Attacks on the Traditional Approaches to MacroeconomicsAlternative Theories to Define Alternative PoliciesNeoclassical Inflation and Unemployment TheoryRational ExpectationsSlide 5The Role of Expectations in Neoclassical Unemployment ModelsReview the Traditional Alternative-- Simple Micro in the Labor Market : Prices, Demand and SupplySimple Micro in the Labor Market : Prices, Demand and SupplySimple Dynamics: Disequilibrium Means Change in the Labor MarketSimple Dynamics: Disequilibrium Means Change in the Labor MarketFluctuations in Unemployment Reveal Job Loss to be the Primary Source of Changes in Unemployment--i.e. action by the employer and not the employeeFluctuations in UnemploymentSlide 13Past and Modern Expectations ModelingSlide 15BRINNER1902mit15.pptAttacks on the Traditional Approaches to MacroeconomicsLecture 14BRINNER2902mit15.pptAlternative Theories to Define Alternative PoliciesMonetarism is an argument against discretionary monetary policy to counter the business cycleOther theories have also been proposed in recent decades to evaluate (and minimize) the theoretical potency of monetary and/or fiscal policy. At least two have added lasting value, although they extend rather than replace traditional theory:–“New Classical or ‘neoclassical’ inflation and unemployment theory”–“rational expectations”BRINNER3902mit15.pptNeoclassical Inflation and Unemployment TheoryClassical (i.e. pre-Keynesian) theory thought of markets as always being in equilibriumBut how could unemployment, particularly of the magnitude and duration experienced in the Depression, be considered an equilibrium? Keynesian thinking evolved to understand unemployment in the terms we have learned with IS-LM analysis and an accelerationist Phillips CurveOther theorists proposed alternative explanations for unemployment that treat it a voluntary and hence equilibrium or market clearing. This return to a contention that markets cleared--everyone who wanted a job at the prevailing wage had a job--was termed “neoclassical” because it was a new version of classical conclusionsTo be an accurate explanation of cycles, neoclassical labor theory fundamentally requires people to be fooled and uninformed about the wages being offered so that they mistakenly, voluntarily turn down job offers and stay unemployedBRINNER4902mit15.pptRational ExpectationsAnother theoretical approach, sometimes even considered to be allied with the neoclassical unemployment and inflation theory, argued that fiscal and monetary policy would be impotent if people understood and anticipated its consequences.. i.e. if they were “rational” in their decisions.In a “rational expectations” world, consumers and businesses see the full IS-LM reactions work out in advance and thus cut off the real output macroeconomic responses.For rational expectations to be an effective denial of the potency of policy and business cycles in the real world, you might say that people must not be fooled. This, of course, is the exact opposite of the neoclassical model but some theorists think they can simultaneously defend both!BRINNER5902mit15.pptNeoclassical Inflation and Unemployment TheoryPhelps, a leading proponent, treats unemployment as a decision under the control of the employeeFour types: speculative, precautionary, search, queue--but the differences are not crisp (note historical link to “money theory”)–spec.: withhold work because wages are low–precaut./wait: individual “between jobs” waiting for the random arrival of the next contract–search: active rejection of offers while actively looking for better offer–queue: like wait unemployment, by worker who believes offering a lower wage will do no good because the employer will only assume he must be worth less if offering to work for less“These are...essentially informational in origin”–“the typical unemployed worker..is acting on an erroneous estimate of the demand for his services”“...lead to the Monetary Phillips Curve”BRINNER6902mit15.pptThe Role of Expectations in Neoclassical Unemployment Models“...Unexpected inflation (of wages and prices) brings with it above-equilibrium employment and the process of unexpected deflation brings with it below-equilibrium unemployment”The hypothesized sequence:–surge of demand from tax or monetary policy brings higher wages (recognized)..–.. and higher prices (not recognized at first) and...–.. lures more workers to accept jobs;–then price increase is recognized..–..and jobs are quit, and the process reverses.The model thus explains the correlation of unemployment and inflation in reverse flow and timing versus traditional theory. Here:–U=E - E\1 = f ( RW\1 - RPexpected)–Unemployment is an error in expectations due to “static expectations about future wages and price levels”BRINNER7902mit15.pptReview the Traditional Alternative--Simple Micro in the Labor Market : Prices, Demand and SupplyDemand: More Workers/Hours Will Be Demanded by Employers the Lower the Real Wage, Other Things EqualSupply: More Hours Will Be Supplied by Individuals the Higher the Real WageEquilibrium: Demand=Supply»All Those Wanting to Work at the Current Real Wage Can Find Work after a Reasonable Period of SearchBRINNER8902mit15.pptSimple Micro in the Labor Market : Prices, Demand and SupplyDEMANDSUPPLYREALWAGEWORKERS or HOURS DEMANDED AND SUPPLIEDEQUILIBRIUMBRINNER9902mit15.ppt Simple Dynamics: Disequilibrium Means Change in the Labor MarketUnemployed Workers:–Voluntary, as in searching for a job at a wage higher than they or their peers are being offered: not a sign of Disequilibrium–Involuntary: Would accept the prevailing wage but no offer forthcoming.»By definition, Supply greater than Demand...at the prevailing wageInvoluntary Unemployment Creates Pressure for (Real) Wages to FallIn the Traditional Model, knowledge of prices, wages, and offers is reasonably complete on the part of both workers and firms but prices and wages simply take time to adjust to gaps that have opened between demand and supply. Note sequence timing and logic of the flow is the reverse of the Neoclassical–RW or RP = f (U or U\1)In the 1970s, the very important improvement in the traditional model was the inclusion of a full response of RW to RPexpected so that there would be only one equilibrium level of
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