of unemployment’. In Friedman’s original paper, and in much subsequent work, the determinants of the ‘natural rate of unemployment’ are seen to relate to the labour market. These have been given a number of meanings, ranging from the form and extent of trade union power and influence, to the setting of minimum wages, and to the operation of unemployment benefits and so on.
Thus the view has been formed that the supply-side equilibrium depends on the labour market, and that measures to make the labour market more ‘flexible’, and thus less ‘regulated’, will lower the ‘equilibrium’ rate of unemployment.
In this chapter we present a rather different analysis of the macro economy;
it is one that we utilize in the chapters that follow. The significant implica- tions which we draw out of our analysis are the following:
● the pace of inflation cannot be associated with a single factor (such as demand) but rather arises from interactions between a range of factors:
in our analysis this range of factors includes the level of productive capacity, the struggle over income shares, the level and rate of change of output and the international inflationary environment;
● what may be viewed as a supply-side equilibrium position, that is one consistent with a constant rate of inflation, depends on the scale of the capital stock (and therefore productive capacity) and hence is con- stantly changing as investment occurs, changing the capital stock;
● there are no strong market forces which push the economy towards that
‘equilibrium position’.
We begin this chapter by elaborating on the key elements of this structural- ist view of inflation, supplemented by an investment relationship that completes the picture. An attempt to draw out the implications of the structuralist analysis to the inflationary process is then provided. This is followed by a discussion of a number of empirical questions, before we conclude this chapter.
The inflationary process 75 recognized, in the NCM model) is that inflation (and notably changes in the rate of inflation) arises from what may be termed ‘real factors’ and that the stock of money expands alongside the rise in prices. As we have seen above, and discuss further below, in Chapter 7, money is endogenous credit money created by the banking system, and comes into existence through the loan process, and the extent of money creation depends on the demand for loans and the willingness of banks to satisfy that demand. Rising prices will require firms and others to seek loans to cover the rising cost of inputs and so on, and higher prices raise the demand for money. The stock of money and prices rise broadly in line and at the same rate, but the causation is seen to run from prices, or nominal income more generally, to money.
In the exogenous money story, it is the rate of increase of the money supply which drives the inflationary process, and the precise mechanisms of price and wage determination may not be particularly significant in the inflationary process. In effect price and wage determination may be the conduit of inflation, but inflation is seen to arise from ‘excessive’ monetary growth. But when money is treated as endogenous, and the changes in the stock of money arise from the inflationary process itself, it is necessary to give attention to the price and wage determination processes.
The endogeneity of money is an important element in the analysis of the inflationary process since it leads to the notion that inflation is not caused by expansion of money, though the expansion of money will occur alongside inflation. Further, the endogeneity of money is also important for the rest of the analysis conducted in this book. Consequently, money is given promi- nence not merely in this chapter but in the rest of the book. It is for this reason that the coverage of this key aspect is rather short in this chapter.
Pricing
There are many ways in which firms set their prices: the ways may vary according to the nature of the industry and markets in which they operate, to their own objectives and organization and so on. (Sawyer, 1983; Lee, 1998).
However, there is a broad similarity amongst these various theories of pric- ing, in that there is the general view that price is set by reference to the level of average costs, which can be summarized as price is set as a mark-up over average costs. If we write this general view as
p= +[1 m cu( )] (⋅ lc+mc), (6.1) where p is price, m is a mark-up which depends on capacity utilization (the presumption being that, at high levels of capacity utilization, firms will be able to set a higher mark-up), lc is unit labour costs, and mc unit material costs.
It has often been assumed that enterprises operate subject to (approxi- mately) constant average direct costs and with significant excess capacity so that further expansion can be undertaken without costs (and presumably prices) rising. This ‘stylized fact’ has often been invoked to explain some degree of price constancy with respect to the level of demand, and evidence (for example Sawyer, 1983) supports the view that price changes are little related with the level of (or changes in) demand. However, the view that average direct costs are broadly constant would add up to the point of full capacity, after which average costs may rise rapidly.
The pace of price increases would then be seen to depend on a combination of the pace of cost increases (actual and anticipated) and the rate of change of capacity utilization. At the level of the individual firm, at least, price inflation arises from cost inflation. It should be further noted that the level of capacity utilization (which would reflect, inter alia, the level of demand) is viewed as influencing the level of prices, and hence the rate of change of prices would be influenced by the rate of change of capacity utilization (and hence rate of change of aggregate demand). This, of course, stands in contrast to the view of the Phillips curve, which stresses the effects of the level of demand (as reflected in, for example, the level of unemployment) on the rate of inflation.
The general view of price inflation, which follows from equation (6.1), is that the rate of price change depends on the rate of change of costs and of capacity utilization. One further element could be added, namely a catch-up effect. Equation (6.1) can be read to indicate the price that a firm desires to charge if it had full information. But price is typically set ahead to transac- tions as the price at which the firm wishes to trade, and then the firm sells whatever is demanded at the price, which it has set. Mistakes can, of course, be made: the firm may misestimate cost changes, make mistakes in forecast- ing demand and so on. In any decision period, then, the firm’s pricing decision depends on estimates of cost and demand change, and some catch-up (or catch-down) of price. This can be written as
˙ ˙ ˙ ˙ { ( ) /[ ( ) ( )] },
p=a w0 +a f1 +a cu2 +a p3 −1 lc− +1 mc − −1 R (6.2) where R = 1 + m(cu) is the desired mark-up of the firm (in light of the demand conditions which it faces), and a dot over a variable indicates propor- tionate rate of change of the variables concerned.
Both equation (6.1) and equation (6.2) can now be further utilized. Equa- tion (6.1) can be expanded and rearranged to give an equation for the real product wage (at the level of the firm). This is
w
p m cu lmc
= l
+ 1 ⋅
1
1 1
( ) , (6.3)
The inflationary process 77
Figure 6.1 The p-curve Real
product wage
Capacity utilization p-curve
where l is amount of labour per unit of output. This is portrayed in Figure 6.1.
Using equation (6.2) we can also envisage that, for points above the line, prices will tend to rise faster than wages (as indicated) and conversely for points below the line.
Each point on the curve labelled ‘p-curve’ in Figure 6.1 (which would be a point on the line of equation (6.3)) corresponds to a particular level of demand facing the firm. As a result of that level of demand, the firm selects a price (which best serves its interests), and the level of capacity utilization is a result of that level of demand. The relationship in equation (6.3) is between real product wage and capacity utilization. For a given capital stock this can be translated into a relationship between real product wage and output (or employment).
Figure 6.2 portrays an aggregate relationship between employment and real wage. To derive the aggregate level relationship we can proceed as follows. For a given level of demand, there would be a specific point on the p-curve of each individual firm, indicating a specific real product wage and level of capacity utilization and of output. Form the weighted average of the real product wage
Figure 6.2 The p-curve: wage and price pressures Real
wage
Employment p-curve
Price change > wage change
Price change < wage change
of each firm to form the overall real wage. Add together the level of output of each firm to give the aggregate level of output. Repeat the exercise for a different level of demand to map out the aggregate relationship.
Three points stand out regarding the aggregate relationship as portrayed in Figure 6.2. The first is that the position of the p-curve depends on the capital stock of the economy. The relationship between price and wage depends on capacity utilization but, the greater is overall capacity, the greater can output be. An increase in the number of firms (and hence in capacity) in the economy would shift the p-curve to the right: more individual p-curves are being added together to generate the aggregate relationship.
The second point is that the pace of price inflation depends on a variety of factors. These include cost pressures, whether from wages or from materials, which would include the effects of exchange rate and world prices on im- ported prices, the rate of change of capacity utilization and attempts by firms to restore profit margins.
The third is that the ‘height’ of the p-curve depends on the mark-up which firms can extract and that may be summarized as reflecting the degree of
The inflationary process 79 market power of firms. The more market power they possess, the higher would be the mark-up, and the lower the real product wage (and hence the lower would be the p-curve).
In Figure 6.2 we have also indicated the presumed price dynamics.
Wage Determination
There are numerous views as to how wages are determined (and also numer- ous wages in which wages are actually determined). Our approach differs substantially from those that view wages as set in a competitive labour market. At least in terms of the algebraic representation of the equilibrium relationship between real wages and employment, many of the approaches that are compatible with ours lead to similar outcomes; for example, trade union bargaining models, efficiency wage models (for more details see Sawyer, 2002, and Layard et al., 1991, especially chs 8 and 9).
The approach to wage determination adopted here comes from suggesting that the rate of change of money wages depends on three sets of factors. The first is the general level of price inflation, such that the faster is the antici- pated rate of price inflation (which may be much influenced by the recent experience of inflation) the higher will be the claims for money wage in- creases. This may happen in a one-for-one manner: that is, with each 1 per cent increase in the anticipated rate of inflation leading to a 1 per cent increase in rate of increase of wages.
The second set is the desire by workers to move the current real wage towards some target real wage. The larger is the gap between the target real wage and the current real wage, the greater will be the push by trade unions and others to close the gap. The target real wage can be viewed in terms of the aspirations and expectations of the workers and trade unions, which in turn depend on factors such as real wage resistance, notions of fair wages and so on. A somewhat different perspective on the target real wage would be to view it as the underlying outcome from bargaining between unions and employers.
The third set is the relative power of employees and employers and hence the ability of workers to secure wage increases. The relative power can depend on many factors, including the general political climate, the nature of industrial relations and labour laws and so on. But the macroeconomic fac- tors which stand out in this regard are those related to unemployment, including the rate of unemployment and the rate of change of unemployment.
This target real wage hypothesis (Sargan, 1964; for detailed elaboration, see Sawyer, 1982a, 1982b; Arestis, 1986) is based on a collective bargaining view of wage determination, which can be set out as
˙ ˙ ( ),
w= +a1 a p2 −1+a U3 +a w4 −1−p−1−T (6.4) where dots over variables again indicate rate of change, w is the log of money wages, p is the log of prices, U is rate of unemployment and T is the log of target real wages. The coefficient a2 may be close to unity, and a3 and a4 are signed as negative. The rate of nominal wage increase depends on the rate of inflation, unemployment (reflecting bargaining power) and the difference between actual real wages and target real wages.
The equilibrium relationship when the rate of wage change equals the rate of (lagged) price change is given in the following equation:
a1+a U3 +a w4( − −p T)=0, (6.5) assuming for convenience that a2 = 1. Defining unemployment as U = (Lf – L)/
Lf, where Lf is full employment (assumed given) and L is actual employment, yields
L L
a a
a
a w p T
f
= 1 + + − −
3 4 3
1 ( ), (6.6)
which gives a positive relationship between real wage and employment and is drawn as the w-curve (which reflects the wage determination process) in Figure 6.3. The inflationary dynamics (from equation (6.4)) are such that for points below the w-curve, wages rise faster than prices, and for points above wages rise less rapidly than prices. In terms of Figure 6.3, the position of the w-curve depends on the coefficients a1, a4 and the target real wage. In repre- sentational terms, any factor which could be viewed as changing one (or more) of those parameters would lead to a shift in the w-curve, and thereby in the inflation barrier.