First of all, we present synthetically a few empirical results regarding changes in the inflation-unemployment relationship in West European countries during last three decades and in few Central and Eastern countries during the last fifteen years. Then, coming from a general standard model for estimating natural unemployment (Ball and Mankiw, 2002) and using four smoothing filters, we estimate some possible trajectories for this relationship and for the potential GDP in Romania.inflation, unemployment, natural unemployment, Romanian economy

Lucian-Liviu Albu

English

Research Papers in Economics

Romanian Economic and Business Review – Vol. 1, No. 3 
 
  25 
TRENDS IN INFLATION-UNEMPLOYMENT 
RELATIONSHIP 
BEFORE AND AFTER ACCESSION TO EU 
 
Lucian-Liviu Albu
* * * * 
 
Abstract 
 
First of all, we present synthetically a few empirical results regarding changes in the 
inflation-unemployment  relationship  in  West  European  countries  during  last  three 
decades and in few Central and Eastern countries during the last fifteen years. Then, 
coming from a general standard model for estimating natural unemployment (Ball and 
Mankiw, 2002) and using four smoothing filters, we estimate some possible trajectories 
for this relationship and for the potential GDP in Romania. 
 
First of all, we present synthetically a few empirical results regarding changes in the 
inflation-unemployment  relationship  in  West  European  countries  during  last  three 
decades and in few Central and Eastern countries during the last fifteen years. Then, 
coming from a general standard model for estimating natural unemployment (Ball and 
Mankiw, 2002) and using four smoothing filters, we estimate some possible trajectories 
for this relationship and for the potential GDP in Romania.  
As in standard literature is asserted there is an implicit circular relationship between 
productivity growth and potential level of production (and consequently the estimation of 
natural  rate  of  unemployment  is  also  altered).  In  order  to  avoid  such  emerging 
impediment in any estimating macroeconomic model, an autonomous dynamic model to 
estimate the trend of productivity growth must be used. Moreover, taking into account 
that current level of productivity is implicitly influenced by the actual unemployment 
rate, usually it is recommended as a more accurate solution to try to obtain firstly an 
estimate for the “pure” productivity. This must be neutral relating to short-run changes in 
employment,  but  in  long-run  it  is  affected  by  factors  such  as  general  technological 
progress,  rising  of  education  level,  growth  of  R&D  system,  extending  of  the  “new 
economy”,  etc.  We  use  a  simple  dynamic  model  to  estimate  the  growth  of  pure 
productivity  independently  from  the  actual  level  of  employment  and  implicitly  of 
unemployment rate. Then estimated changes in pure productivity level are compared with 
potential production trend in case of Romanian economy during transition period. 
Empirical studies demonstrate, on the background of business cycles, several major 
changes in economies of West European countries during last three decades (Dăianu and 
Albu, 1996; Albu, 1998 and 2001). Among trends it can be noted the impressive decrease 
in inflation followed by a continuing growth of unemployment and general diminution of 
the yearly growth rate of production (GDP). An important result of investigation is that of 
a  smaller  volume  in  3D  map  (estimated  by  including  the  variation  of  the  three 
macroeconomic  indicators),  which  represents  a  stronger  economic  stability  and 
                                                            
* Lucian Liviu Albu, Ph.D, works at the Institute for Economic Forecasting in Bucharest.  
  26 
consequently less strain in economic system.  In the figure of Annex 1 it is shown a 
graphical representation of the evolution during three decades (1970-2000) in the three-
dimensional space: unemployment rate (u%) - annual growth rate (y%) - inflation (p%), 
including  ten  EU  countries  (Belgium,  Denmark,  England,  France,  Germany,  Italy, 
Ireland,  Holland,  Portugal,  and  Spain).  The  trend  was  from  a  period  in  which  high 
inflation predominated toward one in which unemployment plays the main role. This 
evolution could mean that on the unemployment-side occurred a relaxation, higher levels 
of unemployment being viewed as normal but is not the case for the inflation level. A 
deeper analysis showed the possibility of some persistent trends and long-run attractors.  
On the other hand, in East European countries there was an opposite situation at least 
during  the  first  years  of  transition;  open inflation  rose  rapidly  in  the region whereas 
unemployment did also rise but at a smaller pace. There are evidences demonstrating that 
the long-run trends tend to be similar to those registered in Western countries. In the 
figure of Annex 2 it is shown a graphical representation of the evolution during the last 
fifteen years (1990-2004) in the three-dimensional space: unemployment rate - annual 
growth rate - inflation, including six transitional economies from Central and Eastern 
Europe (Bulgaria, Czech Rep., Hungary, Poland, Slovakia, and Slovenia). 
In case of each individual Eastern economy the most important question is how long 
the transition period will be. Despite of a relatively short period since 1989, in case of 
Eastern countries it seems to emerge a convergence process relating the natural rate of 
unemployment. The main problem continues to be a relatively high inflation comparing 
with the EU standards (especially in case of Romania where the annual inflation will 
decrease below 10% only since this year). 
Following some studies existing in literature (Staiger et al., 2001; Ball and Moffitt, 
2001; Ball and Mankiw, 2002), in order to estimate natural rate of employment we used 
aside the simple linear trend (Ye) other four trends based on the following filters: regress 
(Y_TR), loess (Y_L), ksmooth (Y_TL), and Hodrick-Prescott (Y_HP). On the base of 
simulations, we can also see the unfavourable impact of positive difference between the 
effective unemployment rate and its natural rate on inflation dynamics (Dp). In case of 
linear trend the unemployment gap is DU=U-Ye, but in case of the four selected filters it 
is  noted  DUR=U-Y_TR,  DUL=U-Y_TL,  DUK=U-Y_TK,  and  respectively  DUH=U-
Y_HP. As we can see from the Figure 1, as general rule, the points in 2D space, DU-Dp, 
are  distributed  in  sectors  II  and  IV  (in  trigonometric  sense)  over  the  right  line 
transcending the origin of coordination axes. Eventual differences (the evading from two 
mentioned sectors) can be attributed to the short run supply shocks. 
  
  27 
150 100 50 0 50 100 150
4
2
0
2
4
0
D Uei
D URi
D ULi
D UKi
D UHi
0
Dp i
Figure 1. 
 
Moreover,  corresponding  to  the  four  used  filters,  we  computed  the  natural  (or 
potential)  level  of  GDP,  the  output  gap,  and  respectively  the  correlation  coefficient 
between it and inflation variation. The general level of correlation coefficient between 
output  gap  and  variance  of  inflation  (Dp),  for  the  period  1992-2003,  was  positive 
(between +0.616 and +0.644). From Figure 2, we can see that in the first part of transition 
period  (before  1998)  the  inflation  is  accentuated  procyclical  relaying  to  output  gap 
(correlation coefficient between +0.669 in case of TL filter and +0.714 in case of HP 
filter). However, after 1998 it is countercyclical (correlation coefficient between -0.420 in 
case of HP filter and -0.836 in case of TR filter), that could mean a favourable temporary 
situation when a growth in output may be accompanied by a negative change in inflation. 
Indeed, after the accession to EU this favourable correlation will probably change, as is 
the standard situation in a consolidated market functioning economy.   
  28 
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
100
50
0
50
100
gapTRi
gapTLi
gapTKi
gapHPi
Dp i
yeari
 
Figure 2. 
 
Related  to  the  past  evolution,  more  explanation  could  be  extracted  in  case  of 
considering  the  dynamic  process  of  real  reforming  and  restructuring  of  the  national 
economy:  a  prolonged  and  hesitant  restructuring  process  of  economy  in  first  part  of 
transition (before 1998); and a more determinate and accelerated process of it during last 
years (after 1998). 
In order to estimate the level of pure productivity and its trend in case of Romanian 
economy, we conceived a simple particular model having as hypotheses the following 
two equations (the time subscript, i, being omitted): 
q  =  A La
a= A L
a m
a  =  qmax m
 a               
s  = s0 La                   
where  q  and  s  are  production  (GDP)  and  respectively  all  costs  implied  by  its 
achievement (taking into account that the production function has an alone factor, so the 
active labour force); La and L are employment and respectively labour force; qmax and 
s0 are production under the hypothesis of an integral utilization of labour force (La=L) 
and unitary cost (indeed including also salary) per person in active labour force, La, 
respectively; a is a positive and sub-unitary coefficient, which determinates how look the 
production curve function of employment share, m, in total labour force, L (m=La/L). For 
the  moment  all  considered  variables  are  evaluated  in  real  terms,  therefore  under  the 
hypothesis of constant prices (of one year selected as base).  
  29 
The  difference  between  q  and  s  can  be  interpreted  as  being  the  profit  or  net 
accumulation,  therefore  the  quantity  that  stimulates  entrepreneurs  to  make  future 
investments and to develop their affaires. It mainly depends on two factors: employment 
degree, m, and respectively coefficient a. Since the evaluation of the employment share in 
total available labour force is not a problem, to estimate a is an extremely difficult issue, 
as  well  as  its  economic  interpretation.  Economists  generally  accept  the  sub-unitary 
restriction,  as  it  ensures the  concavity  of  production  function. The  explanation  is: as 
employment share growths, tending to value one, the average level of labour productivity 
tends  to  decrease  (as  well  as  the  adapting  possibilities  of  entrepreneurs  to  some 
permanent moving markets). In order to solve the problem of estimating the production 
function  curvature,  we  took  into  account  also  the  long-run  price  evolution.  The 
hypothesis that we adopted, however very restrictive, is referring to the absence of some 
pertinent information on the future evolution of prices (as it is the case of an economic 
system functioning in high inflation, as well as that of Romanian economy in transition 
period).  The  remained  solution  is  to  compute  maximization  of  the  future  profit  by 
reporting to actual level of unitary costs (although knowing that in reality this is not the 
case for the future period). It would be reasonable that even such decision (founded on a 
highly restrictive hypothesis, like that of basing the maximization of the future profit on 
maintaining unchanged the specific costs) could yield sweet fruit in the future, in any way 
larger than in case of no evaluation calculus. The real adjustment to be operated (indeed 
instantaneously conforming to the “new wave” theory of rational expectations) then when 
the pressures on cost (such as for instance the trade unions’ pressures) will not confirm 
the effective pre-evaluation. The implicit hypothesis of this “backward dynamics” mode 
of interpretation is that the effective change of unemployment rate in current period from 
precedent  period  corresponds  even  to  the  solution  of  profit  maximization  under  the 
hypothesis of maintaining unchanged cost between the two consecutive periods, but also 
to the modification of total price of production exactly at the value effectively registered. 
So,  the  actual  level  of  unemployment  rate  means  even  its  optimal  level,  however 
computed previously on the base of total cost in precedent period together with the index 
of prices in current period. Since we accept this interpretation, the maximization function 
will be: 
Be (m) = Q - s  =  q p  -  s                   
WHERE BE IS THE ANTICIPATED PROFIT (DESPITE OF KNOWING THAT THE 
PLANED BENEFIT WILL NOT BE INTEGRALLY OBTAINED), Q IS VALUE OF 
PRODUCTION IN CURRENT PRICES, P. THIS FUNCTION ADMITS A MAXIMUM GIVEN BY 
THE SOLUTION OF THE FOLLOWING EQUATION:   
p = ( m 
1-a ) / a                 
   
THE RESTRICTION IMPOSED BY THIS EQUATION ALLOWED US TO ESTIMATE, 
ONLY BY USING A SPECIAL NUMERIC PROCEDURE, THE VALUES OF a a a a       COEFFICIENT 
FOR THE PERIOD 1990 2003. THE MODEL PERMITTED TO ESTIMATE ALSO OTHER 
SYNTHETIC INDICATORS CHARACTERIZING THE EVOLUTION OF THE ROMANIAN 
ECONOMY DURING THE TRANSITION PERIOD, SUCH AS: 
  - Coefficient of using capacity (or the degree of using potential GDP, noted here 
as qmax)  
  30 
k = q / qmax = m
 a                   
   
  - Share of profit 
b  =  B / Q  =  (Q - s p) / Q = (q - s) / q  =  1 - m
 1-a            
In order to identify the type of relation between unemployment and productivity, we 
examined the estimated data supplied by the above two models (model of natural rate of 
unemployment and respectively the “pure” productivity model) together. Many times the 
authors are using for the productivity growth an inverted scale to reflect better the two 
supposed inverse movements: the long-run unemployment trend and productivity growth 
trend.  In  case  of  our  application  on  Romanian  economy  in  transition  period,  we 
maintained the original scales, but used a calibrating procedure to force the two trends to 
come in a closer region of their co-joint space. In Figure 3 we are presenting the natural 
rate trends and the growth rate of “pure” productivity (noted as y_wL90) together. On the 
graph, time, t, means the years in period 1992-2003, noted as 2…13 (the estimated levels 
of natural rate are here considered at the beginning of each year). From this graphical 
representation it is an evident inverse correlation between the estimated natural rate of 
unemployment and productivity growth. So, we could conclude that, at least in case of 
transition  period,  the  productivity  acceleration  is  accompanied  by  a  decrease  in  the 
natural rate and when the productivity decreases the natural rate increases rapidly. 
 
2 3 4 5 6 7 8 9 10 11 12 13
6
7
8
9
10
Yet
Y_TRt
Y_TLt
Y_TKt
Y_HPt
. y_wL90t 8
t  
Figure 3. 
 
  
  31 
References 
 
Albu,  Lucian-Liviu,  1998,  “Strain  and  inflation-unemployment  relationship  in 
transitional  economies:  a  theoretical  and  empirical  investigation”  (monograph),  ACE-
PHARE-F  Project,  CEES,  January,  University  of  Leicester,  Centre  for  European 
Economic Studies, Leicester, Brussels. 
Albu,  Lucian-Liviu,  2001,  “Evolution  of  Inflation-Unemployment  Relationship  in 
the  Perspective  of  Romania’s  Accession  to  EU”,  Romanian  Journal  of  Economic 
Forecasting, 3-4, Bucharest, 5-23. 
Albu,  Lucian-Liviu,  2004,  “Estimating  natural  unemployment  in  transitional 
economies  (Case  of  Romania)”,  Adapted  models  to  estimate  potential  GDP  in  the 
candidate countries, GDN research project, October, Prague. 
Albu,  Lucian-Liviu,  2004,  “Estimating  NAIRU  for  the  Romanian  Economy”, 
Romanian Journal of Economic Forecasting, 2, Bucharest, 5-19. 
Ball, Laurence and Mankiw, Gregory, 2002, “The NAIRU in Theory and Practice”, 
NBER Working Paper Series, 8940, National Bureau of Economic Research, Cambridge. 
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Curve”,  The  Roaring  Nineties:  Can  Full  Employment  Be  Sustained?  (eds.:  Alan  B. 
Krueger and Robert Solow), New York: The Russell Sage Foundation and The Century 
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Daianu,  Daniel  and  Albu,  Lucian-Liviu,  1996,  “Strain  and  the  Inflation-
Unemployment  Relationship:  A  Conceptual  and  Empirical  Investigation”,  Research 
Memorandum ACE Project, 15, University of Leicester, Centre for European Economic 
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Sustained? (eds.: Alan B. Krueger and Robert Solow), New York: The Russell Sage 
Foundation and The Century Foundation Press. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
  32 
 
Annex 1 
 
 
 
 
u% y% , p% ,
 
 
 
 
 
 
 
 
 
 
  
  33 
Annex 2 
 
 
 
 
u% y% , p% ,
 
 
 

Estimating NAIRU for the Romanian Economy”,

Estimating natural unemployment in transitional economies (Case of Romania)”, Adapted models to estimate potential GDP in the candidate countries, GDN research project, October,

Evolution of Inflation-Unemployment Relationship in the Perspective of Romania’s Accession to EU”,

Postwar U.S. Business Cycles: An Empirical Investigation”,

Productivity Growth and the Phillips Curve”, The Roaring Nineties: Can Full Employment Be Sustained?

Strain and inflation-unemployment relationship in transitional economies: a theoretical and empirical investigation” (monograph),

Strain and the InflationUnemployment Relationship: A Conceptual and Empirical Investigation”,

Trends in inflation-unemployment relationship before and after accession to EU

http://www.rebe.rau.ro/RePEc/rau/journl/FA06/REBE-FA06-A4.pdf

Trends in inflation-unemployment relationship before and after accession to EU

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