24 percentage
points indicates a very close fit between actual
and estimated values, since this error represents
only.3 percent of the mean labor-force participation rate (69.9 percent) over the sample period.
LFPR t = 28.1644 - 9.70906TT - (2.34380 - 6.61831 MIX t
(5.27) (-2.30)
(-3.15) (3.16)
.00969 UlB t ) RU t + (.996122 - 4.08348MIX t )(- W )
(2.40)
(2.82) (-2.87)
w* t
- .204513N5 t + .64834ILFPR t _
1
(-4.34)
(9.52)
Adjusted iP
= .95
Durbin Watson = 2.11
Standard Error = .24
Mean LFPR = 69.9
Estimation Period 1950.1-1974.4
Numbers in parentheses are t statistics
39
= rate of unemployment of males between
the ages of 25 and 54, in percent.
W / w* = current real wages of employees in nonfarm private domestic business sector,
divided by normal wage, in percent
TT= l/Time - Time is equal to 13 in 1950.1 and
112 in 1974.4
N5 = number of children 5 years old and under
in the population, divided by number of
people 16 years old and over in this population, in percent
The more pertinent test for a model, however,
is how well it can forecast movements in the
RU
where
LFPR= labor force participation rate of aU
persons between the ages of 16 and 64, in
percent
MIX = numbers of males in the population
between the ages of 25 and 54 divided by
the total population 16 years and over, in
percent
UlB = maximum weekly benefits payable under the unemployment-insurance system,
divided by spendable average weekly earnings of production worker with 3 dependents, in percent
Chart 2
LABOR FORCE PARTICIPATION RATE
(Ages 16-64)
Percent
1950.1 -1976.3
73
72
IForecast
IOutside
Sample
Period
71
I
.. Estimate
70
69
1976
40
the unexplained variance in the participation
rate by 20 percent. In addition, a statistical test
indicated that this reduction represented a statistically significant decrease in the unknown variance in the labor-force participation rate. 15 We
can thus conclude that the wage, unemployment
and unemployment-insurance variables account
for a significant amount of cyclical variation in
labor-supply behavior.
dependent variable after the estimation period.
The years 1975 and 1976 provide a particularly
good test, since that period incorporated a considerable amount of variation in labor behavior,
including (in 1976) the highest labor-force participation rate on record (Chart 2).
The model performed very well over the postsample period, especially by capturing the unusual 1976 increases in labor supply (Table 1). The
mean absolute forecast error for the seven quarters (1975.1-1976.3) is .17 percentage points,
while the average error is only -.07 percentage
points; both are well within the .24 standard
error of the equation over the estimation period.
The movement over time in the supply of labor
has been dominated by population growth,
along with other long-run changes which have
produced a shift in preferences between work
and nonmarket activity. The strong trend-like
movement in the labor-force participation rate is
captured in the model by the time trend, the
constant term, N5 (the children! adult ratio), and
the lagged dependent variable. To determine the
statistical significance of the cyclical economic
variables, we re-estimated the model with only
the time trend, constant, N5 and lagged dependent variables, and then compared the unexplained variation in the participation rate from
this abbreviated model with that of the full
model (equation I). The additional variables
included in the full model were found to reduce
Table 1
Labor Force Participation Rate of
Population aged 16-64
Forecasts Outside the Estimation Period
1975.1-1976.3
labor Force Participation Rate
Forecasted-
72.170
71.933
72.115
72.012
72.146
72.185
72.528
1975.1
.2
.3
.4
1976.1
.2
.3
Actual
Forecast Error
72.155
72.449
72.203
71.932
71.896
72.369
72.585
.015
-.516
-.088
.081
.250
-.184
-.058
Mean Absolute Error, 1975.1-1976.3 .170
"Forecasts are outside the estimation period (1950.1-1974.4) and have been calculated with all variables on the
right hand side of the equation equal to actual values. In a
dynamic ex-post simulation in which estimated values of the
lagged-dependent variable replace actual values, the mean
absolute error is .23 percentage points.
Table 2
Short-term Unemployment Coefficients for Selected Periods
Unemployment Rate-Prime Age Males:
Total Coefficient = -2.34380 + 6.61831 MIX + .00969UIB
(1)
(2)
(3)
Coefficient excluding
Coefficient inclUding only
Total Size
Unemp. Insurance
Unemp. Insurance Benefits
of Coefficient
Benefits
(.00969 UIB)
(1) + (2)
.485
.524
.601
.581
.579
.636
.651
.662
.672
-.039
.0
.005
-.128
-.183
-.133
-.118
(-2.34380 + 6.61831MIX)
1950.4
1955.4
1960.4
1965.4
1970.4
1975.4
1976.1
1976.2
1976.3
-.524
-.524
-.596
-.709
-.762
-.769
-.769
-.769
-.769
41
-.107
-.097
The . coefficients. of .the .l.memployment rate
cline in the average labor~force participation rate
of.524 percentage points in 1950.4, .709 percentage points in 1965.4, and. 769 percentage points
in 1976.
However, the negative response of labor sup~
ply to unemployment~rate changes has been
considerably reduced (in absolute terms) by the
payment of unemployment~insurancebenefits.
As the positive values in column 2 indicate, for
any given unemployment rate, an increase in VI
payll1entsleads to an increase in labor supply.
For example, in 1950.4, when the unemployment
rate of prime~age males was equal to 3.0 percent,
VI payments added 1.46 percentage points to the
participation rate (.485x3.0). If unemployment
conditions had remained unchanged, VIB would
have increased the participation rate by 1.74
percentage points in 1965.4 (.58Ix3.0); 1.91 per~
centage points in 1975.4; and 2.02 percentage
points in 1976.3.
Considering the opposing forces at work-the
cost of finding a job and the payment to unem~
ployed workers-the total size of the unemployment coefficient (column 3) is considerably
smaller than it would be with no benefit payments (column 1). Thus, previous estimates of
the discouraged~worker effect may have over~
estimated the response of labor supply to
unemployment~rate changes by not considering
the positive labor response to increases in VI
payments. Some labor studies have used an
employment rate rather than an unemployment
rate to represent job opportunities and the cost
of job search. Our results suggest that these
studies also may exaggerate the discouragedworker effect when the importance of VI payments is ignored. 17
The MIX variable also has affected the size of
the wage coefficient over time. The signs of the
coefficients indicate that the relative wage effect
had been dominant until the late 1960's. V ntil
1967, whenever wages fell relative to expected
income, the labor force increased as additional
entrants attempted to supplement the family's
desired standard of living. Conversely, whenever
wages rose relative to expected income, supplementary family workers left the labor force.
Subsequently, however, the relationships have
been reversed. Even more strikingly, the impact
of wages upon labor supply has diminished
(RU) and the wage term(W/ W*) vary over time
(Tables 2 and 3},andthe&ecoefficientsare
associated with thecurrentooquarterindependent
variable. The lagged dependent variable in our
equation means that some time is required for
labor to adjustftillytoachangein an independ~
ent variable; ultimately, the ·long~run response
will be about 2.8 times larger-l / (1-.648)-than
the current coefficient estimate. Henceforth, we
will focusuponcurrent~quarter coefficient val~
ues, since this provides the essence of labor~
supply behllVior. TheJonger~fl.I.n reaction can. be
derived easily, by multiplying the reported re~
sults by 2.8.
Our estimates indicate that the impact of
labor~market conditions-represented by the
prime~age male unemployment rate (R V)-on
the labor~force participation rate has varied
significantly over time. In particular, the supply
of labor has become more sensitive to changes in
labor~market conditions in the 1970's than was
evident twenty years ago (column I). Those
estimates measure the unemployment coefficient, excluding the effect of unemployment
insurance but including the response to demo~
graphic changes. The MIX variable (the proportion of prime age males in the population) has
shown a secular decline since the early 1950's,
and this has increased the labor~supply reaction
to changes in the unemployment rate. This
should be expected, since prime-age males are
less likely than others to move in and out of the
labor force in response to changes in the cost and
difficulty of finding ajob. The values in column I
indicate that a l~percentage point increase in
adult male unemployment would lead to a deTable 3
Wage Coefficient for Selected Periods
Coefficient = .996122 -4.08348MIX
Total Size of Coefficient
1950.4
1955.4
1960.4
1965.4
1970.4
1975.4
1976.1
1976.2
1976.3
-.127
-.127
-.082
-.012
+.020
+.024
+.024
+.024
+.024
42
considerably over time. The negative value of
.127 in the early 1950's has even turned to a small
positive .024 in 1976.
The growing weakness in the relative wage
effect may be due to offsetting behavior by
different groups in the labor force. Since the
early 1950's, married women (with husbands
present) have accounted for a growing percent-
age of the labor force. This group of workers has
shown an increasing attachment to the labor
force and has traditionally displayed a strong
positive response to changes in their wages. IS The
increasing importance of married women in the
labor force may have offset the negative response
of other workers 'to temporary increases in the
average wage.
III. Summary and Conclusions
This paper has analyzed the economic variables which determine cyclical behavior in labor
supply, with emphasis upon the influence of
unemployment-insurance benefits in the period
since 1950. The findings indicate that the payment of UI benefits has weakened the
discouraged-worker effect, so that when jobs
become difficult to find, less workers leave the
labor force (or are discouraged from entering)
than would be the case if no payments were
provided to the unemployed. Some individuals
might view an increase in VI payments as a
reduction in the cost of searching for a job and,
hence, as an inducement to remain in the labor
force as an unemployed worker rather than to
leave for nonmarket pursuits. Other individuals
might be encouraged to enter short-term employment when the wages alone from such work
would not be sufficient inducement to do so. Our
model does not distinguish between these or
other motivations. It simply suggests that the
impact of changes in labor-market conditions
should be considered a net response--one allowing for the cost of finding a job on the one hand
and payment of VI benefits on the other. Otherwise, the unemployment/ labor-supply relationship will be overstated.
These findings have implications for the interpretation of the official unemployment data
published by the Bureau of Labor Statistics.
Many observers question the use of the aggregate
unemployment rate as an indicator of the
strength of the economy. Understanding the
economic picture requires understanding the
causes of fluctuations in the jobless rate, such as
the labor-supply factors estimated here.
If the discouraged-worker effect is weaker
than originally thought, the unemployment rate
should have greater amplitude and conform
more closely with cyclical changes in aggregate
output. Fewer workers would leave the labor
force during the recession and fewer would enter
during the recovery, so that changes in the
jobless rate would more likely reflect changes in
aggregate demand.
However, other economic conditions could
stimulate changes in the supply oflabor and thus
interfere with this conformity. Increases in
unemployment-insurance benefits have tended
to add to the labor-force participation rate. For
example, an increase in UI benefits during an
economic downturn acts to increase the labor
supply, and thereby to increase the unemployment rate more than would be justified by
aggregate-demand conditions alone. This behavior helps to explain the unusual and largely
unexpected increases in the labor-force participation rate observed during last year's "pause."
The slowdown in final demand for goods and
services .which began early in 1976 acted to
moderate growth in labor supply. At the same
time, the maximum weekly UI payment increased substantially, and thus acted to stimulate
increased labor-force participation. The increase
in the ratio between UI benefits and weekly
spendable earnings was unusually large, and the
increase between 1976.1 and 1976.3 may have
added about 145,000 workers to the labor force
and about .14 percentage points to the unemployment rate in 1976.3.
In addition, the aggregate labor force has
shown little response to temporary changes in
the relationship between current and expected
real wages. However, this response may represent the offsetting behavior of different groups.
Indeed, it could become a stronger positive
factor in labor-supply growth if married women
continue to increase their representation in the
labor force.
43
APPENDIX I
For normal wages (W*), we assume that the
permanent real-wage rate in a given period of
time is equal to a percentage of the trend level of
labor productivity. The percentage is equal to
labor's share in total income produced (gross
business domestic product)-a ratio which has
been relatively constant over time. We rely upon
the relative constancy of this ratio to derive a
measure of normal wages.
This constancy can be represented as:
k :::: (Total Labor Income I Gross Business
Domestic Product).
Total labor income can be written as the average
wage per worker times the number of workers
(WxN);and Gross Business Domestic Product
ca.n<bewrittenasa measure of the average price
level times a measure of the real quantity of
output produced (PxQ). Or, rewriting the
above,k= (WxN) I (PxQ). This equation can be
rewritten so that real wages (W I P) are expressed
as a constant percentage (k) of the average
output of labor (QI N):
W/P = kx (Q/N).
To derive an estimate of normal or expected real
wages (W*), we substitute the trend level of labor
productivity for the average output of labor,
which we designate as (QI N)'. Then w* = k x
(Q/N)'.
FOOTNOTES
1. For examples of a formal derivation of a labor supply model
see W.G. Bowen and T. Aldrich Finegan, "The Economics of
Labor Force Participation," pages 569-570; Robert E. Lucas, Jr.,
and Leonard A. Rapping, "Real Wages, Employment, and
Inflation," Journal of Political Economy, 1969, pages 721-754.
2. Friedman, Milton, Price Theory, Aldine Publishing Co.,
Chicago, 111.,1962, page 205.
3. Wachter, Michael, "A Labor Supply Model for Secondary
Workers," Review of Economics and Statistics, 1972, pages
141-151, "A New Approach to the Equilibrium Labour Force,"
Economica, February, 1974, pages 35-51.
4. For a review of how unemployment insurance benefit payments are incorporated in general theories of search as well as a
comprehensive review of search theory see "Theories of Search
in a Labor Market," Kenneth Burdett, Technical Analysis Paper
No. 13, Office of Evaluation, Office of the Assistant Secretary
for Policy, Evaluation and Research, Department of Labor,
October 1973.
5. Feldstein, Martin, "The Economics of the New Unemployment," The Public Interest, No. 33, Fall 1973.
6. There has been a particularly large drain on the UI system
caused by the recent recession. "As of October 1, 1976, the 21
states that have depleted their trust funds have borrowed $3.1
billion from the Federal Unemployment Account. In turn, this
account, as well as the Federal Extended Unemployment
Compensation Account (Which finances the Federal share of
extended benefits and all supplemental benefits) have both
been depleted and are borrowing from Federal general revenue
funds. Even with proposed tax increases to be effective January 1, 1978, it is estimated that the deficit in the Federal
accounts will be over $5 billion by the end of 1981." See Steven
Zell, "Unemployment Insurance: Programs, Proced,ures, and
Problems," Monthly Review, Federal Reserve Bank of Kansas
City, February, 1977, especially pages 41-42.
7. ZeU, Steven P., "Unemployment Compensation," Background Paper No. 15, Congressional BUdget Office, Congress
of the U.S., Washington, D.C., December 8; 1976, especially
Chapter 2, page 13.
8. Regarding the increasing attachment to the labor force of
many secondary workers, see Joseph L. Gastwirth, "Estimating
the Number of 'Hidden Unemployed,'" Monthly Labor Review,
U.S. Department of Labor, Bureau of Labor Statistics, March
1973, pp. 17-26.
9. For a review of the use of unemployment rates in labor force
participation rate models, see Jacob Mincer, "Labor Force
Participation and Unemployment: A Review of Recent Evidence," in Prosperity and Unemployment, Robert A. Gordon
and Margaret S. Gordon, editors, John Wiley and Sons, Inc.,
New York, 1966. Mincer points out that the unemployment rate
of the primary labor force is a better cyclical index than the rates
of other sex-age components. It is therefore also likely to be
superior, in this respect, to the aggregate unemployment rate.
The unemployment rate of prime age males may not be a
perfect proxy for overall labor market tightness and therefore
for the general cost of finding a job if, as Mincer points out, "as a
result of minimum wages, employers tend to substitute experienced for inexperienced workers, the unemployment rate in the
primary group may have decreased, in part, at the expense of
higher rates in other groups," page 107. Of the various employment and unemployment rates that may proxy for labor market
tightness, the prime age male unemployment rate appears the
best indicator and is the reason for its use in this paper. This
does not preclude the possibility, however, of finding another
perhaps better indicator of labor market tightness in future
research. For a discussion of the results of several labor market
indicators see Bowen and Finegan referenced in footnote 1,
especially pages 516-522.
10. For a similar treatment of the aggregation problem, see
Wachter, Michael, "A New Approach to the Equilibrium Labour
Force," Ec<momic<l, February, 1974.
11. Actually, I estimated the regression model in two ways. The
first used the maximum average weekly benefits payable to
individuals divided by the consumer price index as a measure of
the real value ofUIB payments. The second estimation used the
ratio of real UIB payments divided by real weekly spendable
earnings iisdescribed in the text above. The first measure
should serve as a useful proxy for the effect of unemployment
insurance since increases in its value indicate an increase in the
cost of remaining out of the labor force. The ratio measure,
however, represents the relative value of an individual's time;
that is, people may value their time at least as high as current
wage rates and UIB payments relative to the current wage rate
may be the relevant value in the trade-off decision between
market and nonmarket activity for individuals. In practice, the
44
bear the relationship expressed in the above equations, I found
that the labor supply function, specified as the second above
equation. did not result in statistically significant estimated
coefficients fo.r the lagged values of the equation's determinants. although the lagged dependent variable was statistically
significant Therefore the adjustment model appears to be the
more meaningful interpretation of labor supply behavior than
models which have assumed no distributed lag in the response
of labor to the model's determinants, The results suggest that
labor supply models which do not take into account a delay in
the response of labor to changes in economic variables may
represent a misspecification of the supply function, For a
detailed discussion of choosing between a Cochrane Orcutt
estimation technique and a distributed lag such as chosen in
this paper, see Mike Salant and Nick Sargen, "The Supply of
Wheat: A StUdy in Cereal Correlation," May 25. 1968, unpUblished Paper. Dr, Sargen is an Economist at the Federal Reserve
Bank of San Francisco,
15, The calculated F-value was 5,33; the critical values at the 5
percent point for F(5.91) is 2,30 and at the 1 percent point is
3,20,
16, Griliches. Zvi. "Distributed Lags: ASurvey."Econometrlca,
Vol. 35, No, 1 January. 1967,
17, The two best-known studies which find a negative relationship between changes in the supply of labor and a measure of
labor market tightness (I.e" an employment rate) are by Alfred
Tella ("Labor Force Sensitivity to Emplci)l'lnent by Age, Sex,"
Industrial Relations, Vol. 4. No, 2. February 1965, pp, 69-83) and
Thomas Dernburg and Kenneth Strand (''Hidden Unemployment 1953-63," American Economic Review, Vol. 56, March
1966, pp, 71-95). More recent stUdies which find a discouraged
worker effect between unemployment and labor force participation are those of Bowen and Finegan, The Economics of
Labor Force Participation, Princeton University Press, 1969;
Wachter. Michael L.. "A New Approach to the Equilibrium
Labour Force." Economica, February. 1974. A recent cross
section study by Arlene Holen and Stanley A, Horowitz, "The
Effect of Unemployment Insurance and Eligibility Enforcement
on Unemployment," The Journal of Law and Economics, October, 1974. especially pages 410-11. finds a strong discouraged worker effect and a positive impact upon participation
rates of a change in an unemployment insurance benefits
index.
18. Mincer, Jacob. "Labor Force Participation of Married Women." Aspects of Labor Economics, National Bureau of Economic Research. Princeton University Press, 1962, Cain, Glen G.,
Married Women in the Labor Force, The University of Chicago
Press, 1966.
estimation results indicated that there was little to choose
between the two measures since they are highly correlated in
time, The close relationship between the two measures may be
the result of state laws which generally increase UIB payments
whenever covered wages increase, The ratio measure was
chosen for the regression results presented in this paper since
the ratio estimate has the most likely property of a limiting value
of one, as does the dependent variable, the labor force participation rate, For a paper with somewhat similar results regarding
the use of real UIB payments and the ratio of payments to
weekly earnings see Thomas W, Wallace, "The Effect of Unemployment Insurance on the Measured Unemployment Rate,"
Discussion Paper No, 155, July 1974, Queen's University,
Kingston, Ontario,
12, The series used in the denominator of the ratio, weekly
spendable earnings of a worker with three dependents, has
been questioned by Geoffrey H, Moore as being an underestimate of what an average family of this type actually earns,
"Workers' Earnings: Higher Than They Look," The Morgan
Guaranty Survey, October, 1976, Nevertheless. the close relationship between the ratio measure and real UIB payments. as
well as other features referenced in footnote 11, led me to use
the ratio measure in the regression estimates of the aggregate
labor force participation,
13, See for example, three articles on women in the labor force
in the Monthly Labor Review, November 1975. U,S, Department
of Labor, Bureau of Labor Statistics,
14, There has been some controversy in the literature as to
whether labor supply responds contemporaneously or with a
distributed lag to the determinants in the supply function, Labo.r
supply functions which assume the former have a high degree
of auto-correlation in the error terms and the Cochrane Orcutt
procedure has been applied to correct for this factor, My tests
indicate. however. that this representation and estimation of the
labor supply function may be a misspecification of the labor
supply behavior. If first-order serial correlation of the error
terms is an appropriate specification of a model, we can write
this model in general terms as:
where Ut-l = Y[-1 - aXt_l' and et is a normally distributed. zero
mean, finite variance random variable uncorrelated over time
and p is the estimated auto-correlation coefficient
If the Cochrane Orcutt estimation procedure is the correct
specification, we should find that the lagged variables, Xt - l and
Yt-l are statistically significant and the estimated coefficients
45
Larry Butler*
The unemployment and capacity-utilization
rates measure the labor and capital market
pressures in the nation's economy. The two
measures have much in common, and between
them provide a reasonably clear picture of how
much slack is present in the economy, and how
much real growth we may expect before the
economy encounters serious bottlenecks.
This article examines relative movements in
the two series throughout the postwar period.
Until 1974, unemployment and unused capacity
bore a stable relationship to one another. Since
1974, however, unemployment has been increasingly higher than one would have predicted on
the basis of its relation to unused capacityl in
previous cycles. Unused capacity, however, has
behaved in the recent recession and in the present
recovery just as it has in previous cycles. This
observation leads to the conclusion that unused
capacity is still a good measure of overall factormarket tightness while unemployment is not.
The economy is thus likely to enter a period with
available capacity constraining output but with
the unemployment rate still well above 6 percent.
The remaining sections document these conclusions. Section I points out the potential noncomparability of the two series, but shows that,
until 1974, they provided similar indications of
factor-market tightness except during a few
strike- or war-affected periods. Section II discusses the normal cyclical pattern of unused
capacity and unemployment. The concluding
Section III turns to the present discrepancyunmatched in the postwar period-between unused capacity and unemployment. Basically, we
find that unused capacity in the current recovery
has generally matched its earlier pattern, as has
the amount of decline (though not the level) of
unemployment. This suggests that unused capacity is as much as ever a relevant measure offactor
market tightness. Further, the elements which
have produced the present very high unemployment, it will be argued, will not disappear quickly. High unemployment, both absolutely and
relative to its past relation to unused capacity, is
likely to remain a feature of the economy for at
least three to five years.
I. Unemployment-Capacity Relationship
Over Time
Both the unemployment and unused capacity
data rest on sample surveys-the first, of the
civilian population, and the second, ofmanufacturers. Both are proximate measures of the
degree of tightness in the markets for the two
main factors of production. There is a strong
reason why the two measures should track closely over time: capital is reproducible, and thus
over long periods of time, the capital-labor ratio
can be altered substantially. For example, an
influx of labor could lower the wage rate as
compared with the return to capital. In this case,
the demand for labor by employers would rise,
the demand for capital would decline, and after
an adjustment period, there would be no important effect on the usage of either capital or labor
(Chart I).
Suppose the wage rate relative to the return of
the capital is (~) 0 with the constantexpenditure line in Chart I showing how a
constant total cost can purchase various combinations of labor and capital. The production
process itself implies a technological trade-off
between added units of capital and labor, which
46
substantially in recessions, and remain high for
some time after recessions end. Historically,
however, the two measures have remained in
close alignment despite three elements which
could have changed their relationship to each
other.
First, labor force composition has changed
over time, reflecting mostly an increase in female
participation. 2 To the extent that different
groups of workers are not good substitutes for
each other in terms of skill, the composition shift
may imply an increase in the observed unemployment rate associated with any given state of
aggregate demand. However, we can analyze
such compositional changes just as we did the
relationship between capital and labor.
If one group enters the labor force in large
numbers, that group's relative wage should fall,
leading employers to increase hiring in that
group. This should create some tendency for
subgroup unemployment rates to equalize over
time. We should note that subgroups of the labor
force are not reproducible in the same sense that
capital assets are, and that the labor market
contains elements which prevent adequate shortterm wage adjustment-among others, the
minimum-wage law and its relationship to high
unemployment among the young. These factors
suggest that market adjustments among laborforce groups will be slower than between aggregate labor and capital, although market pressure
should remain an important long-term force in
equalizing unemployment between groups.
The second problem is that any sample
survey-such as those used to develop our unemployment and unused-capacity measures-is
open to some subjectivity on the part of respondents. For instance, someone who has been laid
off but has stopped seeking work may perceive
himself as unemployed, but may not be counted
as such according to the official definition. In
similar fashion, a manufacturer facing strong
demand pressures may perceive his capacity as
increasing because he has adopted more costly
processes (like added shifts) that he would normally regard as uneconomic.
The Federal Reserve Board's capacityutilization series-like the Bureau of Labor
Statistics' unemployment series-must be regarded as an excellent example of the survey art.
is labelled as the "production possibility curve"
for the fixed output Yo. The point of minimum
cost of production is reached where the marginal
contribution of capital and labor to cost are the
same: where the (~)0 line is tangent to the
possibility curve. The least costly way of producing the output y() is to use an amount KO of
capital and La of labor. Now suppose the labor
supply increases, initially driving unemployment
up and wages down, with the cost line now at
1 . Capital is now relatively less attractive
(T)
than before, so manufacturers will tend to cut
back on investment plans and hire more labor.
Eventually we reach the new point of minimum
cost, with all of the new labor absorbed (at L I)
and with less capital in use (at K I)' The result is a
lower real wage, and a capital-labor ratio
changed from (~) ~o (~ ){ but with little effect
on the long-run unemployment and unused
capacity rates.
This argument applies only over substantial
periods of time, both to allow for enough change
in investment to alter the capital-labor ratio and
to make the assumption of a flexible wage-toprofit ratio reasonable. This type of adjustment
will not affect periods as short as a business cycle,
for it does not pay to adjust production methods
in periods as short as the typical recession. Thus
both unemployment and unused capacity rise
Chart 1
LONG-TERM CAPITAL-LABOR TRADE-OFF
K
Production possibility
curve for output Yo
w~
(r)1
K 1
L..-
- - -
I
-1- - -
1
I
--.:.::
L
Lo
47
Capacity utilization is a relatively ambiguous
concept, and thus the Board uses two independent surveys in constructing its estimates of manufacturing capacity. One source provides data on
real investment over the cycle (the Commerce
Department's Bureau of Economic Analysis),
and the second source provides capacityutilization data (McGraw-Hill). The use of investment data avoids much of the subjectivity
inherent in the utilization survey. For example,
there is some tendency for manufacturers to
report plant shutdowns during recessions as
losses in capacity, when the closings are in fact
temporary. The reported loss must be confirmed
by a reduction in investment or increased scrappage before the Board will lower its capacity
estimates and adjust the utilization data.
The BLS unemployment data are based on a
monthly survey of 47,000 households, designed
to measure the overall unemployment rate to
within 0.2 percent. The survey includes questions
to insure that respondents understand the exact
meaning of the very precise BLS definitions of
unemployment and labor-force participation.
Consequently, any error in the survey must arise
from a difference between the BLS intentmeasuring the labor force-and the respondent's
intent (aside from the pure sampling error in
using 47,000 households to represent a labor
force of nearly 100 million).
The main source of error concerning intent is
probably the unemployment-insurance laws,
which provide that a person who has been laid
off must be looking for work (that is, must be in
the labor force) to receive unemployment benefits. The law thus creates an incentive for some to
say they are in the labor force when in fact they
are not actively seeking work. Recent increases
in unempl'9yment benefits, and in the length of
time benefits are paid, have probably increased
the number of people in this position. (See
companion article by Rose McElhattan.)
Finally, the capacity-usage figures apply by
definition only to manufacturers. Manufacturing has declined fairly steadily relative to GNP
over the postwar generation, reflecting the rise in
government spending and in the consumption of
services from 34.5 percent of GNP in 1950 to 50.1
percent in 1976. This shift may distort any
relationship between unused capacity and unemployment, because the cyclicity of the shrinking
portion of employment in manufacturing may
differ from that of total employment.
II. Cyclical Pattern of Unemployment and
Unused Capacity
To analyze the importance of these considerations in determining movements in unemployment and unused capacity, we may compare the
time series of the two (Chart 2). To make the
series directly comparable, the actual unused
capacity series has been re-scaled with the aid of
the information in Table 1.
Table 1
Unemployment and Unused Capacity
in Five Post-Korea Recessions
(Percent)
1
Mean Level
1950-76
Unused
capacity
Unemploy
ment
3
4=2-3
2
Average al Average al Average
recession pre-recession increase
in
trough
peak
recession
18.1
25.2
11.4
13.8
5.3
7.0
4.1
2.9
48
The re-scaling of the data makes the unusedcapacity series into a series with the same average
recession run-up of 2.9 percent as the unemployment rate, as well as the same 1950-76 mean of
5.3 percent. In the chart, the average levels of
unemployment and unused capacity serve as
measures of normal factor usage, and their
average recession increases serve as measures of
the normal amount of fluctuation in the two
series. It should be kept in mind that the unusedcapacity series normally increases 5 percentage
points-equal to (l3.8j2.9)-for each I-point
increase in unemployment.
The chart data indicate, first, that the two
factor-usage series told the same basic story until
1974. The two series peaked together in each
recession through 1970, generally within one
quarter of each other. Further, unemployment
declined much more slowly than unused capacity
in each post-war recovery (including the present
one), with the unused-capacity measure dropping well below unemployment by the third
quarter of recovery. There is no evidence of any
shift in the observed relationship between the
factor markets until the 1974-76 recession-andrecovery.
A second observation is that unused capacity
rises in periods of very tight labor markets (i.e.,
below about 4-percent unemployment). Increases occurred in 1955-56, and in 1966-67, at
times of quite low unemployment. Increases in
unused capacity did not occur at the recovery
lows in unemployment in 1958-59 and 1972-73
when unemployment remained well above 4
percenP This apparent anomaly is explained by
induced investment in these periods of high
demand for goods. A relatively low level of
unused capacity coupled with a flat level of
unemployment thus appears to be a reliable
measure ofgreat supply pressure in the economy.
A third useful observation is that a steadily
growing gap has appeared between the two rates
Chart 2
Percent of
labor Force
UNEMPLOYMENT AND UNUSED CAPACITY 1953-1977
9
Percent of
Capacity
8
30
7
25
....Unemployment Rate
6
20
5
15
4
Unused Capacity
2
1953
1960
10
~
1965
• Three-quarter moving average
49
1970
1975
1977
since the start of the 1974-75 recession. Only part
of this can. be attributed to the normally more
rapid decline in unused capacity than in unemployment. This point will be discussed later in
this article.
The cyclical behavior of unemployment and
unused capacity in the past five cycles (Chart 3)
also deserves analysis. First, unemployment and
unused capacity have on average declined until
the cyclical peaks were reached. Thus, the factor
markets have generally failed to provide a
systematic warning of the onset of recession. In
effect, there is no "incipient recession" phase of
the cycle, when income growth decelerates to the
point of sluggish unemployment. and unused
capacity, but not to the point of qualifying as a
recession. The unused-capacity rate provided
evidence of tight supply conditions on .two
occasions-1955 and 1965~but recession did
not follow for over two years following 1955, and
for over four years following 1965.
Secondly, unused capacity tends to rise less
rapidly than unemployment in recessions, but
also tends to recover much more quickly, falling
Chart 3
UNEMPLOYMENT AND UNUSED CAPACITY - CYCLICAL AVERAGE'
Percent of
Labor Force
Percent of
Capacity
7
26
24
~Unemployment
Rate
22
6
18
5
14
Quarters from Real GNP Trough
'Five - cycle average, with troughs dated 1953.5, 1958.4, 1961.2, 1970.1, and 1975.3
50
to moderately low pre-recession levels by the
fifth to seventh quarter after the recession
trough. This suggests that unused capacity behaves very asymmetrically with respect to unemploymentj unused capacity relationship probably
usual recession-recovery pattern in GNP is for a
sharp fall during recession (relative to its growth
trend) followed by a long recovery period of
growth above trend. But unused capacity falls in
recovery almost as fast as it rises in recession,
suggesting that early recovery consists for manufacturers of putting machines back to work
before making new hires. This pattern is under-
stan'dable; most machinery costs must be paid
whether the machine is used or not, while most
wage costs depend on the amount of labor hired.
Thirdly, and in contrast, unemployment follows the pattern set by GNP, with a rapid rise in
recession and a prolonged period of slow decline
thereafter. This pattern helps account for the
perception many workers have of recession as
lasting much longer than the official definition
suggests. These workers define recession as a
period of high unemployment, while statisticians
define it as the preceding, much shorter, period
of negative income growth.
III. Outlook for Unused Capacity and
Unemployment
Since 1974, there has been a substantial increase in the unemployment rate relative to
unused capacity. Because unused capacity has
shown no tendency to increase over time, we may
ask whether this increment in unemployment
will persist for any length of time.
In Section I, we argued that reproducibility of
capital helps keep the average level of unused
capacity stable over time, as manufacturers
adjust their investment demand to keep their
capital stock in line with the long-run demand
they expect for their output. A portion of any
needed adjustment can be accomplished fairly
quickly by cutting investment sharply. The fall in
fixed investment in 1974-75 was in fact quite
sharp, and investment has remained sluggish
since, thus accounting for the "normal" behavior
of unused capacity despite the continuing low
level of income relative to past trends.
The labor force does not have the same kind of
self-adjusting capacity, so the severity of the
1974-75 recession has left us with substantial
unemployment two full years after the recession
trough. However, the amount of decline in
unemployment we have experienced-from a
high of 8.8 percent in 1975.2 to 7.4 percent in
I977.1-is closely in line with the decline in
earlier recessions. 4 With unused capacity showing normal cyclical behavior, we may expect that
with a continuing recovery, unused capacity by
mid-1978 will reach a low level while unemployment is still in the neighborhood of 6 1 percent.
1z
There are two scenarios as to what may hap-
pen after mid-I978. The first is a period of longterm adjustment of the capital-labor ratio, as
illustrated in Chart 1, and thus a return to a more
typical unemploymentj unused capacity relation. In the past, this scenario has required a shift
to an investment-led recovery in output, so the
appearance of strong investment growth would'
be a key that this scenario is being followed. The
alternative possibility would be a recession after
mid-1978, and a postponement of the adjustment
until the succeeding recovery. There would be no
reduction in unemployment relative to unused
capacity.
The first scenario has been typical of recoveries with low unused capacity, as we expect in
mid-1978. We may examine the two earlier
periods when quite low levels of unused capacity
were reached well before the trough in unemployment. These periods were in 1955 and 1965. 5
Both periods were part of long recoveries (195457 and 1961-69) and the low points in unused
capacity were accompanied by substantial increases in investment. In both cases, unused
capacity rose significantly (about 2 percent) in
the year following the low point and remained at
that new plateau until the cyclical peak in real
income was reached. Also in both cases, unemployment continued to decline, though rather
slowly, right up to the income peaks, which were
marked by unemployment rates below 4 percent.
Thus both periods marked long-run adjustments
in the capital-labor ratio.
In the past, then, low unused capacity in mid51
recovery has not been a barrier to further expansionofoutput or to further reductions in unemployment. Should these events recur-especially
the. shift to an. investment-led recovery-the
more typical relationship of unemployment to
unused capacity could be restored for the period
after mid-1978.
It should be emphasized that this scenario is
not inevitable, because it relies on a continuation
of the economic recovery through 1978, and
especially on greater investment growth. The
shorter two of the four most recent recoveries
(1958-60 and 1971-73) each ended without a long
period oHow unused capacity, and thus without
a long period ofhigh investment. Both ended
with unemployment quite high by the standards
of the other two recoveries. Should this kind of
truncated recovery occur, the "normal" unemployment/unused capacity relationship probably
would not be restored until well into the following recovery, that is, some time after 1980.
Neither scenario, in any event, suggests the
possibility of a return to historically low levels of
unemployment for some time.
FOOTNOTES
4. Okun's Law, the econometric rule-of-thumb relating
changes in unemployment to growth in income, exactly predicts the 1.4-percentage point decline which has actually
occurred. This indicates that changes in unemployment are still
closely tied to changes in real income.
5. The war in Vietnam tended to limit the number of new
entrants into the labor force in the 1965 period. However, the
relatively small size of that war (as compared with Korea) makes
it hard to adjust for that data.
1. To measure unused capacity, we subtract the pUblished
capacity-utilization rate from 100. Thus, a rise in unused capacity accompanies a rise in unemployment.
2. This aspect of the labor data is examined by Rose McElhattan elsewhere in this Review.
3. Strikes generally appear as one-quarter "blips" in both
unemployment and capacity, and so barely affect the moving
averages in Chart 1. The largest single post-Korea strike-the
1959 steel strike-affects our conclusion only moderately.
52
@FedFRASER