The explanation of unemployment and its cyclical fluctuations is one of the central tasks of macroeconomics.
In fact, it was the existence and persistence of interwar unemployment that prompted Keynes to embark on producing the General Theory.
Two types of questions need to be asked.
The first type asks what determines the equilibrium (or natural) rate of unemployment in an economy, what its properties are, and to what extent equilibrium unemployment reflects frictions and distortions in the labor market. The second type concerns the fluctuations of the unemployment rate during the economic cycle.1Cyclical fluctuations in unemployment can be explained by and large by new Keynesian models with labor market frictions and nominal wage and price contracts. In this chapter, we analyze a model of aggregate fluctuations that is based on periodic nominal wage contracts and can explain unemployment and its fluctuations. The model is based on Gray [1976], Fischer [1977a], and Taylor [1979], who emphasized the periodic adjustment of nominal wages rather than the periodic adjustment of prices.
In the Gray-Fischer-Taylor model, nominal wage contracts are assumed to be negotiated at the beginning of every period or at the beginning of alternate periods. In addition, nominal wages are assumed to remain fixed for at least part of the duration of the contract. Nominal wages depend on prior expectations about the evolution of the price level, productivity, and all other shocks. If inflation turns out to be higher than expected, then real wages fall, firms demand more labor, and employment rises. The opposite happens when inflation turns out to be lower than expected when the contract was negotiated.2
The model builds on one of the key insights of the General Theory, namely, the short-run rigidity of nominal wages, due to nonindexed labor market contracts. In all other respects, it is based on intertemporal optimization on the part of both households and firms.3
The specific model introduced in this chapter is a DSGE model in which nonindexed nominal wage contracts are negotiated periodically by “insiders” in the labor market.
There are two distortions in the model compared to the new classical model without capital that we analyzed in chapter 14, or to the new Keynesian model of staggered pricing in chapter 16. The first is a real distortion, arising from the fact that the unemployed are disenfranchised “outsiders” in the labor market and cannot affect the determination of nominal wages. As a result, wage contracts, which are negotiated by employed insiders, do not seek to maintain full employment and there is a positive natural rate of unemployment, reflecting the pool of unemployed outsiders. The second is a nominal distortion, arising from the assumption that nominal wage contracts are not indexed and can only be reopened at the beginning of each period, before current nominal and real shocks are observed. Thus, nominal wages are set on the basis of prior rational expectations about the various unobserved shocks that may affect output, employment, and inflation.4The real distortion in our model makes the natural rate of unemployment inefficiently high and involuntary, in the sense that outsiders would prefer to work at the current wage. The nominal distortion allows for nominal shocks to have temporary real effects. Thus, nominal shocks (and by extension, monetary policy) are able to affect fluctuations in both inflation and real variables, such as output, employment, unemployment, real wages, and the real interest rate.
The product market is assumed imperfectly competitive as in the model of chapter 16. We analyze the model under both the assumption that prices are perfectly flexible and are set as a constant markup over unit labor costs, and the assumption of staggered pricing.
Even under fully flexible prices, because of nominal wage contracts, the model is characterized by an expectations-augmented Phillips curve. Deviations of current inflation from inflation expected at the beginning of the period depend on deviations of output and employment from their natural rates.
They also depend on unanticipated productivity shocks, which affect the hiring decisions of firms. This is because the predetermined nominal wage contracts are set on the basis of expected and not actual inflation and productivity. Staggered pricing introduces an additional trade-off between inflation and unemployment through the nominal distortion in the pricing decisions of firms.Aggregate demand is determined by the optimal behavior of a representative household that has access to competitive financial markets and chooses the path of consumption and real money balances to maximize its intertemporal utility function. Thus, both the consumption function and the money demand function are derived from intertemporal microeconomic foundations. The model is also characterized by exogenous shocks to productivity and preferences for consumption and money demand.
Thus, the model is in essence a new Keynesian DSGE model that incorporates some of the key features of the AS-AD version of the Keynesian model discussed in chapter 15.
We analyze aggregate fluctuations in this model under a Taylor rule (i.e., a feedback interest rate rule). According to this rule the nominal interest rate deviates from its natural rate in response to deviations of current inflation from the inflation target of the central bank, and deviations of output from its natural rate.
Contrary to the full information new classical model, monetary shocks affect real variables in this model, causing temporary but persistent deviations of output, employment, unemployment, real wages, and the real interest rate from their natural rates. Persistence in deviations of unemployment and output from their natural rates arises from the dynamic evolution of the group of insiders in the labor market, as this group consists of those who were recently employed, as well as “core” insiders in each firm. The propagation mechanism that causes unanticipated nominal and real shocks to produce persistent deviations of unemployment and output from their natural rate is the partial adjustment of the number of labor market insiders to employment shocks.
Under a Taylor rule, the only shocks that cannot be completely neutralized by monetary policy are productivity shocks and, of course, shocks to the nominal interest rate rule of the central bank. Fluctuations of deviations of unemployment and output from their natural rates display persistence and are driven by these two types of shocks. Because of the endogenous persistence of deviations of unemployment from its natural rate, the equilibrium inflation rate also displays persistence around the inflation target of the central bank.
17.1