Brookings: Experts - George A. Akerlof

The Global Jobs Crisis: Sustaining the Recovery through Employment and Equitable Growth

Wed, 13 Apr 2011 10:00:00 -0400

Event Information

April 13, 2011
10:00 AM - 11:45 AM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

The 2008 global economic crisis hit working people around the world the hardest. According to the International Labour Organization (ILO), as many as 30 million people lost their jobs as a result of the crisis. Youth unemployment is especially high, raising the specter of a "lost generation." At the same time, inequality between rich and poor has reached record levels in many countries, which bodes poorly for social cohesion. As recent events in the Middle East and North Africa demonstrate, joblessness and inequality can trigger political instability and unrest.

On April 13, Global Economy and Development at Brookings hosted Dominique Strauss-Kahn, managing director of the International Monetary Fund, and Sharan Burrow, general secretary of the International Trade Union Confederation, for a discussion of the global economic crisis and strategies for spurring employment and promoting more equitable and balanced growth around the world. Other panelists included Stephen Pursey, senior adviser to the director-general of the ILO, and George A. Akerlof, 2001 Nobel Prize recipient and the Koshland professor of economics at the University of California at Berkeley. Kemal Derviş, vice president and director of Global Economy and Development, provided introductory remarks and moderated the discussion.

Following the program, the panelists took audience questions.

Video

Participants

Panelists

Sharan Burrow

General Secretary
International Trade Union Confederation

Dominique Strauss-Kahn

Managing Director
International Monetary Fund

Stephen Pursey

Senior Adviser to the Director-General
International Labour Organization

Regulation of Interstate Wine Shipments

Wed, 15 Sep 2004 00:00:00 -0400

Economists argue that there is no clear economic rationale for regulating interstate shipments of wine.

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George A. Akerlof
Robert Hahn
Robert E. Litan
Daniel L. McFadden, Vernon L. Smith, Donald J. Boudreaux, John M. Letiche

Publication: AEI-Brookings Joint Center

The Copyright Term Extension Act of 1998: An Economic Analysis

Wed, 15 May 2002 00:00:00 -0400

Abstract

This brief provides an economic analysis of the main feature of the Copyright Term Extension Act of 1998 ("CTEA"), a twenty-year extension of the copyright term for existing and future works. Taken as a whole, the authors believe that it is highly unlikely that the economic benefits from copyright extension under the CTEA outweigh the additional costs.

Interest of the Amici Curiae

Amici are professors and scholars who teach and write on economic issues and are concerned about the role of government in promoting economic progress. They are George A. Akerlof, Kenneth J. Arrow, Timothy F. Bresnahan, James M. Buchanan, Ronald H. Coase, Linda R. Cohen, Milton Friedman, Jerry R. Green, Robert W. Hahn, Thomas W. Hazlett, C. Scott Hemphill, Robert E. Litan, Roger G. Noll, Richard Schmalensee, Steven Shavell, Hal R. Varian, and Richard J. Zeckhauser. Various amici have taught, researched, and published analyses of the economics of innovation and the effect of government policy on the incentive to create new works. A summary of the qualifications and affiliations of the individual amici is provided at the end of this brief. Amici file this brief solely as individuals and not on behalf of the institutions with which they are affiliated. Amici represent neither party in this action, and offer the following views on this matter.

Summary of Argument

This brief provides an economic analysis of the main feature of the Copyright Term Extension Act of 1998 ("CTEA"), a twenty-year extension of the copyright term for existing and future works.2 An economist’s perspective may be helpful to the Court as it considers Congress’s reasons for passing the CTEA, particularly with respect to the extension for existing works.

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Authors

George A. Akerlof
Robert Hahn
Robert E. Litan
Kenneth J. Arrow, Timothy F. Bresnahan, James M. Buchanan, Ronald H. Coase, Linda R. Cohen, Milton Friedman, Jerry R. Green, Thomas W. Hazlett, C. Scott Hemphill, Roger G. Noll, Richard Schmalensee, Steven Shavell, Hal R. Varian, and Richard J. Zeckhauser

Publication: AEI-Brookings Joint Center

Options for Stabilization Policy: A New Analysis of Choices Confronting the Fed

George A. Akerlof, George L. Perry and William T. Dickens — Thu, 01 Feb 2001 00:00:00 -0500

Conventional models of the macroeconomy did not anticipate the strong U.S. expansion of the past five years and cannot explain it well even today. Those models are based on the assumption that firms and workers always fully incorporate expectations of future inflation rates into their current wage and price decisions. This assumption leads to the concept of a unique natural unemployment rate for the economy, so that pushing unemployment below this natural rate will yield to ever faster inflation.

In this policy brief, we propose an alternative to the conventional natural rate model. It is based on behavioral assumptions that we believe are more realistic than those underlying the natural rate model and that are backed by research on decisionmaking. In our model, the effect of expected inflation itself varies with the inflation rate. This leads to a range of sustainable unemployment rates. Policymakers can achieve the lowest unemployment rate by operating the economy with a low to modest rate of inflation, in the neighborhood of the rates experienced in recent years.

Whether the U.S. economy now achieves a soft landing, and whether Europe's economies continue to expand fast enough to reduce their excessive unemployment rates, may well depend on whether policymakers reject the conventional natural rate model and adopt a view of economic possibilities that is more in line with the new model presented here.

POLICY BRIEF #69

The economy rarely sees a surprise as favorable as the United States expansion of the last half of the 1990s. That expansion has cast renewed doubt on conventional models of the economy's productive potential and on the relationship between real activity and inflation.

Since the 1970s, the conventional models used by policymakers and analysts have been based on the theory of a natural rate of unemployment which describes a unique equilibrium level of employment and output for the real economy. By the mid-1990s, prevailing estimates of this natural rate, known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), warned that unemployment had already fallen to its NAIRU and that lower unemployment would produce ever faster inflation. Yet over the next five years unemployment fell to 4 percent and core inflation remained in check.

Allowing the economy to expand beyond the old NAIRU target has produced far-reaching benefits, as evidenced by comparisons with projections made in August 1996 by the Congressional Budget Office (CBO). Employment grew by 14.2 million between 1995 and mid-2000, far more than had been projected with the CBO assumption of trend growth at 6 percent unemployment. Together with faster productivity growth—some part of which probably resulted from the faster expansion of the period—this resulted in real Gross Domestic Product (GDP) rising by 12 percent more than had been projected. And rather than a $204 billion federal budget deficit for fiscal year 2000 that the CBO had projected in 1996, the Treasury reported a record $237 billion surplus for 2000, with a strong economic expansion accounting for most of the difference. Whether this historic expansion now transitions into a soft landing for the economy may depend on whether policymakers reject the prescriptions of the conventional NAIRU model and on what alternative view informs their decisions.

Even before its failure to account for U.S. performance of recent years, the model of a relatively constant NAIRU had far less empirical support than its wide acceptance would suggest. Looking back at the first half of the 1960s, an earlier period of low inflation and rapid growth, recent NAIRU studies estimate the economy was at the threshold of accelerating prices by 1963. Yet at that time most economists thought that resources were underutilized and that the economy needed stimulus. In fact, unemployment was steadily reduced without any speedup of inflation until 1966, when the Vietnam war was in full swing. More generally, nowhere have natural rate models worked in periods of low inflation and high unemployment, circumstances in which they predict growing deflation which has never been observed. Nor have they performed particularly well in periods of high inflation. In Europe, the model could only be made consistent with developments over the past two decades by inventing ways to let NAIRU track actual unemployment, which emptied the model of content.

Our New Model

We have developed an alternative to the natural rate model that is based on behavioral assumptions that we find more realistic. They also better fit the facts. The key behavioral assumption that we change concerns the role of expectations in the inflation process. Natural rate models assume that both price and wage setters set prices to exactly offset expected inflation. In econometric estimation this amounts to constraining the effect of expected on actual inflation to be one for one, meaning that changes in expected inflation change actual inflation by the same amount.

The previous controversy in empirical work has been about how to model the formation of expectations so as to formulate and test this assumption. In contrast we see how people use expectations, rather than how they form them, as the key to modeling inflation. We do not accept the standard assumption that people always make the best use of all available information and turn instead to evidence about how people actually use information in making decisions. We recognize that firms and workers are barraged with more relevant information than they can fully process, so that when inflation is low, and thus relatively unimportant for economic decisionmaking, it will be ignored or not given full weight. But when inflation is high it will be the center of attention. This leads us to a model in which the effect of expected inflation on actual wage and price setting will itself vary with the rate of inflation—the effect is small when inflation is low and close to one-for-one when inflation is high.

That small change to the standard model makes a big difference. In natural rate models, the economy has a unique sustainable rate of unemployment. Attempts to push the economy to lower unemployment rates and higher levels of output inevitably lead to ever higher inflation and, eventually yield no reduction in unemployment. By contrast, we find the economy can operate over a range of sustainable unemployment rates corresponding to a range of low-to-moderate rates of inflation. In our model, the old natural rate idea is a special case that is relevant only at high inflation rates.

The difference is crucial both for how models are specified and estimated, and for understanding the options open to policymakers. For specifying and estimating key relations, estimates that are constrained to produce a NAIRU will underestimate the economy's potential, especially during periods of low inflation. For policymaking, either using NAIRU estimates as a target or pursuing zero inflation—as adherents of natural rate models often advocate—will leave unemployment wastefully high and the economy operating well below its potential. In our own analysis, the lowest sustainable unemployment rate is achieved with moderate inflation and is well below the unemployment rate associated with complete price stability.

We now look more closely at econometric evidence that casts doubt on the NAIRU model and then at the behavioral evidence that calls into question the microeconomic underpinnings of natural rate theory. We then turn to our model and its implications.

Preliminary Time Series Evidence

In practice, NAIRU models assume that people form their expectations of future inflation based on an average of past inflation. This average is used in statistical analysis as the measure of expected inflation and, in NAIRU models, it is assumed to move current inflation one-for-one. In econometric terms, that means expected inflation is constrained to have a coefficient of 1.0 in moving the actual inflation rate. Yet this assumption is not consistent with the data.

William Brainard and George Perry recently estimated a historical relation between inflation and unemployment, commonly known as the Phillips curve, using an unconventional estimation technique that permits all the coefficients of the model to vary over time. While the other coefficients of the model were remarkably stable over the last forty years, the coefficient on expected inflation—which the NAIRU model assumes has a constant value of 1.0—in fact varied considerably. Starting from low values in the low-inflation years before the 1970s, estimates of this key coefficient rose to near 1.0 with the high inflation that accompanied the two OPEC oil price shocks, but then declined again to low values when inflation subsequently fell. Thus, this final NAIRU assumption is approximately correct when inflation is high, but not when inflation is at low to moderate levels.

As a preliminary step in our own work, we estimated separate Phillips curves for periods of low and high inflation. We sorted the period from 1954 through 1999 into two samples: low-inflation quarters when the trailing five-year average of inflation in the Consumer Price Index (CPI) was below 3 percent (or, alternatively, 2.5 percent), and high-inflation quarters with this average in excess of 4 percent. The samples have mean inflation rates of 2.0 percent and 6.3 percent, respectively. We then estimated a large number of specifications in which we varied the measure of unemployment and the measure of inflationary expectations. Our findings support the Brainard and Perry results. We consistently found the coefficient on inflationary expectations to be substantially larger in regressions estimated with the high-inflation samples than for the comparable specification estimated with the low-inflation samples.

How People Use Expectations

We now turn to the behavioral underpinnings of our model. Natural rate, or NAIRU, models assume expected inflation is always fully incorporated into the price- and wage-setting decisions of firms and workers. However, a wealth of evidence on actual behavior suggests that this assumption is wrong. For example, psychological studies show that decisionmakers often "edit" the information available to them, ignoring much that is potentially relevant in order to concentrate on the few factors they deem most important. Furthermore, studies of perception show a stimulus must pass a threshold before it is even perceived, let alone used.

In addition, from interviews with compensation professionals, we infer that wage setters do not behave in the way that most economic models assume. Rather than choosing a real wage target and then adjusting it fully for expected inflation, they mix information about inflation with a variety of other information relevant to wage setting in unsystematic ways that are not likely to yield the result economists assume.

Research by Robert Shiller, reported in a 1997 volume on reducing inflation, and research on money illusion by Eldar Shafir, Peter Diamond, and Amos Tversky, published in the Quarterly Journal of Economics, shows that employees systematically underestimate the tendency of inflation to boost their own nominal wages. Therefore, in periods of moderate inflation, so long as their wages do not decline, employees view favorably the salary increases they get and generally remain satisfied with their jobs.

Inflationary Expectations and the New Model

We now sketch how we incorporate expectations into our formal model relating inflation and unemployment. Firms set wages and prices, and workers respond to the wages offered according to their view of job and wage opportunities outside the firm. The crucial issue is how wage and price setting varies with inflation.

Even when inflation is low, some firms' wage and price setting fully incorporates expected inflation. In other firms, wage and price setting responds fully to current conditions in their labor market, but less than fully to expected inflation, perhaps even ignoring it completely. Because all firms adjust to current market conditions each time they set wages, the wage in firms that fail to take full account of inflation trails the average wage, though only by a small, noncumulating percentage. Prices in all firms are a markup over expected unit labor costs. The cost in lost profits from less than complete attention to inflation is negligible when inflation is low, but this cost grows quickly with inflation. As a consequence, the fraction of firms that fully incorporate expected inflation in setting their own wages and prices varies with the inflation rate. In a climate of little or no inflation, a large fraction of firms do not fully adjust their wages and prices, but this fraction declines when inflation rates are higher.

This behavior by firms has important implications for the macroeconomy as illustrated in figure 1, which traces out the trade-off between equilibrium unemployment and inflation for plausible values of the other parameters in the model.

At zero inflation, it does not matter whether firms pay attention to inflation, and equilibrium unemployment corresponds to what would be the conventional natural rate. (In a 1996 study, we showed that at zero inflation, unemployment would be above the natural rate because some inflation is necessary to allow adjustment of relative wages. We ignore that effect here to simplify the exposition of our present model, which focuses on expectation. In reality, both effects are important and coexist.) When inflation is between zero and some moderate rate, higher inflation within this range is accompanied by lower unemployment.

This trade-off reflects two opposing effects. The first effect concerns firms that continue to pay less than full attention to inflation. At a higher inflation rate, the wages and prices of these firms fall somewhat behind those of firms that do pay full attention. As a result, these firms sell more goods and employ more workers than they would if they set their prices higher. The lower prices of their goods also leave consumers with more to spend, increasing demand for the goods of other firms, and raising total employment. The second effect concerns firms that change their behavior. At the higher inflation rate, those firms shift their pricing to fully incorporate expected inflation and, as they do, wages and prices rise more, reducing some of the benefits to employment and output from the first effect.

In the low-to-moderate inflation range, the first effect dominates and higher inflation is associated with lower unemployment. But beyond some inflation rate the second effect dominates and the trade-off goes the other way: higher inflation is associated with higher unemployment.

The left-most point in the graph in figure 1 represents the lowest sustainable unemployment rate. Inflation at this point is moderate but also greater than zero. Unemployment associated either with zero inflation or high inflation is significantly higher. The short-run Phillips curve that follows from this model is one in which the coefficient on expected inflation rises with inflation and eventually approaches one.

Empirical Tests of the Model

We have estimated and tested our model with post-war United States data. The key test is whether the coefficient on expected inflation varies in the way we predicted in our theory. The estimating equation includes a term to capture that effect, if it is in fact present in the data. We specified the term in a variety of ways. We used a number of measures of expected inflation itself, including alternative averages of past inflation as well as direct survey measures of expected inflation, and several alternative measures of unemployment and of price and wage inflation.

The large number of specifications that are available from these combinations of data provide a check on the robustness of our findings. Finally, while all the data we need are available from the first quarter of 1954 through the end of 1999, we sometimes restricted the period of estimation to end in the fourth quarter of 1989 so that the results would not be driven by the 1990s episode of low inflation and falling unemployment.

Nearly all the estimates confirmed our theory and indicated that large, sustainable gains in employment are available by operating the economy at inflation rates moderately above zero rather than either at zero inflation or high inflation. At zero or high inflation rates, the equilibrium in our model corresponds to the natural unemployment rate in conventional models.

To summarize the range of estimates, we calculated the inflation rate associated with maximum employment and the difference between the corresponding unemployment rate and the natural unemployment rate. This difference measures the sustainable gains in employment that are attainable. Not surprisingly, the large number of specifications generates a wide range of point estimates. The densest cluster of estimates spans a range from 1.5 to 3 percent for the inflation rate that maximizes employment in the long run. The estimated unemployment reduction from operating the economy at that inflation rate (rather than at zero or high inflation) falls mainly in the range from 0.5 to 3.0 percentage points.

Guides For Policymakers

Although these estimates provide support for the qualitative features of the model, they do not pin down precise targets for inflation and unemployment. Indeed, it would be unrealistic to seek precise estimates. However, our main results and the departures from conventional natural rate models that they identify appear to be robust and do provide useful guides for policy.

Rather than a unique natural rate of unemployment, the economy has a range of sustainable unemployment rates that are consistent with moderate inflation. Zero inflation is an inappropriate policy target because it raises the sustainable rate of unemployment by a significant amount. High inflation is bad for the same reason, as well as because of other distortions and inequities. Moderate inflation, which includes the range of experience of recent years, with the core CPI rising at a 2 to 2.5 percent annual rate, allows the economy to operate with low unemployment. Such an inflation rate yields maximum prosperity.

The economy is now slowing from the very rapid growth rates of the past few years. Whether the soft landing that everyone is hoping for can be achieved may well depend on whether policymakers managing this slowdown rely on conventional models and prescriptions that aim for complete price stability or, instead, take account of the analysis described here. That analysis suggests policymakers should aim to maintain the moderate core inflation rates of recent years and avoid the substantial increase in unemployment that conventional NAIRU models suggest is inevitable.

A similar choice confronts policymakers in the new European Monetary Union who have only recently seen their persistently high unemployment rates begin to fall. If they now prematurely tighten policies in order to pursue price stability, they are likely to interrupt the expansion before full prosperity has been restored in Europe.

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Publication: Brookings Institution

Near Rational Wage and Price Setting and the Long Run Phillips Curve

George A. Akerlof, George L. Perry and William T. Dickens — Fri, 02 Jun 2000 00:00:00 -0400

Summary

Since the 1970s many economists have accepted the idea of a natural rate of unemployment that describes a unique equilibrium for the real economy. The NAIRU, the empirical counterpart of the natural rate, has become part of the toolkit of policymakers and analysts, especially in the United States. And until the past few years, estimates of a relatively constant natural rate of about 6 percent have fit the actual behavior of the U.S. economy over the previous three decades reasonably well. Since then, however, the persistence of low inflation alongside unemployment rates that have fallen well below 6 percent has led most analysts to conclude that the U.S. NAIRU has fallen. In the first paper of this volume, George Akerlof, William Dickens, and George Perry go further and reject the natural rate model itself.

Over the years there has been considerable controversy about how to model the formation of expectations in empirical work with the natural rate model. The authors, by contrast, see how people use expectations, rather than how they form them, as the key. Rather than accept the standard economic assumption that people make the best use of all available information, the authors turn to a variety of sources for evidence about how people actually use information in making decisions. Supported by this evidence, they develop an alternative to the natural rate model that is based on behavioral assumptions they find more realistic, and that fits the facts better. A striking feature of their model is that, rather than a unique natural rate, it exhibits a range of sustainable unemployment rates consistent with steady, low rates of inflation. The authors show that the lowest unemployment rate in this range is well below the natural rate as usually estimated.

The authors cite psychological studies that have found that decisionmakers "edit" the information available to them, ignoring much that is potentially relevant in order to concentrate on the few factors that matter most. Similarly, studies on the psychology of perception show that an event or stimulus must pass a threshold before it is even perceived, let alone used. In addition, from interviews with compensation professionals, the authors infer that wage setters do not behave as most economic models assume. Rather than choosing a real wage target and then adjusting it fully for expected inflation, they mix information about inflation with a variety of other information relevant to wage setting. And from interviews of the lay public by Robert Shiller and questionnaire studies by Eldar Shafir, Peter Diamond, and Amos Tversky, they find telling evidence about how people perceive and react to inflation. Employees systematically underestimate the tendency of inflation to boost their own nominal wages. Therefore, the authors reason, in periods of moderate inflation, employees' job satisfaction is likely to be high even if their real wage is unchanged.. They are pleased by their wage increases while not fully recognizing the corresponding rise in prices.

Drawing on these insights, the authors construct a model in which firms pay an efficiency wage and workers respond according to their view of job and wage opportunities outside the firm. The crucial issue is how wage-setting behavior varies with the inflation rate. At any given time, some firms and their workers are fully rational, their wage setting fully incorporating expected inflation. At the same time, other firms or their workers are near rational and their wage setting responds fully to current conditions in their labor market, but less than fully or not at all to expected inflation. Because all firms adjust to current market conditions each time they set wages, the wage level in near-rational firms trails the average wage, but only by a small, and not cumulating, percentage. Prices in all firms are a markup on expected unit labor costs. The authors show that the cost in lost profits from near-rational behavior is negligible at low rates of inflation and grows with the inflation rate. This supports their key hypothesis that the proportion of firms that fully adjust for expected inflation when they set wages will rise with the inflation rate. With little or no inflation, a large fraction of firms will be near rational, not fully adjusting their wages and prices in this way. At successively higher rates of inflation, that fraction will decline, and at a sufficiently high rate of inflation all firms will fully incorporate expected inflation.

The authors present a formal model that derives the implications of this firm-level behavior for the inflation-unemployment relation in the macroeconomy. At zero inflation, rational and near-rational behavior coincide, and equilibrium unemployment is at what would be the conventional natural rate. When steady-state inflation is between zero and some moderate rate, higher inflation is accompanied by lower unemployment. This trade-off reflects two effects working in opposite directions: as the inflation rate rises, firms pursuing near-rational behavior increase employment, but firms shifting to fully rational behavior cut their employment as they shift. In this inflation range, the first effect dominates. Beyond some inflation rate, the second effect begins to dominate and higher inflation is associated with higher unemployment, eventually approaching the conventional natural rate as all firms and workers fully incorporate inflationary expectations. There is thus a point of lowest sustainable unemployment. The natural unemployment rate, which is the rate associated both with high levels of inflation and with zero inflation, is significantly above the lowest sustainable unemployment rate. More generally, operating with an inflation rate either higher or lower than that associated with the lowest unemployment rate leads to excessively high unemployment in the long run. The short-run Phillips curve that follows from this model is one in which the coefficient on expected inflation rises with the inflation rate and approaches unity at sufficiently high inflation rates.

The authors provide empirical support for this form of short-run Phillips curve from U.S. data over the period since the Korean War. They first discuss results reported elsewhere by William Brainard and Perry, who used general Kalman filter estimation that permits all Phillips curve coefficients to vary over time. These authors found little or no variation in the intercept or in the coefficient on unemployment. But the coefficient on lagged inflation, the conventional proxy for expected inflation, did vary over time. Starting from low values in the low-inflation years before the 1970s, it rose to its peak values with the high inflation that accompanied the two OPEC oil price shocks, and then declined again as the inflation rate fell to its recent low levels. Akerlof, Dickens, and Perry present their own results from fitting separate Phillips curves to periods of low and high inflation. To do this they sort the quarters from 1954 through 1999 into two samples: those quarters when the trailing five-year average of inflation as measured by the consumer price index was below 3 percent (or, alternatively, 2.5 percent), and those when it was above 4 percent. The samples have mean inflation rates of 2.0 percent and 6.3 percent, respectively. Using a variety of specifications, the authors then estimate their model with three alternative unemployment measures to allow for different treatment of demographic changes, three measures of price inflation, and a measure of wage inflation. They find the coefficient on inflationary expectations to be consistently and substantially larger in the high-inflation-period regressions than in the low-inflation-period regressions. The authors also report parallel regressions using direct survey measures of inflationary expectations, which avoid the ambiguity over whether lagged inflation is an adequate proxy for expected inflation. These estimates show an even sharper difference between the coefficients on price expectations in the low- and high-inflation periods. All the split-sample least-squares regressions thus support the key hypothesis of the formal model: how price expectations are incorporated into wage setting varies with the inflation rate.

The authors go on to derive an approximation to their model that is tractable for nonlinear estimation. In addition to unemployment and expected inflation, the conventional right-hand-side variables in a Phillips curve, the estimation model includes a term representing how past inflation affects the likelihood that people will act rationally toward expected inflation. To provide a check on the robustness of the results, that term is proxied in a variety of ways. So is expected inflation itself, which is represented by alternative forms of distributed lags on past inflation as well as by the direct survey measures of expected inflation. In addition, the several alternative measures of unemployment and price and wage inflation used in the least-squares regressions are used in estimating the nonlinear model. Finally, whereas the full data period ran from 1954:1 through 1999:4, some of the nonlinear regressions were run only through 1989:4 to ensure that the results are not driven simply by the one long episode of low inflation and falling unemployment in the 1990s. The authors find that the estimates from the nonlinear regressions support the formal model.

The most important result is that nearly all the point estimates indicate that large, sustainable gains in employment are available by operating the macroeconomy at inflation rates moderately above zero. To summarize the range of estimates, for each of their regressions the authors calculate the inflation rate associated with maximum employment and the difference between the corresponding unemployment rate and the natural unemployment rate, which measures the employment gains available. Not surprisingly, the large number of specifications generates a wide range of point estimates. The densest cluster of estimates spans a range from 1.5 to 3 percent for the employment maximizing inflation rate and 0.5 to 3 percentage points for the corresponding unemployment reduction.

The authors discuss in detail four estimated equations that are representative of the range of their specifications, including one that is estimated only through the end of the 1980s. In each case the coefficient on inflationary expectations stays at or near one starting some time after the onset of the inflationary period that began in the late 1960s, and takes on much smaller values during the low-inflation periods before and after. The amount of variation in this key parameter, and the timing of the variations, differ across the specifications, but all support the key prediction of the authors' model. The employment maximizing rate of inflation for these equations ranges between 1.6 and 3.2 percent. And the difference in employment below the natural rate ranges from 1.5 to 3.1 percentage points.

Although these estimates provide support for the qualitative features of the model, they do not pin down targets for inflation and unemployment. Indeed, it would be unrealistic to seek precise estimates. However, their main results and the departures from conventional natural rate models that they identify appear to be robust and do provide useful guides for econometricians and policymakers. Rather than a unique natural rate of unemployment, the economy has a range of sustainable unemployment rates that are consistent with moderate rates of inflation. For econometricians the main message is that models that assume a unique natural rate are misspecified and will yield misleading estimates of the economy's potential and the minimum rate of unemployment that is sustainable. For policymakers there are more general guides. Zero inflation is an inappropriate policy target because it raises the sustainable rate of unemployment by an important amount. High rates of inflation are bad for the same reason, as well as because of the distortions and inequities they bring. Moderate rates of inflation, a range that includes the experience of recent quarters when the core CPI has been rising at a 2 percent annual rate, allow the economy to operate with low rates of unemployment and are consistent with a policy seeking to maximize prosperity.

Paper forthcoming in Brookings Papers on Economic Activity, 1:2000

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New Mothers, Not Married: Technology shock, the demise of shotgun marriage, and the increase in out-of-wedlock births

George A. Akerlof and Janet L. Yellen — Sun, 01 Sep 1996 00:00:00 -0400

In 1970 a permanent cure to poverty in America seemed on the horizon. Federal poverty warriors appeared to be gaining ground, and decisions by state courts regarding abortion and by state legislatures regarding the availability of contraception seemed to be giving poor families the tools to control the number and the timing of their children. The dream of eliminating poverty, however, has remained unful lled. Not only have U.S. poverty rates stayed stubbornly constant over the intervening 25 years, but also poor families have seen their lot worsen as huge increases in single-parent families more and more headed by unmarried mothers have led to the feminization of poverty in America.

Since 1970, out-of-wedlock birth rates have soared. In 1965, 24 percent of black infants and 3.1 percent of white infants were born to single mothers. By 1990 the rates were 64 percent for black infants, 18 percent for whites. Every year one million more children are born into fatherless families. If we have learned any policy lesson well over the past 25 years, it is that for children living in single-parent homes, the odds of living in poverty are great. The policy implications of the increase in out-of-wedlock births are staggering.

Searching for an Explanation

Efforts by social scientists to explain the rise in out-of-wedlock births have so far been unconvincing, though several theories have a wide popular following. One argument that appeals to conservatives is that of Charles Murray, who attributes the increase to overly generous federal welfare bene ts. But as David Ellwood and Lawrence Summers have shown, welfare bene ts could not have played a major role in the rise of out-of-wedlock births because bene ts rose sharply in the 1960s and then fell in the 1970s and 1980s, when out-of-wedlock births rose most. A study by Robert MoYtt in 1992 also found that welfare bene ts can account for only a small fraction of the rise in the out-of-wedlock birth ratio.

Liberals have tended to favor the explanation offered by William Julius Wilson. In a 1987 study, Wilson attributed the increase in out-of-wedlock births to a decline in the marriageability of black men due to a shortage of jobs for less educated men. But Robert D. Mare and Christopher Winship have estimated that at most 20 percent of the decline in marriage rates of blacks between 1960 and 1980 can be explained by decreasing employment. And Robert G. Wood has estimated that only 3 4 percent of the decline in black marriage rates can be explained by the shrinking of the pool of eligible black men.

Yet another popular explanation is that single parenthood has increased since the late 1960s because of the change in attitudes toward sexual behavior. But so far social scientists have been unable to explain exactly how that change came about or to estimate in any convincing way its quantitative impact. In recent work we have been able to provide both.

The Answer: No More Shotgun Marriages

In the late 1960s and very early 1970s (well before Roe v. Wade in January 1973) many major states, including New York and California, liberalized their abortion laws. At about the same time it became easier for unmarried people to get contraceptives. In July 1970 the Massachusetts law prohibiting the distribution of contraceptives to unmarried people was declared unconstitutional. We have found that this sudden increase in the availability of both abortion and contraception we call it a reproductive technology shock--is deeply implicated in the increase in out-of-wedlock births. Although many observers expected liberalized abortion and contraception to lead to fewer out-of-wedlock births, the opposite happened--because of the erosion in the custom of shotgun marriages.

Until the early 1970s, shotgun marriage was the norm in premarital sexual relations. The custom was succinctly stated by one San Francisco resident in the late 1960s: If a girl gets pregnant you married her. There wasn t no choice. So I married her.

Since 1969, however, the tradition of shotgun marriage has seriously eroded (see table 1 for the trend from 1965 through 1984). For whites, in particular, the shotgun marriage rate began its decline at almost the same time as the reproductive technology shock. And the decline in shotgun marriages has contributed heavily to the rise in the out-of-wedlock birth rate for both white and black women. In fact, about 75 percent of the increase in the white out-of-wedlock rst-birth rate, and about 60 percent of the black increase, between 1965 and 1990 is directly attributable to the decline in shotgun marriages. If the shotgun marriage rate had remained steady from 1965 to 1990, white out-of-wedlock births would have risen only 25 percent as much as they have. Black out-of-wedlock births would have increased only 40 percent as much.

What links liberalized contraception and abortion with the declining shotgun marriage rate? Before 1970, the stigma of unwed motherhood was so great that few women were willing to bear children outside of marriage. The only circumstance that would cause women to engage in sexual activity was a promise of marriage in the event of pregnancy. Men were willing to make (and keep) that promise for they knew that in leaving one woman they would be unlikely to nd another who would not make the same demand. Even women who would be willing to bear children out-of-wedlock could demand a promise of marriage in the event of pregnancy.

themselves pressured to participate in premarital sexual relations without being able to exact a promise of marriage in case of pregnancy. These women feared, correctly, that if they refused sexual relations, they risked losing their partners. Sexual activity without commitment was increasingly expected in premarital relationships.

Advances in reproductive technology eroded the custom of shotgun marriage in another way. Before the sexual revolution, women had less freedom, but men were expected to assume responsibility for their welfare. Today women are more-- free to choose, but men have afforded themselves the comparable option. If she is not willing to have an abortion or use contraception, the man can reason, why should I sacri ce myself to get married? By making the birth of the child the physical choice of the mother, the sexual revolution has made marriage and child support a social choice of the father.

Many men have changed their attitudes regarding the responsibility for unplanned pregnancies. As one contributor to the Internet wrote recently to the Dads Rights Newsgroup, Since the decision to have the child is solely up to the mother, I don t see how both parents have responsibility to that child. That attitude, of course, makes it far less likely that the man will offer marriage as a solution to a couple s pregnancy quandary, leaving the mother either to raise the child or to give it up for adoption.

Before the 1970s, unmarried mothers kept few of their babies. Today they put only a few up for adoption because the stigma of unwed motherhood has declined. The transformation in attitudes was captured by the New York Times in 1993: In the old days of the 1960s, 50s, and 40s, pregnant teenagers were pariahs, banished from schools, ostracized by their peers or scurried out of town to give birth in secret. Today they are supported and embraced in their decision to give birth, keep their babies, continue their education, and participate in school activities. Since out-of-wedlock childbearing no longer results in social ostracism, literally and guratively, shotgun marriage no longer occurs at the point of the shotgun.

The Theory and the Facts

The preceding discussion explains why the reproductive technology shock could have increased the out-of-wedlock birth rate. How well do the data t the theory?

In 1970 there were about 400,000 out-of-wedlock births out of 3.7 million total births (see table 1). In 1990 there were 1.2 million out-of-wedlock births out of 4 million total. From the late 1960s to the late 1980s, the number of births per unmarried woman roughly doubled for whites, but fell by 5 10 percent for blacks. The fraction of unmarried women rose about 30 percent for whites, about 40 percent for blacks. The fertility rates for married women of both races declined rapidly (also, of course, contributing to the rise in the out-of-wedlock birth ratio).

If the increased abortions and use of contraceptives caused the rise in out-of-wedlock births, the increase would have to have been very large relative to the number of those births and to the number of unmarried women. And as table 1 shows, that was indeed the case. The use of birth control pills at rst intercourse by unmarried women jumped from 6 percent to 15 percent in just a few years, a change that suggests that a much larger fraction of all sexually active unmarried women began using the pill. The number of abortions to unmarried women grew from roughly 100,000 a year in the late 1960s (compared with some 322,000 out-of-wedlock births) to more than 1.2 million (compared with 715,000 out-of-wedlock births) in the early 1980s. Thus the data do support the theory.

Indeed, the technology shock theory explains not only the increase in the out-of-wedlock birth rate, but also related changes in family structure and sexual practice, such as the sharp decline in the number of children put up for adoption. The peak year for adoptions in the United States was 1970, the year of the technology shock. Over the next five years the number of agency adoptions was halved from 86,000 to 43,000. In 1969, mothers of out-of-wedlock children who had not married after three years kept only 28 percent of those children. In 1984, that rate was 56 percent; by the late 1980s it was 66 percent.

Unlike the other statistics we have mentioned, the shotgun marriage rate itself underwent only gradual change following the early 1970s. Why did it not change as dramatically as the others? For two reasons. The first is that shotgun marriage was an accepted social convention and, as such, it changed slowly. It took time for men to recognize that they did not have to promise marriage in the event of a pregnancy in exchange for sexual relations. It may also have taken time for women to perceive the increased willingness of men to leave them if they demanded marriage. As new expectations formed, social norms readjusted, and the shotgun marriage rate began its long decline.

In addition, the decreasing stigma of out-of-wedlock childbirth reinforced the technology-driven causes for the decline in shotgun marriage and increased retention of out-of-wedlock children. With premarital sex the rule, rather than the exception, an out-of-wedlock childbirth gradually ceased to be a sign that society s sexual taboos had been violated. The reduction in stigma also helps explain why women who would once have put their baby up for adoption chose to keep it instead.

One nal puzzle requires explanation. The black shotgun marriage ratio began to fall earlier than the white ratio and shows no signi cant change in trend around 1970. How do we account for that apparent anomaly? Here federal welfare bene ts may play a role. For women whose earnings are so low that they are potentially eligible for welfare, an increase in welfare bene ts has the same effect on out-of-wedlock births as a decline in the stigma to bearing a child out-of-wedlock. The difference in welfare eligibility between whites and blacks and the patterns of change in bene ts rising in the 1960s and falling thereafter may then explain why the decline in the black shotgun marriage ratio began earlier than that for whites. Because blacks on average have lower incomes than whites, they are more aVected by changes in welfare bene ts. As a result, the rise in welfare bene ts in the 1960s may have had only a small impact on the white shotgun rate but resulted in a signi cant decrease in the black shotgun marriage rate.

Policy Considerations

Although doubt will always remain about the ultimate cause for something as diffuse as a change in social custom, the technology shock theory does t the facts. The new reproductive technology was adopted quickly and on a massive scale. It is therefore plausible that it could have accounted for a comparably large change in marital and fertility patterns. The timing of the changes also seems, at least crudely, to the theory.

From a policy perspective, attempts to turn the technology clock back by denying women access to abortion and contraception is probably not possible. Even if it were, it would almost surely be counterproductive. In addition to probably reducing the well-being of women who use the technology, such measures could lead to yet greater poverty. With sexual abstinence rare and the stigma of out-of-wedlock motherhood small, denying women access to abortion and contraception would probably increase the number of children born out of wedlock and reared in impoverished single-parent families. On the contrary, efforts should be made to ensure that women can use the new technologies if they choose to do so.

Finally, if the technology shock theory does explain the rise in single motherhood, cuts in welfare as currently proposed would only further immiserize the victims. Such cuts would have little impact on the number of children born out-of-wedlock while impoverishing those already on welfare yet further. Instead, policy measures to make fathers pay to support their out-of-wedlock children would not only directly contribute to the well-being of children, but also tax men for fathering such children, thereby oVsetting at least partially the change in terms between fathers and mothers. Such measures deserve serious policy consideration.

Authors

George A. Akerlof
Janet L. Yellen

An Analysis of Out-Of-Wedlock Births in the United States

George A. Akerlof and Janet L. Yellen — Thu, 01 Aug 1996 00:00:00 -0400

Around 1970, the United States experienced a reproductive technology shock. The legalization of abortion and dramatic increase in the availability of contraception gave women the tools to control the number and timing of their children. Over the ensuing 25 years, however, there have been huge increases in the number of single-parent families headed by unmarried mothers. The usual economic explanations welfare benefits and the declining availability of good jobs explain only a small fraction of the change. In our view, it was the technology shock itself that, by eroding the age-old custom of shotgun marriage, paradoxically raised out-of-wedlock birth rates instead of lowering them. If so, cuts in welfare benefits will have little effect on out-of-wedlock births, serving mainly to lower the standard of living of the country's poorest children. Better family planning education, birth control advice, and requirements forcing fathers to pay child support are more promising policies to reduce out-of-wedlock births.

POLICY BRIEF #5

Since 1970, out-of-wedlock birth rates have soared. In 1965, 24 percent of black infants and 3.1 percent of white infants were born to single mothers. By 1990 the rates had risen to 64 percent for black infants, 18 percent for whites. Every year about one million more children are born into fatherless families. If we have learned any policy lesson well over the past 25 years, it is that for children living in single-parent homes, the odds of living in poverty are great. The policy implications of the increase in out-of-wedlock births are staggering.

Searching for an Explanation

Efforts by social scientists to explain the rise in out-of-wedlock births have so far been unconvincing, though several theories have a wide popular following. One argument that appeals to conservatives is that of Charles Murray, who attributes the increase to overly generous federal welfare benefits. But as David Ellwood and Lawrence Summers have shown, welfare benefits could not have played a major role in the rise of out-of-wedlock births because benefits rose sharply in the 1960s and then fell in the 1970s and 1980s, when out-of-wedlock births rose most. A study by Robert Moffitt in 1992 also found that welfare benefits can account for only a small fraction of the rise in the out-of-wedlock birth ratio.

Liberals have tended to favor the explanation offered by William Julius Wilson. In a 1987 study, Wilson attributed the increase in out-of-wedlock births to a decline in the marriageability of black men due to a shortage of jobs for less educated men. But Robert D. Mare and Christopher Winship have estimated that at most 20 percent of the decline in marriage rates of blacks between 1960 and 1980 can be explained by decreasing employment. And Robert G. Wood has estimated that only 3-4 percent of the decline in black marriage rates can be explained by the shrinking of the pool of eligible black men.

Yet another popular explanation is that single parenthood has increased since the late 1960s because of the change in attitudes toward sexual behavior. But so far social scientists have been unable to provide a convincing explanation of exactly how that change came about or to estimate in any convincing way its quantitative impact. In recent work we have been able to provide both.

The Answer: No More Shotgun Marriages

In the late 1960s and very early 1970s (well before Roe v. Wade in January 1973) many major states, including New York and California, liberalized their abortion laws. At about the same time it became easier for unmarried people to obtain contraceptives. In July 1970 the Massachusetts law prohibiting the distribution of contraceptives to unmarried people was declared unconstitutional. We have found that this rather sudden increase in the availability of both abortion and contraception we call it a reproductive technology shock is deeply implicated in the increase in out-of-wedlock births. Although many observers expected liberalized abortion and contraception to lead to fewer out-of-wedlock births, in fact the opposite happened because of the erosion in the custom of "shotgun marriages."

Until the early 1970s, shotgun marriage was the norm in premarital sexual relations. The custom was succinctly stated by one San Francisco resident in the late 1960s: "If a girl gets pregnant you married her. There wasn't no choice. So I married her."

Since 1969, however, shotgun marriage has gradually disappeared (see table 1). For whites, in particular, the shotgun marriage rate began its decline at almost the same time as the reproductive technology shock. And the disappearance of shotgun marriages has contributed heavily to the rise in the out-of-wedlock birth rate for both white and black women. In fact, about 75 percent of the increase in the white out-of-wedlock first-birth rate, and about 60 percent of the black increase, between 1965 and 1990 is directly attributable to the decline in shotgun marriages. If the shotgun marriage rate had remained steady from 1965 to 1990, white out-of-wedlock births would have risen only 25 percent as much as they have. Black out-of-wedlock births would have increased only 40 percent as much.

What links liberalized contraception and abortion with the declining shotgun marriage rate? Before 1970, the stigma of unwed motherhood was so great that few women were willing to bear children outside of marriage. The only circumstance that would cause women to engage in sexual activity was a promise of marriage in the event of pregnancy. Men were willing to make (and keep) that promise for they knew that in leaving one woman they would be unlikely to find another who would not make the same demand. Even women who would be willing to bear children out-of-wedlock could demand a promise of marriage in the event of pregnancy.

The increased availability of contraception and abortion made shotgun weddings a thing of the past. Women who were willing to get an abortion or who reliably used contraception no longer found it necessary to condition sexual relations on a promise of marriage in the event of pregnancy. But women who wanted children, who did not want an abortion for moral or religious reasons, or who were unreliable in their use of contraception found themselves pressured to participate in premarital sexual relations without being able to exact a promise of marriage in case of pregnancy. These women feared, correctly, that if they refused sexual relations, they would risk losing their partners. Sexual activity without commitment was increasingly expected in premarital relationships.

Advances in reproductive technology eroded the custom of shotgun marriage in another way. Before the sexual revolution, women had less freedom, but men were expected to assume responsibility for their welfare. Today women are more free to choose, but men have afforded themselves the comparable option. "If she is not willing to have an abortion or use contraception," the man can reason, "why should I sacrifice myself to get married?" By making the birth of the child the physical choice of the mother, the sexual revolution has made marriage and child support a social choice of the father.

Many men have changed their attitudes regarding the responsibility for unplanned pregnancies. As one contributor to the Internet wrote recently to the Dads' Rights Newsgroup, "Since the decision to have the child is solely up to the mother, I don't see how both parents have responsibility to that child." That attitude, of course, makes it far less likely that the man will offer marriage as a solution to a couple's pregnancy quandary, leaving the mother either to raise the child or to give it up for adoption.

Before the 1970s, unmarried mothers kept few of their babies. Today they put only a few up for adoption because the stigma of unwed motherhood has declined. The transformation in attitudes was captured by the New York Times in 1993: "In the old days' of the 1960s, '50s, and '40s, pregnant teenagers were pariahs, banished from schools, ostracized by their peers or scurried out of town to give birth in secret." Today they are "supported and embraced in their decision to give birth, keep their babies, continue their education, and participate in school activities." Since out-of-wedlock childbearing no longer results in social ostracism, literally and figuratively, shotgun marriage no longer occurs at the point of the shotgun.

The Theory and the Facts

The preceding discussion explains why the increased availability of abortion and contraception what we shall call the reproductive technology shock could have increased the out-of-wedlock birth rate. How well do the data fit the theory?

In 1970 there were about 400,000 out-of-wedlock births out of 3.7 million total births. In 1990 there were 1.2 million out-of-wedlock births out of 4 million total. From the late 1960s to the late 1980s, the number of births per unmarried woman roughly doubled for whites, but fell by 5-10 percent for blacks. The fraction of unmarried women rose about 30 percent for whites, about 40 percent for blacks. The fertility rates for married women of both races declined rapidly (also, of course, contributing to the rise in the out-of-wedlock birth ratio).

If the increased abortions and use of contraceptives caused the rise in out-of-wedlock births, the increase would have to have been very large relative to the number of those births and to the number of unmarried women. And as table 1 shows, that was indeed the case. The use of birth control pills at first intercourse by unmarried women jumped from 6 percent to 15 percent in just a few years, a change that suggests that a much larger fraction of all sexually active unmarried women began using the pill. The number of abortions to unmarried women grew from roughly 100,000 a year in the late 1960s (compared with some 322,000 out-of-wedlock births) to more than 1.2 million (compared with 715,000 out-of-wedlock births) in the early 1980s. Thus the data do support the theory.

Indeed, the technology shock theory explains not only the increase in the out-of-wedlock birth rate, but also related changes in family structure and sexual practice, such as the sharp decline in the number of children put up for adoption. The peak year for adoptions in the United States was 1970, the year of the technology shock. In the five years following the shock the number of agency adoptions was halved from 86,000 to 43,000. In 1969, mothers of out-of-wedlock children who had not married after three years kept only 28 percent of those children. In 1984, that rate was 56 percent; by the late 1980s it was 66 percent.

In addition, the decreasing stigma of out-of-wedlock childbirth reinforced the technology-driven causes for the decline in shotgun marriage and increased retention of out-of-wedlock children. With premarital sex the rule, rather than the exception, an out-of-wedlock childbirth gradually ceased to be a sign that society's sexual taboos had been violated. The reduction in stigma also helps explain why women who would once have put their baby up for adoption chose to keep it instead.

One final puzzle requires explanation. The black shotgun marriage ratio began to fall earlier than the white ratio and shows no significant change in trend around 1970. How do we account for that apparent anomaly? Here federal welfare benefits may play a role. For women whose earnings are so low that they are potentially eligible for welfare, an increase in welfare benefits has the same effect on out-of-wedlock births as a decline in the stigma to bearing a child out-of-wedlock. The difference in welfare eligibility between whites and blacks and the patterns of change in benefits rising in the 1960s and falling thereafter may then explain why the decline in the black shotgun marriage ratio began earlier than that for whites. Because blacks on average have lower incomes than whites, they are more affected by changes in welfare benefits. As a result, the rise in welfare benefits in the 1960s may have had only a small impact on the white shotgun rate but resulted in a significant decrease in the black shotgun marriage rate.

Policy Considerations

Although doubt will always remain about the ultimate cause for something as diffuse as a change in social custom, the technology shock theory does fit the facts. The new reproductive technology was adopted quickly and on a massive scale. It is therefore plausible that it could have accounted for a comparably large change in marital and fertility patterns. The timing of the changes also seems, at least crudely, to fit the theory.

Attempts to turn the technological clock backwards by denying women access to abortion and contraception are probably not possible. Even if such attempts were possible, they would now be counterproductive. In addition to reducing the well-being of women who use the technology, such measures would lead to yet greater poverty. With sexual abstinence rare and the stigma of out-of-wedlock motherhood small, denying women access to abortion and contraception would only increase the number of children born out-of-wedlock and reared in impoverished single-parent families. Most children born out-of-wedlock are reported by their mothers to have been "wanted" but "not at that time." Some are reported as not wanted at all. Easier access to birth control information and devices, before sexual participation, and easier access to abortion, in the event of pregnancy, could reduce both the number of unwanted children and improve the timing of those whose mothers would have preferred to wait. Because of mothers' ambivalence toward out-of-wedlock pregnancies, greater availability of these options has considerable promise for reducing the number of out-of-wedlock births.

Most important, our analysis of the changes in out-of-wedlock birth suggests that a return to the old system of shotgun marriage will not be brought about by significant reductions in welfare benefits, and possibly not even by very large reductions. With sexual activity taking place early in relationships and with little social stigma enforcing the norm of shotgun marriage, fathers no longer have strong extrinsic reasons for marriage. Cuts in welfare therefore have little effect on the number of out-of-wedlock births, while reducing dollar-for-dollar the income of the poorest segment of the population. The initial goal of the welfare program was to see that the children in unfortunate families were adequately supported. The support of poor children not the alteration of the behavior of potential mothers should remain the major policy goal of welfare in the United States. This level of support must be tempered by equity between those who collect welfare and do not work and those who do work and also are paying taxes that, at least in part, go to pay for the less fortunate. In this regard a generous Earned Income Tax Credit serves two roles. Not only does it reward those who work, but by increasing the differential between the working poor and the nonworking poor, it allows greater benefits equitably to be paid to nonworking mothers.

This children-oriented approach to welfare should also inform the requirements of welfare. It only makes sense to cut mothers off welfare after two years, for example, if jobs and child care are available so that mothers can support their families and their children can receive adequate child care. It should be remembered that the proper care and nourishment of children should be the first goal of our society.

It has been suggested that measures should be taken to make fathers pay for the support of their out-of-wedlock children. While probably difficult to enforce, such measures give the correct incentives. They will make men pause before fathering such children and they will at least slightly change the terms between fathers and mothers. Such measures deserve serious consideration.

*This Policy Brief was prepared for the Fall 1996 issue of the Brookings Review and adapted from "An Analysis of Out-of-Wedlock Childbearing in the United States," which appeared in the May 1996 issue of the Quarterly Journal of Economics.

Authors

George A. Akerlof
Janet L. Yellen

Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?

George A. Akerlof, George L. Perry and William T. Dickens — Thu, 01 Aug 1996 00:00:00 -0400

Although the Fed's performance has hardly ever been better, with both inflation and unemployment at low levels, some politicians and economists want the Fed to go further and to pursue zero inflation as its primary goal. Economists have argued that the costs of such a policy would be temporary and small while the long-term gains would be great. We reexamine these costs and find that previous studies have seriously understated them. The costs of maintaining zero inflation would be a permanent reduction in gross domestic product of 1 to 3 percent and a permanent drop in employment by the same amount. Complete price stability should not be the Fed's goal.

POLICY BRIEF #4

In recent hearings on Capitol Hill, Senator Daniel Patrick Moynihan (D.-N.Y.) hailed Alan Greenspan as "a national treasure." Such acclaim is unprecedented for a Federal Reserve chairman and the institution he represents. Throughout most of the postwar period, the Fed has drawn fire from one side or another. It was blamed for frequent recessions in the 1950s, high inflation in the 1970s, and high interest rates in the 1980s.

Both by historical precedent and through legislation passed in the 1970s, the Fed's responsibility for stabilizing the U.S. economy has encompassed goals for both employment and inflation. In the past, the Fed has come under attack when one goal conflicted with the other. The widespread appreciation the Fed currently enjoys has come as the rate of consumer price inflation has stabilized at a 30-year low of less than 3 percent, with the economy in its fifth year of expansion and unemployment at less than 5.5 percent.

Although the Fed's performance has hardly ever been better, many policymakers and economists want it to go even further and to pursue zero inflation as its primary goal. Senator Connie Mack of Florida has introduced the Economic Growth and Price Stability Act, which would amend the Federal Reserve Act. It would replace the old instruction that the Fed should "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," with the single instruction that it should "promote price stability." The cosponsors of this legislation included nearly every member of the Senate Republican leadership, including former Majority Leader Bob Dole. The same bill was introduced in the House of Representatives by Jim Saxton (R.-N.J.).

Several studies have been done on the impact of going to zero inflation. Nearly all suggest that the costs would only be transitional. In addition, it has been argued that inflation causes costly distortions in saving and investment, because investment income is taxed on the basis of its nominal rather than inflation-adjusted or real value. These distortions are a permanent cost of even low inflation and could be avoided if the Fed achieved zero inflation. So, some argue, the benefits of achieving zero inflation exceed the temporary costs of getting there.

Whether or not the Mack bill passes, the Fed will certainly have to consider whether or not it still wants to pursue lower inflation. We have examined the costs of maintaining a zero inflation rate and find that contrary to previous work, the costs of zero inflation are likely to be large and permanent: a continuing loss of 1 to 3 percent of GDP a year, with correspondingly higher unemployment rates. Therefore, zero inflation would involve large real costs to the American economy.

The reason that zero inflation creates such large costs to the economy is that firms are reluctant to cut wages. In both good times and bad, some firms and industries do better than others. Wages need to adjust to accommodate these differences in economic fortunes. In times of moderate inflation and productivity growth, relative wages can easily adjust. The unlucky firms can raise the wages they pay by less than the average, while the lucky firms can give above-average increases. However, if productivity growth is low (as it has been since the early 1970s in the United States) and there is no inflation, firms that need to cut their relative wages can do so only by cutting the money wages of their employees. Because they do not want to do this, they keep relative wages too high and employment too low. Spillovers cause effects on the economy as a whole to be greater than the employment effects in the affected firms.

Evidence on the Frequency of Wage Cuts

Employers almost never cut their employees' wages because they fear that doing so would cause serious morale and staff retention problems. Studies of popular sentiment suggest why. Most people consider it unfair for a firm to cut wages, except in extreme circumstances. On the other hand, most do not consider it unfair if a firm fails to raise wages in the face of high inflation.

Downward money-wage rigidity used to be a core tenet of macro economics. But the validity of this assumption is now doubted by many macro economists. A series of recent studies argues that money wages are almost as flexible downward as upward. We have reviewed a wide range of data on this question, and we reject these findings. Downward wage rigidity is indeed an important feature of the economy. Studies of general wage increases in manufacturing, union contracts, employer surveys, and our own phone survey of workers allows us to directly examine whether wage cuts are frequent. These data show that wage changes vary across firms, yet few employees receive wage cuts even when inflation is low. Many receive wage increases and many no wage change at all, but the distribution is abruptly truncated at zero. For example, in 1962, when inflation was about 1 percent, 53 percent of production workers in nonunion manufacturing firms received general wage increases, and the average wage change was a 3.2 percent increase. However, though 47 percent of workers received no general increase in that year, less than one-tenth of one percent of workers were employed by firms that made general wage cuts. Firms are extremely reluctant to cut workers' wages.

So why do some other studies claim that wage cuts are frequent? All share the same significant flaw: They do not look directly at wage changes. Instead, they compute these changes from wages reported by workers in surveys taken a year apart. The problem is that survey data of this type is rife with error. People often cannot remember (or simply don't bother to accurately report) their wages to survey takers. With less than half the respondents reporting their wages accurately, "wage changes" computed in this manner are more likely to result from reporting errors than actual wage changes. A recent study by John Shea of the University of Maryland matched a number of people in one of these survey studies with their union contracts. He found that though 21 percent of the wage changes computed for these survey respondents showed declines, only 1.3 percent actually had wage declines in their respective union contracts. Using direct evidence on survey response error, we have shown that the typical errors from panel surveys are easily large enough to produce the appearance of frequent wage cuts, even when the true distribution of wage changes has no such cuts.

Macroeconomic Implications of Downward Rigidity

If employers cannot cut wages, what does this mean for the economy, and particularly for inflation targets? To answer this question, we developed a simulated economy with thousands of firms, each subject to random demand and supply shocks that affected its desired level of employment and wages. We then simulated the behavior of that economy at high, moderate, low, and zero rates of inflation. In this simulation model, unemployment rises at low rates of inflation. There are costs to pursuing low inflation, and these costs are as permanent as the gains of maintaining zero inflation. The effects are permanent because, in the turbulence of the economy, there are always some firms that would want to cut their workers' real wages, and nominal wage rigidity makes this impossible when inflation is low. For the aggregate economy, the consequence of real wages that are too high is employment that is too low. This real cost is not only permanent but also much larger than any reasonable estimate of the gains created by going to zero inflation.

We conducted thousands of simulation experiments to explore the sensitivity of our results and to determine whether there were plausible parameter values that would produce only small effects from nominal rigidity. Our best estimate of the cost of lowering inflation from 3 percent to zero is an increase in unemployment of between 1 and 3 percentage points. Only a few extreme assumptions yielded effects below this range.

One may ask whether there is any direct evidence that the economy behaves like the simulation. To answer this question, we developed a simplified version of the simulation model using U.S. postwar economic data. When fitted to the data, this model did marginally better at predicting the rate of inflation at any level of unemployment than the standard model. More should not be expected, because for most of this period inflation has been above the range where downward nominal rigidity would play a major role.

As a strong test of the usefulness of our model, we attempted an ambitious exercise. The behavior of prices during the Great Depression has always defied explanation through conventional models which assume that only one level of unemployment (the so-called natural rate) is consistent with constant inflation. Unemployment was always above any reasonable estimate of the natural rate, so standard theory predicts accelerating deflation for the entire decade of the 1930s. In fact, there was deflation for the first few depression years. But then a year of significant inflation was followed by a period of low inflation, more deflation, and then inflation again.

We took our model, which was estimated using postwar data, and back-cast the price behavior of the Great Depression. Figure 1 shows the behavior of the standard natural-rate model and our model. The standard model goes wildly off track, whereas our model (which embodies the effects of nominal rigidity) tracks the Great Depression with uncanny accuracy. Both models predict deflation in the early 1930s. However, in the mid-to late 1930s the standard model predicts continuing deflation. Our model predicts that the effects of nominal rigidity finally catch up with the economy and create positive and varying inflation rates, despite high unem-ployment.

Encouraged by these results, we used our estimated model of inflation and unemployment to see what would happen if the Fed were to attempt to move the U.S. economy from a hypothetical 6 percent inflation and 6 percent unemployment to either 3 percent or zero percent inflation. The results are shown in figure 2. With a target of 3 percent inflation, unemployment settles to where it has been since mid-1994 between 5.5 and 6 percent. However, if the Fed were to shoot for zero inflation, the initial costs would be much higher and the long-term unemployment rate more than 2 percentage points higher.

Conclusion

Zero inflation is far from costless, even in the long run. The fortunes of firms continually change, and inflation greases the economy's wheels by allowing these firms to slowly escape from paying real wages that are too high without actually cutting the wages they pay. This adjustment mechanism allows the economy to avoid a large employment cost. At very low rates of inflation and productivity growth, such adjustments are short circuited, and employment suffers.

Though it might be argued that zero inflation over many years would lessen workers' resistance to wage cuts, the interview studies we cite make this seem unlikely. Workers' resistance to nominal wage cuts is tied to their fundamental feelings about fairness and their suspicions of employer motives. The experience of the Great Depression is instructive. After considerable deflation in the early 1930s, resistance to nominal wage cuts apparently stiffened in the mid-to late 1930s. Legal and institutional changes supporting wage rigidity were put in place. A decade of high unemployment and stable prices left nominal rigidity an even more important feature of the economy than before.

Plausible estimates of the benefits of zero inflation are certainly less than the unemployment costs of zero inflation we have documented. A low, steady rate of inflation is a reasonable target for the Fed. We cannot say precisely what low rate of inflation best serves the American people, but we are confident it is not zero.

Brookings: Experts - George A. Akerlof

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