E C O N O M I C R E P O R T O F T H E P R E S I D E N T

Chart 2-17 shows how this could happen. It assumes that nominal increasesin hourly compensation reflect three factors: a bonus for tight labor markets,as reflected in a low unemployment rate; a full adjustment for expected priceinflation (with backward-looking inflation expectations); and a normalincrease in real wages (which here will be called the “real wage norm”). Thereal wage norm may reflect prevailing views of the trend in labor productivity.But little is known about how the real wage norm is formed, and thereforethe model is estimated on the assumption that the real wage norm reflects theprevious year’s increase in real hourly compensation.With stable productivity growth, and with unemployment equal to thelong-term NAIRU (where the diagonal regression line crosses the x-axis in thechart), wage and price inflation are stable from one year to the next. However,a 1-percentage-point positive surprise in productivity growth has the effectof temporarily lowering the NAIRU by 1¼ percentage point. With nominalwage growth unchanged and productivity growth higher, unit labor costs, andwith them price inflation, would fall if the unemployment rate does notchange. Only with a lower employment rate would unit labor costs and priceinflation be stabilized. Hence the short-term NAIRU is lower.The effect of the increase in productivity growth on unemploymentprobably will not last indefinitely. If productivity growth is maintained at itscurrent high level, it will cease to be “unexpected,” the real wage norm willeventually rise to that same level, and the short-term NAIRU will gravitateback to its long-term level.Chapter 2 | 91