GLA 1001 MACROECONOMICS: MARKETS, INSTITUTIONS AND GROWTH

Transcription

1 GLA 1001 MACROECONOMICS: MARKETS, INSTITUTIONS AND GROWTH LECTURE 3: THE SUPPLY SIDE THE DERIVATION OF THE PHILLIPS CURVE Gustavo Indart Slide 1

2 WHAT IS UNEMPLOYMENT? The labour force consists of those working-age individuals currently working (the employed) plus those who are not working but are actively trying to find a job (the unemployed) The unemployment rate is the percentage of the labour force that is unemployed The current rate of unemployment is 5.6 percent (but it was 8.7 percent at the peak of the recession) Presently, about 1.2 million Canadians are out of work There is a high economic and social cost associated with unemployment Gustavo Indart Slide 2

3 CANADA S UNEMPLOYMENT RATE JANUARY 1980 TO DECEMBER % Source: Tradingeconomics.com / Statistics Canada. Gustavo Indart Slide 3

4 ALTERNATIVE VIEWS OF UNEMPLOYMENT The orthodox (or neoclassical) view is that unemployment is essentially a supply-side phenomenon It s either voluntary or due to rigidities in the labour market such as minimum wages The heterodox (or Keynesian) view is that unemployment is mainly a demand-side phenomenon It s involuntary and essentially caused by an insufficient aggregate demand The sociological view considers unemployment to be a societal problem and not a strictly economic one The economy must be embedded in society Gustavo Indart Slide 4

5 WHY THE LABOUR MARKET DOES NOT CLEAR When the labour market clears, there is neither excess supply nor excess demand Wage would rise when there is excess demand and fall when there is excess supply But the empirical evidence show that this is not the case In general, there are workers willing to work at the going wage who cannot find employment Why do wages not fall when there is an excess supply? Why is there involuntary unemployment? We will build a model that explains the emergence of involuntary unemployment Gustavo Indart Slide 5

6 THE WAGE-SETTING CURVE A worker must exert certain level of effort on the job to be useful to the employer But supply of labour effort is not known to the employer The employer creates an incentive to the worker to provide effort by creating a cost to the worker of losing their job A real wage above the market-clearing real wage increases the productivity or efficiency of labour The efficiency wage is the real wage an employer must pay to obtain a certain effort from the worker The wage-setting curve (WS) relates the efficiency wage to the level of employment and refers to the supply side of the labour market Gustavo Indart Slide 6

7 THE WAGE-SETTING CURVE (CONT D) As a simplification, the labour supply curve (N S ) is assumed to be shaped like an inverse-l The model assumes that two main factors influence the efficiency wage: The income available to the worker if unemployed The probability of getting another job (which depends on the unemployment rate) The wage-setting curve (WS) is thus assumed to be upward sloping (the real wage rises as employment increases) The WS curve shifts up when unemployment benefits, the disutility of work, or workers market power increase Gustavo Indart Slide 7

8 THE WAGE-SETTING CURVE (CONT D) Indeed, the position of the WS curve is determined by wagepush factors These factors include institutional, policy, structural and shock variables For instance, the WS curve shifts down (which reduces equilibrium unemployment) when: Unemployment benefits (or their duration) decrease The disutility of effort decreases (e.g., due to improvements in working conditions) Legal protection of unions is reduced Unions agree to exercise bargaining restraint (e.g., a wage accord) Gustavo Indart Slide 8

9 THE WAGE-SETTING CURVE Real wage, w Unemployment benefit plus disutility of work High wage Low wage For simplicity, the WS curve is assumed to be a straight line // High unemployment Wagesetting curve, WS Low unemployment Labour supply curve, N S N 1 N 2 N 0 The WS curve relates to the supply side of the labour market The efficiency wage indicates the real wage that must be paid to obtain a certain level of effort from workers The efficiency wage increases as unemployment falls Employment, N Gustavo Indart Slide 9

10 THE PRICE-SETTING CURVE We have seen that the wage-setting curve (WS) refers to the supply-side of the labour market Now we will derive the price-setting curve (PS) that refers to the demand-side of the labour market It refers to the demand for labour by imperfectly competitive firms (i.e., by price-setting firms) A firm pays a real wage that makes the employment of workers profitable (i.e., the price-setting real wage) Our model assumes that output per worker is constant and that the firm requires a fixed profit margin Therefore, the price-setting curve (PS) is horizontal Gustavo Indart Slide 10

11 THE PRICE-SETTING CURVE Output per worker, Real wage For simplicity, output per workers is assumed constant Output per worker Real wage // Profits per worker Real wages per worker Pricesetting curve, PS It is assumed that firms required a fixed profit margin This implies a certain real wage that makes profitable for firms to hire workers Therefore, the PS curve is horizontal Employment Gustavo Indart Slide 11

12 HOW FIRMS SET PRICES Firms set prices as a constant mark-up over unit labour cost This means that prices respond to changes in labour costs Since productivity is assumed constant, prices respond to changes in nominal wages The firm sets the price of its product as follows: PP = 11 + μμ WW λλ where μμ is the mark-up, WW is the nominal wage, and λλ = yy/nn is output per worker Gustavo Indart Slide 12

13 PRODUCTIVITY INCREASES, NOMINAL WAGES, PROFITS, AND PRICES PP = (11 + μμ)(ww/λλ) Suppose productivity (i.e., output per worker) increases from λλ = yy/nn to λλ = yy /NN, where yy > yy If WW remains unchanged, then: If μμ also remains unchanged, then PP falls and nominal profits do not change If PP remains unchanged, then μμ rises and nominal profits increase And if WW increases in the same proportion as λλ and μμ remains unchanged, then nominal profits also increase in the same proportion and PP does not change Gustavo Indart Slide 13

14 A PRODUCTIVITY INCREASE AND THE PRICE-SETTING CURVE λ, w λ' Let s assume that the share of wages in total income is 50% (i.e., the firms mark-up over unit labour cost is 100%). λ w' Profits per worker Profits per worker PS Suppose output per worker increases to λ while the markup remains unchanged. w Wages per worker Wages per worker PS Therefore, the PS curve shifts up to PS. // N Gustavo Indart Slide 14

15 LABOUR MARKET EQUILIBRIUM The wage-setting (WS) curve refers to the minimum real wage workers will accept in the next wage round It refers to the supply side of the labour market The price-setting (PS) curve refers to the maximum real wage a firm will pay while maintaining an expected profit margin It refers to the demand side of the labour market Therefore, the intersection of the WS and PS curves determines the equilibrium in the labour market: The equilibrium real wage, the equilibrium level of employment, and the equilibrium level of unemployment Gustavo Indart Slide 15

16 LABOUR MARKET EQUILIBRIUM Real wage, w WS Labour force Equilibrium employment (and unemployment) is achieved when PS = WS w e A PS At point A, wage and price setters are content with the prevailing real wage (w e ) Equilibrium unemployment, U e If N > N e, then the real wage would increase along the WS curve in the next wage round // N e Employment, N Gustavo Indart Slide 16

17 NOMINAL AND REAL WAGES Workers and firms care about real wages Workers care about purchasing power of money wages Firms care about cost of labour relative to price of output But workers are paid nominal wages and firms set the nominal prices of their products Through negotiation, firms and workers set the nominal wage that achieves the desired real wage on the WS curve Therefore, they must assume (i.e., expect) a certain price level Where the price level is the outcome of the pricesetting process by firms across the economy Gustavo Indart Slide 17

18 ASSUMPTIONS OF THE MODEL Wage contracts are reviewed once a year Nominal wages are adjusted following a wage round They are not adjusted due to a demand shock So wages respond to changes in yy DD with a lag Prices are adjusted immediately after a wage adjustment So prices also respond to changes in yy DD with a lag Therefore, changes in yy DD only affect the levels of output and employment in the short run Wages will then be adjusted in the next wage round And prices will be adjusted immediately following the wage adjustment Gustavo Indart Slide 18

19 THE RESPONSE OF WAGES AND PRICES TO A POSITIVE AGGREGATE DEMAND SHOCK w WS Labour force An autonomous increase in yy DD causes employment to increase to N B in the short run with no change in nominal wages and prices. w C w e // A N A B C N B Δw Equilibrium unemployment PS Unemployment decreases in the short run N In the next wage round, the nominal wage increases and the real wage reaches w C. But as soon as the nominal wage is adjusted, firms increase prices in the same proportion and the real wage goes back to w e (but the rate of inflation is now higher). IS curve shifts right Gustavo Indart Slide 19

20 THE DERIVATION OF THE PHILLIPS CURVE At the medium-run equilibrium level of employment (N e ): Inflation is constant Unemployment is at its natural rate or NAIRU If there is a positive (negative) demand shock, output and employment increase (decrease) The rate of unemployment falls (rises) Money wages increase (decrease) in the next round, and so does inflation Therefore, there exists a positive relationship between output and the rate of inflation This relationship is called the Phillips curve (PC) Gustavo Indart Slide 20

21 THE DERIVATION OF THE PHILLIPS CURVE: THE WS AND PS CURVES In the WS curve, the real wage increases with employment (i.e., with the output gap): ww tt = BB + zz ww + αα yy tt yy ee where BB is a constant reflecting the opportunity cost of working, zz ww is the set of wage-push factors, and αα measures the sensitivity of wages to a change in the output gap Firms price-setting action always restores the real wage to the equilibrium real wage: ww ee = BB + zz ww Gustavo Indart Slide 21

22 THE DERIVATION OF THE PHILLIPS CURVE: THE WS AND PS CURVES (CONT D) If yy tt > yy ee, wage setters will attempt to increase the expected real wage by: ww = ww tt ww ee = BB + zz ww + αα yy tt yy ee (BB + zz ww ) = αα yy tt yy ee But since ww = WW/PP, WW must increase in the same proportion as PP is expected to increase (i.e., the expected rate of inflation, ππ tt EE ) for ww just to remain unchanged: ( WW/WW) tt = ππ tt EE Gustavo Indart Slide 22

23 THE DERIVATION OF THE PHILLIPS CURVE: THE WS AND PS CURVES (CONT D) Therefore, for w to increase at time t, WWmust increase by: WW = ππ EE WW tt + αα yy tt yy ee tt And since, at time t, price setters will increase PP (i.e., the rate of inflation, ππ tt ) in the same proportion as the actual increase in WW: ππ tt = WW WW tt Then, here is the Phillips curve: ππ tt = ππ tt EE + αα yy tt yy ee Gustavo Indart Slide 23

24 THE DERIVATION OF THE ADAPTIVE EXPECTATIONS PHILLIPS CURVE ππ tt = ππ tt EE + αα yy tt yy ee We will assume that expectations are adaptive, i.e., they are formed based on the past behaviour of the variable For simplicity, we will assume the expected rate of inflation to be equal to the rate of inflation in the previous period: ππ tt EE = ππ tt 11 Therefore, the adaptive expectations Phillips curve shows that current inflation is equal to lagged inflation plus the impact of the output gap: ππ tt = ππ tt 11 + αα yy tt yy ee Gustavo Indart Slide 24

25 THE DERIVATION OF THE ADAPTIVE EXPECTATIONS PHILLIPS CURVE (CONT D) So the adaptive expectations Phillips curve is: ππ tt = ππ tt 11 + αα yy tt yy ee If the economy is in medium-run equilibrium (i.e., if yy tt = yy ee ), then ππ tt = ππ tt 11 Therefore, the position of the Phillips curve is determined by the actual rate of inflation in the previous period If the rate of inflation increases in period t, then the Phillips curve will shift up in period t+1 Gustavo Indart Slide 25

26 THE DERIVATION OF THE ADAPTIVE EXPECTATIONS PHILLIPS CURVE w w e A B 2% WS PS ππ tt = ππ tt EE + αα yy tt yy ee ππ tt EE = ππ tt 11 Suppose that ππ 00 = 222, so ππ 11 EE = 222. Then at point A, ππ 11 = 22%. π 6% 4% 2% // N e A N H B PC 2 PC 1 N Therefore, PC 1 is the Phillips curve corresponding to ππ 11 EE = 222. Suppose N increases to N H (and y to y H ) in period 1 and wage setters increase nominal wages by an additional 2% (i.e., a total of 4%). Therefore, ππ 11 = 4% (point B on the PC 1 curve). // y e y H y Since ππ 11 = 4% in period 1, the PC curve shifts up to PC 2 in period 2. Gustavo Indart Slide 26