Should One Fix Monetary Policy Or Fix A ‘Sclerotic’ European Labour Market?

Iyanatul IslamPerspectives from a New Keynesian model

New Keynesian macroeconomics (henceforth NK) was born as a defensive reaction to the radical agenda of the new classical economists of the late ‘70s vintage. They aspired to dismantle the entire edifice of Keynesian economics that held sway until the ‘stagflation’ of the post oil-shock period of the mid-1970s. New classical economists could show that, by combining the optimizing behaviour of forward-looking agents with full wage and price flexibility, there was no role for macroeconomic stabilization policies to influence employment and output even in the short run.

The new Keynesians accept the need to anchor macroeconomic analyses in the optimizing behaviour of forward-looking economic agents but do not accept that there is full price and wage flexibility. They invoke notions such as mark-up pricing in product markets populated by monopolistically competitive firms, labour market frictions as well as real wage rigidities. Enormous intellectual energy appears to have been invested in trying to provide a choice-theoretic rationale for price and wage stickiness. Under these circumstances, it is possible to show that there is still scope for macroeconomic policies to stabilize employment and output, although in the long-run the aggregate supply curve is still vertical. The additional assumption that any market economy would have a proportion of liquidity-constrained households allows the rehabilitation of fiscal policy to influence employment and output in the short-run. What emerges is a class of micro-founded ‘dynamic stochastic general equilibrium’ (DSCGE) models that can be empirically calibrated for policy evaluation. This class of models is used by a number of central banks in both emerging and developed economies and as well as in some international organizations (such as the IMF) – although they have been widely criticized.[1]

It is sometimes noted that NK economists ended up with a Faustian bargain with their new classical counterparts.[2] As Olivier Blanchard, a leading NK economist and the current Economic Counsellor and Director of the Research Department of the IMF ruefully admitted,[3] what actually emerged was a work-horse NK model in which the labour market adjusted through voluntary changes of work-hours along a given labour supply curve. There was no presence or persistence of involuntary unemployment! Evidently dissatisfied with this state of affairs, Blanchard has co-authored much-cited papers with Gali to show how one can ‘create’ unemployment in an amended NK model.[4] This relies on frictions in the labour market drawing on the search and matching models pioneered by Diamond, Mortensen and Pissardies, but the core results in the model appear to be driven by real wage rigidities.

Blanchard and Gali (2010) make a distinction between a US-style ‘fluid’ labour market and a ‘sclerotic’ European-style labour market where the latter has a higher incidence of frictions and real wage rigidities. They show how macroeconomic stabilization policies through monetary policy instruments have an important role to play in the amended NK model with real wage rigidities. In particular, they demonstrate that strict inflation targeting, while optimal in the work-horse NK model, is sub-optimal in the amended version leading to high unemployment and unemployment persistence.[5] The associated ‘welfare losses’ based on calibrations are also rather high in Europe – 25 times above the relevant benchmark. On the other hand, a monetary policy regime that cares both about inflation and unemployment in Europe entail minimal welfare losses even in relation to a ‘fluid’ US labour market.

There is, however, an obvious implication that is unstated in the paper. Why not aim to reduce the incidence of frictions and attenuate real wage rigidities? This paves the way for an agenda of comprehensive labour market deregulation that would ‘fix’ a ‘sclerotic’ European labour market. Indeed, these ideas appear to be de rigueur in current debates. However, implementing labour market reforms are politically contentious, entail a protracted process and engender uncertain gains. The Blanchard-Gali model suggests a simple alternative: ‘fix’ monetary policy and adopt a balanced approach towards inflation targeting as its welfare properties are conditioned by prevailing labour market institutions that are not easily amenable to change.[6]

[1] See, for example, Dennis, R (2007) ‘Fixing the New Keynesian Phillips Curve’, Federal Reserve Bank of San Francisco (FRBSF) Economic Letter, No.35, November 30; Gordon, R (2009) `Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis`? Northwestern University, September 12

[2] Mankiw, G (2006) ‘The Macroeconomist as Scientist and Engineer’, Harvard University, May

[3] Islam, I (2012) ‘The state of macroeconomics: reformers vs revolutionaries’, Social Europe Journal, 25 October,

[4] Blanchard, O and Gali, J (2010) ‘Labour Markets and Monetary Policy: A New Keynesian Model with Unemployment’, American Economic Journal: Macroeconomics, 2, April, 1-30; see also Blanchard,O and Gali, J (2007) ‘Real Wage Rigidities and the New Keynesian Model’, Journal of Money Credit and Banking, Supplement to 39(2), 35-65

[5] In this regard, even amended NK models are not necessarily more insightful than conventional expectations- augmented AS/AD models, as forcefully argued by Gordon (op.cit)

[6] In view of these ideas, it is possible to suggest that the ECB, at least in the recent past, pursued strict inflation targeting with sub-optimal outcomes. In 2011, policy rates were raised twice on the ground that headline inflation, buffeted by supply shocks, exceeded the target inflation rate. See The Guardian, ‘ECB raises interest rates despite debt crisis’, July 7, 2011.