Studies of the Impact of Low Inflation and Minimum Wages on Employment and Welfare

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This research consists of four project. The first will analyze the impact of low inflation and minimum wage legislation on employment and welfare. The first question that will be addressed is the benefits from lower tax distortions of lower inflation. Martin Feldstein has estimated the welfare benefits of reducing inflation from two percent to zero as 1.01 percent of GNP. These calculations will be redone taking account of four factors omitted in the Feldstein model. Those four factors are: behavioral responses of savings out of interest income to changes in after tax rates of return on savings, tax shelters, the distribution of benefits by income, and the fall in the rate of return on physical capital with increases in the capital stock. These factors properly considered should result in significant changes in the evaluation of the welfare benefits of lower tax distortions from zero inflation, quite possibly leading to a loss in welfare from pursuit of such a goal. The second project will be the theoretical and empirical consideration of models in which the way inflation enters price and wage decisions changes qualitatively as inflation nears zero. Advocates of price stability have claimed that one of the reasons for pursuit of that goal is that inflation could then be ignored in many economic decisions. If some significant fraction of decision makers ignore inflation in wage and price decisions at very low inflation, there will be a significant trade-off between inflation and unemployment if inflation is low enough. Such behavior will be near rational since the losses to price and wage setters will vary with the square of inflation. The model will yield an optimal rate of inflation which is moderate, but greater than zero. The third project will consider the effects of minimum wage legislation on employment. The PI's will use the same approach as in their earlier work on evaluating the employment impact of nominal wage rigidity at very low inflation to calculate the impact of changes in the real minimum wage on employment. They will explore the differences between the two types of effects. They will also estimate the size of the pass through of changes in minimum wages onto prices. The fourth project will continue the earlier work on nominal wage rigidity. The PI's will test their earlier model using international data. They also will use contract data to see how people now, in times of higher than zero inflation, think that they might behave if inflation should actually fall to zero, by examining indexation provisions in contracts where inflation becomes negative. The PI's will develop a general model of indexation, incorporating both rational and irrational elements, borrowing on the work of Shiller in terms of what people say about indexation and, in particular, will see whether contracts provide for give-backs in the event of deflation, or whether they specifically prohibit them.