The static theory of labour demand does not specify how, or how long adjustments between production factors take. It is therefore necessary to consider the notion of adjustment costs, such as costs incurred by a company to change the number of factors.

We will follow the lines followed in the model of adjustment costs seen in “Le marché du travail”, 2001, by Pierre Cahuc. These adjustments involve production costs that do not correspond to the activity itself. There are two kinds of adjustment costs:

-Internal adjustment costs: those caused by the loss of efficiency due to reorganization within the company (for example, training for use of new machinery, training of new employees to existing machinery, etc.).

-External adjustment costs: those who can be differentiated from production variations (for example, hiring experts to implement the changes, layoff payments, etc.).

As Cahuc explains, previous studies on the labour markets in the United States and France allow us to compare the situation of two types of markets:

-Recruitment costs are higher than firing costs in the U.S.;

-Firing costs are higher than recruitment costs in France;

-Recruitment costs in the U.S. are higher than in France;

-Firing costs are higher in France than in the U.S.

Furthermore, these studies conclude that these costs increase with the level of wage and/or training.

Employment protection by the public sector is less rigorous in the U.S., Canada or the U.K. than in France, Germany and southern Europe. Furthermore, these studies conclude that much of the higher cost of firing in Europe is due to administrative or regulatory costs (due to the legislation of each country).

LINEAR FORMULATION:

In most jobs, costs are represented by a symmetric convex function (usually quadratic). However, this does not explain asymmetrical adjustments and discontinuous employment. Thus, we see the linear formulation, which is commonly used nowadays.

This representation will show us how companies sometimes hire or fire employees, or remain as they are.

c_h and c_f represent hiring costs (h) and firing costs (f). Adjustment of employment will therefore be asymmetricif c_h ≠ c_f.

EMPLOYMENT ADJUSTMENT:

It is possible to differentiate the effects of c_h and c_f when adopting a linear function. Furthermore, the linearity will see how the adjustment in the levels of labour can be immediate.

We define the adjustment cost function as:

The producer’s problem is choosing the level of labour that maximises its profits: 

(r=is the rate at which future profits are actualised to present value)

The employment level is given by the equation:

which translates into the following conditions:

In all other cases, the producer maintains its level of staff. As we assume w, r, c_h and c_f constant, we can define employment levels L_h and L_f  as:

The company adjusts its level of workers L_h (respectively L_f) if this is higher (respectively lower) than the initial level of employment L₀. If not, it means that L₀ is maintained between L_h and L_f, its optimal level:

GRAPHICAL ANALYSIS:

The curves in the lower half of the adjacent figure represent the relationship between initial employment and final employment levels. The conclusions we can derive from this model are:

-↑c_f: An increase in firing costs (U.S. spending levels to levels of FR.) Prevents staff adjustment downwards, and no incentive to hire;

-↑c_h: Increased recruitment costs (FR. spending levels to U.S. levels) prevents new hires;

-↓c_h: A lower recruitment cost always has positive effects on employment because it increases the optimal level of employment L_h;

Therefore, this model explains:

· higher unemployment in France (for little flexibility when firing);

· when wages are equal in both economies, U.S. production levels will be higher;

· in recessions, the situation is worse in France because it’s hard to fire employees;

· in times of expansion, the situation is worse in the U.S. because it’s hard to hire.

The main conclusion that can be derived from this model is that proper management of the costs of hiring and firing ensures greater stability in the demand for labour.

Business cycle, as Joseph Schumpeter saw it, is the economic activity fluctuation that occurs over time, and that comes from the succession of expansionary and contracting seasons. It is analysed comparing real GDP to potential GDP (Y*). There are a few common characteristics, which help differentiate cycles, such as its phases, the way it oscillates, the periodicity and a few stylized facts:

1. Phases:

Four phases can be distinguished, following Richard Lipsey’s classification:

-Trough or depression (A), characterized by a high rate of unemployment and low consumption levels in relation to its real capacity;

-Expansion or recovery (B) of previous employment, income and consumption levels, that usually comes together with a rising in prices;

-Peak (C), distinguished by factors full use, high investment and shortage of labour, particularly for high-skilled jobs;

-Recession (D), demands fall causing unemployment and decreasing production levels.

2. Oscillations:

3. Periodicity:

Economic cycles have been classified depending in their periodicity. The most common are:

-Very short cycles, with duration of 30-40 months; also known as Kitchin cycles, whose studies saw in stock rotation the origin of these cycles;

-Short cycles, with duration of 7-11 years; also known as Juglar cycles, which origin is based on subsequent inventions;

-Long cycles with duration of 15-25 years; commonly known as Kuznets cycles, whose analysis placed the origin of cycles in demographic factors such as birth rates or migrations;

-Very long or Kondratiev cycle with duration of 50-60 years. This cycles originate with breakthroughs in capital goods, such as the steam engine or the Internet.

4. Stylized facts:

Both over time and between countries (a few of numerous reviewed by Robert Lucas in his article “Understanding Business Cycles”, 1977):

-There is positive correlation between variables, which helps smooth fluctuations;

-Co-movement between some variables:

·output fluctuates in the same direction in different sectors (although different amplitudes may apply);

·investment and consumption are clearly pro-cyclical: investment leads and is more volatile, consumption lags and is rather stable;

·income: real wages and profits are pro-cyclical;

·employment and labour force are also pro-cyclical.

-Expansions are usually longer than recessions.

Many papers and works have been written on business cycles and different points of view have taken form. Keynesian economics tries to deal with the economic fluctuation to minimize their impact. Business cycles are seen as a proof of market failure, and justify government intervention in order to assure the correct level of economic activity. Until the optimum level of employment has not been reached, the economy will not be readjusted. Depending on the cycle phase, expansionary or contractionary economic policies may be used.

New Classical Macroeconomics supporters have also dealt with economic cycles, and as a result the Real business cycle theory arises as an alternative view to Keynesian´s. Kydland and Prescott, and in general the Chicago School, are mostly related with the development of this theory. For them, cycles are explained by technological shocks. The fluctuations in the economy are seen to be produced by shifts in the supply curve, as a result of changes in productivity levels. These shocks can be caused by different factors: technology innovation, unusual weather conditions, changes in raw material prices, new policies and regulatory measures, etc. What is basic for these shocks to occur is an alteration in the effectiveness of either capital or labour factors, and therefore changing productivity. As a result in changes in the production quantity, the supply curve shifts, implying a new equilibrium point in the supply and demand model.  Thus they believe that economy will reach its new equilibrium point, through the forces of demand and supply in itself, without the need for a government intervention. In fact from their view, government intervention will only worsen the situation.

The term natural rate of unemployment was introduced by Milton Friedman in 1968, in his article “The Role of Monetary Policy”, following his presidential address delivered at the annual meeting of the American Economic Association, in 1967. It is based in Knut Wicksell’ concept of “natural” rate, which defines how there will be no permanent changes in the considered variable below or above its natural level.

The natural rate of unemployment defines the level at which unemployment will remain, no matter how great the effects of monetary policy. The only way to permanently keep unemployment under its natural rate is to resort to higher and higher inflation rates, which in turn would be highly hazardous for the economy. This can be easily understood using an expectations-augmented Phillips curve.

Even though the natural rate of unemployment is usually merged in the economic literature with the term NAIRU, there are a few differences between both terms. These differences are summarized in the following grid:

New Classical Macroeconomics takes expectations one step further than monetarists did when using adaptive expectations. Rather than supposing that agents will learn to adjust their behaviour based on past experiences, they apply rational expectations, and directly assume that:

• All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;
• All agents assume that markets naturally reach an equilibrium;
• Information is perfect: market force drivers are ‘common knowledge’.

This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:

As New Classical Macroeconomics views it, agents are able to anticipate future events without needing to have experienced them previously. This time around, agents will anticipate expansionist monetary policies, and therefore skip point B. Agents have sufficient working knowledge of the economy and monetary policy is transparent enough for agents to directly associate a fall in interest rates with a rise in inflation. Therefore, they waste no time in asking for salary raises (the change on inflation expectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever reached. Expansionist monetary policy is not even effective in the short term. In the very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.

The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.

Rational expectation models are those where an agent’s future predictions affect the value they assign to a variable in their current time period. In this sort of self-fulfilling prophecy, expectations become truths, and errors in forecasting future variables become random. This makes those forecasts valid, because present expectations about the future become dependent variables of future values. This model was developed and put forwards by John Muthin two articles: “Optimal Properties of Exponentially Weighted Forecasts”,1960, and “Rational Expectations and the Theory of Price Movements”, 1961 and later summarised by Peter Whittle in 1963, before becoming influential in Robert Lucas’ work in the 1970s. Particularly, Lucas developed the use of rational expectations in his article “Expectations and the Neutrality of Money”, 1972, in which he used Edmund Phelps’ island parable, though applying rational expectations, instead of adaptive expectations.

Mathematically, rational expectations can be represented as: 

Which simply means that the value of x today will be the value that we expected it to be plus a random error.

Essential to this hypothesis is the fact that individuals have perfect information and markets are perfect and tend towards equilibrium. This places us firmly back in the realm of neoclassical economics, whose main ideas where retaken by New Classical Macroeconomics.

Thomas John Sargent, born in 1943, is an American economist who has been deeply involved in the new classical macroeconomics, researching the fields of macroeconomics, monetary economics and time series economics. It was in 2011 when he and Christopher A. Sims were awarded the Nobel Prize in Economic Sciences for the use of empirical research when explaining cause and effect in macroeconomics.

Sargent is considered to be one of the leaders in the rational expectations revolution that states that people respond strategically to changes in fiscal and monetary policy, and not passively, as previous models such as the adaptive expectations assumed. In this field, his works with Neil Wallace are of paramount importance, specially their paper “Rational Expectations and the Theory of Economic Policy”, 1976, which focuses on the application of rational expectations to analyze the outcome of monetary policies; and their paper “Some Unpleasant Monetarist Arithmetic”, 1981, which deals with the problem of monetarist arithmetic, and whose main conclusion is that issuing government debt to fund economic policies can cause as high an inflation as monetizing debt.

Sargent has also developed studies on the evolution of unemployment, comparing the United States with Europe, which conclusions are reflected in the work “Two Questions about European Unemployment”, 2007.

Robert Emerson Lucas, Jr., born in 1937, is an American economist and Professor at the University of Chicago. For many, Lucas is probably one of the most notable economists of all times and one of the most influential economists since the late 1970s. It was in the year 1995 when he won the Nobel Prize of Economic Sciences for his development and utilisation of the rational expectations hypothesis, which has transformed macroeconomic analysis.

Robert Lucas is one of the leading figures of the New Classical Macroeconomics, which defies Keynesian economics approach that previously ruled macroeconomic theory. We can date New Classical Macroeconomics birth from Lucas´s work made in 1973, “Some International Evidence on Output-Inflation Tradeoffs”. He builds macroeconomic models using microeconomic foundations such as market clearing and the optimization by economic agents. He regards the economy as having a dynamic equilibrium with economic cycles.

He has worked with great interest in the implications of rational expectations, and formulated his own supply function in which aggregate output for a given period depends on the expectations of prices based on information available at the end of that period. Indeed, these ideas, shown in Robert Lucas’ 1972 paper “Expectations and the Neutrality of Money”, in which he used Edmund Phelps’ island parable (though applying rational, instead of adaptive, expectations), gave strong significance to the use of rational expectations in macroeconomics analysis.

Robert Lucas´s influential “Econometric Policy Evaluation: A Critique”, 1976, had a deep effect on both policy modelling and econometric practice in general. Lucas stands out the implication that parameters may be subject to change when policy does so, thus, opposing to the previous vision were the parameters were thought as being structural never mind changes in economic policy; this is known as the Lucas Critique.

New Classical Macroeconomics (NCM) arise from the development of the neoclassical economics principles, such as market clearing and optimization behavior by economic agents, which relate this school to monetarism. Its rise as a doctrine can be traced to the work in the early 1970s of its lead economist Robert Lucas (Chicago School).

Indeed, Lucas developed in 1973 what is known as rational expectations, an improvement on the adaptive expectations hypothesis used by monetarists, which changed the way macroeconomic analysis (and econometric analysis) is undertaken. These rational expectations are still used nowadays in macroeconomics.

Regarding policymaking, the NCM believes that no government intervention concerning demand is beneficial for the economy, not even in the short run. They argue that government can promote growth and stabilize the economy only through supply-side policies.

Economists such as Thomas Sargent, Edward Prescott, Neil Wallace and Robert Barro are amongst the most renowned NCM economists, whose theories are usually opposed to those of the followers of New Keynesian Economics.