"Europe" and the United States - University of St Andrews

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Change in the NAIRU Figure 2: Change in CPI Inflation vs. Change in the NAIRU: 1980- 1990, 1990-2000 0.00% -20.00% -15.00% -10.00% -5.00% 0.00% -2.00% 5.00% Change in CPI Inflation 10.00% 8.00% 6.00% 4.00% 2.00% -4.00% -6.00% -8.00% -10.00% 2 The Model In this section we will present a New Keynesian model with unemployment and endogenous growth which contributes to explaining the above …ndings. To stress the fact our results stem from the introduction of endogenous growth, we also present an otherwise identical model without endogenous growth which we take as the starting point of our analysis. This is a model to approximate the prevailing consensus on the relationship between unemployment and the NAIRU. We will refer to this model as the JLN economy. This consensus says that while unemployment both in the short and in the long run is determined by aggregate demand, only the NAIRU is consistent with stable in‡ation. In‡ation targeting central banks will push unemployment towards this level. The NAIRU itself will be a¤ected by any variable which directly increases wages in spite of excess supply in the labour market, increases the pricing power of …rms or reduces the e¢ ciency of the labour market to match jobs to workers 5 Below we list the aggregate equations of the JLN economy. After that we introduce endogenous growth. Almost all equations are the same in both models. A longer version of this paper (Rannenberg (2009)) provides the microfoundations. 5 See Nickell et al. (2002), pp. 2-3. 5
2.1 JLN Economy Aggregate demand AD t is the sum of consumption C t , investment I t , the amount of price adjustment costs ' ( 2 t t 1 ) 2 Y t , and expenditure on government employees w t n s : AD t = C t + I t + ' 2 ( t t 1 ) 2 Y t + w t n s (1) Price adjustment costs are the source of nominal rigidities in this model which will give rise to the Phillips curve discussed below. Government employees account for a …xed fraction n s of the workforce. 6 The representative household consists of a continuum of members who might be employed or unemployed but are all allocated the same level of consumption. The household is in…nitely lived and chooses its consumption expenditure, bond holdings and investment expenditure in order to maximise the expected present value of its lifetime utility. We assume a logarithmic instantaneous utility function and, following Smets and Wouters (2002), external habit formation in consumption and adjustment costs in investment. Investment adjustment costs mean that only a fraction of investment expenditure is transformed into additional capital K t . They are convex and vanish when the economy is growing at the steady state growth rate g. The …rst order conditions imply that consumption is governed by 1 1= (C t hab t 1 ) = (1 + i t ) E t (2) (C t+1 hab t ) (1 + t+1 ) where i t ; t , and hab t 1 denote the nominal interest rate, the rate of in‡ation, the individual discount factor and the level of habit respectively, the last of which is determined by hab t 1 = jC t 1 Capital accumulation is given by K t+1 = (1 ) K t + I t 1 ! 2 It (1 + g) 2 I t 1 6 The reason for introducing both state employees and overhead workers n is to achieve a reasonable calibration of steady state values. In the Romer (1986) endogenous growth model, the level of employment a¤ects the growth rate. This is due to the fact that the marginal product of capital is an increasing function of employment. The marginal product of capital governs the growth rate by determining the willingness of households to save. To achieve a reasonable steady state growth rate, we remove a fraction of the labour force from "productive" sector by assuming that they perform necessary tasks without which the productive sector could not operate (managerial work in case of overhead workers, policing etc. in case of the state employees). We assume that government employees are paid the same wage as private sector employees and are funded by means of lump sum taxes. Overhead workers will be interpreted as managers who split the pro…ts of the monopolistically competitive …rms. (3) 6
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Page 49 and 50: RECENT WORKING PAPERS FROM THE CENT

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