1

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 W1), competition

between firms in hiring puts upward pressure on the wage. When there is excess supply

(at W2) 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, LD – L

S = 0, the rate of wage change is

zero. The rate of wage change is:

W/P

W2/P

W1/P

LS

LD

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 demand—the Keynesian case.

When the wage adjustment function lies along the vertical axis the wage adjusts

immediately and excess supply or excess demand cannot emerge—the classical

case.

E

W/P

W2/P

W1/P

LS

LD

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,

LD – 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

4

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

5

(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 year‘s price inflation

will be higher than last year‘s 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

7

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 NAIRU

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)*

LS

LD

V

U

L

E

8

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

LS

LD

1

L

E

9

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.

10

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: If the Bank manages to keep inflation steady, then the economy will be close to

the NAIRU. This is the best that anyone can do in the long run. And the Bank does not

need to know what the NAIRU 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 Bank‘s 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

inflation—perhaps the Bank‘s 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.

11

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 (14th

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.