lecture 1: constructing a theory of equilibrium unemployment i. a macroeconomic framework
TRANSCRIPT
Lecture 1: Constructing a theory of equilibrium unemployment
I. A macroeconomic framework
The traditional Keynesian view
• Unemployment is a short-term phenomenon
• It is due to nominal price rigidities, which create an imbalance between aggregate supply and aggregate demand
• Nominal prices eventually adjust downwards as a result of this imbalance
• Therefore, there is no persistent unemployment
We need a theory of positive equilibrium unemployment
• No economy with zero unemployment has ever been observed
• Two routes to generate unemployment:– Built-in real wage rigidity Labor demand <
labor supply– Built-in frictions: people lose their jobs and it
is physically impossible for them to find another one
The simplest model of real wage rigidity:
Labor demand
Labor supply
Wage floor
UnemploymentEmployment L
w/p
What is wrong with this model?
• No micro foundation for the wage floor we see that later
• It is not a macro model: we do not know where labor demand comes from.
• So we have equilibrium unemployment but we do not know its determinants!
• The model is not very useful
One Step Beyond
• Can we do better and embody the wage rigidity in a growth model?
• Let us try to do it!
Let’s try to add a wage rigidity in the Ramsey model
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In the long-run
• If the wage floor is not binding, the usual Ramsey steady state holds
• If it is binding, then we are in trouble: equilibrium K/L ratio cannot match both the wage floor and the Ramsey condition
• Because capital adjusts, the LR labor demand curve is horizontal
• Unemployment converges to 100 %!
The problem in the labor demand space:
w/p
L
Wage floor
LD, t=1
LD, t=2
LD, t=3
LRLD
The problem in the FPF space
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r
The problem in the phase space
K
C
The Spiral:
• The wage floor pins the return to capital
• But this return to capital is too low for consumers to want to accumulate capital in the long-run
• A spiral of dissaving and unemployment follows
• The issue would be similar in an open-economy model with capital mobility
What is wrong with this model?
• As the economy gets poorer, we expect the wage floor to adjust
• One possibility would be to index it on GDP per capita
• Where would such an indexation come from?
• One intuitive mechanism is that the unemployed exert downward wage pressure
Introducing the wage curve:
• It looks like a labor supply curve• But it is not a labor supply curve• The labor supply curve gives us how much
labor people want to supply at a given wage• The wage curve tells us how the
unemployment rate affects the wage that wage setters ask in a non competitive framework
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How it works:
SR Labor demand
LR Labor demand
SR UnemploymentSR Employment L
w/p
Wage curve
Labor force
LR Unemployment
Introducting Long-Run TFP growth
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In the long-run
• K/L must grow at rate g for the Ramsey condition to hold
• This implies that wages must grow at the same rate g
• But then unemployment must trend down to zero
• This has not been observed in the real world
What is wrong with this model?
• As the economy gets richer, we expect people to ask for higher wages, given u
• Why?
• The wage that is bargained for presumably depends on wage aspirations
• Wage aspirations are proportional to GDP per capita
Augmenting the wage curve
• Wage aspirations depend on variables that grow at g in the long run
• For a BGP with constant u to exist, the wage curve must be homogeneous of degree 1 in these variables
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How it works
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LR natural rate
LRLD1
LRLD2
LRLD3
WC1
WC2
WC3
Primary Determinants of the natural rate:
• These are Shifts factors that affect the position of the wage curve
• They always matter
• They capture the degree of micro and institutional wage rigidity in the economy
Secondary determinants of the natural rate
• Factors that affect the position of the labor demand curve
• How important they are depends on how wage aspirations are defined
• In some cases, they do not matter at all, because wage aspirations move proportionally
Example 1: wage aspiration = labor productivity
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In this example:
• The short-run and long-run natural rates only depend on primary determinants
• This is because wage aspirations are always proportional to the current wage
• This would be a bit more complicated if production function were not Cobb-Douglas!
Example 2: wages aspiration = lagged labor productivity
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In this example:
• The short run natural rate depends positively on TFP and the capital stock
• It depends negatively on past wages
• The only secondary determinant for the LR natural rate is the economy’s growth rate
• Why? As growth is faster, current aspirations fall relative to the wage that employers are willing to pay
Example 3: aspirations grow exogenously at rate g
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In this example:
• Falls in the LR K/L ratio reduce LRLD with no impact on aspirations
• => r and δ increase the LRNR• => g now increases unemployment through a
lower K/L ratio
• A0 reduces u since aspirations do not match the induced increase in labor demand