A Comparison of Optimal and Actual Policies for High Employment and Price Stability under External Inflationary Conditions: The Canadian Experience

Abstract

Short-run macroeconomic policy formulation may be viewed as a process of community choice involving the implicit or explicit balancing of the social cost of increased unemployment against the destabilizing effects of inflation. While the conflict between competing policy objectives has been exhibited in numerous studies of the Phillips curve, the welfare effects of government policy have not been explicitly evaluated in terms of the policy preferences and interests of various community groups. In this paper the revealed preferences of the members of trade unions, employers' organizations and political parties with respect to the trade-off between unemployment and inflation are conceptualized in terms of quadratic disutility functions. An abundance of empirical evidence confirms that in Canada inflation imported from the United States is a significant factor in explaining the upward shift of the short-run Phillips curve. While Canadian policy makers can ex-ante identify an optimal mix of domestic unemployment and overall inflation on a particular momentary Phillips curve, they are unable to avoid completely the adverse consequences of U.S. inflation * The authors thank professors R. Bodkin and J. Tinbergen for their helpful comments on an earlier version of this paper. Thanks also to P. B. Kenen and F. Machlup for stimulating discussions on the problem of imported inflation. Last but not least they thank Brigitte Sellekaerts for valuable technical assist-