The inflation-unemployment trade-off and the significance of the interest rate: some evidence from the United Kingdom

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1 Tao Chen (China), Paul F. Genle (China), Kamal P. Upadhyaya (USA) Banks and Bank Sysems, Volume 5, Issue 1, 2010 The inflaion-unemploymen rade-off and he significance of he ineres rae: some evidence from he Unied Kingdom Absrac Banking pracices of variable loan raes are an imporan consideraion in macroeconomics. This aricle argues ha any empirical sudy on he inflaion-unemploymen rade-off requires he inclusion of he real ineres rae in he model as any changes in he ineres rae affec he capial use by he firms leading o an effec on he level of employmen in he economy. To es he validiy of his argumen an empirical model is developed which includes he real ineres rae as one of he explanaory variables in addiion o inflaion and real wages. The model is esimaed using he annual ime series daa from he Unied Kingdom for he period from 1961 o The esimaed resuls indicae ha he ineres rae variable is indeed significan in explaining he inflaion-unemploymen rade-off. A Wald es conduced also suggess ha exclusion of real ineres rae leads o a misspecificaion problem. Keywords: bank variable loan raes, Phillips Curve, aggregae supply curve, Grea Briain, he Unied Kingdom, shor run, long run. JEL Classificaion: E12, E24, E40. Inroducion The Phillips Curve earned is appellaion from A. W. Phillips seminal work in Economica (1958, 1961). Though his someimes-percepible inverse relaionship beween unemploymen and inflaion has inrigued many economiss (Snowdon and Vane, 2005). Explanaions abou why shor-run Phillips curves could exis have focused on mispercepions of boh he real wage rae and he demand for goods and services. In his paper we show ha any empirical es work on he unemploymen-inflaion rade-off using Phillips Curve requires he inclusion of he real ineres rae. Based on earlier works (Genle and Novak, 1995; Genle e.al., 2005, 2007) we es our hypohesis using daa from he Unied Kingdom. The heoreical background and graphical analysis are presened in he firs secion of his paper. The model, is esimaion and he discussion of he findings are presened in he second and hird secions. The las secion presens he summary and conclusion. 1. Theoreical background New-Keynesians Mankiw (1989, 1993, 2002) and Gordon (1990, 2009) poin ou ha wages and prices can adjus slowly, hus, affecing he macroeconomic flucuaions. The Phillips Curve changes are a macroeconomic flucuaion. Furhermore, Mishkin (2006) noes ha he New Keynesians and oher Schools of hough agree ha unanicipaed governmen policy will have he mos effec on he economy; however, he New Keynesians make i very clear ha anicipaed policy may also affec he economy, specifically making he Shor Run Phillips Curve (SRPC) more possible. Mankiw (2006) and Gordon (2009) describe he Phillips Curve as he shor-run aggregae supply curve (SRAS). Gordon explains ha posiive supply shocks cause he SRPC o shif downward and negaive supply shocks cause Tao Chen, Paul F. Genle, Kamal P. Upadhyaya, he SRPC o shif upward. In his paper s conex we are solely looking a a model where labor inpus are being used in a complemenary way wih capial. We include real wages (he real cos of labor) and real ineres (he real cos of capial) in he model. Business and Consumer confidence uncerainies, characerisic of he New Keynesian model, can also lead o he economy more likely operaing on he SRPC (Mankiw, 2006; Gordon, 2009). Using he Phillips Curves in Figure 1, assume ha he economy is iniially operaing a poin A on SRPC 0. Then he difference beween 2 and 1, an unanicipaed inflaion creaes a money illusion leading he economy o move from poin A o poin B. When economic agens realize ha hey did no accuraely anicipae he inflaion rae, he agens will make an adjusmen. A ha poin he economy shifs o poin C on he LRPC. Boh emporary mispercepions regarding employees knowledge of he real wage and enrepreneurs and managers knowledge of he real ne presen value (NPVr) of invesmen on capial allow he economy o operae on an SRPC. Afer a period of ime, labor agens realize he increase in heir cos of living compared o a decline in real wage. Concurrenly, enrepreneurs and managers realize he increase in he cos of capial leading o a decrease in he NPVr for capial/labor complemenary projecs. A he same ime, managers and enrepreneurs also realize ha an increase in he demand for heir producs has no been susained. A his ime, he abiliy of policy makers o use money illusion o operae on SRPC 0 is los. Therefore, he economy comes back o naural unemploymen rae on he LRPC, due o some workers oping for unemploymen, some capial/labor complemenary projecs being curailed, wih aendan layoffs and a decrease in aggregae demand ha characerisically happens when he real ineres rae is increased (Phelps, 1967, 1968; Genle and Novak, 1995; Genle e al., 2005, 2008; and Gordon, 2008). 87

2 Banks and Bank Sysems, Volume 5, Issue 1, 2010 Inflaion rae as a percenage K Unemploymen rae as a percenage Fig. 1. The Phillips curves Q K1 Q K2 B A O QL2 QL1 L Fig. 2. Effecs of real ineres rae change on capial (K) and labor (L) use The isocos curves and isoquans in Figure 2, show he effec of a change in he real ineres rae on he capial and labor inpus used by a firm and is oupu. Suppose iniially he firm is operaing a poin A and demonsraing an increase in he ineres rae (he price of capial), ceeris paribus, he isocos line will shif inward leading he firm o operae a poin B wih lower oupu. An examinaion of Figure 2 reveals ha he firm now reduces boh he use of capial inpus, due o he higher cos of capial, and he use of labor inpu because less complemenary capial inpu is being used due o he lower level of oupu. Thus, he unemploymen rae may increase. 2. Empirical framework Variable ineres raes are common in he Unied Kingdom (Homer and Sylla, 1996). This analysis is based on he annual ime series daa from he Unied Kingdom for he period of (see Appendix). A deailed hisorical review of he Unied Kingdom s economy during hose years is beyond he scope of his paper. However, some facs are worh noicing a his poin. In 1979, one of he chief aims of Margare Thacher s poliical pary was o bring down he inflaion rae, by emporarily raising ineres raes. In doing so, he Briish economy was aken ono a Shor-Run Phillips Curve (SRPC). The Unied Kingdom was pu hrough high unemploymen for some ime as he inflaion rae was being amed. Ulimaely, he naion s economy was brough back o he Long-Run Phillips Curve (LRPC) (Dell, 1996; Carlin and Sokice, 2006). The Unied Saes was pu hrough some similar high ineres raes and higher han normal unemploymen during he disinflaion policy of Paul Volker, in he early 1980s. Real wage changes are also a facor. This also resuled in some emporary operaing on he SRPC as inflaion was lowered during he same general ime as i was lowered in he Unied Kingdom (Gordon, 2009). A governmen policy ha purposely pus he counry hrough such a deflaionary ime, akes he naion ono an SRPC o he righ side of he LRPC emporarily, as in he direcion of poin D of Figure 1. Evenually, he economy will sele back on he LRPC (Gordon, 2009). 88

3 The following model provides he concepual idea on how U d, deviaion of unemploymen from is naural rae, relaes o inflaion rae ( ), real ineres rae (r) and real wage (W). U f(, W, r). (1) d The coefficien associaed wih inflaion rae is expeced o have a negaive sign, while he coefficiens of real wage and real ineres are expeced o be of posiive signs, a priori. Since all he Model 1: U d 0 Banks and Bank Sysems, Volume 5, Issue 1, 2010 variables in he model are in erms of percenage change, for he sake of consisency, we have also convered he real wage (W) in erms of percenage change in real wage (w). In oher words, he real wage (W) has also been convered ino growh form. Assuming ha all he macroeconomic adjusmens are compleed in wo years for each explanaory variable, heir lag is also included. In order o beer undersand he relaionship beween he unemploymen and is explanaory variables, we developed he following four models., (2) Model 2: U w w, (3) d 0 w w Model 3: U r r, (4) d 0 r r Model 4: U w w r r. (5) d 0 w w r r As indicaed above,, w, and r, respecively, represen he rae of change in he inflaion rae, he real wage, and he real ineres rae, and is he random error erm. Among all he models menioned above, equaion (2) represens he radiional Phillips Curve and equaion (5) represens he model proposed by his paper. 3. Esimaion resuls Table 1 presens he summary saisics of all he variables used in he esimaion of our model. All of variables are in he percenage erm. Of ineres, he average unemploymen rae across he whole sample period is 5.7%; in he meanwhile he mean inflaion rae is 6.2%, which is much higher han he macroconrol arge (2%) se by Briain s cenral bank currenly. The average growh rae (mean and median), he real wage rae and real ineres rae are greaer compared o he change in oher variables in he model. Table 1. Summary saisics of key variables U μ w R Mean Median Max Min Sd. dev Num Noe: The definiions of key variables are given in he Appendix. Before esimaing he equaions menioned above, Spearman and Pearson correlaions are calculaed in order o obain some preliminary knowledge abou he relaionship beween dependen variable and explanaory variables. The calculaed correlaion coefficiens are repored in Table 2. Alhough he esimaed correlaion coefficiens indicae ha he associaion beween unemploymen and inflaion is negaive, hey are no saisically significan. In conras, he real ineres rae is posiive and saisically significanly correlaed wih he unemploymen rae, which is consisen wih our argumen. The real wage growh rae, however, is negaively associaed wih he unemploymen rae, which is a odds wih our expecaion. Table 2. Correlaions of key variables U W R U * ** W ** *** *** *** *** r ** *** *** Noe: ***, ** and * indicae he values are significan a 1, 5 and 10% level of significance. The upper riangle presens he Spearman correlaion beween key variables, while he lower riangle shows he Pearson correlaion among key variables. The definiions of key variables are given in he Appendix. Table 3. Esimaion of he models Variable Model 1 Model 2 Model 3 Model 4 Consan *** *** * (8.647) (8.548) (-1.795) (-1.057) μ ** *** ** (-2.657) (0.369) (-4.884) (-2.417) μ ** ** ** ** (2.496) (2.252) (-2.334) (-2.298) w ** * (-2.262) (-1.927) w * (-1.832) (-0.612) r (-0.777) (0.389) r *** *** (6.610) (3.743) Adj R F-sa Obs Noe: ***, ** and * indicae he values are significan a 1, 5 and 10% level of significance. The numbers in parenheses are he corresponding -saisics for esimaed coefficiens. Models 89

4 Banks and Bank Sysems, Volume 5, Issue 1, , 2, 3, and 4 are differen combinaion of inflaion rae, real ineres rae, and real wage o explain he unemploymen rae. The definiions of key variables are given in he Appendix. The esimaed resuls of Models 1, 2, 3, and 4 are repored in Table 3. As shown in he able, he conemporaneous effec of inflaion is found o be negaive and significan in Models 1, 3, and 4. The esimaed coefficiens sugges ha a 1% increase in inflaion rae lowers he unemploymen by 0.297, 0.464, and percen in he radiional (Model 1 and Model 3) and proposed model (Model 4), respecively. When i comes o he lagged erm of inflaion, such significan negaive effec persiss and is reinforced in Models 3 and 4; however, i reverses o significan posiive in Models 1 and 2. The lagged effec is significanly posiive presumably because overime he agens in he economy change heir behavior in accordance wih he inflaionary condiion. The coefficien of wages and is lag carries a heoreically inconsisen sign. Alhough is lag is no so saisically significan relaive o he inflaion, he coefficien of conemporaneous effec rejecs he null hypohesis a 10% significance level in our proposed model. In a growing economy wih he increase in produciviy, he demand for labor also may increase leading o higher wages and lower unemploymen. In he radiional model boh he coefficiens of real wage and is lag are negaive and significan as well. The main focus of his sudy is he coefficien of ineres rae. The lagged effec of a change in he ineres rae r is posiive and significan a he convenional level of significance (1%). Is conemporaneous effec, however, is insignifican a 10% level of significance. And hese wo erms keep posiive consisenly in he proposed model wih respec o Model 3. Table 4. The significance of differen facors in Model 4 Hypohesis i= i-1=0 (i=μ, w, r) i+ i-1=0 (i=μ, w, r) Wald es p-value i+ i-1 p-value μ ** *** W * ** r *** *** Noe: ***, ** and * indicae he values are significan a 1, 5 and 10% level of significance. References When we compare he goodness of fi of a radiional model (Models 2, 3, and 4) o he proposed model, we find ha in Model 4 (equaion 5) inclusion of he real ineres rae and he wage growh rae produces highes predicive power (adjused R 2 = 0.715). We also conduced a Wald es wih null hypohesis ha real ineres rae is redundan variable. The resuls of his es are repored in Table 4. As seen in Table 4, he esimaed F-saisics is , which is significan a he 1% criical level. This suggess ha he exclusion of he ineres rae variable would lead o a misspecificaion problem in he model. This finding furher validaes our proposiion ha any esimaion of he Phillips Curve should also include he changes in he real ineres rae, in addiion o any changes in he real wage and inflaion raes. Summary and conclusion This paper suggess ha any analysis of a Phillips Curve should include he real ineres rae, as well as inflaion and he real wage rae because any changes in he real ineres rae influence he labor inpu mix in he producion process, which ulimaely affecs he level of employmen in he economy. In order o jusify his argumen, an empirical model is developed, which includes he real ineres rae as one of he explanaory variables in addiion o inflaion and real wages. The model is esimaed using annual daa from he Unied Kingdom beween 1961 and The esimaed resul indicaes ha he ineres rae variable is indeed significan in explaining he Phillips Curve. In order o see if he omission of he real ineres rae leads o misspecificaion of he model, a Wald es for redundan variable is conduced. The esimaed F- saisics indicaes ha exclusion of real ineres rae indeed leads o a misspecificaion problem in he model. Significan coefficien of he real ineres rae and misspecificaion problem due o he exclusion of real ineres rae does suppor our proposiion ha any analysis of he Phillips Curve should include he real ineres rae in addiion o oher variables such as inflaion and real wages. Therefore, our research has added some informaion o wha we believe ha Rober Gordon (2006, 2009) and Gregory Mankiw (2006) have already been doing research on. The Unied Kingdom provides an especially ineresing sudy, in view of is significance o he hisory of hough of Phillips Curve, since A.W. Phillips (1958, 1961) had chosen he Unied Kingdom as he place for his seminal work. 1. Carlin, Wendy, and David Soskice (2006), Macroeconomics: Imperfecions, Insiuions and Policies, Oxford: Oxford Universiy Press. 2. Dell, Edmund (1996), The Chancellors: A Hisory of he Exchequer, London: Harper-Collins. 3. Douglas, S., Sock, J.H., and Wason, M.W. (1997), The NAIRU, Unemploymen and Moneary Policy. The Journal of Economic Perspecive, 11(1), Fair, R.C. (1999), Does he NAIRU Have he Righ Dynamics? American Economic Review, 89 (2),

5 Banks and Bank Sysems, Volume 5, Issue 1, Genle, Paul F. and James Novak (1995), Capial Effecs and Money Illusion: An Addiional Reason for he Exisence of Shor Run and Long Phillips Curves, paper compleed Auburn Universiy, Spring. 6. Genle, P.F., Paudel K.P., and Upadhyaya K.P. (2005), Real Wages, Real Ineres and he Phillips Curve. Applied Economics, 37(4), Genle, Paul F., Krishna Paudel and Kamal Upadhyaya (2008), Real Wages, Real Ineres Raes and he Phillips Curve: Evidence from Canadian Daa, Inernaional Economics, Vol. 60, 3, Augus, Gordon, R.J. (1990), Wha is New Keynesian Economics?, Journal of Economic Lieraure, 28 (3), Gordon, R.J. (2006), Macroeconomics, Tenh Ediion, Hong Kong, China: Pearson Educaion Asia, Addison Wesley. 10. Gordon, R.J. (2009), Macroeconomics, Elevenh Ediion, Hong Kong, China: Pearson Educaion Asia, Addison Wesley. 11. Gordon, R.J. (2008), The Hisory of he Phillips Curve: An American Perspecive, Norhwesern Macro Workshop, Sepember Homer, Sydney and Richard Sylla, A Hisory of Ineres Raes, New Brunswick, New Jersey: Rugers Universiy Press, Mankiw, N.G. (1993), Symposium on Keynesian Economics Today, Journal of Economic Perspecives, 7 (1), Mankiw, N.G. (2002), Macroeconomics, Worh Publishers, Inc., New York, New York. 15. Mankiw, N.G. (2006), Macroeconomics, Sixh ediion, New York: Worh Publishers, Inc. 16. Phelps, Edmund S. (1967), Phillips Curves, Expecaions of Inflaion and Opimal Unemploymen over Time, Economica, 34, Phelps, Edmund S. (1968), Money Wage Dynamics and Labor-Marke Dynamics and Labor-Marke Equilibrium, Journal of Poliical Economy, 76, July/Augus 4, 2, Phillips, A.W. (1958), The Relaion beween Unemploymen and he Rae of Change of Money Wage Raes in he Unied Kingdom, Economica, 25 (100), Phillips, A.W. (1961), A Simple Model of Employmen, Money and Prices in a Growing Economy, Economica, New Series, 28, 12, Snowdon (2005), Brian and Howard R. Vane, Modern Macroeconomics: Is Oigins, Developmen and Curren Sae, Chelenham, U.K.: Edward Elgar. 21. Unied Kingdom Recession hp:// record-gdp-conracion, Augus 20,2009. Appendix. Daa definiion and sources Variable Definiion Sources U Unemploymen rae WDI R Nominal ineres rae WDI µ Inflaion rae WDI r Real ineres rae (R - µ e ) 1 Esimaed W Real wage rae 2 WDI w Percenage change in W Calculaed Un Naural rae of unemploymen 3 Esimaed Noes: 1. μ e = expeced rae of inflaion esimaed regressing inflaion on is pas values. 2. Nominal wage adjused for changes in he price level. 3. Esimaed using following Douglas e al. (1997). WDI = World Developmen Indicaors from he World Bank. 91