Insights from the new AER

Here’s a passage from a recent AER paper by Pierpaolo Benigno and Luca Antonio Ricci:

This paper offers a theoretical foundation for the long-run Phillips curve, by introducing downward nominal wage rigidities in a DSGE model with forward-looking agents and flexible-goods prices, in the presence of both idiosyncratic and aggregate shocks. .  .  .

Several important implications arise. First, the optimal inflation rate may not be zero, but positive, as inflation helps the intratemporal and intertemporal relative price adjustments, especially in countries with substantial macroeconomic volatility or low productivity growth. Second, the ideal inflation rate could differ across countries (and in particular it would be higher in countries with larger macroeconomic volatility and lower productivity growth), and may change over time. Third, stabilization policies can play a crucial role, as they can improve the inflation-output trade-off.

Additional theoretical implications arise. First, the overall degree of wage rigidity is endogenously stronger at low inflation rates and disappears at high inflation rates, unlike in time-dependent models of price rigidities where prices remain sticky even in a high-inflation environment. This arises from the endogenous tendency for upward wage rigidities (as in Elsby 2009), resulting from forwardlooking agents anticipating the effect of downward rigidities on their future employment opportunities. Second, this endogenous wage rigidity also introduces a trade-off between the volatility of the output gap and the volatility of inflation, as at low inflation adjustments occur mainly via changes in output and at high inflation via changes in wages. Third, the Phillips curve may arise not only from the need for intratemporal relative price adjustments across sectors in the presence of downward rigidities (as in the traditional view), but also from the need for intertemporal relative price adjustments, which open the way for the important role of macroeconomic stabilization policies discussed above. Fourth, nominal shocks can have high persistent real effects, suggesting that introducing downward wage inflexibility in a menu-cost model à la Golosov and Lucas (2007) would likely change their conclusion that nominal shocks have only transient effects on real activity at any level of inflation.

So there are models that predict persistent output gaps as a result of downward nominal wage rigidity, especially near zero inflation.  And remember we have conclusive evidence that nominal wages do exhibit downward rigidity, especially near zero inflation.

In the same issue of the AER, Peter Diamond has some interesting comments on the structural/demand-side debate:

Second, for the current moment, the argument about the aggregate demand side is academic, in the negative sense of the word. Current estimates I have seen of how much of the increase in unemployment from a few years ago is “structural,” rather than due to inadequate aggregate demand, still leaves enough need for aggregate demand stimulation that it is clear what direction is needed for further policies.

Third, I am skeptical of the value of attempting to separate cyclical from structural unemployment over a business cycle. When firms evaluate candidates for positions, they consider the quality of the match of available candidates, projections of the availability of new candidates, and the value to the firm of filling the slot. That is, the willingness to hire for a given quality of match depends on expectations about the profitability of investing in a new worker and about the likely pool of future applicants.

The tighter the labor market and the more valuable the filling of a vacancy, the more a firm is willing to hire a worker who is a less good match and who may need more training. In other words, a worker who might be viewed as structurally unemployed, as facing serious mismatch in the current state of the economy, may be readily employable in a tight labor market. The common practice of thinking about the extent of unemployment as a sum of frictional, structural, and cyclical parts misses the point that the tightness of the labor market affects worker quitting decisions and affects employers’ willingness to hire an applicant who needs more training. In so far as direct measures of frictional or structural unemployment are dependent on the tightness of the labor market, they have limited relevance for the design of demand stimulation policies. The idea that the US economy is not adaptable and capable of dealing with the need for skills and jobs to adapt to each other is peculiar, given the long history of unemployment going up and down.

Those are two themes I’ve emphasized.  Structural and demand-side problems are deeply entangled, indeed I think the problem is even worse than Diamond does–as he puts little weight on the UI benefit extension to 99 weeks.  And second, even if we have major structural problems, there is still a clear need for demand stimulus.

Tags: Unemployment, Unemployment Insurance

This entry was posted on August 18th, 2011 and is filed under Labor markets, Misc.. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.