1. © Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 7 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College London

2. © Stephen Hall, Imperial College LondonPage 2 Revision: Demand and Short-Run Supply Obviously we could proceed by super-imposing the (short-run) supply curve on the price-determined demand curve. This would provide us with an over-all equilibrium, determining equilibrium values of Y, P, I, etc. Price P D D S S Y

3. © Stephen Hall, Imperial College LondonPage 3 Demand and Short-Run Supply To incorporate the (short-term) supply curve into the IS-LM model, the only change that is needed is to understand that increased demand (due, say, to expansionary fiscal or monetary policies) will cause not only output to increase, but the equilibrium price level as well. This is known as inflation. In turn, the demand for money will increase, and all other functions and equilibrium values will adjust accordingly.

4. © Stephen Hall, Imperial College LondonPage 4 The Phillips curve It suggests we can trade-off more inflation for less unemployment or vice versa. Prof. A W Phillips demonstrated a statistical relationship between annual inflation and unemployment in the UK Unemployment rate (%) Inflation rate (%) The Phillips curve shows that a higher inflation rate is accompanied by a lower unemployment rate. Phillips curve

5. © Stephen Hall, Imperial College LondonPage 5 The Phillips curve and an increase in aggregate demand Unemployment Inflation PC 0 U* Suppose the economy begins at U*, with zero inflation, unemployment at the natural rate U*... U1U1 11 An increase in government spending funded by an expansion in money supply takes the economy to A, with lower unemployment but inflation at  1. A … but what happens next?

6. © Stephen Hall, Imperial College LondonPage 6 The Phillips curve and an increase in aggregate demand Unemployment Inflation PC 0 U* U1U1 11 A If nominal money supply is fixed in the long run, and prices and wages eventually adjust, the economy moves back to E. E But nominal money supply need not be constant in the long run so we may find the economy finds its way back to the natural rate, but with continuing inflation at C. C

7. © Stephen Hall, Imperial College LondonPage 7 The vertical Phillips curve Unemployment Inflation PC 0 U* U1U1 11 A E C Effectively, the long-run Phillips curve is vertical, as the economy always adjusts back to U*. LRPC The short-run Phillips curve shows just a short-run trade-off – its position may depend upon expectations about inflation. PC 1

8. © Stephen Hall, Imperial College LondonPage 8 Labour Supply and the Nominal Wage As it now stands, the model we have is complete in the sense that we can solve for all our equilibrium values; Y e, i e, T, C, and so on. Mathematically, we have a system of equations and an equivalent number of unknowns. The one glaring weakness in our model, however, is that the amount of labour employed is entirely demand- determined. Firms simply choose how much labour to employ given the price level and the money wage rate. But who or what determines the money wage rate?

9. © Stephen Hall, Imperial College LondonPage 9 Labour Supply and the Nominal Wage In our model, the wage rate is exogenously determined. That is, it is what it is! (Keynes assumed that the wage rate was fixed by convention and “sticky downward”). However, the wage rate rises over time, particularly in periods of high inflation, especially when the economy is growing quickly, labour is relatively scarce, and workers have some leverage in wage negotiations. In other words, we must introduce a labour supply curve!

10. © Stephen Hall, Imperial College LondonPage 10 Some key terms Unemployment rate: –the percentage of the labour force without a job but registered as being willing and available for work Labour force –those people holding a job or registered as being willing and available for work Participation rate –the percentage of the population of working age declaring themselves to be in the labour force

11. © Stephen Hall, Imperial College LondonPage 11 Unemployment in the UK, 1950-99 Source: Economic Trends Annual Supplement, Labour Market Trends

12. © Stephen Hall, Imperial College LondonPage 12 Unemployment (%) in selected countries

13. © Stephen Hall, Imperial College LondonPage 13 Labour market flows It is tempting to see the labour market in static terms Working Unemployed Out of the labour force but...

14. © Stephen Hall, Imperial College LondonPage 14 Labour market flows Working Unemployed Out of the labour force Taking a job Retiring Temporarily leaving New hires Recalls Job-losers Lay-offs Quits Re-entrants New entrants Discouraged workers

15. © Stephen Hall, Imperial College LondonPage 15 More on labour market flows The size of these flows is surprisingly high In 1999 unemployment in the UK began at 1.29 million During the year: –3.14 million became unemployed –but 3.3 million left the ranks of the unemployed

16. © Stephen Hall, Imperial College LondonPage 16 The composition of unemployment Different groups in society are more vulnerable to unemployment, varying by: –age –gender –region –ethnic origin

17. © Stephen Hall, Imperial College LondonPage 17 Types of unemployment Frictional –the irreducible minimum level of unemployment in a dynamic society people between jobs the ‘almost unemployable’ Structural –unemployment arising from a mismatch of skills and job opportunities when the pattern of demand and production changes it takes time for ex-coal miners to retrain as international bankers

18. © Stephen Hall, Imperial College LondonPage 18 Types of unemployment (2) Demand-deficient unemployment –occurs when output is below full capacity –‘Keynesian’ unemployment occurs in the transitional period before wages and prices have fully adjusted Classical unemployment –created when the wage is deliberately maintained above the level at which labour supply and labour demand schedules intersect

19. © Stephen Hall, Imperial College LondonPage 19 A ‘modern’ view of unemployment A similar categorization is retained, but an important distinction is to be noted between: Voluntary unemployment –when a worker chooses not to accept a job at the going wage rate Involuntary unemployment –when a worker would be willing to accept a job at the going wage but cannot get an offer.

20. © Stephen Hall, Imperial College LondonPage 20 The natural rate of unemployment Number of workers Real wage LD LD: labour demand LF LF: size of labour force AJ AJ: the number of workers prepared to accept jobs AJ is to the left of LF because some members of the labour force are between jobs, others are waiting for better offers. w* N*N1N1 Equilibrium is at w*, N*. The distance EF is the natural rate of unemployment. E F

21. © Stephen Hall, Imperial College LondonPage 21 The natural rate of unemployment The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium. This is entirely voluntary. It includes: –frictional unemployment –structural unemployment

22. © Stephen Hall, Imperial College LondonPage 22 w2w2 Suppose that union power succeeds in maintaining a real wage of w 2. Classical unemployment Number of workers Real wage LD LF AJ w* N*N1N1 and AB is involuntary A N2N2 Equilibrium is at A B of which BC is voluntary C and unemployment is AC, To the extent that this unemployment reflects a conscious decision by unions to restrict employment, it is voluntary unemployment.

23. © Stephen Hall, Imperial College LondonPage 23 Labour Supply and the Nominal Wage To complete our model, we need an assumption about labour supply. Three competing assumptions are: The layperson assumption: Workers “need” a certain level of income. So, if the (hourly) wage rate falls, workers must work more hours.This would imply a downward-sloping labour supply curve. But, empirically, this is an invalid assumption.

24. © Stephen Hall, Imperial College LondonPage 24 The Keynesian assumption: Nominal wage rates are fixed by convention with excess labour supply at that wage rate. This would imply a horizontal labour supply curve, which could effectively be ignored by firms. (Graphically, we are back to our previous model with no labour supply curve). The market-clearing assumption: people choose to work more the higher is the real wage rate.This would imply an upward-sloping labour supply curve. In conjunction with the downward-sloping labor demand curve, this would also imply a single equilibrium real wage rate, employment level, and output level.

25. © Stephen Hall, Imperial College LondonPage 25 Labour Supply and the Nominal Wage Graphically, Real Wage w/p (w/p) 0 Le Labour L Labour Demand Labour Supply

26. © Stephen Hall, Imperial College LondonPage 26 Long-Run Supply (W variable) In the preceding “short-run” analysis, the nominal wage rate “w” was assumed fixed at w t. If markets clear, however, then there is only one equilibrium wage rate. If the price level (p) rises, then so too must the nominal wage rate (w), so that the real wage rate (w/p) remains at its equilibrium level. higher P -> higher W -> same W/P?

27. © Stephen Hall, Imperial College LondonPage 27 Long Run Supply Suppose, for example, that the government wishes to increase output by spending more on public works projects like road and rail construction (i.e. a fiscal stimulus). As we know, this causes both the IS-curve and the price-determined demand curve to shift rightward. Previously, we concluded that these measures would indeed cause output to grow. But the economy would also experience inflation.

28. © Stephen Hall, Imperial College LondonPage 28 Long Run Supply Graphically, we must be moving off of the labour supply curve and away from (a long-run) equilibrium. LabourSupply Demand Real Wage Price w/p e Labour Output Le Le L Ye Ye Y S D D S D’ DL DL SL SL

29. © Stephen Hall, Imperial College LondonPage 29 Long-Run Supply Adjustments According to the market clearing assumptions, in response to the higher price level, workers will demand, and will be able to secure, higher nominal wages. Specifically, they will bargain up the nominal wage so that real wages are recovered. Graphically: Supply DemandLabour Real Wage w/p e Labour Output Le Le L Ye Ye Y Price New P e DL DL SL SL S D S D D’ S’ D’ A comment on this adjustment process follows.

30. © Stephen Hall, Imperial College LondonPage 30 Long-Run Supply Adjustments (cont.) From the preceding visual analysis, we can see that the government is only able to increase output so long as workers do not demand higher wages in response to the higher prices. When the wage rate is negotiated upward, the supply curve shifts backward (or upward) and the equilibrium output level returns (roughly) to where it was originally. An intuitive way to think of the preceding analysis is that government activity causes the price level to increase, and only later do wages “catch up” to the new prices. At this point, everything in the labour market is the same as it was before, but prices and nominal wages remain higher.

31. © Stephen Hall, Imperial College LondonPage 31 Long-Run Supply Adjustments (cont.) The preceding analysis suggests a general result: “Expansionary” fiscal or monetary policy, designed to stimulate aggregate demand, is only effective in the short term. The only long-term results is inflation. Indeed, the preceding general result may overstate the case! Such expansionary policies actually drain resources away from private investment and may, in the long run, actually reduce economic growth.

32. © Stephen Hall, Imperial College LondonPage 32 A Note on the Natural Rate Hypothesis The preceding conclusions are embodied in what is know as the Natural Rate Hypothesis (NRH), which states in essence that, in the long run, the economy will grow at a certain rate, and unemployment will remain at a certain level, irrespective of government policy. (More technically, the natural rates of output and unemployment are defined as those compatible with a constant rate of inflation).

33. © Stephen Hall, Imperial College LondonPage 33 A Note on the Natural Rate Hypothesis Graphically, the natural rate of output can be seen as that associated with the intersections of constantly rising aggregate supply and demand curves. Natural Rate of output P S0S0 S1S1 D1D1 D0D0

34. © Stephen Hall, Imperial College LondonPage 34 Short-run aggregate supply If adjustment is not instantaneous, output may diverge from Y p in the short run. Firms may vary labour input –via hours of work (overtime or layoffs) Wages may be sluggish in falling to restore full employment in response to a fall in aggregate demand The short-run aggregate supply schedule shows the prices charged by firms at each output level, given the wages they pay.

35. © Stephen Hall, Imperial College LondonPage 35 The short-run aggregate supply schedule Output Price level YpYp SAS P0P0 SAS 1 SAS 2 In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS 1 and then to SAS 2, A A2A2 P2P2 until equilibrium is restored at A 2. Suppose the economy is initially at Y p in full- employment equilibrium at A, with price P 0 B In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B.

36. © Stephen Hall, Imperial College LondonPage 36 DDS' a fall in nominal money supply shifts DDS to DDS' Output Price level YpYp SAS P E DDS AS A fall in nominal money supply Starting from long-run equilibrium at E: E' P' Given wage levels, firms adjust to E' in the short run With price at P' but wages unchanged, the real wage rises bringing involuntary unemployment. P3P3 SAS 3 E3E3 Equilibrium is eventually reached at E 3, back at Y p. SAS' As the labour market (wage) adjusts SAS shifts e.g. to SAS' P''

37. © Stephen Hall, Imperial College LondonPage 37 An adverse supply shock: e.g. an increase in the price of oil Yp'Yp' DDS Output P P SAS E SAS' Higher oil prices force firms to charge more for their output, so SAS shifts to SAS' Y' Higher prices cause a move along DDS, and output falls to Y' P' E' equilibrium from E to E' In time, unemployment reduces wages and SAS gradually shifts back to SAS, so Y p is restored.

38. © Stephen Hall, Imperial College LondonPage 38 The speed of adjustment Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment). If wages and prices are sluggish, then output may deviate from the potential level. A "Keynesian" world of fixed wages and prices may describe the short run period before adjustment is complete.

39. © Stephen Hall, Imperial College LondonPage 39 Adjustment in the labour market Short-run (3 months) Medium run (1 year) Long-run (4-6 years) WAGES HOURS EMPLOYMENT Largely given Demand- determined Largely given Beginning to adjust Hours/ employment mix adjusting Clearing the labour market Normal work week Full employment

40. © Stephen Hall, Imperial College LondonPage 40 Supply Side Economics Notice that we have come full circle. We started with a simple model in which the government was omnipotent: it could guarantee output and job growth simply by spending more. Our more complicated model reaches the opposite conclusions: the government’s expansionary fiscal and monetary policies can only induce short-term growth, probably at the expense of reduced long-term growth.

41. © Stephen Hall, Imperial College LondonPage 41 Supply-side economics entails the use of microeconomic incentives to alter –the level of full employment –the level of potential output –the natural rate of unemployment In the long run the performance of the economy can only be changed only by affecting the level of full employment and the corresponding level of potential output.

42. © Stephen Hall, Imperial College LondonPage 42 Supply Side Economics Graphically, our model has evolved from simple to complex (or short-term to long-term, or Keynesian to Monetarist) as follows: Simple model:Complex model: higher G -  higher Y higher G -  higher P P S D D Y P S D D Y In other words, in the long run, the government is impotent! Or is it?

43. © Stephen Hall, Imperial College LondonPage 43 Supply To this point, we’ve addressed only demand- side measures. But what about supply? In particular, is there something that government can do that will encourage firms to employ more workers and produce more output?

44. © Stephen Hall, Imperial College LondonPage 44 Supply-Side Policies Supply-side economists believe that demand-side government policies (like fiscal or monetary expansions) are doomed to failure in the long run. However, they believe that the government can still encourage the economy to growth. But it must do so by focusing on the supply side. Graphically, Supply-Side Government Stimulus P S0S0 S1S1 D Y

45. © Stephen Hall, Imperial College LondonPage 45 Supply-Side Policies It should be emphasised that Keynesians (and most politicians!) believe that the government can and should manage economic growth and employment. Supply-siders, on the other hand, believe that the role of the government is to encourage private sector economic growth by creating an environment in which firms seek to invest, create jobs and produce goods for consumption and export. But how to do this?

46. © Stephen Hall, Imperial College LondonPage 46 Supply-Side Strategies Recall that firms seek to maximise profits. Rather than condemn this sort of behaviour (“Public need. Not private greed!”), supply-siders believe that the government should create policies which acknowledge and, indeed, take advantage of this motive. Essentially, the supply-side approach is to make it more profitable for firms to increase investment, employ more workers, and produce more output.

47. © Stephen Hall, Imperial College LondonPage 47 Recall the profit maximising condition (with K variable) maxL,K  P.f(K,L) - (w.L + r.K). Taking the first derivatives of this function with respect to L and K, and setting these equal to zero (for a maximum) gives, P.  f(-)/  L - w = 0 and P.  f(-)  K - r = 0, which can be re-written as: w/P = MPL and r/P = MPk.

48. © Stephen Hall, Imperial College LondonPage 48 Supply-Side Strategies We also have the second-order conditions  MPL /  L  0 and  MPK/  K<0 Some simple comparative static analysis will show:  (w/P)/  MPL  0. All else the same, for any given level of employment, as workers become more productive, the real wage rate increases.  w/  L  0. If workers demand a higher wage rate, firms will employ less workers.  P/  L  0. As the price (i.e. demand) increased, firms will employ more workers.

49. © Stephen Hall, Imperial College LondonPage 49 Supply-Side Strategies Therefore, supply-siders believe that the way to encourage job creation and growth is by: –(i) encouraging capital investment, –(ii) providing a less expensive and more flexible workforce –(iii) making production more profitable by providing economic incentives to growth.

50. © Stephen Hall, Imperial College LondonPage 50 Labour Market Flexibility Since 1979, the government has continually struggled to make the British labour market more flexible and less costly to employ. Flexibility is important because it means that firms do not have to pay for workers they do not wish to employ, or at times they do not wish to employ them. Another aspects of “flexibility” is the ability to eliminate unnecessary workers through redundancy.

51. © Stephen Hall, Imperial College LondonPage 51 Tax cuts and unemployment Number of workers Real wage LD LF AJ w1w1 With an income tax, the gross wage paid by firms (w 1 ) w3w3 is higher than the take-home net pay of workers (w 3 ). N1N1 Equilibrium is at N 1 w2w2 N2N2 E Without tax, equilibrium is at E. EF is less than BC because of the relative slopes of LF & AJ but the differences may not be substantial. AB is the amount of tax A B Unemployment is BC C F Unemployment is now EF.

52. © Stephen Hall, Imperial College LondonPage 52 Other supply-side policies Trade union reform –reducing the power of trade unions may limit distortions in the labour market Other labour supply policies –training and retraining measures –improving the efficiency of the labour market such measures may affect frictional and structural unemployment Investment –higher investment may increase the demand for labour may be achieved via tax incentives or low interest rates

53. © Stephen Hall, Imperial College LondonPage 53 It should be emphasised that labour cost to firms is not the same thing as wages received by employees. Firms’ labour costs are much higher than workers’ wages, and include things like: –Maternity leave –Unemployment taxes –Rights of employees to file lawsuits against their employers –National insurance contributions, etc.

54. © Stephen Hall, Imperial College LondonPage 54 Labour Market Flexibility The government has sought to reduce the power of the unions through a series of measures: Employment Act 1980: restricted secondary industrial action, limited “unfair dismissal” rights, limited “closed shop” agreements. Employment Act 1982; make unions liable for damages from unlawful industrial disputes. Trades Union Act 1984; required prior strike ballots and that union officers be elected. Employment Act 1988: enhanced rights of individuals workers, both union and non-union members. Employment Act 1989; Employment Bill 1990. Recent developments have reversed some of these changes to a small extent.

55. © Stephen Hall, Imperial College LondonPage 55 Improving Economic Incentives Individuals will not work unless there are rewards to do so; and in general, they will work harder and longer the greater those rewards. Firms cannot invest and grow unless: –(i) there are funds to invest, –(ii) there are financial incentives (i.e. profit) associated with investing. In general, firms will invest more, employ more, and produce more the greater are those incentives.

56. © Stephen Hall, Imperial College LondonPage 56 Improving Economic Incentives Particularly since 1979, the government has undertaken several measures to boost work, savings and investment. These include: –Reduced the highest marginal income tax rates from 83% on wages and 93% on “unearned” income to a common 40%. –Reduced the basic rate of income tax from 33% to 25%. –Reduced corporate profit tax rates from 40 - 52% to 25 - 35%. –Reduced income tax threshold for low-income earners. –Introduced various saving and investment schemes.

57. © Stephen Hall, Imperial College LondonPage 57 Hysteresis The idea that a (short-run) fall in labour demand may lead to a permanent fall in labour supply This could help to explain high and persistent unemployment in Europe in the 1980s

58. © Stephen Hall, Imperial College LondonPage 58 Hysteresis (continued) Four channels: –Insider-outsider distinction only those in work take part in wage bargaining & they protect their own positions –Discouraged workers people stop looking for jobs –Search and mismatch firms and workers get used to low search –capital stock low levels of investment in recession lead to permanently low capital stock levels

59. © Stephen Hall, Imperial College LondonPage 59 Exercise 3 DO EXERCISE 3 This exercise has two parts. Part A asks you to analyse the failure of the Phillips Curve and Park B asks you to employ the full supply-demand model to analyse various policy changes and exogenous shocks.