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EC111 MACROECONOMICS Spring term 2012

Lecturer: Jonathan Halket
Week 21
Topic 7: WAGE ADJUSTMENT AND THE PHILLIPS CURVE
Begg, Chp 22
We have contrasted two types of economy, the Keynesian case, where the nominal wage
is fixed and the classical case, where it is perfectly flexible. The truth probably lies
somewhere in between. We assume that wages adjust slowly to eliminate excess demand.











When there is excess demand in the aggregate labour market (at W
1
), competition
between firms in hiring puts upward pressure on the wage. When there is excess supply
(at W
2
) competition between workers for jobs gradually drives the wage down. But
excess supply or demand is only partially eliminated in one period.
The greater is the degree of excess demand, the larger the proportionate adjustment in
the wage. When demand and supply are equal, L
D
L
S
= 0, the rate of wage change is
zero. The rate of wage change is:



W/P

W
2
/P


W
1
/P
L
S
L
D
2










Keynesian and classical models are special cases:
When the wage adjustment function lies on the horizontal axis there is no change
whatever the level of excess demandthe Keynesian case.
When the wage adjustment function lies along the vertical axis the wage adjusts
immediately and excess supply or excess demand cannot emergethe classical
case.













E



W/P

W
2
/P


W
1
/P
L
S
L
D
V

U

L

E

3

In a more realistic labour market there will always be some unemployment. Turnover
due to layoffs or workers quitting and searching for new jobs means that there will
always be some looking for jobs. In this setting employment is read off the EE curve.
The horizontal distance between the EE curve and the demand curve is vacancies, V.
The distance between the EE curve and the supply curve is unemployment, U.
Note that:
There will be an inverse relationship between vacancies and unemployment.
There is a (negative) nonlinear relationship between excess demand for labour,
L
D
L
S
and unemployment.
We can draw the wage adjustment function as a downward sloping relationship
between proportionate wage change, , and unemployment, usually the unemployment
rate, U. This is the Phillips curve.











Looking at data for Britain in the century after 1860, A. W. Phillips found that
proportionate wage change was inversely related to the unemployment rate. He
estimated that there would be zero wage change when the unemployment rate was
about 5.5 percent
This seemed to provide policy makers with menu of choice between (wage) inflation and
unemployment. If fiscal and monetary policies were used to drive down the
unemployment rate below five percent or so then there would be moderate inflation.
U

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But at the end of the 1960s this stable relationship broke down. Britain and other
countries experienced higher unemployment and higher inflation. Why?
The original Phillips curve did not allow for price expectations. If prices were expected
to rise by e.g. 5 percent then this would be taken into account in wage bargaining as
workers (and firms) will be interested in the real wage. This means that there will be a
different Phillips curve associated with each level of expected price inflation, .










The expectations augmented Phillips curve forms part of a circular relationship
between wages and prices:
Wage setting:
Price setting:
Expectations:
The augmented Phillips curve (a linear version) is:
__________________ (1)
We assume that firms main cost is labour, and that they set prices as a markup on
costs, so that prices rise by the same proportion as wage costs.
(2)
A simple assumption about expectation formation is that people expect price inflation to
be the same this year as last year.




U



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(3)
From (2) and (3) we can write: and substituting this into (1) we have:
_____________ or,

Or equivalently:

When there is no change in inflation from one year to the next we have:
= 0
The rate of unemployment that will keep inflation constant is therefore:

This is the Non-Accelerating Inflation Rate of Unemployment, called the NAIRU.
Note that:
The NAIRU is consistent with any constant rate of (wage or price) inflation. Contrast
this with the original Phillips curve where there was a unique rate of inflation
associated with each rate of unemployment. This suggests that there is much less of a
trade-off between unemployment and inflation than was originally thought.
Question: why did the Phillips curve work so well without price expectations for nearly
a century after 1860?
If the unemployment rate is lower than the NAIRU, , this years price inflation
will be higher than last years inflation. Inflation will be accelerating. If unemployment
us above the NAIRU inflation will be decelerating. E.g. last week workers were
complaining that their wage settlements were going to be below expected price inflation.
That is exactly what we should expect if .
We can distinguish between the short-run Phillips curve (now drawn as straight lines
for convenience) and the long run Phillips curve.



6











Starting off on SRPC (1) (for given price expectations), if the government used
monetary and fiscal policy to hold unemployment below the NAIRU, then wage
inflation (and price inflation) will increase. Next year that will feed into even higher
inflation and the same the following year. As long as unemployment is held below the
NAIRU, inflation will keep on accelerating.
Rates of unemployment below the NAIRU are not sustainable in the long run.
Eventually the economy must return to the NAIRU. So the long run Phillips curve is
vertical at the NAIRU.
Disinflation. If inflation is high, then in order to bring it down the unemployment rate
needs to be above the NAIRU for a sustained period. This is what happened in the 1980s
and early 1990s. Eventually prices and wages would accelerate downwards so once an
acceptable rate of inflation is reached the economy can return to the NAIRU.
Note also that if the Phillips curve gets flatter at high unemployment as shown earlier,
then disinflation could be a painful business as wages are not very responsive when
unemployment is relatively high. So unemployment may need either to be very high for
a short time or held above the NAIRU for a long time to bring inflation down.
Note also that this also depends on exactly how expectations are formed. If expectations
are slow to adapt to actual inflation then inflation will accelerate more slowly and will
decelerate more slowly.
These expectations are backward looking: expectations about inflation are formed by
looking back at inflation in the past. If people understood the Phillips curve they would
see that for





U
*
U


LRPC
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Expectations formed on the basis of the past would be systematically wrong. So
expectations might be more forward looking. One version of this is rational
expectations where expectations are more accurate. In this case departures from the
equilibrium level of unemployment will be short-lived. But this requires that people
have a good idea of the actual structure of the economy.
The labour market and the NAI RU
It should be reasonably easy to identify the NAIRU but unfortunately it is not. In the
labour market workers are constantly flowing from employment into unemployment.
Suppose there are 1000 workers and 200 of them become unemployed each year. Each
worker is unemployed for three months. So on average there are 50 workers
unemployed at any one time. The average unemployment rate is 50/1000 = 5 percent. If
workers are unemployed on average for 6 months then, at any one time, there are 100
unemployed and the unemployment rate is 100/1000 = 10 percent.
Under certain assumptions, the unemployment rate can be expressed as













Equilibrium in the labour market implies that labour supply is equal to labour demand.
That means there will be no upward or downward pressure on wage rates. In the
E

W/P

(W/P)
1
(W/P)*



L
S
L
D
V

U

L

E

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diagram, unemployment will be equal to vacancies. This will also be consistent with a
particular duration of unemployment as reflected in the stock/flow equilibrium.
If we also allow for price expectations then this means that the economy will be at the
NAIRU.
There are several things that could cause the NAIRU to increase (or decrease):
If there is a growing mis-match between unemployed workers and vacancies,
either by skill or by location, then some workers will be unemployed for a long
time. Average duration will increase and the equilibrium unemployment rate
will increase. The EE curve shifts to the left.

If trade unions manage to bargain (and sustain) a real wage higher than the
equilibrium wage, say at (W/P)
1
(or possibly a minimum wage might be set at
(W/P)
1
). Vacancies fall, unemployment increases and the duration of
unemployment increases. But excess supply does not push down the wage.

Unemployment benefits are raised, so now workers may search longer for the
best job; they may search less hard. The EE curve shifts to the left. Because
durations are longer, unemployment is higher and vacancies are higher too.

Some things will not cause an increase in the equilibrium rate of unemployment.












U
*
1
U
*
2
E

W/P


(W/P)*
1
(W/P)
*
2



L
S
L
D
1
L

E

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A fall in labour productivity shifts the labour demand curve to the left. At first
there will be a rise in unemployment as workers fail to find jobs at the going
wage. But competition for vacancies increases and the wage adjusts. At the new
equilibrium unemployment, unemployment duration and vacancies are the same
as before.

Try this for a shift in the labour supply curve.
What happened in the past?
In the 1970s there were two big increases in oil prices. This sent inflation up, but
unemployment also began to rise as well. Governments expanded aggregate demand to
try and keep unemployment down. But inflation accelerated to reach 25 percent in
1975.
It was believed then that the oil shocks had shifted the labour demand curve to the left.
Productivity growth slowed down (for other reasons as well). But in fact the NAIRU
had been gradually increasing since the late 1960s. This was probably due to increasing
mismatch, rising trade union power and more generous unemployment benefits.
According to one set of estimates the NAIRU was as follows:
Period 1968-73 1974-80 1981-87 1988-90
NAIRU 2.4 5.7 7.0 6.1
U Rate 2.5 3.8 10.1 6.8

In the early 1980s Mrs Thatcher embarked on a policy of disinflation with deflationary
monetary and fiscal policies, which drove the unemployment rate above the (now
higher) NAIRU to reduce inflation. She also introduced policies to cut unemployment
benefits and reduce union power, i.e to reduce the NAIRU.

How does this link to more recent policy?
Policy makers cannot exploit the Phillips curve trade off in the long run. But they can
exploit it in the short run. If an election is close the government may decide that it is
worth pushing unemployment down now, even though they know that this will cause
inflation in the future and that they (or the party that won the election) will have to
disinflate later on.
One way to get over this (and to reassure those who are forming inflation expectations)
is to make the central bank independent. The Bank of England became independent in
1997. In principle it is not swayed by politics.
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The Bank of England is mandated to keep the inflation rate close to 2 percent. It uses
monetary policy, mainly the interest rate, to do this. If inflation looks like rising above
the band (3 percent) the Bank raises the interest rate in order to reduce aggregate
demand, which according to the Phillips curve, will increase the unemployment rate
and reduce inflation.
The interest rate is a good instrument because it is closely related to aggregate demand
through the IS curve.
Note that: I f the Bank manages to keep inflation steady, then the economy will be close to
the NAI RU. This is the best that anyone can do in the long run. And the Bank does not
need to know what the NAI RU is in order to achieve this.
But note:
Some people think an inflation target of 2 percent is a bit too low. Why?

When there are demand shocks the Banks response is straightforward. Things
are less clear when inflation rises and unemployment increases (as happened in
the 1970s). If it is due e.g. to oil prices then it might be worth not tightening too
much. But if it is a rise in the NAIRU then the Bank should control inflation and
allow unemployment to increase to the new NAIRU.

Inflation performance.
1990-2 Britain was in the European exchange rate mechanism but left in 1992.

Inflation targeting was introduced but inflation expectations were above actual
inflationperhaps the Banks policy was not seen as a credible low inflation
policy.

1997-04 the Bank was independent with a target of 2.5 percent (range 1.5-3.5
percent). Inflation was fairly stable and expected inflation was close to actual
inflation.

In 2004 the target was lowered to 2 percent (the same as the ECB). Inflation
moved out of the range in 2008, but the Bank did not raise interest rates because
of the Global Financial Crisis.
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What happened since 2008?
If inflation falls outside the target zone the Governor of the Bank of England must write
a letter to the Chancellor of the Exchequer explaining why and what the Bank intends
to do.
The Governor has now written ten letters. Currently CPI inflation stands at 4 percent.
Have we abandoned inflation targeting?
In his latest letter (14
th
Feb) the Governor says that this is due to (a) the rise in VAT (b)
the fall in the exchange rate and (c) the rise in commodity prices (esp. fuel). He says that
prices excluding the effects of these factors would probably have increased at a rate
well below the 2% inflation target.
So the Bank is trying to exclude supply side effects. But it risks losing credibility and it
will have to raise rates before too long.