A graphical presentation of the preceding post: i10.photobucket.com
The horizontal axis shows the quantity of output (and hence labor) supplied and the vertical axis shows the price level divided by the wage rate, the curve traces out the supply price of output, normalized to the wage rate.
If we were to consider a policy designed to increase employment as requiring the application of increasing quantities of labor to a given capital structure, we might expect to find increasing marginal costs (in factors other than labor) almost from the beginning, and consequently the supply curve to slope upward immediately. But we know from our previous discussions regarding the heterogeneity of capital that the structure of production can, within limits, adapt itself so that output prices track only the increase in labor costs. Consequently, a wage normalized supply curve will be fairly horizontal for some range of output before we get into problems of increasing marginal costs – as the chart indicates.
If we are on the horizontal arm of the supply curve, both prices and wages rise one for one, this cannot be due to excess demand, or as some would say “too many dollars chasing too few goods.” It is, rather, a market adaptation to full employment policies. In other words, given a heterogeneous capital structure there is a short-run trade-off between employment/output and inflation, even if the economy was in a period of full employment equilibrium. This trade-off superficially mimics a Keynesian underemployment equilibrium, whereby fiscal and monetary stimulus might be effective in putting more factors to work.
Now, if the administration of full employment policies inadvertently puts the economy on the upward sloping portion of the curve, real wages will fall, and this has the effect of causing unemployment to rise to a higher level than before the application of stimulus, which plays itself out once the stimulus is removed. If policy makers are unaware of this connection then levels of inflation and unemployment will continually rise eventually resulting in stagflation.
See: i10.photobucket.com
The fact is policy makers are aware of this. Whether or not the economy ever broaches the “accelerating inflation” portion of the supply curve, there are some who believe that the curve will, over the long-run, incremental shift to the left, such that both output and employment at any given wage will be lower than without full employment policies. Nevertheless, over the last 20 years the economy has stayed primarily on the horizontal arm of the supply curve. Further, the economy has enjoyed positive supply “shocks” from increased world trade, and a decrease in marginal tax rates. The former indicates why using trends in ULC can account for 80% of all Fed policy actions, and the latter helps to understand the decisive break in inflation during the latter 80’s. |
