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WORKING PAPER SERIES NO. 441 / FEBRUARY 2005 THE PHILLIPS CURVE AND LONG-TERM UNEMPLOYMENT by Ricardo Llaudes CONTENTS
WO R K I N G PA P E R S E R I E S N O 4 / F E B R UA RY 0 THE PHILLIPS CURVE AND LONG-TERM UNEMPLOYMENT by Ricardo Llaudes WO R K I N G PA P E R S E R I E S N O 4 / F E B R U A RY 0 THE PHILLIPS CURVE AND LONG-TERM UNEMPLOYMENT by Ricardo Llaudes In 2005 all ECB publications will feature a motif taken from the €50 banknote This paper can be downloaded without charge from http://www.ecb.int or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=648002 I am grateful to Laurence Ball,Thomas Lubik, Christopher Carroll, Benoit Mojon, Adrian Pagan, an anonymous referee, and seminar participants at the European Central Bank and Johns Hopkins University for many helpful comments and suggestions The Johns Hopkins University, Department of Economics, 3400 N Charles Street, Baltimore, MD 21218, USA; e-mail: Ricardo.Llaudes@jhu.edu © European Central Bank, 2005 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved Reproduction for educational and noncommercial purposes is permitted provided that the source is acknowledged The views expressed in this paper not necessarily reflect those of the European Central Bank The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.int ISSN 1561-0810 (print) ISSN 1725-2806 (online) CONTENTS Abstract Non-technical summary Introduction Evolution and studies of unemployment in the OECD 2.1 Studies on long-term unemployment 11 Econometric model: the Phillips curve and the NAIRU 12 3.1 Unemployment duration version of the Phillips curve 13 3.2 Estimation issues 15 Empirical results 16 4.1 Main model results 16 4.2 Time path of the NAIRU 20 4.3 Confidence intervals 21 4.4 Euro area analysis 22 4.5 Implications for forecasting 24 4.5.1 Evaluating the forecasts 26 The role of labor market institutions 27 Robustness to alternative specifications 30 6.1 The wage Phillips curve 31 6.2 The effect of supply shocks 31 6.3 Changes to the signal-to-noise ratio 32 Conclusions 30 References 35 Tables and figures 39 European Central Bank working paper series 45 ECB Working Paper Series No 441 February 2005 Abstract This paper studies the role of long-term unemployment in the determination of prices and wages Labor market theories such as insider-outsider models predict that this type of unemployed are less relevant in the wage formation process than the newly unemployed This paper looks for evidence of this behavior in a set of OECD countries For this purpose, I propose a new specification of the Phillips Curve that contains different unemployment lengths in a time-varying NAIRU setting This is done by constructing an index of unemployment that assigns different weights to the unemployed based on the length of their spell The results show that unemployment duration matters in the determination of prices and wages, and that a smaller weight ought to be given to the long-term unemployed This modified model has important implications for the policy maker: It produces more accurate forecasts of inflation and more precise estimates of the NAIRU Keywords: Long-term unemployment, Phillips curve, NAIRU, Kalman filter JEL classification: C22, E31, E50, J64 ECB Working Paper Series No 441 February 2005 Non-technical summary The emergence of long-term unemployment has shaped the unemployment experiences of many developed (OECD) countries over the last two decades Two key issues concerning this type of unemployment are of particular research interest First, longer unemployment spells can be related to lower transition probabilities out of unemployment and into employment Second, the long-term unemployed are less relevant to wage and price formation than the newly unemployed This paper investigates the importance of the second of these issues for the short-run trade-off between inflation and unemployment implied by the Phillips Curve and the NAIRU (the Non-Accelerating Inflation Rate of Unemployment) This is a relevant question, given that the inverse short-run relationship between prices and unemployment is widely used by policymaking institutions to assess the desired stance of monetary policy Yet in the presence of long-term unemployment, the aggregate rate of unemployment may provide a distorted measure of the true demand pressures exerted on prices and wages This argument rests on the assumption that the long-term unemployed play a marginal role in the wage formation process In this paper, I investigate whether evidence of this behavior is present in a set of 19 OECD countries It is the first paper that undertakes such a systematic, multi-country study The analysis uses a modified version of an otherwise standard Phillips Curve model that allows for different unemployment lengths to enter the estimation This is done by constructing an index of unemployment that assigns different weights to the unemployed based on the length of their unemployment spell This deviates from the standard practice of using the aggregate unemployment rate Optimal weights are determined by the estimation of the model by maximum likelihood using the Kalman filter ECB Working Paper Series No 441 February 2005 The results obtained show that unemployment duration does matter in the determination of prices and wages as concluded by the Phillips Curve estimations, and that a smaller weight ought to be given to the long-term unemployed, confirming theoretical arguments presented in the paper Moreover, the impact of the long-term unem- ployed is not found to be uniform across countries In some countries, in particular some Western European countries, the long-term unemployed have a negligible effect on prices This variation across countries can be explained by some of the institu- tions that characterize labor markets in the OECD, such as employment protection and unionization levels Insofar as the monetary authority employs Phillips Curve models and the corresponding NAIRUs derived to asses inflationary pressures and to forecast inflation, the results in this paper are relevant to the policy maker That is, by looking at a break down of unemployment in terms of duration, the policy maker receives more accurate information concerning inflationary developments This paper finds that this improved measure produces more accurate forecasts of inflation at both, the one-year and two-year horizons There are also implications for the estimation of the NAIRU The modified model of the Phillips Curve generates more precise estimates of the NAIRU, with an average reduction in the mean width of the confidence bands of close to 20 percent ECB Working Paper Series No 441 February 2005 Introduction Over the last two decades, one of the most important labor market phenomena in many developed countries has been the emergence and persistence of long-term unemployment.1 Starting in the early 1980s, the number of long-term unemployed in many OECD countries soared in relation to the already growing number of unemployed.2 As a result, considerable research has been devoted to study issues such as the process leading to long-term unemployment, its effects, and possible solutions.3 The objective of this paper is to study the implications of long-term unemployment in the determination of prices and wages This is an important issue because the inverse short-run relationship between prices and unemployment, as captured by the Phillips Curve and the NAIRU (the Non-Accelerating Inflation Rate of Unemployment), is widely used by policymaking institutions to assess the desired stance of monetary policy and to forecast inflation (Boone et al, 2002) However, in the presence of long-term unemployment, the aggregate rate of unemployment may provide a distorted measure of the true demand pressures exerted on prices and wages On this subject, the OECD argues that when long-term unemployment is high " unemployment becomes a poor indicator of effective labor supply, and macroeconomic adjustment mechanisms- such as downward pressure on wages and inflation when unemployment is high- will then not operate effectively " (OECD, 2002, p.189) The argument rests on the assumption that the long-term unemployed play an unimportant role in the setting of prices and wages This has a number of important implications for the policy maker: If the long-term unemployed become less relevant to price formation, then the downward pressure of unemployment on prices decreases and unemployment becomes more persistent (Blanchard and Wolfers, 2000) Furthermore, if long-term unemployment is high, a given reduction in inflation may require extra contractionary measures as the pool of long-term unemployed will not contribute much to bringing inflation down In this paper I provide evidence of the role that unemployment duration plays in the Following the preferred OECD terminology, I will define as long-term unemployed those individuals in the labor force who have been out of work for one year or longer Short-term unemployed will be those out of work for less than one year The OECD (1983, 1987) mentions 1982 as a year with particularly sharp increases in long-term unemployment in several countries For a more comprehensive analysis of the trends, incidence and composition of long-term unemployment see OECD (1983, 1987, 2002) and Layard et al (1991) Machin and Manning (1999) survey the literature on long-term unemployment ECB Working Paper Series No 441 February 2005 determination of prices and wages using a set of nineteen OECD countries This is the first paper that undertakes such a systematic, multi-country study In the spirit of Nickell (1987) and Manning (1994), I propose a modified version of an otherwise standard Phillips Curve model that allows for different unemployment lengths to enter the estimation This is done by constructing an index of unemployment that assigns different weights to the unemployed based on the length of their unemployment spell These weights are a measure of the impact that the unemployed have on prices This deviates from the standard practice of using the aggregate unemployment rate.4 Optimal weights are determined by the estimation of the model by maximum likelihood using the Kalman filter The use of the Kalman filter enables the estimation of a time-varying NAIRU This is an important point of departure from Nickell (1987) and Manning (1994), who assume a constant NAIRU The results obtained show that unemployment duration does matter in the determination of prices and wages, and that a smaller weight ought to be given to the long-term unemployed The results also show that in those countries where long-term unemployment is high (namely, some Western European countries), the long-term unemployed play little role in the setting of prices and wages This contrasts with non-European OECD countries, where all the unemployed have similar impact, regardless of the length of their spell These cross-country variations can be explained by some of the institutions that characterize labor markets in the OECD, such as union coverage levels and employment protection Insofar as the monetary authority employs Phillips Curve models and the NAIRU to asses inflationary pressures and to forecast inflation, the results in this paper are relevant to the policy maker That is, by looking at a break down of unemployment in terms of duration, the policy maker receives more accurate information concerning inflationary developments As the results will further show, this modified version of the Phillips Curve produces more accurate forecasts of inflation at both the one-year and two-year horizons, and generates more precise estimates of the NAIRU, with an average improvement of around 20 percent The paper is organized as follows Section reviews the evolution of unemployment in the OECD and possible explanations Section presents the baseline and modified econometric models and discusses a number of estimation issues Section lays out the main empirical results of both models Section relates the results to a number of labor market institutions Section checks for robustness of the results Section concludes The standard unemployment rate gives equal weight to all the unemployed, regardless of the length of their spell ECB Working Paper Series No 441 February 2005 Evolution and Studies of Unemployment in the OECD The unemployment experience in the OECD countries over the last two decades shows remarkable contrasts, with large disparities in its evolution across member countries While countries outside Europe have been able to maintain relatively low and stable levels of unemployment, Western European countries have, for the most part,5 suffered from persistently high and fairly volatile levels of unemployment However, this has not always been the case The upper panel of Figure shows the unemployment rates for three different groups of countries: OECD Europe, OECD non-Europe, and OECD non-Europe excluding the US For the greater part of the 1970s unemployment in Europe remained at low levels, comparable to those in other countries (and lower than in the US) Only at the end of the 1970s and early 80s, after the second oil shock and the subsequent disinflationary policies, did unemployment in Europe start to sharply rise in relation to the non-European countries It quickly jumped from a rate of 2.9 percent in 1974 to a peak of nearly 10.5 percent in 1985 It remained at high levels for the rest of the decade On the other hand, growth in unemployment outside Europe was much less pronounced, it reversed trend earlier, and by the end of the 1990s it was back to its pre-shock levels The global slowdown of the early 1990s also had some important and interesting implications for unemployment: While it caused another big increase in unemployment in Europe, it was short-lived and relatively painless outside A large number of studies have attempted to explain these differences in the behavior of unemployment (see Nickell, 1997; Siebert, 1997; Blanchard and Wolfers, 2000; Ljungqvist and Sargent, 1998) These studies argue that the emergence of long-term unemployment provides an insight into the unemployment experiences in many OECD countries from the early 80s into 90s.6 The middle panel of Figure depicts short-term unemployment rates while the lower panel shows long-term unemployment rates It is easy to see that most of the unemployment growth in Europe can be attributed to the striking growth in long-term unemployment Its rate quickly jumped from about percent in 1976 to almost percent in 1985, remaining at high levels ever since.7 On the other hand the behavior of short-term unemployment was Even within the group of European nations, the behavior of unemployment has displayed very little homogeneity across countries Nickell (1997) warns against this lumping but claims that it is convenient for analytical purposes This is related to the concept of hysteresis introduced by Blanchard and Summers (1986): The existence of long-term unemployed will result in unemployment becoming more persistent This deviation of unemployment from its equilibrium value will cause the equilibrium value itself to change over time The problem of long-term unemployment continues to this day The OECD (2002) reports that in 2000, over 50% of the unemployed in Italy, Greece, Belgium, Ireland, and Germany were long-term unemployed ECB Working Paper Series No 441 February 2005 unemployed This paper has investigated the implications of these predictions for the shortrun trade-off between inflation and unemployment implied by the Phillips Curve Using a new way to specify the Phillips Curve that allows different unemployment lengths to enter the model, this paper finds that unemployment duration matters for inflation dynamics, and that the long-term unemployed have a smaller effect on inflation Moreover, the impact of the long-term unemployed is not found to be uniform across countries In some countries, in particular some Western European countries, the long-term unemployed have a negligible effect on changes in prices This variation across countries can be explained by some of the institutions that characterize labor markets in the OECD, such as employment protection and unionization levels These are the same variables that are used to explain the incidence of longterm unemployment Therefore, changes in the labor market geared to promote employment among the long-term unemployed should also have an impact on their ability to influence prices The modified model of the Phillips Curve proposed in this paper has important implications for the policy maker By looking at the distribution of unemployment in terms of duration, a better measure of inflationary pressures can be developed This paper finds that this improved measure produces more accurate forecasts of inflation at both, the one-year and twoyear horizons There are also implications for the estimation of the NAIRU The modified model generates more precise estimates of the NAIRU, with an average reduction in the mean width of the confidence bands of close to 20 percent The results in this paper suggest a number of future research avenues Similar to Schweitzer (2003), it would be interesting to study the relationship between α and the data on reemployment probabilities, and to combine the analysis with alternative measures of labor market slack This paper has also shown that information on unemployment duration can help improve the policy maker’s assessment of the dynamics of inflation Additionally, a model can be developed linking the policy maker’s actions to changes in unemployment and how they translate into short-term and long-term unemployment 34 ECB Working Paper Series No 441 February 2005 References [1] Acemoglu, Daron (1995) "Public 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Ireland Italy 20 15 15 10 10 5 1979 1985 1991 1997 2002 1979 1985 Japan 1991 1997 2002 Netherlands 15 15 10 10 5 1977 1983 1990 1996 2002 1973 1980 New Zealand 1987 1994 2002 Norway 15 15 10 10 5 1986 1990 1994 1998 2002 1979 1985 Portugal 1991 1997 2002 Spain 15 30 25 10 20 15 10 1986 42 ECB Working Paper Series No 441 February 2005 1990 1994 1998 2002 1977 1983 1989 1995 2002 Figure 2: Unemployment and the NAIRU (cont.) Sweden United Kingdom 15 15 10 10 5 1971 1977 1983 1989 1995 2002 1973 1980 1987 1994 2002 United States 15 10 1968 1975 1982 1989 1996 2002 ECB Working Paper Series No 441 February 2005 43 Figure Unemployment and the NAIRU, Euro Area Euro Area 15 10 1973 1979 1985 1991 1997 2002 Bold- UR; Solid - Standard NAIRU; Dash- Modified NAIRU 44 ECB Working Paper Series No 441 February 2005 European Central Bank working paper series For a complete list of Working Papers published by the ECB, please visit the ECB’s website (http://www.ecb.int) 402 “Forecasting euro area inflation using dynamic factor measures of underlying inflation” by G Camba-Méndez and G Kapetanios, November 2004 403 “Financial market integration and loan competition: when is entry deregulation socially beneficial?” by L Kaas, November 2004 404 “An analysis of systemic risk in alternative securities settlement architectures” by G Iori, November 2004 405 “A joint econometric model of macroeconomic and term structure dynamics” by P Hördahl, O Tristani and D Vestin, November 2004 406 “Labour market reform and the sustainability of exchange rate pegs” by O Castrén, T Takalo and G Wood, November 2004 407 “Banking consolidation and small business lending” by E Takáts, November 2004 408 “The great inflation, limited asset markets participation and aggregate demand: FED policy was better than you think” by F O Bilbiie, November 2004 409 “Currency mismatch, uncertainty and debt maturity structure” by M Bussière, M Fratzscher and W Koeniger, November 2004 410 “Do options-implied RND functions on G3 currencies move around the times of interventions on the JPY/USD exchange rate? by O Castrén, November 2004 411 “Fiscal discipline and the cost of public debt service: some estimates for OECD countries” by S Ardagna, F Caselli and T Lane, November 2004 412 “The real effects of money growth in dynamic general equilibrium” by L Graham and D J Snower, November 2004 413 “An empirical analysis of price setting behaviour in the Netherlands in the period 1998-2003 using micro data” by N Jonker, C Folkertsma and H Blijenberg, November 2004 414 “Inflation persistence in the European Union, the euro area, and the United States” by G Gadzinski and F Orlandi, November 2004 415 “How persistent is disaggregate inflation? 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Evolution and studies of unemployment in the OECD 2.1 Studies on long-term unemployment 11 Econometric model: the Phillips curve and the NAIRU 12 3.1 Unemployment duration version of the Phillips curve. .. is the short-term unemployment rate and Ul is the long-term unemployment rate The value of α will be determined by the estimation For the purpose of this paper, the duration version of the Phillips. .. beyond their indirect effect via long-term unemployment On the other hand, unemployment benefits duration and labor market policies only affect the weights via their impact on long-term unemployment The