The Theory of Employment and Unemployment

Transcription

1 Carngi Mllon Univrsity Rsarch CMU Tppr School of Businss Th Thory of Employmnt and Unmploymnt Karl Brunnr Univrsity of Rochstr Allan H. Mltzr Carngi Mllon Univrsity, am05@andrw.cmu.du Follow this and additional works at: Part of th Economic Policy Commons, and th Industrial Organization Commons This Confrnc Procding is brought to you for fr and opn accss by Rsarch CMU. It has bn accptd for inclusion in Tppr School of Businss by an authorizd administrator of Rsarch CMU. For mor information, plas contact rsarchshowcas@andrw.cmu.du.

2 Th Thory of Employmnt and Unmploymnt by Karl Brunnr and Allan H. Mitzr Chaptr 4 of Montary Thory (tntativ titl) Prsntd at th Konstanz Sminar May 1978

3 Rvisd Draft April 1978 Chap. 4 Th Thory of Employmnt and Unmploymnt Classical and Kynsian thoris of mploymnt and unmploymnt start from a common framwork. Thr is a singl composit good, output, producd undr conditions of diminishing rturns to ach scarc factor of production and constant rturns to scal. Th conditions govrning production ar dscribd by a production function, and th dmand for labor is drivd from this function. Th supply of labor is basd on individual dcisions to giv up othr activitis - loosly dscribd as lisur - and allocat tim to labor. Ths rlations yild a ngativly slopd aggrgat dmand curv for labor rlating offrs of mploymnt and th rlativ pric of labor, or ral wag, and a positivly slopd supply curv of labor. Th intrsction of th two curvs dtrmins th markt claring ral wag and th quilibrium lvl of mploymnt. Unmploymnt can b dfind as th diffrnc btwn th amount of mploymnt dmandd and supplid at ach ral wag or as th diffrnc btwn actual and quilibrium mploymnt. Both dfinitions ar in us currntly. Vry arly in th dvlopmnt of systmatic, conomic thory, thr wr attmpts to "xplain" unmploymnt as th rsult of slow adjustmnt of mony wags - wag rigidity. Thornton's clar statmnt (1965, pp ) is rproducd abov."^ Marshall appars to hav bn unawar of Thornton's xplanation and cits Bowly's statistical studis as th sourc of th proposition that ral wags ris in

4 4% 2 rcssions and fall in xpansions. Kyns's (1939, pp. 35-6) rfrnc to Marshall's tstimony maks clar that h did not rgard his us of wag rigidity to "xplain" unmploymnt as novl. Kyns blivd, corrctly, that prvious writrs faild to provid a thory uniting wag rigidity and unmploymnt with th thory of aggrgat output and prics. Although much progrss has bn mad, th charg rmains tru. Fw conomists vr dnid that output and mploymnt fluctuat, and fw would dny that in th prsnc of rigid wags and fluctuating prics and output, thr ar priods of xcss dmand and xcss supply for labor. Th problm is to xplain why wags do not adjust rapidly, why th xcss dmand or supply of labor prsists for months or yars, and what govrns th vntual adjustmnt of wags and mploymnt. Unmploymnt of any good or srvic can b "xplaind" by assrting that prics adjust slowly or that anticipatd prics adjust slowly, ox that buyrs and sllrs hav diffrnt anticipations, or by introducing: costs of adjustmnt Each of ths, and many gjrmlar xplanations, invok rlativ pric changs (in th broadst sns) to "xplain" disquilibrium. Rcurrnt disquilibrium can occur only if buyrs or sllrs do not find a way to profit from th disquilibrium by rallocating dmand to priods with xcss supply from priods with xcss dmand. Th thory of xpctations that has dvlopd from th work of

5 Muth (1961) and Lucas (1972) implis that any systmatic association btwn ral wags and unmploymnt, rsulting from slow adjustmnt of mony wags, should not prsist. Unmployd workrs can offr to supply labor at a lowr mony wag; firms can offr to hir labor at a lowr wag and offr lowr wags to xisting mploys. Why do w not obsrv gratr variability in wags and lss variability in mploymnt? This chaptr dvlops a thory rlating mploymnt, unmploymnt and wags as part of a thory of aggrgat output and prics. Th bhavior of firms and workrs is not autonomous or indpndnt of bhavior in othr markts as in Nordhaus (1972), but is part of th procss by which rlativ prics adjust to ral and nominal shocks. By taking th rsponss on othr markts as givn, w assum what has not bn shown, chifly that thr is a rational xplanation for th prsistnc and duration of fluctuations (or businss cycls) in an conomy that producs a singl composit good - aggrgat output. Th justification for this procdur is that w dpnd on th rsults in this chaptr whn w analyz th fluctuations in output. Our approach follows th long lin from Thornton through Marshall to Kyns by rlying on rigid mony wags as a ncssary condition for xcss supply and dmand on th markts for labor and output and follows th mor rcnt tradition of Phlps t al. (1970), Lucas (1972, 1975) and othrs in providing a rational xplanation for th obsrvd markt conditions.

6 4% 4 Th following sction discusss som of th pattrns that w attmpt to xplain th stylizd facts about labor markts and thir intrprtation. Many of ths "facts" hav bn dvlopd by looking at data for rcnt yars and may giv undu wight to dvlopmnts during th priod of th dollar standard in th Unitd Stats. A broadr st of "facts" for th yars of th gold standard might giv a diffrnt pictur. Aftr prsnting th facts that a thory of labor markts must rconcil, w prsnt a thory of th supply and dmand for labor and our xplanation of th main pattrns. Our xplanation diffrs from th most common xplanation of rcnt yars known as th Phillips curv. A final sction compars th two. Stylizd Facts and Intrprtations Kyns's xplanation of cyclical wag changs starts from a stylizd fact (1936, p. 10). ff Lt would b intrsting to s th rsults of a statistical inquiry into th actual rlationship btwn changs in mony wags and changs in ral wag& [I]n.tha cas of changs in th gnral lvl of wags, it will b found, I think, that th chang in ral wags associatd with a chang in mony-wags... is almost always in th opposit dirction. Whn mony-wags ar rising, that is ta say, it will b found that ral wags ar falling; and whn mony-wags ar flling, ral wags am rising. This is bcaus, in th short priod, falling monywags and rising ral wags ar ach, for indpndnt rasons, likly to

7 4% 5 accompany dcrasing mploymnt; labour bing radir to accpt wag-cuts whn mploymnt is falling off, yt ral wags invitably rising in th sam circumstancs on account of th incrasing marginal rturn.. Kyns, following Marshall, assumd that cyclical changs in ral and mony wags rsult from shifts in th dmand for labor. Fishr (1973) attributd th shift in dmand to unanticipatd pric changs. This is th classical assumption found in Thornton, and if it is combind with slowr adjustmnt of mony wags than of prics, w, lik Kyns, rach th classical conclusion - ral wags ris in rcssion and fall in xpansion. Invstigation has not yildd unqualifid support. Dunlop (1938) showd that Bowly's vidnc, as rportd by Marshall (1926), is contradictd by data for subsqunt priods. Modigliani (1977, p. 7) cits Dunlop 1 s vidnc, which h intrprts as showing that ral wags ris in xpansion, to argu against comptitiv wag dtrmination and th intrprtation of wag rigidity du to Kyns and th 2/ classical conomists. Studis by Kssl and Alchian (1960) cast doubt on prvious findings of a lag of wags bhind prics. A spctral study by Cargill (1969), uss U.S. data for 140 yars and British data for 200 yars. For cyclical frquncs, thr is vry littl vidnc of a uniform pattrn of lads or lags, and th masurd lags ar much too short on avrag to b consistnt with obsrvd unmploymnt Th data suggst that a thory of th labor markt must b capabl of xplaining unmploymnt without rlying on any consistnt timing rlation btwn cyclical changs in wags and prics. Ral wags may ris, fall or rmain unchangd

8 4% 6 cuiring-priods of xpansion and contraction. A thory in which thr ar only nominal shocks to dmand would h consistnt with th stylizd facts rlating wags and prics only if thr is a complx pattrn of lads and lags. A pattrn of this kind cannot b ruld out a priori, but it dos not appar likly that an conomic hypothsis can b dvlopd along ths lins. An mtnsiv sarch for a rlation btwn aggrgat xcss^dmand and th rat of dhang of wags has producd mbcd rsults. Laidlr and Parkin (1975^ p. 754) rport that'th rlation is "wak" Gordon (1977) shows that th rat of wag chang in th Unitd Stats during th postwar priod is affctd vry littl by aggrgat xcss dmand but is affctd somwhat mor by changs in xcss dmand. A scond stylizd fact is th wak rlation btwn xcss>dmand and wag changs. This^fact bcams mor.puzzling in th light of rcnt showinga^stionassociation btwn xcss dmand and unmploymnt. Barros (1977) study of postwarunmplaymnt in th Unitd Stats shows that narly 80% of; th varianc:af:unmploymnt can b xplaind mainly by "unanticipatdmony growth" and th minimum wag. Unanticipatd mony growth is a masur of shifts in aggrgat dmand, so Barro's quation suggsts strongly, that changs in aggrgat dmand and unmploymnt ar rlatd. His study implis that most of th. positiv and ngativ changs in unmploymnt ar th rsult of montary shocks; But his vidnc is limitd to th postwary ars and has a puzzling implication: unanticipatd mony fftiwthatffcts: unmploymnt without much ffct on ral wags; This implication

9 4% 7 follows from th fact that wags and unmploymnt ar not closly associatd and from Barro's finding that th rrors in his quation ar srially uncorrctd. Srial corrlation of th. rrors would suggst that som masur of xcss supply affcting wags and unmploymnt has bn omittd. Barro shows, howvr, that a most obvious masur of labor markt conditions - th laggd unmploymnt rat - is not significantly rlatd to currnt unmploymnt onc th ffcts of unanticipatd mony growth and thi minimum wag rat ar includd (1977, p. 108). Ral wags and th quilibrium rat of mploymnt ar dtrmind simultanously. Barro's quation implis that with constant unanticipatd mony growth, unmploymnt changs only if thr, is som, ffct of past mony growth on th ral valu of th 3/ minimum wag. Barro s intrsting finding lavs much of th bhavior of mploymnt and ral wags to b xplaind. Most rsarch on wags and unmploymnt uss data only for th postwar priod. Two wllrknown studis by Lucas and Rapping (1969) and by Phillips (1958) xamin th long-trm data for th Unitd Stats and th Unitd Kingdom. Both studis show that in priods of rlativly high unmploymnt, during th thirtis in th Unitd Stats and during th intr-waryars in th Unitd Kingdom, th rlation btwn masurs of aggrgat, dmand or xcss dmand and th rat of wag chang ar wak or non-xistnt. This 11 fact " rquirs much mor attntion than it has rcivd sinc th failur to account: for rlativly high unmploymnt calls into qustion any xplanation of smallr fluctuations. A valid xplanation of unmploymnt and wag 4/ changs must accountfor diffrncs btwn arlir and mor rcnt priods.""

10 48 Kjms (1936, p. 15) dfindunmploymntas:" involuntary " if a ris in th^pric lyl that rducs ral wags incrass mploymnt; Th fincung-that unmploymnt is not closly linkd to changs in ral or mony wags suggsts that most cyclical unmploymnt is not involuntary in Kyns's sns. Unmploymnt riss and falls cyclically in rspons to unanticipatd changs in aggrgat-dmand without much chang in wag rats. Airy hypothsis sking to xplain unmploymnt and rogniz th.failur of Kyns's thory to rconcil obsrvdchangs in wags andunmploymnt in WstrnEurop and th Umtd Stats during_th.postwar yars. A third stylizd fact about labor markts is th prsistnc of unmploymnt during rcovris. Adjustmnt from rcssion to full mploymnt is a. procss that continus for svral yars; Usually this procss is dscribd:as a.graduai adjustmnt from disquilibrium tozaanriququikbrium at full mploymnt. Th tim rquirdforadjustmrrt of wags sand, mploymnt is longr than can b -xplaindjby th adjustmnt :of:dmand to a onrtim shock. HaH (1977a) analyzs th. rspons.of unmploymnt to shocks to dmand and findsthat, for th yars ; mor than 90% of th variation in unmploymnt is prdictd by th unmploymnt rat in th prvious ^ight quartrs. Gratst wight is ^ivn by th data to thjnost rcnt past. Hall concluds that th.obsrvd pattrn cannot b xplaind^by, sluggish adjustmnt of unmploymnt :or by. aiailur.to us. ayaflablinformation about conditions in thi labor markt. H, thn, compars th adjustmnt :of mony wags implidly thj rapidarspons of unmploymnt to th

11 4% 9 actual rspons and finds a larg, unxplaind diffrnc. If mony wag and unmploymnt adjust to shifts in dmand, most of th adjustmnt in mony wags should bxompltd within two yars. Th actual spd of adjustmnt is considrably slowr. Hall concluds that a modl in which xpctations ar rational in th sns of Muth (1961) cannot xplain obsrvd wag changs solly as to th rsult of procss in which th dmand for labor and th mony wags adjust to shocks. Hall (1977a, 1977b) suggsts that an quilibrium modl in which th quilibrium (or natural) rat of unmploymnt changs is mor likly to xplain obsrvd pattrns. A-problm with many thoris of unmploymnt is that all unmploymnt is tratd alik. Workrs ar unmployd by rductions in dmand and sarch for nw jobs. Sustaind unmploymnt rsults from lack of information, infficint sarch; th gradual adjustmnt of wags undr fixd contractual arrangmnts and th lik.. Most work in th Unitd Stats is not subjct to contractual arrangmnts with unions, and nothing prvnts mployrs or mploymnt agncis from xploiting th jopportunity providd by slow adjustmnt. A-study of Marston (1976) shows that th avrag duration of unmploymnt in a 1974-samplis 8.5 wks for adult mn and 18 wks for adult womn. Brinnr (1977) analyzd sampl data on rportd rasons for unmploymnt and found that changs in:th unmploymnt rat ar not mainly th rsult of a ris in th "quit rat," a&suggstd by thoris of sarch, but rsults from a mor than proportional incras in-th unmployd classifid as job losrs. Som of th job losrs ar sparatd

12 4% 10 tmporarily laydoff as Eldstin (1975) shows. But Hall (1977b) argus that allowanc for layoffs can xclud no mor than 15% of th unmployd. At last 70% of th unmployd ar job losrs who cannot xpct to rturn to thir prvious mploymnt. Th, rst ar. rcnt ntrants or rntrants. Som of th unmployd ar sking part-tim mploymnt This affcts thnumbr of hours workrs dsir to supply pr wk or pr yar; but dos not affct thianalysis if th quantity of mploymnt dmandd and supplid is xprssd in actual orstandardizd manhours. Th;fourth stylizd fact, or st of facts, is that cyclical variations in unmploymnt aradominatd by job losrs, not voluntary 11 quits." During rcssions bankruptcis ris, firms go out of businss* jobs ar liminatd both prmanntly and tmporarily. Mostraf th unmployd cannot xpct to rturn to thir prvious mploymnt. Tlicnumbrroffunmployd and. th duration of unmploymnt ris in rcssion much mor than can b xplaind solly as a rsult of rrors in forming xpctations and by a dsirrto sarch. Som vidnc, suggsts that rportd quit rats moy opposit to 5:7 thcunmploymntrat. A thory of unmploymnt, or mploymnt and wags camiot rly solly an dmand shocks^ voluntary sarch and changs in th quit rat to xplain unmploymnt duringrcssions and xpansions. Thortical work on labor contractsihy Azariadis (1975:), Baily (1974) and othrs introducs risk sharing, arrang^nts-andimplidt.contra^tsinto^th thory of labormarkts. Firms: absgihriskfromworkrsby offring-contracts that show th adjustmnt of mony

13 wags to changs in product dmand. Risk avrs workrs prfr to absorb fluctuations m product dmand by rducing hours rathr than by rducing mony wags. Nithr Baily nor Azariadis claims to hav producd a thory of aggrgat unmploymnt, and Barro (1977a) shows that risk sharing arrangmnts cannot xplain unmploymnt if th labor markt is comptitiv and xpctations ar rational in th sns of Muth (1961) and Lucas (1972). As an mpirical proposition, risk sharing is falsifid by th divrsity of labor contracts that appar in labor markts. Tnur rangs from th lif-tim mploymnt offrd to school tachrs, profssors and civil srvants, aftr a minimum priod of mploymnt, to th daily or hourly mploymnt offrd to casual labor. Th unmploymnt statistics for layoffs, ntrants and othr unmployd suggst that contract thory applis to a limitd rang of jobs. Many workrs, and most of th unmployd, do not hav implicit or xplicit contracts with spcific mployrs and da not rturn to thir prvious plac of mploymnt, as notd abov. A fifth stylizd fact about labor markts is th vry wid rang of wag agrmnts that ar found in diffrnt countris and tim priods. Cyclical unmploymnt has bn obsrvd undr too many diffrnt sts of institutional and contractual arrangmnts to b xplaind by a spcific contractual arrangmnt. This, of cours, dos not dny that risk avrsion or typs of contractual arrangmnts 6/ 4% 11 altr th magnitud of th rspons to shocks in particular priods. - Nor dos it dny that crtain provisions of contracts sniority provisions ar an xampl appar ubiquitously. A thory of labor markts should b capabl of xplaining th frqunt

14 4% 12 us of sniority provisions without rquiring that all, or most, workrs hav contracts. Th fiv stylizd facts summariz much of what is known or accptd about th cyclical rspons of wags and mploymnt. A thory of th labor markt should b consistnt with th obsrvd facts and capabl of xplaining principal faturs of tabor markts as th rational rsponss of workrs and mployrs. A Thory of th-labor Markt Fluctuations in aggrgat conomic activity and mploymnt rsult from changs in th aggrgat dmand for and supply of output. Th timing of th changs is uncrtain. Th changs may b positiv or ngativ, and may b tmporary or prsistnt. Workrs and mployrs in individual firms do not know whthr shocks or changs ar tmporary or long-lasting, ral or nominal. Th uncrtainty that affcts mploymnt is summarizd by th four way classification of shocks as ral and nominal, tmporary and prsistnt. Uncrtainty ariss bcaus of th inability of workrs and mployrs to distinguish promptly, btwn th four catgoris. Hr w assum that thr is no way to xtract from availabl data fully rliabl information about th typ of shock that has occurrd. Z/W xamin th way in which th labor markt absorbs uncrtainty and th implications for wags and mploymnt. * W start with a discussion of shocks, thn analyz th dmand and supply curvs and draw thir implications.

15 4% 13 Rd and Nominal Th distinction btwn ral and nominal shocks is familiar. Our arlir discussion of th classical thory showd that spnding dpnds on B and B*, th domstic and rst of th world stocks of bas mony. Unanticipatd changs in B and B* chang aggrgat spnding and th dmand for labor. Th qualitativ ffcts of B and B* on spnding ar th sam, but th quantitativ: ffcts diffr. Ral shocks wr introducd in th aggrgat supply functions of classical and Kynsian thory to rprsnt th ffcts of changs in wathr, dgr of monopoly, tchnological chang and th lik. In an opn conomy, ral shocks to supply at hom and abroad affct output and mploymnt undr fixd and floating xchang rats. Floating xchang rats prmit countris to offst th ffcts of forign shocks on domstic output, as shown arlir, but to do so policy authoritis rquir information about th magnitud of ffcts and th duration of th shock. Policy changs introducd to:-o fst:shocks:can incras uncrtainty as Fridman notd yars ago. Fridman (1953) Ral shocks to spnding:hav bn nglctd in prvious chaptrs. Vlocity was assumd aonstant in our discussion of th classical thory and qual vry whr. In our discussion of Kynsian thory, th dmand for mony was tratd as crtain. Hr and in latr chaptrs changs in govrnmnt spnding and in tax rats induc changs in th dmand for mony and in aggrgat spnding which in turn chang th dmand for labor W continu ta trat output as a composit good, so th composition of spnding: in ach country dos not cliang, but changs in th composition of world dmandaffct rlativ prics inanopnconomy and also chang th dmand for labor, mploymnt and ral wags.

16 4% 14 Tmporary and Prsistnt Shocks may b tmporary or prsistnt. A major problm facd by individuals or firms whn choosing a cours of action is to distinguish th two - to dcid on th duration of shocks. To a farmr dciding to xpand or contract acrag knowldg of wathr pattrns is not crtain knowldg. Rainfall or sunshin shift within distributions that can b dscribd by fixd mans and constant variancs, but thr ar, also, shifts in distributions. Climat in various parts of th world has changd; formrly productiv rgions bcom arid, and arid rgions bcom mor productiv. Th problm of duration rquirs a choic of whthr th pattrn obsrvd in wathr, sals, births, daths, rats of rturn or any othr variabl is bst rgardd as a drawing from a distribution with givn man and varianc or as a chang in th man and varianc. Fllr ( ) shows that long runs of obsrvations abov and blow th man may occur bfor it is propr to rjct th hypothsis that th man is unchangd. Nominal shocks prsnt a similar problm. Although it has bcom convntional to dscrib all changs in pric lvl as "inflation, 11 th xpctd duration of pric changs is rlvant for asst choic and for dcisions about th allocation of purchass ovr currnt and futur priods. Btwn th xtrms of on-tim changs in mony stock, govrnmnt spnding, or any othr policy variabl and prmannt changs in th rat of chang lis a trm structur of xpctd rats of chang. For th individual or firm dciding on a rational cours of action, som answr must b givn to th qustion: Ar currnt obsrvations on th growth of mony or govrnmnt spnding bst rgardd as a

17 4% 15 chang in th man of th distribution or as drawings from a distribution with unchangd man? Th answr to this qustion and dcision about duration or xpctd duration ar not th sam for vryon. Th duration rlvant for dcisions by th day tradr in financial markts is shortr than th duration rlvant on avrag, so day tradrs will rspond to changs that othrs rgard as transitory and likly to b rvrsd in th nar trm. Changs in xpctd duration ar most important whn costs of adjustmnt ar high. Th importanc of xpctd duration in choosing whn and how workrs and mployrs rspond maks it usful to look at th dcision problm facd by workrs and firms. Th Supply of Labor Fridman's (1957) thory of consumr bhavior mphasizs th distinction btwn prmannt and transitory incom - or btwn incom dfind as an xpctd 8/ stram and currnt rcipts."" Workrs prfr smooth to variabl strams of consumption. If rcipts ar variabl, consumption can b smoothd by accumulating assts or lnding whn currnt rcipts xcds dsird or plannd consumption and by rducing asst stocks whn currnt rcipts ar lss than consumption. Consistncy rquirs that workrs allocat sufficint tim to arn th xpctd incom rquird to satisfy thir consumption plans. Th concpt of xpctd incom implis that, up to th horizon rlvant for his consumption plan, a workr plans to supply hours of labor at an xpctd wag rat that, in sum, quals th valu of his xpctd labor incom. Incom from proprty is assumd to b constant. Expctd incom for ach workr is y 6 i

18 4% 16 T 1 1 w (4.1) y = 2 ( ) L ( ) + constant 1 x t=0 P t 1+r 4 w whr ( ) is th workr's xpctd ral wag, L is th xpctd supply of P manhours of labor standardizd to allow for diffrncs in productivity, and r is th rat of discount If 0... T dscribs th workr's rmaining liftim and plannd liftim consumption is qual xpctd incom, as is oftn assumd, y. quals th valu 91 of currnt and futur consumption. Formally, w can follow Fridman (1957) and dscrib th individual's dcision as th maximization of th utility of consumption U=U (C Q,...,C T ) subjct to T i t y. = 2 C ( ) 1 1 t=0 1+r Th individual allocats labor and capital to arn y. Th timing of consumption and i th timing with which labor srvics ar supplid ar rlatd, but distinct, problms. Th lattr, not th formr, govrns individual's labor supply. Smooth strams of consumption do not imply or vn rquir smooth strams of rcipts or smooth rats of purchas. Consumption is a masur of th rat of us and in Fridman's prmannt incom hypothsis is rlatd to xpctd incom. Purchass masur th rat of acquisition. Workrs with th sam xpctd incom and diffrnt strams of rcipts may purchas at diffrnt rats, hold invntoris aaid consum at th sam rat. Workrs with highly variabl strams may anticipat

19 4% 17 that ovr thir liftims, thy will supply fwr hours of work at a highr ral wag pr hour. This is accomplishd, for xampl, by rciving a prmium (ovrtim) for hours in xcss of som maximum numbr of hours pr wk. Workrs with variabl strams of rcipts rciv highr wags pr hour if additional compnsation is rquird to induc workrs to accpt variability of rcipts. Paprs by Azariadis (1975) and Baily (1974) dvlop th analysis of risk sharing in labor markts but do not distinguish btwn smooth consumption and variabl rcipts. Whthr workrs with smooth consumption rciv compnsation for variability of rcipts dpnds on th rlation btwn th numbr of workrs who prfr smooth to variabl rcipts and opportunitis for mploymnt at rlativly variabl or constant mploymnt. Whn choosing his occupation, a workr is awar that sasonal and cyclical fluctuations occur. Construction workrs and farmrs anticipat that wathr causs substantial fluctuations in rcipts. Workrs ntring durabl goods industris ar awar that mploymnt is mor variabl cyclically in th durabl goods industris than in industris producing non-durabls or in th civil srvic. Th variability of rcipts that charactrizs ach occupation is known to workrs choosing th occupation and govrns thir anticipation of th tim path of rcipts. As long as rcipts ar intrprtd as a drawing from a distribution with unchangd man, a workrs long-trm anticipation is unaffctd by th variability of actual rcipts. It is only whn th obsrvd stram of rcipts causs th workr to chang his stimat of th tru man that his bhavior changs.

20 4% 18 Diffrncs btwn obsrvd and anticipatd variability of rcipts affct consumption by changing th cost of smoothing consumption and by changing th anticipatd man. A run of positiv or ngativ dviations from th man changs th anticipatd man incom, th consumption associatd with that incom and th supply of labor. Changs in variability and in anticipatd man induc workrs, including nw ntrants to th labor forc, to supply labor so as to adjust th rturn from occupations with diffrnt variability and to adjust ral wags and labor supply to markt conditions. Workrs in diffrnt ag groups may hav th sam anticipation about th stram of futur arnings yt hav diffrnt rsponss to fluctuations in currnt and futur arnings. A prolongd rcssion lowrs th walth of young and old. Both sprad th loss ovr currnt and futur consumption and lisur Bcaus thy ar poorr, workrs consum fwr goods and lss lisur and work:mor in th futur, than thy would hav workd if th rcssion had bn avoidd. For th oldrworkr, tim to rtirmnt is shortr, so thr is a shortr span within which th currnt loss can b distributd. Sniority provisions ar a mans by which youngr workrs rduc th cost"of variability for th currnt gnration of old workrs. In xchang, thy gt a rduction in th cost of variability whn thy ar old. In q. (4.1) a workr maintains constant liftim incom by supplying mor labor whn wags am high and lss labor whn wags arlow. A ris in currnt w/p rlativ to th avrag anticipatd (w/p) is matchd by a ris in currnt L rlativ to avrag hour workd. Aworkr,, thrfor, dos not smooth rcipts: to smooth consumption but, instad, incrass th--variability of rcipts by supplying-mor labor whn currnt ral

21 4% 19 wags ar high and lss labor whn ral wags ar low. Smoothing ral rcipts to smooth consumption rquirs th opposit pattrn: a workrs would supply mor labor whn wags V ar low and lss whn wags ar high. is Th labor supply function for an individual workr, consistnt with q. (4.1) L S = I. [-; - (y?)k, >0; I < p t p Expctd ral wags dpnd on xpctd incom. Labor supply incrass as currnt ral wags w riss rlativ to xpctd wags. Incrass in incras th futur arnings anticipatd by th P workr, so h supplis mor labor in th futur and lss labor now. Rcration and othr non-labor activitis hav lowr currnt and highr futur prics whn w /p riss rlativ to w/p, so mor currnt hours ar dirctd to non-labor (lisur) activitis. Currnt and futur ral wags ris in th sam proportion, labor supply in ach priod is assumd to incras. Consistncy imposs an additional constraint for th aggrgat. Th sum of th xpctd incoms of all workrs and ownrs of capital cannot xcd th aggrgat incom of th community for th sam priod. To obtain th incom xpctd by supplirs of labor and capital, w sum th individual xpctations; y is th prsnt valu of incom xpctd to b producd in th community in ach of th nxt T yars. W assum a constant population, a givn, unchanging ag composition, and lt T «> to obtain, th community's xpctd incom. = y y. t y. 1=1 i. w Givn y, thr is a uniqu _ of work. p that workrs xpct to rciv on avrag for an hour

22 4% 20 s Th aggrgat supply function is obtaind by summing L for th population. Th 1 s currnt supply, L, dpnds on currnt and anticipatd futur wags and in anticipatd nar-trm output. (4.2) L S =L(-, )L >0; L <0. p p 1 2 A ris in th currnt ral wag, givn y, inducs workrs to supply additional manhours now and fwr manhours in th futur. A ris in anticipatd futur wags, givn y, ncourags workrs to rallocat hours of work from prsnt to futur. For th aggrgat, lisur and othr non-labor activitis ar assumd to b normal goods that incras with xpctd incom, so incrass in y incras th currnt and futur w supply of labor by changing and. P p An incras in xpctd inflation w and y constant, raiss p rlativ w to p. Currnt labor supply incrass and xpctd futur supply falls as workrs rallocat labor to quat th rturn to work in diffrnt priods. An quiproportionat incras in w and p, howvr, lavs xpctd ral wags unchangd and has no ffct on supply. Workrs distinguish typs of tchnical chang in q. (4.2). Tchnical chang affcts y and thrfor, w but labor-saving and labor-augmnting tchnical chang P hav diffrnt ffcts on currnt and futur wags. To th xtnt that th ffcts ar anticipatd, thy affct th currnt and futur supply of labor by changing anticipatd wags.

23 4% 21 Tchnical chang is a typ of ral shock. All prmannt or prsistnt ral w shocks affct th labor supply by changing, but tmporary or transitory shocks do P not. Tmporary ral shocks affct labor supply only if thy chang w/p or ar rronously intrprtd as prmannt. Tmporary nominal shocks affct L only to th xtnt that workrs in th aggrgat fail to distinguish ral and nominal changs corrctly. Th Dmand for Labor Each firm's dmand for labor is drivd from th solution for currnt output that quats currnt xpnditur to currnt supply. As in our discussion of classical thory, q. (2.6) abov, aggrgation of individual production functions yilds th long-run xpctd output of th community. Expctd long-run supply dpnds on capital and labor and on prmannt shocks to supply dnotd (4.3) y = F(K,L;*>) Equation (4.3) is not a tchnological rlation btwn inputs and maximal output. That intrprtation of (4.3) lads to Kyns's problm of xplaining why long-run unmploymnt is not rmovd by wag and pric adjustmnt. Our long-run normal output, or full mploymnt output, is th optimal output for givn social institutions and convntions, rprsntd by As long as social institutions for distributing risk and allocating rturns do not produc optimal invstmnt and consumption, output and mploymnt can b incrasd in principl by rmoving

24 4% I distortions and changing social institutions. F(K,L;<p) is th output xpctd to b producd with fficint us of rsourcs undr currnt and xpctd institutions and convntions. Maximal mploymnt diffrs from full mploymnt output and is rachd only if all privat and public institutions and arrangmnts ar chosn to c* Hi minimiz wast. All positions of long-run quilibrium ar at y, but short-run positions ar not. Tmporary and prmannt, ral and nominal shocks ar not asily distinguishd. Suppos in anon-growing conomy, with fixd productiv capital, th short-run supply function is w (4.4) y = y (_,<p). P Th supply of output changs dirctly with th pric lvl and invrsly with th ral wag Earmannt shocks, shifts th short- and long-run supply curvs. Tmporary supplyshocks caus actual supply to fluctuat around th lvl anticipatd by producrs. Tmporary shocks ar, as bfor, dnotd by, a random variabl with unit man and constant (log) varianc In th long-run quilibrium of a stationary conomy, th rat of purchas and th rat of consumption coincid. Ral and nominal shocks to xpnditur caus spnding to diffr from currnt consumption by th nt accumulation of durabl assts. Housholds spnd and accumulat assts whn currnt ral rcipts, y, xcd xpctd incom^ y, and rduc spnding whn currnt rcipts ar lss than xpctd incom.

25 4% 23 Fridman (1957), Darby ( 1978) Firms incras invntoris whn costs of production ar lowr than avrag anticipatd costs. For th prsnt, lt ral spnding dpnd on th domstic pric lvl, p, and a vctor of policy variabls and othr shocks, dnotd q. (4.5) y = d( p, z) Short-run quilibrium output is at th intrsction of th spnding and short-run supply curv. Th quilibrium position dpnds on all ral and nominal shocks, and all shocks that hav bn obsrvd ar rflctd in th prics of assts and output. Th short-run quilibrium position dpnds, also, on currnt blifs about th duration of shocks. Producrs hir labor to produc short-run quilibrium output. Th currnt dmand for labor dpnds on currnt output and on costs of producing in currnt and futur priods. Firms incras finishd goods invntoris whn costs of production ar lowr than avrag anticipatd costs. Ral and nominal shocks shift th dmand for labor by changing currnt spnding and th aggrgat supply curv of output. Th dmand for labor is d,w w w' - (4.6) L = f(, y, )f P P' t I <0;f 2,f 3 >0

26 4% 24 Equilibrium Th labor markt rachs long-run, stady stat quilibrium if thr conditions ar mt. Thr ar no ral shocks; y is constant, and 6 = 0. Producrs 1 xpctd output quals th incom xpctd by supplirs of labor and capital srvics; xpctations about strams of ral incom ar consistnt as to amount and timing. Thr is a common xpctation of quilibrium prics (or rats of chang) qual to th actual pric lvl (or rat of chang). Whn th thr conditions ar mt, and maintaind, mployrs pay and workrs accpt w = w pr standard hour of labor; workrs supply and firms dmand th numbr of manhours of labor, L, that produc long-run normal n output qual to y pr priod. Long-run quilibrium on th labor markt is shown in th lowr panl of Figur 4.1 d s at th intrsction of L and L (y ). Th numbr of manhours is L and th ral n wag is. Th output markt is shown in th uppr panl. Equilibrium output y P is at th intrsction of d and y. This output is producd using L manhours of labor u u n and yilds a stram of consumption srvics qual to xpditur y C. [INSERT FIGURE 4.1 HERE]

27 Figur 4.1

28 4% 25 Th Short-Run Position Suppos that a shock to spnding lowrs ral xpnditur to d^ so that output falls to th short-run quilibrium, dnotd y in Figur 4.1 Employrs rduc th dmand for d labor in rspons to th rduction in output. Th rducd dmand for labor is shown as L^. Altrnativly, assum that, with spnding unchangd at d^, a ral shock to supply shifts th short-run supply curv from y^ to y^. Again,-short-run quilibrium output is s s at y. Fwr workrs ar rquird to produc y, so th dmand for labor falls to lj as bfor. Th rduction in th dmand for labor following th ngativ shock to spnding or to supply lowrs th ral wag at which th labor markt rachs short-run quilibrium. To find th quilibrium ral wag associatd with L^, workrs and mployrs must distinguish spnding and supply shocks. Th rason is that th unambiguous ffct on mony and ral wags rsulting from th rduction in output is mixd with th ffct of th chang in prics. Prics ris in rspons to th rduction in supply and fall in rspons to th rduction in spnding, so th pric chang rinforcs th rduction in mony wags inducd by th dclin in spnding and offsts, to som dgr, th ffct of th supply shock. Although workrs and mployrs can xpct to mak rrors whn prdicting th quilibrium pric lvl, w do not xpct th rrors to b systmatic. To simplify th complx infrnc problm and rcogniz th mpirical vidnc citd in our discussion of th first stylizd fact, w limit our discussion to th choic of ral wags and mploymnt.

29 Employrs offr a ral wag qual to th marginal product of labor. Workrs choos a ral wag and th associatd mploymnt that maximizs th utility of consumption. Thir dcision dpnds on th xpctd duration of th shock. If th shock is prcivd as prmannt, workrs and mployrs accpt y as a position of long-run quilibrium and rduc ral wags and xpctd incom to th nw conditions. Th rduction in xpctd or prmannt incom is distributd btwn currnt and futur priods and btwn th consumption of goods and lisur. Employmnt falls to L^ and ral wags ar rducd corrspondingly. If th s 4% 26 shock is prcivd as tmporary, thr is a loss of ral walth to b sprad btwn currnt and futur priods, so som rduction of ral wags occurs. For convninc of xposition, w nglct this adjustmnt. Th workrs rspons to a tmporary shock is dfind by two polar positions. Thy can maintain ral wags and rduc hours of work to L^. This choic is dscribd w by th disquilibrium L - L at in Figur 4.1. Or workrs can distribut th n 0 p loss of currnt arnings btwn ral wags and hours of work by choosing to work Lj hours at th associatd short-run quilibrium wag. This choic involvs a movmnt along th labor supply curv L (y ). s Th choic of L^ rathr than L^ implis that workrs rspond to all shocks, whatvr th xpctd duration, by rducing ral wags. Thy smooth consumption by rducing ral wags and mploymnt whn output is low and by incrasing ral wags and

30 4% 27 mploymnt whn output is high. Obsrvations by conomists from Thornton to Kyns and byond suggst that workrs in th aggrgat do not bhav in this way. Workrs ar awar that ral and nominal shocks introduc fluctuations into th dmand for products of individual firms, into aggrgat spnding and output. Thy rcogniz that fluctuations affct th dmand for thir srvics and th markt claring pric. A rduction in currntly anticipatd rcipts has vry littl ffct on y or walth. Workrs sprad th loss ovr currnt and futur consumption by supplying mor labor ovr thir liftims. Bcaus long-trm xpctations chang vry littl, labor is rallocatd from priods of low ral wags to priods of high ral wags. Similarly, shocks to supply or to spnding that tmporarily rais short-run output abov th long-run xpctation, y y induc workrs to offr mor labor than is consistnt with s th labor supply function L (y ). A sustaind or prmannt incras spnding and s output inducs workrs to mov along L (y ); a tmporary chang dos not. Workrs do not ignor information about th currnt position of th conomy and th xpctd duration of shocks. Th timing of a rcssion or an xpansion may b unknown; th duration of a particular shock is uncrtain and difficult to anticipat prcisly. Workrs in our analysis, howvr, stimat th ral wag at which thy can obtain mploymnt and us th information whn dciding whthr to sk work at th lowr ral wags xpctd to prvail in rcssions and at th highr ral wags xpctd to prvail during xpansions.

31 4% 28 A workrs currnt and anticipatd nar-trm output asks: Is this a drawing from th anticipatd stram of rcipts that this occupation gnrats, or has th man of th distribution shiftd? If h blivs th man has changd, h movs along s w L (y ) and changs. Othrwis, h stimats th ral wag h could xpct to p 6 w a rciv if h acts as a pric takr. This wag, dpnds on his stimat of th currnt a P and nar-trm position of th conomy. His rational xpctation of currnt ral output a s s is y = E (y ) whr y is th short-run quilibrium output shown in Figur 4.1; th i i w a anticipatd short-run quilibrium ral wag,, dpnds on currnt and nar-trm P a conditions summarizd by y a and th vctor of policy variabls dnotd z. Equation (4.7) shows th workr's supply of currnt and anticipatd futur s hours of labor, th individual s labor supply function, L. l S W w^ 3, w (4.7) L. = g.[, (y.,z), 1 g g X);g <0 l l p pa i p 12 3 w w a a w, L. = g. [, ( y.;z ), ] g <0;g g >0 i l p pa i p Equations (4.7) imply that incrass in th currnt ral wag induc workrs to w rallocat hours of work from futur to currnt priods. Incrass in, givn, P a P rducs currnt and incras anticipatd futur hours of labor supplid. Currnt Bafror supply incrass, at unchangd ral wags, as th anticipatd nar-trm output of th conomy riss. w a

32 4% 29 Aggrgation of q. (4.7) yilds th aggrgat labor supply function. s w w a a w (4.8) L = g [, ( y,r), ]g t,g >0;g <0 p pa p Figur (4.2) shows th quilibrium position of th labor markt at th intrsction d s s d d of L land L givn by qs. (4.6) and (4.8). Th L (y ) L^ and L^ curvs ar rproducd from Figur 4.1. Eq. (+.8) is shown as th g-curv. INSERT FIGURE 4.2 ABOUT HERE Workrs information or blifs about th duration of th shock inducs a shift in labor supply. Instad of accpting th full rduction in ral wags implid by a a a tmporary shock, w /p an Figur 4.2, workrs rducs short-run hours to L^ and rais currnt ral wags to th position shown as w/p. Th rlation of w/p to w a /p a and w /p, and th rlation of L^ to L q and L^ changs as information arrivs to clarify th currnt situation. Th longr L^ is xpctd to rmain unchangd, th s mor th chang is rgardd as prsistnt and th closr is th g - curv to L (y ). Th mor transitory th shock, th closr is L^ to L q and w/p to w /p. Construction workrs do not rduc xpctd incom (y ) vry much whn it rains. Workrs 12 / in durabl goods industris do not substantially chang y in mild rcssions. d d Similarly, whn L is tmporarily to th right of L, th g - function lis to 1 * ^ 0 th right of L S (y C ).

33 Figur L (g)

34 4% 30 Whnvr w obsrv th labor markt, it is in a position of short-run quilibrium. Th ral wag and associatd quilibrium mploymnt ar obtaind by solving qs. (4.6) and (4.8) for w or w/p and L. Th rsponss dpnd on th drivativs of th labor dmand (0 and supply (g) functions. Th vctor z is omittd. Actual output, a s y, varis around anticipatd output, y = y. a y = y (4.9) (4.10) a w w = w(y,y, ) p P x,, a w c L = L(y,y ) P Wj, w^ >0; w^ CO L r L 2 > 0 ; L 3 S 0 Rsponss to Ral and Nominal Shocks Tabl 4.1 shows th rspons of w and L to ral and nominal shocks. Tmporary a ral shocks chang y and y rlativ to y ; prmannt or prsistnt ral shocks chang y and thrfor chang p rlativ to w. Tmporary and on-tim nominal shocks chang p rlativ to p ; prmannt nominal shocks chang p and w in th sam proposition. W assum that th w and L functions ar linar in th logarithms.

35 4.31 Tabl 4.1 Labor Markt Rsponss to Ral and Nominal Shocks ffct of: w ffct on w = f l >0 f 2«l L_ = >0 1 V f i f 2" g 2 > n W 1 2 = r < 0 «1 " f l f 2gl' f lg2 Li + L 2 = g r fl >0 f 3'g3 -w 3 = - Si " f l <0 T f 38l * f ls3 < V T* 1 " 1 5 w w >0 3 L 3 <

36 4% 32 A tmporary ral shock to supply = 1, shifts th supply of output in th dirction of th shock. Positiv shocks incras supply and lowr th pric lvl; ngativ shocks rduc supply and rais th pric lvl. Th dmand for labor and mploymnt chang in th sam dirction as short-run quilibrium output. Mony wags may chang in ithr dirction or rmain unchangd. Th dirction in which mony wags chang and th siz of th rspons dpnds on th slop of th xpnditur curv and on w^ in Tabl 4.1. Th rspons of mony wags to, using A to rprsnt on-tim changs, is Aw _ Ap Ay w p 1 y In classical thory, th slop of th spnding curv is - 1 and a sufficint condition for rigid wags in rspons to ral shocks is w^ = L In th mor gnral cas, mony wags chang by lss than th pric lvl, so ral wags fall in rspons to tmporary rductions in supply and ris following tmporary incrass. Tmporary shocks rsult from unforsn changs in domstic or forign mony, changs in taxs and govrnmnt or forign spnding. Short-run quilibrium output and prics chang in th sam dirction as th shock. Employmnt, ral and mony wags ris and fall togthr, but ral wags ris lss than mony wags. Whn th shock rvrss, prics, output, wags and mploymnt rturn to thir prvious valus. Fluctuations in output, or businss cycls,giv ris to changs in actual and currntly anticipatd output Suppos thr is a dclin in output or a rcssion; output is lss than full mploymnt output, y but quals th output currntly anticipatd, a on avrag, by workrs; y = y. Tabl 4.1 shows that mploymnt, L, riss and falls

37 a with y,. but mony wags may ris, fall or rmain unchangd. Our analysis suggsts that workrs will lowr ral wags, th siz of th rduction dpnding on th loss of ral walth and th duration of th rcssion. Ral and mony wags will appar rigid and unrsponsiv to changs in mploymnt and ral output that charactriz a typical, xpansion or contraction. Fully anticipatd fluctuations and unchangd xpctations ar an xtrm cas. In vry rcovry and rcssion, xpctations chang. Som intrprt th obsrvd or anticipatd chang in ral spnding as vidnc that liftim incom has changd. A svr rcssion or slow rcovry ncourags th blif that y is lowr; a mild rcssion, a fast rcovry or a long xpansion rais y. Markts convrt th intrprtation into currnt prics for assts, output and labor. In th labor markt, changs in long-trm xpctations affct ral wags by changing w rlativ to p. Th blif that rcssion will b mor mild than prviously anticipatd raiss 13 I anticipatd ral wags, incrass w but has an uncrtain ffct on mploymnt. Prmannt or prsistnt ral shocks to supply also chang xpctd ral output and thrfor chang w rlativ to p. Tabl 4.1 shows that a ris in. w /p raiss th currnt mony wag but has an ambiguous ffct on mploymnt. A fall in th xpctd ral wag rducd th dmand for labor and incrass th supply, so currnt wags fall and th ffct on mploymnt is uncrtain. A fully anticipatd inflation changs w and p quiproportionally and has no ffct on wags or mploymnt. A ris in currnt prics with xpctd prics, and wags unchangd, raiss th currnt mony wag but has no ffct on mploymnt. Th ffcts of on-tim changs in pric lvls diffr from th ffcts of inflation, though th diffrnc is not rcognizd in many studis rlating unmploymnt and th rat of pric chang. 4% 33

38 4. Intrprting Unmploymnt Th currnt lgal dfinition of unmploymnt in th Unitd Stats trats a workr as unmployd if h is dscribd as having lookd for work at last onc in a four wk. ^ 14/ pnod. Othr dvlopd countris us similar dfinitions and trat all cyclical unmploymnt as a loss of output. In Figur 4.2 th distanc L - L is n 2 unmploymnt as convntionally dfind and masurd. Our intrprtation of unmploymnt starts from th distinction btwn prmannt and transitory incom - or btwn incom dfind as an xpctd stram and currnt rcipts. A workr who xprincs a cyclical "lay off" has no rason to rduc his ral wag. As long as his xprinc is consistnt with th anticipations h hld whn h chos his job or carr, as modifid by subsqunt xprinc, h rgards unmploymnt as a drawing from th anticipatd distribution of tim btwn labor and lisur that h usd to dtrmin xpctd liftim arnings and consumption. Each day of lay off contains information lading to a rvision of anticipatd incom, but ach day of lay off has littl ffct on workrs accustomd to cyclical swings in mploymnt and output. Evry day of lay off is countd as part of masurd unmploymnt, but as long as incom anticipations ar not rvisd, xpctd incom changs vry littl and th workr is not unmployd in an conomic sns. A workr bcoms unmployd whn h rviss, downward, his prmannt or xpctd incom. Onc h blivs that currnt and futur arnings ar inconsistnt with his consumption plan, his incom and xpctd consumption fall, s h rducs his currnt ral wag and his xpctd futur wag. Th s supply curv of labor in Figur 4.2 shifts from g toward L (y ). Ral wags fall.

39 4.35 Th distinction btwn incom and rcipts or btwn xpctd and actual output carris ovr to mploymnt and unmploymnt. Workrs ar unmployd, in an conomic sns, whn xpctd incom and consumption fall. Diffrncs from Classical and Kynsian Thoris Kyns (1936, p. 15) calld unmploymnt "involuntary" if a ris in th pric lvl that rducs ral wags incrass mploymnt. Th dfinition and its subsqunt us by Kynsians and policymakrs ignors two distinctions. On is th distinction btwn anticipatd and unanticipatd pric and wag changs, th othr th distinction btwn anticipatd incom and currnt rcipts. Th first distinction has bn clarifid in th xtndd discussion of th Phillips curv, but th dgr to which fluctuations in mploymnt ar anticipatd rmains. Th classical intrprtation of unmploymnt diffrs from th Kynsian intrprtation. Th quotation from Thornton, (1965, pp ), rproducd in chaptr 2, dos not dny th possibility of cyclical unmploymnt. On th contrary, Thornton dscribs unmploymnt as "unusual and tmporary distrss" arising for rasons that ar widly known as Kynsian: Mony wags ar mor rigid downward than prics. For Thornton, howvr, mony wags ar rigid upward as wll if anticipatd inflation rmains constant. Thornton's charactrization of unmploymnt as "unusual and tmporary distrss" is no lss ambiguous than Kyns 1 trm, "involuntary." Th mchanism producing mploymnt is clarr, howvr. For classical thorists, cyclical fluctuations in mploymnt and output ar a consqunc of ral shocks acting on th quantity of commoditis currntly dmandd by shifting supply and of montary disturbancs acting on spnding. Shifts in aggrgat spnding and in aggrgat supply induc largr fluctuations in prics than in mony wags, so ral wags chang invrsly to th

40 4% 36 pric lvl whn spnding incrass and chang dirctly with th pric lvl whn supply incrass. Unmploymnt and ral wags ar positivly rlatd following a rduction in spnding but ar ngativly rlatd following a rduction in supply. Thornton (1965, pp ) is xplicit about th rlation of prics and output. Classical writrs did not, as far as w know, provid an conomic xplanation of th slowr adjustmnt of wags than of prics. Kyns, lik Thornton, first assums that wags ar slow to adjust thn offrs an xplanation basd on a particular st of assumptions about anticipations. (1936, Chap. 19). Th prmannt incom thory of mploymnt rcognizs th difficult infrnc problm facd by individual workrs and mployrs in an conomy subjct to ral and nominal shocks. Rlativ prics and th gnral pric lvl chang. A workr who is layd off cannot b crtain whthr th chang is prmannt or tmporary, th rsult of a ral or nominal shock. H is uncrtain whthr h will soon rturn to work at th anticipatd ral wag, as many do, or must sk a nw carr. An offr to rduc ral wags in rcssion to maintain mploymnt introducs variability into xpctd incom and consumption for th purpos of smoothing currnt rcipts. Liftim consumption and utility ar rducd. Th prmannt incom thory givs no rason for workrs to rduc ral wags as long as anticipations ar unchangd. Workrs as a group cannot xpct to find a st of consistnt contract provisions that maintain both mploymnt and ral wags whn thr ar unanticipatd ral and nominal shocks that chang prics and output. Th bst thy can do is rduc th cost of fluctuations in rcipts to th minimum cost consistnt with th risks inhrnt