On expectations
We may recall the 1995 Nobel Prize for Robert Lucas. The Swedish Academy put the following text on the internet:
“The change in our understanding of the so-called Phillips curve is an excellent example of Lucas’s contributions. The Phillips curve displays a positive relation between inflation and employment. In the late 1960s, there was considerable empirical support for the Phillips curve; it was regarded as one of the more stable relations in economics. It was interpreted as an option for government authorities to increase employment by pursuing an expansionary policy which raises inflation. Milton Friedman and Edmund Phelps criticized this interpretation and claimed that the expectations of the general public would adjust to higher inflation and preclude a lasting increase in employment: Only the short-run Phillips curve is sloping, whereas the long-run curve is vertical. This criticism was not quite convincing, however, because Friedman and Phelps assumed adaptive expectations. Such expectations do in fact imply a permanent rise in employment if inflation is allowed to increase over time. In a study published in 1972, Lucas used the rational expectations hypothesis to provide the first theoretically satisfactory explanation for why the Phillips curve could be sloping in the short run but vertical in the long run. In other words, regardless of how it is pursued, stabilization policy cannot systematically affect long-run employment. Lucas formulated an ingenious theoretical model which generates time series such that inflation and employment indeed seem to be positively correlated. A statistician who studies these time series might easily conclude that employment could be increased by implementing an expansionary economic policy. Nevertheless, Lucas demonstrated that any endeavor, based on such policy, to exploit the Phillips curve and permanently increase employment would be futile and only give rise to higher inflation. This is because agents in the model adjust their expectations and hence price and wage formation to the new, expected policy. Experience during the 1970s and 1980s has shown that higher inflation does not appear to bring about a permanent increase in employment. This insight into the long-run effects of stabilization policy has become a commonly accepted view; it is now the foundation for monetary policy in a number of countries in their efforts to achieve and maintain a low and stable inflation rate.”
The Academy is a bit too assertive. The Phillipscurve need not be vertical in the long run. It may well be that there is no fixed solution, and that the long run gives a non-converging movement. Also Phelps (1994) has reminded us that the CWIRU (in his words the NAIRU or ‘natural rate’) need not be constant.
Secondly, there can be other causes than expectations, and these might be more important for understanding the present situation. One important cause is the mechanism of the minimum wage. Hence the models used by Lucas and his predecessors need not be the relevant models for explaining the empirical shifts in the Phillipscurves and their CWIRU’s.
Heterogeneous Phillipscurves
If labour is heterogeneous, then utility maximisation and rational calculation are not only directed at demanding a competitive wage, but they are also directed at selecting the kind of submarket (and its associated wage). This complicates the situation. Can we say that a dentist is ‘unemployed’ in the market for farmers ? Or closer linked, that an assistant professor is ‘unemployed’ in the market for professors ? However, we may note that an individual who sets his wages too high will become unemployed in any submarket. This causes an intuition that the selection of submarkets can still be represented by wage schedules. There will be more equilibrating forces than wages only, e.g. education or migration, but it can be reasonable to concentrate on wages.
With heterogeneity, the unemployment that is relevant for a submarket will have effects on the evolution of the wage in that submarket. Aggregating, however, we get an effect of macro unemployment on the average wage. Hence above simple relationship can be retained, but its interpretation changes from homogeneity to aggregation of heterogeneous submarkets.
More factors that cause a shift
Above we used um to show how the Phillipscurve can shift. Note that this in fact has only been a didactic procedure. I wanted you to understand the formulas, and it appeared very instructive to draw graphs of shifting Phillipscurves. However, when there are LS homogeneous labourers, we have some difficulty explaining why (1 - u) LS could work and u LS could not, even though they essentially are the same. Hence minimum wage unemployment and the shift of the Phillipscurve due to it, properly belong to the world of heterogeneous labour.