Economic Report of the President

job opportunities are very high for workers, and the costs of traininga skilled work force are very large for businesses. Both workers andfirms see benefits in establishing long-term relationships. One wayfor a firm to attract and hold a skilled work force is an implicit agreementnot to engage in extensive wage-cutting during periods of weakmarkets. As a consequence, many firms are unwilling to take a chanceof losing out in the labor market by being among the first to reducewage increases.Other institutions besides those of wage-contracting contribute tothe downward insensitivities of prices and wages. In the case ofprices, the downward pressure that would normally be exerted bycompetitive forces in slack markets is significantly muted in large oligopolisticindustries by market strategy considerations and variousforms of administered prices. Finally, government intervention in individualmarkets through regulation, which may fix wages, the priceor quality of the product, or the conditions under which productiontakes place, adds further rigidity.Some of the economic institutions and practices that contribute towage and price rigidity themselves evolved in response to expectationsthat government economic policy would continue to be supportive.Although the persistent application of demand restraint islikely to reduce them, they should not be expected to disappeareasily or quickly.Downward wage and price rigidity makes the costs of reducing inflationthrough monetary and fiscal restraint quite large. It is difficultto estimate the costs with precision, but representative econometricstudies suggest that reducing inflation by 1 percentage point wouldrequire a sacrifice of $100 billion in lost output (in 1980 pYices) anda one-half percentage point rise in the unemployment rate over aperiod of about 3 years. Most of the costs would be incurred in thefirst half of the period. These statistical estimates, however, are basedon historical relationships. There has never been a period of sustainedeconomic restraint in recent times from which direct evidence ofthe costs could be drawn. The possibility that they would growsignificantly smaller if restraint persisted is discussed later in thischapter.In sum, it is the costs imposed on society when demand restraintclashes with the downward insensitivity of wages and prices thatmakes it so difficult to reduce inflation by applying monetary andfiscal restraint. Viewed in this perspective, the central problem ofeconomic policy is not how to reduce inflation. If that were the onlyobjective, a sufficiently draconian level of demand restraint could befound to do the job. The real issue is twofold: How large are thecosts society is willing to bear to realize the benefits of lower infla-46