April 5, 2018

Full employment, the Phillips Curve, and the end of Gaganomics

Comment on David Glasner on ‘The Phillips Curve and the Lucas Critique’

Blog-Reference and Blog-Reference on Apr 6 and Blog-Reference on Apr 10 adapted to context

The utter failure of economics, of which the Phillips Curve is a well-known example, is due to microfoundations. Economics has to be based on objective macrofoundations. This methodological move is called Paradigm Shift.

Reminder: Economics is NOT about what people do, economics is about what the economy does. Economics is NOT a social science but a systems science.

The macrofoundations approach starts with behavior-free systemic axioms which define the elementary production-consumption economy: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the ‘classical’ conditions of market-clearing X=O and budget-balancing C=Yw in each period, the price is the dependent variable and given by P=W/R, i.e. the market-clearing price is always equal to unit wage costs. This is the most elementary form of the macroeconomic Law of Supply and Demand.

As a corollary, this macroeconomic Law kills the commonplace Quantity Theory because the Quantity of Money is NOT among the price determinants.#1 The price is, under the ‘classical’ conditions, determined by the wage rate W, which takes the role of the nominal numéraire, and the productivity R.

If the budget is not balanced, i.e. if the household sector either saves or dissaves, the macroeconomic Law of Supply and Demand takes the form shown on Wikimedia.#2

An expenditure ratio ρE greater than 1 indicates dissaving/credit expansion of the household sector, a ratio ρE less than 1 indicates saving/credit contraction. The ratio ρE provides the link to monetary theory.

The elementary production-consumption economy is the starting point. Subsequently, things become more complex. Under the conditions of market clearing and independent wage rate- and price-setting, employment becomes the dependent variable. The elementary version of the axiomatically correct (objective, systemic, behavior-free, macrofounded) Employment Law is shown on Wikimedia.#3, #4, #5

From this equation follows:
(i) An increase in the expenditure ratio ρE leads to higher employment L.
(ii) Increasing investment expenditures I exert a positive influence on employment.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The complete Employment Law contains in addition profit distribution, the public sector, and foreign trade. These issues have been dealt with elsewhere.

Item (i) and (ii) cover the familiar arguments about aggregate demand. The factor cost ratio ρF as defined in (iii) embodies the macroeconomic price mechanism. The fact of the matter is that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R. Or, the other way round, overall employment DECREASES if the average price P INCREASES relative to average wage rate W with productivity R unchanged.

Roughly speaking, price inflation is bad for employment, and wage inflation is good. The systemic Phillips Curve defines an inverse relation between price P as the independent variable and employment L as the dependent variable. Since all variables of the macroeconomic Employment Law are measurable the systemic Phillips Curve is testable. Note that there is no recourse to ridiculous behavioral assumptions like constrained optimization or rational expectations. Microfoundations are gone for good. Lucasian Gaganomics is over.

In the Employment Law, wage rate W and price P are the independent variables. So, under the condition of wage rate- and price-setting, the relationship between unemployment and wage rate or wage rate and the price is contingent, i.e. there is NO systemic relationship and no stable correlation.

This, in turn, means that there is NOTHING in the economic system that guarantees that the independent wage rate- and price-setting leads somehow to full employment. The market economy is NOT a self-regulating system with an intrinsic tendency to full employment if left alone. Just the opposite, the market system is inherently unstable.

Because the fundamental premise of standard economics is provably false the independent variables have to be taken as policy parameters. Wage rate- and price-setting have to be managed such that ρF drives employment towards full employment. Monetary and fiscal policies are unfit for the job.

The well-defined systemic Phillips Curve ends all senseless speculation/blather about whether wages rise if the economy approaches full employment or not but tells policymakers exactly how to set the parameters in order to achieve full employment and zero inflation.#6

Egmont Kakarot-Handtke

#1 Forget Friedman, forget the Quantity Theory
#2 Wikimedia AXEC101 Law of Supply and Demand
#3 Wikimedia AXEC62 Employment Law
#4 Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster
#5 NAIRU, wage-led growth, and Samuelson's Dyscalculia
#6 For details of the big picture see cross-references Employment/Phillips Curve

Related 'Economists never understood how the price mechanism works' and 'Mass unemployment: The joint failure of orthodox and heterodox economics' and 'NAIRU and the scientific incompetence of Orthodoxy and Heterodoxy' and 'Full employment through the price mechanism'.