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International Macroeconomics

Lecture 4: Long Run Effect of Economic Policy

4 Lecture Video: The Phillips Curve

• Literature: Blanchard et al. (2017), Chap. 7.3 - 7.6, Chap. 8.1

The short-run trade-off between inflation and unemployment
2
Figure: Inflation versus unemployment in the United States, 1948–1969

The steady decline

in the U.S.
unemployment rate
throughout the
1960s was
associated with a
steady increase in
the inflation rate.

Slide 2
The short-run trade-off between inflation and unemployment
Figure: Inflation versus unemployment in the United States, 1970-2010 3

Beginning in the
1970s, the relation
between the
unemployment rate
and the inflation
rate disappeared.

Explanations:
1. A trade-off relationship does not exist (Friedman, Phelps).
2. Due to an environment with higher inflation rates, wage setters changed the way they
formed expectations.
Slide 3
Labor markets and perfect competition 4
A simple microeconomic textbook model

 Assumption: Labor markets with perfect

competition, like other markets in the economy,
are governed by the forces of supply and
demand
 Labor demand curve results from profit-
maximizing firms that hire workers up to the point
where the value of the marginal product of labor equals
the wage
 Labor supply curve results from utility
maximizing households that choose between
consumption of goods and leisure
 The wage adjusts to balance the supply and
demand for labor – there is no such thing as
involuntary unemployment

 If regulation sets a minimum wage above the

market clearing level, unemployment arises.

Slide 4
Labor markets and imperfect competition 5
Wage determination and wage bargaining

 Sometimes wages are set by collective bargaining – a bargaining between unions and
firms.
• Collective bargaining plays an important role in Japan and most European countries. In the EU,
about 60% of workers are covered by collective agreements.
• Comparatively, only slightly more than 10% of US workers’ wages are set by collective
bargaining.
 Individual bargaining: Workers’ bargaining power depends on
• how costly it is for the firm to find other workers
• how hard it is for workers to find another job if they were to leave the firm
• skills: the higher the skills needed to do the job, the more likely there is to be bargaining
between employers and individual employees.
 Wages depends on labor-market conditions: The lower the unemployment rate, the
higher the wages.
 Observation: Workers are typically paid a wage exceeding their reservation wage – the
wage that would make them indifferent between working and being unemployed.

Slide 5
Labor markets and imperfect competition 6
Wage determination and efficiency wages

 Efficiency wage theories link the productivity of workers to the wage they are paid
• Firms may want to pay a wage above the reservation wage in order to decrease workers’
turnover and increase productivity.
• Firms that see employee morale and commitment as essential to the quality of workers’ work will
pay more than those whose activities are routine.
• When unemployment is low, firms that want to avoid an increase in quits will increase wages to
induce workers to stay with the firms.

Example: Henry Ford and Efficiency Wages

• In 1914, Henry Ford announced that his company would pay all qualified employees a
minimum of $5.00 a day for an eight-hour day, compared to previously an average $2.30 for a
nine-hour day.
• The turnover rate plunged from 370% in 1913 to 16% in 1915.
• The layoff rate collapsed from 62% to nearly 0%.

Slide 6
Labor markets and imperfect competition 7
Wage determination in negotiations
 The aggregate nominal wage W depends on
• the expected price level 𝑃𝑃𝑒𝑒
(7.1) 𝑊𝑊 = 𝑃𝑃𝑒𝑒 � 𝐹𝐹 𝑢𝑢, 𝑧𝑧
• the unemployment rate u (−, +)

• a catch-all variable z
 The nominal wage depends on the expected price level (rather than the actual price level)
because when nominal wages are set, the relevant price levels are not yet known.
 An increase in the unemployment rate u decreases wages.
• Higher unemployment either weakens worker’ bargaining power, or allows firms to pay lower wages
and still keep workers willing to work.

 z stands for all the other factors that affect wages, given the expected price level and the
unemployment rate, e.g.
• unemployment insurance as the payment of benefits to workers who lose their jobs
• employment protection makes it more expensive for firms to lay off workers.
 Since workers care about real wages, equation (7.1) can be rewritten as
𝑊𝑊
= 𝐹𝐹(𝑢𝑢, 𝑧𝑧)
𝑃𝑃𝑒𝑒
 The wage setting relation is the relation between the (expected) real wage and the rate of
unemployment.
• The higher the unemployment rate, the lower the real wage chosen by wage setters.
Slide 7
Labor markets and imperfect competition 8
Price setting by firms

 The prices set by firms depends on their costs, which in turn depends on the nature of the
production function, 𝑌𝑌 = 𝐹𝐹(𝐾𝐾, 𝐿𝐿)
 Assumptions: Labor L is the only input, labor productivity is constant. Then the production
function can be rewritten as
7.2 𝑌𝑌 = 𝐿𝐿
• which implies that the cost of producing one more unit of output is the cost of employing one more
worker at W.
• The marginal cost of production is equal to W.
 Assumption: Firms set their price according to a markup m over the cost, so that:
7.3 𝑃𝑃 = (1 + 𝑚𝑚) � 𝑊𝑊
𝑃𝑃
 Now divide both sides of the price setting equation by W : = (1 + 𝑚𝑚)
𝑊𝑊
 Inverting both sides gives the implied real wage, or the price setting relation
𝑊𝑊 1
7.6 =
𝑃𝑃 (1 + 𝑚𝑚)
 Price setting decisions determine the real wage paid by firms.

Slide 8
Labor markets and imperfect competition 9
The natural rate of unemployment

 Problem:
• Firms set prices P
• Wage of workers depends on 𝑃𝑃𝑒𝑒
 Assumptions: Price level expectations are
correct, 𝑃𝑃𝑒𝑒 = 𝑃𝑃. Then the wage setting relation
(7.1) becomes
𝑊𝑊
7.4 = 𝐹𝐹(𝑢𝑢, 𝑧𝑧)
𝑃𝑃
 The price setting relation is
𝑊𝑊 1
7.6 =
𝑃𝑃 (1 + 𝑚𝑚)
 In equilibrium, the natural rate of
unemployment is determined – it is the
unemployment rate such that the real wage
chosen in wage setting is equal to the real
wage implied by price setting, given price level
expectations are correct.
 The assumption of correct expectations must
not be fulfilled in the short run.

Slide 9
Labor markets and imperfect competition 10
Some comparative static results for the natural rate of unemployment

 An increase in unemployment benefits  An increase in mark-ups m

• can be represented by an increase in z • due to less stringent enforcement of
antitrust legislation,
• makes the prospect of unemployment less
painful • decreases the real wage paid by firms (PS
curve shifts down),
• increases the wage set by wage setters at a
given unemployment rate (WS curve shifts • increases the natural rate of unemployment
upward).
• Higher unemployment is what makes
• The natural rate of unemployment increases. workers accept the lower real wage.

Slide 10
The short-run trade-off between inflation and unemployment 11
Wage and price determination on markets with incomplete competition

 Assumption: Prices and wages are not determined on competitive markets

 Wage determination: 𝑊𝑊 = 𝑃𝑃𝑒𝑒 � 𝐹𝐹 𝑢𝑢, 𝑧𝑧
Assume a simple linear relationship 𝐹𝐹 𝑢𝑢, 𝑧𝑧 = 1 − 𝛼𝛼 � 𝑢𝑢 + 𝑧𝑧

which implies 𝑊𝑊 = 𝑃𝑃𝑒𝑒 (1 − 𝛼𝛼𝛼𝛼 + 𝑧𝑧)

 Price determination: 𝑃𝑃 = 1 + 𝑚𝑚 � 𝑊𝑊

 In equilibrium: 8.1 𝑃𝑃 = 𝑃𝑃𝑒𝑒 � 1 + 𝑚𝑚 � 1 − 𝛼𝛼 � 𝑢𝑢 + 𝑧𝑧

 Expressed in inflation rates: 8.2 π = 𝜋𝜋 𝑒𝑒 + (𝑚𝑚 + 𝑧𝑧) − 𝑎𝑎𝑎𝑎

 An increase in actual inflation, 𝜋𝜋, is caused by

• an increase in expected inflation, 𝜋𝜋 𝑒𝑒 ;
• given expected inflation, 𝜋𝜋 𝑒𝑒 , by an increase in the mark-up, m, or an increase in the
factors that affect wage determination, z;
• given expected inflation, 𝜋𝜋 𝑒𝑒 , by a decrease in the unemployment rate, u.
Slide 11
The expectation-augmented Phillips curve 12
Derivation of equation (8.2) from 𝑃𝑃𝑡𝑡 = 𝑃𝑃𝑡𝑡𝑒𝑒 � (1 + 𝑚𝑚) � (1 − 𝑎𝑎𝑎𝑎 + 𝑧𝑧)

 From price levels to inflation - divide both sides by 𝑃𝑃𝑡𝑡−1 :

𝑃𝑃𝑡𝑡 𝑃𝑃𝑡𝑡𝑒𝑒
= � (1 + 𝑚𝑚) � (1 − 𝑎𝑎𝑎𝑎 + 𝑧𝑧)
𝑃𝑃𝑡𝑡−1 𝑃𝑃𝑡𝑡−1
𝑃𝑃𝑡𝑡 −𝑃𝑃𝑡𝑡−1 𝑃𝑃𝑡𝑡𝑒𝑒 −𝑃𝑃𝑡𝑡−1
• Now define inflation 𝜋𝜋𝑡𝑡 = and expected inflation 𝜋𝜋𝑡𝑡𝑒𝑒 =
𝑃𝑃𝑡𝑡−1 𝑃𝑃𝑡𝑡−1

𝑃𝑃𝑡𝑡 𝑃𝑃𝑡𝑡
• Then 𝜋𝜋𝑡𝑡 = − 1 or = 1 + 𝜋𝜋𝑡𝑡
𝑃𝑃𝑡𝑡−1 𝑃𝑃𝑡𝑡−1

𝑃𝑃𝑡𝑡𝑒𝑒 𝑃𝑃𝑡𝑡𝑒𝑒
• and 𝜋𝜋𝑡𝑡𝑒𝑒 ≡ − 1 or = (1 + 𝜋𝜋𝑡𝑡𝑒𝑒 )
𝑃𝑃𝑡𝑡−1 𝑃𝑃𝑡𝑡−1

• Inserting: 1∗ 1 + 𝜋𝜋𝑡𝑡 = 1 + 𝜋𝜋𝑡𝑡𝑒𝑒 � (1 + 𝑚𝑚) � (1 − 𝑎𝑎𝑎𝑎 + 𝑧𝑧)

1+𝜋𝜋𝑡𝑡
 Simplification / Approximations: = (1 − 𝑎𝑎𝑎𝑎 + 𝑧𝑧)
1+𝜋𝜋𝑡𝑡𝑒𝑒 �(1+𝑚𝑚)

• Approximation for denominator on LHS: 1 + 𝜋𝜋𝑡𝑡𝑒𝑒 � 1 + 𝑚𝑚 ≈ 1 + 𝜋𝜋𝑡𝑡𝑒𝑒 + 𝑚𝑚

1+𝜋𝜋𝑡𝑡
• Further approximation for LHS: ≈ 1 + 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝑒𝑒 − 𝑚𝑚 .
1+𝜋𝜋𝑡𝑡𝑒𝑒 +𝑚𝑚

 Inserting the approximations into (1*): 1 + 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝑒𝑒 − 𝑚𝑚 = (1 − 𝑎𝑎𝑎𝑎 + 𝑧𝑧)

or
8.2 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 + (𝑚𝑚 + 𝑧𝑧) − 𝑎𝑎𝑎𝑎
Slide 12
The short-run trade-off between inflation and unemployment 13
How are expectations formed? 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 + (𝑚𝑚 + 𝑧𝑧) − 𝑎𝑎𝑎𝑎

 Expectations can depend on recent experience with inflation, then the expectation
for period t, 𝜋𝜋𝑡𝑡𝑒𝑒 , is related to actual inflation 𝜋𝜋𝑡𝑡−1 .
 Or expectations are oriented at longer term averages of historic inflation rates, 𝜋𝜋,
�
e.g. 𝜋𝜋� = ∑𝑖𝑖=𝑡𝑡−1
𝑖𝑖=𝑡𝑡−5 𝜋𝜋𝑖𝑖 .

 If 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋� , the PC-relation is 𝜋𝜋𝑡𝑡 = 𝜋𝜋� + (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡

• Interpretation: Assume that inflation is low, non persistent and varies around 𝜋𝜋� (e.g. an
average of the last years). Then expectations are not related to recent inflation, 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋.
�
• In a low inflation environment, expectations are anchored.
 If 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 , the PC-relation is 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡−1 + (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡
• Interpretation: If inflation rates become higher and more persistent, the recently
observed inflation rate determines inflation expectations
• In a high inflation environment, inflation expectations are de-anchored
• The PC is then a relationship between the actual unemployment rate 𝑢𝑢𝑡𝑡 , and the
change in the inflation rate: 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡−1 = (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡

 In general 𝜋𝜋𝑡𝑡𝑒𝑒 can depend on both - on 𝜋𝜋𝑡𝑡−1 , with weight 𝜃𝜃, and on 𝜋𝜋,
� with weight
1 − 𝜃𝜃 , 𝜃𝜃 ∈ 0,1 .
𝜋𝜋𝑡𝑡𝑒𝑒 = 1 − 𝜃𝜃 � 𝜋𝜋� + 𝜃𝜃 � 𝜋𝜋𝑡𝑡−1
Slide 13