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Trev, NAIRU, Philips, Rational expectations

If U1 is not U* (natural rate of unemployment) it is unsustainable.

Monetary Policy cant also for long times keep interest rate different fron the natural rate.

Friedman derived that in his nobel lecture. He had to explain why occasionaly unemployment is different from the natural rate of unemployment. Friedman: Lets assume that as a result of monetary stimulus workers percieve that monetary wages are rising and perhaps percieve that the price level is rising. He does not say how Ms increase causes P rise, lets take this for granted. The real wage does not alter when monetary wage and price rise proportionately. But because of confusion of workers because of this (monetary wages rising, but real not) and thus employment can alter. This is the monetary shock, employers think that the real wage has fallen and thus empploy more. But employment can only rise if employees make the opposite misassumption that the real wage rate is risen. In fact it has remained the same, but in short run employment still rise.

Actual level of employment ia actually determined by minimum of (Ls,Ld).

Once people realise that they have been fooled, they withdraw from labour market and employers employ less.

Only surprise matters. Money supply rises surprisingly (not expected). If the rise in Ms would have been anticipated, workers will not think that real wage has risen. Govenment can only cause changes in output and employment as long as the private sector is confused. If private is not confused there is no scope on the demand management.

Most striking is the return to pre-Keynesian Ls diagram. But empirically the labour market is not clearing right now. They have now been completely abandoned, because it cannot deal with the recession.

NAIRU. Friedman said the Philips was assumig that people did not expect inflation. At the time this was not a problem. But as an approach that has got to be abadonned.

Government wants a trade of between inflation and employment, they want to be at A. But then people revise their expectation of 0-inflation and gradually build up inflationary expectations. So Philips curve shift upwards as long as U is below U*, this is the accelaration principle. So in long-run Philips curve becomes vertical. Economy can settle down at U* with any rate of inflation.

Inflation can be steady at any level. dP/Du=0. If U<U* then P actual>P expected, agents will revise their expectations.

Adaptive expectations mechanism.

P actual (inflation)=f(U)+P (expected inflation)

P (expected inflation) is unemeasurable. The difference between this years expected inflation and last years expectation is a function of last years inflation minus what was expected last year. Everything depends on the function theeta, if it is 0.5, then this year inflation is expected to between last years expected and actual inflation. Actual inflation is bigger if U<U*. If theeta is 0.5 people are constanly systematically underestimating inflation if U<U*, this is conflicting with rational expectations theory. People can't be wrong systematically. Why can't rational agent form a correct model of how the economy works and use it (with the previous data) to correctly predict future economy. The correct model was assumed to be monetarist model or new classical.

The rational expectation school says that private sector can always form a right model of the economy. Unfortunatel in literature only monetary system is considered to be correct.

There is nothing in the rational school that says the money is neutral. Thus it is the enemy of policy management (fiscal policy). So the role of monetary policy is to only bring down inflation. If you convince private sector that you will decrease money suply, so public will build into their inlation expectations the decreased money supply. If the public accepts the policy the side effects are minimal. But if the moentary model is not the correct one, for example the ISLM model.

Rise in moey system in known and anticipated. Nowing that the real income will rise it will rise much more. SO ebate is which model is correct - can policy to be used to change only nominal variables (inflation, monetarists) or also the real variables (keynes, non-market clearing paradigm).

NAIRU - non-accelerating inflation rate of unemployment.

In any point of time there exists an unemployment level on which the inflation rate is not changing. NAIRU is usually hihger than U*(natural unemplyment level)
At that level
dPdot/dT=0 for Nairu.
Ls=Ld for U*

Markup pricing hyphotesis:

P=(1+m(markup))ULC (unit labour costs)

W/(y//L)=ULC

FRW feasable real wage rate, should equal to real wage rate

TRW target real wage rate.

TRW will be an inverse function of the unemployment rate. There is only one unemployment level level in which labour can lower their wage to feasable level. For example if U1 exceeds the wage the employers are prepared to pay. This will lead to an increase in the money wages and this will be passed on to consumer through markup pricing.

Only way to break into this inflationary spiral to introduce monetary policy. Fiscal and Monetary together can reduce inflation. NOte:this is to imperfect competition. It also shows the wage bargaining.

Imortant function has been given to monetary authorities. So to restrict inflation U is temproary rised above NAiru and when inflation is back to target then rlowered to Nairu again. But then some output will be permanently lost, that the cost you have to pay.

Nairu seems to be rising gradually. Current estimate for UK economy NAIRU is 9%.. Estimates 50 years ago are a quarter of this figgure. So the actual NAIRU over time. So if the actual unemployment is above NAIRU then Nairu will follow (path dependency) - Hysteresis.

Markup pricing P=W/(Y/L)*(1+2

Y/L is labour productivity. So every increase in money wage W will bw passed to Prices.

The target real wage (w=W/P). Rise in the unemployment lead the people to aspire less real wages. After 1967 something went wrong. Unempl. rose and inflation accelerated. Actualy when U rises infl. should fall, but it did not. Thats how nairu was developed. So restrictive fiscal/monetary policy was implemented. Inflation fell, but at a very slow rate. Keynesians thought it should not be the core of the policy. There should be incomes policy. Demand deflation was irresponsible.

Respnsible monetary policy TINA - there is no alternative. U should be above NAIRU to bring inflation down and then should be lowered to Nairu again. Nairu rises overtime.

Why should nairu be path-dependent - hysteresis.

Insider outsider appoach. Applied to industries with trade unions.

Outsiders- not in a trade union. TU is indifferent to them. They have no result to wage bargaining (unemployed). Outsiders are unamble to gain employment.

Demand deflation reduces sales and the output start to contract. Unions see the fallof in demand and short time working and realise that time is getting harder. They realise that insiders are in dangers. Next round they want to protect the jobs of insiders and scale down the payincrease rises. So they are accepting a real wage cut. Other unions follow suit. Markup pricing hyphoteses suggests that the reduction int he rate of change of wage inflation will manifests itsself simple in the reduction of price inflation and the real wage remains the same. There will be job shedding(losses). There is nothing firms and unions can do about the rising unemployment. Lets assume that the firm sheds some workers. 20 from 100, 80 is left. This reflects the demand for the firms products. If there is no further contraction in demand trade unions are confident about the 80 jobs (they don't care about the 20 shed). Union returns to its previous position of maximising the wage of insiders. These 20 people are unamble to get a job or to exert pressure on the trade union. The longer they are outsiders the less influence you have.

The second model of hysterisis, it and the long-term unemployment.

The no of longterm unemployed rises as the unemployment rises. This makes differences to wage bargaining. Assume nairu is 5%. If the U is above 5% for longg time it will raise the no. of long term unemployed people from 10% to 20%.

The position of the target real wage shifts upward and we get Nairu2. This is because the outsiders have no influence

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