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Saturday, September 22, 2007

knzn: The Fed Should Target Unit Lbor Costs

knzn says the Fed should target unit labor costs:

Target Unit Labor Costs, by knzn: Last year (here and here, with related posts here, here, here, here, here, here, and here – or just read the August 2006 archives and my post from yesterday) I suggested that the Fed should target unit labor costs. Upon additional thought, I still think so. I won’t go through the whole argument again, but I want to note a few important points.

He goes on to list five reasons for the Fed to follow this policy.

knzn raises a good point - what price index should the Fed target? Here's Michael Woodford:

One goal of my research has been to clarify which kinds of macroeconomic stabilization objectives best serve economic welfare. ... [I]t is not immediately obvious what the conventional goals of monetary stabilization policy --- especially the nearly universal emphasis that central banks place on maintaining a low and stable inflation rate --- have to do with consumer welfare; after all, the arguments of household utility functions generally are assumed to be the quantities of various goods and services, but not their prices. Nonetheless, I have shown that in familiar classes of sticky-price dynamic stochastic general equilibrium (DSGE) models --- models that incorporate key elements of ... empirical models of the monetary transmission mechanism... --- it is possible to show that the expected utility of the representative household varies ... with ... measures of price and wage inflation on the one hand and measures of real activity relative to a (time-varying) target level of activity on the other. .... The theory clarifies both the appropriate definition of ... stabilization objectives, and the appropriate relative weights to assign to them...

The answer obtained depends, of course, on the structure of the economy. In particular, inflation variability reduces welfare because of the presence of nominal rigidities; the precise nature of these rigidities determines the appropriate form of the inflation-stabilization objective. For example, if wages are flexible ..., and price adjustments are staggered in the way assumed ... by Guillermo Calvo ..., then inflation variation results in distortions caused by the misalignment of prices that are adjusted at different times. The resulting welfare losses are proportional to the ... squared deviations of the inflation rate from zero. Other assumptions about the timing of price adjustments also imply that inflation variations reduce welfare, but with a different form of loss function...

The theory also provides important insights into the question of which price index or indexes it is more important to stabilize. Again, the answer depends on the nature of the nominal rigidities. If prices are adjusted more frequently in some sectors of the economy than in others, then the welfare-theoretic loss function puts more weight on variations in prices in the sectors where prices are stickier... This provides a theoretical basis for seeking to stabilize an appropriately defined measure of "core" inflation rather than an equally weighted price index. .... Similarly, if wages are sticky as are goods prices, as implied by many empirical ... models, then instability in the rate of growth of a broad index of nominal wages results in distortions similar to those created by variations in goods price inflation. If [adjustments in] wages are staggered ..., then the welfare-theoretic loss function includes a term proportional to the squared rate of goods price inflation and another term proportional to the squared rate of wage inflation each period. In this case, optimal policy involves a tradeoff between inflation stabilization, nominal wage growth stabilization, and output-gap stabilization...

Thus, though many people object to the Fed linking the federal funds rate to measures of core inflation (as opposed to overall inflation) and wage inflation (why slow the economy just as wages begin to catch up?), there is a theoretical basis for doing so within the class of sticky wage and price dynamic stochastic general equilibrium (DSGE) models (i.e. New Keynesian models). There are two key things about constructing an optimal index. First, the prices that are stickiest should receive the most attention (weight) in the overall index, flexible prices can take care of themselves. That is why you may want to eliminate oil and food prices, both of which are very flexible, as a first approximation to this principle. Second, the split between wage and price stickiness depends upon the relative degree of stickiness in each sector. If wages are much stickier than prices, than wages should receive more weight than prices. This is just the first point extended over both input and output prices, i.e. that sticky prices receive the most weight in the index. Woodford believes that the weight on price and wage inflation should be about equal, but that is an empirical matter and hence subject to dispute. But so long as wages do display stickiness, then they should be part of the Fed's decision rule.

    Posted by on Saturday, September 22, 2007 at 01:26 PM in Economics, Monetary Policy | Permalink  TrackBack (1)  Comments (64)

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    » Why not target unit labour costs? from New Economist

    Perhaps I am missing some fatal flaw, but I have found econoblogger KNZN's arguments in favour of central banks targeting unit labour costs quite persuasive. It has the advantage over inflation targets of excluding exogenous shocks. It also forces the ... [Read More]

    Tracked on Sunday, September 30, 2007 at 09:27 PM


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