Notes for a New Guide to Keynes - CREIStaggered price and wage setting à la Calvo Unemployment...

Notes for a New Guide to Keynes

Jordi Galí

CREI, UPF and Barcelona GSE

EEA Congress, Málaga 2012

Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 1 / 36

Notes for a New Guide to Keynes (I):Wages, Aggregate Demand and Employment

Jordi Galí

CREI, UPF and Barcelona GSE

EEA Congress, Málaga 2012


Outline

Keynes vs the Classics in the General Theory

- The classical theory of employment- The Keynesian theory of employment- The nature of unemployment and its cure

Keynes vs the Classics through the lens of the New Keynesian model

- The standard New Keynesian model: main ingredients- Beyond the General Theory : two "new" insights- The gains from wage flexibility revisited

Implications in the current policy environment



The classical theory of employment


Employment

Wage

Labor demand

( )mpn

w p−

n

The Classical Theory of Employment: Labor Demand

Labor force

Wage Labor supply

( )mrs

w p−

l

The Classical Theory of Employment: Labor Supply

Employment Labor force

Wage Labor supply

Labor demand

( )mpn

( )mrs

w p−

n l=

The Classical Theory of Employment: Equilibrium



"I. The wage is equal to the marginal product of labour.""II. The utility of the wage when a given volume of labour is employed

is equal to the marginal disutility of that amount of employment."Keynes (GT, chapter 2).



Wage Labor supply

Labor demand

( )mpn

( )mrs

w p−

n l

u

Unemployment in the Classical Theory of Employment


Wage Labor supply

Labor demand

( )mpn

( )mrs

w p−

n l

u

Classical Unemployment Cures (I): Real Wage Reduction

ń ´l

´ ´w p−ú


Wage Labor supply

Labor demand

( )mpn

( )mrs

w p−

n l

u

Classical Unemployment Cures (II): Employment Subsidy

ń

ú



The Keynesian theory of employment


The Keynesian Theory of Employment

Aggregate Demand

Output

Employment

Technology

Employment

Wage

n




The Keynesian theory of employment

- Price setting by firms:

pt = µp + (wt −mpnt )

- Implied wage schedule:

wt − pt = mpnt − µp


Employment

Wage

Wage schedule

w p−

n



Wage Labor supply

Wage schedule

( )mrs

w p−

n l

u

Unemployment in the Keynesian Theory of Employment


Wage Labor supply

Wage schedule

( )mrs

w p−

n l

u

Cure for Keynesian Unemployment: Aggregate Demand Expansion

ń

ú´ ´w p−

´l

The Standard New Keynesian Model: Main Ingredients (I)

Households/Preferences

E0∞

∑t=0

βtU(Ct ,Nt ;Xt )

where

U(Ct ,Nt ;Xt ) =

(logCt −

N1+ϕt

1+ ϕ

)Xt

xt = ρxxt−1 + εxt


The Standard New Keynesian Model: Main Ingredients (I)

Households/Preferences

E0∞

∑t=0

βtU(Ct ,Nt ;Xt )

where

U(Ct ,Nt ;Xt ) =

(logCt −

N1+ϕt

1+ ϕ

)Xt

xt = ρxxt−1 + εxt

Firms/TechnologyYt = AtN1−α

t

whereat = ρaat−1 + εat


The Standard New Keynesian Model: Main Ingredients (II)

Monopolistic competition in goods and labor markets




Staggered price and wage setting à la Calvo





Unemployment (Galí (2011)):

ut ≡ lt − nt

where participation lt is given by:

wt − pt = ct + ϕlt





Unemployment (Galí (2011)):

ut ≡ lt − nt

where participation lt is given by:

wt − pt = ct + ϕlt

Monetary policyit = ρ+ φππt + φy yt + vt

wherevt = ρv vt−1 + εvt


The Standard New Keynesian Model: Main Ingredients(III)

Simplifying assumptions

- no fiscal sector- closed economy- no endogenous capital accumulation


The Standard New Keynesian Model: Main Ingredients(III)

Simplifying assumptions

- no fiscal sector- closed economy- no endogenous capital accumulation

Effi cient allocation

net =log(1− α)

1+ ϕ≡ ne

y et = at + (1− α)ne


Beyond the General Theory (I): Cyclical Behavior of Wages



Wage Labor supply

Wage schedule

( )mrs

w p−

n l

u

The Effects of an Aggregate Demand Expansion in the General Theory

ń

ú´ ´w p−

´l

2 4 6 8 10 12 14 160

0.2

0.4

0.6

0.8

1

1.2

1.4Output

2 4 6 8 10 12 14 160.2

0.4

0.6

0.8

1

1.2

1.4

1.6Employment

2 4 6 8 10 12 14 16-2

-1.5

-1

-0.5

0Unemployment Rate

2 4 6 8 10 12 14 160.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2Real Wage

Dynamic Responses to an Aggregate Demand Shock in the NK Model


The wage schedule with flexible prices (General Theory)


↑ n⇒ ↓ mpnt ⇒ ↓ (wt − pt )



The wage schedule with flexible prices (General Theory)


↑ n⇒ ↓ mpnt ⇒ ↓ (wt − pt )The wage schedule with sticky prices (NK model)

wt − pt = mpnt − µpt

↑ n⇒ ↓ mpnt , ↓ µpt ⇒ ↓↑ (wt − pt )



Wage Labor supply

Wage schedule

( )mrs

w p−

n

The Effects of an Aggregate Demand Expansion with Sticky Prices

ń

´ ´w p−

00.1

0.20.3

0.40.5

0.60.7

0.80.9

0

0.2

0.4

0.6

0.8

1-1

-0.5

0

0.5

1

1.5

2

2.5

3

Price Stickiness

Wage Stickiness

Rea

l Wag

e R

espo

nse

to M

onet

ary

Pol

icy

Sho

ckImpact Response of the Real Wage to an Aggregate Demand Shock in the NK Model

Beyond the General Theory (II): The Effects ofTechnology Shocks on Employment



Wage Labor supply

Labor demand

( )mpn

( )mrs

w p−

n

The Effects of Technology Shocks on Employment: the Classical Model

ń

w p′ ′−

Employment

Wage Labor supply

Wage schedule

( )mrs

w p−

n

The Effects of Technology Shocks on Employment: the Keynesian Model

ń

´ ´w p−

Assumption: constant aggregate demand


Equilibrium employment in the NK model

nt =1

1− α(yt − at )




nt =1

1− α(yt − at )

Equilibrium output in the NK model

yt = Et{yt+1} − (it − Et{πt+1}) + (1− ρx )xt




nt =1

1− α(yt − at )



Equivalently:

yt = xt − Et

{∞

∑k=0

(it+k − Et{πt+1+k})}




nt =1

1− α(yt − at )



Equivalently:

yt = xt − Et

{∞

∑k=0

(it+k − Et{πt+1+k})}

Thus,

nt =1

1− α

(xt − Et

{∞

∑k=0

(it+k − Et{πt+1+k})}− at

)⇒ key role for endogenous response of monetary policy


5 10 150

0.2

0.4

0.6

0.8Output

5 10 15-0.35

-0.3

-0.25

-0.2

-0.15Employment

5 10 150.1

0.15

0.2

0.25

0.3

0.35Unemployment Rate

5 10 150.05

0.1

0.15

0.2

0.25

0.3Real Wage

Dynamic Responses to a Technology Shock in the NK Model


Basic evidence on the effects of aggregate technology shocks

Galí (AER 1999)Basu, Fernald and Kimball (AER 2006)Francis and Ramey (JME 2005)Barnichon (JME 2010)...

Evidence on the impact of changes in monetary policy on the effects oftechnology shocks

Galí, López-Salido and Vallés (JME 2003)Fisher (JPE 2006)...

Evidence based on estimated DSGE models

Galí and Rabanal (NBER MA 2004)Smets and Wouters (JEEA 2003, AER 2007)...Jordi Galí (CREI, UPF and Barcelona GSE) Notes for a New Guide to Keynes EEA Congress, Málaga 2012 21 / 36

Gains from Wage Flexibility in the New Keynesian Model




nt =1

1− α

(xt − Et

{∞

∑k=0


)




nt =1

1− α

(xt − Et

{∞

∑k=0


)

Under constant real interest rate:

nt =1

1− α(xt − at )




nt =1

1− α

(xt − Et

{∞

∑k=0


)Under constant real interest rates:

nt =1

1− α(xt − at )

Key message:

- no direct impact of wage adjustments on labor demand and employment- indirect effect:

↓ w ⇒ ↓ π ⇒ ↓ i ⇒ ↓ r ⇒ ↑ y ⇒ ↑ n

⇒ importance of endogenous monetary policy response ("policy rule")




nt =1

1− α

(xt − Et

{∞

∑k=0


)Under constant real interest rates:

nt =1

1− α(xt − at )

Key message:

- no direct impact of wage adjustments on labor demand and employment- indirect effect:

↓ w ⇒ ↓ π ⇒ ↓ i ⇒ ↓ r ⇒ ↑ y ⇒ ↑ n⇒ importance of endogenous monetary policy response (policy rule)

Illustration: Effects of a payroll tax shock on employment

τt = ρττt−1 + ετt


Dynamic Responses of Employment to a Payroll Tax Shock

02

46

810

1214

16 1

1.2

1.4

1.6

1.8

2

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

Inflation Coefficient

Periods

Em

ploy

men

t Res

pons

e to

Pay

roll

Tax

Sho

ck

Gains from Wage Flexibility in the New Keynesian Model:Some Simulations

Two "exogenous factors":

- Wage stickiness: θw ∈ (0, 1)- Policy responsiveness to inflation: φπ ∈ (1, 2]Effects on employment volatility [σ(nt )]

Effects on welfare

L ∼ (1+ ϕ) var(nt ) +(

εpλp(1− α)

)var(πpt ) +

(εwλw

)var(πwt )

Conditional analysis:

(i) technology shocks(ii) preference shocks


1

1.2

1.4

1.6

1.8

2 00.2

0.40.6

0.81

0

1

2

3

4

5

6

Wage StickinessInflation Coefficient

Std

. dev

iatio

n of

em

ploy

men

t

Wage Flexibility, Monetary Policy and Employment Volatility (I): Technology Shocks

1

1.2

1.4

1.6

1.8

2

0 0.1 0.2 0.30.4 0.5 0.6 0.7 0.8 0.9

1

0

100

200

300

400

500

600


Wage Stickiness

Wel

fare

loss

esWage Flexibility, Monetary Policy and Welfare (I): Technology Shocks

Decomposition of Welfare Losses (I): Technology Shocks

11.2

1.41.6

1.82

00.2

0.40.6

0.81

0

50

100

150


Wage Stickiness

Wel

fare

loss

es: E

mpl

oym

ent c

ompo

nent

1

1.2

1.4

1.6

1.8

2

00.2

0.40.6

0.81

0

50

100

150

200

250


Wage Stickiness

Wel

fare

loss

es: W

age

Infla

tion

Com

pone

nt

1

1.2

1.4

1.6

1.8

2

00.2

0.40.6

0.81

0

200

400

600


Wage Stickiness

Wel

fare

loss

es: P

rice

Infla

tion

Com

pone

nt

(i) Employment (ii) Price Inflation

(iii) Wage Inflation

1

1.2

1.4

1.6

1.8

2 00.2

0.40.6

0.81

0

0.5

1

1.5

2

2.5

3

3.5

Wage StickinessInflation Coefficient

Std

. dev

iatio

n of

em

ploy

men

t

Wage Flexibility, Monetary Policy and Employment Volatility (II): Preference Shocks

11.2

1.41.6

1.82

00.2

0.40.6

0.81

0

100

200

300

400

500

600


Wage Stickiness

Wel

fare

loss

es

Wage Flexibility, Monetary Policy and Welfare (II): Preference Shocks

Decomposition of Welfare Losses (III): Preference Shocks

11.2

1.41.6

1.82

00.2

0.40.6

0.81

0

20

40

60

Inflation CoefficientWage Stickiness

Wel

fare

loss

es: E

mpl

oym

ent c

ompo

nent

11.2

1.41.6

1.82

00.2

0.40.6

0.81

0

100

200

300

400

500

Inflation CoefficientWage Stickiness

Wel

fare

loss

es: P

rice

Infla

tion

Com

pone

nt

11.2

1.41.6

1.82

00.2

0.40.6

0.81

0

50

100

150

200

250


Wage Stickiness

Wel

fare

loss

es: W

age

Infla

tion

Com

pone

nt

(i) Employment (ii) Price Inflation

(iii) Wage Inflation

Gains from Wage Flexibility in the New Keynesian Model:Some Simulations

Two "exogenous factors":

- Wage stickiness: θw ∈ (0, 1)- Policy responsiveness to inflation: φπ ∈ (1, 2]Effects on employment volatility [σ(nt )]

Effects on welfare

L ∼ (1+ ϕ) var(nt ) +(

εpλp(1− α)

)var(πpt ) +

(εwλw

)var(πwt )

Conditional analysis:

(i) technology shocks(ii) preference shocks

Gains from wage flexibility under the optimal monetary policy


Wage Flexibility and Welfare under the Optimal Monetary Policy

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 10

1

2

3

4

5

6

7

8

Wel

fare

loss

und

er O

ptim

al P

olic

y

Wage Stickiness

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 10

1

2

3

4

5

6

7

8C

ompo

nent

s of

Wel

fare

Los

s un

der O

ptim

al P

olic

y

Wage Stickiness

employmentwage inflationprice inflation

Decomposition of Welfare Losses under the Optimal Monetary Policy

Some Caveats

Closed economy assumption: no room for "competitiveness channel"

↓ w ⇒ ↓ p ⇒ ↑ q ⇒ ↑ y ⇒ ↑ n


Some Caveats


↓ w ⇒ ↓ p ⇒ ↑ q ⇒ ↑ y ⇒ ↑ n

However:- impact on terms of trade not invariant to monetary policy response- beggar-thy-neighboor policy- effectiveness depends on degree of pass-through (if pricing to market)


Some Caveats


↓ w ⇒ ↓ p ⇒ ↑ q ⇒ ↑ y ⇒ ↑ n

Offsetting channel (I): if no interest rate response (e.g. exchange ratepeg):

↓ w ⇒ ↓ π ⇒ ↑ r ⇒ ↓ y ⇒ ↓ n


Some Caveats


↓ w ⇒ ↓ p ⇒ ↑ q ⇒ ↑ y ⇒ ↑ n

Offsetting channel (I): if no interest rate response (e.g. exchange ratepeg):

↓ w ⇒ ↓ π ⇒ ↑ r ⇒ ↓ y ⇒ ↓ nOffsetting channel (II): additional channel with non-Ricardian households:

↓ w ⇒ ↓ c ⇒ ↓ y ⇒ ↓ n


Concluding Remarks

Current environment: persistently high unemployment, though largeheterogeneity across countries

Recurring calls for structural reforms to make labor markets more flexible

"...Further significant reductions in unit labor costs and excess profitmargins are particularly urgent, especially in countries whereunemployment is very high. To achieve this, first, flexibility in the wagedetermination process has to be strengthened, for example, whererelevant, by relaxing employment protection legislation, abolishing wageindexation schemes, lowering minimum wages and permitting wagebargaining at the firm level..." (ECB, Monthly Bulletin, August 2012)


Concluding Remarks



Main lesson: impact of such reforms on employment likely to be limited,unless accompanied by an expansion of aggregate demand.


Concluding Remarks




However:- Monetary policy : zero lower bound (US, UK, Japan, euro area) orunavailable (euro area countries)- Fiscal policy : emphasis on fiscal consolidation, especially in countrieswith worse employment performance- External demand : global slowdown


Concluding Remarks




However:- Monetary policy : zero lower bound (US, UK, Japan, euro area,...) orunavailable (euro area countries)- Fiscal policy : emphasis on fiscal consolidation, especially in countrieswith worse employment performance- External demand : global slowdown

Challenge: how to stimulate aggregate demand in high unemploymentcountries without amplifying existing imbalances (public and private debt,external,...)


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Notes for a New Guide to Keynes - CREIStaggered price and wage setting à la Calvo Unemployment...

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