In
2013, we published a paper “**Does Banque de France control inflation and unemployment?”**** **We
demonstrated that the French economy would likely sink into a longer period of
deflation or very low inflation rate after 2013. This is an **excerpt** from the paper discussing how
Banque de France could boost labour force growth and inflation by flooding the
French economy with money. Instead of this simple measure, there were several
depressing years of contingency measures introduced by the ECB. This update uses
data for the past three years and proves that austerity is a counterproductive approach.
We just extend inflation prediction by 3 years ahead (to 2019) and put new
measurement without change in the previous estimates. We have nothing to add. The
text is still valid.

“*Here, we
consider the rate of inflation, unemployment, and the change in labour force
altogether. For France, the generalized relationship is obtained as a sum of
(10) and (13), which results, with some marginal tuning of all coefficients in
order to reduce the standard error of the model, in the following equation for
the GDP deflator:*

*π(t) = 2.69l(t-5) - u(t-5) + 0.108; 1971≤t≤1995 *

*π(t) = 6.40l(t-5)
- u(t-5) + 0.059; t≥1996 (14)*

*For the OECD CPI:*

*π(t) = 3.0l(t-5) - u(t-5) + 0.108; 1971≤t≤1995 *

*π(t) = 5.0l(t-5)
- u(t-5) + 0.067; t≥1996 (15)*

*where we model inflation since
it lags by 5 years behind the change in labour force and unemployment.
Formally, one can re-write both relationships for u(t). Notice that the change
in the slopes and intercepts are much smaller than in individual relationships.
The structural break is less prominent and thus its estimate is less
reliable. *

*The annual and
cumulative curves for both cases are presented in Figure 12. Linear regression of the observed inflation
against that predicted according to (14) and (15) is characterized by
outstanding for annual curves statistical properties: R*^{2}=0.87 and RMSFE=0.015
y^{-1},^{ }and^{ }R^{2}=0.83 and RMSFE=0.017 y^{-1},
respectively. For the cumulative curves, both R^{2} are larger than 0.99
and RMSFE~0.025 y^{-1}, i.e. by 20% smaller than the naive ones (see
Table 4). These estimates were obtained for the period between 1972 and 2012 with
a five-year lag. These RMSFEs are the best obtained for France at a five year
horizon so far. They explain the rate of price inflation to the extent beyond
which measurement uncertainty should play the key role. Practically, there is
no room for any further improvements in R^{2} given the accuracy of the
current prediction.

*Conclusion*

*We have successfully modelled
unemployment and inflation in France. Their sensitivity to the change in labour
force requires very accurate measurements for any quantitative modelling to be
reliable. Unfortunately, the OECD labour force time series does not meet this
requirement and poor statistical results are obtained for annual readings. The
best prediction is obtained with the moving average technique applied to the
change in labour force. For the period between 1970 and 2012, linear regression
analysis provides R*^{2} as high as 0.8 to 0.9 for the rate of
unemployment and GDP deflator. The RMSFE for the best CPI model is 0.015 y^{-1}
and 0.010 y^{-1} for the GDP deflator, both at a four year horizon. For
the period after 1994, the best RMSFE=0.005 y^{-1} for both measures of
inflation. In 1994, our models have structural breaks found by the OLS fit. For
the VECM representation, the standard error for the GDP deflator is as low as 0.010
y^{-1} at a four year horizon and 0.005 y^{-1} for a two year
horizon. The whole period and 0.004 y^{-1} for the period after 1994. All
in all, we have obtained a very accurate description of unemployment and
inflation in France during the past 40 years.

*Having discussed
the technically solvable problems associated with the uncertainty in the labour
force measurements, we start tackling the problem associated with the
divergence of the observed and predicted curves starting around 1995. An understanding of this discrepancy is a
challenge for our concept. Potentially, these curves diverge due to the new
monetary policy introduced by the Banque de France. We may claim that the
policy of constrained money supply, if applied, could artificially disturb
relationships (9), (10), and (13). We had to introduce a structural break and
to estimate new coefficients after 1995 for unemployment and after 1994 for
inflation, respectively. These coefficients are less reliable because the relevant
time series are short and vary in narrow dynamic ranges, but they are
definitely different from those before the breaks. One could conclude that
Banque de France has created some new links between the unemployment,
inflation, and labour force, shifting coefficients in the original long term
equilibrium relations. *

*Figure 12. Comparison of the
observed and predicted inflation in France - annual and cumulative inflation
since 1972. The predicted inflation is a linear function of the labour force
change and unemployment.*

*We think that the true money supply in excess of that
related to real GDP growth should be completely controlled by the demand
related to the growing labour force. This excessive money supply is
accommodated in developed economies through employment growth, which then
causes price inflation. The latter serves as a mechanism effectively returning
the normalized personal income distribution to its original shape (Kitov and Kitov,
2013**). The relative amount of money that the economy needs to accommodate
through increasing employment, as a reaction on independently growing labour
force, is constant through time but varies among developed countries. This
amount has to be supplied to the economy by central bank. *
*The ESCB limits
money supply to achieve price stability. For France, the growth in labour force
was so intensive after 1995 that it requires a much larger money supply for
creation of an appropriate number of new jobs. The 2% artificial constraint on
inflation, and thus on the money supply, disturbs relationships (10) and (13).
Due to lack of money in the French economy, the actual (and mainly exogenous)
growth in labour force was only partially accommodated by 2% inflation. The lack
of inflation resulted in increasing employment. In other words, instead of 2%
unemployment, as one should expect according to the relationship before 1995,
France had 9% unemployment. Those people who entered the labour force in France
in excess of that allowed by the target inflation rate had no choice except to
join unemployment in order to compensate the natural 7% rate of inflation,
which was suppressed to 2%. *

*The lags and
amplification factors (sensitivities) found for unemployment and inflation in France
are quite different from those obtained for the USA and Austria (Kitov and Kitov,
2010**). The latter country is
characterized by the absence of time lags and low sensitivities. In the USA,
inflation lags by two and unemployment by five years behind the change in
labour force, with sensitivities much lower than those in France. Apparently,
the variety of lags is the source of problems for the Phillips curve concept. *
*The causal link
between inflation, unemployment, and labour force gives a unique opportunity to
foresee future at extra long time horizons. The accuracy of such long-term
unemployment and inflation forecasts is proportional to the accuracy of labour
force projections. For example, central banks can use labour force projections
as a proxy to “inflation expectation” in their NKPCs. Figures 8 and 12 imply
that France will be enjoying ***a period of low inflation rate in the near future**.
Monetary policy of the ECB is also an important factor for these forecasts
because of its influence on the partition of the labour force growth between
inflation and unemployment. Moreover, this is the responsibility of the ECB and
Banque de France to decide on the partition. “