Notes for a New Guide to Keynes

Notes for a New Guide to Keynes Jordi Galí CREI, UPF and Barcelona GSE EEA Congress, Málaga 2012 Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 1 / 36

Notes for a New Guide to Keynes (I): Wages, Aggregate Demand and Employment Jordi Galí CREI, UPF and Barcelona GSE EEA Congress, Málaga 2012 Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 1 / 1

Outline Keynes vs the Classics in the General Theory - The classical theory of employment - The Keynesian theory of employment - The nature of unemployment and its cure Keynes vs the Classics through the lens of the New Keynesian model - The standard New Keynesian model: main ingredients - Beyond the General Theory: two "new" insights - The gains from wage flexibility revisited Implications in the current policy environment Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 2 / 36

Keynes vs the Classics in the General Theory The classical theory of employment Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 3 / 36

The Classical Theory of Employment: Labor Demand Wage w p Labor demand ( mpn) n Employment

The Classical Theory of Employment: Labor Supply Wage Labor supply ( mrs) w p l Labor force

The Classical Theory of Employment: Equilibrium Wage Labor supply ( mrs) w p Labor demand ( mpn) n = l Employment Labor force

Keynes vs the Classics in the General Theory The classical theory of employment "I. The wage is equal to the marginal product of labour." "II. The utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment." Keynes (GT, chapter 2). Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 4 / 36

Unemployment in the Classical Theory of Employment Wage w p u Labor supply ( mrs) Labor demand ( mpn) n l Employment Labor force

Classical Unemployment Cures (I): Real Wage Reduction Wage w p w p u u Labor supply ( mrs) Labor demand ( mpn) n n l l Employment Labor force

Classical Unemployment Cures (II): Employment Subsidy Wage w p u u Labor supply ( mrs) Labor demand ( mpn) n n l Employment Labor force

Keynes vs the Classics in the General Theory The classical theory of employment The Keynesian theory of employment Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 5 / 36

The Keynesian Theory of Employment Aggregate Demand Output Technology Employment

The Keynesian Theory of Employment Wage n Employment

Keynes vs the Classics in the General Theory The classical theory of employment The Keynesian theory of employment - Price setting by firms: p t = µ p + (w t mpn t ) - Implied wage schedule: w t p t = mpn t µ p Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 6 / 36

The Keynesian Theory of Employment Wage w p Wage schedule n Employment

Unemployment in the Keynesian Theory of Employment Wage w p u Labor supply ( mrs) Wage schedule n l Employment Labor force

Cure for Keynesian Unemployment: Aggregate Demand Expansion Wage w p w p u u Labor supply ( mrs) Wage schedule n n l l Employment Labor force

The Standard New Keynesian Model: Main Ingredients (I) Households/Preferences E 0 t=0 β t U(C t, N t ; X t ) where U(C t, N t ; X t ) = ( ) log C t N1+ϕ t 1 + ϕ X t x t = ρ x x t 1 + ε x t Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 7 / 37

The Standard New Keynesian Model: Main Ingredients (I) Households/Preferences E 0 t=0 β t U(C t, N t ; X t ) where U(C t, N t ; X t ) = ( ) log C t N1+ϕ t 1 + ϕ X t x t = ρ x x t 1 + ε x t Firms/Technology where Y t = A t N 1 α t a t = ρ a a t 1 + ε a t Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 8 / 36

The Standard New Keynesian Model: Main Ingredients (II) Monopolistic competition in goods and labor markets Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 9 / 38

The Standard New Keynesian Model: Main Ingredients (II) Monopolistic competition in goods and labor markets Staggered price and wage setting à la Calvo Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 9 / 36

The Standard New Keynesian Model: Main Ingredients (II) Monopolistic competition in goods and labor markets Staggered price and wage setting à la Calvo Unemployment (Galí (2011)): u t l t n t where participation l t is given by: w t p t = c t + ϕl t Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 10 / 37

The Standard New Keynesian Model: Main Ingredients (II) Monopolistic competition in goods and labor markets Staggered price and wage setting à la Calvo Unemployment (Galí (2011)): u t l t n t where participation l t is given by: w t p t = c t + ϕl t Monetary policy i t = ρ + φ π π t + φ y y t + v t where v t = ρ v v t 1 + ε v t Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 11 / 37

The Standard New Keynesian Model: Main Ingredients (III) Simplifying assumptions - no fiscal sector - closed economy - no endogenous capital accumulation Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 12 / 37

The Standard New Keynesian Model: Main Ingredients (III) Simplifying assumptions - no fiscal sector - closed economy - no endogenous capital accumulation Effi cient allocation n e t = y e t log(1 α) 1 + ϕ n e = a t + (1 α)n e Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 13 / 37

Beyond the General Theory (I): Cyclical Behavior of Wages Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 13 / 36

The Effects of an Aggregate Demand Expansion in the General Theory Wage w p w p u u Labor supply ( mrs) Wage schedule n n l l Employment Labor force

Dynamic Responses to an Aggregate Demand Shock in the NK Model 1.4 Output 1.6 Employment 1.2 1.4 1 1.2 0.8 1 0.6 0.8 0.4 0.6 0.2 0.4 0 2 4 6 8 10 12 14 16 0.2 2 4 6 8 10 12 14 16 0 Unemployment Rate 0.2 Real Wage 0.18-0.5 0.16-1 0.14 0.12-1.5 0.1 0.08-2 2 4 6 8 10 12 14 16 0.06 2 4 6 8 10 12 14 16

Beyond the General Theory (I): Cyclical Behavior of Wages The wage schedule with flexible prices (General Theory) w t p t = mpn t µ p n mpn t (w t p t ) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 14 / 36

Beyond the General Theory (I): Cyclical Behavior of Wages The wage schedule with flexible prices (General Theory) w t p t = mpn t µ p n mpn t (w t p t ) The wage schedule with sticky prices (NK model) w t p t = mpn t µ p t n mpn t, µ p t (w t p t ) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 15 / 36

The Effects of an Aggregate Demand Expansion with Sticky Prices Wage w p w p Labor supply ( mrs) n n Wage schedule Employment Labor force

Impact Response of the Real Wage to an Aggregate Demand Shock in the NK Model Real Wage Response to Monetary Policy Shock 3 2.5 2 1.5 1 0.5 0-0.5-1 1 0.8 0.6 0.4 Wage Stickiness 0.2 0 0 0.1 0.2 0.3 0.4 0.5 Price Stickiness 0.6 0.7 0.8 0.9

Beyond the General Theory (II): The Effects of Technology Shocks on Employment Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 16 / 36

The Effects of Technology Shocks on Employment: the Classical Model Wage Labor supply ( mrs) w p w p n n Labor demand ( mpn) Employment Labor force

The Effects of Technology Shocks on Employment: the Keynesian Model Wage w p Labor supply ( mrs) w p Wage schedule n n Employment Assumption: constant aggregate demand

Beyond the General Theory (II): The Effects of Technology Shocks on Employment Equilibrium employment in the NK model n t = 1 1 α (y t a t ) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 17 / 36

Beyond the General Theory (II): The Effects of Technology Shocks on Employment Equilibrium employment in the NK model Equilibrium output in the NK model n t = 1 1 α (y t a t ) y t = E t {y t+1 } (i t E t {π t+1 }) + (1 ρ x )x t Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 18 / 36

Beyond the General Theory (II): The Effects of Technology Shocks on Employment Equilibrium employment in the NK model Equilibrium output in the NK model n t = 1 1 α (y t a t ) y t = E t {y t+1 } (i t E t {π t+1 }) + (1 ρ x )x t Equivalently: y t = x t E t { k=0 (i t+k E t {π t+1+k }) } Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 19 / 36

Beyond the General Theory (II): The Effects of Technology Shocks on Employment Equilibrium employment in the NK model n t = 1 1 α (y t a t ) Equilibrium output in the NK model Equivalently: Thus, y t = E t {y t+1 } (i t E t {π t+1 }) + (1 ρ x )x t ( n t = 1 1 α y t = x t E t { k=0 x t E t { k=0 (i t+k E t {π t+1+k }) (i t+k E t {π t+1+k }) } } a t ) key role for endogenous response of monetary policy Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 20 / 36

Dynamic Responses to a Technology Shock in the NK Model 0.8 Output -0.15 Employment 0.6-0.2 0.4-0.25 0.2-0.3 0 5 10 15-0.35 5 10 15 0.35 Unemployment Rate 0.3 Real Wage 0.3 0.25 0.25 0.2 0.2 0.15 0.15 0.1 0.1 5 10 15 0.05 5 10 15

Beyond the General Theory (II): The Effects of Technology Shocks on Employment Basic evidence on the effects of aggregate technology shocks Galí (AER 1999) Basu, Fernald and Kimball (AER 2006) Francis and Ramey (JME 2005) Barnichon (JME 2010)... Evidence on the impact of changes in monetary policy on the effects of technology shocks Galí, López-Salido and Vallés (JME 2003) Fisher (JPE 2006)... Evidence based on estimated DSGE models Galí and Rabanal (NBER MA 2004) Smets and Wouters (JEEA 2003, AER 2007) Jordi... Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 21 / 36

Gains from Wage Flexibility in the New Keynesian Model Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 22 / 36

Gains from Wage Flexibility in the New Keynesian Model Equilibrium employment in the NK model ( { } ) n t = 1 x t E t (i t+k E t {π t+1+k }) a t 1 α k=0 Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 23 / 36

Gains from Wage Flexibility in the New Keynesian Model Equilibrium employment in the NK model ( { } ) n t = 1 x t E t (i t+k E t {π t+1+k }) a t 1 α Under constant real interest rate: k=0 n t = 1 1 α (x t a t ) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 24 / 36

Gains from Wage Flexibility in the New Keynesian Model Equilibrium employment in the NK model ( { } ) n t = 1 x t E t (i t+k E t {π t+1+k }) a t 1 α k=0 Under constant real interest rates: Key message: n t = 1 1 α (x t a t ) - no direct impact of wage adjustments on labor demand and employment - indirect effect: w π i r y n importance of endogenous monetary policy response ("policy rule") Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 27 / 38

Gains from Wage Flexibility in the New Keynesian Model Equilibrium employment in the NK model ( { } ) n t = 1 x t E t (i t+k E t {π t+1+k }) a t 1 α k=0 Under constant real interest rates: n t = 1 1 α (x t a t ) Key message: - no direct impact of wage adjustments on labor demand and employment - indirect effect: w π i r y n importance of endogenous monetary policy response (policy rule) Illustration: Effects of a payroll tax shock on employment τ t = ρ τ τ t 1 + ε τ t Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 28 / 38

Dynamic Responses of Employment to a Payroll Tax Shock 1 Employment Response to Payroll Tax Shock 0.8 0.6 0.4 0.2 0-0.2-0.4 0 2 4 6 8 10 12 14 16 1 1.2 1.4 2 1.8 1.6 Inflation Coefficient Periods

Gains from Wage Flexibility in the New Keynesian Model: Some Simulations Two "exogenous factors": - Wage stickiness: θ w (0, 1) - Policy responsiveness to inflation: φ π (1, 2] Effects on employment volatility [σ(n t )] Effects on welfare ( L (1 + ϕ) var(n t ) + Conditional analysis: (i) technology shocks (ii) preference shocks ɛ p λ p (1 α) ) ( ) var(π p ɛw t ) + var(π w t ) λ w Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 27 / 36

Wage Flexibility, Monetary Policy and Employment Volatility (I): Technology Shocks 6 Std. deviation of employment 5 4 3 2 1 0 1 1.2 1 1.4 1.6 Inflation Coefficient 1.8 2 0 0.2 0.4 0.6 Wage Stickiness 0.8

Wage Flexibility, Monetary Policy and Welfare (I): Technology Shocks 600 500 Welfare losses 400 300 200 100 1 0 0 0.1 0.2 0.3 0.4 0.5 0.6 Wage Stickiness 0.7 0.8 0.9 1 2 1.8 1.6 1.4 1.2 Inflation Coefficient

Decomposition of Welfare Losses (I): Technology Shocks Welfare losses: Employment component 150 100 50 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1 1.2 1.4 1.6 Inflation Coefficient Welfare losses: Price Inflation Component 600 400 200 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1.6 1.4 1.2 Inflation Coefficient 1 (i) Employment (ii) Price Inflation Welfare losses: Wage Inflation Component 250 200 150 100 50 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1.4 1.6 1 1.2 Inflation Coefficient (iii) Wage Inflation

Wage Flexibility, Monetary Policy and Employment Volatility (II): Preference Shocks 3.5 3 Std. deviation of employment 2.5 2 1.5 1 0.5 0 1 1.2 1.4 1.6 Inflation Coefficient 1.8 2 0 0.2 0.4 0.6 Wage Stickiness 0.8 1

Wage Flexibility, Monetary Policy and Welfare (II): Preference Shocks 600 500 400 Welfare losses 300 200 100 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1.6 1.4 Inflation Coefficient 1.2 1

Decomposition of Welfare Losses (III): Preference Shocks Welfare losses: Employment component 60 40 20 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1.6 1.4 1.2 Inflation Coefficient 1 Welfare losses: Price Inflation Component 500 400 300 200 100 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1.6 1.4 1.2 Inflation Coefficient 1 (i) Employment (ii) Price Inflation Welfare losses: Wage Inflation Component 250 200 150 100 50 0 0 0.2 0.4 0.6 Wage Stickiness 0.8 1 2 1.8 1.6 1.4 1.2 Inflation Coefficient 1 (iii) Wage Inflation

Gains from Wage Flexibility in the New Keynesian Model: Some Simulations Two "exogenous factors": - Wage stickiness: θ w (0, 1) - Policy responsiveness to inflation: φ π (1, 2] Effects on employment volatility [σ(n t )] Effects on welfare ( L (1 + ϕ) var(n t ) + Conditional analysis: (i) technology shocks (ii) preference shocks ɛ p λ p (1 α) ) ( ) var(π p ɛw t ) + var(π w t ) λ w Gains from wage flexibility under the optimal monetary policy Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 28 / 36

Wage Flexibility and Welfare under the Optimal Monetary Policy 8 7 6 Welfare loss under Optimal Policy 5 4 3 2 1 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Wage Stickiness

Decomposition of Welfare Losses under the Optimal Monetary Policy 8 7 employment wage inflation price inflation Components of Welfare Loss under Optimal Policy 6 5 4 3 2 1 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Wage Stickiness

Some Caveats Closed economy assumption: no room for "competitiveness channel" w p q y n Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 30 / 37

Some Caveats Closed economy assumption: no room for "competitiveness channel" w p q y n However: - impact on terms of trade not invariant to monetary policy response - beggar-thy-neighboor policy - effectiveness depends on degree of pass-through (if pricing to market) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 31 / 37

Some Caveats Closed economy assumption: no room for "competitiveness channel" w p q y n Offsetting channel (I): if no interest rate response (e.g. exchange rate peg): w π r y n Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 32 / 37

Some Caveats Closed economy assumption: no room for "competitiveness channel" w p q y n Offsetting channel (I): if no interest rate response (e.g. exchange rate peg): w π r y n Offsetting channel (II): additional channel with non-ricardian households: w c y n Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 33 / 37

Concluding Remarks Current environment: persistently high unemployment, though large heterogeneity across countries Recurring calls for structural reforms to make labor markets more flexible "...Further significant reductions in unit labor costs and excess profit margins are particularly urgent, especially in countries where unemployment is very high. To achieve this, first, flexibility in the wage determination process has to be strengthened, for example, where relevant, by relaxing employment protection legislation, abolishing wage indexation schemes, lowering minimum wages and permitting wage bargaining at the firm level..." (ECB, Monthly Bulletin, August 2012) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 34 / 37

Concluding Remarks Current environment: persistently high unemployment, though large heterogeneity across countries Recurring calls for structural reforms to make labor markets more flexible Main lesson: impact of such reforms on employment likely to be limited, unless accompanied by an expansion of aggregate demand. However: - Monetary policy: zero lower bound (US, UK, Japan, euro area) or unavailable (euro area countries) - Fiscal policy: emphasis on fiscal consolidation, especially in countries with worse employment performance - External demand: global slowdown Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 35 / 36

Concluding Remarks Current environment: persistently high unemployment, though large heterogeneity across countries Recurring calls for structural reforms to make labor markets more flexible Main lesson: impact of such reforms on employment likely to be limited, unless accompanied by an expansion of aggregate demand. However: - Monetary policy: zero lower bound (US, UK, Japan, euro area,...) or unavailable (euro area countries) - Fiscal policy: emphasis on fiscal consolidation, especially in countries with worse employment performance - External demand: global slowdown Challenge: how to stimulate aggregate demand in high unemployment countries without amplifying existing imbalances (public and private debt, external,...) Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 36 / 36