Boiling Frogs - Slow Recoveries are Deep Recoveries, with Flatter Phillips Curves

Andy Harless' tweet (about the US economy) got me thinking.

"There’s a frog-boiling aspect to this economy. The consistent lack of *rapid* improvement throughout the recovery is enabling us to reach levels of employment that might not otherwise have been attainable."

It reminds me of my old post "Short Run 'Speed Limits' on recovery".  The basic idea is simple: actual inflation (relative to expected inflation) might depend not just on the level of employment (relative to some unknown level of "full employment"), but also on the speed at which employment increases.

I've added an epicycle to the Phillips Curve that I think makes it fit the facts better. But I added that epicycle 10 years before the facts that Andy's tweet asks us to explain. And it's based on an idea that make sense, and goes back further still:

It's difficult and costly to increase employment quickly, and easier and cheaper to increase employment more slowly, even for the same cumulative increase in employment. So if demand for output suddenly increases by (say) 10%, individual firms will raise prices and wages relative to the prices and wages they expect at other firms, or raise them more than they would otherwise have done if demand for output had slowly increased by that same 10%. Even with no underlying trend growth in productivity. Even with the same average level of demand for output.

The search/matching approach to understanding the labour market gives us one reason to think that it's more difficult and costly to increase employment quickly rather than slowly. Workers and jobs are heterogeneous. It's a bit like the marriage market. Getting the right match is important, and difficult and costly. And getting the right match between workers and jobs is even more difficult if you have to find a match quickly.

If demand for your output increases, and it's too difficult and costly to increase employment to increase your output to meet that increased demand, you increase price instead. The more quickly demand increases, the more likely you are to increase price rather than increase employment.

Thinking about "discouraged workers" adds something important to this story.

An individual firm can increase employment by attracting workers away from other firms, by increasing its wage compared to other firms' wages. But that doesn't increase aggregate employment; it doesn't work if all firms try to do the same thing. The only thing that happens in aggregate is that wages rise; and so prices rise too. The only way we can get an increase in total employment from increased demand for output is if unemployment falls, or if discouraged workers (who had given up looking for work, or who didn't even start looking, because they thought they wouldn't find a job) are encouraged to enter or re-enter the labour force.

It seems plausible to me that the quickest way for an individual firm to increase employment and output is to raise wages to attract workers who are currently employed at other firms. There's a lot of them, you know where to find them, and you know they can do the job and hit the ground running. Increasing employment by hiring the unemployed will be slower. There's fewer of them, and finding the ones who can do the job will take time, and they may need on-the-job-training to get them up to speed. And increasing employment by hiring discouraged workers will be even slower. Discouraged workers are like unemployed workers, except they are harder to find than unemployed workers, because the unemployed workers are trying to find you.

What this suggests to me is that a quickly-increasing demand for output, following a recession, will result in more inflation than slowly-increasing demand for output, even if you compare those two paths at the point where they cross and have the same demand for output. And a slow recovery in demand will pull more discouraged workers into the labour force, resulting in a bigger labour force and higher total employment, before the central bank needs to stop demand increasing to prevent inflation rising above target.

Comments

[Peter V Bias]

This whole discussion is important. To me the unemployment problem after a deep recession is resolved only as firms can establish for themselves where their new 'place' is in the economy. Disequilibrium throws everyone off and there is an uncertainty as to what a firm's prices and wages should be relative to all the other firms - who are trying to solve the same problems. Who goes first? Compared to what? Are our new prices too high or too low in this new environment? etc. The grind back to equilibrium, rather than a spring-back, is a testament to this process. The clearer the picture, the easier to make the 'right' decision in an ever-changing environment. Really don't need a Phillips curve at all. Just time.
Nice to see you posting Nick!