Inflation and unemployment I

Inflation and unemployment are probably, along with GDP, two of the most used economic indicators ofhow well a country is doing. Inflation measures increases in the price levels, which can hurt the economyin multiple ways when not under control. Unemployment measures the percentage of people in a countrythat, being able to work, are unemployed. Both are to be carefully measured, in order for governments tobe able to keep them under control.

In this first Learning Path of our series on inflation and unemployment, well learn about what these twoconcepts are, and how to tackle them.

Definitions:Inflation, a continuous general rise in the level of prices;Unemployment, what it is and how to measure it.Government policies:Economic policies, steps taken by governments to fix the economy;Fiscal policy, when government uses public finances;Monetary policy, when banks use special tools to kick-start the economy;Supply-side policies, aimed at increasing the productivity of a country.

Inflation

Inflation is the economic term that refers to a continuous general rise in the level of prices over the time.This will consequently be translated into a fall in the value of money and a loss in purchasing power. Themain measures to calculate inflation are Consumer Price Indexes and the Gross NationalProduct deflator. Oil prices can be an alternative inflation indicator as this product is used throughout theworld for many purposes and it virtually affects all the elements of an economys price formation. It isimportant to understand that when inflation rates remain constant in a positive figure, e.g. 1%, over aperiod e.g. 10 years, and even if inflation didn't change, purchasing power would ultimately be lost.

As an economic phenomenon, inflation can be the result of a different set of causes. The conventional distinctions made between these causes are:

Demand-pull inflation

Demand-pull inflation occurs as a result of an increase in aggregate demand and the inability of an economy to produce enough to meet the demand increase. Aggregate demand is formed by consumer spending, government spending, investment and net exports, and any increase in one of these

components without its correlative effective response will create inflation. Demand-pull inflation is more likely to occur when employment of resources is closer to its full usage and the short run aggregate supply is most inelastic. Therefore, inflation is mainly caused by the inability of the economy of attendingan increase in demand. Increases in aggregate demand might be caused by:

-Expansive monetary policies: when monetary authorities conduct an expansion of money supply, there ismore money available, consumption is incentivized and thus there is an increase in aggregate demand that creates inflation. If economic growth is below money growth there will be inflation. Monetarists defend monetary policies as a way to efficiently control inflation rates counteracting economic growth.-Expansionary fiscal policies: this kind of policies could indirectly increase aggregate demand by increasing consumers disposable income or directly through government intervention.-Increase in exports: exports may rise for two main reasons. The first one is the result of a countrys currency depreciation; there will be an increase in exports, as these products will seem cheaper to foreign countries, thus increasing aggregate demand. The second one is caused by an increase of wealth in the foreign countries, which will allow them to import more of other countries products. Both of these will result in an increase in the aggregate demand and consequently cause inflation.

-Consumers confidence increase: whenever consumers feel confident on the economic situation they willtend to decrease their level of savings and consume more and hence increase aggregate demand.

Cost-push inflation

Cost-push inflation occurs as a response of agents raising prices to maintain their profit margins if there are higher production costs. Production costs may increase because of:

-Rising labor costs: new government measures can imply an increase in the costs of hiring (adjustment costs, see Cahucs adjustment costs model) or increases in the payroll taxes. Trade unions can also force firms to increase workers wages by using negotiation powers, as explained by the Layard-Nichell NAIRU model.-Rising raw materials costs: raw material costs rise can result from different causes. Depreciation of their own currency can affect firms which depend on imported raw material for their productive process, as buying the same materials will cost them more of their domestic currency. Government regulations once more play an important part as subsides, policies and taxes can affect both raw material prices and the overall prices. Raw materials costs can also increase as a result of natural catastrophes. It is also important to remember the part that the price of oil plays in price formation, as the current world economy is highly dependent on it.

Built-in inflation

Built-in inflation, sometimes referred as wage price spiral or expectations-induced inflation (explained by the expectations-augmented Phillips curve), is the consequence of agents previous years experience and their ability to build rational expectations. In an inflationary price rates tendency, agents will try to anticipate the following price increase. On one side, workers will demand higher wages as a measure to avoid losing purchasing power. On the other side, firms will increase prices in order to maintain their profit margins. This is sometimes referred to as the wage price spiral as one will lead to the other, resulting in inflation inertia.Its important to see that inflation plays a key role in the economy. As seen in the Phillips curve, governments face a trade-off between different levels of unemployment and inflation. In pre-elections time, governments may be tempted to decrease unemployment levels at the cost of a higher inflation, in order to make it appear as if the economy is better than it is, and so gain votes. This is why monetary policies should be held by an independent authority, which in most countries translates into a central bank.

Unemployment

Unemployment refers to the situation of a jobless worker. The unemployment rate measures the numberof unemployed workers as a percentage of the labor force. Massive unemployment levels are the resultof situations of economic crisis followed by depressions, and are the result of a large economicreadjustment studied in business cycles theory. During the Great Depression, 1929-1939, unemploymentinsurance benefits were introduced in the U.S. in order to reduce the consequences of highunemployment levels. This measure was introduced to prevent workers misery, and as a way ofmaintaining effective demand, as stated by the Keynesians fiscal policy proposals.

Unemployment can be divided into different types depending on its cause and depending if it is involuntary or voluntary:

Involuntary Unemployment

Classical unemployment is explained as the situation that exists in the labour market when the number ofpeople able and willing to work at the prevailing wage levels exceeds the number of vacancies available. In simple words, demand and supply do not meet. This occurs when real wages are higher than those corresponding to equilibrium at full employment levels. This type of unemployment was explained by theClassical school (hence its name) as those cases in which certain imperfections prevent unemployed people from reducing their aspirations to lower their wages so that firms will believe it is interesting to

create new jobs and hire people.Frictional unemployment, also referred to as searching unemployment, happens when a person is temporarily unemployed between jobs. This is the unemployment in its theoretical lowest possible level. Itoccurs even in full employment conditions because a considerable number of people are moving from one job to another. The only way to reduce this kind of unemployment is for economic institutions to make information more available.

Structural unemployment occurs when people are unable to find jobs in which their skills can be useful because their skills are no longer demanded, and thus creating an excess of labour supply generally at well-defined locations. As structural unemployment is not caused as a result of a general decline in demand, it cannot be softened with reflationary type measures, but instead ad hoc economic policies are needed. These types of policy include retraining of workers and reallocation of industries. The main difference between structural and frictional unemployment relies on the time horizon, as the former is a long lasting phenomenon while the latter a short term one.Seasonal unemployment is generally of short duration and it is generated on a regular basis as a result of the different seasonal activities through the year, especially regarding agriculture activities and tourism.

Disguised unemployment is not actually unemployment. It refers to a characteristic situation of countries that are both underdeveloped economically and highly bureaucratized, in which there is a high number ofworkers with low levels of productivity that would be employed if the country had a better organization or better technology levels.

Voluntary Unemployment

Voluntary unemployment consists of workers that are jobless as they are reluctant to work due to economic, sociological or psychological reasons.

Economic policies

Reducing unemployment and stimulating the economy has been one of the biggest, if not the only,concerns of governments since the dawn of economic science. Economic policies have been very muchtheorized, and by many doctrines. As a result, a rich and plentiful literature has been developed on thistopic. We will discuss the main economic policies:

1. Policies in order to reduce labour supply:By reducing labour supply the government is reducing the number of people that are legally suitable to work, what is known as the labour force, and by doing so it indirectly reduces unemployment. This kind of policy is mostly effective when targeted over a group that has a higher unemployment rate than the

average. If a country suffers from high unemployment amongst the young population, by increasing the minimum age of employment, governments will decrease unemployment levels. It will also be useful evenif the targeted group has a low level of unemployment, as there will be new vacancies that unemployed can fill. Other examples of this policy include retirement age reduction and the increase of military service duration. However, as it can be easily seen, these policies are what Frenchmen would call trompe-loeil, that is, they reduce or eliminate the symptom (unemployment), but without treating the disease (the economy malfunction).

2. Policies to stimulate labour demand:There are different policies depending if they affect demand of labour by using demand-side policies orsupply-side policies.-Demand-side policies stimulate the economy by increasing the demand for goods and services, thus incentivising firms to produce more, which will result in firms hiring more workers. Expansive fiscal andmonetary policies are the tools that governments can use. This kind of policies is considered by their different advocates (Keynesian economists would implement fiscal policies whilst monetarists would implement monetary policies) to be most effective at reducing cyclical unemployment during economic depression.-Supply-side policies focus on firms and their production of goods and services, in order to increase the supply (output) of the economy. These policies aim at the costs of labour and the production function. If the cost decreases there will be more money available to increase the workforce. This kind of policies is nowadays regarded by the latest economic doctrines as the only real possibility to ensure a perdurable economic growth. However, they are less attractive than demand policies since they need time to be implemented and to generate actual effects on unemployment and growth.3. Structural reforms:These policies aim at reducing real wages. With lower wages, the firms will be able to hire more workers.Examples of this policy are: minimum wage reduction, unemployment benefit reduction and removing differences between insiders and outsiders.

4. Income policies:A pact between the firm and its workers allow for reduction of real wages, this way firms can hire more labour force, which reduces unemployment levels.

5. Labour distribution policies:Employees will work fewer hours, they will earn less, and so a greater amount of employees will be able to be hired. Marginal productivity is also increased by these policies. However, these policies are not really popular.

It is important to notice that not all policies are effective in the same time frame nor their effects remain over the same period. While supply-side policies and structural reforms have an effect in the long term, the rest have an effect in a shorter time, being this the reason why they were thoroughly studied by Keynesians and monetarists. However, contemporary economic doctrines, such as New Classical Macroeconomics and New Keynesian Economics have proven their inefficiency, thus turning back to supply-side policies as the only plausible solution.

Fiscal Policy

Fiscal policies are demand-side economic policies through which the government acts over its incomeand expenditure in order to influence the levels of income, output and unemployment of the economy.The government may do this via income taxes and unemployment benefits, or by discretionary measures,such as taxes on spending and increasing public spending. By increasing demand, firms are incentivizedto produce more and therefore to hire more workers.

Keynesianism believed fiscal policies as the best tool to control the economy of a country, especially to reduce cyclical unemployment. Monetarism and following economic doctrines as New Classical Macroeconomicsand New Keynesian Economics consider them to be ineffective in the long run, as demand cannot be increased continually.

Monetary policy

Monetary policies are demand-side economic policies through which the central bank of a country actson the amount of money and interest rates in order to influence on the income levels, output andunemployment in the economy, being the interest rate the link binding money and income. The maintools used by monetary policies are open market operations, loans to commercial banks, and the use ofreserve requirements. Ceteris paribus, an increase (decrease) in the money supply or a decrease(increase) in interest rates will have a positive (negative) ripple effect on private spending (consumptionand investment). This will finally increase (decrease) production and employment. However, this willincrease prices, which may lead to rapidly increasing inflation.

Monetarism is the main economic doctrine that defended this kind of policy. However, Keynesianism, New Classical Macroeconomics and New Keynesian Economics, criticize it and do not believe in their effectiveness as it has been demonstrated that increasing money supply will result in inflation and counteracting the positive effects of this policy. As Milton Friedman said, inflation is always and everywhere a monetary phenomenon.

Supply-side policies

The purpose of supply-side economic policies is to increase the amount of supply and therefore theproductive potential that the economy is able to produce. This kind of policies shift rightward the long-run aggregate supply curve and outward the production possibility frontier. They can be divided inpolicies that act over the production function, and those that act over the cost of labour.

On the one hand, the former are targeted at increasing production levels and examples of this kind of policies include incentives to technological improvement and capital stock increase. On the other hand, the latter are targeted directly on decreasing the cost of labour and this way more workers can be hired. Examples of these policies include reduction of social security contributions, increase of subsidies for firms, reduction of indirect taxes etc.Supply-side policies have been praised by many economists including Nobel laureate Robert Mundell. There have been many studies regarding their effectiveness, and although it is true that they take effect in the long run, they are the only ones that can lead to perdurable economic growth. Furthermore, critics coming frommonetarists and Keynesians have questioned the effectiveness of other policies, such as fiscal and monetary, respectively, pointing out how they are only useful in the short run, but are useless or even harmful for the economy in the long run. In fact, the last two great economic doctrines, New Classical Macroeconomics andNew Keynesian Economics, have proven the ineffectiveness of fiscal and monetary policies, leaving supply-side policies as the only ones that are useful.

Inflation & unemployment II

There is a relationship between inflation and unemployment that can be easily analysed. Governmentsaround the world take this relationship very seriously, since there will always be a trade-off whenimplementing economic policies aiming either at reducing unemployment or keeping inflation at bay. Eventhough this relationship was first analysed by Alban William Housego Phillips in 1958, it has sinceevolved, taking into consideration adaptive and rational expectations.

In this Learning Path, well learn about the Phillips curve and how expectations have made it evolve.

Early developments:Phillips curve, which shows the relationship between inflation and unemployment;NRU and NAIRU, two different views of the unemployment at equilibrium.Monetarist view:Adaptive expectations, using past expectations to form present ones;Expectations augmented Phillips curve.NCMs view:

Rational expectations, introducing future predictions;NCMs view of the Phillips curve, a newer version.

Phillips curve

In 1958, A. W. Phillips wrote a paper on Economica (London School of Economics), entitled TheRelation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom,1861-1957. Analysing data concerning money wages and unemployment rates in the UK, Phillipsmanaged to draw a curve representing the inverse relation between these variables. It must be saidthat Irving Fisher had already pointed out a relationship between price levels and unemployment in hispaper A Statistical Relation between Unemployment and Price Changes, 1926 (cleverly renamed lateras I Discovered the Phillips Curve). The Phillips curve has evolved following other empirical studies,and is widely known nowadays, even though it has also been criticized.

In his article, Phillips drew a curve showingthe inverse relation between the rate ofchange of money wage rates, as apercentage change per year ( ) and theunemployment rate (U).

Two important things must be noted: thepoint where the curve crosses the abscissa,and the fact that the ordinate seems to workas an asymptote. The importance of thepoint of crossing must be highlighted(around 5,5%), since it is the rate of unemployment that an economy will have for a zero increase in the money wages. This point will be named, in further developments of the Phillips curve, Natural Rate of Unemployment and Non-Accelerating Inflation Rate of Unemployment (NAIRU). Regarding the asymptote, as the author pointed out, there was no data of higher rates of change in money wage, nor lower unemployment rates. It can be concluded that unemployment cannot be lowered beyond a certain level.Two years later, Richard G. Lipseywould publish a paper in the same journal deepening the mathematicsregarding the curve, as well as expanding Phillips research by doing further econometrical tests.

Also in 1960, Paul A. Samuelson and Robert M.Solow, in their Analytical Aspects of Anti-InflationPolicy, studied a similar relation, in this case usingdata from the United States. Although theyused inflation ( ) instead of the rate of change inmoney wages, they came up with similar results.Even though the curve might seem different becauseof the scale used, the unemployment rate at pricestability is the same as at money wage stability(around 5,5%), and there seem to be no way to lowerunemployment beyond a certain level (around 1%).It was in this paper that the Phillips curve wasconsidered a menu of choice for the first time. Thismeant that, concerning policy making, governmentswould be able to choose between a low rate ofunemployment with high inflation, and a higher rate of unemployment with lower inflation. However, as the authors pointed out, this menu had to be used only in the short-run, since certain policies or economic events might change the shape of the curve in the longer run.

In the mid 50s, and until the late 60s, the adaptive expectations hypothesis became popular, especially because of the works by Phillip Cagan and Milton Friedman. This hypothesis would endure almost unquestioned until the late 60s and early 70s, when economist Robert Lucas (among others) brought forward a rational expectations hypothesis, from earlier works by J. F. Muth.

NRU

The term natural rate of unemployment was introduced by Milton Friedman in 1968, in his article TheRole of Monetary Policy, following his presidential address delivered at the annual meeting of theAmerican Economic Association, in 1967. It is based in Knut Wicksell concept of natural rate, whichdefines how there will be no permanent changes in the considered variable below or above its naturallevel.

The natural rate of unemployment defines the level at which unemployment will remain, no matter how great the effects of monetary policy. The only way to permanently keep unemployment under its natural rate is to resort to higher and higher inflation rates, which in turn would be highly hazardous for the economy. This can be easily understood using an expectations-augmented Phillips curve.

The term NAIRU (non-accelerating inflation rate of unemployment) is a term first used by James Tobin in1980, in his article Stabilization Policy Ten Years After. It refers to the level of unemployment at which the economy settles if monetary policy is held stable. In these terms, it can be associated to Friedmans natural rate of unemployment.The NAIRU is based on empirical evidence regarding inflation and unemployment. Indeed, in most countries, inflation rises when unemployment is low because of the higher demand this implies; correspondingly, inflation falls when unemployment is high. This relation explains how unemployment may be above or below the NAIRU level not only because of the effects of monetary policy, but also because other factors such as production costs or trade unions negotiation processes. The Layard-Nickell NAIRU model explains it quite simply.Even though the term NAIRU is usually merged in the economic literature with the term natural rate of unemployment, there are a few differences between the two. These differences are summarized in the following grid:

Natural rate of unemployment (NRU) NAIRU

Theoretical starting point

-perfect competition -imperfect competition

Origins of deviation

-solely in labour market rigidities-in labour market rigidities;-supply-side inflation

Inflationist mechanism

-monetary policies-monetary policies;-supply-side inflation

Type of unemployment

-voluntary (therefore NRU can be assimilated to level of full employment)

-voluntary;-involuntary

Uniqueness of equilibrium

-unique-multiple equilibriums when considering open economies

Adaptive expectations

Adaptive expectation models are ways of predicting an agents behaviour based on their pastexperiences and past expectations for that same event. They are first used by Irving Fisher in his bookThe Purchasing Power of Money, 1911, and further developed in the 1940s and 1950s, especially byPhillip Cagan in his article The Monetary Dynamics of Hyper-Inflation, 1956 and, most famously,

by Milton Friedman in 1957, in his book A Theory of the Consumption Function.

Models are usually based around the following formula:

Et xt+1 is our expectation (E) in year for a variable x in the year t+1. It is based on our expectation fromthe year before (t-1) for variable x in our current year, and a weighted proportion of our past expectations. Remember that our expectations from last year were, in turn, based on those of the year before, so all our expectations from the first time we ever dared assume anything are contained within the equation. will depend on how much we were off last year versus this year: if our predictions are proving to be volatile, we will be more likely to adjust them. It will also depend on how much groundbreaking new information we have received, rendering previous expectations useless. Basically, it depends on how much we feel we might have been off last year when we predicted things for next year.

The easiest way to know how adaptive expectations work, is to understand the expectations-augmented Phillips curve. Using also this same curve, it is also easy to understand how rational expectations work.

EA Phillips curve

The expectations-augmented Phillips curve introduces adaptive expectations into the Phillips curve.These adaptive expectations, which date form Irving Fishers book The Purchasing Power of Money,1911, where introduced into the Phillips curve by monetarists, specially Milton Friedman. Therefore, wecould say that the expectations-augmented Phillips curve was first used to explain the monetarists viewof the Phillips curve.

Adaptive expectations models led to an important shift in the perception of a governments ability to act. Under Keynes money illusion, changes in nominal variables (prices, wages, etc) were accepted by agents as real despite overall purchasing power remaining stable.However, monetarism embraced the adaptive expectations theory to mean that people would stumble once or twice on the same stone, but not a third. In this way, if the government decided on an expansionist monetary policy, inflation would rise and unemployment would fall, based on the Phillips curve. However, a second or third time around, agents would be quick to associate higher inflation with rising salaries in a vicious circle, and adjust their behaviour accordingly based on past experiences. Theywould anticipate that inflation would drain their purchasing power accordingly, and monetary policy would have little effect. If we see this graphically:

Initially, unemployment and inflation are at point A. The government decides to embark on an expansionist monetary policy, whichfloods the markets with inexpensive credit, incentivising consumption. Expectations shift to point B along the Phillips curve: unemployment is reduced through economic stimulus with a trade off in the form of inflation. However, after a short period, agents will begin to associate expansionist policies with inflation, which means a drain on

their resources, and they will push for higher wages. This will stop the consumption stimulus and also deincentivise hiring. Eventually, agents will shift their expectations curves to point C. A second time around, D will be achieved, leading more or less rapidly to point E. This is why, in the long term, inflationhas little effect on unemployment and vice versa. Expansionist monetary policy will lead directly to inflation, with no permanent effect on unemployment.

In summary, monetarists sustained that the Phillips curve will hold up in the short term, but not in the long term. In the long term, the Phillips curve is completely vertical and determines the natural rate of unemployment, as Friedman puts it in his article The role of Monetary Policy, 1968.

Rational expectations

Rational expectation models are those where an agents future predictions affect the value they assign toa variable in their current time period. In this sort of self-fulfilling prophecy, expectations become truths,and errors in forecasting future variables become random. This makes those forecasts valid, becausepresent expectations about the future become dependent variables of future values. This model wasdeveloped and put forwards by John Muthin two articles: Optimal Properties of Exponentially WeightedForecasts,1960, and Rational Expectations and the Theory of Price Movements, 1961 and latersummarised by Peter Whittle in 1963, before becoming influential in Robert Lucas work in the 1970s.Particularly, Lucas developed the use of rational expectations in his article Expectations and theNeutrality of Money, 1972, in which he usedEdmund Phelps island parable, though applying rationalexpectations, instead of adaptive expectations.

Mathematically, rational expectations can be represented as:

Which simply means that the value of x today will be the value that we expected it to be plus a random error.Essential to this hypothesis is the fact that individuals have perfect information and markets are perfect and tend towards equilibrium. This places us firmly back in the realm of neoclassical economics, whose main ideas where retaken by New Classical Macroeconomics.

NCM's Phillips curve

New Classical Macroeconomics takes expectations one step further than monetarists did whenusingadaptive expectations. Rather than supposing that agents will learn to adjust their behaviour basedon past experiences, they apply rational expectations, and directly assume that:

All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;All agents assume that markets naturally reach an equilibrium;Information is perfect: market force drivers are common knowledge.This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:As New Classical Macroeconomicsviews it, agents are able to anticipatefuture events without needing to haveexperienced them previously. This timearound, agents will anticipateexpansionist monetary policies, andtherefore skip point B. Agents havesufficient working knowledge of theeconomy and monetary policy istransparent enough for agents todirectly associate a fall in interest rateswith a rise in inflation. Therefore, theywaste no time in asking for salaryraises (the change on inflationexpectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever

reached. Expansionist monetary policy is not even effective in the short term. In the very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.

Inflation & unemployment III

Inflation and unemployment can be very harmful to the economy, and so governments will always try tocontrol them by implementing economic policies. However, knowing how a problem originates is alwayshelpful when trying to fix it. This is the reason why economists have created an incredible amount oftheories and economic models that try to explain how these inflation and unemployment behave.

In this Learning Path well take a look at a few economic models that explain, at least to some extent or in some given context, inflation and unemployment.

NCMs view:NCM, an economic doctrine that appeared in the early 1970s;NCMs Phillips curve, which incorporates rational expectations;Cahucs adjustment costs model, which analyses adjustments in employment levels.NKEs view:NKE, which appeared in the late 1970s, and focused on the analysis of inflation;NAIRU, the non-accelerating inflation rate of unemployment;Layard-Nickell NAIRU model, based on wage determination.Prices and growth:Menu costs are costs that result from price changes;Mankiws menu costs model, Gregory Mankiws view on the issue;Business cycles, which also explain the level of unemployment.

NCM

New Classical Macroeconomics (NCM) arise from the development of the neoclassicaleconomics principles, such as market clearing and optimization behavior by economic agents, whichrelate this school to monetarism. Its rise as a doctrine can be traced to the work in the early 1970s of itslead economist Robert Lucas (Chicago School).

Indeed, Lucas developed in 1973 what is known as rational expectations, an improvement on the adaptive expectations hypothesis used by monetarists, which changed the way macroeconomic analysis (and econometric analysis) is undertaken. These rational expectations are still used nowadays inmacroeconomics.Regarding policymaking, the NCM believes that no government intervention concerning demand is beneficial for the economy, not even in the short run. They argue that government can promote growth and stabilize the economy only through supply-side policies.Economists such as Thomas Sargent, Edward Prescott, Neil Wallace and Robert Barro are amongst the most renowned NCM economists, whose theories are usually opposed to those of the followers of New Keynesian Economics.

NCM's Phillips curve

New Classical Macroeconomics takes expectations one step further than monetarists did whenusingadaptive expectations. Rather than supposing that agents will learn to adjust their behaviour basedon past experiences, they apply rational expectations, and directly assume that:

All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;All agents assume that markets naturally reach an equilibrium;Information is perfect: market force drivers are common knowledge.This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:As New Classical Macroeconomics viewsit, agents are able to anticipate futureevents without needing to haveexperienced them previously. This timearound, agents will anticipateexpansionist monetary policies, andtherefore skip point B. Agents havesufficient working knowledge of theeconomy and monetary policy istransparent enough for agents to directlyassociate a fall in interest rates with a risein inflation. Therefore, they waste no timein asking for salary raises (the change on

inflation expectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever reached. Expansionist monetary policy is not even effective in the short term. Inthe very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.

Cahuc's adjustment costs

The static theory of labour demand does not specify how, or how long adjustments between productionfactors take. It is therefore necessary to consider the notion of adjustment costs, such as costs incurredby a company to change the number of factors.

We will follow the lines followed in the model of adjustment costs seen in Le march du travail, 2001, by Pierre Cahuc. These adjustments involve production costs that do not correspond to the activity itself. There are two kinds of adjustment costs:

-Internal adjustment costs: those caused by the loss of efficiency due to reorganization within the company (for example, training for use of new machinery, training of new employees to existing machinery, etc.).

-External adjustment costs: those who can be differentiated from production variations (for example, hiring experts to implement the changes, layoff payments, etc.).

As Cahuc explains, previous studies on the labour markets in the United States and France allow us to compare the situation of two types of markets:

-Recruitment costs are higher than firing costs in the U.S.;

-Firing costs are higher than recruitment costs in France;

-Recruitment costs in the U.S. are higher than in France;

-Firing costs are higher in France than in the U.S.

Furthermore, these studies conclude that these costs increase with the level of wage and/or training.

Employment protection by the public sector is less rigorous in the U.S., Canada or the U.K. than in

France, Germany and southern Europe. Furthermore, these studies conclude that much of the higher cost of firing in Europe is due to administrative or regulatory costs (due to the legislation of each country).

LINEAR FORMULATION:

In most jobs, costs are represented by a symmetric convex function (usually quadratic). However, this does not explain asymmetrical adjustments and discontinuous employment. Thus, we see the linear formulation, which is commonly used nowadays.

This representation will show us how companies sometimes hire or fire employees, or remain as they are.

ch and cf represent hiring costs (h) and firing costs (f). Adjustment of employment will therefore be asymmetricif ch cf.EMPLOYMENT ADJUSTMENT:

It is possible to differentiate the effects of ch and cf when adopting a linear function. Furthermore, the linearity will see how the adjustment in the levels of labour can be immediate.We define the adjustment cost function as:

The producers problem is choosing the level oflabour that maximises its profits:

(r=is the rate at which future profits are actualized to present value)

The employment level is given by the equation:

which translates into the following conditions:

In all other cases, the producer maintains its level of staff. As we assume w, r, ch and cf constant, we can define employment levels Lh and Lf as:

The company adjusts its level of workersLh (respectively Lf) if this is higher(respectively lower) than the initial level ofemployment L0. If not, it means that L0 ismaintained between Lh and Lf, its optimallevel:

GRAPHICAL ANALYSIS:

The curves in the lower half of the adjacentfigure represent the relationship between initialemployment and final employment levels. Theconclusions we can derive from this modelare:

- c f: An increase in firing costs (U.S.spending levels to levels of FR.) Prevents staffadjustment downwards, and no incentive tohire;

The producer will hire labour as long as its productivity is higher than the adjustment costs of hiring.Producer will start firing employees as soon as productivity falls to the point where firing employees becomes profitable.

The producer will hire labour as long as its productivity is higher than the adjustment costs of hiring.

- c h: Increased recruitment costs (FR. spending levels to U.S. levels) prevents new hires;- c h: A lower recruitment cost always has positive effects on employment because it increases the optimal level of employment Lh;Therefore, this model explains:

higher unemployment in France (for little flexibility when firing);

when wages are equal in both economies, U.S. production levels will be higher;

in recessions, the situation is worse in France because its hard to fire employees;

in times of expansion, the situation is worse in the U.S. because its hard to hire.

The main conclusion that can be derived from this model is that proper management of the costs of hiring and firing ensures greater stability in the demand for labour.

NKE

The New Keynesian Economics seeks to provide Keynesianism with microeconomic foundation support.This contemporary economic doctrine comes as a response to the critiques that Keynesianism receivedfrom theNew Classical Macroeconomics (NCM) advocates.

New Keynesian Economics can be traced back to late 70s when the first foundations were built by economists such as Stanley Fischer, Edmund Phelps and John Taylor. One of the best economists to characterize the New Keynesian Economics is Gregory Mankiw, as he has made many contributions to this doctrine.The main issue of this economic doctrine is to explain why changes in the aggregate price level are sticky. While in NCM competitive price-taking firms make choices on how much output to produce, andnot at what price, in New Keynesian Economics monopolistically competitive firms set their own individualprices and accept the level of sales as a constraint. From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. One ofthem is used both by NKE and NCM approach to macroeconomics, this is the assumption that economic agents, households and firms have rational expectations. However New Keynesian Economics considers that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents cant have a full scope of the economic reality their information will be limited, and there will be no reasons to believe that other agents will change their prices, and therefore maintain their expectations unchanged. Expectations are a crucial part for price determination, as they remain unaltered, so will the price, what leads to price rigidity. For firms, price

rigidity may also come from whats known as menu costs, this is, costs that result from price changes.As a result of this price stickiness, which implies a slow adjustment of the economy and can lead to undesired levels of unemployment, government intervention is justified to stabilize the economy, by usingboth fiscaland monetary policies. However, this intervention ought to be minimal, much lower than New Keynesian Economicss predecessors, the Neoclassical Synthesis, would argue for.

NAIRU

The term NAIRU (non-accelerating inflation rate of unemployment) is a term first used by James Tobin in1980, in his article Stabilization Policy Ten Years After. It refers to the level of unemployment at whichthe economy settles if monetary policy is held stable. In these terms, it can be associatedto Friedmans natural rate of unemployment.

The NAIRU is based on empirical evidence regarding inflation and unemployment. Indeed, in most countries, inflation rises when unemployment is low because of the higher demand this implies; correspondingly, inflation falls when unemployment is high. This relation explains how unemployment may be above or below the NAIRU level not only because of the effects of monetary policy, but also because other factors such as production costs or trade unions negotiation processes. The Layard-Nickell NAIRU model explains it quite simply.Even though the term NAIRU is usually merged in the economic literature with the term natural rate of unemployment, there are a few differences between the two. These differences are summarized in the following grid:

Natural rate of unemployment (NRU) NAIRU

Theoretical starting point

-perfect competition -imperfect competition

Origins of deviation

-solely in labour market rigidities-in labour market rigidities;-supply-side inflation

Inflationist mechanism

-monetary policies-monetary policies;-supply-side inflation

Type of unemployment

-voluntary (therefore NRU can be assimilated to level of full employment)

-voluntary;-involuntary

Uniqueness ofequilibrium

-unique-multiple equilibriums when considering open economies

Layard-Nickell NAIRU model

The Layard-Nickell NAIRU model emerged as a reply from New Keynesian Economics to the natural rateof unemployment, devised by Milton Friedman as a criticism of the Neoclassical Synthesis Phillips curve.This NAIRU model comes from an article entitled Unemployment in Britain, 1986, by Richard Layardand Stephen Nickell.

Indeed, the Layard-Nickell NAIRU model was able to explain the paradigm shift by moving away from assumptions of a perfectly competitive labour market into a model based on wage determination by means of trade union bargaining. In a perfectly competitive market, salaries and the prices of goods are traditionally determined by considering that the price of a product is fixed via its marginal cost (and, in the case of imperfect competition, a mark-up).Trade unions will bargain withemployers in order to get higherreal wages for the workers. In theadjacent figure, it can be seen howthe more people is employed andrepresented by trade unions, thehigher real wages will be, thusmarking the upward sloping BRWcurve (Bargained Real Wages). Theexplanation is quite simple: fromthe workers point of view, higheremployment rates mean loweropportunity costs derived from jobseeking; on the other hand,employers are more likely to pay higher real wages when the economy is in expansion, since they dont want to lower production (which would happen if workers went on strike.Once trade unions have bargained an adequate real wages, the employer will fix prices (P) considering both costs of production and mark-ups (). If we assume real wages (W) as the only production cost (which is a reasonable assumption, since wages usually make up for a large portion of production costs),and we take into consideration also marginal productivity (MPL), we can find out what would be the pricechosen by the employer:

and assuming the following:

we come up with the real wage:

This real wage (called Price-determined Real Wage, PRW) can be represented graphically as shown in the adjacent figure. Note that its a horizontal line, since for any given BRW, and at any employment level, the mark-up would be the same as well as the marginal productivity.

The reciprocal relation betweenwages and inflation is determined.The distance from the level ofemployment at equilibrium (L*) andthe total labour force (LT), is theNAIRU. When, for example, thelevel of employment increases, tradeunions will be able to negotiatehigher real wages (A). Since theemployer wont be willing to accepta decrease in its profits, the mark-upwill be maintained, which will raiseprices. Therefore, an increase onemployment, which will take the employment level higher than the NAIRU, will end-up increasing aggregate price-levels.Anything that affects wage formation or unemployment rates is likely to affect inflation. Thus, fixing salaries above what they would be in a competitive labour market leads to higher prices, which increases

inflation and reduces real wages. In a similar fashion, an increase in unemployment benefits drives salaries above what would naturally be determined, with similar effects. In this battle of the mark-ups between employers and employees, the NAIRU rises. This aims to explain the structural factors between some countries having a higher or lower natural unemployment rate than others. Empirically, it is interesting for example to note that only 15% of salaries in the US are fixed by trade unions, whereas in some countries of Europe, such as France, Italy or Spain, famed for having a naturally high NAIRU, almost 75% of employees are covered by a collective agreement.

Menu costs

Menu costs are costs that result from price changes. An easy way to understand menu costs is bymeans of a typical example: restaurants. When a restaurant manager wants to change prices, the cost ofchanging the menus (in order to show the new prices) must be taken into consideration. Therefore, themanager will need to assess whether the increase in prices will cover for the cost of printing new menus.

As Gregory Makiw demonstrates in his article Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly, 1985, this menu costs may lead to a non-socially optimal situation. Indeed, Mankiws menu costs model shows how higher menu costs may lead to a situation where prices remain unchanged, thus provoking so called price stickiness.Contrary to what economists from the New Classical Macroeconomics think, which is that business cyclesare originated by shifts in supply (which originate mainly from technological shocks), New Keynesian economists believe that business cycles are originated by price stickiness. This price stickiness might be explained by menu costs, since the slow adjustment of the economy may explain business cycles.There is a great debate over the following question: are these menu costs really large enough to cause business cycles? An article from Daniel Levy et al., The Magnitude of Menu Costs: Direct Evidence fromLarge U.S. Supermarket Chains, 1997, demonstrates, using empirical evidence, that these menu costs are indeed large enough to cause business cycles. The authors use store-level data from five multistore supermarket chains to directly measure menu costs. They find that the menu costs per store at those chains average more than 35% of net profit margins, which may be forming a barrier to price changes. When applying these findings to theoretical models of menu costs, the authors conclude that these menucosts are large enough to be capable of having macroeconomic significance. Furthermore, they believe that these menu costs may cause considerable nominal rigidity in other industries or markets, thus amplifying the effects on business cycles. These menu costs, they say, vary largely due to local and regional legislation, which may require, for instance, a separate price tag on each item, thus increasing

menu costs.

Mankiw's menu cost model

New Keynesian Economics argue that menu costs are the reason for price stickiness. Price stickiness,the suboptimal adjustment of prices in response to demand shocks, can result in businesscycles. Gregory Mankiw proved in 1985 in his article Small Menu Costs and Large Business Cycles: AMacroeconomic Model of Monopoly that sticky prices can be both privately efficient and sociallyinefficient. In fact, as Mankiw points out, even small menu costs can cause large welfare losses.

Mankiw uses a static model of a monopoly firms pricing decision, which starts by setting its price in advance and changes it ex post, but incurring in a small menu cost. The monopoly faces a constant costfunction and an inverse demand function:N is a nominal scale variable, which denotes the exogenous level of aggregate demand. It can be regarded, for instance, as the overall price level. C and P increase proportionally to the level of nominal demand N.Now, let c = C/N and p = P/N, which will turn the firms problem independent of aggregate demand:c = kqp = f(q)In the adjacent figure, we see the producersurplus (profits earned by the firm), equal tothe rectangle between k and pm. On the otherhand, the excess value over the price paidrepresents consumer surplus, the triangleabove profits. Total surplus, which representswelfare, is the sum of consumer and producersurplus.The firm needs to set its price one periodahead based on expectations about futureaggregate demand, being this price pmNe. Ifexpectations are correct ex post, the observed

C = kqN whereC: total nominal cost of productionC = kqN whereC: total nominal cost of productionq: quantity producedk: constant

P = f(q)N whereP: nominal price

price p0 is pm. If not, the observed price is pm(Ne/N).The first case Mankiw examines is when aggregatedemand N is lower than expected, and therefore p0 is higherthan pm, as shown in this second adjacent figure. Theproducer surplus is lowered byB-A (since profits as seenbefore were equal to rectangle B plus the rectangle to its left),which is positive because pm is by definition the profit-maximising price. Social welfare (or total surplus) is reducedby B+C, and therefore the reduction in welfare due to thecontraction in aggregate demand is larger than the loss in thesurplus of the firm.Now, lets suppose that the firm is capable of changing its price ex post, at a menu cost of z. The firm can then reduce its price from p0to pm and obtain additional profits of B-A, which the firm will do if B-A >z. However, from the point of view of a social planner, the firm should lower its prize if and only if B+C >z. Lets see Mankiws propositions on different outcomes:-Proposition 1. Following a contraction in demand, if the firm cuts its price, then doing so is socially optimal (if it cuts it, is because B-A > z and therefore B+C > z+A+C > z).-Proposition 2. Following a contraction in demand, if B+C > z > B-A, then the firm does not cut its price topm, even if it would be socially optimal (the inefficiency results because printing new menus result in an external benefit of C+A).-Proposition 3. A contraction in aggregate demand reduces social welfare unambiguously, as shown by the sum of producer and consumer surplus. If the producer reduces its price, then the contraction only has the menu cost z. If the firm does not cut its price, then the contraction has the cost of B+C (probablymuch larger than z).The second case Mankiw analyses is an expansion inaggregate demand (N > Ne), and therefore p0 k (N/Ne < pm/k), as shownin our third adjacent figure. In this case, producer surplus isreduced by D-F, which is positive (pm maximises the firmsprofits) and social welfare increases by E+F. The firm willreset its price if the increase in profits beats the menu cost. Inother words, the firm will change its price if D-F > z.-Proposition 4. If there is an expansion in demand and if thefirm resets its price, social welfare decreases by the menu

cost. If it doesnt, total surplus increases by E+F.Now, lets see what happens if N/Ne > pm/k, andtherefore p0 < k. Then, social welfare decreases by a positiveor negative amount of I-J, which makes for an uncertainwelfare effect. The firms profits, which are now negative,have been reduced by G+H+I. If G+H+I > z, then the firm willreset its price to pm. Doing so would be socially optimal if I-J> z.-Proposition 5. If the firm resets its price following theexpansion in demand mentioned, social welfare (total surplus)will decrease by the menu cost z. If it doesnt, total surplusdoes not decrease by more than the menu cost (if the firm doesnt reset its price is because G+H+I < z, which implies that I-J < z-J-G-H < z and therefore the social welfare reduction I-J < z).-Proposition 6 (as a summary of previous propositions). An expansion in aggregate demand may either increase welfare or reduce it, but never more than the menu cost. On the other hand, a contraction in aggregate demand will reduce welfare, possibly in an amount much larger than the menu cost.

To sum up, Mankiw demonstrates that private incentives ensures a high price adjustment when aggregate demand expands, but a small adjustment following a contraction in aggregate demand. From a social planners point of view, prices may be stuck too high, but never too low, which translates into downward price stickiness, although not into an upward rigidity. Mankiw also points out that a more complete model (general equilibrium) will probably show higher degrees of price stickiness, since interfirm purchases will exacerbate price rigidity. Therefore, the main conclusion of this paper (that small menu costs can translate into large inefficiency effects) would certainly remain in a general equilibrium model.Regarding economic policies required to alleviate these problems, Mankiw explains how an active monetary policy is required. More particularly, he mentions policies that aim at the pricing mechanism, such as tax-based incomes policy and other supply-side policies.

Business cycles

Business cycle, as Joseph Schumpeter saw it, is the economic activity fluctuation that occurs over time, and that comes from the succession of expansionary and contracting seasons. It is analysed comparing real GDPto potential GDP (Y*). There are a few common characteristics, which help differentiate cycles, such as its phases, the way it oscillates, the periodicity and a few stylized facts:

1. Phases:Four phases can be distinguished, following Richard Lipseys classification:

-Trough or depression (A), characterized bya high rate of unemployment and lowconsumption levels in relation to its realcapacity;-Expansion or recovery (B) of previousemployment, income and consumptionlevels, that usually comes together with arising in prices;-Peak (C), distinguished by factors full use,high investment and shortage of labour,particularly for high-skilled jobs;

-Recession (D), demands fall causingunemployment and decreasing production levels.

2. Oscillations:

3. Periodicity:Economic cycles have been classified depending in their periodicity. The most common are:

-Very short cycles, with duration of 30-40 months; also known as Kitchin cycles, whose studies saw in

-Oscillant cycles:

regular oscillations (cyan);

irregular, convergent oscillations (red);

Oscillant cycles

-Non-oscillant cycles: oscillant cycles

convergent (red); regular oscillations (cyan);divergent (green). irregular, convergent oscillations (red); irregular, divergent oscillations (green).

stock rotation the origin of these cycles;-Short cycles, with duration of 7-11 years; also known as Juglar cycles, which origin is based on subsequent inventions;-Long cycles with duration of 15-25 years; commonly known as Kuznets cycles, whose analysis placed the origin of cycles in demographic factors such as birth rates or migrations;-Very long or Kondratiev cycle with duration of 50-60 years. This cycles originate with breakthroughs in capital goods, such as the steam engine or the Internet.4. Stylized facts:Both over time and between countries (a few of numerous reviewed by Robert Lucas in his article Understanding Business Cycles, 1977):-There is positive correlation between variables, which helps smooth fluctuations;

-Co-movement between some variables:

output fluctuates in the same direction in different sectors (although different amplitudes may apply);

investment and consumption are clearly pro-cyclical: investment leads and is more volatile, consumption lags and is rather stable;

income: real wages and profits are pro-cyclical;

employment and labour force are also pro-cyclical.

-Expansions are usually longer than recessions.

Many papers and works have been written on business cycles and different points of view have taken form.Keynesian economics tries to deal with the economic fluctuation to minimize their impact. Business cycles are seen as a proof of market failure, and justify government intervention in order to assure the correct level of economic activity. Until the optimum level of employment has not been reached, the economy will not be readjusted. Depending on the cycle phase, expansionary or contractionary economicpolicies may be used.New Classical Macroeconomics supporters have also dealt with economic cycles, and as a result the Real business cycle theory arises as an alternative view to Keynesians. Kydland and Prescott, and in general the Chicago School, are mostly related with the development of this theory. For them cycles are explained by technological shocks. The fluctuations in the economy are seen to be produced by shifts in the supply curve, as a result of changes in productivity levels. These shocks can be caused by different factors: technology innovation, unusual weather conditions, changes in raw material prices, new policies and regulatory measures, etc. What is basic for these shocks to occur is an alteration in the

effectiveness of either capital or labour factors, and therefore changing productivity. As a result in changes in the production quantity, the supply curve shifts, implying a new equilibrium point in the supplyand demand model. Thus they believe that economy will reach its new equilibrium point, through the forces of demand and supply in itself, without the need for a government intervention. In fact from their view, government intervention will only worsen the situation.

InflationDemand-pull inflationCost-push inflationBuilt-in inflation

UnemploymentInvoluntary UnemploymentVoluntary Unemployment

Economic policiesFiscal PolicyMonetary policy

Supply-side policiesPhillips curveNRUAdaptive expectationsEA Phillips curveRational expectationsNCM's Phillips curveNCMNCM's Phillips curveCahuc's adjustment costsNKENAIRULayard-Nickell NAIRU modelMenu costsMankiw's menu cost modelBusiness cycles