Transcript Long Run Supply - Imperial College London

Economic
Environment
Lecture 7
Joint Honours 2003/4
Professor Stephen Hall
The Business School
Imperial College London
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© Stephen Hall, Imperial College London
Revision: Demand and Short-Run Supply
• Obviously we could proceed by super-imposing the (short-run)
supply curve on the price-determined demand curve. This
would provide us with an over-all equilibrium, determining
equilibrium values of Y, P, I, etc.
Price
S
D
P
S
D
Y
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© Stephen Hall, Imperial College London
Demand and Short-Run Supply
• To incorporate the (short-term) supply curve into the
IS-LM model, the only change that is needed is to
understand that increased demand (due, say, to
expansionary fiscal or monetary policies) will cause
not only output to increase, but the equilibrium price
level as well.
• This is known as inflation.
• In turn, the demand for money will increase, and all
other functions and equilibrium values will adjust
accordingly.
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The Phillips curve
The Phillips curve shows
that a higher inflation rate
is accompanied by a
lower unemployment rate.
Inflation rate (%)
Prof. A W Phillips demonstrated a statistical relationship
between annual inflation and unemployment in the UK
Phillips curve
It suggests we can
trade-off more inflation for
less unemployment or
vice versa.
Unemployment rate (%)
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The Phillips curve and an increase in aggregate demand
Inflation
Suppose the economy
begins at U*, with zero
inflation, unemployment
at the natural rate U*...
1
An increase in government
spending funded by an
expansion in money supply
takes the economy to A,
with lower unemployment
but inflation at 1.
A
PC0 … but what happens
Unemployment
next?
U1
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U*
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The Phillips curve and an increase in aggregate demand
Inflation
If nominal money supply
is fixed in the long run,
and prices and wages
eventually adjust, the
economy moves back to E.
But nominal money supply
need not be constant in the
long run
1
A
C
E
U1
U*
Unemployment
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PC0
so we may find the
economy finds its way
back to the natural rate,
but with continuing
inflation at C.
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The vertical Phillips curve
LRPC
Inflation
1
Effectively, the long-run
Phillips curve is vertical,
as the economy always
adjusts back to U*.
The short-run Phillips curve
shows just a short-run
trade-off –
A
C
E
U1
U*
Unemployment
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its position may depend
PC1 upon expectations about
inflation.
PC0
© Stephen Hall, Imperial College London
Labour Supply and the Nominal Wage
• As it now stands, the model we have is complete in the
sense that we can solve for all our equilibrium values; Ye,
ie, T, C, and so on.
• Mathematically, we have a system of equations and an
equivalent number of unknowns.
• The one glaring weakness in our model, however, is that
the amount of labour employed is entirely demanddetermined. Firms simply choose how much labour to
employ given the price level and the money wage rate.
• But who or what determines the money wage rate?
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Labour Supply and the Nominal Wage
• In our model, the wage rate is exogenously determined.
That is, it is what it is! (Keynes assumed that the wage
rate was fixed by convention and “sticky downward”).
• However, the wage rate rises over time, particularly in
periods of high inflation, especially when the economy is
growing quickly, labour is relatively scarce, and workers
have some leverage in wage negotiations.
• In other words, we must introduce a labour supply curve!
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Some key terms
• Unemployment rate:
– the percentage of the labour force without a job
but registered as being willing and available for
work
• Labour force
– those people holding a job or registered as being
willing and available for work
• Participation rate
– the percentage of the population of working age
declaring themselves to be in the labour force
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Unemployment in the UK, 1950-99
14
12
% p.a.
10
8
6
4
2
19
90
19
70
19
50
0
Source: Economic Trends Annual Supplement, Labour Market Trends
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Unemployment (%) in selected countries
14
12
10
%
8
6
4
2
0
1972
UK
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1982
Ireland
France
1999
EU
USA
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Labour market flows
It is tempting to see the labour market in static terms
Working
Unemployed
Out of the
labour force
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but...
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Labour market flows
New hires
Recalls
Working
Job-losers
Lay-offs
Quits
Discouraged
workers
Retiring
Temporarily
leaving
Taking
a job
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Unemployed
Out of the
labour force
Re-entrants
New entrants
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More on labour market flows
• The size of these flows is surprisingly high
• In 1999 unemployment in the UK began at
1.29 million
• During the year:
– 3.14 million became unemployed
– but 3.3 million left the ranks of the unemployed
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The composition of unemployment
• Different groups in society are more
vulnerable to unemployment, varying
by:
– age
– gender
– region
– ethnic origin
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Types of unemployment
• Frictional
– the irreducible minimum level of unemployment in a dynamic
society
•
people between jobs
•
the ‘almost unemployable’
• Structural
– unemployment arising from a mismatch of skills and job
opportunities when the pattern of demand and production
changes
•
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it takes time for ex-coal miners to retrain as international bankers
© Stephen Hall, Imperial College London
Types of unemployment (2)
• Demand-deficient unemployment
– occurs when output is below full capacity
– ‘Keynesian’ unemployment occurs in the transitional period
before wages and prices have fully adjusted
• Classical unemployment
– created when the wage is deliberately maintained above the
level at which labour supply and labour demand schedules
intersect
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A ‘modern’ view of unemployment
• A similar categorization is retained, but an
important distinction is to be noted
between:
• Voluntary unemployment
– when a worker chooses not to accept a job at the
going wage rate
• Involuntary unemployment
– when a worker would be willing to accept a job at
the going wage but cannot get an offer.
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The natural rate of unemployment
Real wage
AJ
w*
E
F
N* N1
Number of workers
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LF
LD: labour demand
LF: size of labour force
AJ: the number of workers
prepared to accept jobs
AJ is to the left of LF
because some members
of the labour force are
between jobs, others are
LD waiting for better offers.
Equilibrium is at w*, N*.
The distance EF is the
natural rate of unemployment.
© Stephen Hall, Imperial College London
The natural rate of unemployment
• The natural rate of unemployment is the
rate of unemployment when the labour
market is in equilibrium.
• This is entirely voluntary.
• It includes:
– frictional unemployment
– structural unemployment
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Real wage
Classical unemployment
w2
w*
AJ
A B
C
LF
Suppose that union power
succeeds in maintaining a
real wage of w2.
Equilibrium is at A
and unemployment is AC,
of which BC is voluntary
LD and AB is involuntary
N2 N* N1
Number of workers
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To the extent that this
unemployment reflects a
conscious decision by
unions to restrict employment,
it is voluntary unemployment.
© Stephen Hall, Imperial College London
Labour Supply and the Nominal Wage
To complete our model, we need an assumption about
labour supply.
Three competing assumptions are:
• The layperson assumption: Workers “need” a certain
level of income. So, if the (hourly) wage rate falls,
workers must work more hours.This would imply a
downward-sloping labour supply curve. But,
empirically, this is an invalid assumption.
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• The Keynesian assumption: Nominal wage rates are fixed
by convention with excess labour supply at that wage rate.
This would imply a horizontal labour supply curve, which
could effectively be ignored by firms. (Graphically, we are
back to our previous model with no labour supply curve).
• The market-clearing assumption: people choose to work
more the higher is the real wage rate. This would imply an
upward-sloping labour supply curve. In conjunction with
the downward-sloping labor demand curve, this would also
imply a single equilibrium real wage rate, employment
level, and output level.
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Labour Supply and the Nominal Wage
• Graphically,
Real Wage
Labour
Supply
w/p
(w/p)0
Labour
Demand
Le
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Labour L
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Long-Run Supply (W variable)
In the preceding “short-run” analysis, the nominal wage
rate “w” was assumed fixed at wt. If markets clear,
however, then there is only one equilibrium wage rate.
If the price level (p) rises, then so too must the nominal
wage rate (w), so that the real wage rate (w/p) remains
at its equilibrium level.
higher P -> higher W -> same W/P?
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Long Run Supply
• Suppose, for example, that the government wishes to
increase output by spending more on public works
projects like road and rail construction (i.e. a fiscal
stimulus).
• As we know, this causes both the IS-curve and the
price-determined demand curve to shift rightward.
• Previously, we concluded that these measures would
indeed cause output to grow. But the economy would
also experience inflation.
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Long Run Supply
• Graphically, we must be moving off of the labour supply curve
and away from (a long-run) equilibrium.
Labour
Supply Demand
D’
Price
Real Wage
SL
S
D
w/pe
D’
DL
S
Le
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L
Labour
D
Ye
Y
Output
© Stephen Hall, Imperial College London
Long-Run Supply Adjustments
• According to the market clearing assumptions, in response to
the higher price level, workers will demand, and will be able to
secure, higher nominal wages. Specifically, they will bargain up
the nominal wage so that real wages are recovered.
• Graphically:
Labour
Supply Demand
Real Wage
S’
D’
Price
D
SL
New
Pe
w/pe
D’
S
DL
Le
L
Labour
S
D
Ye
Y
Output
A comment on this adjustment process follows.
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Long-Run Supply Adjustments (cont.)
• From the preceding visual analysis, we can see that
the government is only able to increase output so
long as workers do not demand higher wages in
response to the higher prices. When the wage rate is
negotiated upward, the supply curve shifts backward
(or upward) and the equilibrium output level returns
(roughly) to where it was originally.
• An intuitive way to think of the preceding analysis is
that government activity causes the price level to
increase, and only later do wages “catch up” to the
new prices. At this point, everything in the labour
market is the same as it was before, but prices and
nominal wages remain higher.
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Long-Run Supply Adjustments (cont.)
The preceding analysis suggests a general result:
• “Expansionary” fiscal or monetary policy, designed to
stimulate aggregate demand, is only effective in the
short term. The only long-term results is inflation.
• Indeed, the preceding general result may overstate
the case! Such expansionary policies actually drain
resources away from private investment and may, in
the long run, actually reduce economic growth.
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A Note on the Natural Rate Hypothesis
• The preceding conclusions are embodied in what is know
as the Natural Rate Hypothesis (NRH), which states in
essence that,
• in the long run, the economy will grow at a certain rate,
and unemployment will remain at a certain level,
irrespective of government policy.
• (More technically, the natural rates of output and
unemployment are defined as those compatible with a
constant rate of inflation).
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A Note on the Natural Rate Hypothesis
• Graphically, the natural rate of output can be seen as
that associated with the intersections of constantly rising
aggregate supply and demand curves.
S1
P
S0
D1
D0
Natural Rate of output
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Short-run aggregate supply
• If adjustment is not instantaneous, output may
diverge from Yp in the short run.
• Firms may vary labour input
– via hours of work (overtime or layoffs)
• Wages may be sluggish in falling to restore full
employment in response to a fall in aggregate
demand
• The short-run aggregate supply schedule shows
the prices charged by firms at each output level,
given the wages they pay.
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The short-run aggregate supply schedule
P0
Suppose the economy is initially at Yp in fullemployment equilibrium at A, with price P0
SAS In response to a fall in
aggregate demand,
A
SAS1 firms in the short run
B
vary labour input, thus
moving along SAS to B.
SAS2
P2
A2
Yp
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Output
In time, the firm is able to
negotiate lower wages,
and the SAS shifts to
SAS1 and then to SAS2,
until equilibrium is
restored at A2.
© Stephen Hall, Imperial College London
A fall in nominal money supply
AS
SAS
P
P'
P''
P3
E
E'
E3
DDS'
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Starting from long-run
equilibrium at E:
a fall in nominal money
supply shifts DDS to DDS'
SAS'
Given wage levels, firms
SAS3 adjust to E' in the short run
With price at P' but wages
unchanged, the real wage
rises bringing involuntary
DDS unemployment.
As the labour market (wage)
adjusts SAS shifts e.g. to SAS'
Yp
Output
Equilibrium is eventually reached at E3, back at Yp.
© Stephen Hall, Imperial College London
An adverse supply shock:
e.g. an increase in the price of oil
Higher oil prices force
SAS' firms to charge more
for their output, so SAS
SAS shifts to SAS'
P
equilibrium from E to E'
E'
P'
P
E
DDS
Y'
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Yp'
Output
Higher prices cause a
move along DDS, and
output falls to Y'
In time, unemployment
reduces wages and SAS
gradually shifts back to
SAS, so Yp is restored.
© Stephen Hall, Imperial College London
The speed of adjustment
• Adjustment in the Classical world is rapid, so the
economy is always at potential output (full
employment).
• If wages and prices are sluggish, then output
may deviate from the potential level.
• A "Keynesian" world of fixed wages and prices
may describe the short run period before
adjustment is complete.
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Adjustment in the labour market
Short-run
(3 months)
WAGES
Largely
given
HOURS
Demanddetermined
EMPLOYMENT
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Largely
given
Medium run Long-run
(1 year)
(4-6 years)
Clearing
Beginning
the labour
to adjust
market
Normal
work week
Hours/
employment
mix
Full
adjusting
employment
© Stephen Hall, Imperial College London
Supply Side Economics
• Notice that we have come full circle. We started with
a simple model in which the government was
omnipotent: it could guarantee output and job growth
simply by spending more.
• Our more complicated model reaches the opposite
conclusions: the government’s expansionary fiscal
and monetary policies can only induce short-term
growth, probably at the expense of reduced long-term
growth.
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Supply-side economics
• entails the use of microeconomic incentives to
alter
– the level of full employment
– the level of potential output
– the natural rate of unemployment
• In the long run the performance of the economy
can only be changed only by affecting the level of
full employment and the corresponding level of
potential output.
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© Stephen Hall, Imperial College London
Supply Side Economics
• Graphically, our model has evolved from simple to complex (or
short-term to long-term, or Keynesian to Monetarist) as follows:
Simple model:
higher G - higher Y
Complex model:
higher G - higher P
S
P
P
S
D
D
D
D
Y
Y
In other words, in the long run, the government is impotent! Or is it?
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© Stephen Hall, Imperial College London
Supply
• To this point, we’ve addressed only demandside measures. But what about supply? In
particular, is there something that government
can do that will encourage firms to employ
more workers and produce more output?
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Supply-Side Policies
•
•
Supply-side economists believe that demand-side government policies
(like fiscal or monetary expansions) are doomed to failure in the long
run. However, they believe that the government can still encourage the
economy to growth. But it must do so by focusing on the supply side.
Graphically,
Supply-Side Government Stimulus
P
S0
S1
D
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Y
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Supply-Side Policies
• It should be emphasised that Keynesians (and most
politicians!) believe that the government can and
should manage economic growth and employment.
• Supply-siders, on the other hand, believe that the role
of the government is to encourage private sector
economic growth by creating an environment in
which firms seek to invest, create jobs and produce
goods for consumption and export.
• But how to do this?
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Supply-Side Strategies
Recall that firms seek to maximise profits.
Rather than condemn this sort of behaviour (“Public need.
Not private greed!”), supply-siders believe that the
government should create policies which acknowledge
and, indeed, take advantage of this motive.
Essentially, the supply-side approach is to make it more
profitable for firms to increase investment, employ more
workers, and produce more output.
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Recall the profit maximising condition (with K variable)
maxL,K  P.f(K,L) - (w.L + r.K).
Taking the first derivatives of this function with respect to L and K, and
setting these equal to zero (for a maximum) gives,
P.f(-)/L - w = 0 and P.f(-)K - r = 0,
which can be re-written as:
w/P = MPL and r/P = MPk.
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Supply-Side Strategies
We also have the second-order conditions
MPL /L 0 and MPK/K<0
Some simple comparative static analysis will show:
(w/P)/ MPL  0. All else the same, for any given level of
employment, as workers become more productive, the real wage rate
increases.
w/L0. If workers demand a higher wage rate, firms will employ less
workers.
P/L  0. As the price (i.e. demand) increased, firms will employ
more workers.
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Supply-Side Strategies
• Therefore, supply-siders believe that the way to
encourage job creation and growth is by:
– (i) encouraging capital investment,
– (ii) providing a less expensive and more flexible
workforce
– (iii) making production more profitable by providing
economic incentives to growth.
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Labour Market Flexibility
• Since 1979, the government has continually
struggled to make the British labour market more
flexible and less costly to employ.
• Flexibility is important because it means that firms do
not have to pay for workers they do not wish to
employ, or at times they do not wish to employ them.
• Another aspects of “flexibility” is the ability to
eliminate unnecessary workers through redundancy.
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Real wage
Tax cuts and unemployment
w1
w2
w3
AJ
A
E
B
N1 N2
LF
With an income tax, the
gross wage paid by firms (w1)
is higher than the take-home
net pay of workers (w3).
Equilibrium is at N1
F
AB is the amount of tax
C
Unemployment is BC
Without tax, equilibrium
LD is at E.
Unemployment is now EF.
Number of workers
EF is less than BC because of the relative slopes of LF & AJ
but the differences may not be substantial.
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© Stephen Hall, Imperial College London
Other supply-side policies
• Trade union reform
– reducing the power of trade unions may limit distortions in
the labour market
• Other labour supply policies
– training and retraining measures
– improving the efficiency of the labour market
• such measures may affect frictional and structural
unemployment
• Investment
– higher investment may increase the demand for labour
• may be achieved via tax incentives or low interest rates
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• It should be emphasised that labour cost to firms is
not the same thing as wages received by employees.
Firms’ labour costs are much higher than workers’
wages, and include things like:
– Maternity leave
– Unemployment taxes
– Rights of employees to file lawsuits against their
employers
– National insurance contributions, etc.
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Labour Market Flexibility
The government has sought to reduce the power of the unions through
a series of measures:
• Employment Act 1980: restricted secondary industrial action, limited
“unfair dismissal” rights, limited “closed shop” agreements.
• Employment Act 1982; make unions liable for damages from unlawful
industrial disputes.
• Trades Union Act 1984; required prior strike ballots and that union
officers be elected.
• Employment Act 1988: enhanced rights of individuals workers, both
union and non-union members.
• Employment Act 1989;
• Employment Bill 1990.
• Recent developments have reversed some of these changes to a small
extent.
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Improving Economic Incentives
• Individuals will not work unless there are rewards to do so; and
in general, they will work harder and longer the greater those
rewards.
• Firms cannot invest and grow unless:
– (i) there are funds to invest,
– (ii) there are financial incentives (i.e. profit)
associated with investing. In general, firms will
invest more, employ more, and produce more the
greater are those incentives.
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Improving Economic Incentives
Particularly since 1979, the government has
undertaken several measures to boost work, savings
and investment. These include:
– Reduced the highest marginal income tax rates from 83% on
wages and 93% on “unearned” income to a common 40%.
– Reduced the basic rate of income tax from 33% to 25%.
– Reduced corporate profit tax rates from 40 - 52% to 25 35%.
– Reduced income tax threshold for low-income earners.
– Introduced various saving and investment schemes.
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Hysteresis
• The idea that a (short-run) fall in labour
demand may lead to a permanent fall in
labour supply
• This could help to explain high and
persistent unemployment in Europe in the
1980s
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Hysteresis (continued)
• Four channels:
– Insider-outsider distinction
• only those in work take part in wage bargaining &
they protect their own positions
– Discouraged workers
• people stop looking for jobs
– Search and mismatch
• firms and workers get used to low search
– capital stock
• low levels of investment in recession lead to
permanently low capital stock levels
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Exercise 3
DO EXERCISE 3
• This exercise has two parts. Part A asks you
to analyse the failure of the Phillips Curve
and Park B asks you to employ the full
supply-demand model to analyse various
policy changes and exogenous shocks.
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