## David T. Coe and Thomas Krueger^{1}

The closely related concepts of potential output and the natural rate of unemployment have important policy implications because they describe long-run equilibria in product and labor markets and are important determinants of wage and price developments in the short run. These are now particularly important policy concerns because unification of the two German economies implies a significant increase in demand in west Germany, a demand stimulus that is already apparent in 1990. In the long run, the path of potential output, and hence productivity at potential output, in west Germany will determine the magnitude of the “catch up” that is required for living standards in east Germany to match those in the western part of the country.^{2}

Economic developments in the Federal Republic of Germany (FRG) in the 1980s suggest that the relationship between potential output, the natural rate of unemployment, and wage and price inflation may not be straightforward: output expanded steadily after 1982 and, based on most measures, appeared to be at or near capacity in the late 1980s while wage and price inflation was broadly stable;^{3} but unemployment rates, after increasing dramatically in the mid-1970s and the early 1980s, remained stuck at historically high levels of about 8 percent until 1988 (Chart 1).

The coexistence of persistent high rates of unemployment, low and stable wage and price inflation, and output that appeared to be at or near capacity would be consistent with the standard Phillips curve model if the natural rate of unemployment was also about 8 percent in the mid-to-late 1980s. It is difficult, however, to identify structural changes in the labor market that would have increased the natural rate of unemployment from less than 1 percent in the 1960s and early 1970s to 7–8 percent in the 1980s.^{4} Moreover, the rapid rates of growth and the substantial declines in the unemployment rate in 1989–90 did not appear to be accompanied by significant increases in inflation pressures, suggesting the existence of some excess capacity.

This chapter considers an alternative explanation for the coexistence of persistent high rates of unemployment, stable inflation, and output at capacity, an explanation that focuses on the wage bargaining process and other structural features of the labor market. It is argued that, although there has been some increase in structural unemployment since the early 1970s, the natural rate of unemployment in the FRG was well below the actual unemployment rate for most of the 1980s. But because of the nature of wage bargaining in west Germany, the large gap between the actual and the natural rates of unemployment did not exert ongoing downward pressure on the growth of real wages. In this model, unemployment above the natural rate is consistent with stable wage and price inflation because the level of unemployment has little impact on the growth of wages that are negotiated between employers and employees.

This suggests a distinction between the concept of an equilibrium natural rate of unemployment and a quasi-equilibrium unemployment rate that may be closely related to the actual rate of unemployment, as suggested by the hysteresis hypothesis.^{5} Corresponding to these two concepts of equilibrium unemployment are alternative concepts of potential output that differ according to whether labor input is consistent with the quasi-equilibrium rate of unemployment—quasi-potential output—or with the natural rate of unemployment.

Actual output in the FRG may have been near quasi-potential output for much of the 1980s, as suggested by most indicators of capacity utilization. However, a measure of potential output using labor input consistent with the natural rate of unemployment would have indicated that more resources were available to increase output than suggested by the quasi-equilibrium measure of potential. This does not mean, however, that there were no constraints or “speed limits” on the rapidity with which output could be increased and unemployment reduced from their quasi-equilibrium levels. An obvious constraint was the existing stock of capital, suggesting the possibility of capital-shortage unemployment. But developments in 1989–90 underscore that this is a short-run constraint that is not binding over the medium term, as higher rates of investment can be expected to be forthcoming in response to high rates of capacity utilization and an increase in actual or expected demand.^{6}

The objectives of this chapter are threefold. The first is to describe more fully the implications of the alternative models of wage determination noted above. The second objective is to present estimates of potential output and the natural rate of unemployment together with a decomposition of their underlying structural or policy determinants. The third objective is to examine the prospects for potential output and the natural rate of unemployment in light of the additional demand that will be generated by the German economic, monetary, and social union (GEMSU). The chapter concludes with a discussion of the policy implications of the analysis given in the earlier sections.

### Wage Determination

In the 1970s and 1980s, unemployment and output developments in many European countries were similar to those depicted for the FRG in Chart 1. This apparent inconsistency with the Phillips curve/natural-rate model led to the development of theoretical labor market models that provided consistent micro-foundations to explain the persistence of involuntary unemployment.^{7} One of these models, which distinguishes between insiders and outsiders in wage bargaining at the level of the enterprise, is presented below. This is followed by a discussion of the aggregate wage and unemployment dynamics implied by the target-real-wage-bargaining model—an aggregate model of wage determination consistent in many respects with the insider-outsider model—as opposed to a conventional Phillips curve/natural-rate model.

#### An Insider-Outsider Model of Wage Determination

Institutional features of the labor market in west Germany suggest that the unemployed—loosely speaking, the outsiders—have little influence on the wage negotiated by employers and employees—the insiders. Bargaining, for example, is highly centralized and settlements negotiated by unions in key industries or sectors are often extended to include smaller establishments or the nonunionized workforce.^{8} Furthermore, unemployment benefits make up a significant portion of lost wage income, and basic benefits *(Arbeitslosenhilfe)* can, in principle, continue indefinitely after eligibility for unemployment insurance has expired, provided a social need exists on the part of the recipient. These features give the employed workforce a degree of market power in the wage negotiation process. The insider-outsider model presented below illustrates how this market power can give rise to persistent involuntary unemployment.^{9}

The upper panel of Chart 2 depicts the labor demand and supply curves of a representative firm and the lower panel shows aggregate employment and unemployment under the assumption that the economy is made up of *n* identical firms. As a point of reference for the discussion to follow, consider initially the case where insiders have no market power. The firm’s demand for labor is represented by *l*^{d}, the marginal revenue product schedule, and it faces an elastic labor supply curve at the reservation wage (*w*^{r}), which reflects, for example, the generosity of the unemployment insurance system. Equilibrium is at *A*^{*} with nominal wages equal to the reservation wage (*w*^{r}), employment equal to *e*^{*}, and aggregate employment equal to *E*^{*}. Given the total labor force (*L*), aggregate unemployment (*U*^{*}) is at the natural rate of unemployment. Unemployment is “voluntary,” and the natural rate is determined by the reservation wage.

**Unemployment Persistence in an Insider-Outsider Model**

^{d}) of a representative firm and the labor supply curves of insiders [l

^{*}()]. Assuming identical firms (tan

*α*=

*n*), the lower panel shows aggregate employment (

*E*, E

_{0}=

*ne*

_{0}) and (reading down the left axis) unemployment.

**Unemployment Persistence in an Insider-Outsider Model**

^{d}) of a representative firm and the labor supply curves of insiders [l

^{*}()]. Assuming identical firms (tan

*α*=

*n*), the lower panel shows aggregate employment (

*E*, E

_{0}=

*ne*

_{0}) and (reading down the left axis) unemployment.

**Unemployment Persistence in an Insider-Outsider Model**

^{d}) of a representative firm and the labor supply curves of insiders [l

^{*}()]. Assuming identical firms (tan

*α*=

*n*), the lower panel shows aggregate employment (

*E*, E

_{0}=

*ne*

_{0}) and (reading down the left axis) unemployment.

Assume now that the “insiders” (the currently employed) have some market power because it is costly for firms to replace insiders by “outsiders” (the currently unemployed). This turnover cost per employee (*c*) may be related to severance pay or the ability of insiders to harass or withhold cooperation from new employees.^{10} For a given capital stock and technological endowment, the representative firm—which takes output prices, the nominal wages of insiders (*w*^{i}), and the reservation wage of outsiders (*w*^{r}) as given—maximizes profits by choosing the labor input of insiders and outsiders. In Chart 2, the corresponding labor demand curves are shown as *l*^{d}_{0} for insiders and *l*^{d}_{1} for outsiders, the latter differing from the demand curve for insiders by the turnover cost *c*.

Insiders will set a wage (*w*^{i}) to maximize, for example, their joint wage income. But, because they face some competition for jobs from outsiders, to avoid being replaced by outsiders this wage will not exceed the outsiders’ reservation wage by more than the turnover-cost differential. The insiders’ labor supply curve (*l*^{s}(•)) depends on the number of insiders and becomes vertical at the level of insiders engaged in the wage negotiating process, reflecting the assumption that insiders do not take the welfare of outsiders into account. For an initial insider employment of *e*_{0}, the resulting labor supply curve for insiders is *l*^{s}(*e*_{0}). Equilibrium is at *A*, where the labor demand curve for insiders intersects their labor supply curve. Although current wages exceed the reservation wage of the unemployed, they are unable to find jobs because the turnover cost makes their employment unprofitable. Unemployment at *U*_{o}, which is above the natural rate of unemployment, can exist as a quasi-equilibrium because there are no forces in the labor market that would reduce unemployment to the natural rate.

Starting from the equilibrium at *A*, suppose the economy is subjected to an unanticipated negative demand or supply shock and that, at the time, agents perceive this shock to be permanent.^{11} To avoid complicating Chart 2, let the labor demand schedule for insiders shift down from *B*, with lower wages *E*_{1} < *E*_{0}), and higher unemployment (*U*_{1} > *U*_{0}) as some former insiders become unemployed, that is, become outsiders.^{12} Once the economy settles at this quasi-equilibrium there are again no forces in the labor market to reduce unemployment either to its previous level or to the natural rate.

Consider now a reversal of the initial shock and a return of the labor demand schedules to their original positions in Chart 2. Insiders would like to move to a new equilibrium like *B’*, but are constrained in their wage demand by outsiders vying for their jobs. To avoid being laid off, insiders will not demand wages higher than (*w*^{r} + *c*). At this wage, and given the increased demand for labor, it is profitable for the firm to hire additional workers (*e*_{2} − *e*_{1}) at the reservation wage. In the following “period” these new entrants become insiders and a new equilibrium is reached where all employees receive a wage of (*w*^{r} + *c*). The relevant insider labor supply curve becomes *l*^{s}(*e*_{2}), and *D* will be the new equilibrium. Even though the exogenous supply conditions have returned to their original levels, unemployment does not return to its pre-shock level (*U*_{2} > *U*_{0}).^{13}

The insider-outsider model highlights how wage bargaining by insiders may result in persistent aggregate unemployment,^{14} and also shows how a series of supply shocks can ratchet-up the unemployment rate, even if the supply shocks are subsequently reversed.^{15} Although these implications of the model are consistent with unemployment developments in the FRG in the 1970s and the 1980s, a number of aspects of the model—for example, the membership rules determining the insider and outsider groups—are unrealistic characterizations of aggregate labor market behavior. The aggregate model of wage determination discussed in the next section relies on less extreme assumptions, but has a number of implications—particularly with respect to the persistence of unemployment—that are similar to those of the insider-outsider model.

#### The Phillips Curve/Natural-Rate Model and the Target-Real-Wage-Bargaining Model

Sargan’s (1964) target-real-wage-bargaining model is an aggregate model of wage determination that shares some of the characteristics of the insider-outsider model discussed above.^{16} The focus in this alternative to the Phillips curve is on the equilibrium relationship between the *levels* of—as opposed to the changes in—real wages and labor productivity implying that the *growth* of nominal wages will be determined, in part, by a catch-up variable reflecting past deviations of real wages from their target level. This feature of the target-real-wage-bargaining model results in implications for equilibrium unemployment that are very different from those of the standard Phillips curve/natural-rate model. Before presenting a formal nested specification of the two models, the relationship between them is illustrated in the context of the familiar Phillips curve graph.

The top panel of Chart 3 shows the expectations augmented Phillips curve with a vertical long-run Phillips curve at the natural rate of unemployment (*U*^{*}). Demand is represented as a positive relationship between nominal wage inflation (Δ*w*) and unemployment (*U*).^{17} Consider the influence of restrictive monetary policies adopted to reduce wage and price inflation. From an initial equilibrium position of wage inflation at Δ*w*_{0} and unemployment at the natural rate, the more restrictive policies would reduce aggregate demand (*AD*_{0} to *AD*_{1}) and increase unemployment to *U1*. As the declines in wage inflation are incorporated into inflation expectations, the short-run Phillips curves (*PC*) shift down, real wages decline, and unemployment falls.^{18} This process—which is the mirror image of Friedman’s (1968) accelerationist hypothesis—continues until equilibrium is re-established at the natural rate (*U*^{*}) and wage and price inflation is reduced to Δ*w*_{1}.

**The Phillips Curve/Natural-Rate and Target-Real-Wage-Bargaining Models**

**The Phillips Curve/Natural-Rate and Target-Real-Wage-Bargaining Models**

**The Phillips Curve/Natural-Rate and Target-Real-Wage-Bargaining Models**

In the lower panel of Chart 3, the short-run Phillips curve has been replaced with a real-wage-bargaining curve (*RWB*). The only difference between the real-wage-bargaining curve and the Phillips curve is that nominal wage growth will now be influenced by an additional catch-up variable reflecting the deviation of real wages from their target level (as shown in the specification of equation (1) below). Just as in the Phillips curve, the real-wage-bargaining curves will shift with changes in expected inflation.

Consider the impact of the same restrictive monetary policies in the target-real-wage-bargaining model. The first-round effects are similar to the Phillips curve model: unemployment increases and nominal wage growth falls as indicated by point *A*. Real wages also decline with the increase in unemployment as does the target level of real wages. But once the increase in unemployment has been reflected in a reduction in the target level of real wages, the higher level of unemployment does not exert on-going downward pressures on the growth of real wages; because real wages do not decline further, labor demand declines relative to the situation implied by the Phillips curve and *AD* shifts further down. At the same time, there are ongoing downward pressures on nominal wage growth as the decline in wage inflation gets incorporated into expectations. Consequently, the real-wage-bargaining curves (*RWB*) shift down until inflation has been reduced to Δ*w*_{1}.

Although wage and price inflation stabilizes at the same level as in the Phillips curve model, reflecting the same reduction in the growth of money, real wages and unemployment are higher in the target-real-wage-bargaining model due to the market power of the employed labor force. In the target-real-wage-bargaining model, unemployment in excess of the natural rate can exist as a quasi-equilibrium with stable wage and price inflation.^{19} If this quasi-equilibrium is disturbed by a positive demand shock, unemployment will decline and inflation will increase. The magnitude of the drop in unemployment depends on the size and nature of the shock, and whether the rise in inflation is permanent or temporary will be determined by the response of monetary policies.

The relationship between the target-real-wage-bargaining model and the Phillips curve model shown in Chart 3 can be expressed in the following wage equation which nests the two models:^{20}

where τ_{1} < 0, τ_{2} ≤ 0, and τ0 defines the equilibrium relationship between the level of real wages and trend average labor productivity (*q*^{tr}). If the final term is absent (τ2 = 0), the equation is a relatively standard Phillips curve except that trend productivity growth and the natural rate of unemployment are explicitly specified. Including the final term (τ_{2} < 0), converts the equation from a growth rate relationship between real wages, productivity, and unemployment, to a level relationship between the same variables. This can be seen in the long-run, stationary steady-state form of equation (1), assuming that Δ*p*^{exp} = Δ*p*:

Since the level of wages is related to the level of unemployment, the growth of wages is related to changes in unemployment.^{21} In this model, the target real wage ((*w* − *p*)^{T}) is determined by trend productivity and the labor market gap, which can be thought of as a proxy for the bargaining power of labor:

Consider an equilibrium characterized by realized expectations (Δ*p*^{exp} = Δ*p*) and real wages growing the same as trend productivity (Δ*w* − Δ*p* = Δ*q*^{tr}). In the Phillips curve model (τ_{2} = 0 in equation (1)), it is clear that equilibrium defined in this way requires that unemployment be at the natural rate (*U* = *U*^{*}). In the target-real-wage-bargaining model (τ_{2} < 0 in equation (1)), a quasi-equilibrium can exist where unemployment is above the natural rate provided that the target level of real wages has been reduced relative to the level of trend productivity; in terms of equation (1), what is required is that the last two terms sum to zero:

Empirical tests of the alternative models indicate that aggregate wage developments in west Germany are better described by the target-real-wage-bargaining model than by the Phillips curve/natural-rate model.^{22} The persistence of high unemployment in west Germany could therefore be interpreted as a reflection of the nature of aggregate wage formation rather than as a reflection of a high natural rate of unemployment. But if the natural rate of unemployment in west Germany in the 1980s was not approximately 8 percent, what was it? This issue is addressed in the next section which presents estimates relating the natural rate of unemployment to structural features of the labor market in the FRG.

### The Natural Rate of Unemployment and Potential Output

The empirical counterparts to the unobserved concepts of potential output and the natural rate of unemployment have been estimated from a model that exploits the information contained in the relatively well defined and measured wage, price, output, and unemployment data. Equations for wages, prices, multifactor productivity, and unemployment are jointly estimated as a system to ensure that the resulting estimates for potential output and the natural rate of unemployment are consistent, and to incorporate as much relevant information as possible in the estimation procedure.^{23} Given the estimated parameters, the natural rate of unemployment and potential output can be calculated as functions of their structural determinants. The model and the estimation results are summarized in the Appendix.

#### The Natural Rate of Unemployment

The lower panel of Chart 4 shows the estimated natural rate of unemployment. The structural determinants of the natural rate are the age-sex composition of the labor force under the assumption that the higher is the proportion of the labor force which is prime age (25–54 years) and male, the lower is the estimated natural rate; the proportion of the labor force in private sector apprenticeship programs, a unique feature of the labor market in west Germany that contributes to the relatively highly skilled labor force and lowers the natural rate; nonwage labor costs, measured as employers’ social security contributions as a percent of total labor compensation, which increase the natural rate; the proportion of the labor force that is unionized, which is a proxy for insider bargaining power and increases the natural rate; and the unemployment insurance replacement ratio, which affects the reservation wage, and hence increases the natural rate.

**Federal Republic of Germany: Potential and Quasi-Potential Output and the Natural Rate of Unemployment, First Quarter 1968–Fourth Quarter 1989**

*Volkswirtschaftliche Gesamtrechnungen*;and authors’ estimates.

^{1}Seasonally adjusted; actual output in the first quarter of 1968

*=*100.

^{2}Seasonally adjusted; in percent of the labor force.

*Volkswirtschaftliche Gesamtrechnungen*;and authors’ estimates.

^{1}Seasonally adjusted; actual output in the first quarter of 1968

*=*100.

^{2}Seasonally adjusted; in percent of the labor force.

*Volkswirtschaftliche Gesamtrechnungen*;and authors’ estimates.

^{1}Seasonally adjusted; actual output in the first quarter of 1968

*=*100.

^{2}Seasonally adjusted; in percent of the labor force.

The natural rate of unemployment is estimated to have increased steadily from its assumed value of 0.7 percent in 1968 to about 4¼ percent in 1976, and then to have fluctuated between 2½ percent and 3½ percent from 1977–88. Actual rates of unemployment were below the estimated natural rate by about 1¼ percentage points from 1970–73, and followed closely the natural rate after 1975 until the end of the decade. In the 1980s, however, it is estimated that this gap widened considerably and averaged about 5 percentage points from 1983 to 1988.

Table 1 presents a decomposition of the changes in the estimated natural rate of unemployment. The large increases in the natural rate in the early 1970s reflected increases in nonwage labor costs, which rose from about 15 percent of wages and salaries in 1969 to 20 percent in 1975, and in unionization, which increased from 29½ percent of the labor force in 1969 to 32½ percent in 1975. During the late 1970s, the natural rate declined somewhat as the number of apprentices increased from 5 percent of the labor force in 1975 to 6 percent in 1979, although this was partially offset by continued increases in nonwage labor costs (1 percentage point) and unionization (2 percentage points). The natural rate of unemployment is estimated to have averaged about 3¼ percent in the 1980s, reflecting the net effect of some upward pressure from demographic changes, reductions in the share of apprentices in the labor force, and continued increases in nonwage labor costs, offset by reductions in unionization. There was a small increase in unemployment insurance replacement ratios in the mid-to-late 1970s, which tended to increase the estimated natural rate of unemployment somewhat, but this effect was largely reversed in the 1980s.

**Federal Republic of Germany: The Natural Rate of Unemployment**

(In percent of labor force)

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**Federal Republic of Germany: The Natural Rate of Unemployment**

(In percent of labor force)

1969–73 | 1973–75 | 1975–79 | 1979–83 | 1983–88 | |||
---|---|---|---|---|---|---|---|

Change in the unemployment rate | 0.4 | 3.0 | −0.8 | 5.0 | −0.3 | ||

Change in the natural rate | 1.4 | 1.0 | — | −0.2 | 0.1 | ||

Due to: | |||||||

Demographics | −0.1 | 0.1 | — | 0.3 | — | ||

Apprentices | 0.1 | −0.1 | −1.3 | −0.3 | 0.4 | ||

Nonwage labor costs | 0.7 | 0.3 | 0.4 | 0.3 | 0.2 | ||

Unionization | 0.5 | 0.5 | 0.8 | −0.4 | −0.3 | ||

Unemployment insurance replacement ratios | 0.1 | 0.2 | 0.2 | −0.2 | −0.1 | ||

Unemployment rates at end of period | |||||||

Actual | 1.0 | 4.0 | 3.2 | 8.2 | 7.8 | ||

Natural | 2.5 | 3.5 | 3.5 | 3.3 | 3.4 | ||

Difference | −1.5 | 0.5 | −0.3 | 4.9 | 4.4 |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**Federal Republic of Germany: The Natural Rate of Unemployment**

(In percent of labor force)

1969–73 | 1973–75 | 1975–79 | 1979–83 | 1983–88 | |||
---|---|---|---|---|---|---|---|

Change in the unemployment rate | 0.4 | 3.0 | −0.8 | 5.0 | −0.3 | ||

Change in the natural rate | 1.4 | 1.0 | — | −0.2 | 0.1 | ||

Due to: | |||||||

Demographics | −0.1 | 0.1 | — | 0.3 | — | ||

Apprentices | 0.1 | −0.1 | −1.3 | −0.3 | 0.4 | ||

Nonwage labor costs | 0.7 | 0.3 | 0.4 | 0.3 | 0.2 | ||

Unionization | 0.5 | 0.5 | 0.8 | −0.4 | −0.3 | ||

Unemployment insurance replacement ratios | 0.1 | 0.2 | 0.2 | −0.2 | −0.1 | ||

Unemployment rates at end of period | |||||||

Actual | 1.0 | 4.0 | 3.2 | 8.2 | 7.8 | ||

Natural | 2.5 | 3.5 | 3.5 | 3.3 | 3.4 | ||

Difference | −1.5 | 0.5 | −0.3 | 4.9 | 4.4 |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

The 4½ to 5 percentage point gap between the estimated natural rate of unemployment and the actual unemployment rate in the FRG throughout most of the 1980s is striking. It is noteworthy, however, that a number of other studies based on different methodologies arrive at a similar result. Franz and König (1990) estimate a disequilibrium model and calculate an equilibrium structural unemployment rate that was close to actual rates of unemployment in the 1960s, and then increased to a maximum of 3¾ percent in 1985. The principal determinants of changes in the structural unemployment rate in Franz and König’s analysis were nonwage labor costs and, to a much lesser extent, the unemployment insurance replacement ratio, which is consistent with the results presented above. Similarly, Torres and Martin (1990), based on estimated Phillips curves, calculate that the unemployment rate consistent with nonincreasing wage inflation in the FRG rose from about 3 percent in the late 1960s to about 4 percent in 1988.^{24}

As discussed earlier, the target-real-wage-bargaining model implies that unemployment in excess of the natural rate will result in a downward adjustment of the target real wage relative to labor productivity. Based on the system estimation results, the 5 percentage point gap between the estimated natural rate and the actual unemployment rate that opened from 1980 to 1988 implies a reduction in real compensation relative to productivity at potential (*w* − *p*^{c} − *q*^{pot}) of about 11 percent. During this period, the actual increase in real consumption wages (*w* − *p*^{c}) was about 10 percent less than the increase in the estimated labor productivity at potential output (*q*^{pot}).^{25}

#### Potential Output and Multifactor Productivity

Average output growth in the private nonfarm sector slowed considerably in the FRG over the 1969–88 period. Possible sources of this slowdown are suggested by the growth accounting framework in Table 2, based on a Cobb-Douglas production function with actual income shares used to weight labor and capital inputs.^{26}

**Federal Republic of Germany: Contributions to Output Growth in the Private Nonfarm Sector**

(Average annual percentage changes)

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**Federal Republic of Germany: Contributions to Output Growth in the Private Nonfarm Sector**

(Average annual percentage changes)

Output | Hours Worked | Capital | Multifactor Productivity | ||
---|---|---|---|---|---|

1969:II-1988:IV | 2.50 | − 0.46 | 1.76 | 1.20 | |

1969:II-1974:I | 4.16 | −0.08 | 2.59 | 1.65 | |

1974:II-1980:I | 2.73 | −0.61 | 1.35 | 1.99 | |

1980:II-1988:IV | 1.41 | −0.57 | 1.56 | 0.42 | |

1983:I-1988:IV | 2.89 | −0.08 | 1.68 | 1.29 |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**Federal Republic of Germany: Contributions to Output Growth in the Private Nonfarm Sector**

(Average annual percentage changes)

Output | Hours Worked | Capital | Multifactor Productivity | ||
---|---|---|---|---|---|

1969:II-1988:IV | 2.50 | − 0.46 | 1.76 | 1.20 | |

1969:II-1974:I | 4.16 | −0.08 | 2.59 | 1.65 | |

1974:II-1980:I | 2.73 | −0.61 | 1.35 | 1.99 | |

1980:II-1988:IV | 1.41 | −0.57 | 1.56 | 0.42 | |

1983:I-1988:IV | 2.89 | −0.08 | 1.68 | 1.29 |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

For the three subperiods identified in the middle of Table 2, all factors contributed to the decline in output growth, although their contributions varied over the different subperiods. Multifactor productivity growth first increased after 1974 before declining sharply in the 1980–88 period, becoming the major “source” of the further decline in output growth. A comparison of developments in 1983–88 with developments from the second quarter of 1969 to the first quarter of 1974 is instructive, since the latter period also began during an early phase of a business cycle upturn (the other subperiods are peak-to-peak). While the contribution of labor was the same in the two periods, the growth of both capital and multifactor productivity was considerably slower in the 1980s expansion.

Based on the system estimation results, the two alternative measures of equilibrium output discussed above—quasi-potential output and potential output—can be calculated. Both measures of potential output are determined by normalized capital and labor inputs and by multifactor productivity. The only difference between the two measures is that for potential output labor input is defined as total manhours consistent with employment at the levels implied by the estimated natural rate of unemployment, whereas for quasi-potential output actual manhours are used.^{27} The determinants of multifactor productivity are the stock of research and development (R&D) capital;^{28} non-German immigration, which is estimated to have reduced the productivity of labor and thereby reduced potential output per unit of labor; and the integration of the European Community (EC), measured as intra-EC trade as a percent of the GNP of the EC countries, which is assumed to increase efficiency in west Germany.^{29}

The upper panel of Chart 4 depicts the time paths of potential, quasi-potential, and actual output in the private nonfarm sector of the FRG. There was little difference between potential and quasi-potential output in the 1970s, reflecting the similar levels of the actual and the natural rates of unemployment. Thereafter, the steep rise in the actual rate of unemployment in contrast to the stability in the estimated natural rate of unemployment is reflected in the opening of a gap between potential output and the lower levels of quasi-potential and actual output. Even though this gap narrowed slightly after 1986 as unemployment rates declined, potential output is estimated to have exceeded actual output by about 2½ percent at the end of 1988; and quasi-potential output is estimated to have been about equal to actual output in 1988.

The annual growth rate of potential output declined by about 1 percent between the early 1970s and the late 1970s, a decline that was even more pronounced in quasi-potential output growth (Table 3). The slowdown in growth reflected primarily a slower pace of capital expansion and a decrease in multifactor productivity growth. Potential output growth increased in the 1980s reflecting increased growth of the capital stock and a slowing in the trend decline of labor input, which were sufficient to offset the continued decline in multifactor productivity growth. During the expansion from 1983 to 1988, however, potential output growth remained about 1 percentage point lower than in the 1969–73 period.

**Federal Republic of Germany: Contributions to Potential and Quasi-Potential Output Growth in the Private Nonfarm Sector**

(Annual percentage changes)

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**Federal Republic of Germany: Contributions to Potential and Quasi-Potential Output Growth in the Private Nonfarm Sector**

(Annual percentage changes)

1969:II–1988:IV | 1969:II–1974:I | 1974:II–1980:I | 1980:II–1988:IV | 1983:I–1988:IV | |||||
---|---|---|---|---|---|---|---|---|---|

Potential output | 2.5 | 3.2 | 2.1 | 2.4 | 2.2 | ||||

Due to: | |||||||||

Hours worked | −0.4 | −0.8 | −0.5 | −0.2 | −0.4 | ||||

Capital | 1.8 | 2.4 | 1.3 | 1.7 | 1.8 | ||||

Multifactor productivity | 1.2 | 1.6 | 1.3 | 0.8 | 0.8 | ||||

Due to: | |||||||||

R&D capital | 0.6 | 0.7 | 0.6 | 0.6 | 0.5 | ||||

Foreign arrivals | 0.2 | 0.3 | 0.2 | 0.2 | 0.2 | ||||

EC trade share | 0.3 | 0.6 | 0.4 | 0.1 | 0.1 | ||||

Quasi-potential output | 2.4 | 3.4 | 2.0 | 2.1 | 2.2 | ||||

Quasi-potential hours worked | −0.6 | −0.7 | −0.6 | −0.4 | −0.4 | ||||

Actual output | 2.5 | 4.2 | 2.7 | 1.4 | 2.9 |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**Federal Republic of Germany: Contributions to Potential and Quasi-Potential Output Growth in the Private Nonfarm Sector**

(Annual percentage changes)

1969:II–1988:IV | 1969:II–1974:I | 1974:II–1980:I | 1980:II–1988:IV | 1983:I–1988:IV | |||||
---|---|---|---|---|---|---|---|---|---|

Potential output | 2.5 | 3.2 | 2.1 | 2.4 | 2.2 | ||||

Due to: | |||||||||

Hours worked | −0.4 | −0.8 | −0.5 | −0.2 | −0.4 | ||||

Capital | 1.8 | 2.4 | 1.3 | 1.7 | 1.8 | ||||

Multifactor productivity | 1.2 | 1.6 | 1.3 | 0.8 | 0.8 | ||||

Due to: | |||||||||

R&D capital | 0.6 | 0.7 | 0.6 | 0.6 | 0.5 | ||||

Foreign arrivals | 0.2 | 0.3 | 0.2 | 0.2 | 0.2 | ||||

EC trade share | 0.3 | 0.6 | 0.4 | 0.1 | 0.1 | ||||

Quasi-potential output | 2.4 | 3.4 | 2.0 | 2.1 | 2.2 | ||||

Quasi-potential hours worked | −0.6 | −0.7 | −0.6 | −0.4 | −0.4 | ||||

Actual output | 2.5 | 4.2 | 2.7 | 1.4 | 2.9 |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

The slowdown in multifactor productivity growth after 1974 contributed significantly to the lower rates of growth of potential and quasi-potential output.^{30} The estimation results suggest that this decline was attributable to all of the determinants of multifactor productivity: a decline in the growth of the R&D capital stock, a slowing in the trend reduction in the arrival rate of foreigners in the 1980s, and a smaller contribution from the integration of the EC.

### Prospects for the Natural Rate of Unemployment and Potential Output

Prospects for future developments in the natural rate of unemployment and potential output can be assessed based on assumptions or projections of the likely developments in their determinants. Such an assessment, needless to say, is particularly hazardous at this juncture as it is difficult to gauge the effects of unification on investment and the labor market in west Germany. Nevertheless, it is interesting to consider the possible evolution of potential output in the period to 1995 based on the same growth accounting framework used above.

The estimated natural rate of unemployment has been broadly stable since the mid-1970s, and, for the 1983–88 period, this is also true of the structural determinants of the natural rate. Although unification with the GDR, and the associated movement of labor, may affect some characteristics of the labor force, it seems unlikely that this would have large effects on the natural rate of unemployment. Accordingly, the natural rate of unemployment in west Germany is assumed to remain relatively stable at about 3½ percent over the 1989–95 period.

The future course of potential output depends on developments in factor inputs and in multifactor productivity. The contribution of capital inputs is based on the assumption that the real business fixed investment boom of 1989–90 gradually gives way to more typical annual rates of growth of about 3½ percent. Hours worked by each employee are assumed to decline by 0.2 percent a year. Given a stable natural rate of unemployment, potential employment would rise in line with labor force growth, which is assumed to increase to more than 1 percent a year in 1990–91, reflecting, principally, high immigration from the GDR and from Eastern Europe, and then decline to more normal rates of increase of about ½ of 1 percent a year. Actual rates of unemployment—needed to calculate quasi-potential output—are assumed to drop by almost 1½ percentage points from the end of 1988 to 1991 (much of this reduction has already occurred by mid-1990) and then to decline more gradually to about 6 percent in 1994–95.

Multifactor productivity growth is expected to recover only slowly from the relatively low rates of growth at the end of the sample period. Given the strong expansion of actual R&D expenditures in recent years, the contribution of the R&D capital stock to potential output is assumed to increase slightly to equal its average contribution to multifactor productivity growth over the 1969–88 sample period. The impact on multifactor productivity growth in the FRG from the increased integration of the EC was estimated to have declined to zero in the mid-to-late 1980s. With the completion of the unified European market in 1992, it seems reasonable to assume that this will result in some modest contribution to multifactor productivity growth in west Germany, although nothing as large as the estimated impact in the 1970s when intra-EC trade was expanding rapidly. Finally, the trend decline of non-German immigration to west Germany is assumed to continue at a decreasing rate until 1991, with the number of foreign arrivals thereafter constituting a constant fraction of the labor force.

Based on these assumptions, the projected contributions to potential and quasi-potential output growth from 1989 to 1995 are summarized in Table 4, which also reports the estimated contributions to potential output growth in 1986–88, the last three years of the sample period. The annual rate of growth of potential output is projected to increase from 2¼ percent in 1986–88 to 3 percent in 1989–91, reflecting higher contributions from both capital and labor inputs. The slowdown in the trend decline of labor input is a reflection of substantial increases in the growth of the labor force coupled with a constant natural rate of unemployment. Much of the increased contribution of capital and labor inputs from 1989 to 1991 reflects the robust investment and increased labor force growth that took place in the period up to mid-1990.^{31} Quasi-potential output is projected to grow more rapidly than potential output, owing to the decline in the actual unemployment rate over this period. The 2½ percentage point gap by which potential output was estimated to have exceeded actual output in 1988 is reduced to about ¼ of 1 percentage point by 1991 as actual output growth is projected to outpace the growth of potential output by ¾ of 1 percentage point a year. And actual output, which was roughly equal to quasi-potential output in 1988, is projected to exceed quasi-potential output by about 1½ percentage points in 1991.

**West Germany. Potential and Quasi-Potential Output Growth in Private Nonfarm Sector**

(Annual percentage changes)

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**West Germany. Potential and Quasi-Potential Output Growth in Private Nonfarm Sector**

(Annual percentage changes)

Projections | |||||||
---|---|---|---|---|---|---|---|

1986–88 | 1989–91 | 1992–95 | |||||

Potential output | 2.2 | 3.0 | 3.0 | ||||

Due to: | |||||||

Hours worked | −0.6 | −0.2 | — | ||||

Capital | 2.2 | 2.5 | 2.2 | ||||

Multifactor productivity | 0.7 | 0.7 | 0.8 | ||||

Due to: | |||||||

R&D capital | 0.5 | O.6 | 0.6 | ||||

Foreign arrivals | 0.1 | 0.1 | — | ||||

EC trade share | — | — | 0.2 | ||||

Quasi-potential output | 2.5 | 3.2 | 3.1 | ||||

Quasi-potential hours worked | −0.3 | 0.1 | 0.1 | ||||

Memorandum items: | |||||||

Actual output | 2.6 | 3.7 | … | ||||

GDP | 2.6 | 3.7 | … | ||||

Unemployment rate (end year) | 7.8 | 6.4 | … | ||||

Natural rate of unemployment (end year) | 3.5 | 3.5 | … |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

**West Germany. Potential and Quasi-Potential Output Growth in Private Nonfarm Sector**

(Annual percentage changes)

Projections | |||||||
---|---|---|---|---|---|---|---|

1986–88 | 1989–91 | 1992–95 | |||||

Potential output | 2.2 | 3.0 | 3.0 | ||||

Due to: | |||||||

Hours worked | −0.6 | −0.2 | — | ||||

Capital | 2.2 | 2.5 | 2.2 | ||||

Multifactor productivity | 0.7 | 0.7 | 0.8 | ||||

Due to: | |||||||

R&D capital | 0.5 | O.6 | 0.6 | ||||

Foreign arrivals | 0.1 | 0.1 | — | ||||

EC trade share | — | — | 0.2 | ||||

Quasi-potential output | 2.5 | 3.2 | 3.1 | ||||

Quasi-potential hours worked | −0.3 | 0.1 | 0.1 | ||||

Memorandum items: | |||||||

Actual output | 2.6 | 3.7 | … | ||||

GDP | 2.6 | 3.7 | … | ||||

Unemployment rate (end year) | 7.8 | 6.4 | … | ||||

Natural rate of unemployment (end year) | 3.5 | 3.5 | … |

*Volkswirtschaftliche Gesamtrechnungen*; and authors’ estimates.

Potential output growth is projected to remain unchanged at 3 percent a year from 1992 to 1995. A decline in the contribution of capital inputs is offset by increased contributions from labor inputs and multifactor productivity. The halt to the negative contribution of labor inputs that were a feature of the 1970s and the 1980s reflects the projections of higher employment growth. The marginal improvement in multifactor productivity stems from the assumed impact of the unified European market in 1992, partially offset by a leveling off in the reduction in the number of non-German immigrants to west Germany. Since the decline in the unemployment rate is projected to be relatively small after 1991, quasi-potential and potential output are projected to increase at broadly the same rate. Actual output growth is expected to grow marginally slower than potential output from 1992 to 1995, implying that the gap by which potential output exceeds actual output may increase to about ¾ of 1 percent; actual output is projected to exceed quasi-potential output by about ¾ of 1 percent by the mid-1990s.

### Summary and Policy Implications

The results presented above have a number of implications for economic policy in Germany and for the likely effects of economic and monetary unification with the GDR. The output gaps that were estimated for 1988—2½ percent with respect to potential output and zero with respect to quasi-potential output—indicate that there was room for the relatively robust growth and the substantial declines in unemployment that occurred in 1989 and the first half of 1990. The estimation results imply, however, that there would have been some upward pressure on inflation in 1990–91, although this pressure would have been relatively small.^{32} To the extent that the growth of quasi-potential output outpaces that of actual output over the next few years, pressures on capacity that built up in 1989–90 will be attenuated.

Perhaps the most important implications derive from the distinction between potential output and quasi-potential output. This distinction is based on two results: first, that the natural rate of unemployment, which is empirically determined by structural aspects of the labor market in west Germany, is about 3½ percent compared with actual rates of unemployment of about 6–7 percent; and second, that aggregate wage determination in west Germany is best characterized by a target-real-wage-bargaining model.

The gap between potential and quasi-potential output in the period to 1995 is a reflection of the high actual unemployment rates that are expected to persist relative to the lower structurally determined natural rate of unemployment. As long as unemployment exceeds the natural rate and actual output is below potential output, there is scope to absorb increases in employment and output without setting in place an ongoing inflationary process. This suggests that some aspects of the constraints on output growth may only be binding in the short run.^{33} However, the need for macroeconomic policies to be consistent with medium-term objectives, particularly with regard to price stability and fiscal sustainability, limits the extent to which traditional aggregate demand policies can, by themselves, close the gaps between the actual and the natural rates of unemployment and between quasi-potential and potential output.

The model does point to areas where government policies can increase the supply responsiveness of the west German economy. Policies that improve the qualifications of the labor force, reduce the reservation wage, or increase the bargaining power of outsiders in the wage negotiation process can be expected to restrain real wages, increase actual employment, and lower the natural rate of unemployment. For a given natural rate of unemployment, active labor market policies can contribute to reductions in actual unemployment. Similarly, structural measures aimed at increasing the productivity of capital and labor inputs can raise quasi-potential and potential output, both directly and by stimulating investment. The recent increased flexibility in work arrangements, particularly the greater use of multiple shifts and weekend work, for example, has raised the effective size of the physical capital stock. Finally, the results also suggest that the completion of the unified European market in 1992 and increased expenditures on research and development may stimulate output, raise total factor productivity, and increase the growth of potential output.

## Appendix

### An Empirical Model of the Natural Rate of Unemployment and Potential Output

This appendix presents a brief description of the model used to estimate the natural rate of unemployment and potential output and summarizes the estimation results. A more complete discussion, including a data appendix, is contained in Coe and Krueger (1990). The variables are defined in Table 5, the specification of the system of equations is given in Table 6, and the estimation results are reported in Table 7.

**Federal Republic of Germany: Variable Definitions**

^{1}Foreign arrivals exclude ethnic Germans (*Aussiedler* and *Übersiedler)*. When ethnic German immigration was included in the regressions, the coefficients were generally insignificant; this may in part have resulted from the relatively low variability in these series over most of the sample period.

**Federal Republic of Germany: Variable Definitions**

y | real output (private nonfarm business sector, NF) |

y^{pot} | quasi-potential output (NF) |

y^{POT} | potential output (NF) |

λ | share of employee compensation in total income (NF) |

h | total hours worked (NF) |

k | real stock of capital (NF) |

rd | real stock of research and development capital |

FOR | foreign arrivals as a percent of the labor force^{1} |

NFOR | foreign arrivals less departures as a percent of the labor force^{1} |

EC | intra-EC trade as a percent of EC GNP |

U | unemployment rate |

U^{TR} | trend unemployment rate (spline) |

(U^{NAT} | the natural rate of unemployment |

w | hourly compensation per employee (NF) |

p^{e} | implicit deflator for private consumption expenditures |

p | implicit output deflator (NF) |

p^{m} | implicit deflator for imports of goods and services |

p^{x} | implicit deflator for exports of goods and services |

p^{o} | price of oil |

q | output per hour (NF) |

q^{pot} | labor productivity at quasi-potential output (NF) |

NWLC | nonwage labor costs as a percent of total wages and salaries |

DEM | impact on the unemployment rate of changing labor force shares |

APP | apprentices as a percent of the labor force |

UNION | union members as a percent of the labor force |

UIRR | unemployment insurance replacement ratio |

^{1}Foreign arrivals exclude ethnic Germans (*Aussiedler* and *Übersiedler)*. When ethnic German immigration was included in the regressions, the coefficients were generally insignificant; this may in part have resulted from the relatively low variability in these series over most of the sample period.

**Federal Republic of Germany: Variable Definitions**

y | real output (private nonfarm business sector, NF) |

y^{pot} | quasi-potential output (NF) |

y^{POT} | potential output (NF) |

λ | share of employee compensation in total income (NF) |

h | total hours worked (NF) |

k | real stock of capital (NF) |

rd | real stock of research and development capital |

FOR | foreign arrivals as a percent of the labor force^{1} |

NFOR | foreign arrivals less departures as a percent of the labor force^{1} |

EC | intra-EC trade as a percent of EC GNP |

U | unemployment rate |

U^{TR} | trend unemployment rate (spline) |

(U^{NAT} | the natural rate of unemployment |

w | hourly compensation per employee (NF) |

p^{e} | implicit deflator for private consumption expenditures |

p | implicit output deflator (NF) |

p^{m} | implicit deflator for imports of goods and services |

p^{x} | implicit deflator for exports of goods and services |

p^{o} | price of oil |

q | output per hour (NF) |

q^{pot} | labor productivity at quasi-potential output (NF) |

NWLC | nonwage labor costs as a percent of total wages and salaries |

DEM | impact on the unemployment rate of changing labor force shares |

APP | apprentices as a percent of the labor force |

UNION | union members as a percent of the labor force |

UIRR | unemployment insurance replacement ratio |

^{1}Foreign arrivals exclude ethnic Germans (*Aussiedler* and *Übersiedler)*. When ethnic German immigration was included in the regressions, the coefficients were generally insignificant; this may in part have resulted from the relatively low variability in these series over most of the sample period.

**Equation Specification ^{1}**

^{1}The estimated equations also include a number of dummy variables which are specified in Coe and Krueger (1990). Θ^{n}*(L)* represents an *n*-quarter moving average lag operator.

**Equation Specification ^{1}**

1. Production function |

$y-\lambda h-(1-\lambda )k={\alpha}_{0}+{\alpha}_{1}rd+{\alpha}_{2}{\mathrm{\Theta}}^{8}\left(L\right)FOR+{\alpha}_{3}EC+{\alpha}_{4}(U-{U}^{TR})+{\epsilon}^{y}$ |

2. Wage level |

$w={\beta}_{0}+{\beta}_{1}{p}^{c}+{\beta}_{2}{q}^{pot}+{\beta}_{3}(U-{U}^{NAT})+{\beta}_{4}({p}^{c}-p)+{\beta}_{5}NWLC+{\beta}_{6}NFOR+{\epsilon}^{w}$ |

3. Wage growth |

$\begin{array}{cc}\mathrm{\Delta}w=& {\gamma}_{1\mathrm{\Delta}{p}^{c}+}{\gamma}_{2}{\mathrm{\Theta}}^{4}\left(L\right)\mathrm{\Delta}q+{\gamma}_{3}\mathrm{\Delta}({p}^{c}-p)+{\gamma}_{4}\mathrm{\Delta}({p}^{c}-p)+{\gamma}_{5}\mathrm{\Delta}(U-{U}^{NAT})\\ & {\gamma}_{6}\mathrm{\Delta}\mathrm{\Delta}(U-{U}^{NAT}{)}_{-1}+{\gamma}_{7}{\epsilon}_{-1}^{w}+{\epsilon}^{\mathrm{\Delta}w}\end{array}$ |

4. Price inflation |

$\mathrm{\Delta}p={\delta}_{1}\left({\mathrm{\Theta}}^{12}\left(L\right)\mathrm{\Delta}w-\mathrm{\Delta}{q}^{pot}\right)+{\delta}_{2}(\mathrm{\Delta}{p}^{m}-\mathrm{\Delta}{p}_{-2}^{m})+{\delta}_{3}(y-{y}^{pot}{)}_{-1}+{\epsilon}^{p}$ |

5. Unemployment rate change |

$\begin{array}{cc}\mathrm{\Delta}(U-DEM)=& {\psi}_{1}\mathrm{\Delta}(y-{y}^{pot})+{\psi}_{2}\mathrm{\Delta}(y-{y}^{pot}{)}_{-1}+{\psi}_{3}\mathrm{\Delta}({p}^{0}-p{)}_{-3}+{\psi}_{4}\mathrm{\Delta}({p}^{x}-{p}^{m})\\ & +{\psi}_{5}\mathrm{\Delta}APP+{\psi}_{6}\mathrm{\Delta}AP{P}_{-1}+{\psi}_{7}\mathrm{\Delta}AP{P}_{-2}+{\psi}_{8}\mathrm{\Delta}NML{C}_{-1}+{\psi}_{9}\mathrm{\Delta}UNION*UIR{R}_{-2}\\ & +{\psi}_{10}\mathrm{\Delta}(U-DEM{)}_{-1}+{\epsilon}^{U}\end{array}\phantom{\rule{0ex}{0ex}}$ |

Memorandum: |

The following expressions for quasi-potential output (y^{pot}), labor productivity at quasi-potential output (q^{pot}), and the natural rate of unemployment (U^{NAT}) must be substituted into the above equations:
$\begin{array}{cc}{y}^{pot}=& \lambda \text{h}+(1-\lambda )\text{k}+{\alpha}_{0}+{\alpha}_{1}\text{rd}+{\alpha}_{2}\text{FOR}+{\alpha}_{3}\text{EC}\\ {q}^{pot}=& (\lambda -1)\text{h+}(1-\lambda )\text{k}+{\alpha}_{0}+{\alpha}_{1}\text{rd}+{\alpha}_{2}\text{FOR}+{\alpha}_{3}\text{EC}\\ {U}^{NAT}=& \begin{array}{c}\begin{array}{c}0.7+\mathrm{\Sigma}\mathrm{\Delta}DEM+\left(({\psi}_{5}+{\psi}_{6}+{\psi}_{7})/(1-{\psi}_{10})\right)\mathrm{\Sigma}\mathrm{\Delta}APP+({\psi}_{8}/(1-{\psi}_{10}\left)\right)\mathrm{\Sigma}\mathrm{\Delta}NWLC\end{array}\\ ({\psi}_{9}/(1-{\psi}_{10}\left)\right)\mathrm{\Sigma}\mathrm{\Delta}UNION*UIRR\end{array}\end{array}\phantom{\rule{0ex}{0ex}}$ where the variables in bold print in the first two expressions have been smoothed and labor input is consistent with actual rates of unemployment. |

^{1}The estimated equations also include a number of dummy variables which are specified in Coe and Krueger (1990). Θ^{n}*(L)* represents an *n*-quarter moving average lag operator.

**Equation Specification ^{1}**

1. Production function |

$y-\lambda h-(1-\lambda )k={\alpha}_{0}+{\alpha}_{1}rd+{\alpha}_{2}{\mathrm{\Theta}}^{8}\left(L\right)FOR+{\alpha}_{3}EC+{\alpha}_{4}(U-{U}^{TR})+{\epsilon}^{y}$ |

2. Wage level |

$w={\beta}_{0}+{\beta}_{1}{p}^{c}+{\beta}_{2}{q}^{pot}+{\beta}_{3}(U-{U}^{NAT})+{\beta}_{4}({p}^{c}-p)+{\beta}_{5}NWLC+{\beta}_{6}NFOR+{\epsilon}^{w}$ |

3. Wage growth |

$\begin{array}{cc}\mathrm{\Delta}w=& {\gamma}_{1\mathrm{\Delta}{p}^{c}+}{\gamma}_{2}{\mathrm{\Theta}}^{4}\left(L\right)\mathrm{\Delta}q+{\gamma}_{3}\mathrm{\Delta}({p}^{c}-p)+{\gamma}_{4}\mathrm{\Delta}({p}^{c}-p)+{\gamma}_{5}\mathrm{\Delta}(U-{U}^{NAT})\\ & {\gamma}_{6}\mathrm{\Delta}\mathrm{\Delta}(U-{U}^{NAT}{)}_{-1}+{\gamma}_{7}{\epsilon}_{-1}^{w}+{\epsilon}^{\mathrm{\Delta}w}\end{array}$ |

4. Price inflation |

$\mathrm{\Delta}p={\delta}_{1}\left({\mathrm{\Theta}}^{12}\left(L\right)\mathrm{\Delta}w-\mathrm{\Delta}{q}^{pot}\right)+{\delta}_{2}(\mathrm{\Delta}{p}^{m}-\mathrm{\Delta}{p}_{-2}^{m})+{\delta}_{3}(y-{y}^{pot}{)}_{-1}+{\epsilon}^{p}$ |

5. Unemployment rate change |

$\begin{array}{cc}\mathrm{\Delta}(U-DEM)=& {\psi}_{1}\mathrm{\Delta}(y-{y}^{pot})+{\psi}_{2}\mathrm{\Delta}(y-{y}^{pot}{)}_{-1}+{\psi}_{3}\mathrm{\Delta}({p}^{0}-p{)}_{-3}+{\psi}_{4}\mathrm{\Delta}({p}^{x}-{p}^{m})\\ & +{\psi}_{5}\mathrm{\Delta}APP+{\psi}_{6}\mathrm{\Delta}AP{P}_{-1}+{\psi}_{7}\mathrm{\Delta}AP{P}_{-2}+{\psi}_{8}\mathrm{\Delta}NML{C}_{-1}+{\psi}_{9}\mathrm{\Delta}UNION*UIR{R}_{-2}\\ & +{\psi}_{10}\mathrm{\Delta}(U-DEM{)}_{-1}+{\epsilon}^{U}\end{array}\phantom{\rule{0ex}{0ex}}$ |

Memorandum: |

The following expressions for quasi-potential output (y^{pot}), labor productivity at quasi-potential output (q^{pot}), and the natural rate of unemployment (U^{NAT}) must be substituted into the above equations:
$\begin{array}{cc}{y}^{pot}=& \lambda \text{h}+(1-\lambda )\text{k}+{\alpha}_{0}+{\alpha}_{1}\text{rd}+{\alpha}_{2}\text{FOR}+{\alpha}_{3}\text{EC}\\ {q}^{pot}=& (\lambda -1)\text{h+}(1-\lambda )\text{k}+{\alpha}_{0}+{\alpha}_{1}\text{rd}+{\alpha}_{2}\text{FOR}+{\alpha}_{3}\text{EC}\\ {U}^{NAT}=& \begin{array}{c}\begin{array}{c}0.7+\mathrm{\Sigma}\mathrm{\Delta}DEM+\left(({\psi}_{5}+{\psi}_{6}+{\psi}_{7})/(1-{\psi}_{10})\right)\mathrm{\Sigma}\mathrm{\Delta}APP+({\psi}_{8}/(1-{\psi}_{10}\left)\right)\mathrm{\Sigma}\mathrm{\Delta}NWLC\end{array}\\ ({\psi}_{9}/(1-{\psi}_{10}\left)\right)\mathrm{\Sigma}\mathrm{\Delta}UNION*UIRR\end{array}\end{array}\phantom{\rule{0ex}{0ex}}$ where the variables in bold print in the first two expressions have been smoothed and labor input is consistent with actual rates of unemployment. |

^{1}The estimated equations also include a number of dummy variables which are specified in Coe and Krueger (1990). Θ^{n}*(L)* represents an *n*-quarter moving average lag operator.

**Three-Stage Least Squares Estimation Results ^{1}**

^{1}The following variables were considered to be endogenous in addition to the dependent variables: output prices, unemployment, and the level and change of output and consumer prices. The instruments were all exogenous and predetermined variables, lagged values of all endogenous variables, and the current and two lags of the logarithm of M2.

**Three-Stage Least Squares Estimation Results ^{1}**

Equation | |||||
---|---|---|---|---|---|

1 | 2 | 3 | 4 | 5 | |

α_{0} = 0.022(0.02) | β_{0} = −0.243(0.02) | γ_{1} = 1.593(O.18) | δ_{1} = 1.0(const.) | ψ_{1} = −0.011(0.003) | |

α_{1} = 0.129(0.009) | β_{1} = 1.0(const.) | γ_{2} = 0.351(0.22) | δ_{2} = −0.069(0.02) | ψ_{2} = −0.004(0.002) | |

α_{2} = −0.064(0.007) | β_{2} = 1.0(const.) | γ_{3} = −2.399(0.52) | δ_{3} = 0.281(0.12) | ψ_{3} = 0.002(0.0006) | |

α_{3} = 0.012(0.002) | β_{3} = −0.022(0.001) | γ_{4} = −2.336(0.45) | ψ_{4} = −0.013(0.005) | ||

α_{4} = 0.022(0.002) | β_{4} = −0.002(0.0007) | γ_{5} = −5.626(1.78) | ψ_{5} = −3.495(0.59) | ||

β_{5} = −0.014(0.001) | γ_{6} = 4.990(1.88) | ψ_{6} = −5.835(0.99) | |||

β_{6} = −0.005(0.0008) | γ_{7} = −0.350(0.07) | ψ_{7} = −2.712(0.59) | |||

ψ_{8} = 0.066(0.02) | |||||

ψ_{9} = 0.267(0.08) | |||||

ψ_{10} = 0.705(0.06) | |||||

R^{2} | 0.984 | 0.999 | 0.692 | 0.499 | 0.805 |

SEE | 0.009 | 0.011 | 3.116 | 2.391 | 0.105 |

DW (Durbin h) | 1.014 | 1.381 | 2.388 | 1.458 | (2.785) |

^{1}The following variables were considered to be endogenous in addition to the dependent variables: output prices, unemployment, and the level and change of output and consumer prices. The instruments were all exogenous and predetermined variables, lagged values of all endogenous variables, and the current and two lags of the logarithm of M2.

**Three-Stage Least Squares Estimation Results ^{1}**

Equation | |||||
---|---|---|---|---|---|

1 | 2 | 3 | 4 | 5 | |

α_{0} = 0.022(0.02) | β_{0} = −0.243(0.02) | γ_{1} = 1.593(O.18) | δ_{1} = 1.0(const.) | ψ_{1} = −0.011(0.003) | |

α_{1} = 0.129(0.009) | β_{1} = 1.0(const.) | γ_{2} = 0.351(0.22) | δ_{2} = −0.069(0.02) | ψ_{2} = −0.004(0.002) | |

α_{2} = −0.064(0.007) | β_{2} = 1.0(const.) | γ_{3} = −2.399(0.52) | δ_{3} = 0.281(0.12) | ψ_{3} = 0.002(0.0006) | |

α_{3} = 0.012(0.002) | β_{3} = −0.022(0.001) | γ_{4} = −2.336(0.45) | ψ_{4} = −0.013(0.005) | ||

α_{4} = 0.022(0.002) | β_{4} = −0.002(0.0007) | γ_{5} = −5.626(1.78) | ψ_{5} = −3.495(0.59) | ||

β_{5} = −0.014(0.001) | γ_{6} = 4.990(1.88) | ψ_{6} = −5.835(0.99) | |||

β_{6} = −0.005(0.0008) | γ_{7} = −0.350(0.07) | ψ_{7} = −2.712(0.59) | |||

ψ_{8} = 0.066(0.02) | |||||

ψ_{9} = 0.267(0.08) | |||||

ψ_{10} = 0.705(0.06) | |||||

R^{2} | 0.984 | 0.999 | 0.692 | 0.499 | 0.805 |

SEE | 0.009 | 0.011 | 3.116 | 2.391 | 0.105 |

DW (Durbin h) | 1.014 | 1.381 | 2.388 | 1.458 | (2.785) |

^{1}The following variables were considered to be endogenous in addition to the dependent variables: output prices, unemployment, and the level and change of output and consumer prices. The instruments were all exogenous and predetermined variables, lagged values of all endogenous variables, and the current and two lags of the logarithm of M2.

The first equation in Table 6 is the production function where the coefficients on labor and capital inputs have been constrained to equal their factor shares. With this constraint, the dependent variable is multifactor productivity which is determined by the stock of research and development capital, a proxy for the impact of foreign arrivals on the “quality” of labor input, a proxy for increased efficiency related to integration among the countries of the EC,^{34} and a proxy for the utilization of capital. The multifactor productivity equation, rewritten as an output equation and with some smoothing of the long-run determinants of output, is then used to define potential output as specified at the bottom of Table 6.

Equation 2 in Table 6 determines the equilibrium level of wages and corresponds to equation (1′) in the main text. In addition to the variables discussed in the context of equation (1′), the level of wages is determined by the difference between consumer and output prices,^{35} nonwage labor costs and the net immigration of non-German foreigners. Equation 3 in Table 6 determines the growth of wages and corresponds to equation (1) in the text.^{36} The lagged residual from the levels equation (∊^{w}_{-1}) is included as an error-correction term in the wage growth equation and corresponds to the final term in equation (1) discussed in the main text.

The fourth equation in Table 6 determines output price inflation as a variable markup on the growth of unit labor costs with the markup depending on the gap between actual and potential output, and, temporarily, on changes in import prices.

The final equation in Table 6 distinguishes between cyclical and structural unemployment. Changes in cyclical unemployment are determined by changes in the output gap, real oil prices, and the terms of trade. Changes in structural unemployment are determined by the number of apprentices as a percent of the labor force—which affects the quality of the labor force—nonwage labor costs, unionization, and unemployment insurance replacement ratios. The long-run, steady-state relationship between unemployment and its structural determinants is used to determine the natural rate of unemployment as specified at the bottom of Table 6.

Since potential output and the natural rate of unemployment are unobserved, the three expressions given at the bottom of Table 6 must be substituted into each of the five equations. With these substitutions, the system is internally consistent, includes no proxies for trend output or trend productivity growth, and the relationship between the actual and the natural rate of unemployment is explicitly incorporated into the two wage equations.^{37} These substitutions give rise to a large number of nonlinear parameter restrictions across the five-equation system. Because of the simultaneous nature of the system, and given that the errors can be expected to be correlated across the five equations, the system has been estimated using nonlinear three-stage least squares. The estimation results are presented in Table 7.

## References

Adams, Charles, and David T. Coe, “A Systems Approach to Estimating the Natural Rate of Unemployment and Potential Output for the United States,”

, International Monetary Fund, Vol. 37 (June 1990), pp. 232-93.*Staff Papers*Alogoskoufis, George S., and Alan Manning, “On the persistence of unemployment,”

, Vol. 3 (October 1988), pp. 428-69.*Economic Policy*Baldwin, Richard, “The Growth Effects of 1992,”

, Vol. 4 (October 1989), pp. 247-81.*Economic Policy*Bean, Charles, “Capital shortages and persistent unemployment,”

, Vol. 4 (April 1989), pp. 11-53.*Economic Policy*Blanchard, Olivier J., and Stanley Fischer.

(Cambridge: MIT Press, 1989).*Lectures on Macroeconomics*Blanchard, Olivier J., and Lawrence H. Summers, “Hysteresis and the European Unemployment Problem,” in

, ed. by Rod Cross (New York: Basil Blackwell, 1988).*Unemployment Hysteresis of the Natural Rate Hypothesis*Burda, Michael, and Jeffrey Sachs, “Institutional Aspects of High Unemployment in the Federal Republic of Germany,”

*NBER Working Paper No. 2241*(Cambridge: National Bureau of Economic Research, May 1987).Carruth, Alan A., and Andrew J. Oswald, “On Union Preferences and Labour Market Models: Insiders and Outsiders,”

, Vol. 97 (June 1987), pp. 431-45.*Economic Journal*Coe, David T., “Nominal Wages, the NAIRU and Wage Flexibility,”

(Autumn 1985), pp. 87-126.*OECD Economic Studies*, No. 5Coe, David T. “Hysteresis Effects in Aggregate Wage Equations,” in

, ed. by Rod Cross (New York: Basil Blackwell, 1988).*Unemployment, Hysteresis and the Natural Rate Hypothesis*Coe, David T. “Insider-Outsider Influences on Industry Wages,”

, Vol. 15, Issue 2 (1990), pp. 163-83.*Empirical Economics*Coe, David T., and Thomas Krueger, “Why is Unemployment So High at Full Capacity? The Persistence of Unemployment, the Natural Rate, and Potential Output in the Federal Republic of Germany,”

*IMF Working Paper No. 90/101*(October 1990).Commission of the European Communities,

, Supplement B, “Business and Consumer Survey Results,” No. 5 (May 1990).*European Economy*Cross, Rod, ed.

(New York: Basil Blackwell, 1988).*Unemployment, Hysteresis and the Natural Rate Hypothesis*Dornbusch, Rudiger, and Stanley Fischer,

(New York: McGraw Hill, 2nd ed., 1981).*Macroeconomics*Englander, Steven A., and Axel Mittelstadt, “Total Factor Productivity: Macroeconomic and Structural Aspects of the Slowdown,”

(Spring 1988), pp. 7-56.*OECD Economic Studies*, No. 10Franz, Wolfgang, “Hysteresis, Persistence, and the NA1RU: An Empirical Analysis for the Federal Republic of Germany,” in

, ed. by Richard Layard and Lars Calmfors (Cambridge: MIT Press, 1987).*The Fight Against Unemployment*Franz, Wolfgang, and Heinz König, “The Nature and Causes of Unemployment in the Federal Republic of Germany since the 1970s: An Empirical Investigation,”

(Supplement, 1986), pp. S219-44.*Economica*Franz, Wolfgang, “A Disequilibrium Approach to Unemployment in the Federal Republic of Germany,”

, Vol. 34 (May 1990), pp. 413-22.*European Economic Review*Friedman, Milton, “The Role of Monetary Policy,”

, Vol. 58 (March 1968), pp. 1-17.*American Economic Review*Gordon, Robert J., “What is New-Keynesian Economics?”

, Vol. 28 (September 1990), pp. 1115-71.*Journal of Economic Literature*Gottfries, Nils, and Henrik Horn, “Wage formation and the persistence of unemployment,”

, Vol. 97 (December 1987), pp. 877-84.*Economic Journal*Griliches, Zvi, “Productivity Puzzles and R&D: Another Nonexplanation,”

, Vol. 2 (Fall 1988), pp. 9-21.*Journal of Economic Perspectives*International Monetary Fund,

(October 1990).*World Economic Outlook: A Survey by the Staff of the International Monetary Fund*Jaeger A., and M. Parkinson, “Testing for Hysteresis in Unemployment: An Unobserved Components Approach,”

, Vol. 15, (1990), pp. 185-98.*Empirical Economics*Kuh, Edwin, “A Productivity Theory of Wage Levels—An Alternative to the Phillips Curve,”

, Vol. 34 (October 1967), pp. 333-60.*Review of Economic Studies*Layard, Richard, and Stephen Nickell, “The Labor Market,” in

, ed. by Rudiger Dornbusch and Richard Layard (Oxford: Clarendon Press, 1987).*The Performance of the British Economy*Lindbeck, Assar, and Dennis Snower,

(Cambridge: MIT Press, 1988).*The Insider-Outsider Theory of Employment and Unemployment*Lipschitz, Leslie, Jeroen Kremers, Thomas Mayer, and Donogh McDonald,

(International Monetary Fund, January 1989).*The Federal Republic of Germany: Adjustment in a Surplus Country*, Occasional Paper No. 64Maddison, Angus,

, Development Centre of the Organization for Economic Cooperation and Development (Paris, 1989).*The World Economy in the 20th Century*Nickell, Stephen, “The Supply Side and Macroeconomic Modeling,” in

, ed. by Ralph Bryant and others (Washington: The Brookings Institution, 1988).*Empirical Macroeconomics for Interdependent Economies*Oswald, Andrew J., “The Economic Theory of Trade Unions: An Introductory Survey,”

, Vol. 87 (1985), pp. 160-93.*Scandinavian Journal of Economics*Sargan, J.D., “Wages and Prices in the United Kingdom: A Study in Econometric Methodology,” in

, Vol. 16, ed. by Peter Hart and others (London: Butterworths, 1964).*Econometric Analysis for National Economic Planning*, Colston PapersSolow, Robert M., “Technical Change and the Aggregate Production Function,”

, Vol. 39 (August 1957), pp. 312-20.*Review of Economics and Statistics*Torres, Raymond, and John P. Martin, “Measuring Potential Output in the Seven Major OECD Countries,”

(Spring 1990), pp. 127-49.*OECD Economic Studies*, No. 14

^{}1

The authors thank Palle S. Andersen and Geoffrey Woglom for helpful comments and suggestions; and Wolfgang Franz, Heinz-Jϋrgen Scheid, and Wolfgang Scheremet for providing a number of data series.

^{}2

An estimate of this productivity gap is the starting point for most empirical analyses of the effects of German economic, monetary, and social union; see Chapters IV-VI and the references cited therein.

^{}3

Capacity utilization in manufacturing in the late 1980s was at its highest level for over a decade; see Commission of the European Communities (1990) and International Monetary Fund (1990), Chart 9.

^{}4

Unemployment in the FRG averaged less than 1 percent in the 15 years to 1974 and was never greater than 2 percent. A number of studies based on estimated Phillips curves have calculated that the nonaccelerating inflation rate of unemployment (the NAIRU) increased to 7–8 percent in the mid-1980s. These estimated increases in the NAIRU were not related to changes in structural aspects of the labor market but reflected increases in unemployment needed to offset the inflation implications of developments such as increases in import prices or secular declines in productivity growth. See, for example, the alternative calculations of the NAIRU presented in Table 8 of Coe (1985), Franz and Konig (1986), and Franz (1987).

^{}5

See Blanchard and Summers (1988) and the other papers in Cross (1988).

^{}6

This point is emphasized in Bean (1989). In the labor market there may also be speed limits to reductions in unemployment if, for example, changes in unemployment have direct impacts on wage growth.

^{}7

These models, which are not necessarily mutually exclusive, focus on the relationship between employers and employees and include insider-outsider models, implicit contract models, efficiency wage models, union bargaining models, and hysteresis models. See, for example, Oswald (1985), Blanchard and Summers (1988), Carruth and Oswald (1987), Gottfries and Horn (1987), Alogoskoufis and Manning (1988), and Lindbeck and Snower (1988).

^{}8

This feature of the labor market in the FRG is discussed in Burda and Sachs (1987) and Lipschitz and others (1989), p. 32.

^{}9

A formal derivation of the results in this section is similar to that in Carruth and Oswald (1987). See also the survey article by Oswald (1985) and Lindbeck and Snower (1988).

^{}10

Sources of this turnover cost, which need not be constant as assumed in Chart 2, are discussed in Lindbeck and Snower (1988), Chapter 3. In general, the results that follow would be similar in the case of firm-specific human capital that depreciates when a worker becomes unemployed.

^{}11

A negative demand shock would lower prices for the firm’s output, and a negative supply shock would reduce the marginal product of labor. In terms of Chart 2, which has nominal wages on the axis, either shock would shift down the marginal revenue product curve, which is the firm’s demand for labor schedule.

^{}12

Less simple membership rules for the insider and outsider groups would, in general, not affect the qualitative results discussed here.

^{}13

This would not be the case if the initial equilibrium was a corner solution, that is, if *w*^{i}_{o} = (*w*^{r} + *c*).

^{}14

As mentioned before, the insider-outsider model presented here is one example of a broader class of labor-market models that give qualitatively similar results with regard to the persistence of unemployment. See also Layard and Nickell (1987), who emphasize the distinction between short- as opposed to long-duration unemployment in the determination of aggregate wages, a distinction not unlike that between insiders and outsiders.

^{}15

Moreover, the insider-outsider model suggests that sizable positive supply shocks might be needed before an economy can be expected to experience a fall in unemployment rates. For example, at *B* supply shocks that result in an upward shift of the labor demand curve to intersect *l*^{s}(*e*_{1}) below *w*^{r} + *c* will only lead to higher real wages for insiders (*e*_{1}) without any increase in employment.

^{}16

See also Kuh’s (1967) productivity theory of wages.

^{}17

Dornbusch and Fischer (1981, pp. 429–51) derive a similar aggregate demand curve in terms of inflation and the level of output.

^{}18

The aggregate demand curves also shift down with the declines in inflation expectations, giving a clockwise path to the new equilibrium at (Δ*w*_{1}, *U*^{*}); these shifts of the *AD* curve are not shown in Chart 3. The description given above of the dynamics of a policy-induced disinflationary process is broadly consistent with developments in the United States in the early to mid-1980s, although macroeconomic policies, particularly fiscal policies, were not consistently restrictive and import price developments provided additional stimulus to the disinflation process. Note that the change formulation of the Phillips curve implies that transitory disturbances can have permanent effects on the real wage; this is one of the main theoretical problems with the Phillips curve discussed by Blanchard and Fischer (1989), pp.542–46.

^{}19

Whether the quasi-equilibrium unemployment rate is above or below the short-run rate *U*_{1} depends on the relative impact of the factors shifting *AD*_{1} and *RWB*_{0}.

^{}20

See Nickell (1988), pp. 215–17 and Coe (1990). Lower-case letters indicate logarithms and Δ*w* = *w* − *w*_{−1}.

^{}21

Whether the growth of wages is related to the level or the change in unemployment has been suggested as a test for hysteresis; see Coe (1985, 1988), Blanchard and Summers (1988), and Gordon (1990), pp. 1124–46.

^{}23

This approach to estimating the natural rate and potential output encompasses many of the methods found in the literature; see the discussion in Adams and Coe (1990) where a similar methodology is applied to the United States.

^{}24

In contrast to these results, Jaeger and Parkinson (1990) estimate that the natural rate of unemployment in the FRG in 1988 exceeded 8 percent, the actual rate of unemployment. This result reflects the application of an unobserved-components model that uses capacity utilization to pick up movements in the cyclical component of unemployment. Because the measure of capacity utilization indicates that output was above capacity in 1988, the estimated natural rate of unemployment is, necessarily, above the actual rate of unemployment.

^{}25

The total impact on real wages from the other variables in the wage level equation roughly summed to zero over this period.

^{}26

See Maddison (1989) and Englander and Mittelstadt (1988) for international comparisons.

^{}27

The relationship between potential (*y ^{POT}*) and quasi-potential output (

*y*) can be approximated by

^{pot}*y*⋍

^{POT}*y*+ λ(

^{pot}*U*−

*U*

^{NAT})/100.

^{}29

See the discussion about the impact of the unified European market in Baldwin (1989).

^{}30

A comparison of the growth contributions to potential output with those for actual output (Table 2) reveals differences, not only for hours worked, as could be expected, but also for multifactor productivity. Actual multifactor productivity growth, for example, increased in the second half of the 1970s, whereas multifactor productivity implied by the system estimates did not, suggesting a relatively intensive utilization of factor inputs in this period. During the recession period of 1980–82, this pattern was reversed, and from 1980 to 1988, estimated multifactor productivity at potential output expanded about twice as fast as did actual multifactor productivity.

^{}31

Although the impact on potential output has been attenuated somewhat by the smoothing applied to the determinants of potential output as discussed above.

^{}32

The upward pressure on inflation in 1989 and 1990 was much less than implied by the estimated growth of potential for 1988 because the robust growth of investment increased productive capacity substantially. In mid-1990, actual output may have exceeded the level of quasi-potential output by about 1 percent implying about ¼ of 1 percentage point upward pressure on inflation. The 1 percentage point decline in the unemployment rate in the year to mid-1990 implied an increase in the level of real wages relative to productivity at potential of about 2 percent. This is consistent with the 1990 wage agreements that suggest some pickup in wage growth.

^{}33

One such short-run constraint is capital that would normally be expected to respond to actual or expected increases in demand as suggested by the following quote from the May 1990 business survey reported by the Commission of the European Communities (1990), p. 1: “Industrial capacity is virtually fully utilized in the member countries. Despite this, the companies questioned are not expecting serious capacity constraints in the near future. The intention is to increase output further,”

^{}34

See Baldwin (1989).

^{}35

This is approximately equal to the terms of trade and implies that wages are indexed to a weighted average of the two prices.

^{}36

Both the level and the change specifications of the wage equation are included in the system to take advantage of the relationship between the unemployment gap and the equilibrium level of wages, as well as the relationship between changes in the unemployment gap and short-run changes in wages.