Wage Movements and the Labour Market Equilibrium Hypothesis

The view that aggregate monetary and fiscal policies cannot affect unemployment in long run is now accepted by both academic economists and public officials.' Some academics were convinced early on that demand management policies must have a neutral effect on real activity on grounds that money illusion could not persist indefinitely. Other academics and many public officials were finally convinced when predictions that continued reflationary policies must ultimately produce a permanently higher inflation rate without any reduction in unemployment were verified by experience of 1970s. This remarkable post-Keynesian revolution has led to a flurry of new research activity aimed at building macroeconomic models that are consistent with the facts. Many of these models assume that markets, including labour markets, clear rapidly, standing Phillips Curve relating price or wage changes to unemployment on its head. They posit that unemployment is determined by discrepancy between expected future wages and prices and current wages and prices and reflects variations in supply of labour.2 This influential interpretation of unemployment as intertemporal substitution of leisure was first offered by Lucas and Rapping (1970) and Lucas (1973). Its importance is twofold. First, it offers a convenient and tractable analytical mechanism for constructing models that incorporate unemployment and inflation and are consistent with proposition that aggregate government policy ultimately does not affect level of resource utilization. Second, a serious labour market hypothesis must explain key fact that employment moves cyclically and in a strong negative relationship with movements in percentage of persons who say they would like to work but do not have jobs. The interpretation of employment fluctuations as result of demand shifts up a short-run labour supply curve that is very elastic because of intertemporal substitution offers a potential explanation for this key fact while simultaneously maintaining that labour supply and demand are continuously equal. Unemployment is then interpreted as a measure of labour supply that would be forthcoming at expected future wage relative to labour supply that is forthcoming at actual wage. The implication is that, if long-run supply curve of labour is taken to be inelastic, then movements in unemployment and labour supply are interchangeable (after suitable normalization). This convenient analytical interpretation of unemployment is at complete odds with conventional Keynesian view. In latter, unemployment represents quantity constraints on labour supply that offer possibility for mutually beneficial trades for workers and employers. It is this promise of increased resource utilization and its implied increase in welfare of workers whose offers of labour supply have been frustrated that provides basis for Keynesian policy activism. The widely held view that aggregate monetary and fiscal