Chapter 17 Unemployment, Inflation, and Growth

2 Introduction In Chapter 4, 5, 6, we have studied a classical model of the complete economy, but said little about economic growth, inflation and unemployment because the model is static. In this chapter, we start to study these dynamic issues based on the classical model of AD, the new-Keynesian theory of AS and wage equation. The reason we use the classical AD is that it is simpler.

3 Introduction Advantage of using the classical AD : -- We can highlight the most important advances in the economic dynamics that occurred over the past 20 years without getting bogged down in details. Disadvantage : -- It makes the false assumption that the propensity to hold money is independent of the interest rate and then is unable to account for channels through which fiscal policy influences AD.

4 Introduction Steps : 1.We alter the classical AD and the Keynesian AS to explain how variables change over time by allowing for productivity growth. 2.Plot the dynamic AD curve and the short-run dynamic AS curve on a graph of inflation against growth. 3.We can show how AS and AD interact to determine all of the endogenous variables of our theory.

5 The Classical Approach to Inflation and Growth We build the dynamic new-Keynesian theory of AD and AS in two stages. 1. We explore how the dynamic model works if unemployment is always as the natural rate. (the classical approach) 2. Then, we study the new-Keynesian wage equation, a theory that explains how the nominal wage changes over time when unemployment fluctuates from its natural rate.

6 Natural Paths and Natural Rates In a dynamic, growing economy, when a firm pays a turnover cost to manage its pool of workers, the natural unemployment rate and the natural level of employment remain constant each period, just as in the static economy. However, the natural level of output and the natural real wage grow from one year to the next as technology improves. The list of natural level of output (efficiency wage levels) one for each year, is called the natural output path (the natural real wage path).

7 Figure 17.1 ©2002 South-Western College Publishing GDP and Its Natural Path

8 The Classical Dynamic AD Curve The classical AD (Chapter 5) is : This is the static version of the quantity theory of money, based on 3 assumptions: 1. The quantity of money demand is proportional to income (Y). 2. M S =M D. 3. The propensity to hold money (V) is constant.

9 The Classical Dynamic AD Curve The classical AD can be written in the form of proportional changes : where the variables are referred as the price inflation rate, the money growth rate and the GDP growth rate.

10 The Classical Dynamic AD Curve When we develop the theory according to growth rates, the outcome is the dynamic theory of aggregate demand.

11 The Classical Dynamic AS Curve We amend the efficiency wage model of unemployment and allow for changes in productivity (exogenous discovery of new technology) from one year to the next. This form the basis of the dynamic theory of AS because it predicts that GDP will grow each year even if employment does not.

12 The Classical Dynamic AS Curve Two versions of the dynamic theory of AS: 1. The classical version: We assume the real wage always grows at the natural rate of productivity growth. (unemployment is always at its natural rate) 2. The new-Keynesian version: Real wage growth can differ from its natural rate.

13 The Classical Dynamic AS Curve In the classical dynamic theory of AS, employment is equal to its natural level, L*. (We assume that the population or the labor force are constant for simplicity) Then, the classical dynamic AS curve is

14 ©2002 South-Western College Publishing Figure 17.2A Growth and the Real Wage

15 ©2002 South-Western College Publishing Figure 17.2B Growth and the Real Wage

16 The Classical Dynamic AD-AS Curve

17 ©2002 South-Western College Publishing Figure 17.3 Inflation and Growth (the Classical Case)

18 The Wage Equation in the Classical Model How is the real wage chosen each period in the dynamic classical theory? By the assumption of perfect competitive market (zero profit) and L=L*, we must have which implies

19 Box 17.1 ©2002 South-Western College Publishing FOCUS ON THE FACTS The Third Industrial Revolution?

20 The New Keynesian Approach The new-Keynesian theory of aggregate supply is more realistic than the classical theory and allows unemployment to fluctuate from its natural rate. In the new-Keynesian model, GDP may depart from its natural path for short periods, but it tends to return to the natural path in the long run.

21 The New Keynesian Approach Three elements of the new-Keynesian approach to aggregate supply: 1. A theory of wage determination. 2. A theory that explains how inflation and growth are related in the short run, the period during which the real wage differs from its natural growth path. 3. The third explains how inflation and growth are related to each other when the real wage is on its natural growth path (long-run, the classical AS).

22 Aggregate Supply and the Real Wage In the short run, the real wage can differ from its natural path, changes in the real wage will relate to changes in employment and therefore to growth. If the real wage grows slower (faster) than its natural rate, firm will increase (decrease) employment and then raise (lower) GDP above (below) its natural rate.  Excess Output growth is inversely related to excess real wage growth along the aggregate supply curve.

23 Figure 17.4A ©2002 South-Western College Publishing Real Wage Growth and Aggregate Supply: The New-Keynesian Model

24 ©2002 South-Western College Publishing Figure 17.4B Real Wage Growth and Aggregate Supply: The New-Keynesian Model

25 The Dynamic New Keynesian AS Curve In the previous section, we know that the growth rate of the real wage will equal the output (productivity) growth rate (g) in the long run. In the short run, excess output growth is inversely related to excess real wage growth along the aggregate supply curve and may be modeled as

26 The Dynamic New Keynesian AS Curve Assume that the nominal wage grows at the rate of productivity growth, g, then

27 The Dynamic New Keynesian AS Curve Assume that the nominal wage grows at the rate of productivity growth, g, then

28 The Dynamic New Keynesian AS Curve Assume that the nominal wage grows at the rate of productivity growth, g, then

29 The Dynamic New Keynesian AS Curve We can discuss the case that the excess nominal wage inflation is non-zero. Figure 17.5 graphs the new-Keynesian dynamic aggregate supply curve (SRAS) and its position depends on excess nominal wage inflation, (the intercept). The purple line is the long run (classical) dynamic aggregate supply curve (LRAS).

30 ©2002 South-Western College Publishing Figure 17.5 Dynamic Aggregate Supply in the New-Keynesian Model

31 The Dynamic New Keynesian AS Curve SRAS and LRAS intersect when price inflation equals excess wage inflation, i.e. the real wage and output rates both grow at the natural rate, g. If price inflation exceeds (is less than) the excess nominal wage inflation, output growth must be more (less) than g. But what determines excess wage inflation ? -- the new-Keynesian wage equation.

32 The New-Keynesian Wage Equation In the classical theory, the real wage follows its natural path, and there are never any opportunities for firms to make extra profits by offering to trade with workers at a either lower or higher real wage. In the new-Keynesian model, the real wage is not necessary equal to the natural rate. However, it always moving toward its natural path although adjustment takes time.

33 The New-Keynesian Wage Equation For example, if the real wage rate is higher than its natural rate and the unemployment is thus above the natural rate. Hence, firms can lower the wage rate and lower its cost due to excess supply of labor until the real wage returns to its natural rate. This idea is modeled as

34 The New-Keynesian Wage Equation This is the new-Keynesian wage equation.

35 The New-Keynesian Wage Equation Expected price inflation influences wage inflation because wages are typically set for a period of time. Unemployment influences wage inflation because if U is different from U*, all of the possible gains from trade between workers and firm have not been exploited, leaving an opportunity for firm to profit.

36 The New-Keynesian Wage Equation The parameter c determines how fast the real wage returns to its natural path. If firms are very quick (slow) to react to profit opportunities, the parameter c will be very large (small), and the profit opportunities will quickly (slowly) disappear. For large c, the model will behave like the classical model.

37 Wage Adjustment and the Phillips Curve What evidence do we have for the new- Keynesian theory of wage adjustment? We can check the theory by searching for the existence of a relationship between wage inflation and unemployment by controlling the variable, expected price inflation.

38 Wage Adjustment and the Phillips Curve For the period, , expected price inflation might reasonable be expected to have been constant. (Figure 17.6) -- Price inflation from 1949 to 1965 hovered at around 2% per year. -- After 1956, inflation began to increase at a faster rate, but it is reasonable to workers and firm took some time to adjust their expectations to the changing conditions.

39 ©2002 South-Western College Publishing Figure 17.6A The History of Inflation, 1949–1969

40 ©2002 South-Western College Publishing Figure 17.6B The History of Inflation, 1949–1969

41 Wage Adjustment and the Phillips Curve If both this assumption and the new-Keynesian wage equation are correct, we should see a negative relationship between wage inflation and unemployment. Figure 17.7 presents evidence on the relationship. A.W. Phillips first noticed the stability of this relationship and so called the Phillips curve which provided an important stimulus to the research of theorists working on the dynamic new-Keynesian model.

42 ©2002 South-Western College Publishing Figure 17.7A Wage, Inflation, and Unemployment

43 ©2002 South-Western College Publishing Figure 17.7B Wage, Inflation, and Unemployment

44 The Dynamic New-Keynesian Model The three pieces of the dynamic new-Keynesian model : 1. The dynamic aggregate demand curve. 2. The dynamic short-run aggregate supply curve. 3. The new-Keynesian wage equation.

45 ©2002 South-Western College Publishing Figure 17.8A The Three Pieces of the Dynamic New-Keynesian Model

46 ©2002 South-Western College Publishing Figure 17.8B The Three Pieces of the Dynamic New-Keynesian Model

47 ©2002 South-Western College Publishing Figure 17.8C The Three Pieces of the Dynamic New-Keynesian Model

48 Inflation and Growth when Expectation are Fixed If the expected price inflation is assumed to be fixed (like in the U.S. in the 1950s), excess wage inflation depends only on whether the unemployment rate is current higher or lower than its natural rate. (Figure 17.8A) Because wage are typically set in advance, the determination of nominal wage inflation occurs before the determination of price inflation and growth.

49 Inflation and Growth when Expectation are Fixed Once the wage inflation rate is known, the position of the new-Keynesian (short-run) AS curve is then determined. Inflation and growth are then determined at the point where the short-run AS (Figure 17.8B) intersects the aggregate demand curve (Figure 17.8A). Typically, both the demand and the supply curve fluctuate from one year to the next.

50 Inflation and Growth when Expectation are Fixed Typically, both the demand and the supply curve fluctuate from one year to the next. -- If money growth is higher (lower) than average, the AD curve will shift to the right (left) and growth and inflation will be higher (lower) than the average. -- If the productivity growth rate (g) is higher (lower) than average, the short-run AS curve will shift to the right (left) and inflation and growth will be higher (lower) than average.

51 Inflation and Growth under Changing Expectations The results of previous section are based on a condition where the price inflation is stable. If the price inflation rate changes to a higher level for a long time, the expected price inflation rate will be raised.  The positions of the wage equation and the dynamic AS curve will shift upward.

52 More-Realistic Theories of AD In this chapter, we justified our use of the classical theory of aggregate demand rather than the Keynesian theory on the ground of simplicity. What’s different if we adopt the Keynesian? -- The long-run properties are the same – inflation is determined by the rate of money creation and output growth is determined by its natural rate.

53 More-Realistic Theories of AD What’s different if we adopt the Keynesian? -- In the short-run, variables other than the rate of money creation, like the government policy, can shift the dynamic AD curve. Besides, changes in the interest rate interact with money creation and inflation, and these interaction add further dynamic elements to the adjustment path from the short run to the long run.

54 Homework Question 5, 7, 10, 11

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