The Suntory and Toyota International Centres for Economics and Related Disciplines

Employment, Inflation and Growth Author(s): A. W. Phillips Source: Economica, New Series, Vol. 29, No. 113 (Feb., 1962), pp. 1-16 Published by: Blackwell Publishing on behalf of The London School of Economics and Political Science and The Suntory and Toyota International Centres for Economics and Related Disciplines Stable URL: http://www.jstor.org/stable/2601516 Accessed: 08/11/2008 10:51
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1962]

Employment, Inflation and Growth'
By A. W. PHILLIPS
1. INTRODUCTION

Since the end of the second world war economic policy and controversyin Britainhave been directedto ways of attaininga number of related objectives,prominentamong which are the maintenance reasonablestabilityof the of a high and stable level of employment, averagelevel of final productprices, a fairly rapid rate of economic balanceof foreigntradeand reasonablestability growth,a satisfactory of foreign exchangerates. It can hardly be claimed that there has been complete success in the attainmentof these objectives. It is has at high level. true that employment been maintained an extremely since 1948 has been little more The averagelevel of unemployment than 12 per cent. of the work force. This is probablya lower level than that attainedin any single year in peace time of unemployment during the previous century, except perhapsin 1872. Even in the of tradecyclethe percentage tradeunionists boom yearsof the pre-war rarelyfell below 2 per cent. and over the 53 years from unemployed 1861 to 1913it averaged42 per cent. The actions taken to improve the stability of the system have also had some measureof success. Beforethe first world war there was a fairly regulartrade cycle with an averageperiod of about eight years, during which trade union fluctuatedbetween about 2 and 10 per cent. Since unemployment the second world war the cyclical movementsin economic activity have becomemore rapid,with a period of four or five years, but the fluctuationshave been smaller. Unemployment,indeed, has only fluctuatedbetweenabout 1 per cent. and 21 per cent., that is, over a in range of about 12 per cent., but the percentagefluctuations gross nationalproductabout the growth trend have been about five times as large as this,2the range of the fluctuationsas a percentageof the trend being about 7 or 8 per cent. Between 1948 and 1960, gross national productincreasedat an averagerate of about 2i per cent. per annum and productivityper man hour at perhaps 1l per cent. per annum. Thoughthese rates of increaseprobablycomparefavourably with those in earlierperiods of British history they are lower than those of a number of other industrialcountries in the same period. The averagerate of rise of the retailpriceindex between1948 and 1960was 3.7 per cent. per annum. Therewould be fairlygeneral that this rate of inflationis undesirable.It has undoubtedly agreement
1 Inaugural lecture given at the London School of Economics and Political Science on 28th November, 1961. 2 See F. W. Paish, " Output, Inflation and Growth ", to be published. 1
A

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beena majorcauseof the generalweaknessof the balanceof payments and the foreign reserves,and if continuedit would almost certainly make the presentrate of exchangeuntenable. that It is my belief that one of the main reasonsfor the difficulties have been experiencedin devising and implementingappropriate economic policies is lack of adequate quantitativeknowledge and of understanding how the economicsystemworks. Of course, econin omists do understand, a generalsort of way, quite a lot about the workingof the economicsystemand do now have a mass of quantitative informationabout importanteconomic variables. But in order and to bring this knowledgeto bear on the problem of formulating we a attaining consistentset of policyobjectives requirealso knowledge relationsbetweeneconomicvariables. In particular of the quantitative to relationshold betweenthose it is necessary know what quantitative economic variableswhich are either the objectivesof policy or the instruments throughwhich we attempt to attain the objectives. For example,if some relationholds, in given institutionalconditionsand on averageover a period of years, betweenthe level of employment and the speed of inflation,failureto take account of it may lead to the adoptionof inconsistentobjectivesand to a type of schizophrenic behaviouras attempts are made to attain these inconsistentaims. Knowledgeof the relation would lead either to modificationof the objectivesto make them consistent or perhaps, since an economic of relationis only the resultof fairlyregular patterns humanbehaviour, to some modificationof institutionsor behaviourwhich would alter the relation so as to permit some more desirablecombinationsof is consistentaims. Or again, if at a certaintime unemployment felt interestrates are loweredin order to to be too high and short-term raise the demand for goods and so for labour, how large will the effects be and when will they occur; will the higher demand also and lead to an increasein fixedinvestment if so how large an increase and afterwhat intervalof time; will wage rates and pricesrise more rapidly as a result of the higher demand; if internal demand and pricesrise will importsrise and exportsfall, and if so when and by to how much? If we are to assessthe effectsof our attempts influence the course of economic affairswe need answers,numericalanswers, to questionslike these. If we do not have this knowledgethe policy in will almost certainlybe inappropriate magnitudeor adjustments timingor both and may well cause,as I believethey have often caused and in in the past, unnecessary harmfulfluctuations economicactivity. We may obtain tentative estimates of a quantitativerelation in economics by making a preliminarysubjectiveanalysis of human motivationand behaviourand then carryingout a statisticalanalysis of relevantdata from past records. We also need to investigatethe degreeof errorthat theremay be in the estimate,the extentto which the relationin successiveshort time periodsdepartsfrom its average overlongerperiodsand whetherthereis any evidencethat the average

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relation changesin any systematicway throughtime. On the basis estimatesof this sort it is possibleto set up simplified of quantitative models of the economic system and by studying the propertiesof differentmodels with a variety of policy relationshipswe can form types of economic some judgementof the likely effectsof alternative studyof economicrelationsand the quantitative policy. The empirical investigationof the behaviourof models of economic processesare recent developmentsin our subject. The knowledge comparatively which have so far been gained are far from being and understanding adequate for a firm and detailed appraisalof economic policy. I think they do, however,make possible some attemptat clarification of the problemswe face and justify some suggestionsfor methodsof dealingwith them.
2.
SOME GENERAL PRINCIPLES OF FLUCTUATIONS AND STABILITY

The first policy objectiveI should like to consideris that of maintaining a stable level of employment; but before proceedingto this it seems desirableto illustratesome generalpoints about equilibrium, in stabilityand fluctuations the simplestpossibleway. Let me therefore consider a single commoditywhich is being continuouslyproduced market. and consumedand whichis tradedon a perfectlycompetitive functionof price, Assumethat the rate of productionis an increasing functionof price and that the is the rate of consumption a decreasing to rate of changeof the price is proportional the excess demand,i.e., minusthe rate of production. This is the to the rate of consumption simpletext-bookexampleof supplyand demandin a singlecompetitive stated,and has indeedbeen statedwith some market. It is frequently and as economists Walras,Marshall Wicksell, by emphasis sucheminent stable,i.e., that it alwaystends to an that such a systemis necessarily in equilibrium whichthe priceis suchthat the ratesof productionand is are consumption equal. The argument usuallyvery simple. Suppose the systemis not in equilibrium;for example,supposethereis excess demand. Then the price will rise. This will increaseproductionand and reduceconsumption so reducethe excessdemand. Sincethe price continuesto rise so long as there is any excess demandand any rise in price reduces the excess demand the process will continue until the excess demandis eliminated. In brief; the existenceof any discrepancybetween productionand consumptioncauses a movement in price which tends to correctthe discrepancy. Therefore,the arguis, mentruns,the systemis stable. This argument of course,fallacious except on the assumptionthat the completeresponseof the rates of productionand consumptionto any change in price occurs instanthe taneously. If thereare any time lags in any of the responses system will the willusuallyfluctuate.Whether fluctuations die awayor whether and they will increasein amplitude tend to some regularand sustained limit cycle dependson the preciseformsof the time lags, on the slopes

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of the supplyand demandcurvesand on the speed at whichthe price changeswhen there is a given excess demand. The competitivemodel which we have been considering,and other models of economic processesare, in so-called" self-equilibrating" fact, examplesof what are knownin otherfieldsof studyas " negative feed-backcontrol systems". In order to see intuitivelywhy these systemsare often oscillatoryand may well be unstable(whichmeans in practicethat they tend to producefairly large and regularcyclical movements)let us consider again the competitivemarket. Assume this timethat somefactorotherthanpricecausessmallcyclicalchanges in productionor consumption,so that excess demand is alternately positiveand negative(see curve a of Figure 1). We shall call this an exogenousmovementof excess demandand see what furthermovements in excess demandwould be induced by price changes which dependedonly on this exogenousmovement. In otherwordswe shall movementsin excess find what would usuallybe called the corrective demandwhich result from the price changescaused by the exogenous in movements excess demand. Since we are assumingthat the rate of to changeof priceis proportional the exogenousmovementsin excess demand,the rate of changeof pricewould have the sametime pattern as the exogenousmovement. The price itself, however, would lag behindthe rate of changeof priceby a quarterof a cycle (see curveb)

a. Exogenous movement,and rate of change of price +

b. Price +

C.Induced movement,with no time lag +

d. Induced movement, with time lag Figure 1

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since the price would be at its maximumwhen its rate of changewas zero and changingfrom positiveto negative,and would be at a minimum when its rate of changewas zero and changingfrom negativeto to positive. If the completeresponseof productionand consumption the any change in price was instantaneous, excess demand induced by the movementsof price would be at its minimumwhen price was at its maximumand vice versa(see curvec). Suppose,however,that respondedto changes in price with a productionand consumption time lag equal to one quarterof the period of the cycle. Then the excessdemandinducedby the pricechangeswould be exactlyin phase in with the exogenousmovements excessdemand(see curved). Instead of tendingto offset or correctthe exogenousmovement,the induced or in changeswould tend to accentuate amplifythe fluctuations excess plausible, demandcausedby the exogenousmovement. It is intuitively and can in fact be proved,that if, in this case, what are usuallycalled or the equilibrating correctiveforces are strong enough to make the amplitudeof the inducedmovementsin excess demandgreaterthan the of movements, systemwill be unstable, the amplitude the exogenous will increaseand tend towardsa regularand that is, the fluctuations sustainedlimit cycle. which affect economic The exogenousmovementsor disturbances activityare not usually,of course,of the simpletype assumedin this or example. They are more likely to be of a ratherarbitrary random or whichcanbe described only in termsof a statistical stochastic pattern by can,however,be analysed, a methodknown process. Suchprocesses as spectral density analysis, into cyclical componentswith periods from zero to infinity. If disturbances rangingover the whole spectrum any of this sort operateon the modelwe havebeenconsidering, cyclical componentwhose periodis such that the time lag in the responseof excess demand to price results in a lag in the neighbourhoodof a quarterof the cyclical period will be amplified,while cyclical componentswhose periodsare widely differentfrom this will be reduced strong the in amplitude. If the " correctingforces" are sufficiently or withina particular rangeof frequencies periods cyclicalcomponents to will be amplified such an extentthat they will dominatethe market movements,which will then exhibit large and somewhat irregular fluctuations,in which, however, cycles with this particularrange of will predominate. periodicities that I should like Thereare two more mattersof some importance of and to referto whiledealingwith the generalprinciples fluctuations stability. The first concernswhat I shall call the form or distribution of the time lags. Supposethe pricein the commoditymarketwe have was been considering constantfor a long time and then suddenlyrose would constantat the new level. The rate of production and remained eventuallyincreaseto some higher value, but there are any number of time pathsthat this increase mightfollow. For example,production might start to rise immediatelyand continue to rise at a gradually

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diminishingrate, or it might remain constant for a while and then increasegradually,or it might remainconstantfor a longer time and then increasevery suddenly(see curves a and b and c in Figure 2). Now it can be shown,but by methodswhichI shall not inflicton you here, that the existenceof a time lag of the firstform in the corrective process is much less likely to cause fluctuationsand instabilitythan a lag of the second form, and a lag of the second form is less likely

Price

c Production
Figure 2

to cause these troublesthan is the third form of lag. An important rule in devisinga correctivesystem is thereforeto get the corrective it startedimmediately discrepancy is intendedto correct the adjustment beginsto be observed. Provideda fair proportionof the effectof the correctiveaction is obtainedfairly quicklyit does not much matter if the remainingeffectsare delayed; but it does mattervery much if action itself or all of its effectsare delayed. the corrective The secondmatterwhichI shouldlike to deal with brieflyis that of action. It is perhapsbest introduced by alternative types of corrective askingwhat would happen if in the simple commoditymodel which earlierit was the priceratherthan the rate of changeof we considered pricewhich dependedon the excessdemand. We see from the curves that the price movementswould occur a quarterof a cycle earlieras a result of this modification,and the induced movementsin excess demandwould no longer be in phasewith the exogenousmovements, effects of the inducedmovementswould be so that the destabilising reducedor eliminated. Dependingon the form of the time lag, it might or might not be possible to find a cycle of higher frequency, that is, of shorterperiod,for which the lag in the responseof excess demandto pricewas half a cycle insteadof a quartercycle. If so, an movement this higherfrequency of wouldlead to an induced exogenous in movement phasewiththe exogenousmovementand if the amplitude

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of the inducedmovementwas sufficiently large instabilitycould still occur at the higherfrequency. But since most forms of time lag are in effect weightedaveragesand tend to producea low amplitudeof responseto high frequencycycles the likelihoodof cyclicalinstability would be reduced. On the other hand this form of correction,which is called proportional control,could neverensurethat productionand consumptionwere brought into equality, since the price would be constant if excess demandwere constant, even if it were not zero. However, a combinationof proportionalcontrol and the type of correctionused before, which is called integral control, overcomes this difficulty givesbetterperformance and than integralcontrolalone. We may go furtherin this directionand considerthe effectof adding to the correctiveaction a componentbased on the rate of change of in excessdemand. Sincethe fluctuations the rateof changeof a cyclical variablelead the fluctuations the variableitself by a quarterof a in of cycle,this component corrective action,knownas derivative control, has a somewhatsimilareffect to that which would be obtained by action on a forecastof excessdemand. A derivbasingthe corrective ative componentof controlis used in combinationwith proportional and integralcomponentsin most negativefeed-backcontrol systems. combinationof the three componentsit is usually By an appropriate of possibleto obtainvery good regulating performance a system,with correctiveactions based only on the actual values of the variables and their rates of change in the immediatepast, and without any recourseto predictedvalues or forecasts. 3.
FLUCTUATIONS IN EMPLOYMENT AND ECONOMIC ACTIVITY

I hope I have not boredyou too muchby this ratherlong and somewhat technicaldigressionon the generalprinciplesof fluctuations and of is stability. But I think some understanding these principles helpful in a discussionof the stabilityof employmentand economicactivity. which affect employmentand activity For the correctiveadjustments in the whole economy, whetherthey be inherentin the working of of instruments policy, are again the economyor appliedas deliberate examplesof control by negativefeed-back. The use of forecastsin affectthis statement,since the forecasts policy does not substantially are themselveslargelybased on observationsof the economy and its movementsin the recent past. Indeed,given the presentstate of the art of forecastingI believe that better results might be obtained by of action directlyon observations the econbasing suitablecorrective omy and its changesrather than on forecastswhich are themselves fromthoseobservations. largelyderived,perhaps dubiousprocesses, by Even if there were no specialfeatureswhich might accentuatedisin turbancesand fluctuations the economyas a whole, it could not be assumed that the existence of corrective adjustments,even quite would stabilisean economy. If they powerfulcorrectiveadjustments, operate with long time lags, and especiallyif there are long delays

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beforethey commenceto operate,they will cause cyclicalfluctuations, and the strongerthe correctiveforces the more violent will be the among economists fluctuations. But thereis fairlygeneralagreement the that thereare specialfeaturesof an economicsystem,in particular in multiplierprocess and adjustments inventoriesand capital equipdisturbances tend to causecyclicalfluctuaand ment,whichaccentuate tions. These featuresincrease the need for deliberatestabilisation policies, but also make it more difficultto devise suitablepolicies. The problem is best studied by investigatingthe propertiesof a variety of models in which use is made of the limited amount of knowledgeat presentavailableabout economicrelationquantitative ships. The work involved in such investigationsis greatly reduced and the range of possible models is widenedby the use of modern electronicequipment. The results obtained in this way cannot, of I course,be conclusive,but from the investigations have done so far confidencein two simple propositions. The first I have considerable is that correctiveaction taken in an attemptto reducethe anmplitude of the short cycle of four or five yearswhichis typicalof the post-war period is not likely to be successfulunless it is based on recently observedrates of changeof economicactivityas well as on the level actionis appropriate of activity. The otheris that evenif the corrective unless a fair proportionof in this respectit will still be unsuccessful its ultimatedirecteffecton demand,say about a quarterof it, occurs of withinthreeor fourmonthsof the occurrence the errorit is designed to correct, and at least one half of the full effect within about six months. Let us examinesome of the existingmeans of influencingdemand in the light of these requirements. The response of investmentto changesin monetaryconditionsand interestrates is almost certainly delayedand slow. There is probablya delay of some monthsbefore decisionsto invest are significantly affectedand with most types of investmentthere is probably a further long time lag between the decisions to invest and the actual productionof capital goods. If are ratherthan reduced this is so, fluctuations likely to be intensified by attemptsto correctthem throughoperatingon long-terminterest in ratesand investment fixedcapital. This does not mean that interest rate policy is unimportant.I believeit has a vital role to play in the slower adjustments requiredas a result of changes in the desire to the level of employment save or invest,and thus in influencing average rate andthe average of changeof the priceleveloverfairlylong periods. It is more difficultto judge the effect of operatingon short-term credit and short interestrates. Adjustmentsin these can be made more quicklythan in long rates, and to the extentthat they affectthe desire or ability to hold inventoriesthey might have a significant effect on production within two or three months. But I think much work will be needed before one can judge with conmore empirical fidencethe magnitude, speed and reliabilityof these effects. I suspect

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in that if fairly large and rapid adjustments short-termcredit conditionsweremadein responseto both the level and the rate of change of economicactivitythey would help to reducethe amplitudeof the of short cycle. But there is a difficultyin using adjustments shorttermcreditandinterestratesfor this purpose. Shortrates,and perhaps to a lesser extentcredit,are closelyrelatedto bank rate, and the level of bank rate is often made to depend as much on the state of the foreignreservesas on the internalconditionof the economy. To the are in extentthat fluctuations the foreignreserves the resultof fluctuations in the balanceof tradethey will tend to lag behindfluctuations in the balanceof trade by a quarterof a cycle. Since the balanceof trade moves fairly closely with internal activity, fluctuationsin the reservestend to lag behindinternalactivity,so that changesin bank of correction economicfluctuarate tend to be too late for satisfactory tions. My conclusionconcerningmonetarypolicy is thus similarto that
of the Radcliffe Committee;' " . . . monetary measures cannot alone

be relied upon to keep in nice balancean economy subjectto major strainsfrom both without and within. Monetarymeasurescan help, but that is all ". My reasonsfor this conclusionare perhapsa little fromthose of the Committee.I thinkthat changesin interest different rates and credit conditionsprobablydo have quite powerfuleffects on demand, but that their usefulness for correcting short-period is fluctuations seriouslylimitedas a result of the long time lags in the to responseof investment changesin interestrates, and in the case of credit as a result of the temptationor need to make the adjustments in responseto the state of the foreignreservesratherthan at the times appropriateto the correction of fluctuationsin internal economic activity. Much more researchwill have to be done, however,before the last word is said on these matters,and I would heartilyendorse
the Committee's statement2 that " . . . it is essential to have much

greaterand more systematicknowledgeof the factors that make up ". the financialsystemand of theirrelativemovements Turningto fiscal methods of influencingdemand, it is clear that I throughannual budgetsdo not meet the requirements adjustments cycles. Budgetchanges have stated for the correctionof short-period have probablyplayed some part, together with monetarypolicy, in days, though the overcoming more severeand longercyclesof pre-war of this may have come about as muchthroughthe confidence business men that the budgetcould and would be used to averta severeslump, with the consequent greater stability of their investmentplans, as of throughthe actual use of budgetchanges. The recentintroduction of purchasetax as a regulatingdevice is a more generaladjustments promisingdevelopment. It suffers,however,from two defects; the
I Reportof the Committeeon the Working the MonetarySystem, Cmnd. 827, of (1959), p. 183. 2 Ibid., p. 336.

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and ratherarbitrary limitedrangeof goods affected,and the fact that when demandis high there might be expectationsof an increasein purchasetax which would lead to a furtherincreasein demand and of when demandis low there might be expectations a decreasein tax which would furtherdiminishdemand.Hire purchasecontrols suffer even more severelyfrom these defects. at None of the fiscal instruments presentin use satisfiesthe conditions for a satisfactorymeans of correction. If the purchasetax were changedinto a generalsales tax and adjustedby small amounts alternative at frequentintervalsit would do the job. But a preferable would be the introductionof adjustmentsof direct taxes. A fairly simple way of adjustingdirect taxes would be to calculateevery tax to be paid in exactlythe sameway as is now done and then to add or to subtracta certainpercentage the calculatedfigureas a stabilisation adjustment.In the case of P.A.Y.E., which is calculatedon the basis of income and allowancescumulatedfrom the beginningof the tax in year,the figureaddedor subtracted eachpay periodas a stabilisation would be kept separate from the figurefor the normaltax adjustment tax and wouldbe neglectedin formingthe cumulated paid. The figure calculatedfor the normaltax in each pay period would thus not be and adjustments, no changewould be affectedby earlierstabilisation needed in existingP.A.Y.E. tables or in the method of using them. to The percentage be added or subtractedcould be changedif necessary at regular intervals; qaarterlyintervals might prove to be shortenough,thoughchangesat monthlyintervalsshouldbe possible. In this case those P.A.Y.E. taxes which are paid quarterlyshould be in prevailing the preceeding by adjusted the averageof the percentages for three months. Similarlyall annual assessments direct tax should be calculatedas at present and then the average of the percentage overthe yearappliedto this figure. Sufficiently prevailing adjustments fine adjustmentwoald probably be obtained if the changes in the to percentage be added or subtractedwere made in steps of 2-. per cent.,i.e., sixpencein the pound. The absolutevalueof the tax adjustmentwould of coursebe muchlargerfor a personwith a high income from the point than for one with a low income. This has advantages is of view both of equityand of efficacy; the largeradjustment needed to inducethe personwith the higherincometo changehis expenditure. in difficulties introducing Therewouldno doubtbe someadministrative a schemeof this sort, but once it was in operationthe additionalwork involvedwouldnot be verygreat. I believethat the choicelies between acceptingthe minor inconvenienceof such a scheme and accepting the continuationof the fluctuationsin employmentand economic since the war. activitywhich we have experienced
4.
EMPLOYMENTAND INFLATION

in fluctuations employment and econI have so far been discussing omic activitywithout any referenceto the averagelevel about which

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employmentis fluctuating. Considerationof the average level of employment bringsus to the questionof the relationsbetweenemployment, or unemployment, inflationand the rate of growth. In the and past few years a numberof people have carriedout empiricalstudies of the relation betweenunemployment, some other index of the or demandfor labour,and the rate of changeof wage ratesor earnings. Somewhat different methods and hypotheses have been used by different people. In my own verycrudeattemptto studythis relation' I assumedthat changesin the cost of living only affectwage changes in years when prices are risingrapidly,usuallyas a result of rapidly have assumedthat changesin the cost rising import prices. Others2 effecton wage ratesin everyyear. For of living have a proportionate nearerthe truththanthe assumption the post-war yearsthis is probably I used. But we must then recognisethat changesin the cost of living are in turn mainlythe resultof earlierchangesin wage rates and to a lesser extent of changes in import prices. If these two behaviour data we can proceedto eliminateprice relationsare fittedto empirical wage changesin terms changesand obtaina singlerelationexpressing we of unemployment and changes in import prices, or alternatively may eliminatewage changes and expressprice changes in terms of unemploymentand changes in import prices. These new relations relations,but they are valid relationsfor are not, of course,behaviour prediction purposes,and areindeedin the most usefulform for predicas relation tion. The relationI obtainedis best considered a prediction in of this sort. If the other studiesare also interpreted this way there is reasonableagreement the resultsobtained. It seems that if the in were kept at a little less than 2-1per averagelevel of unemployment cent. the averagerate of increasein wages over a period of years could be expectedto be about 2 per cent. per annumso that with the since the war the average rate of increaseof productivity experienced level of priceswould be almost constant. Also, in the range between for 1-1per cent. and 2-- per cent. unemployment, every 0. 1 per cent. was that the averagelevel of unemployment reduced, wages and prices wouldrise at about 6. 3 per cent. per yearfaster. If it is true that such choice. Thenwe can only a relationholds we are facedwith a difficult at reduceinflation,for any given rate of increaseof productivity, the cost of higherunemployment.I think such a relationdoes hold now, and unless it can be changedwe shall probably move towards a compromisesolution with a ratherhigheraveragelevel of unemployment than in the past few yearsand a lower, thoughnot zero, speed
1 " The RelationBetweenUnemployment and the Rate of Changeof MoneyWage Rates in the United Kingdom, 1861-1957", Economica,vol. xxv (N.S.), (1958). 2 See L. A. Dicks-Mireauxand J. C. R. Dow, " The Determinantsof Wage Inflation: United Kingdom, 1946-56 ", Journal of the Royal Statistical Society, vol. 122 (1959); L. R. Klein and R. J. Ball, " Some Econometricsof the Determination of Absolute Prices and Wages ", EconomicJournal,vol. LXIX (1959), and R. G. Lipsey," The Relation BetweenUnemploymentand the Rate of Changeof Money Wage Rates in the United Kingdom, 1862-1957: A FurtherAnalysis", Economica, vol. xxvii (N.S.), (1960).

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of inflation; perhaps about 2 per cent. unemploymentwith about 1 per cent. per yearrise in prices. To consider whetherthe relation can be modifiedwe must know why it is that wagescontinueto risewhilethereis significant unemployment. A numberof possiblecausesare often mentioned,in particular lack of mobilityof labourandindustry, resulting unevengeographical in and occupationaldistributionof unemployment, competitivebidding by employersfor the most suitablelabour and-trade union pressure. The mobility of labour and industrywould be increasedif geographicaland occupational movementsin relativewages were allowed to take place more freely. If wages in areas and occupationswhere is unemployment low or excess demandis high rise more than those is whereunemployment high or excess demandis low, therewill be a greaterincentivefor labour to move to the areas and occupationsin which wages have risen most, and for industryto move to the areas wherewageshaverisenleast, and also for industryto adaptits production methodsto use more labourin those occupationsin whichwages have risen least. Competitivebidding up of wages in a particularoccupation and area by employers can easily occur even when some labour in the same occupationand area is unemployed. The basic reason for this is the wide range of abilitythat exists amongdifferent individuals in the same occupation. Somepeople,even in a singlenarrowoccupational classification,are worth to an employer considerablymore than the averagerate of pay in the occupation; othersthroughindividual defects of character, intelligenceor physique,are worth less. A wide awake employerwill often find it profitableto pay 5 or 10 per cent. above the averagerate of wages for a particular class of labour in his locality. In this way he can choose the best men and may well whoseproductivity 10 or 15 per cent. above is finishup with employees the average. If a large proportionof employersadopt this practice wages may be bid up quite rapidly even when there is a significant amount of unemployment. The best solution would seem to be to allow more flexibilityin the wages paid to differentindividuals the in same occupation. The fourth possiblereason I mentionedfor wage rates rising when there is significantunemploymentwas the power and pressure of tradeunions. I have some doubtswhetherthis has been an important the factor,but if it has, and if the tradeunionsfully understand results of their actions, it can only be counteredat the cost of occasional use major strikes. But have the results of an irresponsible of their ? powerbeen made clear to trade unions by Governments If it were widely and clearly understoodamong the membersof trade unions that the full use of their power to force up money wages would only to lead, at a given level of unemployment, a faster rate of inflation and that the Governmentwould have no alternativebut to check this higherrate of inflation,in part at least, by loweringdemandand

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it causing some increasein unemployment, seems possible that the tradeunionsmight see wheretheir trueinterestslay. I am not so naive as to expectthat the suggestions have made for I trying to shift the relation betweenemploymentand the rate of rise of wage rates in a way which would make it possible to maintaina with anygiven speed of inflationarelikely higherlevel of employment to meet with an enthusiasticresponse. They are all suggestionsfor moreflexiblearrangements whichwould allow freerplay to the market forces of supply and demand. But for at least a centuryand a half beforethe secondworldwar wage-earners had frequently a prettyraw deal from the marketforces of supply and demand,for in most of the yearsof the tradecycle,and especially the catastrophic in inter-war years, there was a deficiencyof aggregatedemand. The traditions built up over that period still persist and will continueto persistfor some yearsyet. But in due courseit may be realisedthat continuously rising standardsof living come only from continuouslyrising productivity and that provided the Governmentis not prevented by a inflationfrommaintaining high aggregate level of demandfor labour the marketforcesareno longerharmfulbut play a vital partin helping adaptationand progress.
5. EMPLOYMENT AND GROWTH

I have suggestedthat a slightlyhigher averagelevel of unemploymentthanthat whichwe havehad in the last few years,perhapsa little over2 per cent.,may be acceptedas a necessary conditionfor moderating the speed of inflation. One often hearsheated arguments against checkinginflationin this way, on the groundsthat if the rateof growth of the economy were more rapid prices would not rise so fast, and that the rate of growthwill be reducedby operatingthe economy at a slightlylowerlevel of employment.It is true,of course,that a higher rate of growthwith the samerate of changeof wages would lead to a lower speed of inflation. It is also true that while unemployment was let actuallyincreasing, us say from 1 per cent. to 2 per cent., output would be risingless rapidlythan it would have been if unemployment had been kept at 1I per cent. But the argumentis often phrasedas if the steadyrate of growthof the economywith unemployment constant at 2 per cent. would be less than the steadyrate of growthwith constantat 12 per cent. I doubt whetherthis is true. unemployment the During short-period cyclicalfluctuations variationsin outputas a percentageof the growthtrend are about five times as large as the variationsin the percentage is unemployment.The difference largely accounted for by variationsin short-timeand overtime; by some people, mainly marriedwomen, moving into and out of the labour force; and by " hoarding" of labour during a recession which is were to rise by 2 per cent. expectedto be short. If unemployment and stay at the new level, the hoardingof labour and some of the initial change in short-timeand overtimewould be only temporary

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and when the adjustmentswere completed the percentagefall in output would be considerably than five times the increasein ihe less percentage unemployment. accountweretakenof the valueof leisure If the fall in real incomewould be still smaller,sincethat part of the fall in outputwhichwas due to a reductionin overtimeand movementof people out of the labour force would be partly compensatedby the value to the people concernedof the extra leisure. If an increaseof i per cent. in unemployment causeda decreaseof 12 per cent. in output, with equal proportional decreasesin investmentand non-investment expenditures, investmentwould fall by 1 per cent. of its own to value, and assumingthat the growthrate was proportional investment the growthrate would also decreaseby 1I per cent. of its own from2.5 percent.to 2.4625 percent.; an extremely value,for example, small decrease. If all the decreasein outputresultedfrom a decrease in non-investment expenditure there would be no change in the rate of growth.The main conclusionfrom this is that the difference the in to steadystateratesof growthbeforeand afterthe transition the higher unemployment would be extremelysmall if the growth rates were proportionalto investment. Other influences,such as possibleextra incentiveor compulsionto invest in cost-reducingequipmentmight easilyoutweighany small difference to the slight changein investdue ment. It is sometimesargued that the decreasein demand would slow down growthby reducingthe desireof firmsto invest; but this could always be remediedby reducinginterestrates. Indeed since we are assumingthat a Governmentcould hold unemployment the new at level, investmentin the new steadystate, as in the earlierone, would have to be broughtinto equalitywith savings. It is on the willingness to save, and the more generalinfluencesof educational improvement, research, so on, that the rate of growthdependsin presentcircumand stances. I do not think that very small changesin aggregate demand have much effecton these. and unemployment
6.
RATES OF EXCHANGE

The final questionI wish to discuss,very briefly,is that of rates of of haveproblems employexchange.The othermajortradingcountries ment,inflationand growthwhich are similarto those of Britain. The questionariseswhetherall countriesare likely to hold that balanceof of internalobjectiveswhichwould be consistentwith the maintenance fixed exchangerates. Professors Samuelson and Solowl have considered the relation betweenunemployment the rate of changeof the consumerprice and indexin the United States. Theirtentativeconclusionis that assuming of continuation the conditionsof the post-warperiod the price index were held at 5 to 6 per cent., and might be stable if unemployment
I P. A. Samuel.on and R. M. Solow, " Analytical Aspects of Anti-Inflation EconomicReview,vol. L, no. 2 (1960). Policy ", American

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were might rise at about 2 per cent. per annum if unemployment 4 per cent. Some estimateswhichI have made lead me to think that the situationin the UnitedStatesis less favourable thanthis. I estimate that 7 to 8 per cent. unemployment would be needed to maintaina stable price level, and that at 4 per cent. unemployment price the level would rise at about 4 per cent. per annum. Of course efforts to increasethe rate of growthand to reducestructural unemployment may improvethe relationbetweenunemployment price changes; and but unless my estimatesare badly out or considerable improvements is are obtainedit seemslikely that if unemployment reduced,as seems to be hoped, to 4 or 5 per cent., the United States may well have a rather faster rate of inflation than Britain would have with 2 per cent. unemployment. In Germanysimilarproblemsare beginningto appear. Unemployment has fallen steadilyfrom about 10 per cent. in 1950 to 1.2 per cent. in 1960, and labour costs are now rising rapidly. The growth to rate is still high but some specialfactorswhichcontributed it, such as reconstructionafter the war and the currency difficulties,and availabilityof skilled labour from unemployedor from refugees,are passing. It may well be that in Germanytoo the problemof choosing betweeninflationand unemployment become acute. These three will countries,and others, may perhapsbe preparedto adjust their own choices about internalbalancein orderto make them consistentwith a regimeof fixed exchanges. But I have some doubts whetherthey to will be prepared do so, or if they are whetherthey in fact know the quantitative workingsof their own and other economieswell enough to choose the appropriateobjectivesbefore gradual divergenciesin to pricelevelshave cumulated such a degreethat they imposea heavy strain on the international monetarysystem. If this is so, it might be betterto allow a limitedflexibilityinto the exchangesystem,so that gradualdriftsin relativeprices,whichwould probably be at a rateof morethan 1 or at most 2 percent. peryear, not in would not producecumulative disequilibria balancesof tradewhich necessitate might eventually large and suddenmovementsof exchange monetarysystem. A rates and do seriousdamageto the international limited flexibilitycould be introducedby an agreementthat the par in value of any one currency, termsof gold, could be changedat any time providedthe total changein one directionin any periodof twelve monthsdid not exceed1 percent. Therewould,I think,be muchmore that a countrycould in fact work withinthis rule than that confidence it could for ever succeed in keeping the par value constant, so the fear,or hope, of a suddenlargechangein the rate,with the tremendous speculativemovementsit causes, would be greatly diminished. The rate of change of the par rate, 1 per cent. per maximumpermissible so year, could easily be offset by short-terminterestdifferentials, it of neednot lead to any majortransfers capital. And this limiteddegree of exchangeflexibilitywould allow each countrytime to find by trial

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betweenits internalobjectiveswhich was and errorthat compromise consistentwith its exchangerate policy. of I said at the beginning this lecturethat I believedone of the main economicpolicies difficulties devisingand implementing in appropriate of knowledgeand understanding how the econis lack of quantitative at omic systemworks. By now I have no doubt amplydemonstrated and any rate my own lack of knowledgeand understanding, it only remainsto apologiseto any of you who may have come hereexpecting clear and definiteanswersto the problemsI have been discussing. I hope the next personto face the ordealof givingan inaugurallecture on electionto the Tooke Chairwill be in a position to explainthese mattersmore clearly.
The London School of Economics.

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