Cyclical adjustments of wages, prices and employment:: A comment on Parkin, Summer and Ward

Abstract

The standard theoretical rationalization for the observed, empirical relationship between the rate of wage change and the unemployment rate is that the unemployment rate measures the extent of excess supply in the labor market and that wages gradually adjust in order to eliminate this excess supply. Parkin, Sumner and Ward adopt essentially this justification for their Phillips curve relationship. In their analysis, the quarter to quarter percentage change in the wage rate is the endogeneous variable. The wage rate is assumed to adjust to eliminate the existing disequilibrium in the labor market and to correct for anticipated changes in prices and taxes. Existing disequilibrium is measured by the four quarter moving average of the unemployment rate, lagged two quarters (or by an alternative proxy for the excess supply of labor which is also calculated as a four quarter moving average, lagged two quarters). My purpose in these remarks is to develop an alternative, theoretical explanation for the observed Phillips curve relationship between wage inflation and unemployment. This alternative explanation is based on a simple mode1 of macroeconomic adjustment in which the time paths of prices, wages, employment, and output are all simultaneously and endogeneously determined.’ In this model, the basic cause of fluctuations in employment and output is the failure of those price expectations relevant to the determination of labor supply to move in phase with the prices relevant for the determination of labor demand. Given this failure, fluctuations in nominal aggregate demand, induced by fluctuations in the rate of growth of the money supply (or other exogeneous influences onaggregate demand), produce fluctuations in employment and output. The wage rate also fluctuates. But the unemployment rate is neither the proximate nor the ultimate determinant of the rate of wage change. The observed, empirical relationship between the rate of wage change and the unemployment rate is explained as a statistical artifact, not as a causal relationship.