Inflation targets can create jobs

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Up to 500,000 workers may have jobs because of the UKs adoption of an inflation target. That is the central conclusion of research by Professor Christopher Martin and colleagues, presented at the Royal Economic Society’s Annual Conference.

Monetary policy in the UK has been highly successful in recent years. Following the introduction of inflation targets in October 1992, inflation has remained within 1 percentage point of the target of 2.5%. This stability is in marked contrast to the high and volatile inflation rates experienced before 1992.

But it has been argued that the relentless focus on inflation has lead to high interest rates, which have affected employment. Therefore, the apparent success of inflation targeting has come at the price of fewer jobs. This research finds that this argument is wrong. Indeed, the results suggest that adopting an inflation target has increased employment; inflation targets may lead to up to 500,000 extra jobs.

Economists focus on the natural rate of unemployment the underlying equilibrium rate of unemployment. The natural rate depends on the structure of the labour and goods markets; in particular, it depends on the power of trade unions. More powerful trade unions demand higher wages; this pressure for higher wages leads to a higher natural rate.

But since Milton Friedman, economists have believed that monetary policy does not affect the natural rate of unemployment. This means that monetary policy-makers (in the UK, the Monetary Policy Committee of the Bank of England) can only reduce unemployment in the short run. It cannot keep unemployment below the natural rate in the long run.

This research argues that monetary policy can in fact affect the natural rate of unemployment. Specifically, the natural rate depends on the objectives of monetary policy.

Suppose that wages rise. If policy-makers aim to keep inflation as close as possible to the target, they will respond to the inflationary pressures caused by higher wages by increasing interest rates aggressively. This will reduce demand and increase unemployment. Higher unemployment will lead to lower wage increases and so inflation will remain close to the target.

So trade unions are less able to achieve higher wages in this case and so are less powerful. But this implies a lower natural rate of unemployment. In other words, having an inflation target reduces the natural rate of unemployment.

Contrast this with what happens when policy-makers aim to stabilise unemployment and do not care about inflation (arguably, as in the 1970s). In this case, policy-makers will try to keep the level of demand constant.

Since demand is reduced by the higher prices caused by higher wages, policy-makers will allow the real interest rate to fall (they will increase interest rates by less than the rate of inflation and may even reduce interest rates) in order to boost demand. Trade unions are now very powerful. As a result, the natural rate of unemployment is higher.

The conclusion is clear. Inflation targets can both maintain low inflation and reduce the natural rate of unemployment.

Does this fit the evidence? Since inflation targets were introduced in October 1992, UK unemployment has fallen markedly. Since inflation has remained low, the natural rate must have fallen.

The results of this research suggest that about half of this fall is due to greater openness and flexibility in labour and product markets. But about half, amounting to 2-3% of the workforce, is the result of adopting an inflation target. In other words, up to 500,000 workers may have jobs because of inflation targets.

Notes

Monetary Policy and the Natural Rate of Unemployment by George Bratsiotis, Christopher Martin and Theo Panagiotidis was presented at the Royal Economic Society’s 2004 Annual Conference at the University of Wales Swansea.

Dr Bratsiotis is at the University of Manchester; Professor Martin is at Brunel University; and Dr Panagiotidis is at Loughborough University.

For Further information contact Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).

Related information

You can find other publications by these authors, related research and citations from IDEAS and you can search for more Internet resources on the topic of Macroeconomic Policy on SOSIG.

Economics in Action is a collaboration between the Royal Economic Society, the Economics Network of the Higher Education Academy and SOSIG, the Social Science Information Gateway. It forms part of the Why Study Economics initiative.

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