I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
This is the continuation of the Chapter on unemployment and inflation – the series so far is:
- Unemployment and inflation – Part 1
- Unemployment and inflation – Part 2
- Unemployment and inflation – Part 3
- Unemployment and inflation – Part 4
- Unemployment and inflation – Part 5
- Unemployment and Inflation – Part 6
- Unemployment and Inflation – Part 7
- Unemployment and Inflation – Part 8
I am now continuing the discussion of the Phillips Curve …
Chapter 12 – Unemployment and Inflation
MATERIAL HERE NOT REPEATED
[PICKING UP FROM HERE]
Figure 12.11 captures the accelerationist hypothesis. The short-run Phillips curves are shown conditional on a specific expectation of inflation held by the workers. The superscript e denotes “expected” inflation. We use the terminology, expectations are realised to denote a state where the expectations formed are equal to the actual outcome.
Start at Point A, where the inflation rate is Pdot1 and the unemployment rate is at its so-called “natural rate” (U*). At this point, the inflationary expectations held by workers (Pdote1) are consistent with the actual inflation rate Pdot1. According to Friedman, the labour market will be operating at the natural rate of unemployment, whenever inflationary expectations are realised.
To see how the accelerationist hypothesis plays out, we assume that the government is under political pressure and forms the view that U* unemployment rate is too high. It believes it can use expansionary fiscal and monetary policy to achieve a lower target rate of unemployment, UT. They also think they can exploit the Phillips Curve trade-off and move the economy to Point B, with an inflation rate of Pdot2 as the “cost” of the lower unemployment rate.
As a consequence government stimulates nominal aggregate demand to push the economy to point B. The increased demand for labour pushes up the inflation rate (to Pdot2) and money wage rates also rise in the labour market. The accelerationist hypothesis assumes that the price level accelerates more quickly than money wages and as a consequence the real wage falls.
The Monetarists resurrected the Classical labour market and placed it at the centre of their attack on Keynesian macroeconomics. Accordingly, firms will offer more employment because the real wage has now fallen and they can still profit maximise at the lower level of marginal productivity.
Why would workers supply more labour if the real wage was falling? In the Classical labour market it is assumed that labour supply is a positive function of the real wage so workers will withdraw labour if the real wage falls.
The Monetarist approach overcome that seeming problem by imposing asymmetric expectations on the workers and firms. The firms were assumed to have complete price and wage information at all times so they knew what the actual real wage was doing at any point in time.
However, the workers were assumed to gather information about the inflation rate in a lagged or adaptive fashion and thus could be fooled into believing that the real wage was rising when, in fact, it was falling.
Thus, workers are assumed to be initially oblivious to the rising inflation – that is, their inflationary expectations do not adjust to the actual inflation rate immediately. As a consequence they mistake the rising nominal wages for an increasing real wage and willingly supply more labour even though the real wage has actually fallen.
The central proposition of the Classical labour market is that workers care about real wages not money wages. The accelerationist hypothesis added the idea that workers form adaptive expectations of inflation, which means that it takes some time for them to differentiate between movements in money wages and movements in real wages.
Monetarists asserted that Point B is unstable and can only persist as long as workers are fooled into believing the money wage increases they received were equivalent to real wage increases.
But inflationary expectations adapt to the actual higher inflation rate after a time. Once the workers increase their inflationary expectations to Pdote2 then the SRPC shifts out and the labour market settles at Point C when the new expectations catch up with the higher inflation rate (Pdot2).
The path the labour market takes as it inflationary expectations adjust to the actual inflation rate and the short-run Phillips curve shift (that is, from Point B to Point C or Point D to Point E) is an empirical matter. But for Monetarists, once inflationary expectations have fully adjusted to the current inflation rate (at Points C and E, for example), the economy will return to the natural rate of unemployment (U*), irrespective of government attempts to target the lower unemployment rate.
For Friedman, the short-run dynamics of the labour market were driven by the capacity of the government to “fool” workers into believing the inflation rate was lower than the actual inflation rate. As long as some of the inflation rate is unanticipated by workers, the government can maintain the unemployment rate below the natural rate but at a costs of rising inflation.
This narrative seeks to explain mass unemployment in the same way. The Friedman story is that mass unemployment occurs when workers refuse to accept money wage offers that they think generate a real wage below the actual real wage consistent with these offers. Workers think the real wage implied by the wage offers is too low because they wrongly believe that inflation is higher than it is. That is, their inflationary expectations exceed the actual inflation rate.
As a consequence, they start quitting their jobs and/or refuse to take new job offers thinking it is better to search for higher real wage paying positions. Once they realise they have mistakenly thought inflation was higher than it actually is, they start to accept the job offers at the current money wage levels and increase their labour supply.
Friedman thus was forced to explain changes in unemployment in terms of swings in the supply of labour, driven by misconceptions of what the actual inflation rate was. And at the empirical level this theory predicts that quits will fall as employment
The simplest fact then, which would give support to this notion of supply-side shifts, is whether the quit rate is, indeed, counter-cyclical – as the theory predicts. The empirical evidence is that quit rates are pro-cyclical, which means they rise when the labour market is strong and workers feel confident about their job chances and fall when the labour market is weak and workers fear unemployment. This is exactly the opposite to what would be required to substantiate Friedman’s natural rate theory.
American economist, Lester Thurow summarised this issue succinctly:
… why do quits rise in booms and fall in recessions? If recessions are due to informational mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the real world.
[REFERENCE: Thurow, L. (1983) Dangerous Currents, Oxford University Press; First Edition edition.]
In the Advanced Material Box – The Expectations-Augmented Phillips Curve, we present a more analytical version of the Friedman natural rate hypothesis.
Advanced material – The Expectations-Augmented Phillips Curve
The original Phillips curve related the growth of money wages to the unemployment rate. In linear form we would write this as:
where U is the unemployment rate, the subscript t denotes the current period, and β is the slope of the Phillips curve or the sensitivity of the growth of money wages to changes in the unemployment rate. The simple Phillips curve depicts a negative relationship between the growth of money wage rtes and movements in the unemployment rate. You should recall from Chapter 4 that the convention is to typically use positive signs for all terms and then specify the hypothesis about the direction of the sign of the coefficient separately. So β < 0 tells us that the impact of the changes in the unemployment rate on money wages growth is negative.
As we saw earlier in the Chapter, in the price-mark up framework we have developed, the rate of price inflation (Ṗ) is equal to the growth in money wages (Ẇ) less the growth in productivity (ġ):
If we substitute, the simple Phillips curve (12.A1) into the price inflation relationship (12.A2) we find the price Phillips curve relationship:
This tells us that the rate of general price inflation will be higher the lower is the unemployment rate and the lower is the productivity growth.
Friedman claimed that the simple version of the Phillips curve, whether specified in its original form or in the price inflation form, overlooked the fact that workers would be concerned about the growth in real wages. That is, in considering the state of the labour market (captured by the unemployment rate), they would set their money wage demands after considering what the inflation rate was likely to be.
In other words, the rate of money wages growth would be influenced by the expected inflation rate independently of the unemployment rate.
This conjecture led Friedman to modify the simple Phillips curve to include the influence of inflationary expectations in the wage bargaining process:
The additional term Pdote represents inflationary expectations that are formed by workers, which condition the wage bargaining process. We assume that the coefficient φ lies between 0 and 1. If φ = 0, then the EAPC collapses back into the price Phillips curve (12.A2). If φ = 1, then any change in inflationary expectations is passed on fully to wages growth.
The subscripts might be confusing here. We assume that workers form expectations of the inflation in period t, in the prior period and then bargain for wages growth in the current period based on what they think the inflation rate will be.
Adding this term to the Phillips curve led to the development of the Expectations-Augmented Phillips Curve (EAPC):
Here we have assumed that productivity growth is constant and captured by the term α (< 0).
In terms of Figure 12.11, the inflationary expectations term on the right hand side of Equation (12.A5) shifts the short-run Phillips curve, denoted by the remaining right-hand side terms.
If workers' inflationary expectations increase, then the short-run Phillips curve shifts out and vice-versa.
After the EAPC replaced the simple price Phillips curve as the main framework for considering the relationship between inflation and unemployment, economists began to focus on the value of φ. Many econometric studies were conducted to estimate the value.
Why does the value of φ matter? What would happen if φ = 1?
Friedman defined the long-run steady-state (stable inflation) to occur when the actual rate of inflation was equal to the expected rate of inflation. That is, workers finally caught up with the actual inflation rate and their inflationary expectations captured that knowledge. At this point, he claimed the economy would be operating at the natural rate of unemployment.
In the case, the EAPC would collapse to what is referred to as the long-run steady-state Phillips curve:
Examine this relationship carefully because it looks similar to the short-run Phillips curve (12A.3), except the coefficients are now divided by the term (1 – φ). The slope of this long-run Phillips curve, β/(1 – φ) is steeper than the slope of the short-run Phillips curve, β and the closer φ is to one, the steeper is the slope of the long-run Phillips curve. Once φ equals one, the slope becomes vertical and there is no longer any relationship between inflation and the unemployment rate. In other words, the trade-off vanishes.
Figure 12.12 depicts the two cases. There is a family of short-run Phillips curves (SRPC) (two are shown). The first long-run Phillips curve drawn on the assumption that 0 < φ < 1, is steeper than the short-run curves but non-vertical. It means that in the long-run there is still a trade-off between the inflation rate and the unemployment rate but it is a steeper trade-off than occurs in the short-run before inflationary expectations adjust upwards to the new inflation rate.
The second long-run Phillips curve assumes that φ = 1 and is vertical as a consequence, which means there is no long-run trade off between inflation and the unemployment rate that can be exploited by the government. Under these assumptions, the economy always tends back to the natural rate of unemployment U* once inflationary expectations adjust to the actual inflation rate.
You can now see why economists who became captive of this framework were interested in the value of φ. For Keynesians, a value of φ less than one maintained their policy position that the government could use expansionary fiscal and monetary policy to reduce the unemployment rate should they consider the current rate to be too high.
For Monetarists, a value of φ = 1, was consistent with their claims that the Keynesian aggregate demand management framework was flawed and would only cause inflation should the government try to push the unemployment rate below the natural rate, which was established when inflationary expectations were equal to the actual inflation rate.
Thus, at the time, the focus of the macroeconomic debate was on the value of φ.
To see the way the natural rate of unemployment emerges out of this framework, we can solve Equation (12.A6) for the long-run unemployment rate. After the relevant algebraic manipulation we get:
Which shows there is still a trade-off in the long-run between unemployment and inflation as long as φ ≠ 1. Once, φ = 1, the long-run unemployment rate becomes Friedman’s natural rate and the equation representing that case is written as:
This means that in the Friedman natural rate hypothesis, there are only two factors which influence the long-run or natural rate of unemployment: (a) the rate of growth of productivity captured in the α term; and (b) the short-run responsiveness of wage inflation to movements in the unemployment rate (β). Note that given β is assumed to be negative, the sign on the term -(α/β) is positive.
As a result, the higher is the growth in productivity, other things equal, the lower will be the natural rate. The Monetarists assumed that productivity growth was a structural phenomenon and invariant to aggregate demand policies.
It is clear, that in the Expectations-Augmented Phillips Curve framework, the government could only achieve temporary reductions in the unemployment rate below the natural rate as long as it could drive a wedge between the expected inflation rate and the actual inflation rate, Once the workers’ inflationary expectations adjusted, then the trade-off disappeared and the economy would return to the natural rate of unemployment, albeit with higher inflation.
Continued attempts at driving down the unemployment rate below the natural rate would, according to the Monetarists just result in accelerating inflation.
The introduction of the role of inflationary expectations in the Phillips curve focused attention on how such expectations were formed. What behavioural models could be invoked to capture expectations. There were two main theories advanced by economists: (a) adaptive expectations, and later; (b) rational expectations.
Both theories considered the formation of expectations to be endogenous to the economic system. That is, developments within the system conditioned the way in which workers (and firms) formed views about the future course of inflation.
We consider the implications of these two theories in the Advanced material box – Inflationary Expectations.
Advanced material – The Adaptive Expectations Hypothesis
The assumption that workers formed their expectations of inflation in an adaptive manner allowed the Monetarists to conclude the government attempts to reduce the unemployment rate would only cause accelerating inflation and that the economy would always tend back to the natural rate of unemployment.
The only way the government could sustain an unemployment rate below the natural rate using aggregate demand stimulus would be if they continually drove the price level ahead of the money wage level and forced the workers to continually misperceive the true inflation rate.
The Adaptive Expectations hypothesis is expressed in terms of the past history of the inflation rate. The assertion is that the workers adapt their expectations of inflation as a result of learning from their past forecasting errors.
The following model expresses this idea:
The left-hand side of Equation 12A is the expected inflation rate in the next period (t + 1) formed by workers in period t. Equation 12A has to components on the right-hand side. First, Pdott is the actual inflation rate in the current period. Thus, workers use the current inflation rate as a baseline to what they think the inflation rate in the next period will be.
Second, the term λ(Pdott – Pdotet) captures the forecast error from the previous period. Pdotet was the inflation expectation that workers formed in period t-1 of inflation in period t. The difference between that expectation and the actual rate than occurred is the size of their forecast error. The coefficient λ measures the strength of adaption to error. The higher is λ, the more responsive workers will be to actual conditions.
MORE LATER HERE
[MORE TO COME NEXT WEEK]
THE CHAPTER WILL CONSIDER THE CONCEPT OF HYSTERESIS WHICH QUESTIONED THE RELEVANCE OF THE φ COEFFICIENT. WE WILL THEN CONSIDER THE ARGUMENT THAT TRADE UNIONS CANNOT AFFORD TO BE TOO SUCCESSFUL IN THEIR WAGE DEMANDS WHICH LEADS TO THE CONFLICT THEORY OF INFLATION AND TAKEN TOGETHER WITH THE HYSTERESIS HYPOTHESIS A BROAD CONCEPT OF MACROECONOMIC EQUILIBRIUM WITH A LONG-RUN TRADE-OFF
THEN WE CONSIDER BUFFER STOCKS AND SHOW THAT THE PHILLIPS CURVE CAN BE RENDERED FLAT RATHER THAN VERTICAL WITH THE INTRODUCTION OF EMPLOYMENT GUARANTEES. ALL NEXT WEEK.
Major Anti-Neo-Liberal attack on Australian Treasury Building
The Canberra Times article yesterday (March 14, 2013) – Early morning city flight goes down like a lead balloon – reported on a strange attack on the Australian Federal Treasury Building in Canberra.
The Balloon Attack was probably devised as part of a strategy to regain the macroeconomic policy initiative from the neo-liberals who have infested the ranks of the government.
Clearly, the instigator was sick of the neo-liberal macroeconomic policies coming from the building and decided to do something about it.
You can see more photos of the attack and its aftermath – HERE.
The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.