Wage and Price Adjustment

Wage and price adjustment in the short run (Chapter 9) • In the IS-LM model, we assumed that prices were given in the short run • But prices are not constant. We need a theory for how wages and prices adjust in the short run • In the long run, production and employment should go back to the equilibrium levels found in Lectures 2 and 6 • Analysis of wage and price adjustment ties the short and the long run together 2 Wage and price adjustment: Introduction Questions: • What factors determine short run wage and price adjustment? • Is there a choice between low inflation and low unemployment? 3 Wage and price adjustment: The Phillips curve The wage-setting equation: If unemployment is lower (higher) DW DW = - b (u - u ) W W than the equilibrium level, companies want to raise wages more (less) than the average rate of wage growth d t n t t t-1 t-1 4 Wage and price adjustment: The Phillips curve Wage-setting in the short run: • Share 1- l of companies set wages W r at the end of the previous year • Share l of companies that have flexible wages: W x • Average rate of wage increase in the economy: DWt DWt x DWt r =l + 1- l Wt-1 Wt-1 Wt-1 ( ) Wage increase in firms that can adjust wages during the period Wage increase in firms that can’t adjust wages during the period 5 Wage and price adjustment: The Phillips curve • Wage-setting in companies that can adjust wages: DWt x DWt = - b ut - u n Wt-1 Wt-1 ( ) these firms set their desired wage • Wage-setting in companies that cannot adjust wages: DWt r DWt e = Wt-1 Wt-1 these firms set wages based on their expectations about average wage development Intuition: If they were to set any other wage, they would be consciously setting the wrong wage! Those who are flexible set the wage correctly given the labour market situation 6 Wage and price adjustment: The Phillips curve Average rate of wage increase in the economy: é DW ù DWt DWt x DWt r DWt e n t =l + 1- l = lê - b ut - u ú + 1- l Wt-1 Wt-1 Wt-1 W Wt-1 ë t-1 û ( ( ) ) (  DWt DWt e (1- l ) = (1- l ) - lb ut - u n Wt-1 Wt-1  DWt DWt e lb = ut - u n Wt-1 Wt-1 1- l  DWt DWt = - b̂ ut - u n Wt-1 Wt-1 ( ( e ( ) ) ) ) where b̂ = lb 1- l The Phillips curve 7 Wage and price adjustment: The Phillips curve The Phillips curve: DWt DWt e = - b̂ ut - u n Wt-1 Wt-1 ( ) where b̂ = lb 1- l 8 Wage and price adjustment: The Phillips curve The slope of the Phillips curve is determined by: • The parameter b How much unemployment influences the company’s wagesetting decisions • The parameter l What percentage of companies can adjust wages freely If b and l are large, the Phillips curve has a steep slope and vice-versa 9 Wage and price adjustment: The Phillips curve Definition of inflation: Pt - Pt-1 pt = Pt-1 To analyse short run wage and price adjustment, we simplify the production function and set a = 0 : Y =E Y = EN N Price-setting: P = (1+ m )MC = (1+ m ) W = (1+ m ) W MPL E DW DE Inflation: p= W E DW e DE e e Expected inflation: p = W E Þ MPL = APL = 10 Wage and price adjustment: The Phillips curve We can write the Phillips curve in terms of unemployment and price inflation: DW DE DW e DE p= = - b̂ u - u n W E W E ( ) æ DE DE e ö DE e DE n e n p =p + - b̂ u - u = p - b̂ u - u - ç ÷ E E E ø è E e ( ) ( ) Inflation is determined by: • expected inflation • unemployment • unexpected changes in productivity 11 Wage and price adjustment: The Phillips curve The Phillips curve in terms of unemployment and inflation: æ DE DE e ö p = p - b̂ u - u - ç ÷ E ø è E e ( n ) To simplify, we write: ( ) p = p e - b̂ u - un + z where z represents unexpected changes in productivity and also changes in cost or taxes that affect prices when wages have been set 12 Wage and price adjustment: The Phillips curve • Definition, unemployment: • Production function: • u= L- N L Y n = EN n Y = EN L- N L- Nn N - Nn Y / E -Y n / E Y n Y -Y n u-u = ===L L L L EL Y n n When production is above the natural level, unemployment is below the natural level n Y -Y • Definition, output gap: Yˆ = n Y • The Phillips curve: p = p e + bYˆ + z where Yn lb Y n b = b̂ = EL 1- l EL 13 Wage and price adjustment: The Phillips curve p = p + bYˆ + z e 14 Wage and price adjustment: The Phillips curve p = p + bYˆ + z e Inflation is determined by: • Expected inflation • Output gap • Unexpected shocks to productivity and non-wage costs such as energy prices 15 Wage and price adjustment: The Phillips curve Adjustment is probably slower for several reasons: • Many wage agreements are multi-year agreements • Those who set wages and prices have imperfect information about the economic situation and it takes time to react • Changes in wages and prices are not synchronised All these factors influence the speed of wage and price adjustment and hence the slope of the Phillips curve 16 Expectations: Introduction Question: The position of the Phillips curve depends on expected inflation, but how are expectations about inflation formed and what are the consequences for the relation between inflation and production/employment? 17 Expectations: Introduction Three cases: pe = 0 The price level is expected to be the same as last year p te = p t-1 Inflation is expected to be the same as last year p e = p Ä Inflation is expected to equal the inflation target 18 Expectations: Price level the same (p e = 0) Phillips curve: p = bYˆ + z What happens if the money supply increases more quickly? The effect of increasing M will be higher inflation and higher production and employment. There is a trade-off between inflation and unemployment 19 Expectations: Inflation the same (p e = p -1 ) But if inflation is higher, people should realise that sooner or later. An alternative Phillips curve is p t = p t-1 + bYˆt + zt 20 Expectations: Inflation the same What happens if the money supply increases faster? p = p -1 + bYˆ + z Phillips curve is not stable: when expectations have adjusted, the effect of a faster increase of M is higher inflation but no effect on unemployment 21 Expectations: Inflation the same • Phillips curve: • Subtraction of p = p -1 + bYˆ + z p -1 yields Dp = bYˆ + z • If production is kept above the equilibrium level, inflation will accelerate and vice-versa • Equilibrium unemployment is sometimes called the non-accelerating-inflation rate of unemployment (NAIRU) • The vertical line at the equilibrium level of production (or unemployment rate) is sometimes called the long-run Phillips curve (LRPC) 22 Expectations: Inflation the same • In the long run there is no real choice between inflation and unemployment • It is costly to keep production above the natural level: the result will be permanently higher inflation • If inflation is high, it can be worthwhile to try to reduce it even if it is costly in terms of production and employment in the short run. The result is permanently lower inflation 23 Expectations: A strict and credible inflation target (p e = p Ä ) p = p Ä + bYˆ + z Phillips curve: What happens if the money supply increases faster? The effect of increased M is higher inflation and production. The Phillips curve is not affected as long as the target remains credible 24 Relation between economic activity and inflation 25 Relation between economic activity and inflation Why is there no clear relation – no stable Phillips curve? • When inflation has increased to a high level, it tends to remain high because expected inflation is higher • Equilibrium unemployment can change over time On the other hand there is a fairly strong relation between the output gap and the change in inflation, which supports the Phillips curve with p e = p -1 p = p -1 + bYˆ + z that is Dp = bYˆ + z 26 Relation between economic activity and inflation 27