Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 19 July 2013

Unemployment, the output gap and wage flexibility

This post is about the impact of nominal and real wage flexibility on unemployment and the output gap. It starts in an academic, abstract sort of way, but the policy implications do follow. I try and make the analysis as accessible as I can to non-economists.

Start with an economy with a zero output gap (defined below) and no involuntary unemployment. Everything in the economy is just fine, which is a non-technical way of saying it is efficient. Then a ‘crisis’ happens that leads consumers to consume less and save more, so aggregate demand falls. Normally in these situations the central bank cuts nominal and real interest rates sufficiently to restore aggregate demand. Once this has happened, call everything in this economy ‘natural’, so the real interest rate that restores demand is the natural rate of interest. The natural level of output may not be the same as the pre-crisis level, because for example the new natural rate of interest can have knock on effects on how much people want to work. [1] However the natural level is the level of output that policymakers should aim for. [2]

In the Great Recession this mechanism did not work because nominal interest rates hit zero, and maybe also because monetary policy put a cap on inflation expectations. As a result, actual real interest rates are above the natural level. In addition, fiscal policy is in the hands of people who know nothing about macroeconomics, so there is no help from there. However monetary policymakers still think they could do something ‘unconventional’, so they want to know what to aim for. The answer is that, as long as what they do does not seriously distort the economy, they should try to get to the natural level of output, because that produces an efficient economy.

The difference between the actual level of output and the hypothetical natural level is called the output gap. The traditional way of defining the output gap was the difference between actual output and ‘productive potential’, which was the amount that could be produced if all factors of production were fully utilised. That is still how the gap is often measured in practice, although the measurement problems can still be huge, as Paul Krugman notes here. The problem at a conceptual level is that this approach downplays considerations of optimality, so nowadays theoretical macroeconomics uses the natural level of output to define the output gap. This has the advantage that we know what policy should be aiming to do: achieving the natural level of output.

Now imagine three almost identical economies where an output gap exists because nominal interest rates have hit zero. The level of real interest rates that would eliminate the output gap is the same in all three economies (i.e. they have the same natural levels of output). In the first economy, workers resist nominal wage cuts, so this puts a floor on how much unemployment reduces real wages. (Equally firms may be reluctant to impose wage cuts, as this research suggests - HT Kevin O’Rourke.) If nominal wages stop falling, at some point firms will stop cutting prices to protect their profits. We settle down to a new lower level of demand deficient output, high unemployment, but stable wages and prices. There is plenty for unconventional monetary policy to do, even though inflation is not falling.

In the two other economies nominal wages carry on falling. In the second economy prices get cut pari passu, so real wages remain unchanged, while in the third they do not, so real wages fall. So in the second economy inflation is lower than in the first, but real wages are the same. Does this lower rate of inflation increase or decrease the output gap? That depends only on whether actual output falls or increases because of lower inflation: the natural level of output involves a hypothetical economy which is unaffected by whether nominal wages fall or not in the actual economy [3]. Actual output may fall if negative inflation makes debtors spend a lot less but creditors not much more - this and other mechanisms are discussed in Mark Thoma’s post here. However, if monetary policymakers have been inhibited from doing much because inflation was not falling (which would be one interpretation of UK policy, for example), then as David Beckworth says, lower inflation may raise actual output by encouraging expansionary unconventional monetary policy.

How about the third economy, where real wages have fallen? Suppose firms respond to lower real wages by substituting labour for capital, and this process continues until all those who want to work can find a job. So in the third economy involuntary unemployment goes away. But is the output gap any lower? Once again, the natural level of output has not changed. (It was set in our hypothetical economy where real interest rates fell to their natural level.) So the key question becomes whether lower real wages and lower unemployment reduces or increases aggregate demand, and therefore actual output. It could go either way. So it is perfectly possible that both actual output and therefore the output gap is exactly the same in all three economies, even though unemployment has returned to its natural rate in one, and the other two have very different inflation rates. 

This comparison suggests that those who say unemployment in the first two economies is caused by wage inflexibility kind of miss the point. The basic problem is lack of aggregate demand. You could argue (I would) that the third economy is better off than the other two, because the pain of deficient demand is evenly spread (everyone has lower real wages), rather than being concentrated among the unemployed. But the first best solution is to raise aggregate demand, because that gets rid of the pain.

I started writing this post because of a recent study by Pessoa and van Reenan, who argue that the mysterious decline in UK labour productivity that I have talked about before can in large part be explained by unusually slow growth in UK real wages. The mechanism they have in mind is entirely traditional: if real wages are low firms substitute labour for capital. This in turn may explain (see Neil Irwin here for example) why UK unemployment originally rose by less than in the US (see first chart), even though the UK’s output performance was worse. On this issue looking at consumer price based measures of real wages will be misleading, so below is a very simple measure of real product wage growth in the two countries: compensation per employee less the GDP deflator. Real wage growth in the UK has noticeably fallen since the recession, whereas the fall has at least been less abrupt in the US (2013 is a forecast).

Unemployment in the US and UK: Source ONS and BLS

Growth in compensation per employee less GDP deflator: OECD Economic Outlook

In terms of just the UK economy, whether Pessoa and van Reenan are right is debatable. When I discussed this in an earlier post I referenced a Bank of England paper by MPC member Ben Broadbent, which argued that for the factor substitution story to explain most of what we have seen in the UK, investment should have completely collapsed, which it has not. This difference in view reflects a number of nitty gritty issues, like how you measure the capital stock, and whether the substitution elasticity is one (as implied by the Cobb Douglas production function), or nearer one half.

However most seem to agree that some of this factor substitution is going on in the UK. So my hypothetical discussion above suggests that, by spreading the pain of deficient aggregate demand further, this ‘real wage flexibility’ in the UK has been a good thing, but it does not mean the aggregate demand problem has decreased. If anything, it suggests that looking at unemployment underestimates the size of the output gap. Monetary policy makers please note.

[1] New Keynesian economists sometimes call the natural economy the outcome when all prices are completely flexible. That is OK, as long as we note that flexible prices here has to include the possibility that nominal interest rate can go negative, which in the real world it cannot.

[2] Opinions may differ on whether the crisis itself is a necessary correction for past errors, or whether it is itself a distortion. For example, was risk undervalued before the crisis, or is it overvalued now. In other words, was the pre-crisis economy efficient, or would there be a distortion in the post-crisis economy even without an aggregate demand problem? These are important complications compared to the story I tell here, but they will have to wait for another post.

[3] The idea is that the economies are identical except for the extent of nominal inertia in goods and labour markets. In economy 1 wages are sticky, in economy 3 prices are sticky but wages are flexible, and in economy 2 the degree of wage and price stickiness is such that real wages do not change. 


  1. "As David Beckworth says, lower inflation may raise actual output by encouraging expansionary unconventional monetary policy"

    This seems like a powerful point and implies that flexible wages plus an appropriate monetary policy will be the best option to minimize the output gap. Without monetary policy then the effects of of falling wages on AD are indeterminate. But introduce monetary policy and that changes. Monetary policy can in theory hit any level of AD (expressed in nominal terms) that it wants to but may be constrained by inflation fears from actually doing so. The more downward flexibility in wages the less these inflation fears will come into play and the smaller the output gap.

    1. I disagree. You pretty well have to work with the degree of wage flexibility you have got. The resistance to nominal wage cuts is very deep. What you should ask is why are there inflation fears that are stopping monetary policy closing the output gap in the first place.

      In other words, you cannot choose to be like economy 2 or 3 rather than economy 1. And in economy 1 monetary policy should be trying to close the output gap.

    2. I don’t like using monetary policy to adjust aggregate demand. It distorts the economy towards the production of investment goods, a distortion that has to be unwound come the recovery.

    3. I agree that you don't get to choose the level of wage flexibility you have to deal with at least in the short run (though I'm guessing that Britain did a good job of changing this via non-monetary policy in the 1980's and 1990's ?).

      I also agree the key thing to understand is "why are there inflation fears that are stopping monetary policy closing the output gap in the first place". Is there a simple answer to that question ? Despite much empirical evidence that unconventional monetary policy helps to narrow the output gap and has done so without causing inflation expectations to increase markedly, it still seems like it is fear of inflation on the part of CBs that prevents unconventional monetary policy from being used to the level that would be needed to bring something like a full recovery.

    4. To finish the thought: If flexible wages cause deflation then monetary policy aimed at ending this deflation will be more acceptable to inflationophobes than unconventional monetary policy that may increase inflation from a low positive inflation rate, even if the macroeconomic effects are identical.

  2. Let's remember Keynes' concept of effective demand. (Chapter 3 of the General Theory...)

    "This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment."

    Are you measuring effective demand in your scenarios above?

    1. Yes, that is what determines actual output in all these cases.

    2. Productive potential being constant in all scenarios implies constant productivity.
      productivity = real hourly wage/labor share

      In scenario 2, if real wages stay the same and productivity stays the same then labor share of income must stay the same and productive capacity stays the same.

      In scenario 3, if real wages fall, and labor share does not change, then productivity falls and productive capacity should fall too.

      You mention that firms are protecting their profits, but you don't mention if they are lowering or raising labor share. In scenario 3, labor share would have to fall to keep productivity and productive capacity constant.

      If labor's share of income is changing, this affects effective demand, since labor's relative income to output determines the purchasing power for finished goods.

      What is happening to labor share in your 3 scenarios?

  3. I know that Krugman uses the employment-population ratio for prime-age adults aged 25-54 (see for example blogs September 7, 2012 'The Employment Situation' and July 12, 2013 'Les Not So Miserables'). By this measure, US unemployment has been flat for years, not falling as shown on the above graph.

    I don't know if there is an equivalent UK measure, but our figures seem so shrouded in zero hours contracts and self-employed people on unemployment benefits to the point where I wouldn't know the extent of their reliability.

  4. so when my wages fall, will my two year lease and all my payments on debt become lower as well? no will not. refinancing not guaranteed neirher.

  5. Output gap and commondity prices

    The main problem of output gap is it emphasize on employment level and the interest rate. It is not surprising that most of the economic models are focused in these two issues. It is not surprising after all since the 1929 crisis and the total failure of the economic leadership of the time to cope with the unemployment problem and the horrendous consequences of their failure the main aim of the economist is to prevent anything similar to happen. However, if the model of output gap is focused too much on the unemployment, it naturally neglects the other limiting factors of the output. What if the economy reached its limits not because of limited aggregated demand, not because of limited labor force but because of limited other resource, for example energy and let’s assume the supply of the energy is with very limited flexibility. Any policy trying to stimulate the economy will case immediate increase in energy prices and with it the economy will be balanced at higher price levels. Nevertheless, if increased energy prices will be necessarily followed by increase of production prices. Now since the wages and the profit remain at the same level, the aggregated demand will stay at its nominal level previous to the energy price increase. The result will be decrease of the aggregated demand in real prices. Yet do not forget the energy price increase necessarily caused price increase and central bank as reaction to it will probably rise the interest rate.

    World Oil Prices 1970-2008.PNG

    The two graphs above show obvious correlation between the oil price and the unemployment. As to the inflation, it is in no correlation with the unemployment and the oil price, since 2008 but it was in correlation in the previous energy crisis at 1973 and 1979-1980. What can be the reason to this inconsistency? Probably that the oil price is not so crucial as it used to be in the seventies.

    World energy consumption by fuel type Source: 1965-1979: BP Statistical Review of World Energy (2008) (excludes wind, geothermal and solar energy); 1980-2030: U.S. Energy Information Administration International Energy Outlook (2008).

    Does it mean there is no danger of a new stagflation as it happened in the seventies? To my opinion such a danger still exists, since the energy is not the only economic resource that can become scarce. Before the 2008 economic crisis the prices of all many commodities raised immensely as seen in the following chart, yet this price hike was short lived because it started at 2006 and with 2008 economic crisis the prices collapsed again. But since 2009 the commodity prices started to rise again and if this trend will continue, probably the phenomena of the stagflation of the seventies will be back.


  7. On interestrates.
    Imho reality is mch more complicated. Next to the technical stuff how to calculate it. Interestrates are determined by both fundamental and by technical stuff.
    Your definition is basically purely fundamental. This is probably not correct. Your natural rate could differ at no output gap simply because of marketcircumstances. And say the following year (also with no output gap and say similar inflation might give another natural rate).
    Probably the most correct description is that there is a fundamental/normal/natural rate. Which however can be affected by technical circumstances in both directions.

    From a finance pov interest is something in which risk plays an important role. We often assume riskfree but that is just a definition. All things in life have risks attached and so do riskfree loans.
    What looks clear from that angle that if risk goes up so will interest demands.
    That is one of the reasons why if things get in the percepotion of markets far from the normal riskpremia will be pushed upwards (whatever CBs do). CBs could push it back even completely but that is hardly a natural situation. What we have now by several meaures CBs are lowering marketdemands for risks involved. However there will remain a friction. If that actually comes to the surface is another point.

    In a nutshell a 'natural' interest with a CB heavily interfering most of the time is a bit of a contradictio.

    Anyway what we see is Macro like yourself says interestrates are still too high. What Finance however says is that they are probably too low (looking at the risk). And subsequently that from a Macro perspective all sort of unnatural stuff is done to make it effectively even lower). And from a Finance perspective investors are looking constantly for alternatives (abroad, but also in-out-in-out stuff and going into high risky stuff (with low yields, like PIIGS bonds).
    This is probably the reason why there is so much friction/turbulence and it looks like CBs possibilities have come to their borders (even that the CBs have lost grip on certain markets according to some).
    Looking from a Finance perspective the technical influence should be huge to compensate for the fundamental (risk) in such a way that the present low interestrates are accepted by markets. And putting these rates under heavy pressure when the excess demand created by QE and indirectly via lowering rates is lifted even for a relatively small part. And almost per definition you create a bubble unless you assume that CBs should constantly interfere (basically what we have now).

  8. «This has the advantage that we know what policy should be aiming to do: achieving the natural level of output.»

    I understand that this is a blog post and there are warnings in the text about "distortion" and hysteresis effects, but this very conventional statement is the usual very short-termist approach.

    Because it is as important and far perhaps more important that the main objective of policy be the aim to *increase* the natural level of output via productivity growth, and that *achieving* it instant-by-instant is a secondary consideration.

    Long term improvements in living standards come from *increasing* the natural level of output, and that can be a far bigger effect than trying to *reach* the natural level of output at all times.

    In an ideal world there is no compromise between these two goals: everything that is done to *reach* the natural level of output also helps *increasing* level of natural output, or at least does not decrease it.

    But in theory as well as in practice a lot of things that help reach the natural level of output can work against increasing the natural level of output.

    Even more subtly, things that can help reach the natural level of output today can make it much harder to reach it later on, by creating countervailing factors whose full effects happen later, as described cogently by Kindleberger and Minsky among others.

    Among the ways that focusing on *reaching* the natural level of output can damage the chances of *increasing* the natural level of output are various forms of under-depreciation of capital, such as encouraging the assumption of tail risk, for example if the form of excessive leverage, or the subsidy of wasteful forms of demand, for example for beachfront properties in Arizona.

    Also, as the Sraffian "return of the technques" and other amusing scenarios show, the economy can achieve multiple mostly-steady states (calling one "equilibrium" is appalling IMNHO), and is also definitely path dependent.

    Keynesian/class economists care a great deal about that, about capital formation ("supply side" economics) as well as or even more than the vagaries of the cycle ("demand side" economics).

    Thus I really take exception to:

    «The answer is that, as long as what they do does not seriously distort the economy, they should try to get to the natural level of output, because that produces an efficient economy.»

    because the level of policy-interest and the availability of credit at that interest level deeply influence:

    * the distribution of income;
    * capital formation;
    * the composition of capital.

    Because for example while the policy rate of interest of close to zero, I personally cannot borrow at close to zero, by deliberate policy design; only the friends of the Prime Minister, the Chancellor and of the Governor of the Bank of England are favoured with such a gift.

    The result of these massive distortions is that like in the past 30 years of reckless (private) credit policy perhaps demand has been sustained as in the Great Moderation, but also *increasing* a higher natural output level has been made more difficult.

    Keynes himself held a long term view of the economy, remarking that almost all capital is long term, that when a casino drives capital formation the job is unlikely to well done etc., that eventually the rentier would be euthanized and most people might choose to work 2 days a week; for him short term demand management, which involved dampening extremes, was just smoothing the path towards increasing level of natural output, and purely to ensure that *people* were not the collateral damage of creative destruction.

    Let's not forget that. Because often the advocates of policies that forget that are usually working to further the interests of shysters and rentiers.


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