i 1f10N,, WOTKETS eens aye cor workers, Being in’a weak bargaining PosiiDilal < may haveno choice but to accept a lower wage. : Efficiency Wage Regardless of workers’ bargaining power, firms may want to pay more than the reser- vation wage. They may want their workers to be productive, and « higher-wage can help them achieve that goal. If, for example, it takes a while for workers to lear how to do a job correctly, firms will want their workers to stay for some time, But if worker are: paid only their reservation wage, they will ndifferent to staying or leaving: In this tre enany of them will quit, and the tumnover rate will be high. Paying a wage above the reservation wage makes it financially attractive for workets to stay. It decreases turnover and increases productivity. Behind this example lies a more general proposition. Most firring want thelt work. ers 10 feel good about their jobs, Feeling good promotes goad work, which leads to. : higher productivity. Paying a high wage is one instrument the firm nN use to-achieve these goals. (See the Focus box on “Heniy : ord and Efficiency Wages”) Economists eull the theories that link the productivity or the effta ney of workers to the wage they are fd efficiency wage theories, Like theorles based on bargaining, depend on both the nature of the job an efficiency wage thedries d on labor market conditic Firms—such as high-tech firms—that see employee morale essential to the quality of their work will pay more than fh workers’ activities are more routine, Labor market conditions will affect the wage, A-low uniempl einekenn . employment rat more attractive for employed workers to olen ie ace ie asy to finel another job. "Tlrat means that when unemploymentdecrenies: a ting that wants to avoltl an increase in quits will have oe workers to stay with the firm. Whe lead to higher wages, Conversely, SUBgest that wages ons: e and-‘commitment as quit. When wiemy 44 ‘ms in sectots where Before the op; rity wa wages high tu socurity higher to mak tive ani “4 got mo compo! duce tu“Na ‘Ment (which is why I used the subscript n to denote {t). The terminology has become ; Standard, so 1 will adopt tt, but this Js ural” suggests a constant of nature, one that is tinaffected by fastitution: t its derivation niakes clear, however, the “natural ‘The equilibrium unemployment rate tty 19 called the natural rate of vinemploy- Fone c vide and poticy. As < mod ally a bad choice of words, The.word “nat- rate of tinemployment is anything Dut natural. The positions of the wage-setting and price-setting curves, arid:thus the ‘equilibritm unemployment rate, depend on both z and u. Consider two exarnples: An increase in unemployment benefits. An increase in unemployment benefits éan be represented by an increase in.2, Because an increase in benefits makes the An Prospect of uriemployment less painful, it increases the wage set-by wage-setters ata given unemployment rate, So, it shifts the wage-setting relation up, from WS fy to WS"In Figure 6-7. The economy moves along the PS line, from Ato A’. The nat- Eq ural rate of unemployment increases from uy 0.10. ere In words: At a given unemployment rate, higher unemployment beriefits lead toa higher real wage. A highe: unemployment rate is needed to bring the real qh wage back to what firms are willing to pay. ea mA less stringent enforcement of existing antitrust legislation: Yo the extent that this _ Pl allows firms to collude more easily and increase theirsharket, power, itlads to an PI Increase in their markup—an increase in y. The increase Mny-impliesailecrease In the real wage paid by firms, and so it shifts the price-setting gelation awn, from. PS to PS' in Figure 6-8, The economy moves along WS. ‘The equilibrium moves from A to A’, and the natural rete of unemployment increases from ty to Uy aA In words: By letting firms increase their prices given the wage, less stringent 4 enforcement of antitrust legislation leads to a’decrease in the real wage. Higher * ! unemployment is required to make workers accept this Jower real wage, leading to" an increase in the natural rate of unemployment. ; Factors like the generosity of unemployment benefits or antitrust legislation can ' E hardly be thought of as the result of nature, Rather, they reflect various charnetet ere he apoio Wor thatreason. ahettarnamntnbee a isticsat gure, Ou ; 2 ~ Markups and the Natural “a «Rate of Unomplaymant ‘An Inereote in markups de- crecves the real wage ond leads : eee in the natural rate v LE & nt Taner "Bates ph 4 Ll we +h ‘Unemployment rate, u This name has been suggested > of unemployment would be the structural rate of unemployment, but so far, by Edmund Phelps, from Co- lumbia University. For more ‘on Phelps’ contributions, see Chapters 8 and 27, b=N+U2USl-N name has not caughtnn. From Unemployment to Employment Associated with the natural rate of unemployment is @ natural level of employs the level of employment that prevails when unemployment is equal to its natura Let's review the relation between unemployment, employment, and the force. Let Udenote unemployment, Ndenote employment, and Lthe labor force. U_LL-N ‘The first step follows from the definition of the unemployment rate, The follows from the fact that, from the definition of the labor force, » ment, U, equals the labor foree, L, minus employment, N.'the thitd step follon sinplifying the fraction, Putting all three steps together, the unemploymen “equals one minus the Yatio’of employment N to the labor force L. Rearrangingto gel employment in terms of the labor force and the unemp! He gives: - the level of une N=LO-w Employment Nis equal to the labor for rate w s So, ifthe najutnt rate of uneriy haturallevel of employment N), 1, times one minus the unem ployment is up, and the labor foree is equa 4s given by Nu LQ =u) Vor example, if the Inbor force is'150 million and the natural x; 0 ‘ate of ‘ment is 9% then the natural level ofemploymentis 142. million 0 ; nt a oe) | : Given the production function we used in this chapter (Y= N), the natural level of OUTPUT Ty Is EASY Co derive. It is given by i Yo = Nn =U = uy) . ig Using Equation (6.7) and the relations between the uitermployment rate,.ernploy-. eaeoeiens; ‘the output we just derived, the natural level of output satisfies the following uation: ‘The natvital level of output (¥;) is such that at the associated rate of unemploy- MENT (Hh, = 1 = Yp/L), the real wage chesen in wage setting—the left side of Equation {G.8)—is equal to the real wage Implied by price setting—-the Hght-side. of Equa {G.2). Equation (6.8) will turn out to be very useful in the next chapter. We have gone through many steps in this section, Let's summarizs Assume that the expected price level is equal to the actuul prigé level. Then; (68) T+ The real wage chosen in wage setting is a decreasing function of the unemploy- ment rate. s The real wage implied by price setting is constant Equilibrium in the labor market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting. This determines the unemploy- ment rate. : This equilibrium unemployinent 1 ment. Associated with the natural rate of unemployment is a natural level. of employ- ment anda natural level of output is known as the natural rate of uirerhploy- (239 rere Wie Ge frome: Reve ‘We haye just seen how equilibrium in the labor market determines the unemploynient rate (we called this equilibrium rate of unemployment the natural rate of unemiploy- (we ca nL AICP A RENEE Pa a haa am eb bitRaia Wier ton, thd Fash ad “, Aswe will'sug in the néxt chapter, the factors that detern dotormine movements in output * outpiit in the short run are, indeed, the factors we focused 0 aro the factors we focused on thive chapters; niénetary policy, fiscal policy, and so on. Your ti Wn the praceding thrae chapters: "hot wasted, monetary policy, fiscal pelley, we Bul uxpoctations are unlikely to be systematically wrong (say Seen always too low) forever, That is why, in the medium run, une rotuun to the natural rate, and output tends to return to the n: In the medium run, output Jivthe medium run, the factors that determine unemploy tends to raturn to tho natural &! tha fiictors that appear in Equations (6.7) and (6.8). lovel, ond the factors that Pee determine output are the fac~ ‘These,'iv short, are the answers to the questions asked in | rz wea have focused on in this this chapter, Developing these answers in detail will be our t chapter. chapters, aReplacing w by 1 ~(¥71) In Equation (7.1) gives us the aggreyiite supply relation, or 4 NE AS relation for short: : oa beec 2 gray » (7.2) (the . betv P= ple wel a ‘) ‘the price level P depends on the expe {and also on the markup p., the catchall varia al] $ constant here). The AS re! ed price level Péand the leveFof output ¥ ply uble z, and the labor force L, whichwe take fy lation has (wo tinportant properties: 8) An increase in output leads to an increase in the price level. Vhis is thé result of four Yin underlying ste nga re fe 1. An increase Mn output leads to-un increase in employnient. ; ye oye 2. The increase in employment leads to a decrease in unempléyment and, there= fore, to a decrease in the unemployment rate, ANI 3. The lower unemploymeitt rate leads to an increase 4. The increase in the nominal wage leads to an incré: and, therefore, to an increas: in the nominal wage. ‘asc ini the prices set by firms in the price level. aw “tud An increase in the expected pricé level leads, one for one, price level. For examp! will also double. This e to ani inéréase inthe actual , ifthe expected price level doubles; then the price level fect works through wage: “ape J. If wage setters expect the price level to be higher, they set a hii wage. 2. The increase in the nominal wage leads to an increase in cost an increase in the prices set by firms and a higher price level, igher hominal oS SR a ts, which leads to i iw The relation between the price level P and output ¥, for a given value of the expected price level P*, is represented by the curve AS in Figure 7-1, The AScurve has three properties that will prove to be useful in whatfollows: > : ™ The aggregate supply curve is upward sloping. Put another way, an, increase in py output Y Jeads to an inerease in the price level R You saw why edglien - + hoc a ‘The aggregate supply curve goes through point A, where.¥'= ¥,and P=-P* Put on another way, when output Y 1s equal to the natural level of ov tput. Yj, the price level Pturns out to be equal to the expected price level R*markets is lower, In Figure 7-4, the ‘aggregate demand curve shifts to the left, from AD to AD", . a ae Let's represent what you have just leaned by the following.aggregate demand © relation: i es M/P, ani incre fey vieanG VY Gi Gis ————— easing Tunction of taxes, 2 en monetary and fiscal policy—that is, given M,G, and T-—an increasé in-the price level; P, leads to a decrease in the teal money stock, M/P, which leads to a decrease in output. This is the relation captured by the AD curve-back in Panel 7-94b). Let's summarize: (7.3) Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation. > This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the. aggregate demand curve. ; Changes in monetary or fiscal policy—or more generally in any yatiablé, other than the price level, that shifts the JS or the LM curves—shift the-aggregate demand curve, si : , FABER WegenilGttowieven tee dine Slee eit kann and im the Medium Raw ahd We now put together the AS and the AD relations. From Sections:7-1 ud 7-2, the two relations are given by ASrelation P= Pe + F(t ¥ ): ee. os 7] “ For a given value of the expected price level, P* (which enters tie aggregate supply’ relation), atid for given values of the monetary and fiscal poli lables M, G, and T (which enter the aggregate demand relation), these two relations determine the equi- ice level, P ies librium values of output, ¥, and the price level, 2 ; Note that the equilibrium clearly depends on the value-of P¥, The value.of Pé Panel regate supply curve (go baek to Figure 7-2), and the determines the position of the aggregate supply curve (go back to Figure 7-2), and the ADrelation Y = xlm Atpoint A, output exceeds the natural level of output. So We J highel rt 7-1 that the price level is higher than the expected price leve tt price level wage setters expected when they set nominal wages. s likely to The fact that the price level is higher than wage setters €X! ‘will bein the Joad them to revise upward thelr expectations of what the price lev that decision “ future, So, next time they set nominal wages, they are likely.t0 make poate based ona higher expected price level, say based on P’%, where P This increase in the expected price level implies th aggregate supply curve shifts up, from AS to AS'. Ata given. setters expect a higher price level. They set a higher nominal wage, a Jeads firms to set a higher price. The price level therefore Increases. . This upward shift in the AS curve implies that the economy moves Up along the ADcurve. The equilibrium moves from A to A’. Equilibrium output decreases from ¥ to Y'. m The adjustment does not end at point 4’. At A’, output Y" still exceeds the natural level of output Y,, so the price level is still higher than the expected price level. Recause of this, wage setters are likely to continue to revise upward their expecta- tion of the price level. ‘This means that as long as equilibrium output exceeds the natural level of the expected price level increases, shifting the AS.curve upward. As the quilib- han the. pected | Sri at In the next period, the Jevel of output, wage which, in turn, output Y,,, AS curve shifts upward, and the economy moves up along the AD curve, e« rium ‘output continues to decrease. Does this adjustnent eventually come to an end? Yes, It ends when the AS curve has shifted all the way to AS", when the equilibrium has moved all.the wa’ x to A’, and the equilibrium level of output is equal to Y,. At A’, equilibrium out ug s is equal to the natural level of output, so the price Jevel is.equal to the ex; bole | price level. At this point, wage setters have no reason to change caeiterneaae ° a the AS curve no Jonger shifts, and theeconomy stays ata’, - 4 ay In words: So long as output exceeds the natural level of. a 3 exceeds the expected price Tevel, This leads wage setters td revise thelr celevel tions’ rice Tevel upward, leading to an increase-in the ptice Teo increase 4 decrease in the real money stock, wl wht e to an increase in the interest rate, which leads to a decrease in output, TI Re ment stops when output Is equal to the natural level of output, At that beacuse Chapter 7 Pung All Markel Toguher the ASAD Model er D Modeprice levelis equal to the expected price level, expectations no longer chang in the medium ru output remains at the ivatural level of output, Put another way, it Output retuins to the natural level of outputs a We have looked at the dynamics of adjustment startingfrom a case {s which initial output wag higher than the natural Jevel of output. Cleatly, asymmetric argument holds whien initial output is below the natural level of output. In this case, the price level is lower than the expected price level, leading wage setters to lower + their expectations of the price level. Lower expectations of the price level cause + the AS cur've to shift dows and the economy to move down the AD curve until out- ‘put has increased back to the natural level of output. ae summarize: - Wi the shor? run, output can be above or below the natural Jevel of output. Changes iwany of the variables that enter vither the aggregate supply relation or the agere- gate demand relation lead to changes in output and to changes in the price level. 1 Tn the medi yun, output eventually returns to the natural level of output. The adjustment works, through changes in the price level. When output is above the -natural level of output, the price level increases. ‘The higher price level decreases _ demand and output, When output is Uelow the natural level of output, the price level decreases; increasing demand and output, * Fie rest of the chapter, we usb the AS-AD model to look at the dynamic effects of changes in policy or in the economic environment. We focus on three such changes. The first two—a change In the stock of nominal money and a change in the budget deficit—are old favorites by now. The third, which we could not examine until we had developed a theory of wage and price determination, is an increase in the price of oil. Each of these changes is interesting on Its own: uw A monetary contraction was responsible for the recession of 1980-1982. And, as we have seen,-a monetary expansion was used to fight the recession of 2001. a Budget deficit reductions made headlines throughout the 1990s. Increasing bud- got deficits are making headlines in the 2000s. m licreases in the price of oil were the main cause of the 1973-1975 recession, And in the 2000s; there are worries that a similar scenario may-be in store. CCN Wine: 4 What are the short-run and medium-run effects of an expansionary monetary policy, , of an Increase in the level of nominal money from M to M'? Kecte of a Monetary Expousiex The Dynamics of Adjustment Lookat igute 7- I @ i) Figure 7 7, Assume that before the change in nominal money, output is at the hd y inte te shen eed ent gl ope ie be rrPARE IEMs, Sheyusrey Fe The Dynamtc Fffects ofa Monetary Expansion ‘K monetary expansion leads to ‘an increase in output in the short run but has no effect on output in the medium run. . AD’ a (tor. M’ > M) : & AD 5 |_|. hh {fer nominal money M) Y, y’ Output, Y stment of price expectations comes into play..As output is evel of output, the price level is higher (han wage setters vise their expectations, which causes the aggregate supply xe. The economy moves up along the aggregate demand curve ocess stops when output has returned to the natural level of price Jevel is equal to the expected price level. In the medium y curve is given by AS", and the economy ig.t point 4", Output ice level is equal to 1’", beti., : A down the exact size ofthe eventual iierexse inthe pricé level, Cole ead oor atural Jevel of output, the real money stock must also-be hack also unchanged), then M/P er words, the, proportional increase In prices must be equall to «4 must also be unchanged. se in the nominal money stock, If the initial increase in nomi- if M/P ls unchanged, it must be 9%, then the price level ends up 10% higher, “¢ that M and P each increase in ‘ The same proportion. a. ahars The real money stock is, therefore, imchanged. With the teal troney stock unchanged, outst is back to its initial vale, Yo which 18 the natural level of oisput and the Interest rate is also back to its intial valtie, i ; s The Neutrality of Money Ler's summarize what you have just learr . etl about the effects of monetary policy: oi us short run, a monetary expansion leads to an increase in output 4 decrease n Ice Tovel. Now Huetrorthe etrecrora monetary expansion falls {nittally on putput and how much on the price level depends on the slope of tite aggregate supply Curve. In Chapter 5, we assumed the price level did not respond at all to.an increase in output—we assumed, in effect, that the aggregate supply curve was flat. Although we intended this as a simplification, empirical evidence shows that the initial effect of changes in output on the price level is quite small, We saw this when we looked at estimated responses to changes in the Federal Kinds rate in Figure 5-11. Despite the increase in output, the price level remained practically unchanged for nearly a year. Over time, the price level increases, and the effects of the monetary expansion on ‘output and on the interest rate disappear. In the medium run; the jncreas .e in nom- inal money is reflected entirely in a proportional inéreasein the price level. The increase in nominal money has Ho effect on ourput or on the interest rate. (How Jong it takes he clfects of money on output to disappear Is the topic of the Focus box “How Long Lasting Are the Real Effects of Money”) Economists tefer to the absence of a medium-run effect of money on output and on.the inter est rate by saying that money is neutral in the medium run. ‘The neutrality of money in the medium run does not mean that movétary policy eaninot or should not be ised to affect output, An expansionary monetary Policy can, for example, help the econcmy move out of « zecession and return Faster to the natural level of output. As we saw in Chapter 5, this is exactly. the way monetary policy was used to fight the 2001 recession, But, Its a warning that tnonetary policy cannot sustain higher output forever, ; he 1a eee vee Aatually, the way tt tion is typleclly ste money is neutral | run. This is because comists use “long r to what I coll in th << “mediurn run.”AD! (for G’ < G) Output, ¥. se in nominal money, a reduction in the budgetideficit, does not ver, Eventually, output returns to its natural Jevel; But there is an ce between the effects of a change in money and the effects of a it. At point A’, not everything is the same as: before. Output is back ‘of output, but the price level and the interest rate are lower-than e best way to see why is to look at the adjustment in terms’of the looking ot'an economy in nodel, tion, Output, and the Interest Rate duces Figure 7-9, showing the adjustment of output aid the price: 9 the increase in the budget deficit (but leaving out AS" (0 keep’ le), Figure 7-10(b) shows the adjustment of output and tha.interest e same adjustment process, but in ferms of the IS-LMmoidel, ure 7-10(b). Before the change in fiscal policy, the equilibrium { ction of the IS curve and the LM curve, at polnt A—which c ae 1 Figure 7-10(a). Output Is equal to the natural level of i Oitput y_ gre Pot 1c Bffects of @ the Budget ‘The Dynam' Decrease int Deficit e i deficit decredse in the budget detic! sal ‘tially to a decrease in Saul. Overtime, however, OF he natural level o| put returns to fl output. The fact that the price level decreases for some time seems strongo, We rarely observe deflation (although remember Japan, in Chapter 1). This result comes from the fact that we ore which money growth is zero. (We are assuming that M is constant, not growing.) So, there is no inflation in the medium run, When we intro* duce money growth In the Next chapter, we will see that @ recession typically leads to a decrease in inflation, not fo a decrease in the priceOutput, ¥ - also different, To see how and why, let’s rewrite the JS relation, taking into account that at A’, output is-back at the natural level of output, so that Y= Yn: Y= CM T) + 1%) +S Because income. ¥, and taxes Tare unchanged, consumption Cis the same as before deficit reduction. By assumption, government spending Gis lower than before. Therelore, investmént J must be higher than before the deficit reduction—higher by an amount exactly cqual to the decrease in G, Put another way, in the medium run, a -reduction In the budget deficit unambiguously leads to a decrease in the interest rate and an increase in investment. Budget Defi ¢ what'youhave justlearned about the effects of fiscal policy: ts, Output, and Investment Let's summariz ay ‘In the short tun, a budget deficit reduction, if implemented alone—that is, with- vilvan accompanying change in monetary policy—leads to a decrease in output and may Jead to a decrease in investment, The Modij, Run ° The Core 43 im ‘Note the qualificat \ < Hon “without an accompanying change In, monetary pol te In prineipt,theso ndverse shorter effects on nutput et Be avOlded DY as sing the right monetnry-fiscal mlx. What Is needed Is for the central bank to Coe increase the money supply enough to affyet the advorse effets of the decrease 1A ao Figure 7-10. What Rovernment spending on aggregate demand. This lswhat happened in the United {ous the Fed neod to do in States in the 1990s. As the Ginton administration reduiceg! Iyulget deftlts, the Ped order to avoid « decrease tf nade sure that, even in the short-rin, the defielt reictlon«lid not lead tf a feces output in response fo the 2 a and lower output. 3 4 contraction? = Un the medium run, output returns to the natural level of output, ani tie interest Fate is lower. In the medium run, a doficit reduction leads unnmbiguourly to ai increase in investment 2 We have: into account so far the effects of investment on capital accu: mulation and the effects of capital on production, (We will do this from Chapter 10 and beyond when we look at the long run.) But It's easy to sce how our conclusions, me would be modified if we did take Into account the effects on capital accumulation.” jfecfom run: Yunchongeds tine In the long run, the level of output depenitson the capital stock in the economy. So Mesem & if a Jower government budget deficit leads to more investment, it will lead to a Long run: ¥ increases, higher capital stock, and the higher capital stock willlead to higher output. A creates Za ai vobcon ee lecrearens Te, Everything we have just said about the effects of deficit reduction would apply equally to measures aimed at increasing private (rather than public) saving. An increase in the saving rate increases output and investment inthe médium'ran and in the long run. But it may also create a recession and a decrease in Investment In the short run. Disagreements among economists about the effects of measures aimed at increasink either public saving or private saving often come from differences tn time frames. Those who are concerned with short-run effects worry that measutes (0 increase saving, public or private, might create a recession and dectease-saving and investment for some time, Those who look beyond the short run see the eventual le increase in saving and investment and emphasize the favorable nieditim-tun and Jong-run effects on output.q i { i | i : oer. eee x ‘Figure FoR waa ¢ The Effects of an Increase tn the Price of Oiton the - € Natural Rate of Unemployment ‘a ncaa in he pre of of ord Towar reel wage Chgher teal eet aa ployment, \ 4 uy i Unemployment rato, u! The wage-serting curve brice-setting relation Js repre- > sented by the horizontal tine at WIP = 1c The initial qratiormnriranpaint A, and the inital natural unemployment rate ig {in An increase in the miirkup leads to A 4 Do not be confused: v and 4x Gowenward shift of the price-setting line, trong BS to PS. the higher the markup, the, of not the some; v Fae lower the real wage implied by price Setting, The equilibrium moves from Ato A'."The _ ¥samployment rate, ah nals Teal wage is lower. The natural tinemployment ate ishigher, Getting workers to accept. # markup. Se lower real wage requires an increase in unemolonn’ he increase in tue-natural rate of ural level of employment Two ss01 ts downward sloping, ‘The uployinent leads to a decrease in tlie nat ( the relation between employment'and Sd dio a etatged—that is, hat each unit of output sill equines one worker In Feaaitton to the enengy input—then the decrease in the natural Week ce employment jeads toan identical decrease in the natural level of output, Putting things together; air tase‘arthe price of oll leads to a decrease in the natutal level of outpar, The Dynamics of Adjustment Lats now turn to dynamics, Suppose that before the inerease tn.ihe price of oli; the sberonate demand curve and the aggregate supply curve are given by AD and As Tepartvely, so the economy is at point A in Figuro.7-13, with output at the maturg Jevel of output, ¥,, and by implication, P=. P*, Hie have just established that the incense in the rice of oil decreases the natural level of output Call this lower level ¥,'. We novr want to knaw whathappens the short run, and how the economy moves from ¥,, (0 3 ‘To think about the short run, recall thatthe aggregate supply Felation is given by ae fare P= Pp Bit) T Recall that we capture the effect of an Increase in the price of oil by-an. increase in the markup 1 $0, in the shat run (given 2"), The erent MANE DTICG oT IT aNeyry as an Increase in the markup j. This Incrense In the markup leads firms-tc ircrease thelr prices, leading eats, in the price. overran Tevel state v0 Teaupply curve shite typ, i ok shift will be useful in what follows, We know from Section 7-1 thatthe aggreguee supply. curve always goes through the point such (hat ourput equuls'the natural lene ey(ise h-the price ol oil) necteeses ine. ua ncaa qgmnscTpeToades tre natura rte O sen ie Mae eretore Glecreases Me nature He an re ora The difference between: short. YUN, effects, and ‘mediun: sre eC an potiets Io one Df the rensons economists Aisigies in thelr policy reoommendations,, Some sin smat beteve the economy adjusts quickly 0 if nedlinn-runsequillbritim)“so" théy xemphasize -mediuiniruin tinplications of.policy: Others believe the “Hajustinent mecNtinjent through Whieh’outpurretuins to the natural level of oltput ie @'slow process at heat sund'so they putmore' empbasts'on the'short-run effect 7? oe he sash mney stockend leads. ror-demts a inthe medium: nny monetary Policy Jeadsin the Ant a ise tivtheset oe one “Sncredses ene ¥ _Dlsnyingshant ints sshediuin an), Se eaan M ae i Sm Rerediieriony\ ihe budge detionTexer ate shox Be tecet (War gonds'tind, ase siding toransncrease Inthe teal | i renerest ne ‘invihie: liciuntlons aré the result of q continua hidek.to agareuato supply oF £6 agatonat -dériontl sid the dynamile effects of each of thes shocks on output, Sometimes the shocks aro suficient ‘advursejalone'ot In Gomblnation that they lend 0eg mec l Gl Lone hts vit Teer ae" eet arr each of thie effects at work in Equation (8.2) An increase in expected inflation, 1, leadli roan increase in actual inflation, 4 From now on, 10 | To see why; ‘uation (8,1). An increase in the expected price level” reeding, 1 shall o Pleads, one for one, to an increase in the actual price level B If wage setters — {the inflation rake expect a higher price level, they set higher nominal wage-which leads to aN ployment rate” increase inthe price level. “unemployment.” Now note that, given last perlod’s price level, a higher price level this period implies a higher rate of increase in the price level from last period to this period — that is, higher inflation, Similarly, given last period’s price level, a higher expected price level this period implies a higher expected rate of increase in-the price level from last period to this period—that is, higher expected inflation. So, the fact that an increase in the expected price level leads to an increase in the actual price level can be restated as: An increase: in expected inflation leads to an increase in inflation. 4 Increase in 7° =9 | m Gitien expected inflation, 1'_an increase in the markup u, or an increase in the fgctors that affect wage determiration—an increase in 2—lead to an increase in inflation, m. : ~ From Equation (G1): Given the expected price level P*, an increase in either pr ‘orzingreases the price level 2 Using the same argument as in the previous bullet to restate this proposition. in terms of inflation. and expected inflation; Given expected inflation 7, anincrease in ejther 4 or z leads to an increase in inflation 7, < Increase in » or um * Given expected inflation, 7, an increase in the unemployment rate uleads.to. a inm decrease minflation Tr. - “FronrEquation (6.1); Given the expected price level P*, an increase in the unem- ployment rato w leads to a lower nominal wage, which leads to a lower price level 2 Restating this in terms of inflation and éxpected inflation: Given expected inflation # an increase in the unemployment fate wleads to a decrease in inflation 7, “4 Increase in u #9 ¢ + We need ane more step) before we return to a discussion of the Phillips curve. When we look at movements in inflation‘and unemployment inthe rest of the chapter, it.will often be convenient to use time indexes so that we can refer to variables like SR ne Ss fa aig neeas deflation, in other words—was I see later in this chapter, average < Phillips, Samuelson, and Solow ‘The last year inflation was negative—when there W ~ 1955. In that yen, inflation was —0.3%, But 48 we will inflation was close to zero during much of the: perior were looking at. 4 ore Have © How will @ zero inflation rate affect wage aelterk chobsing nominal wages for aig coming year? With the average inflation rate cqual to zero in the past, it Is reasonal i for wage setters to expect that {islation will bé equal to zero over the next year as We" So, let’s assume that expected inflation is equi! to:zero—that 77 = 0. Equation (8.3) then becomes ce ‘ (8.4) This is precisely the negative relation between unemployment and inflation that Phillips found for the United Kingdom, and Solow and Samuelson found for the United States. The story behind it is simple. Given the expected price level, which workers simply take to be last year's price level, lower unemployment Jeads to a higher nominal wage. A higher nominal wage leads to a higher. price level. Putting the steps together, lower unemployment leads to a higher price level this year relative to last year’s price level—that is, to higher inflation. This mechanism ha sometimes been called the wage-price spiral, an expression {hat captures well the basic mechanism at work: am = (w+ 2) — ally aa m Low unemployment leads to a higher.nominal wage. =. Inresponse to the higher nominal wagé, firms increase their prices. The price! el increases. # In response to the higher price level, worker next time the wage is set. m@ The higher nominal wage leads firms to further: incre the price level increases further. pi ea : w - In response to:this further increase in the price level, workers, when they set the wage again, ask for a further increase in thie nominal wage. ’ m -And so the race between prices and wagés results ia steady wage ‘and price ~ inflation. . rahe i , sk for a higher nominal wage the se their prices. As’a result, Mutations ‘The combination of an apparently reliable empirical relation, together with a plausi- ble’story to explain it, led to the adoption of the Phillips curvé by macroeconomists and policy makers, During the 1960s, U.S. macroeconomic policy was aimed at main- taining unemployment in the.range that appeared corisistent with moderate inflation, SUE Nee i i tT ote Aiea oe gin onWhen the inflation rate becomes high, inflation tends to become more variable. More « Asa result, workers and firms béconie more reluctant to enter into labor contracts that nse< set nominal wages for a long period of time. If inflation turns out higher than he expected, real wages may plunge, and workers will suffer large cuts in their living stan= —g,47 dards, If inflation turns oui lower than expected, real wages may go up sharply. Firms gyera may not be able to pay thelr workers. Some may go bankrupt. setters For this reason, the terms of wage agicements change with the level of inflation. will b Nominal wages are set for shorter periods of time, down from a year to a month or oe ion that automatically increases wags i for inflation, becomes more prevalent, set th ‘These changes lead, in turn, toa stronger response of inflation to unemployment. ond « To see this, an example based on wage indexation will help. Imagine an economy that’ highe has two types of labor contracts. A proportion A (the Greek lowercase letter lambda) oF OR labor contracts is indexed. Nominal wages in those contracts move one for one with ten variations in the actual price level. A proportion 1 — A of labor contracts is not indexed. Nominal wages are set on the basis of expected inflation. Under this assumption, Equation (8.9) becomes F + amy = (Amr + (1 — Alf] ~ a(t = Un) The term in brackets on the right reflects the fact that a proportion A of contracts is indexed and thus respotids to actual inflation (7), and a proportion (1 — A) responds to expected inflation, (mf). If we assume that this year’s expected inflation is equal to last year’s aciual inflation (7f = 7-1), we get mia [amt = Amal aly td), When A ™ 0, all'wages are seton the basis of expected inflation—which is equal to last year’s inflation, 7-;—and the equattom reduces fo Equation (8.10); ay tren Baal, = Un)When A is posttive, however, a proportion Aof wages is set On the basis of actual infla- tion rather than on expected Inflation, ‘fo sve, what this impligs, reorganize Hquation (8.11). Move the term in brackets to the lef factor (1:--A)on the left of the equation, and divide both sides by 1 ~ A, to get f Ge ma m1 Wage indexation Increases the'effe Gi employment on Inflation. The higher the | tency of wage contracts that are incdexed—the higher A—the larger the eles ‘the unempl fehas on the change mn Mllation—the higher the coefficient —». Theintuition ts_as follow: 4 ihout wage indexation, Tower unemployment increases wages, which, in turn, increases prices. But because wages ‘do notregpond to pricéS Hight away, there is no further increase in prices within the year. With wage indexation, however, an increase in prices leads.to a further increase in wages within the year, which leads to a further increase in prices, and:so on, so that the effect of employment on inflation within the year is higher. 7 When, A gets close to 1—which {s when most labor contracts allow for wage indexation n—small changes in unémploynrent can lead to. very large changes in infla- tion. Put another way, there can be large changes in infl ation with nearly no change in unemployment. This is what happens in countries where: inflation is very high. The relation between inflation and unemployment becomes.more tenuous and eventually f >\ disappears altogether. isee XA OF OUtPUt growth needed to maintain: the normal growth rate in what follows, The coefficient on the right side of Lquation (9,2) is 0.4, compared to, -1.0.in Equation (9,1). Put another way, output growth 1% above normal leads only toa 0.4% reduction in the unemployment rate in Tquation (9:2) rather than.v 1% reduction in Equation (9.1), There are two reasons why: constant unemployment rate the U.S, 2002-21 pee nthe Seo dee z J. Firms adjust employment less than one for one in response to deviations of output growth from:normal. More specifically, output growth’]% above normal for 1 year leads to only a 0.6% increase in the employment rate, 4 output, One reason is that some workers are needed tio matter what the level of output is, The accounting department ofa firm, for example, needs roughly the same number of employees, whether the firm is selling more or le : than normal, : i Employm cone for Another reason is that training new employees is costly; for this reason, firms prefer to keep current workers around rather than lay them off whén out- put is lower than normal, and to ask them to work overtime rather than hire new employees when output is higher than normal.In bad times, firms, in effect, hoard labor—the labor they will need when times are better; this is why this behavior of firms is called labor hoarding. a Sa So Chapter 9 ilation, Activity, and Nominat Morey Grawih2, An increase in thé employment rate does not lead to a one-for-one decrease in __the.unemployment rate. More specifically, a 0.6% increase in the employment Fate deals to only 0.4% decrease in the unemployment rate, The reason is that labor force participation increases, When employment increases, not all the . Dew jobs are filled by the unemployed, Some of the jobs go to peopke who were classified as out of the labor force, meaning they were not actively looking fora job. Also, as labor-imarket prospects improve for the unemployed, some dis- “couraged workers—who were previously classified as out of the labor force— decide to start actively looking for a job, and they become classified as unem- ployed. For both reasons, unemployment decreases less than employment increase: “Let's writé Equation (9.2) using let(ers rather than numbers. Let & denote the nor- al growth fale "(about 3% per year for the United States). Let the coefficient B (the reek lowercase beta) measure the effect of output growth above normal on the range in-the unemployment rate. [As you saw in Equation (9.2), in the United States, equals 0.4. The evidence for other countries is given in the Focus box “Okun’s Law cross Countries.”| We can then write: Uy ~ Wy -1 = “BB yt — By) (9.3) * Output growth above normal leads to a decrease in the unemployment rate; out- ut growth: below normal leads to an increase in the unemployment rate.(7.3), based on equilibrium in both goods and financial markets i nae bet we apie Gz My tion for aggregate demand = (= (ts.n] Yoel 6, Th wes: % which we did not need in Chapter 7 but will. m We focus on the relation ~ between the real money "To focus on the relation between the real money stock and output, we will ignore eck M/P ond output Y, changes in factors other than real money here, and write tiisagetegate decaind rclaaieee aetna wale Geal Eg icy variables, G ond T. We cio &r jon simply as en te ero : B Wile the aggre: ee Note thét [have added time indices, need in this chapter. ' gate demand relati re f 5 (96) YM/P), — 1m We assume the relation between the real money where 7 (the Greek lowercase gamnina) is a positive parameter ‘This equation states stock and output is lineor. reve tic demand for goods, and thus output, is simply proportional to the real money eccsand aaa Youcahould keep in mind, however that behind this simple relation hides the This implies we can rte mechanism you saw in the IS-LM model: ‘ apa ea rela. Ge : Chapter 9 Infltion, Aci, ond Neminel Money Growahi 08 Increase in the:1eial money stock leads to a decrease in the interest rate, uw Thodocrersemmemterest rare Teuds 10 an increase in the demand for goods and, * therefore, toran Therease In output. the ratio of two Equation (9,6) glves a relation between levely—the output level, the level of age prow is money, and the price level. We need to go from thig relation to a relation between yonce growth rales—the growth rate of output, the growth rate of money, and rd inflation of these fwo : Lesa Oil aeged rate (the growtlvrate of the ptice level), Por tunately, this is easy. of the price level— Proposition 8 in } , ‘the end of the « Let gy-be the growth rato-of output, Let m be the growth rate = yM/Pand y the rate “of inflation—and gy, be the growth rate of nominal money. Thev, from > Equation (9.6), it fallows that B= Ba — MH ag growth éxceeds inflation Ifominal mone 2 i xp gr on T o n ond reloion: > atGTIRE SOs ointput growth Tn other words, given inflation, expansionary monetary i etary policy Yow honiinal money growl) leads to lov, possiblynegative, output growth. unemployment, and output growth Let's collect the three telations between inflation, we have just derived: wm _ Okun’s law'relates the change in (he unemployment rare to the deviation of out- put growth from normal [Equation (9.9): Uy = Ur = “BB = By) supply relation—relates the e—equivalently, the aggiegate from the natural a The Phillips’ cuiv fhe deviation of the unemployment rate change in inflation to t rate [Equation (9.5): nym iti = rath = Un) tion relates output growth (o the difference between w ‘Thiedggregate demand rela lation [Equation (9.7)|: nominal:money growth and inf ni & ions are shown in Figure 9-2, Start on the right. Through aggre- ermine output growth. Through Okun’s - ‘These tliree tel: gate dlemind; moriey growth and inflation det gure Fd a ota ant, Inflation, iat | Money |