EC111LectNG16

EC111LectNG16 - EC111 MACROECONOMICS Spring term 2012...

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1 EC111 MACROECONOMICS Spring term 2012 Lecturer: Jonathan Halket Week 21 Topic 7: WAGE ADJUSTMENT AND THE PHILLIPS CURVE Begg, Chp 22 We have contrasted two types of economy, the Keynesian case, where the nominal wage is fixed and the classical case, where it is perfectly flexible. The truth probably lies somewhere in between. We assume that wages adjust slowly to eliminate excess demand. When there is excess demand in the aggregate labour market (at W 1 ), competition between firms in hiring puts upward pressure on the wage. When there is excess supply (at W 2 ) competition between workers for jobs gradually drives the wage down. But excess supply or demand is only partially eliminated in one period. The greater is the degree of excess demand, the larger the proportionate adjustment in the wage. When demand and supply are equal, L D – L S = 0, the rate of wage change is zero. The rate of wage change is: W/P W 2 /P W 1 /P L S L D
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2 Keynesian and classical models are special cases: When the wage adjustment function lies on the horizontal axis there is no change whatever the level of excess demand—the Keynesian case. When the wage adjustment function lies along the vertical axis the wage adjusts immediately and excess supply or excess demand cannot emerge—the classical case. E W/P W 2 /P W 1 /P L S L D V U L E
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3 In a more realistic labour market there will always be some unemployment. Turnover due to layoffs or workers quitting and searching for new jobs means that there will always be some looking for jobs. In this setting employment is read off the EE curve. The horizontal distance between the EE curve and the demand curve is vacancies, V. The distance between the EE curve and the supply curve is unemployment, U. Note that: There will be an inverse relationship between vacancies and unemployment. There is a (negative) nonlinear relationship between excess demand for labour, L D – L S and unemployment. We can draw the wage adjustment function as a downward sloping relationship between proportionate wage change, , and unemployment, usually the unemployment rate, U. This is the Phillips curve. Looking at data for Britain in the century after 1860, A. W. Phillips found that proportionate wage change was inversely related to the unemployment rate. He estimated that there would be zero wage change when the unemployment rate was about 5.5 percent This seemed to provide policy makers with menu of choice between (wage) inflation and unemployment. If fiscal and monetary policies were used to drive down the unemployment rate below five percent or so then there would be moderate inflation. U
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4 But at the end of the 1960s this stable relationship broke down. Britain and other countries experienced higher unemployment and higher inflation. Why?
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This note was uploaded on 03/15/2012 for the course EC 111 taught by Professor Timhatton during the Spring '12 term at Uni. Essex.

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EC111LectNG16 - EC111 MACROECONOMICS Spring term 2012...

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