One of the most recurrent criticisms of central banks is that they are not interested in the labor market. In Colombia, different sectors question that The decisions of the Bank of the Republic only take into account considerations regarding inflation and leave aside any implications for employment. However, by definition, the study of the labour market situation is always immersed in monetary policy analyses.
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In the long term, the economy converges to levels of full employment and sustainable growth only when there is price stability. In other words, price stability is the means to achieve the main objective and end point of monetary policy, which is precisely to lead the economy to a level where it operates at maximum capacity.
Let us begin by explaining how what happens in the labor market is related to price stability. First, employment levels are associated with household spending capacity and the demand for goods and services in the economy. Second, Workers’ wages are costs that companies must assume and that are passed on to consumers in final prices.
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To illustrate this, consider what happens during an economic boom: with job growth, household demand increases, leading to a general rise in prices given the inability of supply to adjust and increase production in the short term; in addition, in the face of greater production needs, demand for workers by companies also increases, which is reflected in more available vacancies and a tightening of the labor market that manifests itself in higher wages and results in higher prices for consumers. In this context, Monetary policy reacts to eliminate excess demand (and smooth employment dynamics) which allows for the stabilization of wages and prices.
Bibiana Taboada.
This initial look at the interaction of the labor market and inflation highlights the trade-off between employment levels and price stability. This is what economists refer to as the Phillips curve, which is usually diagrammed as a negative relationship between the inflation rate and the unemployment rate (Phillips, 1958). The Phillips curve shows that lower employment levels can indeed be tolerated to achieve price stability: that is, higher unemployment can be tolerated to reduce inflation (and vice versa).However, it is essential to bear in mind that this relationship is only sustained in the short term and with different intensities depending on the characteristics of each economy. In the long term, the dilemma for monetary policy disappears, since the level of full employment that is compatible with the potential production of the economy is precisely that which is made possible with price stability.
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A key measure in this analysis is the non-accelerating inflation rate of unemployment, or Nairu. This unemployment rate is precisely the one in which the labor market does not generate price pressures and corresponds to the condition in which the labor market is in line with the potential of the economy (Modigliani and Papademos, 1975).
Mauricio Villamizar-Villegas.
The level of Nairu is associated with structural factors of the labour market and the fundamentals of the economy, rather than with a specific situation. Therefore, it does not depend on monetary policy, nor can monetary policy aspire to change it. Another important tool for characterizing the labor market and its possible impact on prices is the Beveridge curve, which relates available vacancies to unemployment, to show how tight or loose the labor market is (Beveridge, 1945).
A tight labor market has many vacancies and low unemployment, while a loose one has few vacancies and high unemployment. Intuitively, the Beveridge curve helps us understand how easy it is for an employer to fill its vacancies given the availability of workers; or, alternatively, how easy it is for a worker to get a job (and better wages) given the availability of vacancies.
The Colombian labor market has constraints that result in a high Nairu and vacancies that are not easily filled despite unemployment. These frictions have been studied in employment missions, as well as in academic studies, some conducted by Bank researchers, to inform possible structural reforms to the labor market.
According to the recommendations of the last employment mission (Alvarado et al., 2021), first, it is important to increase the level of formality in the labor market, both to increase productivity and to achieve greater coverage in social protection; second, it is necessary to change the incentives for formalization by adjusting the financing mechanism and access to social protection benefits; third, the role of the minimum wage must be reconsidered in view of the fact that it is at very high levels in relation to the total wage distribution; and fourth, it is necessary to ensure an effective training and labor intermediation system aligned with the demands of the productive sector.
In this context, we can conclude by stating that what happens in the labour market does matter (and a lot) in monetary policy decisions. The evolution of employment and price stability are two sides of the same coin: there is no way to think about monetary policy without analysing the situation of the labour market. However, if we want to see improvements in the long-term levels of the economy and the labour market, we need structural reforms, not monetary policy adjustments.
-Bibiana Taboada Arango
-Mauricio Villamizar Villegas
Co-directors of the Bank of the Republic.
**The opinions in this text do not represent the views of Banco de la República or its Board of Directors.
**A longer version of this article can be found at: https://www.banrep.gov.co/es/publicaciones-investigaciones/presentaciones-discursos/mitos-importa-mercado-laboral-politica-monetaria
