GLA 1001 MACROECONOMICS MARKETS, I G 03 - GLA1001 - W… · Unemployment benefit plus disutility of work. Labour supply curve, N. S. High unemployment. Low unemployment. N 1. 2. N

GLA 1001MACROECONOMICS:

MARKETS, INSTITUTIONS AND GROWTH

LECTURE 3:THE SUPPLY SIDE – THE DERIVATIONOF THE PHILLIPS CURVE

© Gustavo Indart Slide 1

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


CANADA’S UNEMPLOYMENT RATEJANUARY 1980 TO DECEMBER 2018


Source: Tradingeconomics.com / Statistics Canada.

5.6 %

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


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

WHY THE LABOUR MARKET DOESNOT CLEAR


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


THE WAGE-SETTING CURVE (CONT’D)

As a simplification, the labour supply curve (NS) 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

THE WAGE-SETTING CURVE (CONT’D)

Indeed, the position of the WS curve is determined by wage-push 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

THE WAGE-SETTING CURVE


Real wage, w

Employment, N

Wage-setting

curve, WS

Low wage

High wage

Unemployment benefit plus disutility of work

Labour supply

curve, NS

High unemployment

Low unemployment

N1 N2 N0

• The WS curve relates to the supply side of the labour market

• The efficiency wageindicates the real wage that must be paid to obtain a certain level of effort from workers

• The efficiency wage increases as unemployment falls

For simplicity, the WScurve is assumed to be a straight line

//

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


THE PRICE-SETTING CURVE


Output per worker, Real wage

Employment

Output per worker

Profits per worker

Price-setting

curve, PS

Real wages per worker

Real wage

For simplicity, output per workers is assumed constant

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

//

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:

where 𝝁𝝁 is the mark-up, 𝑾𝑾 is the nominal wage, and 𝝀𝝀 =𝒚𝒚/𝑵𝑵 is output per worker

𝑷𝑷 = 𝟏𝟏 + 𝝁𝝁𝑾𝑾𝝀𝝀

HOW FIRMS SET PRICES


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

𝑷𝑷 = (𝟏𝟏 + 𝝁𝝁)(𝑾𝑾/𝝀𝝀)

PRODUCTIVITY INCREASES, NOMINALWAGES, PROFITS, AND PRICES


A PRODUCTIVITY INCREASE AND THEPRICE-SETTING CURVE


λ, w

N

λ

PSw

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%).

Suppose output per worker increases to λ’ while the mark-up remains unchanged.

Therefore, the PS curve shifts up to PS’.

PS’

λ'

w'

Profits per worker

Wages per worker

Profits per worker

Wagesper worker

//

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


LABOUR MARKET EQUILIBRIUM


Real wage, w

Employment, N

PSwe

WS

Labour force

Ne

Equilibrium unemployment, Ue

If N > Ne, then the real wage would increase along the WS curve in the next wage round

Equilibrium employment (and unemployment) is achieved when PS = WS

At point A, wage and price setters are content with the prevailing real wage (we)A

//

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 price-

setting process by firms across the economy© Gustavo Indart Slide 17

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 𝒚𝒚𝑫𝑫 with a lag

Prices are adjusted immediately after a wage adjustment So prices also respond to changes in 𝒚𝒚𝑫𝑫 with a lag

Therefore, changes in 𝒚𝒚𝑫𝑫 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

THE RESPONSE OF WAGES AND PRICES TOA POSITIVE AGGREGATE DEMAND SHOCK


w

N

PSwe

WS

Labour force

NA

Equilibrium unemployment

A

B

NB

Unemployment decreases in the short run

Δw

IS curve shifts right

C

An autonomous increase in 𝒚𝒚𝑫𝑫causes employment to increase to NB in the short run with no change in nominal wages and prices.

In the next wage round, the nominal wage increases and the real wage reaches wC.

wC

But as soon as the nominal wage is adjusted, firms increase pricesin the same proportion and the real wage goes back to we (but the rate of inflation is now higher).

//

THE DERIVATION OF THE PHILLIPS CURVE

At the medium-run equilibrium level of employment (Ne): 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)


In the WS curve, the real wage increases with employment(i.e., with the output gap):

where 𝑩𝑩 is a constant reflecting the opportunity cost of working, 𝒛𝒛𝒘𝒘 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:

𝒘𝒘𝒕𝒕 = 𝑩𝑩 + 𝒛𝒛𝒘𝒘 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

𝒘𝒘𝒆𝒆 = 𝑩𝑩 + 𝒛𝒛𝒘𝒘

THE DERIVATION OF THE PHILLIPS CURVE: THE WS AND PS CURVES


If 𝒚𝒚𝒕𝒕 > 𝒚𝒚𝒆𝒆, wage setters will attempt to increase the expected real wage by:

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, 𝝅𝝅𝒕𝒕𝑬𝑬) for 𝒘𝒘 just to remain unchanged:

(∆𝐖𝐖/𝐖𝐖)𝐭𝐭 = 𝝅𝝅𝒕𝒕𝑬𝑬

∆𝒘𝒘 = 𝒘𝒘𝒕𝒕 − 𝒘𝒘𝒆𝒆

= 𝑩𝑩 + 𝒛𝒛𝒘𝒘 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆 − (𝑩𝑩 + 𝒛𝒛𝒘𝒘)= 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

THE DERIVATION OF THE PHILLIPS CURVE: THE WS AND PS CURVES (CONT’D)


Therefore, for w to increase at time t, 𝑾𝑾must increase by:

And since, at time t , price setters will increase 𝑷𝑷 (i.e., the rate of inflation, 𝝅𝝅𝒕𝒕) in the same proportion as the actual increase in 𝑾𝑾:

Then, here is the Phillips curve:𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕𝑬𝑬 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

𝝅𝝅𝒕𝒕 =∆𝑾𝑾𝑾𝑾 𝒕𝒕

∆𝑾𝑾𝑾𝑾 𝒕𝒕

= 𝝅𝝅𝒕𝒕𝑬𝑬 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

THE DERIVATION OF THE PHILLIPS CURVE: THE WS AND PS CURVES (CONT’D)


𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕𝑬𝑬 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

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:

𝝅𝝅𝒕𝒕𝑬𝑬 = 𝝅𝝅𝒕𝒕−𝟏𝟏

Therefore, the adaptive expectations Phillips curve shows that current inflation is equal to lagged inflation plus the impact of the output gap:

𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕−𝟏𝟏 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

THE DERIVATION OF THE ADAPTIVEEXPECTATIONS PHILLIPS CURVE


So the adaptive expectations Phillips curve is:

𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕−𝟏𝟏 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆

If the economy is in medium-run equilibrium (i.e., if 𝒚𝒚𝒕𝒕 = 𝒚𝒚𝒆𝒆), then 𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕−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

THE DERIVATION OF THE ADAPTIVEEXPECTATIONS PHILLIPS CURVE (CONT’D)


THE DERIVATION OF THE ADAPTIVEEXPECTATIONS PHILLIPS CURVE


w

PSwe

WS

Ne Nπ

y

NH

2%

PC1

ye

2%4%

yH

A

B

PC2

6%

𝝅𝝅𝒕𝒕 = 𝝅𝝅𝒕𝒕𝑬𝑬 + 𝜶𝜶 𝒚𝒚𝒕𝒕 − 𝒚𝒚𝒆𝒆A

Suppose that 𝝅𝝅𝟎𝟎 = 𝟐𝟐𝟐, so 𝝅𝝅𝟏𝟏𝑬𝑬 = 𝟐𝟐𝟐. Then at point A, 𝝅𝝅𝟏𝟏 = 𝟐𝟐𝟐.

𝝅𝝅𝒕𝒕𝑬𝑬 = 𝝅𝝅𝒕𝒕−𝟏𝟏B

Therefore, PC1 is the Phillips curve corresponding to 𝝅𝝅𝟏𝟏𝑬𝑬 = 𝟐𝟐𝟐.

Suppose N increases to NH (and y to yH) in period 1 and wage setters increase nominal wages by an additional 2% (i.e., a total of 4%). Therefore, 𝝅𝝅𝟏𝟏 = 4% (point B on the PC1 curve).

Since 𝝅𝝅𝟏𝟏 = 4% in period 1, the PCcurve shifts up to PC2 in period 2.

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GLA 1001 MACROECONOMICS MARKETS, I G 03 - GLA1001 - W… · Unemployment benefit plus disutility of work. Labour supply curve, N. S. High unemployment. Low unemployment. N 1. 2. N