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Unit 2 Unemployment, wages, and inequality: Supply-side policies and institutions

2.12 How good is the model?

Before you start

If you would like more background, read Sections 1.8 and 1.9 before reading this section.

The WS–PS model of the macro economy that you learned in Unit 1 and applied to problems of economic policy in Unit 2 has a number of features:

  • It provides a framework to understand what will determine the equilibrium level of employment, real wages, unemployment, and profits, taking account of the unique features of the labour market and the fact that the degree of competition in both product and labour markets may vary across countries and over time.
  • These results determine the level of income inequality in the model.
  • One determinant of a rise in structural unemployment is the increased cost of imported raw materials. This is visible in the data, for example, for the three European economies in Figure 2.29 in the wake of the global oil price increases of 1973 and 1979, referred to as the OPEC oil price shocks.
  • Empirical measures of many of the main variables in the model are available, allowing the model predictions to be applied to particular national economies.
  • The effects of policies that might be pursued by governments, trade unions, or employers’ organizations can be readily determined by shifting either the WS or the PS curves or both.
  • The model provides some clues as to why countries differ in their capacity to provide both a low level of unemployment and rising real wages.
This line chart shows the unemployment rates of Germany, Spain, and Denmark over time. The horizontal axis depicts the year, ranging from 1960 to 2022. The vertical axis displays the unemployment rate in %, ranging from 0% to 25%. Germany’s unemployment rate begins at around 1% in 1960 and starts to rise steadily at the onset of the first oil shock in 1973–74, plateauing at around 9% from 1994 to 2009, after which it falls steadily to around 4% in 2022. Spain’s unemployment rate begins at a higher level of around 3% in 1960 and rises rapidly at the onset of the first oil shock in 1973–74, plateauing at around 20% from 1984–1999. It then falls when the Eurozone is launched in 1999 to around 11% until the Global Financial Crisis in 2007 to 2010 when it rises rapidly to around 23%. Spain’s unemployment rate begins to fall from 2014, reaching around 15% in 2022. Denmark’s unemployment rate begins at around 3% in 1960, and rises moderately at the onset of the first and second oil shocks above Germany’s to around 7% in 1984. It fluctuates around this until 1994, and then falls steadily to around 4%, below Germany’s in 2009. It rises again moderately during the global financial crisis and the eurozone crisis to around 7%, and in 2022 it falls to 5%.
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https://www.core-econ.org/macroeconomics/02-unemployment-wages-inequality-12-how-good-is-the-model.html#figure-2-29

Figure 2.29 Unemployment in Spain, Germany, and Denmark (1960–2022). The data in Figure 2.29 shows that the differences in the unemployment rate between Spain on the one hand and Germany and Denmark on the other, are long-standing, dating back to the late 1970s.

D. R. Howell, D. Baker, A. Glyn, and J. Schmitt. 2007. ‘Are Protective Labor Market Institutions at the Root of Unemployment? A Critical Review of the Evidence’. Capitalism and Society, 2 (1); OECD. 2023. Harmonized unemployment rates.

But this model, like any simplification, has shortcomings. The first is that the equilibrium of the model may not be what we observe in the economy. The second is that the two fundamental parts that make up the model—the WS and PS curves—may not be an adequate representation of the structure of the economy in question.

The economy may take a long time to get to the Nash equilibrium

We have provided reasons in Section 1.8 why we can think of the equilibrium in the model as a magnet that pulls the economy in its direction. But the magnet may be weak and slow acting. Understanding why the pull towards the equilibrium can be weak in the model sheds light on cases that countries in the world face. We use reunified Germany as an example.

Until 1990, Germany did not exist as a country in the post-World War II era and the data for unemployment shown in Figure 2.29 before then is for West Germany only. Prior to unification, unemployment in East Germany was very low. In 1994, the unemployment rate in the East was 16.0% and 9.1% in the West. As the shock of unification was absorbed, unemployment in both parts of the country and the gap between them fell. In 2022, the unemployment rate was down to 7.4% in the East and to 5.4% in the West.

The unification of Germany provides an example of slow adjustment towards equilibrium after a large shock. Following the unification of East and West Germany in 1990, an upward shift in unemployment is observable in the data (Figure 2.29). This ‘hump’ lasts until the mid-2000s. Unemployment in East Germany rose dramatically when most manufacturing enterprises in the region were closed down. They were unable to produce at a profit for two reasons. First, the mechanism that the model suggests would pull the economy towards equilibrium is falling wages (Section 1.8), yet wages increased rapidly towards West German levels. The second reason is that East German firms failed in competing for sales in the unified German market and in the rest of the world. Had the mechanisms in the model worked swiftly, adjustment would have occurred much faster.

What is missing from the model?

The supply-side model predicts that the economy will return to equilibrium at the structural unemployment rate because of the way wages, prices, and levels of employment and output adjust. Read Section 1.8 to recall how this works. But if this is the case, why are so many resources devoted to stabilizing the economy when it experiences a shock, such as a collapse in investment by firms, that takes it away from the equilibrium? It would be hard to explain why central banks and finance departments employ so many economists to devise appropriate policy responses to shocks like this if the economy was rapidly self-stabilizing in the way suggested in Figures 1.24 and 1.25.

The Great Depression of the late 1920s and early 1930s divided economists between those who thought the economy was self-stabilizing and those who used a newly developed theory—Keynes’ General Theory—to argue the opposite and make the case for government intervention to limit the damage caused by recessions.

To explore how the economy can get stuck at a higher rate of unemployment than the structural rate at the WS–PS intersection requires that we expand the model to include the demand side. Starting in Unit 3, we introduce aggregate demand to the model. This will provide tools we need to explain the role of governments and central banks in stabilizing the economy.