Academic journal article Federal Reserve Bank of New York Economic Policy Review

# Macroeconomic Implications of Shifts in the Relative Demand for Skills

Academic journal article Federal Reserve Bank of New York Economic Policy Review

# Macroeconomic Implications of Shifts in the Relative Demand for Skills

## Article excerpt

My assignment for this conference on U.S. wage trends was, as an outsider, to draw the macroeconomic implications of widening wage inequality. I shall do so in six points.

THE RACE BETWEEN RELATIVE DEMAND AND RELATIVE SUPPLY

The first point is not specifically about macroeconomic implications. It emerges from my reading of the body of research. What has happened is usually described as having come from an increase in relative demand for skills. It is in fact better described as a race, over the last twenty years, between increases in relative demand for skills and increases in relative supply. In the 1970s, relative supply won; in the 1980s, relative demand won. But in both decades, the race has been fast on both sides.

To make the point more precisely, let me rely on the work of Larry Katz and Kevin Murphy. In Katz and Murphy (1992), they aggregate labor in two groups, high school (H) and college (C), and estimate the following relative demand relation, in inverse form, using data from 1963 to 1987:

(1.1) ([W.sub.C/W.sub.H]) = -0.709log C/H

+ constant+ .033 time

The relative wage depends on the relative supply of C and H--the coefficient implies a fairly high elasticity between the two, o = 1/.709 = 1.4--and a time trend, which captures the shift in relative demand. The coefficient on time is the same throughout: contrary to common perceptions, Katz and Murphy find little evidence that the relative demand shift is accelerating.

Now do the following computation. Suppose that there had been no change in relative supply, so that log(C/H) had remained constant. Then over those twenty-four years, the relative wage of college workers would have increased by .033 times (24) = 79 percent! The actual increase was only 10 percent. The difference is accounted for by the increase in relative supply. Table 1 builds on Katz and Murphy to show the contribution of shifts in demand and supply to the evolution of the wage.

```Table 1
RELATIVE DEMAND AND SUPPLY SHIFTS
```

```                                       1963-71   1971-79   1979-87
Change in (WC/WH)
Due to increase in demand (estimated)   26.4     26.4      26.4
Due to increase in supply (estimated)   -22.2    -28.9     -18.0
Net  estimated)                         4.2      -2.5      8.4
Net (actual)                            7.7      -10.4     12.8
```

What is striking is how large the numbers in the first two lines of the table are, how large the shifts in relative demand and supply have consistently been. If one is an optimist, one can read this table as suggesting that it would not take much change in either the rate of change of supply or demand to reestablish balance. If one is a pessimist, one can read it as suggesting that things could easily get much worse, that wage inequality may easily deteriorate faster. But in any case, the message of the table--that both demand and supply have changed rapidly--strikes me as important.

UNEMPLOYMENT

Let me now turn to macro implications. The main macro implication of the increase in net relative demand for skills is likely to be higher aggregate unemployment, or more generally, nonemployment.

The reason is obvious. The labor supply of the unskilled is much more elastic than that of the skilled workers. Thus, the increase in the wage of skilled workers does not increase their labor supply very much, if at all. But the decrease in the wage of unskilled workers can lead to a large decrease in their labor supply.

How large has the effect been so far? The question has been looked at carefully by Chinhui Juhn, Kevin Murphy, and Robert Topel in Juhn et al. (1991). Estimating labor supply elasticities of workers with different levels of wages, they found that they could explain all of the increase in nonemployment of 2.3 percent for prime age males from the early 1970s to the late 1980s (of which 0.7 percent took the form of higher unemployment). …

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