Real Wage Dynamics and the Phillips Curve

Since Friedman (1968), the traditional derivation of the accelerationist Phillips curve has related expected real wage inflation to the unemployment rate and then invoked markup pricing and adaptive expectations to generate the accelerationist price inflation equation. Blanchflower and Oswald (1994) have argued that microeconomic evidence of a low autoregression coefficient in real wage regressions invalidates this approach, a conclusion that has been disputed widely on the grounds that the true autoregression coefficient is close to one. This paper shows that the accelerationist relationship between the change in price inflation and the unemployment rate is consistent with any type of microeconomic real wage dynamics. However, these dynamics will determine how supply shocks affect inflation. Evidence on supply shocks and inflation points against the traditional real wage formulation. Implications for the recent behavior of the NAIRU are explored. This is a substantially revised version of my 1997 working paper “Wage Curve vs. Phillips Curve: Are There Macroeconomic Implications?”. I am grateful to Daron Acemoglu, Olivier Blanchard, Charles Fleischman, Michael Kiley, Spencer Krane, and Calvin Schnure for comments. The views expressed in this paper are those of the author and do not necessarily reflect the views of the Board of Governors or the staff of the Federal Reserve System. Email: [email protected]. Robert Solow (1976) has said that any time is a good time to reflect upon the Phillips curve. This seems particularly true right now, given that the combination of low inflation and low unemployment in recent years has provoked a debate over the legitimacy of the Phillips curve framework, with some seeing a “New Economy” in which the Phillips curve has become irrelevant, and others seeing the recent period as a temporary anomaly brought on by fortuitous supply shocks and labor market developments.1 Recent years have also seen an important debate over the micro-foundations of the Phillips curve, stemming from the contributions of David Blanchflower and Andrew Oswald (1994, 1995). Blanchflower and Oswald have reported regressions for the level of real wages with coefficients well below one for the lagged real wage and pointed out that these results directly contradict the traditional formulation of the accelerationist Phillips curve, due to Milton Friedman (1968), which views expected real wage inflation as a function of the unemployment rate. They have suggested that “Conventional macroeconomics seems to be at threat from these results. They are consistent with the view that it is wrong to believe in a Phillips curve”.2 This conclusion has been challenged by a number of authors, including David Card (1995) and Olivier Blanchard and Lawrence Katz (1997, 1999), on the grounds that Blanchflower and Oswald’s estimates of the coefficient on lagged real wages are biased downward. This paper explores the relationship between real wage bargaining dynamics and aggregate price inflation. The paper has two purposes, relating to each of the recent strands of research on the Phillips curve. The first part of the paper explores the relationship between microeconomic real wage dynamics and aggregate inflation. I show that the legitimacy of the accelerationist Phillips curve does not rest upon Friedman’s real wage inflation formulation: Under the traditional textbook assumption of a constant price markup over unit labor costs, all types of microeconomic real wage dynamics generate observably equivalent behavior for aggregate nominal wage and price inflation. However, once markups can vary, real wage dynamics play a role in determining the effect of these variations on price inflation. In particular, real wage dynamics will determine how supply shocks to import and energy prices, which are unrelated to domestic costs, affect aggregate consumer price inflation. Specifically, if workers bargain in terms See Gordon (1998), Katz and Krueger (1999), and Stock (1998) for three insightful contributions. Blanchflower and Oswald (1994).