Lecture 1: Constructing a theory of equilibrium unemployment

I. A macroeconomic framework

The traditional Keynesian view

• Unemployment is a short-term phenomenon

• It is due to nominal price rigidities, which create an imbalance between aggregate supply and aggregate demand

• Nominal prices eventually adjust downwards as a result of this imbalance

• Therefore, there is no persistent unemployment

We need a theory of positive equilibrium unemployment

• No economy with zero unemployment has ever been observed

• Two routes to generate unemployment:– Built-in real wage rigidity Labor demand <

labor supply– Built-in frictions: people lose their jobs and it

is physically impossible for them to find another one

The simplest model of real wage rigidity:

Labor demand

Labor supply

Wage floor

UnemploymentEmployment L

w/p

What is wrong with this model?

• No micro foundation for the wage floor we see that later

• It is not a macro model: we do not know where labor demand comes from.

• So we have equilibrium unemployment but we do not know its determinants!

• The model is not very useful

One Step Beyond

• Can we do better and embody the wage rigidity in a growth model?

• Let us try to do it!

Let’s try to add a wage rigidity in the Ramsey model

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In the long-run

• If the wage floor is not binding, the usual Ramsey steady state holds

• If it is binding, then we are in trouble: equilibrium K/L ratio cannot match both the wage floor and the Ramsey condition

• Because capital adjusts, the LR labor demand curve is horizontal

• Unemployment converges to 100 %!

The problem in the labor demand space:

w/p

L

Wage floor

LD, t=1

LD, t=2

LD, t=3

LRLD

The problem in the FPF space

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The problem in the phase space

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The Spiral:

• The wage floor pins the return to capital

• But this return to capital is too low for consumers to want to accumulate capital in the long-run

• A spiral of dissaving and unemployment follows

• The issue would be similar in an open-economy model with capital mobility

What is wrong with this model?

• As the economy gets poorer, we expect the wage floor to adjust

• One possibility would be to index it on GDP per capita

• Where would such an indexation come from?

• One intuitive mechanism is that the unemployed exert downward wage pressure

Introducing the wage curve:

• It looks like a labor supply curve• But it is not a labor supply curve• The labor supply curve gives us how much

labor people want to supply at a given wage• The wage curve tells us how the

unemployment rate affects the wage that wage setters ask in a non competitive framework

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How it works:

SR Labor demand

LR Labor demand

SR UnemploymentSR Employment L

w/p

Wage curve

Labor force

LR Unemployment

Introducting Long-Run TFP growth

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In the long-run

• K/L must grow at rate g for the Ramsey condition to hold

• This implies that wages must grow at the same rate g

• But then unemployment must trend down to zero

• This has not been observed in the real world

What is wrong with this model?

• As the economy gets richer, we expect people to ask for higher wages, given u

• Why?

• The wage that is bargained for presumably depends on wage aspirations

• Wage aspirations are proportional to GDP per capita

Augmenting the wage curve

• Wage aspirations depend on variables that grow at g in the long run

• For a BGP with constant u to exist, the wage curve must be homogeneous of degree 1 in these variables

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How it works

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LR natural rate

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WC2

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Primary Determinants of the natural rate:

• These are Shifts factors that affect the position of the wage curve

• They always matter

• They capture the degree of micro and institutional wage rigidity in the economy

Secondary determinants of the natural rate

• Factors that affect the position of the labor demand curve

• How important they are depends on how wage aspirations are defined

• In some cases, they do not matter at all, because wage aspirations move proportionally

Example 1: wage aspiration = labor productivity

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In this example:

• The short-run and long-run natural rates only depend on primary determinants

• This is because wage aspirations are always proportional to the current wage

• This would be a bit more complicated if production function were not Cobb-Douglas!

Example 2: wages aspiration = lagged labor productivity

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In this example:

• The short run natural rate depends positively on TFP and the capital stock

• It depends negatively on past wages

• The only secondary determinant for the LR natural rate is the economy’s growth rate

• Why? As growth is faster, current aspirations fall relative to the wage that employers are willing to pay

Example 3: aspirations grow exogenously at rate g

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In this example:

• Falls in the LR K/L ratio reduce LRLD with no impact on aspirations

• => r and δ increase the LRNR• => g now increases unemployment through a

lower K/L ratio

• A0 reduces u since aspirations do not match the induced increase in labor demand