Monetary Policy Versus Wage Adjustment as a Response to Demand Shocks

Abstract

One of the central questions in macroeconomic theory is whether aggregate demand shocks are best dealt with by government intervention or by price flexibility. If prices clear the market instantaneously there will be no unemployment problem, while, as shown by Fischer (I977) and Phelps and Taylor (I977), monetary policy can help alleviate unemployment if it is faster to respond to shocks than prices. The case for monetary policy does not, however, rely on it being fast to react relative to prices. As shown by Marini (i986), rational expectations imply that anticipated Government policy can help clear current markets. While rationality of expectations strengthens the case for monetary policy it may weaken the argument for increased price flexibility as a method of dealing with shocks. De Long and Summers (1 986) show that increased price flexibility can lead to an increase in the variance of output in an economy facing demand shocks; the expectation of quick price adjustment exacerbates short-run disequilibrium. This paper examines the effectiveness of price flexibility and monetary policy in a simple model where neither price makers nor the monetary authorities can react instantaneously to shocks. The model is one of overlapping generations, with a single shock. The advantage of such a simple framework is that it clarifies the forces at work and allows direct welfare comparisons between adjustment rules. The first result is that greater price flexibility may decrease welfare, particularly if the effect of expected inflation on demand is non-linear. Slow price adjustment spreads the adjustment cost over many periods, and if demand is concave in expected inflation the aggregate volume of unemployment may be smaller if prices are reduced to their equilibrium level in stages rather than in one jump. Quick monetary policy aimed at full employment is shown to Pareto dominate a slow response. Both give full employment but a slow response requires the imposition of a higher inflation tax. While quick monetary policy is better than a slow response there is a case against instantaneous response to shocks. If full employment is guaranteed costlessly by government the wage and price level become indeterminate. Guaranteeing full employment by means of an inflation tax gives an incentive for wage and price setters to minimise the need for government intervention.