Hysteresis in a Three-Equation Model

Abstract

This paper introduces two post-Keynesian hysteresis mechanisms into a standard textbook three-equation model. The mechanisms work through wage bargaining and price setting. Workers are assumed to change their wage aspirations when the actual wage differs from their target wage, and firms are assumed to change their mark-up norm when the actual profit share differs from their target share. These mechanisms do not themselves guarantee hysteresis. A pure inflation shock will create hysteresis even if expectations are anchored to the central bank’s inflation target. After a demand shock, if inflation expectations are not anchored, these mechanisms generate persistence but not true hysteresis. But if expectations are partially (as they seem to be) or fully anchored, a demand shock will have a permanent effect on output, employment, and the real wage, because in this case the central bank is not obligated to reflate as aggressively in order to manage expectations. Hysteresis effects may explain the absence of disinflation and the fall in the wage share in the aftermath of Global Financial Crisis.