Snowdon & Vane Modern Macroeconomics

has since been used to describe estimates of the natural rate of unemployment (see Cross et al., 1993; Cross, 1995). However, according to King (1999):

the natural rate of unemployment and the NAIRU are quite different concepts. The former describes a real equilibrium determined by the structural characteristics of the labour and product markets – the grinding out of Friedman’s Walrasian general equilibrium system (modified, if necessary, by non-Walrasian features of labour markets such as imperfect competition, search behaviour and efficiency wages). It exists independently of the inflation rate. In contrast, the latter, as well as being affected by these structural characteristics, is also affected by the gradual adjustment of the economy to past economic shocks that determine the path of inflation. Because it is defined as the unemployment rate at which there is no immediate pressure for a change in the inflation rate, it is a reduced form – not a structural – variable.

Therefore, the NAIRU concept takes into account inertia in the system which allows a protracted response of the economy to various economic shocks.

Another way to distinguish between these concepts relates to their microfoundations. Friedman’s natural rate is a market-clearing concept, whereas the NAIRU is that rate of unemployment which generates consistency between the target real wage of workers and the feasible real wage determined by labour productivity and the size of a firm’s mark-up. Since the NAIRU is determined by the balance of power between workers and firms, the microfoundations of the NAIRU relate to theories of imperfect competition in the labour and product markets (see Carlin and Soskice, 1990; Layard et al., 1991). However, while recognizing these differences between the concepts of the natural rate and the NAIRU, Ball and Mankiw (2002) argue that NAIRU is ‘approximately a synonym for the natural rate of unemployment’. Therefore, in the discussion that follows we will assume that the two concepts can be used interchangeably.

According to Friedman’s natural rate hypothesis, fluctuations of aggregate demand cannot exercise any influence over the natural rate of unemployment, which is determined by real supply-side influences. The conventional natural rate view allows monetary and other demand shocks to shift aggregate demand, thereby influencing the actual rate of unemployment in the short run. But, as inflationary expectations adjust, unemployment returns to its long-run equilibrium (natural) value. In new classical models, if the change in aggregate demand is unanticipated, the combined effect of perfectly flexible prices and rational expectations ensures that unemployment will quickly return to its natural rate.

This conventional view is illustrated in Figure 7.11, where the natural rate of unemployment (UN) is given by point A. Any decline in aggregate demand will increase the actual rate of unemployment temporarily to point B, while an expansion of aggregate demand will lower actual unemployment and will

B

Unemployment

Falling rate of inflation

UN

A

Rising rate of inflation

C

Figure 7.11 The ‘natural rate’ view of the relationship between actual unemployment and equilibrium unemployment

move the economy temporarily to point C. However, in the long run, unemployment returns to the natural rate of unemployment at point A.

The dramatic rise in unemployment rates, particularly in Europe during the 1980s, suggested that this conventional view of the natural rate of unemployment (or NAIRU) must be wrong. It seems that the NAIRU must have risen, and estimates made by econometricians, such as those presented in Table 7.1, confirm this view. Several explanations have been put forward to explain these higher levels of unemployment. One view explains it as a result of specific policy changes that have reduced the flexibility of the labour market; more powerful trade unions, higher unemployment compensation and longer duration of benefits, minimum wage laws, excessive regulations, employment protection, and higher taxation are, or have been, favourite candidates (see Minford, 1991; Nickell, 1997; Siebert, 1997; Ljungquist and Sargent, 1998; Fitoussi et al., 2000; Roed and Zhang, 2003). However, while some of these factors may account for rising unemployment in the 1970s, many economists do not believe that they offer a complete explanation of the unemployment experienced in the 1980s and 1990s (union power, for example, has been significantly reduced in the UK and has never been a major factor in the US economy).

The simultaneous rise in the actual and equilibrium rates of unemployment has led some new Keynesian economists to explore a second explanation which allows aggregate demand to influence the natural rate (or NAIRU). Models which embody the idea that the natural rate depends on the history of the equilibrium rate are called ‘hysteresis’ theories. It was Phelps (1972) who first suggested that the natural rate equilibrium will be partly influenced by the path taken to reach equilibrium. Phelps called this path dependence ‘hysteresis’, a term borrowed from physics, where it is used to describe the lagging of magnetic induction behind the source of magnetism (see Cross, 1995).

In hysteresis models the natural rate of unemployment will increase if the actual rate of unemployment in the previous period exceeds the former time period’s natural rate (Hargreaves-Heap, 1980). This can be expressed as follows:

In equation (7.14) UNt is the natural rate of unemployment at time t, UNt–1 is the previous period’s natural rate of unemployment, Ut–1 is the previous period’s actual rate of unemployment and bt captures other influences on the natural rate such as unemployment compensation. If we assume bt = 0, then equation (7.14) can be rearranged as (7.15):

From equation (7.15) it can be seen that UNt > UNt–1 if Ut–1 > UNt–1. In other words, the shifting actual rate of unemployment acts like a magnet, pulling

the natural rate of unemployment in the same direction. Thus while it may be reasonable to argue that aggregate demand does not affect UN in the short run, it is likely that prolonged periods of abnormally high or low economic activity will shift the natural rate of unemployment.

The impact of hysteresis is illustrated in Figure 7.12. The initial equilibrium unemployment rate is represented by point A. If the economy is subject to a negative aggregate demand shock, output falls and unemployment rises to point B. When the economy recovers from recession, the unemployment rate does not return to point A. Instead, because of hysteresis effects, the new NAIRU is at point C. If the economy is now subject to a positive aggregate demand shock, unemployment falls to point D. When the economy returns to equilibrium the NAIRU has now fallen to point E. A further recession traces out a path for this economy through points F to G. In other words, the NAIRU is influenced by the actual rate of unemployment which itself is determined mainly by aggregate demand.

Unemployment

D

Rising rate of inflation

A

Figure 7.12 The hysteresis view of a ‘time-varying’ NAIRU

Theories of hysteresis fall into two main categories, namely duration theories and insider–outsider theories. Duration theories point out that, when Ut > UNt, the problem of structural unemployment is exacerbated because the unemployed suffer a depreciation of their human capital (skills) and as a result become increasingly unemployable. A high rate of unemployment also tends to generate an increasing number of long-term unemployed who exercise little influence on wage bargaining, which also raises the NAIRU. Insider–outsider theories emphasize the power of insiders which prevents the downward adjustment of wages in the face of high unemployment. As a result, outsiders are unable to price their way back into jobs following a rise in unemployment (see Blanchard and Summers, 1986, 1988). If hysteresis effects are important, the sacrifice ratio associated with disinflation and recessions is much greater than is suggested by the original natural rate hypothesis, since high unemployment will tend to persist (for an extended discussion of the issues raised in this section, the reader is referred to Cross, 1988; Cross et al., 1993, Layard et al., 1991; Blanchard and Katz, 1997; Gordon, 2003).

Another distinctive approach to explaining movements in the equilibrium rate of unemployment over time has been developed by Edmund Phelps and

his co-researchers. In a series of books and papers Phelps has sought to construct an endogenous theory of the natural rate of unemployment where ‘the equilibrium path of unemployment is driven by the natural rate that is a variable of the system rather than a constant or a forcing function of time … hence a moving-natural-rate theory holds the solution to the mystery of what is behind the shifts and long swings of the unemployment rate’ (Phelps, 1994; see also Fitoussi and Phelps, 1988; Phelps and Zoega, 1998; Phelps, 2000). While in Friedman’s natural rate model equilibrium unemployment can change due to supply-side influences, in Phelps’s dynamic intertemporal non-mon- etary equilibrium model it is real demand shocks that are ‘the great movers and shakers of the economy’s equilibrium path’, although real supply (energy) shocks also play an important role. Phelps (1990, 1994) classifies his approach to explaining unemployment as both ‘modern’ and ‘structuralist’, although it does contain both neoclassical (the role of real interest rates determined in the capital market), Austrian (the effect of the rate of interest on the supply of output) and new Keynesian elements (asymmetric information and efficiency wages). Phelps highlights the impact on the path of the equilibrium unemployment rate of real influences such as technology, preferences, social values and institutions. As Phelps (1994) recalls, by the 1980s he had decided that any chance of accounting for the major swings in economic activity since the war would require:

abandoning the simplification of a natural rate unemployment rate invariant to non-monetary (not just monetary) macro shocks in favour of models making the equilibrium rate an endogenous variable determined by a variety of non-monetary forces … the longer booms and slumps … must be explained largely as displacements of the equilibrium path of unemployment itself, not as deviations of unemployment around an impervious equilibrium path.

In looking for the causes of what Fitoussi et al. (2000) call ‘the great slump’, that is, the upward shift of equilibrium unemployment rates in the 1980s, the chief suspects identified are five OECD-wide real shocks to business profitability and worker’s incentives (see Phelps, 1994), namely:

1.reduced expectations of productivity growth, hence increased effective cost of capital;

2.an increase in the expected real interest rate which also raises the effective cost of capital;

3.an increase in services from workers private assets (see Phelps, 2000);

4.an increase in social entitlements relative to after-tax real wages resulting from the 1970s productivity slowdown and expansion of the welfare state;

5.the two OPEC oil price shocks in 1973 and 1979.

In the Phelps (1994) model the main driving force behind the rise of the NAIRU is the increase in real interest rates that occurred across the OECD countries after the mid-1970s and on into the 1980s (Blanchard and Wolfers, 2000). The rise in world real interest rates, to a large extent induced by US fiscal expansion in the early 1980s, lowered incentives to accumulate capital, and, for a given real wage, led to a reduction of labour demand. The high real interest rate which induced an appreciation of the US dollar (real depreciation of European currencies) during this period also led to an increase in European price mark-ups (firms do not lower their export prices in proportion to the depreciation) and, in consequence, this led to a reduction in labour demand and a rise in the equilibrium rate of unemployment. For example, Phelps and Zoega (1998, p. 788) find a very strong correlation between the world real rate of interest and UK unemployment for the period 1975–95. Note that in contrast to real business cycle models, where changes in the real interest rate influence the supply of labour through the intertemporal labour substitution hypothesis, in Phelps’s model changes in the real interest affect the demand for labour (for a critique see Madsen, 1998).

While the impact of real shocks as an explanation of increases in the broad evolution of European unemployment is persuasive, Blanchard and Wolfers (2000) argue that ‘there is insufficient heterogeneity in these shocks to explain cross-country differences … Adverse shocks can potentially explain the general increase in unemployment. Differences in institutions can potentially explain differences in outcomes across countries.’ Therefore, a more convincing story of the evolution of the NAIRU in Europe must involve the interaction of observable real shocks combined with a recognition of the institutional diversity present across European countries (see Nickell, 1997; and Layard and Nickell, 1998).

7.10New Keynesian Economics and the Stylized Facts

The new Keynesian model is relatively successful in explaining many of the business cycle stylized facts (see Abel and Bernanke, 2001):

1.new Keynesian analysis is consistent with the procyclical behaviour of employment as well as procyclical consumption, investment and government expenditures and productivity (see Chapter 6 for a discussion of procyclical productivity);

2.the non-neutrality of money in new Keynesian models is consistent with the stylized fact that money is procyclical and leading;

3.more controversial (see Chapter 6) is the new Keynesian prediction that inflation will tend to be procyclical and lagging. Procyclical inflation is consistent with new Keynesian models which emphasize aggregate de-

mand disturbances. However, this stylized fact has in recent years been challenged (see Kydland and Prescott, 1990, and Chapter 6);

4.new Keynesian models, unlike the old Keynesian models, do not imply a countercyclical real wage. When sticky nominal prices are introduced, the real wage in new Keynesian models can be procyclical or acyclical (see Mankiw, 1990). If the efficiency wage is sensitive to the rate of unemployment, then real wages will tend to be mildly procyclical in such models (see Shapiro and Stiglitz, 1984).

Greenwald and Stiglitz (1988) in their survey of macroeconomic theories conclude that no model successfully explains all the data, but the new Keynesian model does better than either the traditional Keynesian or real business cycle alternatives. For those economists who see involuntary unemployment as a stylized fact in need of explanation, the new Keynesian models rooted in imperfect competition are ‘impressively better’ than the new classical or real business cycle alternatives (Carlin and Soskice, 1990).

7.11Policy Implications

Following the contributions of Fischer (1977), Phelps and Taylor (1977), it was clear that the new classical conclusion that government demand management policy was ineffective did not depend on the assumption of rational expectations but rather on the assumption of instantaneous market clearing. In new Keynesian models which emphasize sticky prices, money is no longer neutral and policy effectiveness is, at least in principle, re-established. Since in the Greenwald–Stiglitz model greater price flexibility exacerbates the problems of economic fluctuations, new Keynesians have also demonstrated the potential role for corrective demand management policies even if prices are flexible (but not instantaneously so). In a world where firms set prices and wages in an uncoordinated way, and where they are uncertain of the consequences of their actions, it is not surprising that considerable inertia with respect to prices and wages results.

In a market economy endogenous forces can frequently amplify the disturbing impact of exogenous shocks. While new Keynesians tend to be more concerned with the way an economy responds to shocks than with the source of the shocks, experience during the past quarter-century has confirmed that economies can be disturbed from the supply side as well as the demand side. Indeed, as Benjamin Friedman (1992) has observed, it is often practically and conceptually difficult to draw a clear distinction between what is and what is not the focal point of any disturbance. Because in new Keynesian models fluctuations are irregular and unpredictable, new Keynesians are not enthusiastic supporters of government attempts to ‘fine-tune’ the

macroeconomy. Many new Keynesians (such as Mankiw) accept the monetarist criticisms relating to old-style Keynesianism as well as several of the criticisms raised by new classical economists, such as those related to dynamic consistency (see Chapter 5). There is no unified new Keynesian view on the extent of discretionary fiscal and monetary action that a government may take in response to aggregate fluctuations (see Solow and Taylor, 1998). However, most new Keynesians do see a need for activist government action of some form because of market failure, especially in the case of a deep recession. For example, Taylor (2000a) argues that while fiscal policy should normally be used to achieve long-term objectives such as economic growth, there is a strong case for the explicit use of fiscal expansionary policy in ‘unusual situations such as when nominal interest rates hit a lower bound of zero’.

Because of uncertainty with respect to the kinds of problems an economy may confront in the future, new Keynesians do not support the fixed-rules approach to monetary policy advocated by Friedman (1968a) and new classical equilibrium theorists such as Lucas, Sargent, Wallace, Barro, Kydland and Prescott during the 1970s. If the monetarists and new classicists successfully undermined the case for fine-tuning, new Keynesians have certainly championed the case for what Lindbeck (1992) has referred to as ‘coarsetuning’ – policies designed to offset or avoid serious macro-level problems.

Here it is interesting to recall Leijonhufvud’s (1973, 1981) idea that market economies operate reasonably well within certain limits. Leijonhufvud argues that

The system is likely to behave differently for large than for moderate displacements from the ‘full coordination’ time path. Within some range from the path (referred to as the corridor for brevity), the system’s homeostatic mechanisms work well, and deviation counteracting tendencies increase in strength.

However, Leijonhufvud argues that outside ‘the corridor’ these equilibrating tendencies are much weaker and the market system is increasingly vulnerable to effective demand failures. More recently Krugman (1998, 1999) has also reminded economists about the dangers of ‘Depression Economics’ and the potential for a liquidity trap (see Buiter, 2003b).

Echoing this concern, new Keynesian analysis provides theoretical support for policy intervention, especially in the case of huge shocks which lead to persistence, because the adjustment process in market economies works too slowly. An increasing consensus of economists now support the case for some form of constrained discretion in the form of an activist rule. Indeed, during the last decade of the twentieth century, macroeconomics began to evolve into what Goodfriend and King (1997) have called a ‘New Neoclassical Synthesis’. The central elements of this new synthesis involve:

1.the need for macroeconomic models to take into account intertemporal optimization;

2.the widespread use of the rational expectations hypothesis;

3.recognition of the importance of imperfect competition in goods, labour and credit markets;

4.incorporating costly price adjustment into macroeconomic models.

Clearly this new consensus has a distinctly new Keynesian flavour. Indeed, Gali (2002) refers to the new generation of small-scale monetary business cycle models as either ‘new Keynesian’ or ‘new Neoclassical Synthesis’ models. This ‘new paradigm’ integrates Keynesian elements such as nominal rigidities and imperfect competition into a real business cycle dynamic general equilibrium framework.

According to Goodfriend and King, the ‘New Neoclassical Synthesis’ models suggest four major conclusions about the role of monetary policy. First, monetary policy has persistent effects on real variables due to gradual price adjustment. Second, there is ‘little’ long-run trade-off between real and nominal variables. Third, inflation has significant welfare costs due to its distorting impact on economic performance. Fourth, in understanding the effects of monetary policy, it is important to take into account the credibility of policy. This implies that monetary policy is best conducted within a rules-based framework, with central banks adopting a regime of inflation targeting (Muscatelli and Trecroci, 2000). As Goodfriend and King note, these ideas relating to monetary policy ‘are consistent with the public statements of central bankers from a wide range of countries’ (see, for example Gordon Brown, 1997, 2001, and the ‘core properties’ of the Bank of England’s macroeconometric model, Bank of England, 1999; Treasury, 1999).

7.11.1 Costs of inflation

An important element of the growing consensus in macroeconomics is that low and stable inflation is conducive to growth, stability and the efficient functioning of market economies (Fischer, 1993; Taylor, 1996, 1998a, 1998b). The consensus view is that inflation has real economic costs, especially unanticipated inflation. The costs of anticipated inflation include ‘shoe leather’ costs, menu costs and the costs created by distortions in a non-indexed tax system. The costs of unanticipated inflation include distortions to the distribution of income, distortions to the price mechanism causing efficiency losses, and losses due to increased uncertainty which lowers investment and reduces economic growth. Also important are the costs of disinflation (the ‘sacrifice ratio’), especially if hysteresis effects are present (Ball, 1999; Cross, 2002). Leijonhufvud also argues that during non-trivial inflation the principal–agent problems in the economy, particularly in the government sector, become