Firm-Specific Labor, Trend Inflation, and Equilibrium Stability

The present paper explores the implications for monetary policy of different labor market structures. In one labor market workers are identical and thus easily interchangeable between firms, while in another labor market workers are specialized to fill the needs of specific firms. The labor market structure turns out to be a crucial determinant of the effectiveness of monetary policies guided by the Taylor principle in an environment of high trend inflation. ; According to the Taylor principle, an undesirable rise in inflation requires a disproportionately strong response of interest rates. Otherwise, self-fulfilling private-sector expectations of inflation may push prices upward. It is widely believed that the Federal Reserve’s approach to setting interest rates did not conform to the Taylor principle prior to the early 1980s, but since then has done so, to good effect. Recent research, however, has suggested that when trend inflation is high—about four percent or higher—the Taylor principle may become less effective. ; Studies on the subject have made varying assumptions about the structure of the labor market, with some presuming that all firms hire the same type of labor, while others assume that firms need specialized labor. These differing assumptions matter: the need for specialized labor affects the way firms’ costs adjust in reaction to shifts in demand, and that has implications for inflation dynamics and for the Taylor principle. ; We find that in a model economy with specialized labor, a policy rule for setting interest rates cannot ensure keeping inflation stable even if it satisfies the Taylor principle, if trend inflation is high. This differs from a model where workers are identical, in which adhering to the Taylor principle does achieve stability of inflation, whether trend inflation is high or low. The finding suggests that whether the Federal Reserve’s policy shift in the early 1980s was sufficient, alone, to bring about the period of stable inflation that followed, or whether it also depended on a decline in trend inflation, depends on the structure of the labor market.