The Relation Between Inflation and Regional Unemployment and

Sectoral Income Growth Dispersion:

Evidence From EU Countries

David G Mayes Bank of Finland

HYPOTHESES

• The Phillips curve is not linear so there is a problem of aggregation across regions/sectors– At lower levels of unemployment/postive output gaps

the effect on inflation may be much stronger

• The dispersion across labour markets may matter because it is the tightest labour markets that tend to drive the inflationary process

NOT A NEW ISSUE

• Brechling (1973); Archibald (1969); Phillips (1958); Lipsey (1960)

'If one wishes to predict the rate of change of money wage rates, it is necessary to know not only the level of unemployment but also its distribution between the various markets of the economy.'

• Laxton et al. (1995, 1999)

SOURCES OF ASYMMETRY

• In the labour market – unions– Real and nominal wages sticky downwards?– Capacity constraints– Mayes and Buxton (1986)

• In the growth process– ‘loops’ (Lipsey, Phillips)– Okun curve (Harris and Silverstone, 2001)

• In policy – Fiscal policy– Monetary policy (Mayes and Virén, various)

THE MODEL

• Hybrid New Keynesian

pt = α1ut + α2sdt + α3pt-1 + α4pet + vt

• Threshold model (Tang, Teräsvirta)

pt = α11u-t + α12u+

t + α2sdt + α3pt-1 + α4pet + vt

• Backward-looking with shocks

pt = α11u-t + α12u+

t + α2sdt + α3pt-1 + α4pmt

+ α4taxt + vt

• (VAR in u, p and pe)

THE DATA

• Unbalanced panel of the 15 ‘old’ EU countries 1974-2004 – annual data – (no Luxembourg)

• Regional data on unemployment from Regio database 248 regions (no Portugal or Greece)

• 6 sectors: agriculture; construction; rest of industry; private non-financial services; financial services; public services (no Ireland)

• Output gap (HP) (also use output growth)• Expectations – published OECD forecasts

RESULTS 1

• Inflation positively related to unemployment dispersion

• Expected inflation more important than lagged inflation

• Inflation falls over the period so may not be well specified (GMM OK)

• Feedbacks indicated by VAR – expected inflation tends to increase unemplyment and actual inflation to decrease it

RESULTS 2

• Clear non-linearity – greater impact in low unemployment positive output gap periods

p = .797pe + .325p-1 - .031u|u>u* - .101u|u<u* + .053sd (13.24) (8.43) (2.31) (3.78) (1.62) • Dispersion right sign but significance weak• Adding import prices and VAT changes as shock

variables removes much of the effect of dispersion• Backward-looking expectations reinstate role of

dispersion

CONCLUSIONS

• Nonlinearities large enough to matter in EU

• Unemployment dispersion suggests a labour market effect

• But other sources of asymmetry also at work

• Does euro area monetary policy