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Federal Reserve
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SEPTEMBER 1971
High Employment Without Inflation: On the
Attainment of Admirable Goals .............. 12
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
SEPTEMBER 19 7 ,
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TITLE OF ARTICLE
T hree Approaches to Money Stock D eterm ination
M onetary Policy, Balance of Paym ents, and Business Cycles —
The Foreign Experience
Money, Interest Rates, Prices and O utput
The Federal Budget and Stabilization Policy in 1 9 6 8
1 9 6 7 — A Y ear of Constraints on M onetary M anagem ent
Does Slower M on etary Expansion Discrim inate Against Housing?
The Role o f Money and M onetary Policy
The M on etary Base — Explanation and Analytical Use
Interest Rate Controls — Perspective, Purpose, and Problems
An Approach to M on etary and Fiscal M anagem ent
M on etary and Fiscal Actions: A Test of Their Relative Im portance
in Economic Stabilization
A Program o f Budget Restraint
The Relation Between Prices and Em ploym ent: Two Views
M on etary and Fiscal Actions: A Test of T heir Relative Im portance in
Economic Stabilization — C o m m en t and Reply
Towards a Rational Exchange Policy: Som e Reflections on the
British Experience
Federal Open M arket C o m m ittee Decisions in 1 9 6 8 —
A Year of W atchful W aiting
Controlling Money
The Case for Flexible Exchange Rates, 1 9 6 9
An Explanation of Federal Reserve Actions (1 9 3 3 -6 8 )
International M onetary Reform and the “ Crawling Peg”
C o m m en t and Reply
The Influence o f Economic Activity on th e Money Stock: Com m ent; Reply;
and Additional Em pirical Evidence on th e Reverse-Causation Argum ent
A Historical Analysis of the Credit Crunch of 1 9 6 6
Elem ents of Money Stock Determ ination
M on etary and Fiscal Influences on Economic Activity —
The Historical Evidence
The Effects of Inflation (1 9 6 0 -6 8 )
Interest Rates and Price Level Changes, 1 9 5 2 -6 9
The New, New Economics and M onetary Policy
Som e Issues in M onetary Economics
M on etary and Fiscal Influences on Economic Activity: The Foreign Experience
The Adm inistration o f Regulation Q
M oney Supply and T im e Deposits, 1 9 1 4 -6 9
A M onetarist Model fo r Economic Stabilization
N eutralization of the Money Stock, and C om m ent
Federal Open M arket C o m m ittee Decisions in 1 9 6 9 —
Year o f M onetary Restraint
M etropolitan Area Growth: A Test of Export Base Concepts
Selecting a M onetary In d ic a to r— Evidence from the United States and
O ther Developed Countries
The "C row ding O u t” of Private Expenditures by Fiscal Policy Actions
Aggregate Price Changes and Price Expectations
The Revised Money Stock: Explanation and Illustrations
Expectations, M oney and the Stock M arket
Population, The Labor Force, and Potential Output: Im plications for
the St. Louis Model
O bservations on Stabilization M anagem ent
The Im p lem en tation Problem o f M onetary Policy
Controlling Money in an Open Economy: The G erm an Case
The Y ear 1 9 7 0: A “ M od est” Beginning fo r M on etary Aggregates
Central Banks and the Money Supply
A M on etarist View of Dem and M anagem ent: T he United States Experience
High Em ploym ent W ithout Inflation: On the A tta in m e n t of Adm irable Goals
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ISSUE
O ctober 1 967
Novem ber 1 967
N ovem ber 1967
M arch 1 9 6 8
M ay 1 9 6 8
June 1 9 6 8
July 1 9 6 8
August 1 9 6 8
S eptem ber 1968
N ovem ber 1 968
N ovem ber 1 968
March 1 9 6 9
M arch 1 969
April 1 9 6 9
April 1 9 6 9
May 1 9 6 9
M ay 1 9 6 9
June 1 9 6 9
July 1 969
February 1 969
July 1 969
August 1 969
Sep tem ber 1969
O ctober 1 969
Novem ber 1 969
Novem ber 1969
Decem ber 1969
January 1970
January 1 9 7 0
February 1 9 7 0
February 1970
March 1 970
April 1 970
May 1 9 7 0
June 1 9 7 0
July 1 9 7 0
Septem ber 1970
O ctober 1 9 7 0
N ovem ber 1 970
January 1971
January 1971
February 1971
Decem ber 1970
March 1971
April 1971
M ay 1971
August 1971
Septem ber 1971
Septem ber 1971
A Monetarist View of Demand Management:
The United States Experience
by LEO N A LL C. ANDERSEN, Senior Vice President,
Federal Reserve Rank of St. Louis,
Paper Presented at the
Conference on Demand Management — Illusion or Reality?
Bergedorfer Gesprachskreis, Ham burg-Bergedorf, West Germany, June 20-21, 1971
[ AM PLEASED to have this opportunity to present
a monetarist view of demand management with spe
cial reference to the United States’ experience. I will
attempt to present what appears to me to be, in my
country, a general statement of this view of economic
stabilization. My remarks, however, may not be con
sistent with every aspect of the views held by all of
those actively engaged on the monetarist side of the
current debate.
This paper first identifies quite generally the major
factors which set the monetarist position apart from
the prevailing view regarding economic stabilization.
Then, there is a summary of the major propositions of
this view of demand management. Following this dis
cussion, the United States’ experience of the last two
decades is analyzed.
The General Monetarist View
In the United States, monetarists have stressed the
importance of monetary actions in determining the
course of economic activity. Monetary actions include
such actions of the Federal Reserve System as changes
in the discount rate, changes in commercial bank
reserve requirements, and open market purchases and
sales of Government securities. They also include the
Treasury's management of its cash position. These are
the basic exogenous variables of monetary manage
ment, with the major emphasis given to open-market
transactions.
The role assigned to the money stock in the mone
tarist analysis is not generally understood. The money
stock is most frequently used as an indicator of the
thrust or influence of monetary actions on the econ
omy. In the United States, there is a close empirical
relationship between current and lagged changes in
money and changes in nominal GNP. Money is not
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necessarily considered a causal factor. It is used, in
stead, as a summary measure of the influence of
exogenous monetary variables, primarily those con
trolled by the Federal Reserve, on aggregate demand.
Actions of commercial banks regarding their holdings
of excess reserves and actions of households and busi
ness firms regarding their holdings of currency, de
mand deposits, and time deposits are recognized as
influencing movements in the money stock. Never
theless, it is maintained that the usefulness of money
as an indicator of central bank monetary influences
is not seriously impaired by such actions, because
there is considerable empirical evidence that Federal
Reserve actions dominate movements in the money
stock.
The role assigned to interest rates in this analysis
has also been subject to misunderstanding. Contrary
to general opinion, interest rates are an important
aspect of the monetarist transmission mechanism link
ing monetary actions to economic activity, but interest
rates are no more important than prices of goods and
services. In many aspects, this transmission mechan
ism is close to the Tobin view, except that it takes
into consideration many more rates of return and
market prices of goods and services. Monetary actions
of the Federal Reserve are considered a disturbance
which influences the acquisition of financial and real
assets. Rates of return on real and financial assets and
market prices adjust to create a new equilibrium posi
tion of the economy; therefore, these changes are
considered the main channels of monetary influence
on aggregate demand.
The influence of monetary actions through market
interactions is considered to be widely diffused across
all of the markets for financial assets, real assets, and
services. Consequently, it is contended that the influ
ence of monetary actions on movements in total de
Page 3
F E D E R A L R E S E R V E B A N K O F ST. L O U IS
mand is more important for monetary analysis than
their influence on demands of individual sectors. This
is contrary to the more conventional view which first
considers the response of individual sector demands to
monetary actions. Such responses, in turn, are then
summed to give aggregate demand. The monetarist
position is that the allocative effects of monetary
actions have little bearing, if any, on movements in
aggregate demand.
A central monetarist proposition is that the economy
is basically stable and is not necessarily subject to
wide variations in output and employment. In other
words, the economy will naturally move along a trend
path of output determined by growth in its productive
potential. Exogenous events such as wars, droughts,
strikes, shifts in expectations, changes in preferences,
and changes in foreign demand may cause variations
in output around the trend path. Such variations,
however, under most circumstances, will be mild and
of relatively short duration. This basic stability is
brought about by market forces which change rates
of return and prices of goods and services in response
to these exogenous events. It is admitted that markets
are not perfectly competitive and are subject to many
rigidities. Such market “imperfections,” however, do
not greatly impair the stabilizing function of markets;
they mainly result in an inefficient allocation of re
sources. Market imperfections also influence the time
pattern of the response of output and prices to mon
etary actions.
The basic source of short-run economic instability,
which will be discussed in more detail later, is mon
etary actions which result in accelerations and decel
erations in the rate of money growth. In the long run,
however, the trend rate of monetary expansion does
not influence output and employment, but only move
ments in the price level and other nominal variables.
Monetarist View of Demand Management
The monetarist view of the role of monetary and
fiscal actions in demand management makes a clear
distinction between the influence of such actions on
real and nominal economic magnitudes. It also dif
ferentiates between the short-run and the long-run
aspects of monetary and fiscal actions.
SEPTEMBER 1 9 7 ,
output and employment are considered to be little
influenced, if at all, by monetary actions. Trend move
ments in real variables are essentially determined by
growth in such factors as the labor force, natural
resources, capital stock, and technology.
In the short run, however, actions of the central
bank which change the trend rate of monetary expan
sion or produce pronounced variations around a given
trend rate exert an impact on both real and nominal
variables. The timing and the extent to which such real
variables as output and employment are affected de
pends on initial conditions at the time of a change
in the rate of monetary expansion. Two major initial
conditions are the level of resource utilization and
the expected rate of inflation. For example, an accel
eration in the rate of monetary expansion at a time
of a high level of resource utilization will have little
short-run influence on output but a quick influence on
the price level. On the other hand, a reduction in the
rate of monetary expansion will result in slower growth
in real output in the short run, with a faster and
larger response if there is a high level of inflationary
expectations than if there is a low level.
Fiscal Actions
The monetarist view of fiscal actions is that their
main impact is on long-run movements of real output.
Government spending and taxing programs can
change the rate of growth of potential real output by
altering the composition of actual output. An expendi
ture program which re-allocates resources from cur
rent consumption (for example, reduced low income
subsidies) to investment (for example, education)
will tend to increase the growth rate of potential out
put. Or, a tax program which encourages private
investment will have a similar impact on potential
output. Since actual output naturally grows at the
same rate as potential output in the long run, these
allocative fiscal actions do influence the rate of growth
of actual output.
Monetary Actions
While a faster rate of growth of potential output
will tend to reduce the inflationary aspect of a given
rate of monetary expansion, this influence is b e l i e v e d
to be relatively minor and slow to develop. The reason
for this is that the allocative affects of the usua
magnitude of such fiscal actions on potential output
are not too large and take time to appear.
The major impact of monetary actions is believed
by monetarists to be on long-run movements in nom
inal economic variables such as nominal GNP, the
general price level, and market interest rates. Longrun movements in real economic variables such as
I n the short run, fiscal actions are believed by mon
etarists to exert some but little lasting i n f l u e n c e on
nominal GNP expansion and, therefore, have litt e
affect on short-run movements of output and emp oy
ment. I t is a r g u e d that Government e x p e n d i t u i e s
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by taxes or borrowing from the public tend
crowd out over a fairly short period of time an
equal amount of private expenditures, either by
interest rate and price changes or by credit rationing.
There is some influence exerted over the first part of
the adjustment period by a given change in Govern
ment expenditures financed in this manner; conse
quently, an acceleration or deceleration in the rate
of Government spending will exert a short-lived in
fluence on total demand. Changes in tax rates, accord
ing to some monetarists, can influence economic
activity in the short run inasmuch as such changes
alter rates of return on capital assets.
f in a n c e d
Sum m ary of Views on Demand Management
The monetarist position on demand management
may be summarized as follows:
1. Demand m anagem ent is mainly the use of mone
tary actions to foster an acceptable trend rate of
inflation.
2. Short-run instability of output and employment
can be greatly reduced if monetary actions are
avoided w hich result in accelerations and decel
erations in the rate of money growth.
3. Fiscal actions are not an important aspect of
short-run demand management, but the alloca
tive aspect of such actions can be important for
such other purposes as promoting economic
growth or redistributing wealth.
A Monetarist View of Two Decades of
Demand Management in the United States
In analyzing the demand management experience
in the United States from the monetarist point of view,
the last two decades will be divided into three epi
sodes involving different trend rates of growth of
the money stock. The experience of each episode will
be presented, and then reasons for the recorded
course of money supply growth will be developed.
Demand Management Experience
The last twenty years can be divided into three
episodes according to trend rates of monetary expan
s io n -1 9 52 to 1962, when money grew at a 1.7 per
cent average annual rate; 1962 to 1966, when the
trend rate of monetary growth was accelerated to a
3.7 per cent annual rate; and 1966 to the present,
when there was a further acceleration to a 6.1 per
cent annual rate of growth in the money stock
(Chart I ) .
’
During the decade ending in 1962, demand man
agement was primarily the Federal Reserve’s respon-
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S E P T E M B E R 1971
sibility. Only one major fiscal action, the income tax
cut of 1954, was undertaken for the purpose of influ
encing aggregate demand. An examination of the
published minutes of the Federal Open Market Com
mittee indicates that several monetary actions were
taken for the purpose of promoting economic stability.
From 1952 to 1962, the United States’ money stock
increased at a 1.7 per cent average annual rate. There
was, however, considerable short-run variability around
this trend rate, with periods of fairly rapid increase
followed by absolute decrease.
The price level performance, except for a short
burst of inflation in 1956 and 1957, was very good,
and such performance continued into 1965. The GNP
deflator rose at a trend rate of less than 2 per cent
from 1952 to 1965. Performance of the real sector of
the American economy, however, was far from ac
ceptable as the decade was marked by three reces
sions. Over this ten year period, the unemployment
rate averaged 4.5 per cent. Despite an average unem
ployment rate of this magnitude, however, real output
grew only slightly less rapidly than the 3.5 per cent
estimated growth rate of potential output.
The next episode — 1962 to 1966 — marked the
emergence of attempts at “fine tuning” movements in
aggregate demand. Fiscal actions became the main
tool of such management of the economy, while
monetary actions, in the Keynesian tradition, were
assigned a purely accommodative role. Little consid
eration was given to the possibility that monetary
actions could exert any independent influence.
Major fiscal actions undertaken during this period
for purposes of stimulating aggregate demand were
the investment tax credit and accelerated deprecia
tion provisions of the Revenue Act of 1962, the Rev
enue Act of 1964 which reduced individual and
corporate income tax rates, and the Excise Tax Reduc
tion Act of 1965. Then as inflationary pressures
began to mount late in the period, the Investment
Credit Suspension Act of 1966 was adopted to reduce
growth in aggregate demand.
Monetary actions, in their accommodative role,
were expansive. The money stock rose at a 3.7 per
cent trend rate from mid-1962 to the end of 1966
(Chart I). The rate of monetary expansion was vari
able over this period. It accelerated to a 6 per cent
rate from April 1965 to April 1966, and then money
did not grow to the end of 1966.
This episode marked the beginning of accelerating
inflation in the United States. The GNP deflator rose
at over a 3 per cent annual rate during 1966, comPage 5
F E D E R A L R E S E R V E B A N K O F ST. L O U IS
pared with a rate less than 2 per cent during the
1952-1962 period.
Many have viewed the movements in output and
employment from 1962 to 1966 as very satisfactory.
Output rose rapidly, eliminating the gap between
potential and actual output which had existed in the
early 1960’s. As a result, the unemployment rate fell
from 5.5 per cent in 1962 to less than 4 per cent in
1966. These developments have been cited as evi
dence proving the success of the fiscal, “fine-tuning”
view of demand management.
The last episode — 1966 to the present — is one in
which attempts were made to dampen growth in
aggregate demand so^as to curb an accelerating infla
tion. An overriding consideration, however, was to
accomplish this objective without too great a loss of
output and employment. First, fiscal actions were
used, and then monetary actions.
The Revenue and Expenditure Control Act of 1968
imposed a temporary 10 per cent surcharge on in
dividual and corporate income taxes and restricted
the rate of increase in Federal Government expendi
tures. Next, the investment tax credit, which had
been restored in early 1967, was repealed. Then as
output grew more slowly later in the period and the
unemployment rate rose, the income tax surcharge
was allowed to phase out.
Monetary actions were of a stop-and-go nature
similar to fiscal actions. At times during the period,
monetary actions were assigned an independent role
in demand management in contrast to the purely
accommodative role during the 1962-66 episode. In
addition, greater emphasis was placed on controlling
movements in the money stock. Money grew at a 7
per cent annual rate in 1967 and 1968. Then, steps
were taken to curb inflation, and money grew at a
markedly lower 3 per cent rate in 1969. But when
considerable economic slack appeared, the rate of
monetary expansion was accelerated to a 5 per cent
rate in 1970 and to a 10 per cent rate thus far in 1971.
The over-all trend rate of monetary expansion over
the whole four and one-half year period was about
6 per cent, a marked acceleration from the 3.7 per
cent rate recorded from 1962 to 1966 (Chart I).
The performance of the American economy since
1966 has been considered highly unsatisfactory. The
results of monetary and fiscal actions since 1966 have
been a recession accompanied by a high rate of infla
tion. Inflation accelerated to over a 5 per cent annual
rate, and the unemployment rate rose to over 6 per
cent.
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SEPTEMBER 19 7 ,
The experience of the last two decades demon
strates the great lack of success of demand manage
ment in the United States. This is particularly evident
in the 1960’s when very activist stabilization actions
were undertaken. Some cite this experience as dem
onstrating the inability of traditional monetary and
fiscal actions to promote economic stability. I do not
accept such a view. Instead, I contend that the gen
erally accepted economic foundation of demand man
agement is faulty. Basing stabilization actions on this
foundation is a sure formula for failure.
Reasons for Failure of Stabilization Policies
I attribute the very poor record of United States
economic stabilization efforts to four main factors.
First, and foremost, is lack of understanding of the
independent impact of monetary actions, as measured
by changes in the money stock, on the course of
economic activity. Second, is the great emphasis given
to guiding the course of real variables — output and
employment — and the little emphasis, except for short
intervals of time, given to controlling inflation. Third,
is the great emphasis given to fiscal actions, espe
cially in the 1960’s. Fourth, is the use of market inter
est rates as an indicator of the influence of monetary
actions on economic activity.
R ole o f M onetary Actions Ignored — According to
the monetarist view, central bank actions which alter
the trend growth rate of the money stock exert an im
portant long-run influence on nominal GNP and the
price level. Accelerations and decelerations of the
money stock have only an important short-run in
fluence on output and employment. Evidence sup
porting these two propositions is presented in Charts
I and II *
The money stock panel (Chart I) indicates three
trend growth rates of monetary expansion, which
were set forth in the preceding section. Money grew
at a 1.7 per cent average annual rate from 1/1952 to
III/ 1962. Money growth then accelerated to a 3.7 per
cent trend rate to IV/1966 and to a 6.1 per cent trend
rate to 11/1971. Total spending (nominal GNP) and
the price level responded to the changes in the trend
rate of monetary expansion as postulated by mone
tarists. Total spending rose at a 4.9 per cent annual
rate from 1/1952 to 1/1963 and then rose at a 7.4 per
cent trend rate. The price level (GNP deflator) rose
first at a 1.8 per cent rate, then at a 3.8 per cent rate,
and since 11/1969 at a 5.4 per cent rate. The corporate
“Charts have been updated from those presented at the con
ference to include data for 11/1971.
FE. p E R A U R E S E R V E B A N K O F ST. L O U I S
S E P T E M B E R 1971
C h a rt I
1952
1953
1954
1955
1956
1957
1958
1959
I960
1961
1962
1963
1964
1965
1966 1967
1968
1969
1970
1971
1972
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for FRASER
FRA SER ntages are annval rates of change for periods indicated.
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Page 7
F E D E R A L R E S E R V E B A N K O F ST. L O U IS
Aaa bond rate, another nominal magnitude, also
moved in a manner similar to changes in the trend
growth of money.
Chart II, top panel, presents deviations in the money
stock from its trend growth. These deviations are
expressed as the ratio of the money stock to its trend
value for each quarter. The dashed line at the end
of each episode is the ratio calculated on the basis of
the previous episode’s trend for a few quarters after
a change in the trend. This overlap is used to allow for
the fact that a change in the trend growth of money
is not recognized immediately. The second panel pre
sents the ratio of actual real GNP to potential real
GNP. The trend groyvth of potential real GNP, as
indicated on the second panel, has been estimated
by the Council of Economic Advisers. The bottom
panel presents the unemployment rate.
Regardless of the trend rate of monetary growth
(1.7, 3.7, or 6.1 per cent), whenever the ratio of
money to its trend value rose (an acceleration in
money growth), the ratio of actual real GNP to its
potential value rose soon thereafter, and the unem
ployment rate fell. The opposite happened whenever
the rate of money growth decelerated. Despite such
short-run developments and despite different trend
rates of money growth, the unemployment rate aver
aged about the same from 1952 to 1962, when money
growth was relatively slow, as from 1962 to 1971,
when the trend rate of money growth was much
greater.
The developments summarized in Chart II are
consistent with the monetarist view that accelerations
and decelerations of monetary expansion exercise a
short-run influence on output and employment, but
there is little, if any, long-run influence. These influ
ences were given little consideration in demand man
agement, particularly during the activist period from
1962 to 1968.
Focus P laced on Output and Em ploym ent —An
other factor accounting for the poor stabilization record
in the United States is the fact that demand manage
ment has been primarily focused on producing desired
movements in output and employment. This was true
of monetary actions for the 1950’s and early 1960’s
when some independent monetary actions were taken,
the period in the mid-1960’s of fine tuning using planned
fiscal actions and accommodative monetary actions,
and the active use of monetary actions after 1968.
If the economy responds to monetary actions, as
indicated above, a focus of policy primarily on output
and employment can explain the existence of both
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SEPTEM B ER 197j
inflation and high unemployment. In attempting to
promote rapid expansion of real output after mid1962, active use of fiscal actions and accommodating
monetary actions resulted in the money stock rising
at an accelerated rate until early 1966. Inflation ac
celerated, and in response, monetary authorities re
duced drastically the rate of money growth for two
quarters. But then when economic slack appeared in
early 1967, money growth was allowed to accelerate
to a trend rate greater than the previous one. This
sequence of events happened again in 1969 and 1970,
producing a still higher rate of money growth. In
these latter years, however, monetary actions were
on more of a discretionary basis than earlier.
The end result, thus far, of guiding stabilization
policy on real variables has been higher and higher
trend rates of monetary expansion and greater infla
tion. Periodically, there have been temporary periods
of monetary restraint to curb inflation, which in turn
have produced slower output growth and rising un
employment. Such developments, in turn, induce
stabilization authorities to initiate a still higher trend
rate of money growth, which leads to further inflation.
Thus, the American economy may be faced with
high rates of inflation without achieving economic
stability, unless the main emphasis of policy is shifted
to curbing inflation.
Main Em phasis Given to Fiscal Actions —A third
reason for the poor record of economic stabilization
in the United States is the emphasis given to fiscal
actions, particularly from 1962 to 1968. Until recently,
fiscal actions in the form of Government spending and
taxing programs have been given the main emphasis
in economic stabilization efforts to the virtual exclu
sion of monetary actions. Such a development was
an outgrowth of conventional economics which for
the past 25 years has taught that Federal Reserve
actions exercise little independent influence on total
demand for goods and services.
According to this widely accepted view, changes
in the money stock bring about changes in market
interest rates, but total demand is little influenced by
interest rate movements. Consequently, monetary ac
tions have been thought to be of little use in any
program of economic stabilization. On the other hand,
increased Government expenditures are viewed as
adding directly to total demand and tax reductions
as adding to disposable income which would be used
to purchase goods and services. Consequently, this
view has argued that fiscal actions have an immediate
and powerful influence on total spending. This analy
sis has received wide acceptance as evidenced in dis-
f£ D £RAL
R E S E R V E B A N K O F ST. L O U I S
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S E P T E M B E R 1971
Page 9
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
cussions of economic stabilization by the general pub
lic, in the press, in the Congress, and in the Reports
of the Council of Economic Advisers from 1962 to
1969.
It is my belief that the accelerating inflation of the
last half of the I960’s can be attributed, in large part,
to the great emphasis given to fiscal actions and the
downgrading of monetary influence. Monetary author
ities did not reduce the rapid rate of monetary expan
sion during a large part of that period because there
was a desire to let fiscal actions curb inflation and a
belief by some that only fiscal actions would be effec
tive. Then, when restrictive fiscal actions were taken
in mid-1968 —the surtax and slower increases in Gov
ernment spending —many economists, on the basis
of conventional wisdom, predicted “fiscal over-kill”
by early 1969. In response to such predictions, mone
tary authorities continued even more expansionary
actions.
Faulty M ethod of M onetary M anagement Used —
A fourth reason for the poor stabilization record of
the last 20 years has been due to the fact that the
usual method of carrying out United States monetary
policy in the 1950’s and 1960’s was faulty. Discre
tionary monetary policy was reinstated in 1951 after
its suspension during World War II and up through
the early part of the Korean War. The purpose of
the 1951 change was to permit monetary authorities
to fight die inflation of the Korean War. In conducting
its monetary policy responsibilities since then, the
Federal Open Market Committee has relied almost
exclusively, until just recently, on measures of money
market conditions as a guide to its operations. I am
sure that most of you are familiar with the view that
falling interest rates indicate expansionary monetary
actions, while restrictive actions are indicated by
rising interest rates.
Such a view was in general agreement with the
conventional wisdom, which holds that monetary ac
tions work primarily through changes in market inter
est rates. It also was in agreement with the view that
the Federal Reserve has great ability to “set” market
interest rates. Recent research and experience, how
ever, have tended to reject these propositions. For
example, it has been demonstrated that rapid mone
tary expansion, such as in 1967 and 1968, stimulates
total spending, fosters inflation, and thereby generates
rapidly growing demand for credit and rising interest
rates, not lower rates.
By using market interest rates to indicate the thrust
of its actions in the 1950’s, the Federal Open Market
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SEPTEMBER ig 7 ,
Committee frequently resisted the pace at which
rates fell during recessions and rose during recoveries
Such actions did not alter the trend growth of money
or inflation, but they produced accelerations and de
celerations which led to economic instability.
Then in the fine tuning of the 1960’s, the Com
mittee concluded that, despite very rapid monetary
growth, rising interest rates indicated considerable
monetary restraint during 1967 and 1968. Conse
quently, it was believed by many that further steps
need not be taken to reduce the excessive rate of
monetary growth. In retrospect, it is now apparent
that the traditional reliance on such measures of money
market conditions as market interest rates contributed
to our present inflation and to instability in the real
sector.
The focus on market interest rates in conducting
monetary management during the last half of the
1960’s also led to higher trend rates of monetary
expansion in two other ways. Constraints on interest
movements imposed by public opinion and the Con
gress on Federal Reserve actions caused, in part, the
very expansive monetary actions during 1967 and
1968. Following the rapid rise in market interest rates
during the credit crunch of 1966, there was a belief
that the extent of the increase was too great because
of the dislocations which had occurred in the savings
and housing industries. In order to forestall further
dislocations, there was a desire to hold back the
magnitude of interest rate increases; this led to pas
sage of the Interest Rate Control Act of 1966. Pres
ently there is a reluctance to allow rates to rise for
fear of “choking-off” the economic recovery. A ttem pts
to hold back interest rate increases at a time of ex
panding economic activity require great injections of
bank reserves which contribute to a rapid growth in
the money stock. This, in turn, fosters excessive total
demand and feeds further the fires of inflation.
The focus on market interest rates also helped to
bring about the extremely high rates of monetary
growth during 1967 and 1968 as a result of the deci
sion to finance the expansion of the Vietnam War and
rapidly rising welfare programs by borrowing rather
than exclusively by taxes. During 1967 and 1968, large
Government financings in the security markets caused
the Federal Reserve, because of an even-keel policy
of stabilizing m o n e y m a rk e ts at times of G o v e rn m e n t
borrowing, to buy large quantities of Government
securities. As m e n tio n e d earlier, there was great up
ward pressure on market interest rates from the private
sector. Hence, with large demands for funds from
f E D E R A L
r e s e r v e B A N K O F ST. L O U IS
both private sources and the Government, large injec
tions of member bank reserves were required for
even-keeling by the Federal Reserve. These injections
helped to foster rapid growth in the money stock.
Conclusions
Now to answer the question posed for this confer
ence, “Demand Management, Illusion or Reality?”
According to the monetarist view, the answer is
“reality,” but the essence of such reality is markedly
different than that of the more conventional, activist
view of demand management. Monetary actions
should be directed primarily at fostering an
acceptable rate of inflation; this requires the follow
ing of an appropriate trend rate of monetary expan
sion. With regard to output and employment, mone
tary actions should be conducted so as not to be a
source of economic instability; this requires the avoid
ance of periods of marked accelerations and decelera
tions in the rate of money growth. Thus, I believe
that there are strong economic reasons for the mone
tary growth rule and little room for discretionary,
short-run monetary management.
The recent American experience demonstrates the
potential of short-run monetary actions to produce
both inflation and economic instability. For instance,
the 6 per cent trend growth of money since 1966,
given the 1.5 per cent trend increase in velocity that
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S E P T E M B E R 1971
has occurred since then, is consistent with a 7 to 8
per cent annual rate of increase in nominal GNP. If
potential real output should continue to rise at its
recent 4.3 per cent annual rate, this rate of money
growth implies a trend rate of inflation between 3 and
4 per cent. If velocity, however, should resume its
higher 3.5 per cent average annual rate of increase
recorded from 1952 to 1966, the recent trend rate of
money growth implies a 5 to 6 per cent rate of infla
tion. The monetary restraint of 1969, when money
rose at only a 3 per cent rate, produced the recent
recession in the United States, but since this was only
a relatively short-lived deceleration in money growth,
the rate of inflation was little influenced.
Stabilization actions since 1966 have not been con
ducive to a marked reduction in the rate of inflation.
The United States inflation will not be reduced sub
stantially until a lower trend rate of money growth
is established; a 3 to 4 per cent rate probably would
be optimal. Since the present high rate of inflation
has been in existence for several years, however, ex
pectations are for a continued high rate of price
advance. In such a case, a move to less expansionary
monetary actions will result in considerable adjust
ment costs in terms of slower expansion in output and
employment. Such costs cannot be avoided if the
United States inflation is ever to be contained, and
attempts to avoid them will probably lead to higher
rates of inflation.
This article is available as Reprint No. 70.
Page 11
High Employment Without Inflation:
On the Attainment of Admirable Goals
by ROGER W. SPENCER
,
IGH EMPLOYMENT and price stability are two
of this country’s foremost economic goals. In contrast
to the early part of the 1960’s when prices were
relatively stable but unemployment was high, and
the latter part of that decade when unemployment
was low but inflation was rapid, the early 1970’s have
been marked both by high unemployment rates and
by rapid inflation. Since the adoption by the Con
gress in 1946 of goals calling for the achievement of
maximum purchasing power and full employment, the
simultaneous realization of price stability and full
employment has been rare.
These goals were reaffirmed by the Joint Economic
Committee (JE C ) in a recent R eport.1 The Committee
recommended that “The President and Congress
should adopt as a long-term objective the twin goals
of an unemployment rate no higher than 3 per cent
and an annual increase in the GNP deflator of no
more than 2 per cent.”2
In only two years since 1946 have the Committee’s
employment and price stability goals been achieved
simultaneously. In 1952 and 1953 an unemployment
rate of 3 per cent or less and a rise in prices of less
than 2 per cent were attained. Moderate monetary
growth at a 3.7 per cent annual rate in the 1951-53
period facilitated the attainment of the inflation goal.
Employment as a proportion of the labor force in
1952 and 1953 was enhanced by the fact that many
1“Report of the Joint Economic Committee, Congress of the
United States, on the February 1971 Econom ic Report of
the President,” (Washington, D. C., 1971 Joint Econom ic
Report, U. S. Government Printing Office, 1971), p. 34.
2Ibid. Representative Richard Bolling (Missouri) rejects the
increase in prices of 2 per cent as being inconsistent with
the 1946 Employment Act’s objective of stable prices.
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potential young workers were in the armed forces
(proportionally more than during the Vietnam War).
Moreover, there were fewer of these young individ
uals (whose unemployment rate is typically higher
than the average) than usual because of the low
birth rates of the 1930’s.
Many of the conditions surrounding the 1952-53
attainment of the employment and price goals do
not exist presently and are not likely to exist in the
near future. For example, young inexperienced
workers are expected to enter the labor force at more
rapid rates than during the early 1950’s for some time
to come. Moreover, the money stock has expanded at
a much more rapid rate in recent years than in the
early 1950’s. Thus, the Committee’s endorsement of
stable prices and a 3 per cent unemployment rate
appears somewhat optimistic. Stabilization policy ef
forts to achieve such a low rate of u n e m p l o y m e n t
could prove quite costly in terms of inflationary pres
sures. Low rates of unemployment could be achieved
without aggravating inflation, however, by the adop
tion of measures designed to remove constraints on
the functioning of labor markets.
This article examines the reasons for the occurrence
and duration of unemployment, and, given this analy
sis, explores ways in which unemployment might be
reduced without generating excessive inflationary pres
sures. The emphasis on unemployment reflects the
fact that over the past twenty-five years, the Com
mittee’s 3 per cent unemployment rate target has
not been attained as often as the 2 per cent per year
price target (see the following chart).
Unemployment has long been described as arising
from frictional, structural, and “inadequate demand
FEDERAL
r e se r v e
S E P T E M B E R 1971
B A N K O F ST. L O U IS
Prices and Unem ploym ent
1 9 4 8 -7 0
Rat es c,{
C h a n g e of Price IS
Rates of
Unem ploym ent
A n n u a l D a ta
8
7
6
A
/ \
i
^
\
5
6
5
7
Unemployment
^ S r A IF
yT
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h
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---- - /
2
1
JOINT E ZONOMIC COMMITTEE LL
UNEMPLO'l MENT AND PRICE GOALS
------- Prices r—— —
SCA LE|
2
1
0
...
.
1948
------- 1
---- 1
-----
1950
1952
i
i
1954
i
i
1956
---- 1
----
L
1958
1960
L
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_
1962
■
1
1964
1
1
1966
U — s----1
---- U --- 1
--- ■
1968
1970
1972
|_1_The J o in t E co n o m ic C o m m itte e o f th e U n ite d S ta te s C o n g re s s , in its F e b ru a ry 1971 R e p o rt o n th e E c o n o m ic R e p o rt o f th e P re s id e n t, p . 3 4 ,
r e c o m m e n d e d g o a ls o f 3 p e r c e n t u n e m p lo y m e n t a n d 2 p e r c e n t a n n u a l in c re a s e in p ric e s .
factors, along with wage-price inflexibility. More re
cently, a theory of unemployment based on job in
formation and relocation costs has emerged. This
article investigates the unemployment issue through
integration of these basic approaches.
The first section of the article explains why there
is unemployment. The explanation is facilitated by
spelling out conditions under which the unemploy
ment rate would be equal to zero. This euphoric
situation is developed to make a clear contrast with
the actual world in which some unemployment in
evitably exists. The underlying cause of real world
unemployment is the fact that job information and
relocation costs are positive. Next, a “normal” unem
ployment rate and the reasons for deviations from it
are explored.3 The term “normal rate” of unemploy
ment does not imply that such unemployment is
either desirable or immutable. One of the principal
objectives of the advancement of the normal rate
concept is to determine methods of lowering such
a rate.
The second major section of the article outlines
ways in which the rate of unemployment could be
3The “normal” unemployment rate, which has also been
termed the “natural’ rate, the “warranted” rate, and the
full employment” rate, is not a constant, but can vary over
\ sh°rt period with changes in the institutional setting of
the labor market.
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reduced without aggravating inflation. The roles of
legislative, fiscal and monetary policies with regard
to employment are analyzed in this context. Finally,
the econometric model of this Bank is used in the
third section to examine possible future patterns of
economic adjustment to alternative monetary policies
designed to achieve the Committee’s economic goals.
The model draws on data from a period in which
labor market restrictions were little different from
what may be expected in the near future. Through
simulation techniques, the model suggests that ac
celerating inflation would be required to achieve and
maintain an unemployment rate(near 3 per cent.
WHY UNEM PLOYM ENT?
Unemployment is usually considered undesirable
from both the social and private points of view. Yet,
there has always been some unemployment. Con
trasting a hypothetical world in which there is no
unemployment, with the real world, in which positive
costs of information and relocation as well as fric
tional, structural, and aggregate demand-related
forces combine to foster unemployment, should pro
vide insight into the problem.
A World of Zero Unemployment
In developing an illustration of a hypothetical world
in which there exists no unemployment, that is, every
Page 13
F E D E R A L R E S E R V E B A N K O F ST. L O U IS
one who wants a job at the market wage rate has one,
we assume: (1) prices and nominal wage changes are
correctly anticipated; (2 ) all labor is homogeneous;
and (3 ) there are no market imperfections.
The correct anticipation of wages and prices means
that each firm and each worker has such knowledge.
Wages and prices are flexible both upward and down
ward. Labor homogeneity implies that each worker is
like that of every other in terms of such factors as
skill, age, and sex. A perfect market is characterized
by complete, costless knowledge of job information
and unlimited, immediate and costless ability to trans
fer labor resources from one job to another. There are
no artificial impediments to labor opportunities such
as a minimum wage law or job discrimination on a
nonprice basis. Markets are cleared instantaneously
under the assumptions of this simple model (see the
figure below) and, consequently, there is no unem
ployment. That is, all those who desire to work at the
prevailing wage rate are employed.
S E P T E M B E R 1 9 71
A downward shift in the demand for labor (brought
about, for example, by a long-lasting drop in consumer
confidence) results in an excess quantity of labor sup
plied at the existing wage rate, and an immediate
decline in the wage rate occurs to clear the market.
The lower rate is immediately recognized by the
workers as being widespread, and there is a decline
in the total quantity of labor (in man-hours) worked.
The fall in the quantity of labor worked may be re
flected in fewer hours worked per employee or fewer
employees. If no workers decide to drop out of the
labor force and all accept the lower wage, the lower
quantity of manhours is reflected in fewer hours of
work per employee. Still, every worker who wants a
job at the lower wage can find one, and a state of full
employment is maintained continuously. Those who
make the economic choice not to work at the lower
rate have left the labor force voluntarily and are not
considered unemployed. An increase in the supply of
labor, due to a sharp increase in immigration, for ex-
Demand for and Supply of Labor in a Zero Unemployment World
Assume wages and prices are correctly anticipated by
all economic units, labor is homogeneous, and there are
no market imperfections. The demand schedule for labor
reflects the additional revenue provided by the labor serv
ices of an additional worker, that is, the worker’s “mar
ginal revenue product.” The lower the price (or wage)
of labor, the greater the amount of labor that will be
demanded. The supply of labor depends on the pop
ulation of labor force age and that population’s
evaluation of income-leisure considerations. A sharp
increase in the population of labor force age would
shift the supply curve to the right, as would a shift
in workers’ preferences toward income and away
from leisure.
A fall in the demand for labor is illustrated by the shift
to the left of the demand curve to D’ with a concomitant
fall in wages to wi and a drop in the quantity of labor
worked to Qi. An increase in the supply of labor is indi
cated by a rightward shift in the supply curve, which is
associated with a fall in the wage rate to wi and a rise
in the quantity of labor worked to Qj.
WAGE
RATE
The exact position and slopes of the curves, even
under the highly abstract conditions postulated, can
not be outlined definitively. Some analysts, for exam
ple, believe the labor supply curve is not only vertical
in its upper regions, but bends backwards, indicat
ing a lower quantity of labor supplied for increas
ingly higher wage rates. Labor studies of some
underdeveloped countries suggest that with a target
level of income in mind, workers will work less and
maintain that target level of income at ever-higher
wage rates.
The intersection of the demand for labor services
and the supply of those services, under the de
scribed assumptions, gives the equilibrium quantity
of labor (Qo) and wage rate (wo). At the equilib
rium wage, firms are able to hire all the labor they
want and the labor force is fully employed. Full
employment in the present context is interpreted
to mean that all workers desiring jobs at the existing
wage find them, not that every possible hour of
labor (24 hours of labor per worker per day) is
worked.
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Q U A N T IT Y O F LABOR
N o t e : The a r r o w s illustrate a d e c r e a s e
in d e m a n d a n d a n i n c r e a s e in
supply.
p E D E R A L.
r e se r v e
B A N K O F ST. L O U IS
uiiple is accompanied by a lower wage rate and a
larger total quantity of labor worked. Thus, in this
assumed world of perfect labor markets and no costs
of adjustment, full employment is maintained con
tinuously. Although the level of employment may vary,
both the market (or actual) rate of unemployment
and the normal rate are zero.
Underlying Cause of Unemployment
In contrast to the hypothetical world in which
there is no unemployment, consider the real world
situation in which there is always a positive rate of
unemployment.4 This positive unemployment rate
emerges when the rigid assumptions of the “Zero
Unemployment World” are dropped. The following
Exhibit provides an overview of the causes of unem
ployment and a classification of the sources. “Sources”
refers to the original reason for unemployment, that
is, why unemployment initially occurs, and “causes”
is concerned with its continuance, or why the unem
ployed individual does not immediately locate a job.
The underlying cause of unemployment is the fact
that job information and relocation costs are positive.
This lack of perfect ( costless) knowledge and mobility
means that a worker seeking a job for any reason
(better pay, industry lay-offs, downturn in the econ
omy) cannot immediately locate and accept the best
employment for which he is suited. So long as there
is some service he can perform (whether in the pro
fession or trade in which he is trained, or some other
economic services such as manual labor) for some
positive wage rate, he need not be unemployed, but
he cannot, in general, discover his best employment
alternative without some costly period of search.
4According to the Department of Labor, “Unemployed per
sons comprise all persons who did not work during the
survey week, who made specific efforts to find a job within
the past 4 weeks, and who were available for work during
the survey week (except for temporary illness). Also in
cluded as unemployed are those who did not work at all,
were available for work, and (a ) were waiting to be called
back to a job from which they had been laid off; or (b )
were waiting to report to a new wage or salary job within
30 days.” U. S. Department of Labor, Bureau of Labor
Statistics, Em ploym ent and Earnings (August 1971), p. 120.
Much of the following analysis (especially those sections
on frictional, structural, and aggregate demand-related un
employment) is oriented toward explaining the observed
unemployment rate as computed by the Bureau of Labor
Statistics. The costs of information and relocation analysis
applies not only to this measure of “involuntary” unemploybut also to voluntary (or hidden) unemployment
which is not accounted for in the observed unemployment
rate. In many cases, labor market adjustment costs are so
nigh as to discourage potential workers from seeking jobs.
An estimate of the significance of hidden unemployment
is provided by N. J. Simler and Alfred Telia, “Labor Re
serves and the Phillips Curve,” T he Review o f Econom ics
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S E P T E M B E R 1971
During the period of search he is, by definition,
unemployed.
The foregoing passage is of sufficient importance
to require re-statement. If there is a service of any
kind anywhere which an unemployed individual could
perform for an above-zero wage, his unemployment
may be attributed to the fact that he lacks complete
knowledge of all job possibilities or that he does not
have the resources to permit him to relocate. The
unemployed normally prefer to seek jobs in fields in
which they are skilled and in favored geographical
areas, but after some period of fruitless search, they
often scale down their requirements as to work field,
geographical location, and/or wage rate.5
Since there are positive costs of information and
mobility in the labor market, the unemployed expend
scarce resources (time and money) to locate the
vacancy they may eventually fill. Contrary to popular
belief, job search (which accompanies unemployment)
is a rational economic decision which often benefits
the worker, the firm, and the economic system. The
worker is best off (in terms of wealth and utility) by
locating the job which offers him the greatest present
value as discounted over some finite time span.8
By taking the first job he is offered, he may pass
up jobs which would be more rewarding both mone
tarily and nonmonetarily over his working life. He is
most able to obtain a preferable job by a search
process which often accompanies unemployment.7 If
5The significance of information and relocation costs in the
determination of unemployment is reflected in the description
of the plight of an unemployed husband and his wife in a
recent issue of a popular magazine.
After a month of fruitless job hunting, Tim
[layed off from his job as a tooknaker] and Rose
mary sat down to consider theit alternatives. He
could take an unskilled job and supplement it with
work in a tool shop. Rosemary could go back to
work. They could move. None of the choices looked
good. For Tim to work 60 hours for less than his
former pay seemed a drastic backslide —besides,
he would have no time to look for suitable work.
Rosemary wants to be home with her children, if
possible, at least until they’re all in school. Moving
would be a terrible sacrifice; . . .
Rollie Hochstein, “When the Pay Checks Stopped,” G ood
H ousekeeping (September 1971), p. 183.
6The principle that the probability of a worker obtaining the
“best” job by taking the first offer is lower than with additional
search finds its mirror image with firms and vacancies. A firm
has a higher probability of selecting the best applicant for a
vacancy by interviewing more than one applicant, despite the
fact that the vacancy must remain open for a longer period.
7“Gathering and disseminating information about goods or
about oneself is in som e circumstances m ore efficiently done
w hile the good or person is not em ployed, and thus able to
specialize (i.e., w hile specializing) in the production o f infor
mation.” Armen A. Alchian, “Information Costs, Pricing and
Page 15
F E D E R A L R E S E R V E B A N K O F ST. L O U IS
S E P T E M B E R 197]
E xh ib iH
Unemployment Causes and Classifications
POSITIVE
UNEMPLOYMENT
ARISING FROM
FRICTIONAL FORCES:
1. Random business failures
and em ployee layoffs
2. Em ployer-employee
dissatisfaction
3. Seasonal factors
4. Strikes
5. Random entry of workers
into labor force
COSTS
OF
INFORMATION
AND
MOBILITY
UNDERLIE
UNEMPLOYMENT
ARISING FROM
STRUCTURAL FORCES:
1. Changes in relative
demand for labor
2. Changes in relative
supply of labor
ALL
UNEMPLOYMENT
UNEMPLOYMENT
ARISING FROM AN
UNANTICIPATED
DECLINE IN
AGGREGATE
DEMAND
Note: Some o ve r-s im p lific a tio n is in h e re n t in the a bo ve unem ploym ent d istinctio n s.
Resource Unemployment,” M icroeconom ic Foundations of
Unemployment and Inflation Theory, Phelps, et. al. (New
York: W. W. Norton & Co., Inc., 1970), p. 29. A large body
of literature on the intensity and duration of job search has
emerged in recent years. George J. Stigler, in “Information
in the Labor Market,” Journal o f Political Econom y (Supple
ment: October 1962), pp. 94-105, attempted to find the deter
minants of worker’s wage demands and generated some data
which suggested that workers who invested in some job
search were better off than those who engaged in virtually
no search. Armen A. Alchian and William R. Allen, in Uni
versity Economics, (Belmont, California: Wadsworth Pub
lishing Company, Inc., 1968), set down several postulates of
job search in their text, and Alchian, “Information Costs,
Pricing and Resource Unemployment,” developed the theory
of job search and costs of information more rigorously. Charles
C. Holt, in “Job Search, Phillips’ Wage Relation, and Union
Influence: Theory and Evidence,” Phelps, et. al., related the
length of job search to wage aspirations, a concept given
more attention heretofore by psychologists than economists.
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he is well satisfied with the job he takes, (1) his firm
will not have to advertise for and retrain a replace
ment for him after a brief period of employment; and
(2) society will receive the benefits of a worker who
is more productive the more satisfied he is with his
position.
The search process is a two-way street — workers
search for jobs and firms search for workers. Workers
expend resources to secure information about job
opportunities, and firms do the same to obtain informa
tion on the qualifications of job candidates. Trans
portation costs are often a part of the search process
also. Firms may move plants near available labor
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B A N K O F ST. L O U I S
supply or absorb the costs of employee job transfer.
Workers, however, often must bear the monetary and
nonmonetary costs of obtaining work in other areas.
The Normal Rate of Unemployment
Given the underlying job search costs, observed
unemployment derives from frictional, structural or
aggregate demand-related factors.8 In addition, the
o b s e r v e d unemployment rate may be viewed as con
sisting o f a “normal” rate of unemployment and devi
ations from the normal rate. The level of the normal
rate is determined by frictional and structural forces
(see the Exhibit). The normal rate of unemployment
reflects the adjustment of firms and workers to chang
ing economic conditions independent of aggregate
demand changes. Deviations from the normal rate
may be ascribed to changes in aggregate demand
which result in overall prices and wages changing at
rates not correctly anticipated by firms and workers.
At the normal rate of unemployment, there is an
equilibrium of a particular sort in the labor market.
The equilibrium is not one which exists in the sense
that the labor market clears at a single wage rate,
and there are no excess supplies of or demands for
labor.
Equilibrium in the labor market at the normal rate
of unemployment is indicative of some average length
of search time before a vacancy is filled or, alterna
tively, a job is taken.9 This average length of job
search at the normal rate is a function of the degree
of heterogeneity and imperfection in the job market.
In this context, heterogeneity refers to the fact that
all workers do not share the same skills and training,
S E P T E M B E R 1971
nor do all job vacancies require the same qualifica
tions. Job market imperfections mean that there is
not perfect (costless) information about vacancies or
qualifications, costless mobility, or equal job oppor
tunities for workers with similar job qualifications.
The normal rate of unemployment at any time is
not easily measured, but conceptually it can be de
fined as that rate which exists (given labor market
imperfections and heterogeneity) when wages and
other prices conform on average correctly with
anticipations. Some firms and workers underestimate
price and wage changes and some overestimate, but
on average for the overall economy, prices and wages
are correctly foreseen. Since the wage rate associated
with vacancies at some firms will be below the rate
expected by some applicants, these applicants will
continue to search for higher wages.10 During the
period of search, these particular applicants are un
employed, and their unemployment constitutes the
normal rate of unemployment. Other applicants, how
ever, are pleasantly surprised that the wage rate asso
ciated with a particular vacancy is higher than they
anticipated. Their search time is shorter than the aver
age associated with the normal rate of unemployment.
When nominal wages are rising faster than antici
pated on average, job search time on average falls
and there is “over-full” employment, that is, a fall in
unemployment below the normal rate. When wages
are increasing slower than anticipated on average,
there is less than “full” employment, as unemployment
rises above the normal rate. The normal rate itself
varies with changes in the amount of frictional and
structural unemployment.
Frictional Sources of Unemployment
8These are not perfectly separable categorizations, but for
expositional purposes, the generalization is useful.
9Since there is not a uniform wage rate at which everyone
accepts employment, and market clearance in the usual sense
does not occur, it is difficult to depict any sort of realistic
labor market equilibrium with a static demand-supply dia
gram. Moreover, the equilibrium which exists at the normal
rate of unemployment is dynamic and cannot be readily
analyzed within the diagrammatical framework of compara
tive statics. The unemployment rate implied by the intersec
tion of labor market demand and supply curves is zero, a
figure not attained in an actual economy.
Holt, p. 58, uses the phrase “stochastic equilibrium” to
describe the near equality between the large flows of workers
mt° unemployment and from unemployment over any period.
He points out that over the course of a year, the sum of quits
and layoffs is about equal to the sum of new hires and recalls,
rhelps, p. 8, discusses equilibrium in the non-Walrasian sense,
that is, labor market equilibrium “in the large” which occurs
despite the existence of some vacancies and some unemDigitized for
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Workers who are unemployed'for short periods due
to “standard” market adjustments are frictionally un
employed. Standard market adjustments refer to those
situations in which workers enter the job market with
little experience, quit jobs voluntarily to look for
better ones, or are released from employment due
to employer-employee dissatisfaction, strikes, seasonal
factors, or business failures unrelated to changes in
aggregate or relative demand. Frictional unemploy
ment, characterized by a continual churning of jobs
and workers, is basically institutional in that a so10The expectation of a higher wage than is offered is also a
proxy for other reasons that a job seeker is not hired. For
example, in the cases of both frictional and structural un
employment, the actual wage associated with a vacancy may
be zero for unqualified applicants.
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F E D E R A L R E S E R V E B A N K O F ST. L O U IS
ciety’s laws —both those of man and nature — govern
its degree. The existence of frictional unemployment
arises with the relaxation of only one of the assump
tions made in the discussion of the zero unemploy
ment model — labor market imperfections.11
The following example illustrates the interplay of
frictional sources and search and information costs
in bringing about unemployment. If a worker is re
leased from his job because of a strike in an industry
which supplies his employer’s firm with materials, he
probably will not know whether he can get a similar
job with another firm, or in another field, or with his
own firm after the strike is ended. That is, he does
not have perfect job'ymarket information. He is tem
porarily unemployed while seeking a similar job with
another firm, or a different job in another field, or
waiting to be called back to his old job. If he had
complete information on all alternative employment
opportunities, he could take the best job situation, but
the absence of such information often requires costly
search and/or relocation. Strikes, bad weather condi
tions, a jump in the number of random business fail
ures, increased random worker entry, and worsening
overall employer-employee relations lead to higher
frictional unemployment and a higher normal rate of
unemployment (because frictional unemployment is a
major component of the normal rate of unemployment).
Such unemployment is basically a product of the
institutional setting of the labor market. Changes in
the institutions lead to changes in the degree of fric
tional unemployment. Since institutions change slowly,
frictional unemployment probably does not tend to
vary a great deal. If, however, there is a long-lasting
change in, say, labor laws which affect the propensity
to strike, or weather conditions which permanently
change rainfall patterns, or communications develop
ments which alter job information costs, there will
likely be a permanent change in frictional unemploy
ment and the normal unemployment rate. Aggregate
stabilization policies could do little to alter unemploy
ment arising from institutional sources.
Structural Sources of Unemployment
Unemployment resulting from shifts in relative de
mands for and supplies of labor is attributable to
structural factors. These shifts are of sufficient magni
tude to constitute a shock to the economic system,
as opposed to the steady churning that marks fricn Continuing the parallel with the zero unemployment world
assumptions, structural unemployment is marked by dissimi
larities among workers (labor heterogeneity), and unem
ployment arising from aggregate demand-related sources is
attributable to incorrect anticipations of prices and wages.
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SEPTEMBER 19 7,
tional unemployment. Relative demands change due
to technological advances, changes in tastes, or deple
tion of a natural resource. Relative supplies may
change with shifts in particular categories of workers
(such as a large increase in sixteen-year-olds initially
entering the labor force), minimum wage increases
or changes in the ability of some groups (such as
unions) to alter the supply of labor in particular
fields. Since the shifts in either demand or supply
(and the degree of the shift) are not immediately
evident to all workers, unemployment often arises as
workers ( and relative wages) adjust to the shift.
Search costs are incurred during the period of
adjustment.
Institutional factors are often responsible for shifts
in labor supply much as with changes in frictional
unemployment. A one-time-only change in the birth
rate (which affects the size of the labor force sixteen
years later) or military employment (which affects
the civilian labor force, and, in turn, unemployment)
gives rise to temporary changes in structural unem
ployment and the normal rate of unemployment. A
long-lasting change in the birth rate ( due to advances
in birth control technology, for instance) or military
requirements (due to war or threats of war) would
tend to have a long-lasting influence on unemployment.
Changes in relative demand, however, are not
likely to have a permanent effect on unemployment,
because the affected workers eventually adjust to the
demand shift. Workers who become unemployed be
cause of a drop in the demand for their particular
skill (due to, for instance, technological advances or
changes in taste) may alter their skills over time. Also,
a long-lasting shift in demand is likely to discourage
workers from entering the field in which demand de
clined. By way of contrast, there is little on the supply
side that sixteen-year-olds, for example, can do to en
hance their employment opportunities. Moreover,
workers cannot be “discouraged” from reaching the
age of sixteen. Examples of the demand and supply
shifts should help to illustrate unemployment caused
by structural changes.
Shifts in relative dem ands for labor — Technological
advances in the transportation industry have been
accompanied by substantial shifts in the demand for
particular types of transportation workers. The de
mand for ferryboat operators, pony express riders, and
streetcar conductors has declined in the last century,
while technological advances have created a demand
for bus drivers, truck drivers and commercial airline
pilots. In some cases, workers may be able to retain
ed
E r AL- R E S E R V E B A N K O F S T . L O U I S
||S in their particular field by lowering their wage
jj n n a n d s , but in other instances, jobs become unavailble r e g a r d l e s s of the wage decline a worker is willing
' a c c e p t . 1” The latter is the more likely case when
w o rk e rs ’ wages are a relatively small portion of the
o v e ra ll cost of providing a good or service. Large
fixed (nonlabor) costs are typically characteristic of
th e t r a n s p o r t a t i o n
in d u s try .
In those cases in which a worker could retain his
job by accepting a wage cut, he will often prefer to
look elsewhere for employment in his own field or
take a job not in his primary field. He may look for
a job requiring little or no skill ( and accept the com
mensurately low pay) to obtain employment quickly
and/or retrain himself in another field in order eventu
ally to take a job paying skilled labor wages.
When a blacksmith, railroad fireman or ferryboat
operator is told he must leave or accept a pay cut,
he may not realize that demand for his particular
occupation has fallen everywhere, not just within his
own firm. It will probably take him some period of
search to learn that the fall in demand is pervasive.
Such unemployment is generally reduced over time
as workers adapt to the changed composition of de
mand for their services. Hence, unemployment re
sulting from a change in relative demands for labor
is temporary.
The effect of the changed composition in demand
can also be illustrated by considering a change in
tastes. If the public, through its representatives in
government, decides to lower its demand for
government-employed engineers and increase its
demand correspondingly for government-employed
school teachers ( aggregate demand remaining the
same), a likely result is that unemployment among
engineers will rise, as will vacancies in the teaching
field. The cutback in demand for engineers is reflected
in both a less attractive wage and fewer hours of
work required in that field. If each engineer were
willing to take a wage cut13 and/or if each engineer1-Unemployment compensation provides a partial lower limit
for the wage cut a worker is likely to consider.
hiAcceptance of a wage cut by employees may at first appear
somewhat unrealistic, but workers in the recent past have
taken such cuts to avoid losing their jobs.
In recent months, such diverse groups as taxi
drivers in Cleveland, paper mill employees in New
York, and watchmakers in Pennsylvania have taken
pay cuts, some on a temporary basis. Now there’s
talk of wage-cutting among many of the 11,000
hourly workers at General Motors Corporation’s
Frigidaire Division in Dayton. It’s still too early
to call wage-cutting a trend. But both union officials
and corporate labor experts in a number of in
dustries concede that if the economy stays in the
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S E P T E M B E R 1971
ing firm reduced the hours of work required equally
for all engineering employees, there would be no
change in the number of people employed in engi
neering. In practice, however, the engineers will
probably not realize until after some period of search
that the decline in demand is not restricted to their
firm alone, but is widespread. Also, the firms nor
mally do not ask all their employees to work say, six
hours, instead of eight; the firm accepts a reduced
number of employees working the full eight-hour day.
Eventually, the engineers learn of the permanent
decline in demand in their own field after some
period of costly search, and take employment in other
occupations for which they may be qualified, or
retrain themselves to become, say, school teachers.14
The unemployed engineers may well have to move
from their home area, particularly if government de
mand for engineers accounted for a sizeable portion
of jobs in that area, to another location to find
employment.15 After such adjustments they are once
again employed.
doldrums, they may be forced to join the list of
businesses that have already whittled pay checks.
Jim Hyatt, “Some Workers Accept Pay Cuts as Alternatives
to Losing Their Jobs,” T he W all Street Journal (July 23,
1971), p. 1.
14The situation of the unemployed toolmaker described in foot
note 5 also provides an illustration of the case in which
workers, after some period of unsuccessful search for work
in their own field, switch to other occupations. With his
unemployment benefits about to run out, . . . “His [Tim’s]
choice then may be to take a job, any job, or go on relief.
He knows he will choose to work. Meantime he has applied
for a job on the Trumbull police force. As a policeman he
will not approach his AVCO Lycoming salary, but the re
spectability and security of that job appeal to him. Further
more, he expects that the working hours will leave time for
a second job.” Hochstein, p. 184.
Another example is provided by the experience of recent
college graduates who have had difficulty locating jobs in
their field: “Most resist it, but sooneV or later those [college
graduates] who can’t land a desired- position or one even
vaguely related to their field of study wind up considering
something like secretarial work, driving a taxicab or waiting
on tables.” Gary Ronberg, “Many College Graduates Jobless
After Trying for 3 Months,” St. Louis Post Dispatch (Sep
tember 7, 1971), p. 3.
15There is some question as to whether a worker who is quali
fied for a vacancy in an area not immediately accessible to
him is frictionally or structurally unemployed. From the
worker’s point of view, if he must bear excessive moving
costs, he is structurally unemployed since the costs of reloca
tion make him, in effect, unqualified (or unavailable) for the
vacancy. Assuming the firm would employ the worker if he
were available, they would probably consider him frictionally
unemployed.
Structural and frictional unemployment are not only re
lated to each other, but also to aggregate demand-related
unemployment. For example, an expansionary policy action
which fosters a higher level of aggregate demand also tends
to create more job vacancies in all occupations. Increases in
vacancies will tend to lower structural unemployment be
cause there will be, other things equal, more vacancies for
which there are qualified job applicants.
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F E D E R A L R E S E R V E B A N K O F ST. L O U I S
Shifts in relative supplies of labor — One important
way in which unemployment due to structural factors
is aggravated is through limitations on the supply of
qualified workers. At any time in an economy, there
are workers in the labor force who are unable to
obtain jobs in a particular field because of artificial
barriers to entry. These workers (1 ) are qualified to
fill a vacancy, but are kept from filling the vacancy
by unions, formal lobbying groups, loosely organized
associations of workers or “concerned citizens,” or
(2 ) would be qualified to fill the vacancy if it were
not for the hindrance of such groups.
Unions, for example, have some control over the
size of their membership. If they were to restrict the
size of their membership, they would be able to en
hance the wage earning power of the current mem
bers.111 To see how the ability to restrict labor affects
unemployment, take the example of a carpenter
newly arrived from another country. If he is pro
hibited from entering the local union, and if the
union controls most of the carpenter jobs (that is,
determines who fills the vacancies and how many
vacancies will be left temporarily unfilled), he will
not be able to obtain work as a carpenter immedi
ately. As a result, the immigrant carpenter is un
employed while he attempts to enter the union, seeks
nonunion work in his own field locally or in other
communities, or seeks work in other fields. With union
control of vacancies being continually encountered
by different workers over time, there may be at any
time some unemployment attributable to union in
fluence. Structural unemployment and the normal rate
of unemployment may rise with an increase in union
ability to control jobs and fall with a decline in that
ability.
The prevention of blacks, women and others by any
group from gaining qualifications for work through
training programs may also be interpreted as giv
ing rise to structural unemployment. If the worker
were permitted to increase or upgrade his work skills,
he could find more vacancies for which he would be
qualified and, quite likely, reduce his unemployment
search time. The costs of search underlie un employ 16No attempt is made here to criticize unions or any other
groups. The power to control labor supply does not neces
sarily mean such power is inevitably exercised. We agree
with the Committee for Economic Development that “Unions
should be able to give adequate expression to the legitimate
interests of their members. At the same time, steps must be
taken to assure that they do not have excessive powers to
restrict the supply of labor through such means as outdated
apprenticeship requirements or racial discrimination, nor the
power to place undue restrictions on productivity improve
ments.” Committee for Economic Development, Further
W eapons Against Inflation (November 1970), pp. 18-19.
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ment arising from frictional, structural, or aggregate
demand-related sources.
Unions are not the only groups who may effectively
curtail job entry. The practice of licensing job appli
cants to insure that qualitative standards are met is
accompanied by the power to control entry. Those in
charge of the licensing are often affiliated with the
group in whose interest it is to limit the supply of
workers. These groups may range from doctors to taxi
drivers. One analyst, for example, found evidence
suggesting discrimination by doctors against admitting
Jews to medical schools for fear they might become
price cutters.17
Besides licensing, other legal means of curbing the
effective supply of workers include such laws as na
tional and state minimum wage regulations. These
laws are designed to set a floor under particular wage
rates, but a side effect is a tendency to aggravate un
employment. A young, inexperienced worker entering
the labor force for the first time might be able to con
tribute something to the value of a firm’s output, but
if his contribution to the firm is not worth the minimum
wage, he is not likely to be employed. The young
worker may eventually find a job, but the tendency
of the law is to lengthen his search time beyond what
it would be without the law. That is, it is an addi
tional factor tending to lengthen his search time, and
consequently, his period of unemployment. Thus, an
increase in the minimum wage ( so long as it is higher
than the value of the worker’s contribution to the
firm) increases the normal rate of unemployment.
Those most adversely affected by the minimum wage
are the young, the old, the disabled, the uneducated
and the disadvantaged.18
17Reuben A. Kessel, “Price Discrimination in Medicine,’ The
Journal o f Law and Econom ics (October 1958), pp. 20-53.
18In profitable periods, firms may hire such workers to improve
their image, but during cyclical downturns, these w o r k e r s are
often the first to be released. Milton Friedman and ^ale
Brozen, in “The Minimum Wage Rate —Who Really;>Pays'
An Interview with Yale Brozen and Milton Friedman,” Free
Society Association, Inc., (Washington D. C., 1966), contend
that the minimum wage has a strong adverse effect on blacK
unemployment rates. Other evidence of possible detrimental
minimum wage effects on unemployment has been found by
John M. Peterson, “Employment Effects of State Minimurn
Wages for Women: Three Historical Cases Re-examined,
Industrial and L abor Relations Review ( April 1959), PE’
406-422; Colin D. Campbell and Rosemary G. Campbe1,’
“State Minimum Wage Laws as a Cause of Unemployment,
Southern Econom ic Journal (April 1969), pp. 323-332; f1M. Douty, “Some Effects of the $1.00 Minimum Wage ^
the United States,” Econom ica (May 1960), pp. 137-14 >
Arthur F. Burns, The Management o f Prosperity (New Y '•
Columbia University Press, 1966); and William J. Shkur
and Belton M. Fleisher, “Employment and Wage P at®s.11p
Retail Trade Subsequent to the 1961 Amendments of tn
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The normal rate of unemployment, in summary,
tends to rise with increases in information and moving
costs unanticipated changes in tastes and technologi
cal developments, and certain shifts in the supply of
libor. These factors help explain the existence of a
variable normal rate of unemployment, but deviations
from the normal rate itself can best be explained
by changes in aggregate demand.
Deviations From the Normal
Rate of Unemployment
If aggregate demand is rising at a steady rate such
that wages and prices are anticipated correctly on
av erag e
( some overanticipation and ' some under
anticipation), unemployment is defined to be at its
normal rate, and there exists a state of equilibrium “in
the large.” Policy actions which slow the rate of
growth of aggregate demand, so that wages (and
prices) rise less on the average than anticipated,
cause unemployment to rise above the normal rate.
These actions, like shifts in the relative demands
for and supplies of workers, are of sufficient mag
nitude to constitute a shock to the economic sys
tem. Policy actions which stimulate the rate of
growth of aggregate demand, so that wages (and
prices) rise faster on the average than anticipated,
push unemployment below the normal rate. These
two cases are explored more fully below.
Unemployment Above the Normal Rate
Starting at a condition of equilibrium in the large
with unemployment at the normal rate, the slowing
of aggregate demand growth by, for instance, restric
tive monetary actions, results in a decline in the
demand for labor. Employers at first may reduce
output by cutting back overtime and not filling vacan
cies created by normal attrition. If the slowing of
aggregate demand is more than temporary, employers
will have to reduce output and their wage bill by
dismissing workers or possibly asking them to accept
Fair Labor Standards Act,” Southern E conom ic Journal (July
1968), pp. 37-48. Criticism of such studies usually has
emphasized that the causes of unemployment are difficult to
unravel, and that the statistical techniques employed to do
so are inadequate.
The minimum wage also has the potential to aggravate
inflation, since raising prices is one alternative which firms
have to meeting increased labor costs. Firms may meet the
rise in labor costs caused by the minimum wage—which often
rosters an upward shift in the firm’s whole wage structure
—by reducing profits, increasing efficiency, raising the prices
of their products, reducing the quantity of labor worked, or
any combination of these. Firms which, for various reasons,
achieving low profits, or already are operating at peak
efficiency, would have only the options of increasing unem
ployment or prices. The increase in prices would be per
manent if validated by expansive policy actions.
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S E P T E M B E R 1971
lower wages. Because they do not have complete
information on labor market conditions, many workers
will seek employment at their earlier, higher wage
level and will not discover for some time that overall
prices and wages have fallen.
Prices may well fall relative to wages (an increase
in the real wage rate) initially, because wage con
tracts are often of a longer-run nature than commod
ity prices.19 A rise in the real wage rate (a lag of wage
changes after price changes) is not necessary for an
increase in unemployment. All that is necessary is a
lag in workers’ realization of the fact that a wide
spread decline in the demand for labor has occurred.
The costs of acquiring information about job vacan
cies increase for workers, since employers will have
reduced their outlays, such as advertising, for recruit
ing new employees. Unemployment, which rises with
the increased costs of information, will continue to
rise until workers decide to accept employment at the
new, lower money wage rate.20 The workers, as a
whole, revise their wage expectations downward over
the period of increased unemployment less than in
proportion to the actual fall in wages.21
Not until anticipated wage (or price) changes
equal, on average, actual wage (or price) changes,
1!,Tho cyclical relation between employment and the real wage
has long been of concern to economists. Keynes assumed an
inverse relationship between employment and the real wage,
but subsequent empirical studies provided little support for
his thesis. See Ronald G. Bodkin, “Real Wages ancl Cyclical
Variations in Employment: A Re-Examination of The Evi
dence,” Canadian Journal o f Econom ics (August 1969), pp.
353-74. Barro and Grossman synthesized the work of Patinkin
and Clower to develop a macroeconomic model in which
unemployment may be explained without resort to real wage
movements. Robert J. Barro and Herschel I. Grossman, “A
General Disequilibrium Model of Income and Employment,”
T he American Econom ic Review (March 1971), pp. 82-93.
Note that real wage changes are not an essential feature of
the analysis given above, but provide a supplementary ex
planation of cyclical unemployment. The lag in workers’
realizations of a pervasive change in aggregate demand
behind the actual change is the essential feature.
20The failure of workers to realize the pervasiveness of the
decline in demand for their services is often interpreted to
represent a “money illusion” on the part of the workers. The
fall in prices will have increased their real (price-deflated)
wages, but because money wages have fallen, workers will
prefer to continue job search rather than initially accept the
lower wages. There need be no irrationality on the part of
those who continue their job search: they simply lack the
complete information on which to base job search decisions.
The acquisition of that information is often costly and time
consuming.
21Some workers become discouraged enough about the wage
and employment situation to drop out of the labor force
and accept leisure instead. On the other hand, some mem
bers of the household who do not normally work for wages,
such as housewives and students, will enter the labor force
during slack periods to augment the household’s income.
The evidence on balance indicates that more workers are
discouraged from working in a slack labor market than are
encouraged to work. See Simler and Telia, pp. 32-49.
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F E D E R A L R E S E R V E B A N K O F ST. L O U I S
will unemployment return to the normal rate. Stabili
zation at the normal unemployment rate will occur
eventually unless monetary growth, and hence aggre
gate demand, not only declines but continually de
celerates so that, on average, actual wages continually
fall faster than expected wages.
Unemployment Below the Normal Rate
With unemployment initially at the normal rate,
an increase in the rate of growth of the money stock
will increase output, prices and the demand for labor.
Initially, money wages rise more, on average, than
anticipated, thereby -providing the inducement for the
unemployed to stop fceir search earlier than planned.
The shorter average job search time is accompanied
by a fall in unemployment below the normal rate.
Also, search costs to workers decline as firms, recruit
ing more aggressively than before the increase in
aggregate demand, absorb more of the search costs
than previously. Prices may rise faster initially than
wages ( real wages decline), and many workers evalu
ate the new, higher money wages at the old price
level.
Unemployment will remain below the normal rate
until workers correctly anticipate, on average, the
increases in prices and wages. With the realization
that a wide-spread increase in the demand for their
services has occurred, workers will become more selec
tive in appraising job offers (to obtain the best one),
average search time will rise and unemployment will
rise to the normal rate. So long as the monetary
expansion does not continually accelerate, workers
will eventually demand money wages adequate to
compensate them for the rise in prices. Real wages
return to their earlier level and employers no longer
find additional labor resources attractive. Growth in
the demand for labor falls and unemployment returns
to its normal rate.
Only if monetary growth accelerates will antici
pated wages continue to increase less, on average,
than actual money wages. Unemployment can be kept
below the normal rate in this way, but the cost of
continued monetary acceleration is the continued ac22Studies supporting the “accelerationist hypothesis” can be
found in Milton Friedman, “The Role of Monetary Policy,”
The American Econom ic Review (March 1968), p. 10; Ed
mund S. Phelps, “Money Wage Dynamics and Labor Market
Equilibrium,” Phelps, et. al.; and Robert E. Lucas, Jr. and
Leonard A. Rapping, “Price Expectations and the Phillips
Curve,” American Econom ic Review (June 1969), pp. 342
50. Some additional empirical evidence is provided in the
final section of this paper. For an opposing view, see Robert
M. Solow, Price Expectations and th e Behavior o f the Price
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SEPTEMBER 19 7 ,
celeration of price rises.22 The cost of reducing job
search time for a small minority of unemployed is
excessive inflation for all. Job search time for such
a group can be reduced by more efficient methods
than monetary acceleration, as will be discussed below
LEG ISLA TIV E, FISCAL AND MONETARY
PO LIC IES TO R ED U C E UNEMPLOYMENT
Legislative and allocative fiscal actions can best be
used to lower the normal rate of unemployment, and
monetary actions can foster a stable climate for prices
consistent with a prevailing normal rate of unemploy
ment.23 Legislative actions which would reduce mo
nopolistic powers of employers and unions in a world
in which the costs of information are positive would
tend to lower the normal rate of unemployment.
Stronger legislation to eliminate job discrimination
on nonprice grounds and improve the overall func
tioning of labor markets are examples of actions which
could be taken by law-making bodies to improve the
employment outlook. Legislation to mitigate the neg
ative employment impact of the minimum wage would
be particularly helpful to the young, the old, the
inexperienced, and the disadvantaged.
Allocative fiscal policies could be oriented toward
lowering the normal rate of unemployment by trans
ferring government resources from a sector distantly
related to employment, such as foreign aid, to direct
employment assistance. One way of lowering the nor
mal rate would be through actions designed to lower
the costs of information and job transfer.24 Job inforL evel, (M a n c h e s te r ; Manchester University Press, 1969), P17; and Robert J. Gordon, “The Recent A c c e le ra tio n 01
Inflation and Its Lessons for the Future,” B r o o k in g s P apers
on Econom ic Activity (1 :1 9 7 0 ), pp. 8-47.
23Allocative fiscal actions are those designed to affect activity
in a particular sector of the economy; aggregative nsca
actions are taken to influence overall activity.
-4Since unemployment associated with changes in agg reg ate
demand is also ultimately related to information and m
bility costs, a decline in these costs could help to low
aggregate demand-related unemployment. Under certain c
ditions, however, lower information costs may not l0'
unemployment. See Phelps, et. al., p. 18. Governme
sponsored programs to provide statewide information on J
vacancies are currently operational in a number ot s
•
Not enough experience with the programs has yet
gained to assess adequately their contribution to employn
assistance.
Other proposals which would have the effect °f lowering
the normal rate of unemployment have been introduce
^
the “Report of the Joint Economic Committee, Congre
the United States, on the February 1971 Econom ic J _
o f the President,” and the Committee for Economic L,eX _ o )J
ment, Further W eapons Against Inflation (November r
’
p. 18. The Joint Economic Committee relies strongly
proposal for a price-wage review board to rnaintain ^ ^
prices in the face of high employment. However, tn
F EDERAL- R E S E R V E B A N K O F ST. L O U I S
nation banks, training outlays and relocation subsidies
ould reduce the search time of workers between
■01)S and possibly increase the rate of growth of in
c o m e because of a more efficient utilization of re
sources. Such policies to reduce the normal unemploy
ment rate need not cause inflation.
as discussed in the preceding section,
when monetary actions are taken which push
tlie m a rk e t rate of unemployment below the nor
mal rate. Stimulative monetary policies may be ap
p rop riate when resources are underutilized and the
m arket rate of unemployment is above the normal
rate, but the temporary employment gains achieved
by monetary actions when unemployment is already
at the normal rate are offset by rising prices. Exper
ience of the last two decades indicates that the use of
monetary actions to reduce unemployment when it is
above the normal rate runs the risk of creating infla
tionary pressures. First, there is not sufficient knowl
edge with regard to the existing level of the normal
rate at any point in time, and second, stimulative
monetary policies often have been carried on too
long. Therefore, the proper role of monetary policy
is the creation of an atmosphere of stable prices,
while fiscal and legislative actions can be taken to
lower the normal unemployment rate.
Inflation,
results
The normal rate of unemployment may rise in the
near future unless legislative and fiscal actions are
taken to counter such a tendency. In the decade of
the 1970’s, an increase in the supply of available
labor is expected because of the increase in the popu
lation of labor force age, much of which will be
attributable to young people.25 Also, increases in
labor force participation rates, particularly women
and nonwhites, and expected reductions in military
calls of draft-age males will tend to increase the
civilian labor force. Attempting to lower the unem
ployment rate tli rough monetary actions alone entails
the risk of generating inflationary pressures.26
little evidence that such incomes policies could exercise
much long-lasting restraint on prices and wages, especially
during periods of high employment. See Lloyd Ulman and
Robert J. Flanagan, W age Restraint: A Study o f Incom e
Policies in W estern E urope (University of California Press,
1971), especially pp. 223-8.
-dThe population of working force age 16 to 24 years old is
expected to increase in the 1970’s at a rate faster than dur
ing the 1945-60 period but slower than during the 1960’s.
The population of such young people actually declined in
1952 and 1953, when the overall unemployment rate last
reached the 3 per cent level. The unemployment rate for
workers aged 16 to 24 averages much higher than the overall
unemployment rate. Since males between the ages of 25 and
54 are designated “primary workers,” the young people are
a part of the large group often termed “secondary workers.”
~6The appropriate degree to which monetary actions may be
used to reduce unemployment without aggravating inflation
ls primarily a function of the amount of unemployment
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S E P T E M B E R 1971
LIMITATIONS O F MONETARY POLICY
IN TH E ATTAINMENT O F TH E
JE C GOALS
The use of legislative, allocative fiscal, and mone
tary policy actions working together is required to
attain such ambitious goals as those advanced by the
Joint Economic Committee. The fact that legislative
and allocative fiscal actions to lower the normal rate
of unemployment may be politically unpopular (such
as actions curbing the employment influence of unions
and minimum wage laws) tends to throw the burden
of achieving these two admirable economic goals on
monetary policies alone. In order to obtain some quan
titative estimate of the implications of altering price
and employment movements through monetary actions
alone, it is useful to employ an econometric model
which allows for the impact of monetary actions.
The econometric model of this Bank permits the
manipulation of monetary variables to influence un
employment and prices. The model has been ex
plained in full detail elsewhere.27 Basically, monetary
and fiscal actions (aggregative fiscal actions, not al
locative) exercise an influence over prices and un
employment in the model by altering the course of
total spending relative to the economy’s productive
potential. Changes in the rate of growth of the money
stock have a positive multiplier effect on the economy,
while the net effect of aggregate fiscal actions alone
on total spending over time is negligible. Price an
ticipations are an important feature of the model,
forming a part of the linkage between total spending
and its division between current prices and output.
Changes in actual output relative to potential output
provide estimates of the unemployment rate.
traceable to aggregate demand influences. The discussion of
actions to lower unemployment related to aggregate demand
as opposed to unemployment fostered'Jay frictional and struc
tural factors finds historical precedent in the “Structural
Unemployment vs. Insufficient Demand” controversy of the
early 1960’s. See, for example, Richard Perlman, Labor
Theory (New York: John Wiley and Sons, Inc., 1969), pp.
167-196; and Eleanor G. Gilpatrick, Structural Unemploy
ment and Aggregate D emand (The Johns Hopkins Press,
1966).
27See Leonall C. Andersen and Keith M. Carlson, “A Mone
tarist Model for Economic Stabilization,” this Review (April
1970), pp. 7-25; and Roger W. Spencer, “Population, The
Labor Force, and Potential Output: Implications for the St.
Louis Model,” this R eview (February 1971), pp. 15-23. This
econometric model is basically a reduced form model in that
it does not develop structurally various submarkets of the
economy, such as the labor market for aggregation. Labor
market imperfections can be captured by a reduced form
model, however, as well as by a structural model. The model
does not have the capability to capture the effect of partic
ular legislative and fiscal actions on unemployment and
prices. For example, actions to lower the costs of information
to workers cannot be shown with this model, nor is it likely
that such actions could be reflected adequately by other
models.
Page 23
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
S E P T E M B E R i g 71
Implications for Prices of Attaining and Holding Unemployment
N ear 3 Per Cent, 1975-85^
Per Cent
Per Cent
Q u a rte rly D a ta
45
45
X
40
.»*
/
35
/ '*
'
30
/
/
/
M o n e y S to c k £
/
/
/
40
35
30
V
/
25
25
/
/
/
20
'
20
P r ic e S L2
s
15
15
............
10
10
’
T-_
__
U n e m p lo y m e n t R a te
___ __ - .1.............................. - L
1971
1972
1973
_______1 _____ _
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
[1 2.6 to 3 .4 p e r c e n t o f th e la b o r fo rc e .
[2 M o n e y sto c k a n d th e G N P p r ic e d e f la t o r p r o je c tio n s a r e c o m p o u n d e d a n n u a l ra te s o f c h a n g e .
N o te : The a b o v e p ro je c tio n s a re b a s e d o n a c tu a l d a t a th ro u g h 11/1971. The m o n e y sto c k p r o je c tio n h a s b e e n s m o o th e d .
G o v e r n m e n t e x p e n d itu r e s a re e s tim a te d th ro u g h 11/1972 a n d a re a s s u m e d to g r o w a t a n 8 p e r cent ra te th e re a fte r.
N o te : The c o lo re d h o riz o n ta l lin e re p re se n ts th e 3 p e r c e n t u n e m p lo y m e n t g o a l re c o m m e n d e d b y J o in t E co nom ic C o m m itte e
S ta te s C o n g re s s . See th e JEC's F e b ru a ry 1971 R e p o rt on th e E co n o m ic R e p o rf o f the P resident, p.34.
Various monetary policy alternatives were at
tempted through standard simulation procedures to
attain simultaneously the Joint Economic Committee’s
3 per cent unemployment and 2 per cent per year
price goals. These twin objectives could not be
achieved at the same time over the arbitrarily selected
1971-85 period, given the current initial economic
conditions. The goals, however, could be reached
individually. Since unemployment considerations have
been of dominant concern in this article, the attain
ment of a 3 per cent unemployment rate was given
priority in the following simulation.
It is necessary to allow some reasonable period of
time for unemployment to reach approximately 3 per
cent of the labor force, because a wide gap between
potential and real output exists in mid-1971. Increases
in the money supply at a 10 per cent annual rate
from 11/1971 to IV/1975, a period of approximately
four years, foster a steady decline in the unemploy
ment rate from 6 per cent in 11/1971 to 3.4 per cent
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Federal
(JEC)
o f th e U n ite d
in IV/1975 ( high-employment Government expendi
tures were estimated to 11/1972 and assumed to grow
at an 8 per cent rate thereafter for all simulations).
“Appropriate” manipulations in the rate of growth of
the money stock from 1975 to 1985 permit the model
to generate unemployment rates within a narrow
range (2.6 per cent to 3.4 per cent) near the employ
ment objective for ten years. The attainment of this
goal requires accelerating monetary growth from a
10 per cent annual rate in 1975 to a 44 per cent
annual rate at the end of 1985 (see the above chart for
the rates of change in the money stock).28 The price
level, according to the simulation, increases at a 41
per cent annual rate at the end of 1985. Accelerating
monetary growth leads to accelerating inflation —a
situation in which actual price rises continue to exce
28Little significance should be attached to exact figures such
as “44 per cent” for a fifteen-year simulation. The *mPorw(j1
aspect of this simulation is that accelerating monetary gi°
and inflation are required to maintain a 3 per cent un
ployment rate.
S E P T E M B E R 1971
e p E RAL. R E S E R V E B A N K O F ST. L O U I S
•
f] rises —to keep the actual unemployment
aiiticip;u
„
ate below some normal rate.
Other alternative simulations which take into aciiint the JE C price goals are explored in the apLl ndix. The price goal of 2 per cent per year is
pei
(r])t after varying degrees of price anticipations
sou;
re permitted to develop. The results of these simula
tions suggest that if inflation, as well as unemploy
ment, is deemed an important policy goal, it is far
better (in terms of lost employment and output) to
a t t a c k inflation as early as possible to halt its mo
m e n tu m and curtail inflationary expectations.
SUMMARY
The reasons for unemployment and ways to im
prove the unemployment situation were explored in
this article through the use of an analytical frame
work based in large measure on the fact that costs of
information and job transfer are positive. The con
clusion reached is that the normal rate of unemploy
ment can be lowered by appropriate allocative fiscal
and legislative actions; monetary actions are best
used to stabilize prices at the lower normal unemploy
ment rate.
Positive costs of information and resource mobility,
nonprice labor discrimination, and legal constraints on
the supply of labor such as minimum wage legislation
have curtailed the quantity of labor worked in the
past and will, quite likely, continue to do so in the
future. Moreover, expected increases in the supply of
secondary workers at a rapid rate over the next dec
ade suggest shifting the target rate of unemploy
ment above, rather than below, 4 per cent, unless
legislative and allocative fiscal actions are taken to
curtail labor market costs and restrictions.29 With such
legislative and fiscal actions to supplement monetary
actions, a rate of unemployment below 4 per cent
might be achieved and maintained without generating
strong inflationary pressures.
Given current labor market conditions, it was not
possible to reach simultaneously the Joint Economic
Committee’s twin goals of 3 per cent unemployment
and 2 per cent annual rise in prices using simulations
of this Bank’s econometric model with alternative
monetary policies. Attainment of the 3 per cent un
employment rate goal from 1975 to 1985 required
accelerating monetary expansion over that period.
This expansion was accompanied by accelerating infla
tion — a condition which implies that actual price
rises continue to exceed anticipated rises — in order
to keep unemployment below its “normal rate.” The
inflation rate required to maintain the 3 per cent un
employment rate was so high that it is unlikely a
price review board (as recommended by the Com
mittee) or any price-wage control measure would
succeed in stemming such great price pressures.
Two conclusions which emerge from the simulations
of the econometric model are: (1) monetary actions
must be supplemented by legislative and/or allocative
fiscal measures to reach and maintain the JE C ’s goals
of a 3 per cent rate of unemployment without exces
sive inflationary pressures; and (2) if inflation is per
mitted to develop through attempts to achieve an
admirable unemployment goal such as that of the
JEC , it is better to stem inflationary pressures at an
early stage than later.
29George L. Perry, “Changing Labor Markets and Inflation,”
Brookings Papers on Econom ic Activity (3 :1 9 7 0 ), pp. 411-41,
has also developed evidence consistent with this hypothesis.
APPENDIX
The aim of the following simulations of the econo
metric model of this Bank is to obtain some idea of
the costs of stopping inflationary pressures at various
stages of build-up. These costs may be measured
approximately by the degree and duration of the rise
in unemployment accompanying a fall in the rate of
price inflation to the JE C ’s goal of 2 per cent per year.
We may allow for the possibility that after taking
actions to achieve the Committee’s 3 per cent un
employment goal, the cost in terms of inflation will
become sufficiently high for policymakers to alter their
focus from the unemployment goal to price stability.
By assuming that inflation costs have become exces
sively burdensome by 1980 (after 5 years of 3 per
cent unemployment and a peak 14 per cent rate of
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inflation) to cause a shift from easy to tight money, it
is possible to track the movements of the pertinent
variables from 1980 to 1985, as the stabilization au
thorities attempt to achieve a 2 per cent annual price
rise by the end of the five-year period. A deceleration
in the annual growth rate of the money stock
from about 19 per cent in 1980 to a negative 6 per
cent in 1985 (see the lower portion of the next chart)
is required to slow the advance of prices from
14 per cent in 1980 to 2 per cent in 1985 (because
of lags, prices continue to rise from a 14 per cent
rate in 1980 to a 16 per cent rate in 1982 before
decelerating). Unemployment rises from a 3.2 per
cent rate in 1980 to 16 per cent of the labor force
in 1985, and real product (not shown on the chart)
Page 25
F E D E R A L R E S E R V E B A N K O F ST. L O U I S
The U n e m p lo y m e n t Costs
of S ubduing In fla tio n - N o w or Later’
‘This St. Louis M o d e l sim u la tio n d ep icts rates o f m o n ey g ro w th w h ich w ill reduce in fla tio i
b e lo w a 2 p e r cent rate o ver 5 ye a rs b e g in n in g in 1971.
Unem ploym ent Rate
P ric e s '
*This sim u la tio n d e p ic ts rates o f m o n ey g ro w th w h ic h w ill re d uce the u n e m p lo ym e n t rate
b e lo w 4 p e r cent b y 1975. Then, w ith in fla tio n a c c e le ra tin g , the sim ula tio n illu stra te s the
rates o f m o n ey g ro w th w h ich w ill a ch ie ve 2 p e r ce n t in fla tio n w ith in five m o re ye a rs.
P ric e s 1
U n em ploym e n t Rate
"This s im u la tio n d e p ic ts rates o f m o n ey g ro w th w h ich w ill re d uce the u n e m p lo ym e n t rate
b e lo w 4 p e r cent b y 1975, a n d h o ld it there fo r five ye a rs. Then, w ith in fla tio n a c c e le ra tin g ,
the sim u la tio n illustra tes the ra te o f m o n e y g ro w th w hich w ill a ch ie v e 2 p e r ce nt in fla tio n
w ith in five m ore ye a rs.
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SEPTEMBER 197,
declines in every successive
quarter from 1981 to 1985. The
severity of such a recession has
been matched in recent years
only by the experience of the
1930’s.
If stabilization authorities de
cide five years earlier to switch
priority goals from unemploy
ment to inflation, and adopt a
tight money policy in 1975
(when the unemployment rate
is 3.7 per cent and prices are
rising at about a 6 per cent
rate), it is much less costly to
bring prices to the 2 per cent
goal over a five-year period.
The required deceleration in the
rate of growth of money is
from a 10 per cent rate in 1975
to a 3 per cent rate in 1980 ( see
the middle portion of the chart).
Unemployment rises to 8 per
cent (compared with 16 per cent
in the previous simulation), and
real output growth never drops
below zero. If the money stock
is increased at a 6 per cent rate
beginning in the third quarter
of 1971, prices fall below a 2
per cent rate by 1975 and the
unemployment rate does not ex
ceed 6.3 per cent (see the upper
portion of the chart).
The clear implication of these
results is that it is far better
(in terms of lost e m p l o y m e n t
and output) to attack inflation
as early as possible in order to
halt its momentum and curtail
inflationary expectations.
Unem ploym ent Rate
This article is available
as Reprint No. 71
S E P T E M B E R 1971
Ep E R A L R E S E R V E B A N K O F ST. L O U I S
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