Inflation and pandemic recoveries in five major economies

My discussion about current inflation two weeks ago focused on the UK. Over a year ago I wrote a post called “Inflation and a potential recession in 4 major economies”, looking at the US, UK, France and Germany. I thought it was time to update that post for countries other than the UK, with the UK included for comparison and with Italy added for reasons that will become clear. I also want to discuss in general terms how central banks should deal with the problem of knowing when to stop raising interest rates, now that the Fed has paused its increases, at least for now.

How to set interest rates to control inflation

This section will be familiar to many and can be skipped.

If there were no lags between raising interest rates and their impact on inflation then inflation control would be just like driving a car, with two important exceptions. Changing interest rates is like changing the position of your foot on the accelerator (gas pedal), except that if the car’s speed is inflation then easing your foot off the pedal is like raising rates. So far so easy.

Exception number one is that, unlike nearly all drivers who have plenty of experience driving their car, the central banker is more like a novice who has only driven a car once or twice before. With inflation control, the lessons from the past are few and far between and are always approximate, and you cannot be sure the present is the same as the past. Exception number two is that the speedometer is faulty, and erratically wobbles around the correct speed. Inflation is always being hit by temporary factors, so it’s very difficult to know what the underlying trend is.

If driving was like this, the novice driver with a dodgy speedometer should drive very cautiously, and that is what central bankers do. Rapid and large increases in interest rates in response to increases in inflation might slow the economy uncomfortably quickly, and may turn out to be an inappropriate reaction to an erratic blip in inflation. So interest rate setters prefer to take things slowly by raising interest rates gradually. In this world with no lags our cautious central banker would steadily raise interest rates until inflation stopped increasing for a few quarters. Inflation would still be too high, so they might raise interest rates once or twice again to get inflation falling, and as it neared its target cut rates to get back to the interest rate that kept inflation steady. [1]

Lags make the whole exercise far more difficult. Imagine driving a car, where it took several minutes before moving your foot on the accelerator had a noticeable impact on the car’s speed. Furthermore when you did notice an impact, you had little idea whether that was the full impact or there was more to come from what you did several minutes ago. This is the problem faced by those who set interest rates. Not so easy.

With lags, together with little experience and erratic movements in inflation, just looking at inflation would be foolish. As interest rates largely influence inflation by influencing demand, an interest rate setter would want to look at what was happening to demand (for goods and labour). In addition, they would search for evidence that allowed them to distinguish between underlying and erratic movements in inflation, by looking at things like wage growth, commodity prices, mark-ups etc.

Understanding current inflation

There are essentially two stories you can tell about recent and current inflation in these countries, as Martin Sandbu notes. Both stories start with the commodity price inflation induced by both the pandemic recovery and, for Europe in particular, the war in Ukraine. In addition the recovery from the pandemic led to various supply shortages.

The first story notes that it was always wishful thinking that this initial burst of inflation would have no second round consequences. Most obviously, high energy prices would raise costs for most firms, and it would take time for this to feed through to prices. In addition nominal wages were bound to rise to some extent in an attempt to reduce the implied fall in real wages, and many firms were bound to take the opportunity presented by high inflation to raise their profit margins (copy cat inflation). But just as the commodity price inflation was temporary, so will be these second round effects. When headline inflation falls as commodity prices stabilise or fall, so will wage inflation and copy cat inflation. In this story, interest rate setters need to be patient.

The second story is rather different. For various (still uncertain) reasons, the pandemic recovery has created excess demand in the labour market, and perhaps also in the goods market. It is this, rather than or as well as higher energy and food prices, that is causing wage inflation and perhaps also higher profit margins. In this story underlying inflation will not come down as commodity prices stabilise or fall, but may go on increasing. Here interest rate setters need to keep raising rates until they are sure they have done enough to eliminate excess demand, and perhaps also to create a degree of excess supply to get inflation back down to target.

Of course reality could involve a combination of both stories. In last year’s post I put this collection of countries into two groups. The US and UK seemed to fit both the first and second story. The labour market was tight in the US because of a strong pandemic recovery helped by fiscal expansion, and in the UK because of a contraction in labour supply partly due to Brexit. In France and Germany the first story alone seemed more likely, because the pandemic recovery seemed fairly weak in terms of output (see below). 

Evidence

In my post two weeks ago I included a chart of actual inflation in these five countries. Here is a measure of core inflation from the OECD that excludes all energy and food, but does not exclude the impact of (say) higher energy prices on other parts of the index because energy is an important cost.

Core inflation is clearly falling in the US (green), and rising in the UK (red). In Germany (light blue) core inflation having risen seems to have stabilised, and the same may be true in France and Italy very recently. The same measure for the EU as a whole (not shown) also seems to have stabilised.

If there were no lags (see above) this might suggest that in the US there is no need to raise interest rates further (as inflation is falling), in the UK interest rates do need to rise (as they did last month), while in the Eurozone there might be a case for modest further tightening. However, once you allow for lags, then the impact of the increases in rates already seen has yet to come through, so the case for keeping US rates stable is stronger, the case for raising UK rates less clear (the latest MPC vote was split, with 2 out of 7 wanting to keep rates unchanged) , and the case for raising rates in the EZ significantly weaker. (The case against raising US rates increases further because of the contribution of housing, and falling wage inflation.)

As we noted at the start, because of lags and temporary shocks to inflation it is important to look at other evidence. A standard measure of excess demand for the goods market is the output gap. According to the IMF, their estimate for the output gap in 2023 is about 1% for the US (positive implies excess demand, negative insufficient demand), zero for Italy, -0.5% for the UK (and the EU area as a whole), and -1% for Germany and France. In practice this output gap measure just tells you what has been happening to output relative to some measure of trend. Output compared to pre-pandemic levels is strong in the US, has been pretty strong in Italy, has been quite weak in France, even weaker in Germany and terrible in the UK (see below for more on this).

I must admit that a year ago this convinced me that interest rate increases were not required in the Eurozone. However if we look at the labour market today things are rather different. Ignoring the pandemic period, unemployment has been falling steadily since 2015 in both Italy and France, and for the Euro area as a whole it is lower than at any time since 2000. In Germany, the US and UK unemployment seems to have stabilised at historically low levels. This doesn’t suggest insufficient demand in the labour market in the EZ. Unemployment data is far from an ideal measure of excess demand in the labour market, so the chart below plots another: employment divided by population, taken from the latest IMF WEO (with 23/24 as forecasts).

Once again there is no suggestion of insufficient demand in any of these five countries. (The UK is the one exception, until you note how much the NHS crisis and Brexit have reduced the numbers available for work since the pandemic.)

This and other labour market data suggests our second inflation story outlined in the previous section may not just be true for the US and UK, but may apply more generally. It is why there is so much focus on wage inflation in trying to understand where inflation may be heading. Of course a tight labour market does not necessarily imply interest rates need to rise further. For example in the US both wage and price inflation seem to be falling despite a reasonably strong labour market, as our first inflation story suggested they might. The Eurozone is six months to a year behind the US in the behaviour of both price and wage inflation, but of course interest rates in the EZ have not risen by as much as they have in the US.

Good, bad and ugly pandemic recoveries

The chart below looks at GDP per capita in these five countries, using the latest IMF WEO for estimates for 2023.

Initially I will focus on the recovery since the pandemic, so I have normalised all series to 100 in that year. The US has had a good recovery, with GDP per capita in 2023 expected to be five percent above pre-pandemic levels. So too has Italy, which is forecast to do almost as well. This is particularly good news given that pre-pandemic levels of GDP per capita were below levels achieved 12 years earlier in Italy.

Germany and France have had poor recoveries, with GDP per capita in 2023 expected to be similar to 2019 levels. The UK is the ugly one of this group, with GDP per capita still well below pre-pandemic levels, something I noted in my post two weeks ago. Unlike a year ago, there is no reason to think these differences are largely caused by excess demand or supply, so it is the right time to raise the question of why there has been such a sharp difference in the extent of bounce back from Covid. To put the same point another way, why has technical progress apparently stopped in Germany, France and the UK since 2019.

Part of the answer may be that this reflects long standing differences between the US and Europe. Here is a table illustrating this.

Real GDP per capita growth, average annual rates	2000/1980	2007/2000	2019/2007	2023/2019
France	1.8	1.2	0.5	0.1
Germany	1.8	1.4	1.0	-0.1
Italy	1.9	0.7	-0.5	0.8
United Kingdom	2.2	1.8	0.6	-0.7
United States	2.3	1.5	0.9	1.1

Growth in GDP per capita in the US has been significantly above that in Germany, France or Italy since 1980. At least part of that is because Europeans have chosen to take more of the proceeds of growth in leisure. However this difference is nothing like the gap in growth that has opened up since 2019. (I make no apology in repeating that growth in the UK, unlike France or Germany, kept pace with the US until 2007, but something must have happened after that date to reverse that.)

I have no idea why growth in the US since 2019 has been so much stronger than France or Germany, but only a list of questions. Is the absence of a European type furlough scheme in the US significant? Italy suggests otherwise, but Italy may simply have been recovering from a terrible previous decade. Does the large increase in self-employment that occurred during the pandemic in the US have any relevance? [1] Or are these differences nothing to do with Covid, and instead do they just reflect the larger impact in Europe of higher energy prices and potential shortages due to the Ukraine war. If so, will falling energy prices reverse these differences?

[1] If wage and price setting was based on rational expectations the dynamics would be rather different.

[2] Before anti-lockdown nutters get too excited, the IMF expect GDP per capita in Sweden to be similar in 2023 to 2019.

The Brexit interest rate increases and misunderstanding inflation

Last week’s rise in UK rates has been extensively analysed (see for example Tony Yates here) so I will be very selective. First, the justification for the title of this post is provided by an extract from the inflation report:

“The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.”

The last sentence is particularly important: in plain language it is saying that Brexit is contributing to lower trend productivity growth, which the Bank now put at 1.5% compared to a pre-recession level of 2.25%. The wording is chosen carefully: they are not talking about uncertainty effects, but permanent effects from a likely deal. So last year worries about the demand side effects of Brexit led the Bank to reduce rates, and now concerns about the supply side effects of Brexit are contributing to higher rates.

Whether these modest increases in interest rates continue, as the Bank are signalling, should largely depend on whether the pickup in earnings growth they anticipate actually happens. As Torsten Bell from the Resolution Foundation argues here, the set of information that might justify the Bank’s expectations of an imminent recovery in earnings growth is not empty, but nevertheless many economists regard it as a brave forecast.

However the labour market is not the only reason the Bank is raising rates. Putting labour market issues aside, they think that because firms are operating with little ‘spare capacity’, any large increases in demand will be met by firms raising prices. Ergo the Bank’s job is to use higher interest rates to stop demand rising too fast. I think this is conceptually wrong, because it underestimates the role that demand and expectations about demand play in determining investment decisions.

A firm can meet rising demand in three ways: by investing in more productive processes, by raising prices or by using more of its spare capacity. In a traditional economic upswing firms first use spare capacity, then invest, and when capacity utilisation is at a peak and there are no profitable investments to make it raises prices. At that point it is right for a central bank to step in to moderate demand growth.

This has not been a typical recovery from a recession. Firms have used up spare capacity, but have not invested in more efficient processes. This is what measures of capacity utilisation suggest (taken from an earlier Bank of England Inflation Report).

If you just take these surveys as measuring the state of the cycle (and if we ignore the Bank Agents) since 2013 the economy has been experiencing an economic boom. Yet from 2013 core inflation has been below target and falling. You can resolve this paradox by thinking about firms acting unusually, by failing to invest and meeting additional demand by utilising capacity as if they are in a boom The result of that is stagnant productivity growth.

The conceptual error is to read these capacity utilisation numbers as indicating that there are no profitable investments to make. We know these profitable investments exist, because leading firms are improving their productivity.* What we have is an innovations gap, where lagging firms are not copying leading firms and are instead holding back on investing. We do not know why they are holding back, but one obvious reason is they have expectations of low future growth and/or high uncertainty about this growth. Empirical evidence shows the strongest determinant of investment is output growth, and the obvious rationalisation for that ‘accelerator effect’ is that current growth influences expectations about future growth.

If this is right, increases in demand will be met by firms finally coming off the fence and investing, rather than raising prices. But if the central bank starts raising interest rates to choke off demand, even when it is growing slowly by historical standards, it will validate the pessimism that has been holding back investment and productivity will continue to stagnate. There is a very real danger that the Bank may be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.

Did the Bank of England cause Brexit?

Suppose that by the mid-2000s, immigration from the EU (and the potential for additional immigration) had led to an important shift in the UK labour market. The possibility of bringing labour from overseas meant that old relationships between the tightness of labour market and wage increases no longer held.

You might think that was bad for workers, but that is not so. It would mean what economists call the natural rate of unemployment (or NAIRU) has fallen. Unemployment can be lower without leading to wage increases that threaten the inflation target, because workers fear that the employer can resort to finding much cheaper overseas labour. It reduces the power of workers in the labour market, but also leads to overall benefits. (This is just an example of the standard result that reducing monopoly power is socially beneficial.)

But it is only good news if the Bank of England recognises the change. If they do not, we get stagnant wage growth and unemployment higher than it need be. The obvious response is that the Bank will know there has been a change because wages will start falling faster than they would expect based on previous relationships. However that effect may be masked by the well documented employee and employer reluctance to actually cut nominal wages. Add in the shock of the financial crisis, and this change in the way the labour market works might well be missed.

Here is the big leap. Suppose the above had happened, and the Bank of England did not miss the change. Monetary policy would have been much more expansionary, bringing unemployment well below the 5% mark. Nominal wage growth would have been stronger, and a buoyant labour market would have generated a feel good factor among workers. With more vacancies and less unemployment, concerns about immigration would have begun to fade. The Brexit vote would still have been close, but would have gone the other way.

You may say how could monetary policy be more expansionary given how close we are to the Zero Lower Bound? If that was the case the Bank should have said they were out of ammunition, and placed responsibility with the government and austerity. But for the last two years at least, the Bank could have cut interest rates and has not. You could blame the relentless expectation in the media and financial sector that rates would increase, but the Bank should be able to rise above that.

Of course the Brexit blame game is easy to play when the vote was so tight. The most speculative aspect of this chain of thought is the initial premise about a shift in the NAIRU created by immigration potential. While the possibility makes sense, whether the data backs it up is much less clear. Yet there is some evidence of a structural shift in the UK labour market in the mid-2000s, as Paul Gregg and Steve Machin report.    

Aggregate demand and the labour market

I’m surprised I do not see a diagram like this more often:

The black lines are familiar from any introductory macro textbook. There is a labour supply curve. It is drawn such that a higher real wage encourages more labour supply, but I will consider what happens if it is vertical later. What I call the ‘unconstrained labour demand’ curve is what firms would choose to do if (a) labour gets less productive as output increases (which is why the curve slopes downward), and (b) firms can sell whatever they like. This is the classical model, and you will find this diagram in nearly every introductory textbook. With flexible wages the level of employment is determined at the intersection of the two curves, and we could call it the ‘natural’ employment level.

However (b) is a fiction. No (surviving) firm produces what it wants to, irrespective of whether people want to buy its product. Aggregate demand can diverge from the level of output implied by the intersection of the two black curves for all kinds of reasons: Says Law does not hold. For simplicity, suppose the aggregate demand for goods in the economy is independent of the real wage, and there is no factor substitution. In that case employment is determined by my red line - it is determined only by aggregate demand. This is pretty clear in the case that I have drawn, where we have deficient aggregate demand. Firms produce what they can sell: they would like to sell more, but there is no point producing more if no one wants to buy more.

It is less clear what happens if the red line shifts right until we have excess aggregate demand. If the number of firms is fixed, why would they produce more than they want to - i.e. at a level where they are losing money on the extra products they are producing? In New Keynesian models where firms are monopolistic and prices are sticky they will produce more if excess demand is modest, because for given prices it is profitable to produce more up to some limit. But will firms be prepared to pay higher (e.g. overtime) wages to workers for long, or will workers be prepared to work more for unchanged wages for long? I will come back to this at the end.

If there is deficient demand, is there anything that makes the red line move right to achieve the natural employment level? With deficient demand, prices may tend to fall, but that alone is unlikely to shift the red line to the right: few people talk about Pigou effects anymore, and the general concern is that deflation is deflationary because the real value of debt has increased. It is monetary policy that shifts the red line in the required direction, either because it responds to falling prices or because it wants to reduce the output gap. Ironically, Real Business Cycle models, which assume the red line is always at the natural employment level, only make sense in a world where monetary policy is very efficient. However, monetary policy does normally work over the medium term, which is why the classical or RBC model makes sense if we are just doing medium/long term analysis.

What happens to the real wage? In the most basic of New Keynesian models, the labour market clears, which means real wages fall until the labour supply curve intersects the red line. (Here a vertical supply curve would be a problem.) If, in contrast, real wages were sticky, we would get involuntary unemployment - rationing in the labour market. Which is true matters a great deal to those unemployed, but it terms of modelling deviations from the natural rate the difference is not that great. Real wages have no direct impact on aggregate demand, and so all that might happen is that monetary policy could be influenced one way or the other. If it is not, what happens to real wages is irrelevant to the basic problem, which is deficient aggregate demand. This is one reason why New Keynesian economists may be happy to work with a model where the labour market clears, but there may be other reasons.

The vertical red line assumes no factor substitution. With factor substitution it can become downward sloping: falling real wages lead firms to substitute labour for capital, which can increase employment even if output is unchanged because aggregate demand is unchanged. As I speculate in this post, based on the work of Pessoa and Van Reenen, something like this could help explain the current UK productivity puzzle. If this speculation is correct, at some point as aggregate demand and investment expands real wages will rise, and labour productivity will increase as factor substitution is reversed.

I was prompted to write this post by this from Noah Smith, which in turn comments on a post by John Quiggin. (See also Mike Konczal and Nick Rowe.) They talk about models of labour market matching, which I have not mentioned, but similar considerations apply with matching models taking the place of the classical model (although there are key differences between the two). This gives me another chance to plug an AER paper by Pascal Michaillat, which addresses the possible asymmetry that may occur when we have excess demand. Michaillat’s model is a matching model when aggregate demand is strong, but a rationing model (with Keynesian involuntary unemployment) when aggregate demand is low. This is one, rather interesting, answer to the question I asked above about possible asymmetry. Putting matching together with Keynesian rationing is complicated, but if Michaillat’s paper is ignored just for this reason, that says something rather sad about current macro methodology. 

New Keynesian models and the labour market

Do all those using New Keynesian models have to believe everything in those models? To answer this question, you have to know the history of macroeconomic thought. I think the answer is also relevant to another frequently asked question, which is what the difference is between a ‘New Keynesian’ and an ‘Old Keynesian’?

You cannot understand macro today without going back to the New Classical revolution of the 1970s/80s. I often say that the war between traditional macro (Keynesian or Monetarist) and New Classical macro was won and lost on the battlefield of rational expectations. This was not just because rational expectations was such an innovative and refreshing idea, but also because the main weapon in the traditionalists armoury was so vulnerable to it. Take Friedman’s version of the Phillips curve, and replace adaptive expectations by rational expectations, and the traditional mainstream Keynesian story just fell apart. It really was no contest. (See Roger Farmer here, for example.)

I believe that revolution, and the microfoundations programme that lay behind it, brought huge improvements to macro. But it also led to a near death experience for Keynesian economics. I think it is fairly clear that this was one of the objectives of the revolution, and the winners of wars get to rewrite the rules. So getting Keynesian ideas back into macro was a slow process of attrition. The New Classical view was not overthrown but amended. New Keynesian models were RBC models plus sticky prices (and occasionally sticky wages), where stickiness was now microfounded (sort of). Yet from the New Classical point of view, New Keynesian analysis was not a fundamental threat to the revolution. It built upon their analysis, and could be easily dismissed with an assertion about price flexibility. Specifically NK models retained the labour leisure choice, which was at the heart of RBC analysis. Monetary policymakers were doing the Keynesian thing anyway, so little was being conceded in terms of policy. [1]

So labour supply choice and labour market clearing became part of the core New Keynesian model. Is this because all those who use New Keynesian models believe it is a good approximation to what happens in business cycles? I doubt it very much. However for many purposes allowing perfect labour markets does not matter too much. Sticky prices give you a distortion that monetary policy can attempt to negate by stabilising the business cycle. The position you are trying to stabilise towards is the outcome of an RBC model (natural levels), but in many cases that involves the same sort of stabilisation that would be familiar to more traditional Keynesians.

This is not to suggest that New Keynesians are closet traditionalists. Speaking for myself, I am much happier using rational expectations than anything adaptive, and I find it very difficult to think about consumption decisions without starting with an intertemporally optimising consumer. I also think Old Keynesians could be very confused about the relationship between aggregate supply and demand, whereas I find the New Keynesian approach both coherent and intuitive. However, the idea that labour markets clear in a recession is another matter. It is so obviously wrong (again, see Roger Farmer). So why did New Keynesian analysis not quickly abandon the labour market clearing assumption?

Part of the answer is the standard one: it is a useful simplifying assumption which does not give us misleading answers for some questions. However the reason for my initial excursion into macro history is because I think there was, and still is, another answer. If you want to stay within the mainstream, the less you raise the hackles of those who won the great macro war, the more chance you have of getting your paper published.

There are of course a number of standard ways of complicating the labour market in the baseline New Keynesian model. We can make the labour market imperfectly competitive, which allows involuntary unemployment to exist. We can assume wages are sticky, of course. We can add matching. But I would argue that none of these on its own gets close to realistically modelling unemployment in business cycles. In a recession, I doubt very much if unemployment would disappear if the unemployed spent an infinite amount of time searching. (I have always seen programmes designed to give job search assistance to the unemployed as trying to reduce the scaring effects of long term unemployment, rather than as a way of reducing aggregate unemployment in a recession.) To capture unemployment in the business cycle, we need rationing, as Pascal Michaillat argues here (AER article here). This is not an alternative to these other imperfections: to ‘support’ rationing we need some real wage rigidity, and Michaillat’s model incorporates matching. [2]

I think a rationing model of this type is what many ‘Old Keynesians’ had in mind when thinking about unemployment during a business cycle. If this is true, then in this particular sense I am much more of an Old Keynesian than a New Keynesian. The interesting question then becomes when this matters. When does a rationed labour market make a significant difference? I have two suggestions, one tentative and one less so. I am sure there are others.

The tentative suggestion concerns asymmetries. In the baseline NK model, booms are just the opposite of downturns - there is no fundamental asymmetry. Yet traditional measurement of business cycles, with talk of ‘productive potential’ and ‘capacity’, are implicitly based on a rather different conception of the cycle. A recent paper (Vox) by Antonio Fatás and Ilian Mihov takes a similar approach. (See also Paul Krugman here.) Now there is in fact an asymmetry implicit in the NK model: although imperfect competition means that firms may find it profitable to raise production and keep prices unchanged following ‘small’ increases in demand, at some point additional production is likely to become unprofitable. There is no equivalent point with falling demand. However that potential asymmetry is normally ignored. I suspect that a model of unemployment based on rationing will produce asymmetries which cannot be ignored.

The other area where modelling unemployment matters concerns welfare. As I have noted before, Woodford type derivations of social welfare give a low weight to the output gap relative to inflation. This is because the costs of working a bit less than the efficient level are small: what we lose in output we almost gain back in additional leisure. If we have unemployment because of rationing, those costs will rise just because of convexity. [3]

However I think there is a more subtle reason why models that treat cyclical unemployment as rationing should be more prevalent. It will allow New Keynesian economists to say that this is what they would ideally model, even when for reasons of tractability they can get away with simpler models where the labour market clears. Once you recognise that periods of rationing in the labour market are fairly common because economic downturns are common, and that to be on the wrong end of that rationing is very costly, you can see more clearly why the labour contract between a worker and a firm itself involves important asymmetries - asymmetries that firms would be tempted to exploit during a recession. 

Yet you have to ask, if I am right that this way of modelling unemployment is both more realistic and implicit in quite traditional ways of thinking, why is it so rare in the literature? Are we still in a situation where departures from the RBC paradigm have to be limited and non-threatening to the victors of the New Classical revolution?

[1] When, in a liquidity trap, macroeconomists started using these very same models to show that fiscal policy might be effective as a replacement for monetary policy, the response was very different. Countercyclical fiscal policy was something that New Classical economists had thought they had killed off for good.

[2] Some technical remarks.

(a) Indivisibility of labour, reflecting the observation (e.g. Shimer, 2010) that hours per worker are quite acyclical, has been used in RBC models: early examples include Hansen (1985) and Hansen and Wright (1992). Michaillat also assumes constant labour force participation, so the labour supply curve is vertical, and critically some real wage rigidity and diminishing returns.

(b) Consider a deterioration in technology. With flexible wages, we would get no rationing, because real wages would fall until all labour was employed. What if real wages were fixed? If we have constant returns to labour, then if anyone is employed, everyone would be employed, because hiring more workers is always profitable (mpl>w always). What Michaillat does is to allow diminishing returns (and a degree of wage flexibility): some workers will be employed, but after a point hiring becomes unprofitable, so rationing can occur.  

(c) Michaillat adds matching frictions to the model, so as productivity improves, rationing unemployment declines but frictional unemployment increases (as matches become more difficult). Michaillat’s model is not New Keynesian, as there is no price rigidity, but there is no reason why price rigidity could not be added. Blanchard and Gali (2010) is a NK model with matching frictions, but constant returns rules out rationing.

[3] I do not think they will rise enough, because in the standard formulation the unemployed are still ‘enjoying’ their additional leisure. One day macroeconomists will feel able to note that in reality most view the cost of being unemployed as far greater than its pecuniary cost less any benefit they get from their additional leisure time. This may be a result of a rational anticipation of future personal costs (e.g. here or here), or a more ‘behavioural’ status issue, but the evidence that it is there is undeniable. And please do not tell me that microfounding this unhappiness is hard - why should macro be the only place where behavioural economics is not allowed to enter!? (There is a literature on using wellbeing data to make valuations.) Once we have got this bit of reality (back?) into macro, it should be much more difficult for policymakers to give up on the unemployed.

References (some with links in the main text)

Olivier Blanchard & Jordi Galí (2010), Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment,  American Economic Journal: Macroeconomics, vol. 2(2), pages 1-30

Hansen, Gary D (1985) “Indivisible Labour and the Business Cycle” Journal of Monetary Economics 16, 309-327

Hansen, Gary D and Wright, Randall (1992) “The Labour Market in Real Business Cycle Theory” Federal Reserve Bank of Minneapolis Quarterly Review 16, 2-12.

Pascal Michaillat (2012), Do Matching Frictions Explain Unemployment? Not in Bad Times, American Economic Review, vol. 102(4), pages 1721-50.

Shimer, R. ‘Labor Markets and Business Cycles’, Princeton, NJ: Princeton University Press, 2010.

The trouble with teaching macroeconomics: minimum wages and immigration

                I’m in the middle of lecturing on our second year macroeconomics course. There is so much ground to cover in a short amount of time, so on many occasions I have to stop myself launching into a long discussion about why the world is much more complicated than the simple model I’m presenting. One example that will be familiar to many is the impact of minimum wages on employment, where the evidence may not fit the standard textbook model. (The work of Card &  Krueger is well known, but those in the US may be less familiar with similar work in the UK. Some recent work discussing international evidence is here.)

                I used to be more comfortable about using the standard labour market model, coupled with the variant involving imperfectly competitive goods and labour markets, to analyse the impact of immigration. The idea that immigration was initially unpopular because it led either to lower real wages for the indigenous workforce, or an increase in the amount of involuntary unemployment generated by imperfect competition, seemed to accord with popular perceptions (although see here (10/2/2012) for a discussion of the origin of such perceptions). And I was always careful to add that any decline in real wages would disappear in the long run, as it would be eliminated by increased investment. However work in the UK has suggested that in this case the simple model may be seriously misleading once again.

In early January the Government’s independent Migration Advisory Committee (MAC) published a report which was widely reported as finding that “an increase of 100 foreign-born working-age migrants in the UK was associated with a reduction of 23 natives in employment for the period 1995 to 2010.” However further reading of the report finds this result is not at all robust. At the same time the National Institute published findings that found no impact of immigration on unemployment. The two pieces of analysis are compared by Jonathan Portes here. Ian Preston at the Centre for Research and Analysis of Migration (CReAM) at UCL notes (16/1/2012) that ‘There have been studies in several countries and the preponderance of evidence is strongly suggestive that employment effects are small if they exist at all.’ (Here is a recent US study focusing on the impact on poverty.)

What about wages? The MAC study’s summary of empirical work on the impact of immigration on wages concludes “The majority of studies estimate that migrants had little impact on average wages, differing in their assessments of whether migrants raised or lowered average wages.”  There seems to be a common finding that immigration lowers wages a little at the bottom of the income distribution, but raises them at the top. This is hardly consistent with the simple textbook labour market model.

Perhaps we can content ourselves that the textbook model might still be reliable for much larger changes in migration or minimum wages, but that for more modest changes factors like heterogeneity due to skill shortages or monopsony can account for the empirical evidence cited above. However, even if I did have time to make these qualifications to the basic model in my lectures, would students remember them, or just remember the predictions of the model?