The Suntory and Toyota International Centres for Economics and Related Disciplines

Employment, Inflation and Growth

Author(s): A. W. Phillips
Source: Economica, New Series, Vol. 29, No. 113 (Feb., 1962), pp. 1-16
Published by: Blackwell Publishing on behalf of The London School of Economics and Political
Science and The Suntory and Toyota International Centres for Economics and Related
Disciplines
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1962]

Employment, Inflation and Growth'

By A. W. PHILLIPS

1. INTRODUCTION
Since the end of the second world war economic policy and con-
troversyin Britainhave been directedto ways of attaininga number
of related objectives,prominentamong which are the maintenance
of a high and stable level of employment,reasonablestabilityof the
averagelevel of final productprices, a fairly rapid rate of economic
growth,a satisfactorybalanceof foreigntradeand reasonablestability
of foreign exchangerates. It can hardly be claimed that there has
been complete success in the attainmentof these objectives. It is
true that employmenthas been maintainedat an extremelyhigh level.
The averagelevel of unemploymentsince 1948 has been little more
than 12 per cent. of the work force. This is probablya lower level
of unemploymentthan that attainedin any single year in peace time
during the previous century, except perhapsin 1872. Even in the
boom yearsof the pre-wartradecyclethe percentageof tradeunionists
unemployedrarelyfell below 2 per cent. and over the 53 years from
1861 to 1913it averaged42 per cent. The actions taken to improve
the stability of the system have also had some measureof success.
Beforethe first world war there was a fairly regulartrade cycle with
an averageperiod of about eight years, during which trade union
unemploymentfluctuatedbetween about 2 and 10 per cent. Since
the second world war the cyclical movementsin economic activity
have becomemore rapid,with a period of four or five years, but the
fluctuationshave been smaller. Unemployment,indeed, has only
fluctuatedbetweenabout 1 per cent. and 21 per cent., that is, over a
range of about 12 per cent., but the percentagefluctuationsin gross
nationalproductabout the growth trend have been about five times
as large as this,2the range of the fluctuationsas a percentageof the
trend being about 7 or 8 per cent. Between 1948 and 1960, gross
national productincreasedat an averagerate of about 2i per cent.
per annum and productivityper man hour at perhaps 1l per cent.
per annum. Thoughthese rates of increaseprobablycomparefavour-
ably with those in earlierperiods of British history they are lower
than those of a number of other industrialcountries in the same
period. The averagerate of rise of the retailpriceindex between1948
and 1960was 3.7 per cent. per annum. Therewould be fairlygeneral
agreementthat this rate of inflationis undesirable.It has undoubtedly
1 Inaugural lecture given at the London School of Economics and Political
Science on 28th November, 1961.
2 See F. W. Paish, " Output, Inflation and Growth ", to be published.
1 A
2 ECONOMICA [FEBRUARY

beena majorcauseof the generalweaknessof the balanceof payments

and the foreign reserves,and if continuedit would almost certainly
make the presentrate of exchangeuntenable.
It is my belief that one of the main reasonsfor the difficultiesthat
have been experiencedin devising and implementingappropriate
economic policies is lack of adequate quantitativeknowledge and
understandingof how the economicsystemworks. Of course, econ-
omists do understand,in a generalsort of way, quite a lot about the
workingof the economicsystemand do now have a mass of quantita-
tive informationabout importanteconomic variables. But in order
to bring this knowledgeto bear on the problem of formulatingand
attaininga consistentset of policyobjectiveswe requirealso knowledge
of the quantitativerelationsbetweeneconomicvariables. In particular
it is necessaryto know what quantitativerelationshold betweenthose
economic variableswhich are either the objectivesof policy or the
instrumentsthroughwhich we attempt to attain the objectives. For
example,if some relationholds, in given institutionalconditionsand
on averageover a period of years, betweenthe level of employment
and the speed of inflation,failureto take account of it may lead to
the adoptionof inconsistentobjectivesand to a type of schizophrenic
behaviouras attempts are made to attain these inconsistentaims.
Knowledgeof the relation would lead either to modificationof the
objectivesto make them consistent or perhaps, since an economic
relationis only the resultof fairlyregularpatternsof humanbehaviour,
to some modificationof institutionsor behaviourwhich would alter
the relation so as to permit some more desirablecombinationsof
consistentaims. Or again, if at a certaintime unemploymentis felt
to be too high and short-terminterestrates are loweredin order to
raise the demand for goods and so for labour, how large will the
effects be and when will they occur; will the higher demand also
lead to an increasein fixedinvestmentand if so how large an increase
and afterwhat intervalof time; will wage rates and pricesrise more
rapidly as a result of the higher demand; if internal demand and
pricesrise will importsrise and exportsfall, and if so when and by
how much? If we are to assessthe effectsof our attemptsto influence
the course of economic affairswe need answers,numericalanswers,
to questionslike these. If we do not have this knowledgethe policy
adjustmentswill almost certainlybe inappropriatein magnitudeor
timingor both and may well cause,as I believethey have often caused
in the past, unnecessaryand harmfulfluctuationsin economicactivity.
We may obtain tentative estimates of a quantitativerelation in
economics by making a preliminarysubjectiveanalysis of human
motivationand behaviourand then carryingout a statisticalanalysis
of relevantdata from past records. We also need to investigatethe
degreeof errorthat theremay be in the estimate,the extentto which
the relationin successiveshort time periodsdepartsfrom its average
overlongerperiodsand whetherthereis any evidencethat the average
1962] EMPLOYMENT,INFLATIONAND GROWTH 3

relation changesin any systematicway throughtime. On the basis

of quantitativeestimatesof this sort it is possibleto set up simplified
models of the economic system and by studying the propertiesof
differentmodels with a variety of policy relationshipswe can form
some judgementof the likely effectsof alternativetypes of economic
policy. The empiricalstudyof economicrelationsand the quantitative
investigationof the behaviourof models of economic processesare
comparativelyrecent developmentsin our subject. The knowledge
and understandingwhich have so far been gained are far from being
adequate for a firm and detailed appraisalof economic policy. I
think they do, however,make possible some attemptat clarification
of the problemswe face and justify some suggestionsfor methodsof
dealingwith them.

2. SOME GENERAL PRINCIPLES OF FLUCTUATIONS AND STABILITY

The first policy objectiveI should like to consideris that of main-

taining a stable level of employment; but before proceedingto this
it seems desirableto illustratesome generalpoints about equilibrium,
stabilityand fluctuationsin the simplestpossibleway. Let me therefore
consider a single commoditywhich is being continuouslyproduced
and consumedand whichis tradedon a perfectlycompetitivemarket.
Assumethat the rate of productionis an increasingfunctionof price,
the rate of consumptionis a decreasingfunctionof price and that the
rate of changeof the price is proportionalto the excess demand,i.e.,
to the rate of consumptionminusthe rate of production. This is the
simpletext-bookexampleof supplyand demandin a singlecompetitive
market. It is frequentlystated,and has indeedbeen statedwith some
emphasisby sucheminenteconomistsas Walras,MarshallandWicksell,
that such a systemis necessarilystable,i.e., that it alwaystends to an
equilibriumin whichthe priceis suchthat the ratesof productionand
consumptionare equal. The argumentis usuallyvery simple. Suppose
the systemis not in equilibrium;for example,supposethereis excess
demand. Then the price will rise. This will increaseproductionand
reduceconsumptionand so reducethe excessdemand. Sincethe price
continuesto rise so long as there is any excess demandand any rise
in price reduces the excess demand the process will continue until
the excess demandis eliminated. In brief; the existenceof any dis-
crepancybetween productionand consumptioncauses a movement
in price which tends to correctthe discrepancy. Therefore,the argu-
mentruns,the systemis stable. This argumentis, of course,fallacious
except on the assumptionthat the completeresponseof the rates of
productionand consumptionto any change in price occurs instan-
taneously. If thereare any time lags in any of the responsesthe system
willusuallyfluctuate.Whetherthe fluctuationswill die awayor whether
they will increasein amplitudeand tend to some regularand sustained
limit cycle dependson the preciseformsof the time lags, on the slopes
4 ECONOMICA [FEBRUARY

of the supplyand demandcurvesand on the speed at whichthe price

changeswhen there is a given excess demand.
The competitivemodel which we have been considering,and other
so-called" self-equilibrating"models of economic processesare, in
fact, examplesof what are knownin otherfieldsof studyas " negative
feed-backcontrol systems". In order to see intuitivelywhy these
systemsare often oscillatoryand may well be unstable(whichmeans
in practicethat they tend to producefairly large and regularcyclical
movements)let us consider again the competitivemarket. Assume
this timethat somefactorotherthanpricecausessmallcyclicalchanges
in productionor consumption,so that excess demand is alternately
positiveand negative(see curve a of Figure 1). We shall call this an
exogenousmovementof excess demandand see what furthermove-
ments in excess demandwould be induced by price changes which
dependedonly on this exogenousmovement. In otherwordswe shall
find what would usuallybe called the correctivemovementsin excess
demandwhich result from the price changescaused by the exogenous
movementsin excess demand. Since we are assumingthat the rate of
changeof priceis proportionalto the exogenousmovementsin excess
demand,the rate of changeof pricewould have the sametime pattern
as the exogenousmovement. The price itself, however, would lag
behindthe rate of changeof priceby a quarterof a cycle (see curveb)

a. Exogenous movement,and rate of change

of price

b. Price

C.Induced movement,with no time lag

d. Induced movement, with time lag

Figure 1
1962] EMPLOYMENT,INFLATIONAND GROWTH 5

since the price would be at its maximumwhen its rate of changewas

zero and changingfrom positiveto negative,and would be at a mini-
mum when its rate of changewas zero and changingfrom negativeto
positive. If the completeresponseof productionand consumptionto
any change in price was instantaneous,the excess demand induced
by the movementsof price would be at its minimumwhen price was
at its maximumand vice versa(see curvec). Suppose,however,that
productionand consumptionrespondedto changes in price with a
time lag equal to one quarterof the period of the cycle. Then the
excessdemandinducedby the pricechangeswould be exactlyin phase
with the exogenousmovementsin excessdemand(see curved). Instead
of tendingto offset or correctthe exogenousmovement,the induced
changeswould tend to accentuateor amplifythe fluctuationsin excess
demandcausedby the exogenousmovement. It is intuitivelyplausible,
and can in fact be proved,that if, in this case, what are usuallycalled
the equilibratingor correctiveforces are strong enough to make the
amplitudeof the inducedmovementsin excess demandgreaterthan
the amplitudeof the exogenousmovements,the systemwill be unstable,
that is, the fluctuationswill increaseand tend towardsa regularand
sustainedlimit cycle.
The exogenousmovementsor disturbanceswhich affect economic
activityare not usually,of course,of the simpletype assumedin this
example. They are more likely to be of a ratherarbitraryor random
patternwhichcanbe describedonly in termsof a statisticalor stochastic
process. Suchprocessescan,however,be analysed,by a methodknown
as spectral density analysis, into cyclical componentswith periods
rangingover the whole spectrumfrom zero to infinity. If disturbances
of this sort operateon the modelwe havebeenconsidering,any cyclical
componentwhose periodis such that the time lag in the responseof
excess demand to price results in a lag in the neighbourhoodof a
quarterof the cyclical period will be amplified,while cyclical com-
ponentswhose periodsare widely differentfrom this will be reduced
in amplitude. If the " correctingforces" are sufficientlystrong the
cyclicalcomponentswithina particularrangeof frequenciesor periods
will be amplifiedto such an extentthat they will dominatethe market
movements,which will then exhibit large and somewhat irregular
fluctuations,in which, however, cycles with this particularrange of
periodicitieswill predominate.
Thereare two more mattersof some importancethat I should like
to referto whiledealingwith the generalprinciplesof fluctuationsand
stability. The first concernswhat I shall call the form or distribution
of the time lags. Supposethe pricein the commoditymarketwe have
been consideringwas constantfor a long time and then suddenlyrose
and remainedconstantat the new level. The rate of productionwould
eventuallyincreaseto some higher value, but there are any number
of time pathsthat this increasemightfollow. For example,production
might start to rise immediatelyand continue to rise at a gradually
6 ECONOMICA [FEBRUARY

diminishingrate, or it might remain constant for a while and then

increasegradually,or it might remainconstantfor a longer time and
then increasevery suddenly(see curves a and b and c in Figure 2).
Now it can be shown,but by methodswhichI shall not inflicton you
here, that the existenceof a time lag of the firstform in the corrective
process is much less likely to cause fluctuationsand instabilitythan
a lag of the second form, and a lag of the second form is less likely

Price

c
Production

Figure 2

to cause these troublesthan is the third form of lag. An important

rule in devisinga correctivesystem is thereforeto get the corrective
adjustmentstartedimmediatelythe discrepancyit is intendedto correct
beginsto be observed. Provideda fair proportionof the effectof the
correctiveaction is obtainedfairly quicklyit does not much matter
if the remainingeffectsare delayed; but it does mattervery much if
the correctiveaction itself or all of its effectsare delayed.
The secondmatterwhichI shouldlike to deal with brieflyis that of
alternativetypes of correctiveaction. It is perhapsbest introducedby
askingwhat would happen if in the simple commoditymodel which
we consideredearlierit was the priceratherthan the rate of changeof
pricewhich dependedon the excessdemand. We see from the curves
that the price movementswould occur a quarterof a cycle earlieras
a result of this modification,and the induced movementsin excess
demandwould no longer be in phasewith the exogenousmovements,
so that the destabilisingeffects of the inducedmovementswould be
reducedor eliminated. Dependingon the form of the time lag, it
might or might not be possible to find a cycle of higher frequency,
that is, of shorterperiod,for which the lag in the responseof excess
demandto pricewas half a cycle insteadof a quartercycle. If so, an
exogenousmovementof this higherfrequencywouldlead to an induced
movementin phasewiththe exogenousmovementand if the amplitude
19621 EMPLOYMENT,INFLATIONAND GROWTH 7
of the inducedmovementwas sufficientlylarge instabilitycould still
occur at the higherfrequency. But since most forms of time lag are
in effect weightedaveragesand tend to producea low amplitudeof
responseto high frequencycycles the likelihoodof cyclicalinstability
would be reduced. On the other hand this form of correction,which
is called proportionalcontrol,could neverensurethat productionand
consumptionwere brought into equality, since the price would be
constant if excess demandwere constant, even if it were not zero.
However, a combinationof proportionalcontrol and the type of
correctionused before, which is called integral control, overcomes
this difficultyand givesbetterperformancethan integralcontrolalone.
We may go furtherin this directionand considerthe effectof adding
to the correctiveaction a componentbased on the rate of change of
excessdemand. Sincethe fluctuationsin the rateof changeof a cyclical
variablelead the fluctuationsin the variableitself by a quarterof a
cycle,this componentof correctiveaction,knownas derivativecontrol,
has a somewhatsimilareffect to that which would be obtained by
basingthe correctiveaction on a forecastof excessdemand. A deriv-
ative componentof controlis used in combinationwith proportional
and integralcomponentsin most negativefeed-backcontrol systems.
By an appropriatecombinationof the three componentsit is usually
possibleto obtainvery good regulatingperformanceof a system,with
correctiveactions based only on the actual values of the variables
and their rates of change in the immediatepast, and without any
recourseto predictedvalues or forecasts.
3. FLUCTUATIONS IN EMPLOYMENT AND ECONOMIC ACTIVITY
I hope I have not boredyou too muchby this ratherlong and some-
what technicaldigressionon the generalprinciplesof fluctuationsand
stability. But I think some understandingof these principlesis helpful
in a discussionof the stabilityof employmentand economicactivity.
For the correctiveadjustmentswhich affect employmentand activity
in the whole economy, whetherthey be inherentin the working of
the economyor appliedas deliberateinstrumentsof policy, are again
examplesof control by negativefeed-back. The use of forecastsin
policy does not substantiallyaffectthis statement,since the forecasts
are themselveslargelybased on observationsof the economy and its
movementsin the recent past. Indeed,given the presentstate of the
art of forecastingI believe that better results might be obtained by
basing suitablecorrectiveaction directlyon observationsof the econ-
omy and its changesrather than on forecastswhich are themselves
largelyderived,perhapsby dubiousprocesses,fromthoseobservations.
Even if there were no specialfeatureswhich might accentuatedis-
turbancesand fluctuationsin the economyas a whole, it could not be
assumed that the existence of corrective adjustments,even quite
powerfulcorrectiveadjustments,would stabilisean economy. If they
operate with long time lags, and especiallyif there are long delays
8 ECONOMICA [FEBRUARY

beforethey commenceto operate,they will cause cyclicalfluctuations,

and the strongerthe correctiveforces the more violent will be the
fluctuations. But thereis fairlygeneralagreementamong economists
that thereare specialfeaturesof an economicsystem,in particularthe
multiplierprocess and adjustmentsin inventoriesand capital equip-
ment,whichaccentuatedisturbancesand tend to causecyclicalfluctua-
tions. These featuresincrease the need for deliberatestabilisation
policies, but also make it more difficultto devise suitablepolicies.
The problem is best studied by investigatingthe propertiesof a
variety of models in which use is made of the limited amount of
quantitativeknowledgeat presentavailableabout economicrelation-
ships. The work involved in such investigationsis greatly reduced
and the range of possible models is widenedby the use of modern
electronicequipment. The results obtained in this way cannot, of
course,be conclusive,but from the investigationsI have done so far
I have considerableconfidencein two simple propositions. The first
is that correctiveaction taken in an attemptto reducethe anmplitude
of the short cycle of four or five yearswhichis typicalof the post-war
period is not likely to be successfulunless it is based on recently
observedrates of changeof economicactivityas well as on the level
of activity. The otheris that evenif the correctiveactionis appropriate
in this respectit will still be unsuccessfulunless a fair proportionof
its ultimatedirecteffecton demand,say about a quarterof it, occurs
withinthreeor fourmonthsof the occurrenceof the errorit is designed
to correct, and at least one half of the full effect within about six
months.
Let us examinesome of the existingmeans of influencingdemand
in the light of these requirements. The response of investmentto
changesin monetaryconditionsand interestrates is almost certainly
delayedand slow. There is probablya delay of some monthsbefore
decisionsto invest are significantlyaffectedand with most types of
investmentthere is probably a further long time lag between the
decisions to invest and the actual productionof capital goods. If
this is so, fluctuationsare likely to be intensifiedratherthan reduced
by attemptsto correctthem throughoperatingon long-terminterest
ratesand investmentin fixedcapital. This does not mean that interest
rate policy is unimportant.I believeit has a vital role to play in the
slower adjustmentsrequiredas a result of changes in the desire to
save or invest,and thus in influencingthe averagelevel of employment
andthe averagerateof changeof the priceleveloverfairlylong periods.
It is more difficultto judge the effect of operatingon short-term
credit and short interestrates. Adjustmentsin these can be made
more quicklythan in long rates, and to the extentthat they affectthe
desire or ability to hold inventoriesthey might have a significant
effect on productionwithin two or three months. But I think much
more empiricalwork will be needed before one can judge with con-
fidencethe magnitude,speed and reliabilityof these effects. I suspect
1962] EMPLOYMENT,INFLATIONAND GROWTH 9

that if fairly large and rapid adjustmentsin short-termcredit con-

ditionsweremadein responseto both the level and the rate of change
of economicactivitythey would help to reducethe amplitudeof the
short cycle. But there is a difficultyin using adjustmentsof short-
termcreditandinterestratesfor this purpose. Shortrates,and perhaps
to a lesser extentcredit,are closelyrelatedto bank rate, and the level
of bank rate is often made to depend as much on the state of the
foreignreservesas on the internalconditionof the economy. To the
extentthat fluctuationsin the foreignreservesare the resultof fluctua-
tions in the balanceof tradethey will tend to lag behindfluctuations
in the balanceof trade by a quarterof a cycle. Since the balanceof
trade moves fairly closely with internal activity, fluctuationsin the
reservestend to lag behindinternalactivity,so that changesin bank
rate tend to be too late for satisfactorycorrectionof economicfluctua-
tions.
My conclusionconcerningmonetarypolicy is thus similarto that
of the Radcliffe Committee;' " . . . monetary measures cannot alone
be relied upon to keep in nice balancean economy subjectto major
strainsfrom both without and within. Monetarymeasurescan help,
but that is all ". My reasonsfor this conclusionare perhapsa little
differentfromthose of the Committee.I thinkthat changesin interest
rates and credit conditionsprobablydo have quite powerfuleffects
on demand, but that their usefulness for correcting short-period
fluctuationsis seriouslylimitedas a result of the long time lags in the
responseof investmentto changesin interestrates, and in the case of
credit as a result of the temptationor need to make the adjustments
in responseto the state of the foreignreservesratherthan at the times
appropriateto the correction of fluctuationsin internal economic
activity. Much more researchwill have to be done, however,before
the last word is said on these matters,and I would heartilyendorse
the Committee's statement2 that " . . . it is essential to have much
greaterand more systematicknowledgeof the factors that make up
the financialsystemand of theirrelativemovements".
Turningto fiscal methods of influencingdemand, it is clear that
adjustmentsthroughannual budgetsdo not meet the requirementsI
have stated for the correctionof short-periodcycles. Budgetchanges
have probablyplayed some part, together with monetarypolicy, in
overcomingthe more severeand longercyclesof pre-wardays, though
this may have come about as muchthroughthe confidenceof business
men that the budgetcould and would be used to averta severeslump,
with the consequent greater stability of their investmentplans, as
throughthe actual use of budgetchanges. The recentintroductionof
generaladjustmentsof purchasetax as a regulatingdevice is a more
promisingdevelopment. It suffers,however,from two defects; the
I Reportof the Committeeon the Workingof the MonetarySystem, Cmnd. 827,
(1959), p. 183.
2 Ibid., p. 336.
10 ECONOMICA rFEBRUARY

ratherarbitraryand limitedrangeof goods affected,and the fact that

when demandis high there might be expectationsof an increasein
purchasetax which would lead to a furtherincreasein demand and
when demandis low there might be expectationsof a decreasein tax
which would furtherdiminishdemand.Hire purchasecontrols suffer
even more severelyfrom these defects.
None of the fiscal instrumentsat presentin use satisfiesthe con-
ditions for a satisfactorymeans of correction. If the purchasetax
were changedinto a generalsales tax and adjustedby small amounts
at frequentintervalsit would do the job. But a preferablealternative
would be the introductionof adjustmentsof direct taxes. A fairly
simple way of adjustingdirect taxes would be to calculateevery tax
to be paid in exactlythe sameway as is now done and then to add or
subtracta certainpercentageto the calculatedfigureas a stabilisation
adjustment.In the case of P.A.Y.E., which is calculatedon the basis
of income and allowancescumulatedfrom the beginningof the tax
year,the figureaddedor subtractedin eachpay periodas a stabilisation
adjustmentwould be kept separatefrom the figurefor the normaltax
and wouldbe neglectedin formingthe cumulatedtax paid. The figure
calculatedfor the normaltax in each pay period would thus not be
affectedby earlierstabilisationadjustments,and no changewould be
needed in existingP.A.Y.E. tables or in the method of using them.
The percentageto be added or subtractedcould be changedif nec-
essary at regular intervals; qaarterlyintervals might prove to be
shortenough,thoughchangesat monthlyintervalsshouldbe possible.
In this case those P.A.Y.E. taxes which are paid quarterlyshould be
adjustedby the averageof the percentagesprevailingin the preceeding
three months. Similarlyall annual assessmentsfor direct tax should
be calculatedas at present and then the average of the percentage
adjustmentsprevailingoverthe yearappliedto this figure. Sufficiently
fine adjustmentwoald probably be obtained if the changes in the
percentageto be added or subtractedwere made in steps of 2-. per
cent.,i.e., sixpencein the pound. The absolutevalueof the tax adjust-
mentwould of coursebe muchlargerfor a personwith a high income
than for one with a low income. This has advantagesfrom the point
of view both of equityand of efficacy; the largeradjustmentis needed
to inducethe personwith the higherincometo changehis expenditure.
Therewouldno doubtbe someadministrative difficultiesin introducing
a schemeof this sort, but once it was in operationthe additionalwork
involvedwouldnot be verygreat. I believethat the choicelies between
acceptingthe minor inconvenienceof such a scheme and accepting
the continuationof the fluctuationsin employmentand economic
activitywhich we have experiencedsince the war.
4. EMPLOYMENTAND INFLATION
I have so far been discussingfluctuationsin employmentand econ-
omic activitywithout any referenceto the averagelevel about which
1962] EMPLOYMENT,INFLATIONAND GROWTH 1I1

employmentis fluctuating. Considerationof the average level of

employmentbringsus to the questionof the relationsbetweenemploy-
ment, or unemployment,and inflationand the rate of growth. In the
past few years a numberof people have carriedout empiricalstudies
of the relation betweenunemployment,or some other index of the
demandfor labour,and the rate of changeof wage ratesor earnings.
Somewhat different methods and hypotheses have been used by
differentpeople. In my own verycrudeattemptto studythis relation'
I assumedthat changesin the cost of living only affectwage changes
in years when prices are risingrapidly,usuallyas a result of rapidly
rising import prices. Others2have assumedthat changesin the cost
of living have a proportionateeffecton wage ratesin everyyear. For
the post-waryearsthis is probablynearerthe truththanthe assumption
I used. But we must then recognisethat changesin the cost of living
are in turn mainlythe resultof earlierchangesin wage rates and to a
lesser extent of changes in import prices. If these two behaviour
relationsare fittedto empiricaldata we can proceedto eliminateprice
changesand obtaina singlerelationexpressingwage changesin terms
of unemploymentand changes in import prices, or alternativelywe
may eliminatewage changes and expressprice changes in terms of
unemploymentand changes in import prices. These new relations
are not, of course,behaviourrelations,but they are valid relationsfor
predictionpurposes,and areindeedin the most usefulform for predic-
tion. The relationI obtainedis best consideredas a predictionrelation
of this sort. If the other studiesare also interpretedin this way there
is reasonableagreementin the resultsobtained. It seems that if the
averagelevel of unemploymentwere kept at a little less than 2-1per
cent. the averagerate of increasein wages over a period of years
could be expectedto be about 2 per cent. per annumso that with the
rate of increaseof productivityexperiencedsince the war the average
level of priceswould be almost constant. Also, in the range between
1-1per cent. and 2-- per cent. unemployment,for every 0. 1 per cent.
that the averagelevel of unemploymentwas reduced,wages and prices
wouldrise at about 6. 3 per cent. per yearfaster. If it is true that such
a relationholds we are facedwith a difficultchoice. Thenwe can only
reduceinflation,for any given rate of increaseof productivity,at the
cost of higherunemployment.I think such a relationdoes hold now,
and unless it can be changedwe shall probably move towards a
compromisesolution with a ratherhigheraveragelevel of unemploy-
ment than in the past few yearsand a lower, thoughnot zero, speed
1 " The RelationBetweenUnemploymentand the Rate of Changeof Money Wage
Rates in the United Kingdom, 1861-1957", Economica,vol. xxv (N.S.), (1958).
2 See L. A. Dicks-Mireauxand J. C. R. Dow, " The Determinantsof Wage Infla-
tion: United Kingdom, 1946-56 ", Journal of the Royal Statistical Society, vol.
122 (1959); L. R. Klein and R. J. Ball, " Some Econometricsof the Determination
of Absolute Prices and Wages ", EconomicJournal,vol. LXIX (1959), and R. G.
Lipsey," The Relation BetweenUnemploymentand the Rate of Changeof Money
Wage Rates in the United Kingdom, 1862-1957: A FurtherAnalysis", Economica,
vol. xxvii (N.S.), (1960).
12 ECONOMICA [FBRUARY

of inflation; perhaps about 2 per cent. unemploymentwith about

1 per cent. per yearrise in prices.
To consider whetherthe relation can be modifiedwe must know
why it is that wagescontinueto risewhilethereis significantunemploy-
ment. A numberof possiblecausesare often mentioned,in particular
lack of mobilityof labourandindustry,resultingin unevengeographical
and occupationaldistributionof unemployment,competitivebidding
by employersfor the most suitablelabour and-trade union pressure.
The mobility of labour and industrywould be increasedif geo-
graphicaland occupationalmovementsin relativewages were allowed
to take place more freely. If wages in areas and occupationswhere
unemploymentis low or excess demandis high rise more than those
whereunemploymentis high or excess demandis low, therewill be a
greaterincentivefor labour to move to the areas and occupationsin
which wages have risen most, and for industryto move to the areas
wherewageshaverisenleast, and also for industryto adaptits produc-
tion methodsto use more labourin those occupationsin whichwages
have risen least.
Competitivebidding up of wages in a particularoccupation and
area by employers can easily occur even when some labour in
the same occupationand area is unemployed. The basic reason for
this is the wide range of abilitythat exists amongdifferentindividuals
in the same occupation. Somepeople,even in a singlenarrowoccupa-
tional classification,are worth to an employer considerablymore
than the averagerate of pay in the occupation; othersthroughindivi-
dual defects of character,intelligenceor physique,are worth less. A
wide awake employerwill often find it profitableto pay 5 or 10 per
cent. above the averagerate of wages for a particularclass of labour
in his locality. In this way he can choose the best men and may well
finishup with employeeswhoseproductivityis 10 or 15 per cent. above
the average. If a large proportionof employersadopt this practice
wages may be bid up quite rapidly even when there is a significant
amount of unemployment. The best solution would seem to be to
allow more flexibilityin the wages paid to differentindividualsin the
same occupation.
The fourth possiblereason I mentionedfor wage rates rising when
there is significantunemploymentwas the power and pressure of
tradeunions. I have some doubtswhetherthis has been an important
factor,but if it has, and if the tradeunionsfully understandthe results
of their actions, it can only be counteredat the cost of occasional
major strikes. But have the results of an irresponsibleuse of their
powerbeen made clear to trade unions by Governments? If it were
widely and clearly understoodamong the membersof trade unions
that the full use of their power to force up money wages would only
lead, at a given level of unemployment,to a faster rate of inflation
and that the Governmentwould have no alternativebut to check
this higherrate of inflation,in part at least, by loweringdemandand
1962] EMPLOYMENT,INFLATIONAND GROWTH 13

causing some increasein unemployment,it seems possible that the

tradeunionsmight see wheretheir trueinterestslay.
I am not so naive as to expectthat the suggestionsI have made for
trying to shift the relation betweenemploymentand the rate of rise
of wage rates in a way which would make it possible to maintaina
higherlevel of employmentwith anygiven speed of inflationarelikely
to meet with an enthusiasticresponse. They are all suggestionsfor
moreflexiblearrangements whichwould allow freerplay to the market
forces of supply and demand. But for at least a centuryand a half
beforethe secondworldwar wage-earnersfrequentlyhad a prettyraw
deal from the marketforces of supply and demand,for in most of
the yearsof the tradecycle,and especiallyin the catastrophicinter-war
years, there was a deficiencyof aggregatedemand. The traditions
built up over that period still persist and will continueto persistfor
some yearsyet. But in due courseit may be realisedthat continuously
rising standardsof living come only from continuouslyrising pro-
ductivity and that provided the Governmentis not prevented by
inflationfrommaintaininga high aggregatelevel of demandfor labour
the marketforcesareno longerharmfulbut play a vital partin helping
adaptationand progress.
5. EMPLOYMENT AND GROWTH
I have suggestedthat a slightlyhigher averagelevel of unemploy-
mentthanthat whichwe havehad in the last few years,perhapsa little
over2 per cent.,may be acceptedas a necessaryconditionfor modera-
ting the speed of inflation. One often hearsheated argumentsagainst
checkinginflationin this way, on the groundsthat if the rateof growth
of the economy were more rapid prices would not rise so fast, and
that the rate of growthwill be reducedby operatingthe economy at
a slightlylowerlevel of employment.It is true,of course,that a higher
rate of growthwith the samerate of changeof wages would lead to a
lower speed of inflation. It is also true that while unemploymentwas
actuallyincreasing,let us say from 1 per cent. to 2 per cent., output
would be risingless rapidlythan it would have been if unemployment
had been kept at 1I per cent. But the argumentis often phrasedas
if the steadyrate of growthof the economywith unemploymentcon-
stant at 2 per cent. would be less than the steadyrate of growthwith
unemploymentconstantat 12 per cent. I doubt whetherthis is true.
During short-periodcyclicalfluctuationsthe variationsin outputas
a percentageof the growthtrend are about five times as large as the
variationsin the percentageunemployment.The differenceis largely
accounted for by variationsin short-timeand overtime; by some
people, mainly marriedwomen, moving into and out of the labour
force; and by " hoarding" of labour during a recession which is
expectedto be short. If unemploymentwere to rise by 2 per cent.
and stay at the new level, the hoardingof labour and some of the
initial change in short-timeand overtimewould be only temporary
14 ECONOMICA [FEBRUARY

and when the adjustmentswere completed the percentagefall in

output would be considerablyless than five times the increasein ihe
percentageunemployment.If accountweretakenof the valueof leisure
the fall in real incomewould be still smaller,sincethat part of the fall
in outputwhichwas due to a reductionin overtimeand movementof
people out of the labour force would be partly compensatedby the
value to the people concernedof the extra leisure. If an increaseof
i per cent. in unemploymentcauseda decreaseof 12 per cent. in out-
put, with equal proportionaldecreasesin investmentand non-invest-
ment expenditures,investmentwould fall by 1 per cent. of its own
value, and assumingthat the growthrate was proportionalto invest-
ment the growthrate would also decreaseby 1I per cent. of its own
value,for example,from2.5 percent.to 2.4625 percent.; an extremely
small decrease. If all the decreasein outputresultedfrom a decrease
in non-investmentexpenditurethere would be no change in the rate
of growth.The main conclusionfrom this is that the differencein the
steadystateratesof growthbeforeand afterthe transitionto the higher
unemploymentwould be extremelysmall if the growth rates were
proportionalto investment. Other influences,such as possibleextra
incentiveor compulsionto invest in cost-reducingequipmentmight
easilyoutweighany small differencedue to the slight changein invest-
ment.
It is sometimesargued that the decreasein demand would slow
down growthby reducingthe desireof firmsto invest; but this could
always be remediedby reducinginterestrates. Indeed since we are
assumingthat a Governmentcould hold unemploymentat the new
level, investmentin the new steadystate, as in the earlierone, would
have to be broughtinto equalitywith savings. It is on the willingness
to save, and the more generalinfluencesof educationalimprovement,
research,and so on, that the rate of growthdependsin presentcircum-
stances. I do not think that very small changesin aggregatedemand
and unemploymenthave much effecton these.
6. RATES OF EXCHANGE
The final questionI wish to discuss,very briefly,is that of rates of
exchange.The othermajortradingcountrieshaveproblemsof employ-
ment,inflationand growthwhich are similarto those of Britain. The
questionariseswhetherall countriesare likely to hold that balanceof
internalobjectiveswhichwould be consistentwith the maintenanceof
fixed exchangerates.
Professors Samuelson and Solowl have considered the relation
betweenunemploymentand the rate of changeof the consumerprice
indexin the United States. Theirtentativeconclusionis that assuming
continuationof the conditionsof the post-warperiod the price index
might be stable if unemploymentwere held at 5 to 6 per cent., and
I P. A. Samuel.on and R. M. Solow, " Analytical Aspects of Anti-Inflation
Policy ", AmericanEconomicReview,vol. L, no. 2 (1960).
1962] EMPLOYMENT,INFLATIONAND GROWTH 15
might rise at about 2 per cent. per annum if unemploymentwere
4 per cent. Some estimateswhichI have made lead me to think that
the situationin the UnitedStatesis less favourablethanthis. I estimate
that 7 to 8 per cent. unemploymentwould be needed to maintaina
stable price level, and that at 4 per cent. unemploymentthe price
level would rise at about 4 per cent. per annum. Of course efforts
to increasethe rate of growthand to reducestructuralunemployment
may improvethe relationbetweenunemploymentand price changes;
but unless my estimatesare badly out or considerableimprovements
are obtainedit seemslikely that if unemploymentis reduced,as seems
to be hoped, to 4 or 5 per cent., the United States may well have a
rather faster rate of inflation than Britain would have with 2 per
cent. unemployment.
In Germanysimilarproblemsare beginningto appear. Unemploy-
ment has fallen steadilyfrom about 10 per cent. in 1950 to 1.2 per
cent. in 1960, and labour costs are now rising rapidly. The growth
rate is still high but some specialfactorswhichcontributedto it, such
as reconstructionafter the war and the currency difficulties,and
availabilityof skilled labour from unemployedor from refugees,are
passing. It may well be that in Germanytoo the problemof choosing
betweeninflationand unemploymentwill become acute. These three
countries,and others, may perhapsbe preparedto adjust their own
choices about internalbalancein orderto make them consistentwith
a regimeof fixed exchanges. But I have some doubts whetherthey
will be preparedto do so, or if they are whetherthey in fact know the
quantitativeworkingsof their own and other economieswell enough
to choose the appropriateobjectivesbefore gradual divergenciesin
pricelevelshave cumulatedto such a degreethat they imposea heavy
strain on the internationalmonetarysystem.
If this is so, it might be betterto allow a limitedflexibilityinto the
exchangesystem,so that gradualdriftsin relativeprices,whichwould
probablynot be at a rateof morethan 1 or at most 2 percent. peryear,
would not producecumulativedisequilibriain balancesof tradewhich
might eventuallynecessitatelarge and suddenmovementsof exchange
rates and do seriousdamageto the internationalmonetarysystem. A
limited flexibilitycould be introducedby an agreementthat the par
value of any one currency,in termsof gold, could be changedat any
time providedthe total changein one directionin any periodof twelve
monthsdid not exceed1 percent. Therewould,I think,be muchmore
confidencethat a countrycould in fact work withinthis rule than that
it could for ever succeed in keeping the par value constant, so the
fear,or hope, of a suddenlargechangein the rate,with the tremendous
speculativemovementsit causes, would be greatly diminished. The
maximumpermissiblerate of change of the par rate, 1 per cent. per
year, could easily be offset by short-terminterestdifferentials,so it
neednot lead to any majortransfersof capital. And this limiteddegree
of exchangeflexibilitywould allow each countrytime to find by trial
16 ECONOMCA [FERUARY

and errorthat compromisebetweenits internalobjectiveswhich was

consistentwith its exchangerate policy.
I said at the beginningof this lecturethat I believedone of the main
difficultiesin devisingand implementingappropriateeconomicpolicies
is lack of quantitativeknowledgeand understandingof how the econ-
omic systemworks. By now I have no doubt amplydemonstratedat
any rate my own lack of knowledgeand understanding,and it only
remainsto apologiseto any of you who may have come hereexpecting
clear and definiteanswersto the problemsI have been discussing. I
hope the next personto face the ordealof givingan inaugurallecture
on electionto the Tooke Chairwill be in a position to explainthese
mattersmore clearly.
The London School of Economics.