Unemployment was much lower in Europe than in the US from 1960 to the early 1970s but substantially higher during the late 1980s. In Discussion Paper No. 777, Research Fellows Wolfgang Franz and Robert Gordon examine the relationship between inflation and unemployment using a non-structural model of wage and price adjustment which integrates several concepts that have often been treated separately. These include Phillips curve `level effects', hysteresis `change effects', the error-correction mechanism and the role of changes in labour's share that act as supply shocks.

Franz and Gordon apply this model to 1973-90 data for the US and West Germany, which they take as representative of the European economy, on account of its size and anchor role in the EMS. Their German and US wage equations yield almost identical estimates of the Phillips curve slope, hysteresis effect and non-accelerating inflation rate of unemployment (NAIRU). The two countries also displayed very similar patterns of inflation, which depends on capacity utilization rather than unemployment. There was no feedback from wages to prices in Germany, however, as found in the US, so high unemployment induced no downward pressure on inflation. During the 1970s and 1980s, a growing mismatch emerged between the size of the German labour force and available industrial capacity, so the (constant-inflation) `mean utilization rate of unemployment' (MURU) increased sharply while it remained stable in the US.
Franz and Gordon conclude that German investment in productive capacity was inadequate to maintain full employment of the labour force. This required the Bundesbank to pursue a tight monetary policy to cope with the acceleration of inflation in the tight product market, and that spilled over to the rest of Europe. Restrictive demand policies and structural impediments therefore interacted to depress investment and slow the growth of industrial capacity, leaving Europe with insufficient capital to employ its labour force fully.

German and American Wage and Price Dynamics: Differences and Common Themes
Wolfgang Franz and Robert J Gordon

Discussion Paper No. 777, June 1993 (HR)