Wednesday, December 3, 2008

Krugman on wages and employment in the 1930s

Nobel laureate Paul Krugman has some interesting thoughts on the effect of wage increases during a period of very low interest rates. At the margin low interest rates can lead to liquidity trap conditions, as experienced for example in the US in the 1930s and Japan in the 1990s. During those times nominal wage increases were generally believed to decrease output and employment (Y). Economists determine an aggregate supply curve (S) that depends on the ratio of the aggregate price level (P) to the wage rate (W):

Y = S(P/W)

Macroeconomic equilibrium is determined by the intersection of the aggregate supply (AS) curve with the aggregate demand (AD) curve, representing the demand side of the economy. By increasing nominal wages the AS curve is shifted upwards, which leads to a higher price level and lower output (see left panel on the chart below).

Krugman challenges this assumption:
"Well, in normal times the AD curve slopes down, we think, because other things equal a higher price level increases the demand for money, which drives up interest rates, which reduces desired spending. (In
terms of IS-LM analysis, higher P leads to lower M/P which shifts LM left.) But in liquidity trap conditions, the interest rate isn’t affected at the margin by either the supply or the demand for money – it’s hard up against the zero bound."

click for chart

to Krugman during liquidity trap conditions there is no adverse effect of a wage increase on output.

Paul Krugman 12/2/08

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