Knowledge that Transforms

The response of nominal interest rates to price increases has been intensively studied since the onset of substantial inflation and historically high interest rates in the late 1960s. Early empirical investigations (Yohe and Karnosky (1969), Gibson (1972), and Pyle (1972)) tested the Fisher hypothesis that nominal rates react one-for-one to changes in the expected inflation rate. Paralleling results in the wage-price literature, these studies often found that nominal rates appeared to adjust too little to imply neutrality with respect to expected inflation. Theoretical work by Mundell (1963) and Tobin (1965) that incorporated wealth effects, by Sargent (1972) that considered an extended macromodel, and by Darby (1975) and Feldstein (1976) that allowed for income tax effects, however, suggested that additional variables, like measures of fiscal and monetary policy, may be relevant and that nominal rates may change by either more or less than unity in response to a one unit change in expected inflation. Two puzzling features of the response of nominal rates to expected inflation remain. First, even when other factors are included, estimates of that response are unstable for the postwar period (see Cargill and Meyer (1977)). Second, empirical studies to date have failed to produce any statistically discernible impact of expected inflation on interest rates during the 1950s (see Cargill and Meyer (1974) and Cargill (1976)). Similarly striking is the sizeable residual autocorrelation exhibited by nearly all estimates that include the 1950s. These symptoms of model misspecification imply that an important factor may have been omitted from previous models. A reduced form model of nominal interest rates that allows for an additional impact, that of factor supply shocks, is advanced in section II. The empirical tests in section III show that, once this variable is included, a significant relation between interest rates and expected inflation emerges for the 1950s. We also show that our specification is stable over the entire post-Accord period. Section IV concludes.

Economies, unpublished mimeograph, Jerusalem, The Falk Institute for Research in Israel, 1962. Lindley, D. V., and A. F. M. Smith, 'Bayes Estimates for the Linear Model, Journal of the Rox'al Statistical Soc ietv 34, Series B, no. 1 (1972), 1-18. Mundlak, Yair, On the Pooling of Time Series and CrossSection Data, Econometrica 46 (Jan. 1978), 69-86. Pakes, Ariel, Economic Incentives in the Production and Transmission of Knowledge: An Empirical Analysis, Ph.D. Thesis, Harvard University, 1978. , 'On the Asymptotic Bias of Wald-Type Estimators of a Straight Line when Both Variables Are Subject to Error International Review 23 (June 1982), 491-497.

T HE traditional view of market dynamics implies that when demand varies, intertemporal variation in quantities exchanged increases as prices become less flexible. This reasoning leads to the proposition that wage and price rigidities are important contributors to cyclical fluctuations in output. Fischer (1977a) and Gray (1978) based formal macro models on this principle. Although this view is common, it has little empirical support.' The coexistence of union and nonunion establishments engaged in similar activities contains potential for testing its merits. Economists have long maintained that in the short run, union wages are less flexible than nonunion wages (Dunlop (1950), Rees (1951)). This difference should produce larger fluctuations in union employment and hours. Empirical studies have generally supported the union wage rigidity hypothesis (Lewis (1963), Ashenfelter, Johnson, and Pencavel (1972), and Hendricks (1981)),2 but until recently, lack of data precluded analysis of hours and employment. Definitive answers to the important questions concerning unions' influence on cyclical behavior require yet unavailable information matching the behavior of firms and characteristics of workers, but data from modem surveys have allowed considerable progress. Nevertheless, it remains a challenge to determine how much of differences observed in the stability of labor utilization are attributable to differences in the stability of demand. Medoff (1979) and Raisian (1979) report that cyclical variation of employment and hours is indeed greater for union labor. But despite attempts to allay suspicion that their finding arises primarily from concentration of union members in cyclically sensitive industries, both studies leave room for doubt. Raisian estimated functions relating an individual's wage and weeks worked in a year to a proxy for excess demand (that year's unemployment rate) in the worker's industry. The technique is attractive, but Raisian's data included workers from the entire economy, and the industries were broad aggregates. Thus, differences in the union and nonunion groups' compositions may play a large role. Medoff, who confined his study to production workers in manufacturing and used data allowing finer partitions, investigated the importance of composition more thoroughly. But he did not estimate relationships between adjustments in employment or hours and a measure of demand. Furthermore, his focus was principally on the composition of manhours adjustments rather than their size. In this paper I combine the strongest features of the Medoff and Raisian studies in further examination of the influence of unionism on cyclical fluctuations. Using Current Population Surveys (U.S. Department of Commerce (1978)) from May of 1973-75, my analysis covers production workers in manufacturing during a period of rising inflation and unemployment. The heart of the analysis is a measure of residual employment that quantifies, by three-digit industry and year, shortrun excess demand for labor. I construct this variable from employment time series and use it to estimate union-nonunion differences in the cyclical responses of unemployment, hourly wage rates, and hours worked. The results are consistent with the view that increasing rigidity in wages amplifies cyclical fluctuations in the utilization of labor. The wage regressions add further to the literature's already strong support for the union wage rigidity hypothesis. The employment status and hours regressions imply that the sensitivities of employment Received for publication August 12, 1981. Revision accepted for publication February 11, 1983. * Federal Reserve Bank of Dallas. This paper is based on my Ph.D. dissertation, which was completed at UCLA with financial assistance from the Rand Corporation and the Department of Labor. Comments by referees and by participants of labor workshops at UCLA and the University of Chicago, as well as the computation assistance of Brian McKee, are gratefully acknowledged. I am responsible for any remaining errors. The views expressed should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System. ' One study is Gordon (1982), who concludes (page 41) that, macroeconomic instability in the United States has been aggravated by the unusually sluggish behavior of nominal wages in the postwar era. 2See also Johnson (1975), Parsley (1980), and Moore and Raisian (1980).

Arthur S. De Vany, Wendy L. Gramm, Thomas R. Saving, Charles W. Smithson, Production in a Service Industry Using Customer Inputs: A Stochastic Model, The Review of Economics and Statistics, Vol. 65, No. 1 (Feb., 1983), pp. 149-153

Don Coursey, Hans Nyquist, On Least Absolute Error Estimation of Linear Regression Models With Dependent Stable Residuals, The Review of Economics and Statistics, Vol. 65, No. 4 (Nov., 1983), pp. 687-692

Richard V. Burkhauser, James T. Wilkinson, The Effect of Retirement on Income Distribution: A Comprehensive Income Approach, The Review of Economics and Statistics, Vol. 65, No. 4 (Nov., 1983), pp. 653-658

omy 86 (Aug. 1978), 673-700. , A Note on Maximum Likelihood Estimation of the Expectations Model of the Term Structure, Journal of Monetary Economics 5 (1979), 133-143. Sargent, Thomas J., and Neil Wallace, Rational Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule, Journal of Political Economy 83 (Apr. 1975), 241-254. Zellner, Arnold, An Efficient Method of Estimating Seemingly Unrelated Regressions and Tests for Aggregation Bias, Journal of the American Statistical Association 57 (1962), 348-368.