Labour market flows, unemployment and the Phillips curve
Summary
Focus
We investigate how transitions within the labour market – such as people moving between employment, unemployment and inactivity – affect inflation and wage growth. A new measure called the "unemployment gap" captures the difference between two types of unemployment:
- Stock-based unemployment – the traditional measure, which looks at the number of unemployed people at a specific point in time.
- Flow-based unemployment – a new measure that reflects the unemployment rate implied by current transitions in the labour market.
We combine empirical analysis (based on US labour market data) with a theoretical model to show how this unemployment gap can predict future inflation and wage behaviour.
Contribution
We address a key challenge in economics – understanding the relationship between labour market conditions and inflation. Traditional measures of slack, such as the unemployment rate or the output gap, often fail to account for the dynamic nature of the labour market. We provide a new way to measure labour market dynamics using flow-based unemployment and develop a theoretical framework that explains why labour market flows matter for wages and prices.
Findings
The unemployment gap offers better insights into inflationary pressures than traditional measures:
- A positive unemployment gap (where flow-based unemployment exceeds stock-based unemployment) signals that inflationary pressures are likely to decrease. This occurs when the labour market is loosening.
- A negative unemployment gap (where flow-based unemployment is below stock-based unemployment) suggests rising inflationary pressures, indicating a tightening labour market.
Transitions into employment (eg job retention rates and hiring rates) are the primary drivers of the unemployment gap. These flows provide valuable information about future wage and price dynamics.
The model shows that firms' willingness to pay higher wages depends on both the stock of unemployed workers and the flow of people moving between labour market states. Persistent changes in labour market flows (eg sustained high hiring rates) have a strong and long-lasting impact on wages and prices.
We highlight that the direction and momentum of labour market changes (flows) provide deeper insights into inflationary pressures than traditional static measures. This approach has practical implications for policymakers and businesses, providing a more accurate tool for understanding labour market conditions and how they affect inflation.
Abstract
We present empirical evidence from the United States demonstrating that labour market flows provide valuable insights into subsequent wage and price inflation. Specifically, we introduce a novel measure of the unemployment gap, defined as the difference between the unemployment rate implied by current labour market transitions -referred to as "flow-based unemployment"- and the observed, or stock-based unemployment, rate. Our findings reveal that inflationary pressures tend to subside when the unemployment gap becomes positive, i.e., when flow-based unemployment exceeds stock-based unemployment. To further investigate this relationship, we develop a search-and-matching model incorporating nominal wage rigidities and persistent (non-i.i.d.) shocks. In this framework, while firms face wage rigidities, they retain the ability to negotiate wages with new hires, making firms' bargaining power endogenous and dependent on both stock- and flow-based unemployment. Consistent with our empirical results, the model demonstrates that a larger unemployment gap-whether driven by higher flow-based unemployment or lower stock-based unemployment-typically leads to lower wages, provided that shocks to transition probabilities exhibit sufficient persistence.
JEL classification: E23, E24, E31, E32, E52, J64
Keywords: labour market flows, unemployment gap, search-and-matching, nominal rigidities, inflation, Phillips curve