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 Unemployment Employment 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

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 w r

The problem in the phase space K C

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

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

Introducting Long-Run TFP growth

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

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

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

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

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

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 A 0 reduces u since aspirations do not match the induced increase in labor demand