Alan Greenspan's Tradeoff

Fortune issue: December 8, 1997

First Principles


Alan Greenspan's Tradeoff

By N. Gregory Mankiw

Life is full of tradeoffs. Consumers trade off spending today against saving for tomorrow. Congress trades off tax cuts against deficit reduction. And the Federal Reserve trades off inflation against unemployment.

But wait: The U.S. is now enjoying low inflation and low unemployment. Doesn't this refute the old theory of an inflation-unemployment tradeoff? Not at all, and Alan Greenspan knows it. The Fed has a single policy lever, and this lever pushes inflation and unemployment in opposite directions.

When the Fed wants to reduce unemployment, it reduces interest rates by increasing the money supply. Lower interest rates stimulate spending on goods and services, and this encourages firms to hire more workers. But with more dollars circulating in the economy, over time each dollar becomes worth less. The result is higher inflation.

Conversely, when the Fed wants to fight inflation, it reduces growth in the money supply. Yet this causes a rise in interest rates, which depresses spending and increases unemployment. How, then, does the U.S. economy now find itself enjoying both the lowest inflation and the lowest unemployment in decades? The answer is that while the Fed always faces an inflation-unemployment tradeoff, the tradeoff does not stay the same from year to year.

Consider an analogy. As a consumer, you face a tradeoff between spending and saving. The more you spend, the less you save. Of course if your income rises, you can both spend more and save more. And if your income falls, you might choose to both spend less and save less. But this in no way denies the tradeoff between spending and saving that you face every day.

What, then, can alter the short-run tradeoff between inflation and unemployment? There are three answers--inflation expectations, supply shocks and labor-market conditions--and each is important for understanding the economic environment the Fed now faces.

INFLATION EXPECTATIONS: When expected inflation is high, workers demand larger wage increases. Employers acquiesce, expecting that they can pass higher costs on to consumers. As a result, high expected inflation leads to rapid cost escalation, which in turn leads to high actual inflation. Economist Robert Solow put the point succinctly during the high inflation of the 1970s: "Why is our money ever less valuable? Perhaps it is simply that we have inflation because we expect inflation, and we expect inflation because we've had it."

Just the opposite is true today. Now we have low inflation because we expect low inflation, and we expect low inflation because we've had it. Greenspan has bought for himself a favorable tradeoff between inflation and unemployment by giving the public many years of low inflation.

SUPPLY SHOCKS: Sometimes outside events affect the prices at which firms supply their goods and services. The classic inflationary supply shocks were the OPEC oil price increases of the 1970s. As the cost of all oil-related products rose, the Fed had to cope with a less favorable tradeoff between inflation and unemployment. Greenspan has been more fortunate. Shortly before he was appointed Fed chairman in 1987, world oil prices plummeted, improving the inflation-unemployment tradeoff.

Over the past two years, the foreign-exchange market has provided a similar benefit. The rise in the exchange rate from 90 to 120 yen per dollar has put downward pressure on the prices of imports and import-competing goods. And because wages respond to consumer prices, the strong dollar has also kept down growth in labor costs.

� LABOR-MARKET CONDITIONS: Monetary policy is only one determinant of the unemployment rate. More important, especially in the long run, is how well the labor market matches workers and jobs. In many European countries, unemployment remains high because welfare policies give unskilled workers little incentive to find jobs. The U.S. is less generous, and one result is a more favorable tradeoff between inflation and unemployment.

The declining unemployment rate over the past several years has led some economists to wonder whether the U.S. labor market is getting better at matching workers and jobs. Why might that be? The increasing role of temporary-help agencies is one possible explanation.

Because so many variables can shift the inflation-unemployment tradeoff, the Fed tries to keep track of it all. Many economist summarize the answer with a number called the NAIRU, standing for "non-accelerating inflation rate of unemployment." When unemployment rises above the NAIRU, inflation tends to fall below rates experienced in the recent past. When unemployment falls below the NAIRU, inflation tends to rise.

But here's the rub: Estimates of the NAIRU are notoriously imprecise. This uncertainty makes the task facing the Fed chairman and his colleagues all the more difficult. But it should not delude us into thinking that the Fed can push unemployment lower without risking higher inflation. Indeed, unless Greenspan's good luck continues, there is reason to fear that high inflation may be around the corner.


N. GREGORY MANKIW is a Harvard economics professor and author of Principles of Economics.