Near-Rational Wage and Price Setting and the Optimal Rates
of Inflation and Unemployment
George A. Akerlof, William T. Dickens, and George L. Perry*
May 15, 2000
*The authors would like to thank Pete Kimball, Katherine Withers, Marc-Andreas Muendler, and
Megan Monroe for invaluable research assistance. We also thank Zarina Durrani for her patient
instruction in how compensation professionals make decisions and how they take inflation into
account. The authors wish to thank William Brainard, Pierre Fortin, David Romer, Maurice
Obstfeld, Robert Solow, and participants at seminars at Williams College, Georgetown
University, University of California at Berkeley, the Levy Institute and at the Bank of Canada for
valuable comments.
George Akerlof
is grateful to the Canadian Institute for Advanced Research,
the MacArthur Foundation, and the Brookings Institution for financial support. William Dickens
and George Akerlof also wish to thank the National Science Foundation for financial support
under research grant number SBR 97-09250.
1
Also see Phelps [1968] for analysis very similar to that of Friedman.
2
See Akerlof and Yellen (1985) and Mankiw (1985).
1
Near-Rational Wage and Price Setting and the Optimal Rates
of Inflation and Unemployment
George A. Akerlof, William T. Dickens, and George L. Perry
Over thirty years ago, in his Presidential Address to the American Economic Association,
Milton Friedman [1968] asserted that in the long run the Phillips Curve was vertical at a natural
rate of unemployment that could be identified by the behavior of inflation.
1
Unemployment
below the natural rate would generate accelerating inflation—above it, accelerating deflation.
Five years later the New Classical economists posed a further challenge to the stabilization
orthodoxy of the day. In their models with rational expectations, not only was monetary policy
unable to alter the long term level of unemployment, it could not even contribute to stabilization
around the natural rate (see, for example, Lucas [1973], Sargent [1973)].) The New Keynesian
Economics has shown that even with rational expectations small amounts of wage and price
stickiness permit a stabilizing monetary policy.
2
But the idea of a natural unemployment rate
that is invariant to inflation still characterizes macro modeling and informs policy making.
The familiar empirical counterpart to the theoretical natural rate is the nonaccelerating
inflation rate of unemployment, or NAIRU. Phillips curves embodying a NAIRU are estimated
using lagged inflation as a proxy for inflationary expectations. NAIRU models appear in most
textbooks and estimates of the NAIRU—which is assumed to be relatively constant—are widely
used by economic forecasters, policy analysts and policy makers. However the inadequacy of
such models has been demonstrated forcefully in recent years as low and stable rates of inflation
2
have coexisted with a wide range of unemployment rates. If there is a single relatively constant
natural rate we should have seen inflation slowing significantly when unemployment was above
that rate and rising when it was below. Instead, the inflation rate has remained fairly steady with
annual CPI-U inflation ranging from 1.6 percent to 3.0 percent since 1992 while the annual
unemployment rate has ranged from 6.8 to 3.9 percent. In this paper we present a model that can
accommodate relatively constant inflation over a wide range of unemployment rates.
Another motivation is a recent finding by William Brainard and George Perry (2000).
They estimate a Phillips Curve in which all the parameters are allowed to vary over time and find
that the coefficient on the proxy for expected inflation in the Phillips Curve has changed
considerably while other parameters of that model have been relatively constant. In particular,
Brainard and Perry found that the coefficient on expected inflation was initially low in the 50's
and 60's, grew in the 70's, and has fallen since then. The model we present below can explain
both why the coefficient on expected inflation might be expected to change over time and, to
some extent, the time pattern of changes observed by Brainard and Perry.
Our paper also allows an interpretation of the findings of King and Watson (1994) and
Fair (2000). Both find a long-run trade-off between inflation and unemployment. In addition,
King and Watson find that the amount of inflation that must be tolerated to obtain a given
reduction of unemployment rose considerably after 1970. Our model allows a trade-off, but only
at low rates of inflation such as those that prevailed in the 50s, 60s and 90s. At higher rates of
inflation no trade-off is apparent.
Much of the empirical controversy surrounding the relationship between inflation and
unemployment has focused on how people form expectations. This may be neither the most
3
important theoretical or empirical issue. Instead, this paper suggests that it is not how people
form expectations, but how they use them—even whether they use them at all that is the issue.
Economists typically assume that economic agents make the best possible use of the information
available to them. In contrast, psychologists who study how people make decisions have a
different view. They see individuals as acting like intuitive scientists, who base their decisions
on simplified abstract models (see Nisbett and Ross [1980]). But these simple intuitive models
can be misleading -- sometimes they are incorrect. Psychologists have studied the use of the
simplified abstractions, often called mental frames or decision heuristics, and the mistakes that
result from them. Economists should not assume absence of cognitive error in economic
decisions; nor should they assume that their own models and those of the public exactly coincide.
We propose that there are three important ways in which the treatment of inflation by
real world economic agents diverges from the treatment assumed in economic models. First,
when inflation is low, a significant number of people may ignore inflation when setting wages
and prices. Second, even when they take it into account, they may not treat it as economists
would assume. In particular, we hypothesize that the informal use of inflationary expectations in
wage and price decisions leads to less than complete projection of anticipated inflation, with
consequences for the aggregate relation between inflation and unemployment. Finally, we believe
that workers have a different view of inflation from that of trained economists. Workers see
inflation as increasing prices and reducing their real earnings and they do not fully, if at all,
appreciate that inflation increases the nominal demand for their services. Thus they have a
tendency to view the nominal wage increases they receive at low rates of inflation as a sign that
their work is appreciated and to be happier in their jobs as a result. They may also be unaware of
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