Lecture 1: Constructing a theory of equilibrium unemployment

1. Lecture 1: Constructing a theory of equilibrium unemployment I. A macroeconomic framework

2. 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

3. 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

4. The simplest model of real wage rigidity: Labor supply w/p Wage floor Labor demand L Employment Unemployment

5. 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

6. One Step Beyond • Can we do better and embody the wage rigidity in a growth model? • Let us try to do it!

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

8. 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 %!

9. The problem in the labor demand space: LD, t=1 w/p Wage floor LRLD LD, t=2 LD, t=3 L

10. The problem in the FPF space r w

11. The problem in the phase space C K

12. 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

13. 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

14. 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

15. How it works: LR Unemployment w/p LR Labor demand SR Labor demand Wage curve Labor force L SR Employment SR Unemployment

16. Introducting Long-Run TFP growth

17. 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

18. 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

19. 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

20. How it works LD, t=1 w/p LRLD3 WC3 LRLD2 LRLD1 WC2 WC1 LR natural rate L

21. 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

22. 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

23. Example 1: wage aspiration = labor productivity

24. 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!

25. Example 2: wages aspiration = lagged labor productivity

26. 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

27. Example 3: aspirations grow exogenously at rate g

28. In this example: • Falls in the LR K/L ratio reduce LRLD with no impact on aspirations • => r and δincrease 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