Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Unit Labor Costs and the Price Level

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Unit Labor Costs and the Price Level

Article excerpt

A popular theoretical model of the inflation process is the expectations augmented Phillips-curve model. According to this model, prices are set as markup over productivity-adjusted labor costs, the latter being determined by expected inflation and the degree of demand pressure.(1) It is assumed further that expected inflation depends upon past inflation. This model thus implies that productivity-adjusted wages and prices are causally related with feedbacks running in both directions.

In this article, I investigate empirically the causal relationship between prices and productivity-adjusted wages (measured by unit labor costs) using cointegration and Granger-causation techniques.(2) In my recent paper, Mehra (1991), I used similar techniques(3) to show that inflation and growth in unit labor costs are correlated in the long run and that the presence of this correlation appears to be due to Granger-causality running from inflation to growth in unit labor costs, not the other way around. The results presented there indicate that the "price markup" hypothesis is inconsistent with the data and that growth in unit labor costs does not help predict the future inflation rate.

This article examines the robustness of the conclusions in Mehra (1991) to changes in the measure of the price level, the sample period, and unit root-cointegration test procedures used there. In particular, the price series used in Mehra (1991) is the fixed-weight GNP deflator that covered the sample period 1959Q1 to 1989Q3; the test for cointegration used is the two-step procedure given originally in Engle and Granger (1987); and the stationarity of data is examined using Dickey-Fuller unit root tests. This article considers an additional price measure, the consumer price index, which covers consumption goods and services bought by urban consumers. In contrast, the implicit GNP deflator, the other price measure used here, covers prices of consumption, investment, government services, and net exports. Since the consumer price index is also a widely watched measure of inflation pressures in the economy, the article examines whether the causal relationships found between the general price level and unit labor costs carry over to consumer prices.

In my earlier empirical work (1991), I used Dickey-Fuller unit root tests to determine whether the relevant series contain stochastic or deterministic trends. Recently, some authors including Dejong et al. (1992) have shown that Dickey-Fuller tests have low power in distinguishing between these two alternatives. These studies suggest that economists should supplement unit root tests by tests of trend stationarity. Thus, a series now is considered having a unit root if two conditions are met: (1) the series has a unit root by Dickey-Fuller tests and (2) it is not trend stationary by tests of trend stationarity. Furthermore, the test for cointegration recently proposed by Johansen and Juselius (1990) overcomes several pitfalls associated with the Engle-Granger test for cointegration.(4) This article employs these additional, refined cointegration-stationarity tests to determine the stationarity of data and to study the nature of the causal structure between the general price level and unit labor costs.

The empirical evidence reported here indicates that wage and price series contain stochastic, not deterministic, trends and that long-run movements in prices are correlated with long-run movements in unit labor costs. That is, the wage and price series used here are cointegrated as discussed in Engle and Granger (1987). This result holds whether the particular price series used is the implicit GDP deflator or the consumer price index.

Tests of Granger-causality presented here indicate that short-run movements in prices and unit labor costs are also correlated, with Granger-causality running one way from prices to unit labor costs when the price series used is the implicit GDP deflator. …

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