CENTRE FOR DYNAMIC MACROECONOMIC ANALYSIS

WORKING PAPER SERIES

* I would like to thank Andrew Hughes-Hallett, Arnab Bhattachariee, Atanas Christev,Campbell Leith, Charles Nolan and the participants of the RES Easter School 2008 for helpfulcomments. All remaining errors are of course my own. Furthermore, I am grateful forgenerous financial support which I am receiving from the Centre for DynamicMacroeconomic Analysis (CDMA) at the School of Economics and Finance at the Universityof St. Andrews.

† School of Economics and Finance, Castlecliffe, The Scores, St Andrews, Fife KY16 9AL,Scotland, UK. Tel: +44 (0) 1334 462445. E-mail: ar435@st-andrews.ac.uk.

CASTLECLIFFE, SCHOOL OF ECONOMICS & FINANCE, UNIVERSITY OF ST ANDREWS, KY16 9ALTEL: +44 (0)1334 462445 FAX: +44 (0)1334 462444 EMAIL: cdma@st-and.ac.uk

www.st-and.ac.uk/cdma

CDMA09/03

Shocks, Monetary Policy and Institutions:Explaining Unemployment Persistence in

"Europe" and the United States*

Ansgar Rannenberg†

University of St Andrews

MAY 2009

ABSTRACT

This paper examines the rise in European unemployment since the 1970sby introducing endogenous growth into an otherwise standard NewKeynesian model with capital accumulation and unemployment. Wesubject the model to an uncorrelated cost push shock, in order to mimic ascenario akin to the one faced by central banks at the end of the 1970s.Monetary policy implements a disinflation by following an interestfeedback rule calibrated to an estimate of a Bundesbank reaction function.40 quarters after the shock has vanished, unemployment is still about 1.8percentage points above its steady state. Our model also broadlyreproduces cross country differences in unemployment by drawing oncross country differences in the size of cost push shock and the associateddisinflation, the monetary policy reaction function and the wage settingstructure.

Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52.1 JLN Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62.2 Introducing Endogenous Growth . . . . . . . . . . . . . . . . . . . . . 9

3 Simulation Setup and Calibration . . . . . . . . . . . . . . . . . . . . . . . 104 Explaining the Evolution of Unemployment across Time . . . . . . . . . . 124.1 Unemployment and the NAIRU in the New Growth and JLN Economy 124.2 Understanding the Evolution of Unemployment in the New Growth

Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154.3 The In�ation-Unemployment Trade-O¤ . . . . . . . . . . . . . . . . . 19

5 Cross Country Aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 Appendix A: Derivation of the JLN and the Endogenous Growth Model . . 267.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267.2 Cost Minimisation and E¢ ciency Wages . . . . . . . . . . . . . . . . 297.3 Price Setting and Nominal Rigidities . . . . . . . . . . . . . . . . . . 327.4 De�nition of the Output Gap . . . . . . . . . . . . . . . . . . . . . . 347.5 Introducing Endogenous Growth . . . . . . . . . . . . . . . . . . . . . 34

8 Appendix B : Normalised Version of the New Growth Model . . . . . . . . 36

9 Appendix C: Steady State Relations . . . . . . . . . . . . . . . . . . . . . . 3810 Appendix D: Normalised Version of the JLN Economy . . . . . . . . . . . 3911 Appendix E: Estimation of the Wage Setting Function . . . . . . . . . . . 40

1

1 Introduction

The persistent increase in continental European unemployment since the 1970s is of-ten blamed on labour markets having become more rigid. There is however growingevidence that labour market institutions, while powerful at explaining cross countrydi¤erences in unemployment at a given point in time, are less so at explaining theevolution of unemployment across time, or at least leave a lot to be explained. Find-ings along these lines include the IMF (2003), Nickell (2002), Blanchard and Wolfers(2000), Fitoussi et al. (2000) and Elmeskov (1998).This paper examines the rise in European unemployment by introducing endoge-

nous growth into a New Keynesian model featuring unemployment. We subject theeconomy to a 1 quarter non-serially correlated cost-push shock and let the centralbank disin�ate the economy - as happened in many industrialised economies at thebeginning of the 1980s. This temporary shock can cause a persistent and substan-tial increase in unemployment, lasting over 10 to 20 years in an order of magnitudeof 1 percentage points or more. The model also sheds light on some cross-countrydi¤erences in the unemployment experience.More precisely, we aim to shed light on the following set of stylised facts and

empirical �ndings:

� Unemployment has increased substantially in many large European economiessince the 1970s. Figure 1 displays quarterly unemployment rates from 1975 to2000 for six selected European Economies and the United States. Note thatunemployment is very persistent: It increases relatively quickly, as for instanceduring the recessions at the beginning of the 80s, but reverts only relativelyslowly, incompletely, or not at all. By contrast, unemployment in the UnitedStates shows less persistence. It also does not show much of a trend.

� There has been a decline in the growth rate of labour productivity (measured asoutput per hour worked) across OECD countries in the 1980s. This decline hasbeen substantially larger in Western European Economies than in the UnitedStates. Average annual productivity growth in Western European economieswas 1.5% lower in the period from 1981 to 1990 than in the previous decade,while it declined by merely 0.2% in the United States.1 Skoczylas and Tissot(2005) estimate changes in trend productivity growth for OECD economies from1960 to 2004. They locate declines between one and 3.9% between 1976 and1985 in 9 Western European Economies but none in the United States.

� It is a consistent �nding that a decline in productivity growth increases un-employment. Examples include Bassanini and Duval (2006), Pissarides and

1The number is based on cross country averages for 1971-1980 and 1981-1990 of the productivitygrowth rates of Belgium, Denmark, Western Germany, Ireland, Spain, France, Italy, the Netherlands,Finland, Sweden, the United Kingdom and Norway. These rates are based on the series on GDP atconstant prices and total hours worked from AMECO (2008).

2

Vallanti (2005), Nickel (2002, 2005), Ball and Mo¢ tt (2001) and Fitoussi et al.(2000). Three of these studies (Bassanini and Duval, Blanchard andWolfers, Fi-toussi et al.) explicitly model interactions between productivity growth declinesand labour market institutions. They �nd that macroeconomic shocks helpto explain the evolution of unemployment across time while cross country-di¤erences in institutions help to explain why in some countries unemploymentresponds more strongly to macroeconomic shocks than in others.

� Based on a study of 17 OECD countries, Ball (1999) argues that those centralbanks willing to aggressively lower real interest rates during the recessions of theearly 1980s reduced the subsequent increase in the NAIRU in their countries.

� There seems to be a negative medium run relationship between the change inin�ation and the change in the NAIRU. This is illustrated in Figure 2, whichplots the change in the NAIRU against the change in CPI In�ation for 21 OECDcountries from 1980 to 1990 and from 1990 to 2000. The negative correlationis not perfect but still obvious: Countries with a larger decrease in in�ationsu¤ered on average a larger increase in their NAIRU.2 Ball (1996) was the �rstto draw attention to this link and also investigated it more formally.

Our results resemble in some respects those of Sargent and Ljungqvist (1998,2007) in that the model proposed here generates an increase in unemployment with-out relying on changes in labour market rigidity, while the "level" of labour marketrigidity does matter.3 However, their approach di¤ers from ours in that in theirmodel, unemployment increases via the interaction of an unemployment insurancepaying bene�ts linked to past income and a permanent increase in "microeconomicturbulence". "Microeconomic turbulence" is the probability that a worker looses hishuman capital in case his job is exogenously destroyed. The increase in turbulencecreates a fraction of unemployed workers who enjoy high bene�ts (because they usedto be high skilled) but are now low skilled and thus have a low earnings potentialon the labour market. Therefore they have little incentive to engage in (costly) jobsearch, which reduces their probability of regaining employment. By contrast, ourapproach is a macroeconomic one in that the driving force pushing up unemploymentis an in�ationary shock and the response of the central bank to this shock.This paper is structured as follows: Section 2 develops a model which broadly

re�ects the mainstream consensus on the long and short run dynamics of unemploy-ment as for instance developped by Jackman et al (1991). In this model, a temporarycost push shock only has a short lived e¤ect on unemployment and so has the mon-etary policy response to the shock. We coin this model "Jackman, Layard, Nickell",

2The data is taken from the OECD Economic Outlook. The countries are Australia, Austria,Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands,New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, U.S.A.

3See Sargent and Ljungqvist (1998) and (2007).

3

or JLN economy. We then add the New Growth extension. Section 3 discusses thecalibration, which is informed by empirical evidence on some of the model parametersand by the comparison of the second moments of a couple of model variables withtheir empirical counterparts. This moment comparison can be found in an extendedversion of this paper.4 Section 4 then discusses the response of the economy to aone quarter cost push shock calibrated to induce a disin�ation of about 4 percentagepoints and focuses on the induced evolution of unemployment across time. It alsolooks at the tradeo¤s policymakers face between stabilising in�ation and stabilisingunemployment. Section 5 adds a cross-country dimension to our analysis. First, wevary the size of the cost push shock and record the resulting changes in in�ation andthe NAIRU over a 10 year horizon. We then compare the di¤erences in the unem-ployment response generated by a Bundesbank and a Federal Reserve Policy rule asestimated by Clarida et al. (1998), and �nally we investigate the e¤ects di¤erencesin real wage rigidity between Europe and the United States. Section 6 concludes.

Figure 1: Unemployment for 6 European Economies and the UnitedStates

0

5

10

15

20

25

1975q1 1980q1 1985q1 1990q1 1995q1 2000q1

Germany

France

Italy

Spain

Belgium

United States

United Kingdom

4See Rannenberg (2009). This version is available online: http://mpra.ub.uni-muenchen.de/13610/

4

Figure 2: Change in CPI Inflation vs. Change in the NAIRU: 1980-1990, 1990-2000

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

-20.00% -15.00% -10.00% -5.00% 0.00% 5.00%

Change in CPI Inflation

Cha

nge

in th

e N

AIR

U

2 The Model

In this section we will present a New Keynesian model with unemployment and en-dogenous growth which contributes to explaining the above �ndings. To stress thefact our results stem from the introduction of endogenous growth, we also present anotherwise identical model without endogenous growth which we take as the startingpoint of our analysis. This is a model to approximate the prevailing consensus on therelationship between unemployment and the NAIRU. We will refer to this model asthe JLN economy. This consensus says that while unemployment both in the shortand in the long run is determined by aggregate demand, only the NAIRU is consis-tent with stable in�ation. In�ation targeting central banks will push unemploymenttowards this level. The NAIRU itself will be a¤ected by any variable which directlyincreases wages in spite of excess supply in the labour market, increases the pricingpower of �rms or reduces the e¢ ciency of the labour market to match jobs to workers5

Below we list the aggregate equations of the JLN economy. After that we introduceendogenous growth. Almost all equations are the same in both models. A longerversion of this paper (Rannenberg (2009)) provides the microfoundations.

5See Nickell et al. (2002), pp. 2-3.

5

2.1 JLN Economy

Aggregate demand ADt is the sum of consumption Ct, investment It, the amount ofprice adjustment costs '

2(�t � �t�1)

2Yt, and expenditure on government employeeswtn

s:

ADt = Ct + It +'

2(�t � �t�1)

2Yt + wtns (1)

Price adjustment costs are the source of nominal rigidities in this model which willgive rise to the Phillips curve discussed below. Government employees account for a�xed fraction ns of the workforce.6

The representative household consists of a continuum of members who might beemployed or unemployed but are all allocated the same level of consumption. Thehousehold is in�nitely lived and chooses its consumption expenditure, bond holdingsand investment expenditure in order to maximise the expected present value of itslifetime utility. We assume a logarithmic instantaneous utility function and, followingSmets and Wouters (2002), external habit formation in consumption and adjustmentcosts in investment. Investment adjustment costs mean that only a fraction of in-vestment expenditure is transformed into additional capital Kt. They are convex andvanish when the economy is growing at the steady state growth rate g.The �rst order conditions imply that consumption is governed by

1= (Ct � habt�1) = � (1 + it)Et

�1

(Ct+1 � habt) (1 + �t+1)

�(2)

where it; �t, � and habt�1 denote the nominal interest rate, the rate of in�ation,the individual discount factor and the level of habit respectively, the last of which isdetermined by

habt�1 = jCt�1

Capital accumulation is given by

Kt+1 = (1� �)Kt + It

1� �

2

�ItIt�1

� (1 + g)�2!

(3)

6The reason for introducing both state employees and overhead workers n is to achieve a rea-sonable calibration of steady state values. In the Romer (1986) endogenous growth model, the levelof employment a¤ects the growth rate. This is due to the fact that the marginal product of cap-ital is an increasing function of employment. The marginal product of capital governs the growthrate by determining the willingness of households to save. To achieve a reasonable steady stategrowth rate, we remove a fraction of the labour force from "productive" sector by assuming thatthey perform necessary tasks without which the productive sector could not operate (managerialwork in case of overhead workers, policing etc. in case of the state employees). We assume thatgovernment employees are paid the same wage as private sector employees and are funded by meansof lump sum taxes. Overhead workers will be interpreted as managers who split the pro�ts of themonopolistically competitive �rms.

6

The optimal investment dynamics are then given by

�t =1

Ct � habt�1(4)

�Et

��t+1�t

�rkt+1 + qt+1 (1� �)

��= qt (5)

�tqt

" 1� �

2

�ItIt�1

� (1 + g)�2!

� ItIt�1

�

�ItIt�1

� (1 + g)�#

(6)

+�Et

"�t+1qt+1

�It+1It

�2�

�It+1It

� (1 + g)�#

= �t

where �t, rkt and qt denote the marginal utility of consumption, the real capital rental,and the real value of another unit of capital, also referred to as Tobin�s q, respectively.The second equation says that the value (or price) of another unit of capital is givenby the present value of the t+1 rental income it generates plus its t+1 value. Thelast equation says that �rms invest until the value of the additional unit of capitalproduced plus the present value of t+1 adjustment costs saved equals one.Aggregate demand determines aggregate output:

ADt = Outputt

Total output is given by the sum of private sector output and the output of stateemployees, where private sector output is produced using a Cobb-Douglas productionfunction:

Outputt = AKt�(TFPtet (nt � n� ns))1�� + wtn

s (7)

TFPt and et denote total factor productivity and the e¤ort level of employees, re-spectively.7 In the absence of endogenous growth, TFPt evolves exogenously. Firmschoose capital and labour to minimise their costs of producing a given level of output.The capital rental is given by

rkt = �mctYtKt

(8)

where Yt denotes private sector output.Following Dantine and Kurman (2004), the members of the household supply one

unit of labour inelastically but have preferences over e¤ort while they are at work.One of the �rst order conditions of the household is thus an e¤ort function whichdetermines the level of e¤ort. Households are willing to make a higher e¤ort if theyare compensated with a higher wage relative to the past real wage. In addition,the e¤ort level is determined by a couple of other variables as well. We assumethat for a given real wage e¤ort also depends negatively on past productivity (as

7Firms �nd it optimal to choose a constant e¤ort level .

7

the �rm gets more productive, employees demand a higher wage) and the level ofunemployment income (for instance bene�ts), which in turn depends on past realwages and productivity as well.Firms choose the real wage as they are aware of the relationship between workers

morale, e¤ort and the real wage. An extensive survey of Bewley (1998) providesstrong support for this view of wage setting. An increase in any of the variableslisted before will induce �rms to increase their wage o¤er. Accordingly, the real wagedoes not clear the labour market but evolves according to the following wage settingfunction:

logwt� logwt�1 = a+b�(nt � n)+c log

�wt�1 (nt�1 � n� ns)

Yt�1

�; b > 0; c < 0: (9)

This is very close to a speci�cation derived by Blanchard and Katz (1999) fromintuitively plausible relationships between average wages, the reservation wage andproductivity.8 The growth rate of the real wage wt is positively related to employmentand negatively to the labour share. The e¤ect of the labour share stems from thedirect impact of productivity on e¤ort and the indirect impact through bene�ts. Ifthese are absent, we have c=0.Empirical estimates of (9) (usually replacing nt with the unemployment rate) or

variants thereof repeatedly �nd c=0 (or even c>0) for the United states but c<0 forEuropean countries.9 The di¤erence could be due to the direct e¤ect of productivityon e¤ort being close to zero in the U.S. but positive in Europe because of a largerin�uence of unions who establish the idea that the reference wage should be linked toproductivity, as is also argued by Blanchard and Katz (1999). Using individual dataon compensation matched with �rm level data on performance and inputs, Abowd etal. �nd that the relationship between �rm level wages and performance measures likevalue added and sales per employee is stronger in France than in the United States.One could also imagine that bene�ts are linked more closely to productivity in Europebecause policymakers are more likely to believe in concepts of relative poverty ratherthan absolute poverty and therefore would aim to link bene�ts to a country�s overallincome.10

Marginal cost mct is given by

mct =

�rkt��w1��t

A��(1� �)1��(�1TFPt)1�� (10)

The evolution of in�ation �t is determined by the Phillips Curve. It is derivedfrom the maximisation problem of a monopolistically competitive �rm producing a

8Blanchard and Katz (1999) specify the wage as a function of productivity and the reservationwage, which in turn is a convex combination of average wages and productivity, as in our model.

9See Blanchard and Katz (1999), p.73, Blanchard and Katz (1997), p.62, OECD(1997), p. 21and Cahuc and Zylberberg (2004), p.484-486.10See Abowd et al. (2001), pp. 429-433.

8

variety from a CES basket. It faces quadratic price adjustment costs in the changeof the in�ation rate. The resulting non-linear Phillips Curve is given by

�(� � 1)�

+mct �'

�(�t � �t�1 � ut) (1 + �t � ut) +

'

2(�t � �t�1 � ut)

2

+�Et

�Ct � habt�1Ct+1 � habt

'

�

Yt+1Yt

(�t+1 � �t � ut) (1 + �t+1)

�= 0 (11)

where ut, � and ' denote a cost push shock, i.e. a shock increasing in�ation for a givenlevel of marginal costs, and the elasticity of substitution between di¤erent varietiesof the output good the household is consuming, respectively. It can be easily shownthat up to �rst order, this equation is a hybrid Phillips Curve with coe¢ cients onlagged in�ation and expected future in�ation of 1

1+�and �

1+�; respectively.

Finally, monetary policy is speci�ed by

it = (1� �)

�i+ ��t +

Y4gpt�1

�+ �it�1 (12)

with gpt denoting the percentage deviation of output from potential output. The lateris de�ned as the output level at which in�ation is not accelerating in the absence ofcost push shocks, given the level of technology, the capital stock and past real wages.As can be easily checked, this output level has to satisfy mct =

(��1)�; where (��1)

�is

the inverse of the mark-up �rms would charge in the absence of any nominal rigidities.The unemployment rate associated with output at its potential is the NAIRU.

2.2 Introducing Endogenous Growth

We introduce endogenous growth following Romer (1986).11 We assume that invest-ing �rms discover ways to produce more e¢ ciently and that knowledge is a publicgood. Therefore total factor productivity TFPt is assumed to be proportional to theaggregate capital stock. Hence we replace TFPt with Kt in the above equations. Theequations for output and marginal costs are modi�ed as follows:

Outputt = AKt((nt � n� ns)�1)1�� + wtn

s (13)

while in the presence of endogenous growth, we have

mct =

�rkt��w1��t

A��(1� �)1��(�1Kt)1��(14)

The capital stock now has a stronger e¤ect on both marginal costs and output thanin the JLN economy. An increase in the capital stock by 1% for a given employment

11The exposition here follows Barro and Sala-i-Martin (2004), pp. 212-215.

9

level (implying that output expands at the same rate) reduces marginal costs by 1%.In the absence of endogenous growth the e¤ect is only � %, where � would typicallybe calibrated to match the capital share and would thus be substantially smallerthan one. This can be seen by substituting the capital rental out of equations (14)and (10) and then substituting Yt

Ktusing the respective production functions. For the

New Growth economy, the real wage - capital ratio is now the main driver of marginalcosts.

3 Simulation Setup and Calibration

We aim to create a scenario akin to the one faced by central banks in Western Europeat the end of the seventies and the beginning of the 1980s. That means we would liketo create a situation where annual in�ation increases several percentage points aboveits target level for some time and is then subsequently reduced. Therefore ut is setequal to 0.03 for the �rst quarter and the model is simulated under perfect foresight.To put it di¤erently, for given values of marginal cost, past and expected in�ation,in�ation in that quarter is increased by three percentage points. In the baselinesimulation, this will give rise to a disin�ation of a bit more than 4.6 percentagepoints over 5 years, if we compare annual rates in the �rst and the sixth year. Thisis at the lower end of disin�ations actually experienced during that period. Forinstance, in Germany, annual in�ation was at 6.3% in 1981, which was then reducedto -0.1% in 1986, which is a rather small disin�ation compared to the UK, France orItaly where in�ation declined by 8.6, 10.8 and 13.7 percentage points over the sameperiod, respectively. Note that there is no endogenous persistence in the shock itselfbeyond the �rst quarter, implying that any persistence in the path of the variables andin particular unemployment beyond that point is endogenous. The models are solvedemploying a second order approximation to the policy function using the approachof Schmitt-Grohe and Uribe (2004). We use the software Dynare to implement thesolution.12

The calibration of the non-monetary policy model parameters for the experimentdescribed above is presented in table 1. It was arrived at as follows. We distinguishbetween four di¤erent types of parameters. The �rst set is calibrated according tostandard values in the literature. This set contains the discount factor �, the privateoutput elasticity of capital �, the elasticity of substitution between varieties of goods�, the depreciation rate �; and the price adjustment cost parameter '. ' is calibratedas to generate marginal cost coe¢ cient in the linearised version of equation (12)whichwould also be generated in a Calvo Phillips Curve with full backward indexing ofunchanged prices and a probability of no re-optimisation is 2/3.The second set, consisting of ns, a, b and c, is based on empirical evidence. ns

12To be able to solve our two growth models, we normalise with respect to the capital stock andtotal factor productivity (see Appendix).

10

is calculated from data of the German statistical o¢ ce on the number of full timeequivalent employees in the public sector and on total hours worked in the economyin 2006. b and c are calibrated to be consistent with an estimate of that function.We estimate (9) on German data on hourly labour costs, unemployment (instead ofemployment, as is done in the empirical literature) and the labour share in GDPranging from 1970 to 2000. We then calibrate the intercept a to achieve a steadystate unemployment rate of 4%.The third set consists of the three "free" parameters A, � and j the production

function shifter, the parameter indexing adjustment costs and the degree of habitformation. They were calibrated to match second moments of a couple of importantvariables in German data. The results are discussed in an extended version of thispaper.Table 1: Baseline Calibration of non-policy Parameters� � j A � � �1 ' a b c � u1 n0.33 0.99 0.4 0.38 6 0.025 0.452 30 -0.1123 0.08 -0.1 0.65 0.03 0.1793ns i gTFP �u0.18 0.0181 0.0079 0.003The baseline calibration of the monetary policy reaction function is taken from

Clausen and Meier (2003), who estimate a Bundesbank policy rule over the periodfrom 1973 to 1998 for quarterly data. Clausen and Meier�s best performing modelyields the statistically signi�cant coe¢ cients on output, in�ation and the lagged in-terest rate reported in table 2 which in fact correspond to the original coe¢ cientsproposed by Taylor (1993) to characterise the policy of the Federal Reserve. Theirestimate of the output gap coe¢ cient is of particular interest because the Bundes-bank was often perceived as paying less attention to output than the Fed. This isalso borne out by other Taylor-rule estimates, one of which we discuss below. Forthe purpose at hand, we consider using the least hawkish baseline coe¢ cients for thepolicy rule in the literature of Bundesbank Taylor rule estimates. It will become clearwhy this is the case when we discuss the simulation results.Table 2: Baseline Calibration of the Policy Rule: Clausen and Meier

(2003)13

� Y �1.5 0.52 0.75However, we are also interested in comparing the e¤ects of di¤erent policies esti-

mated for the Bundesbank and the Federal Reserve. Therefore we would like to drawon a study using the same methodology to estimate policy rules for di¤erent coun-tries, Clarida et al. (1998). Their rule is estimated using monthly data. A quarterlydata version of their speci�cation would be

it = (1� �)

�i+ �Et

��t+1 + �t+2 + �t+3 + �t+4

4

�+ Y4gpt

�+ �it�1 (15)

13See Clausen and Meier (2003), p. 22.

11

Hence the central bank responds to a one year forecast of in�ation, the currentoutput gap and the lagged interest rate.14 They measure potential output using aquadratic trend of a West German industrial production index and their data setstretches from 1979 to 1993 and estimate the policy rule using the general methodof moments.15 The point estimates are replicated in table 3. Clearly, the smallcoe¢ cient on the output gap corresponds more to the conventional wisdom on howthe Bundesbank was conducting policy.Table 3: Forward looking interest rate Rule: Clarida et al. (1998)16

� Y �1.31 0.25 0.91

4 Explaining the Evolution of Unemployment acrossTime

We now discuss the response of the New Growth and the JLN economy to a cost pushshock. This section focusses on understanding the induced evolution of unemploymentand in�ation across time. We �rst examine the results under the baseline calibration,while subsection 4.3 examines the e¤ects of varying the ouput gap coe¢ cient Y inthe interest feedback rule.In all �gures, the initial value is the steady state value of the respective variable.

Furthermore, when we refer to �Baseline�in �gures or in the text, we always meanthe New Growth economy in its baseline calibration. The abbreviation "NGE" usedin the �gures refers to "New Growth Economy".

4.1 Unemployment and the NAIRU in the New Growth andJLN Economy

Figure 3 plots the response of actual unemployment for the JLN and the New Growtheconomy to the one quarter cost push shock. In the JLN economy, unemploymentincreases by about 3 percentage points on impact but starts recovering after reachinga maximum of 10.4%. It then quickly recovers and in quarter 8 practically returns toits steady state value and then slightly overshoots for some time. Employment wouldbe expected to decrease because the cost push shock will increase in�ation whichwill ultimately lead to an increase in ex ante real interest rates via equation 13. Asconsumers and investors are forward looking, this causes a contraction of aggregatedemand on impact. Figure 4 plots the in�ation rate, which peaks in quarter 1 at avalue of about 3.8% and then quickly declines back to zero.

14See Clarida et al. (1998), p. 1039 and 1042.15See Clarida et al. (1999), p. 1040.16See Clarida et al (1998), p. 1045.

12

Figure 3: Unemployment in the New Growth and the JLN Economy

3.00%

5.00%

7.00%

9.00%

11.00%

13.00%

15.00%

0 10 20 30 40 50 60 70 80

Quarters

NGE

JLNE

Figure 4: Inflation in the New Growth and the JLN Economy

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

0 10 20 30 40 50 60 70 80

Quarters

NGE

JLNE

13

Figure 5: New Growth Economy, Baseline- Unemployment and NAIRU

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

0 10 20 30 40 50 60 70 80

Quarters

Unemployment

NAIRU

By contrast, in the New Growth economy, unemployment increases by more onimpact than in the JLN economy. Even more important, the increase is far morepersistent. After about 11 quarters (10 quarters after the end of the shock), whenemployment is already overshooting in the JLN economy, only a bit more than halfof the on-impact loss in employment has vanished and employment is still about 3.2percentage points below its steady state value. What is more, employment growththen comes to a halt: quarterly increases are around 0.06 percentage points perquarter or less. As can be seen in table 4, in the New Growth economy, after 10years unemployment is still about 1.8 percentage points above its steady state valueand after 15 years the di¤erence is still about 1.2 percentage points. Thus as oftenobserved in the Europe, unemployment increases quickly but falls only very slowly.Furthermore, Figure 5 reveals that the persistent increase in actual unemployment ismatched by an increase in the NAIRU, as after six quarters, actual unemploymentfalls below the NAIRU, which gradually increases during and after the recession. Aglance at Figure 4 shows that in�ation (after peaking in quarter 1 at a quarterlyrate of about 3.3 percentage point) indeed stops declining at about the same timeactual unemployment falls below the NAIRU, as we would expect from the de�nitionof the NAIRU. Thus the disin�ation engineered by the central bank, while clearlysuccessful, has come at a cost beyond a temporary reduction in employment: Theunemployment level consistent with constant in�ation has increased.

14

Table 4: Unemployment deviation from the Steady State in the NewGrowth Economy, Baseline and y = 5, percentage Points

Quarters 10 20 30 40 50 60 70 80Baseline 3.1 2.8 2.3 1.8 1.5 1.2 1 0.8 Y = 5 1.9 1.5 1.2 1.0 0.8 0.6 0.5 0.4Associated with the increase in unemployment in the New Growth economy is a

persistent slowdown in labour productivity growth. This is in line with the evidencecited above. After 10 quarters it falls short of its steady state value by about 0.21%per quarter or 0.88% at an annualised rate, while 40 quarters after the shock it is stillabout 0.13% lower than in the steady state, or 0.54% at an annualised rate. Averageannualised productivity growth over the �rst 10 years after the shock equals 2.46%.Assuming that average productivity growth before the shock hit equalled its steadystate rate of 3.42%, this implies a decline of average productivity growth from onedecade to the next of 0.96%. Interestingly, average German productivity growth diddecline by 1.44% from the 1970s to the 1980s.17

4.2 Understanding the Evolution of Unemployment in theNew Growth Economy

We know from (9) that an increase in unemployment will reduce real wage growthwhich would tend to lower marginal costs, so there must be a strong countervailingforce pushing marginal costs up in order to explain why in�ation stops falling. Figure6 shows that while real wage growth drops sharply, in quarter 2 the growth rate ofthe capital stock falls by even more and remains considerably below real wage growthfor about 9 quarters. After that they are about equal. Slower capital stock growthentails slower technological progress and thus slower growth of labour productivity,which will tend to generate a higher trajectory of marginal cost for a given level ofreal wage growth. In the New Growth model, the movement of real wages relative tolabour productivity for a given employment level is thus captured by the evolutionof the wage capital ratio. This variable matters a lot for marginal cost, as shownby (14). Figure 7, which plots the deviations of marginal cost and the wage capitalratio from their steady state values con�rms that it is the movement of the real wagecapital ratio which drives marginal cost back up, as both move broadly in parallel.

17Productivity is measured as real GDP per hour worked. The data was taken from StatistischesBundesamt Wiesbaden (2007b). A sophisticated analysis of changes in trend productivity growthby Skoczylas and Tissot (2005) �nds a negative break for Germany in 1979 of -2.75%

15

Figure 6: New Growth Economy, Baseline- Capital Stock Growth and Real Wage Growth

0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

0.80%

0.90%

0 10 20 30 40 50 60 70 80

Quarters

Capital Stock Growth

Real Wage Growth

Figure 7: New Growth Economy, Baseline- Real Wage Capital Ratio and Marginal Costs

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

0 10 20 30 40 50 60 70 80

Quarters

Real Wage - Capital Ratio

Real Marginal Cost

16

By contrast, in the JLN economy, the e¤ect of the capital stock on marginalcosts is much weaker. The major determinant of marginal costs apart from realwages is total factor productivity TFPt. This grows exogenously no matter whetheroutput and investment are contracting or growing. Thus marginal costs or, to put itdi¤erently, the permissible, non-in�ationary rate of real wage growth are much lessa¤ected by changes to the capital stock.Turning back to the New Growth economy, the recovery of actual employment

has to slow down after about 6 quarters because unemployment arrives at a levelbeyond which any reduction would cause in�ation to accelerate as it pushes real wagegrowth above the growth rate of the capital stock and thus pushes up marginal cost.This would trigger interest rate increases via the policy rule. In fact this is alreadyhappening as actual unemployment is falling below the NAIRU and in�ation startsto pick up. To put it di¤erently, the central bank does not have a reason to boostemployment by aggressively lowering the interest rate because although in�ation issomewhat below target, the output gap is closed as marginal cost equals its steadystate value. Figure 8 shows that the central bank stops lowering the real interest rateit � Et�t after 8 quarters, when it is 0.45 percentage points (about 1.81 percentagepoints at an annualised rate) below the steady state value, and begins to tightenagain.This level of the real interest rate, while below its steady state value, is not very

expansionary. Figure 9 summarises the bene�ts from investing by plotting the presentdiscounted value of an additional unit of capital, qt. qt recovers quickly after the shockhas passed and reaches its steady state value of one after �ve quarters. It then slightlyexceeds it�s steady state level for six quarters. However, this is not su¢ ciently high tomove the capital stock growth rate up quickly because of the investment adjustmentcosts: The �rst order condition (6) determines the investment growth rate, which dueto fast recovery of qt; moves much closer to it�s steady state value as well. However,the capital stock growth rate depends on the investment capital ratio, as can be seenfrom equation (3), which has declined during the recession and subsequent periodof slow growth. Thus a faster recovery of capital stock growth would require aninvestment growth rate exceeding the steady state, which would have to be inducedby an above steady state qt which in turn would require a lower real interest rate.

17

Figure 8: New Growth Economy, Baseline-Real Interest Rate

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

0 10 20 30 40 50 60 70 80

Quarters

Real Interest Rate

Figure 9: New Growth Economy, Baseline- Tobin's q

0.95

0.96

0.97

0.98

0.99

1.00

1.01

1.02

0 10 20 30 40 50 60 70 80

Quarters

Baseline - Tobin's q

18

The speed of recovery is then governed by the relative growth rates of real wagesand the capital stock. From quarter 9 onwards, the capital stock grows slightly fasterthan real wages. This causes a slow decline in the wage-capital ratio (�gure 8), anda slow reduction in unemployment as higher productivity growth implies �rms canaccommodate the increased real wage growth associated with a tighter labour marketwithout facing an increase in marginal costs. This, in turn, again increases capitalstock growth by increasing the marginal product of capital.

4.3 The In�ation-Unemployment Trade-O¤

These results provoke the question how changes to the central bank�s reaction functionwould a¤ect the long-run paths of employment and in�ation. Intuition suggests thata stronger weight on the output gap in the reaction function would lead to a smallerdecrease in employment not just in the short but also in the long run. As investmentwould be squeezed less, there would be a smaller decline in capital stock growth whichcould accommodate higher non-in�ationary employment after the recovery from therecession. To show this we increase the coe¢ cient on the output gap, y, to 5, leavingall other parameters the same. The corresponding evolution of unemployment canbe obtained from �gure 10. Indeed unemployment not only increases considerablyless in the short run (in fact it decreases on impact), and after 40 quarters, it is stillabout 0.8 percentage point lower than in the Baseline case, as can be obtained fromthe second line of table 4. Hence a less hawkish monetary policy has indeed verylong-lasting benign e¤ects on unemployment.

19

The lower increase in unemployment comes at the cost of a considerably strongershort run in�ation surge. While in the baseline simulation, in�ation peaks at a (quar-terly) rate of 3.3%, it now increases as high as 4.9% in the �rst quarter (�gure 11),

20

while the annual in�ation rate over the �rst year amounts to 15%. Note however thatthe increase in in�ation is only temporary. After 10 quarters, it has already decreasedto 0.42%. Thus the stronger acceleration in in�ation is a short run phenomenon. Thegain in employment is of more persistent nature.As mentioned above, Ball (1999) �nds that during the recessions of the early 1980s,

countries whose central banks aggressively lowered interest rates experienced smallerincreases in the NAIRU than those which did not. Ball calculates the di¤erencebetween the NAIRU in the year before the recession and �ve years after. He de�nes arecession as one year with GDP growth below 1%. He regresses this on the maximumreduction of the ex-post real interest rate during any time of the recessions �rst year,which he refers to as maximum easing.18 The coe¢ cient on maximum easing is -0.42and is signi�cant at the 10% level.19 We try to replicate this relationship with ourNew Growth model by varying the output gap coe¢ cient between 0 and 4, leavingeverything else the same, thus obtaining data on maximum easing and the �ve yearchange in the NAIRU. Our resulting coe¢ cient on maximum easing is negative aswell and varies between -0.24 and -1.16. This is for the most part consistent withBall�s estimate.

5 Cross Country Aspects

The previous section shows that our New Keynesian model with endogenous growthis able to produce a persistent increase in unemployment as a consequence of a dis-in�ation. This is an important result because economists have been struggling toexplain the evolution of unemployment in continental Europe over time. This begsthe question whether we can also use the model to replicate di¤erences in unemploy-ment evolutions across countries. We address this issue in three di¤erent ways in thissection. For that purpose, we will draw on the di¤erences in the size of the disin�ationacross the OECD, in (estimates of) the policy reaction function coe¢ cients betweenthe Bundesbank and the Federal Reserve and in real wage rigidity.We noted earlier that there is a negative correlation between the change in in�a-

tion and the change in the NAIRU. Ball (1996) investigated this for the 1980s andwe plotted it over two decades and across 21 OECD countries in �gure 2. Thereare various possible reasons why countries might have di¤erently sized disin�ations.Economies might di¤er in the way they respond to global supply shocks, perhapsdue to di¤erences in energy intensity of production. Their past record of monetarypolicy might di¤er as well, (in the sense that some central banks have let in�ationspiral more out of bounds than others, leading to larger deviations of in�ation fromtarget), as might choices of how much to disin�ate (a central bank might just bewilling to accept a higher in�ation rate following a supply shock). Finally, exchange

18Ball controls for the duration of unemployment bene�ts.19See Ball (1999), p. 207.

21

rate volatility might di¤er as well. Incorporating these various sources of in�ationvolatility into our model would be far beyond the scope of this paper. However, wedo try to mimic their in�ationary impact by varying the size of the cost push shock.We vary the size of the cost push shock from 0.01 to 0.05, leaving all other parame-

ters unchanged. Then we calculate the change from year 1 to year 10 of the in�ationrate during those years and the NAIRU in the �rst quarter of those years, and plotthe later against the former in �gure 12.20 There is a clear negative correlation. Theslope of the line varies between -0.41 and -0.56, which is not too far away from thesimple regression coe¢ cient of -0.33 (or -0.36 if, like Ball (1996) we exclude Greece)resulting from a regression of the change in the NAIRU on the change in in�ationusing the OECD data presented earlier.

Figure 12: Change in Inflation vs. Change in the NAIRU over 10Years

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

-8.00% -7.00% -6.00% -5.00% -4.00% -3.00% -2.00% -1.00% 0.00%

Change in Inflation

Cha

nge

in th

e N

AIR

U

Let us now take a look at the e¤ect of observable di¤erences in the monetarypolicy rule. To get a proper idea of the e¤ects of these it is obviously important20We take the di¤erence of the �rst quarter of both years since the NAIRU moves up very fast

during the �rst four quarters. Di¤erencing the annual averages of the two years would create amisleading impression of the correlation between the medium run change in the NAIRU (by undulyreducing this change) and the change in in�ation. The quarterly movements of the NAIRU in theOECD data are very slow and redoing �gure one with the di¤erence in the NAIRU between 1980quarter1 1990 quarter 1 rather than with the di¤erences in the annual averages as is the case nowwould not change the result.

22

to have comparable estimates. Therefore we make use of the fact that Clarida etal. (1998) estimated the same policy rule using the same methodology for severalcountries, including Germany and the United States. We would have liked to drawon real time estimates as in the previous section but to our knowledge, internationallycomparable estimates of this kind do not exist. The coe¢ cient estimates of Claridaet al. of (15) for the Federal Reserve are reproduced in table 3.We now repeat the same experiment we conducted in the last section for both the

estimates for the Bundesbank reaction function and the coe¢ cients of the FederalReserve. The �rst two lines of Table 5 show the deviation of unemployment fromsteady state for both set of coe¢ cients. Note �rst that the persistent increase inunemployment with the policy rule as speci�ed and estimated by Clarida et al. forthe Bundesbank is substantially higher than the increase we saw with the policy ruleused in the Baseline. This illustrates that, in terms of the unemployment e¤ectswhich are the subject of this paper, we were quite conservative in specifying andcalibrating our Baseline policy rule. Apart from that, unemployment is persistentlyhigher under the Bundesbank rule than under the Federal Reserve one, though thedi¤erence is for the most part less than one percentage point. For instance after 10years, unemployment and the NAIRU are about 0.5 percentage points higher underthe Bundesbank Rule than under the Federal Reserve rule.It is, however, informative to take a look at the standard errors associated with

Clarida et al.�s estimate. For instance, the standard error associated with the co-e¢ cient on the lagged interest rate � has as standard error of 0.03. Thus a valuefor � of 0.06 is still consistent (at a 5% level of con�dence) with Clarida et al.�s es-timate. The third row of table 9 shows the implied evolution of unemployment ifwe set � = 0:91. The resulting unemployment trajectory is substantially lower thanbefore. After 40 quarters, the unemployment and the NAIRU are now 1.1 percentagepoints lower than under the Bundesbank rule, while after 50 quarters, the di¤erenceis still 1 percentage point. In the same manner, we can also make use of the stan-dard error of the estimate of Y , which equals 0.16. Increasing Y to 0.88 yieldsthe employment trajectory shown in the �nal row of table 5, which is again lowerthan with the point estimate. After 40 quarters, unemployment is and the NAIRUare about 0.9 percentage points lower than under the Bundesbank policy rule. Thusin the New Growth model, di¤erences in policy function parameters consistent withClarida et al.�s estimate can contribute to explaining the di¤erent evolutions of theunemployment rate in Germany as compared to the United States.Accordingly, di¤erences in monetary policy also explain di¤erences in the change

in the productivity growth rate between Germany and United States from the 1970sto the 1980s. As noted above, average US productivity growth declined by only about0.18% from the 1970s to the 1980s, whereas the decline in Germany was about 1.4%.Table 6 displays the di¤erence between average annualised productivity growth duringthe �rst decade after the shock and the decade before the shock.21 Thus within the21As above we assume that during the decade before the shock hits, the average productivity

23

New Growth model, di¤erences in monetary policy would account for between 0.24and 0.6 percentage points of the di¤erence in productivity growth.

Table 5: Results for Clarida et al.�s Policy RulesUnemployment Deviation from the Steady State, percentage PointsQuarter 10 20 30 40 50 60 70 80Bundesbank 3.8 3.8 3.1 2.5 2.1 1.7 1.4 1.1Federal Reserve 2.9 3.1 2.5 2 1.7 1.3 1.1 0.9Federal Reserve, � = 0:91 2.1 2.1 1.7 1.4 1.1 0.9 0.7 0.6Federal Reserve, Y = 0:88 2.4 2.5 2 1.6 1.3 1.1 0.9 0.7

Table 6: Results for Clarida et al.�s Policy RulesChange in ten Year Averageproductivity Growth, percentage PointsBundesbank -1.28%Federal Reserve -1.04%Federal Reserve, � = 0:91 -0.68%Federal Reserve, Y = 0:88 -0.88%Finally, we explore the e¤ects of the observed cross continental di¤erences in the

nature of real wage rigidity. As was mentioned above, empirical estimates of wagesetting functions repeatedly �nd that real wage growth is negatively related to thelabour share in Europe but not in the United States. Therefore, in our �nal exper-iment aimed at highlighting cross country dimensions, we set c = 0 in the Baselinecalibration, leaving everything else as in the Baseline. The resulting deviation of un-employment from its steady state can be obtained from table 7. Clearly, the increasein unemployment is persistently lower. After 40 quarters, unemployment is only 0.6percentage points higher than in the steady state, compared to 1.7 percentage pointsin the Baseline. Average annualised productivity growth is only 0.36% lower than inthe previous decade as opposed to 0.96% in the baseline calibration.Within our model, c=0 would arise if there is no direct e¤ect of productivity

on e¤ort and if bene�ts are not linked to productivity. We suggested above thatthese results might be rooted in stronger unions and perhaps a stronger link betweenunemployment bene�ts and productivity in Europe. Blanchard and Wolfers (2000)�nd that the impact of macroeconomic shocks on unemployment is a¤ected by thelabour market structure. They �nd that both unobservable macroeconomic shocks(captured by a time e¤ect) as well as a one percentage point reduction in total factorproductivity growth increase unemployment by more the higher is union density.22

This result is con�rmed by Fitoussi et al. (2000).23 In that sense, our model providessome theoretical to the notion that both "shocks and institutions" (Blanchard and

growth rate equalled its steady state.22See Blanchard and Wolfers (2000), pp. C20-C28.23See Fitoussi et al. (2000), p. 250.

24

Wolfers) are crucial to explaining the cross country evidence on the evolution ofunemployment.Table 7: c = 0 - Percentage point Deviation of Unemployment from its

Steady State for selected Quarters

10 20 30 40 50 60 70 800.9 1.1 0.9 0.7 0.6 0.5 0.4 0.3

6 Conclusion

This paper employes a New Keynesian model with unemployment and endogenousgrowth to explain the persistent increase in continental European unemployment andthe lack thereof in the United States. We calibrate key parameters like the coe¢ cientsin the wage setting equation and the interest feedback rule of the central bank toWestern German data. The model economy is hit with a one quarter cost-push shockcalibrated to induce a disin�ation of an order of magnitude seen at the beginning ofthe 1980s in many industrialised OECD economies. We perform the same experimenton a model without endogenous growth: The JLN economy.Under the baseline calibration, unemployment will still be about 1.8 percentage

points above its pre-shock value after about 10 years. As can be observed with con-tinental European unemployment rates, unemployment increases quickly but revertsonly very slowly. At the same time, in�ation stops declining soon after the cost pushshock has vanished, implying that the NAIRU has increased. Unsurprisingly, no suche¤ect is seen in the JLN economy, where unemployment is back to its steady stateafter about two years.The increase in the NAIRU in the New Growth economy is brought about by the

decline in investment during the recession required to disin�ate the economy. In theNew Growth economy, for a given employment level, capital stock growth determineslabour productivity growth. Hence the real wage-capital ratio is the main driverof marginal costs. Thus, although wage growth declines as employment contracts,marginal cost returns back to its steady state level soon after the shock has vanishedbecause capital stock growth for while declines even more. This stops the disin�ation.The subsequent recovery is very slow because the central bank has no reason to lowerinterest rates. Its reaction function dictates that it reacts solely to in�ation, beingclose to target, and the output gap, de�ned as the deviation of output from the levelconsistent with constant in�ation, which is zero.The model thus also contributes, to explaining the productivity slowdown ob-

served across advanced OECD economies, and why negative shocks to productivitygrowth are frequently signi�cant variables in regression of unemployment on thisvariable and others.Finally, apart from generating a persistent increase in unemployment, the model

also contributes to explaining cross country di¤erences in unemployment. Varying the

25

size of the cost push shock generates a relationship between the change in the in�ationrate and the change in the NAIRU over a ten year horizon similar to a relationshipin the data �rst observed by Ball (1996). Using comparable policy rule estimatesof Clarida, Gali and Gertler (1998) for the Bundesbank and the Federal Reserveswhile holding the cost-push shock constant creates higher persistent unemploymentwith the later than with the former. Finally, taking account of a well establishedcross-continental di¤erence in the structure of the wage setting function, namely theabsence of a labour share term, also proves informative. In the absence of the labourshare term, we see a lower increase in the NAIRU. The size of the labour share termin wage setting can be linked, if coarsely so, to features of the labour market likeunion density or the bene�t system. Thus the paper lends support to the view that,as suggested by Blanchard and Wolfers (2000), it is both "shocks and institutions"which are at the heart of explaining the evolution of unemployment across time andthe di¤erences across countries.

7 Appendix A: Derivation of the JLN and the En-dogenous Growth Model

7.1 Households

Danthine and Kurmann (2004) introduce unemployment in a general equilibriummodel without moving away from the representative agent framework. In the Danthine-Kurmann setup individuals are organized in in�nitely lived households. All decisionsregarding the intertemporal allocation of consumption and the accumulation of cap-ital are made at the household level. Each household member supplies one unit oflabour in-elastically but derives disutility from the e¤ort G(et) he or she suppliesin their job. The share of unemployed members is the same for each family. Thelarge family assumption means that although there are unemployed individuals inthe economy, it is not necessary to track the distribution of wealth.In addition, some workers supply overhead labour. They can be thought of as the

owners of the monopolistically competitive �rms. Overhead workers never becomeunemployed because no �rm can produce without managerial sta¤. A share ns of theworkforce is employed by the government who is assumed to pay the same wage asthe private sector. They are funded by lump sum taxes. All families have the sameshare of managers and government employees.Families solve the following constrained maximisation problem by choosing con-

sumption Ct (which is a CES consumption basket Ct =hR 10(ct(i))

(��1)� di

i ���1); bond-

holding Bt; investment expenditure It, next periods capital stock Kt+1 and the e¤ort

26

level et of the typical working family member:

U = Et

( 1Xi=0

�i [u(Ct+i � habt+i�1)� (nt+i � n)G(et+i)]

); u0 > 0; u00 < 0 (16)

s:t: (nt � n)wt +Bt�1Pt

(1 + it�1) +zt + rktKt � Ct +BtPt+ Tt + It and (17)

Kt+1 = (1� �)Kt + It

�1� S

�ItIt�1

� (1 + g)��

; S (0) = 0; S (0)0 = 0; S (0)00> 0

(18)

where Pt denotes the price index of the consumption basket. A family�s periodt income consists wages wt, interest income it�1 on risk less bonds they bought inthe previous period Bt�1, the pro�ts of the monopolistically competitive �rms in theeconomy zt, and dividends rkt from renting out their accumulated capital Kt. Theyhave to pay lump sum taxes Tt: We assume adjustment costs in investment: Onlya fraction of one unit of investment expenditure is actually turned into additionalcapital. This fraction decreases in the investment growth rate. The assumptions onthe �rst derivative of the S (:) function imply that adjustment costs vanish when theeconomy is growing at its steady state growth rate g.24 This implies that the steadystate growth rate does not depend on the parameters of the adjustment cost functionS: Setting up the lagrangian and denoting the lagrange multipliers of the budgetconstraint and the capital accumulation constraint as �t and �tqt yields the following�rst order conditions with respect to consumption, capital and investment:

u0(Ct � habt�1) = �Et

�u0(Ct+1 � habt)

1

1 + �t+1

�[1 + it] (19)

�t = u0(Ct � habt�1) (20)

�Et��t+1r

kt+1 + �t+1qt+1 (1� �)

�= �tqt (21)

�tqt

��1� S

�ItIt�1

� (1 + g)��

� ItIt�1

S 0�

ItIt�1

� (1 + g)��

(22)

+�Et

"�t+1qt+1

�It+1It

�2S 0�It+1It

� (1 + g)�#

= �t (23)

Note that with this notation, qt denotes the present discounted value of the futurepro�ts associated with buying an additional unit of capital today, also known asTobin�s q. We assume logarithmic instantaneous utility. Following Schmitt-Grohe

24There are two advantages of assuming investment adjustment costs and external habit formation.Firstly, it facilitates matching the second moments of investment and consumption, and secondly,it makes the on impact response of unemployment to the cost push shock in the simulation we aregoing to perform later more reasonable. By contrast, the impact on the longer run response ofunemployment is rather small.

27

and Uribe (2005), we assume S�

ItIt�1

� (1 + g)�= �

2

�ItIt�1

� (1 + g)�2: Applying

these functional forms yields the expressions discussed in section 2 of the paper.The cost of e¤ort function of individual j G(et+i (j)) is of the form

G (et(j)) (24)

=

�et(j)�

��0 + �1 logwt(j) + �2(nt � n)

+�3 logwt + �4 logwt�1 � �5 log bt � �8 log (Yt�1= (nt�1 � n� ns))

��2;(25)

log bt = �6 log (Yt�1= (nt�1 � n� ns)) + (1� �6) logwt�1 + �7 (26)

�1; �5 > 0; 1 = �6 = 0; �2; �3; �4 < 0; �1 > ��3where Yt is private sector output. Note that the e¤ort function enters the fami-

lies�utility separately which implies that it is independent of the budget constraint.Furthermore, state employees are assumed not to perform any e¤ort while at work.The �rst order condition with respect to e¤ort is

et(j) = �0 + �1 logwt(j) + �2 (nt � n) + �3 logwt (27)

+�4 logwt�1 � �5 log bt � �8 (Yt�1= (nt�1 � n� ns))

The structure of the cost of e¤ort function is motivated by the idea of "gift ex-change" between the �rm and the worker. The worker�s gift to the employer is e¤ort.The employer has to show his appreciation for the employees�contribution by payingan appropriate wage wt(j). A higher contemporary average wage wt reduces e¤ortbecause it represents a "reference level" to which the current employers�wage o¤eris compared. Put di¤erently, it requires the �rm to pay a higher wage if it wantsto extract the same amount of e¤ort. A higher average past real wage wt�1 booststhe workers�aspirations as well.25 The aggregate employment level of non-overheadworkers nt � n summarizes labour market tightness. It is thus positively related tothe workers�outside working opportunities, and thus also tends to reduce e¤ort.The view that wages have a big e¤ect on workers morale and thus productivity

because they signal to the worker how his contribution to the organizational goalsis valued is supported by an extensive microeconomic survey conducted by Bew-ley (1989). Bewley found that wage changes (in particular wage cuts) seem to beespecially important. Bewley interviewed over 300 business people, labour leadersand business consultants in search for an explanation why wages are rarely cut inrecessions.26

25See Danthine and Kurmann (2004), pp. 111-113. It would be desirable to have the individualworkers past real wage wt (j) in the equation but that would considerably complicate the max-imisation problem of the representative �rm dealt with later, so we follow Danthine and Kurmanin assuming a dependence of e¤ort on the average wage. For the same reason we include averageproductivity rather than the respective �rm�s productivity.26See Bewley (1998), pp. 459-490. A discussion of further evidence is Bewley (2004). Bewley

also argues that his �ndings contradicts essentially all theoretical justi�cations of real wage rigiditynot based on gift exchange considerations, like implicit contracts, insider outsider models or thee¢ ciency wage models based on no-shirking conditions.

28

The terms bt and (Yt�1= (nt�1 � n� ns)) represent and a modi�cation to the Dan-thine and Kurman (2004) cost of e¤ort function. bt denotes unemployment income.This will be chie�y unemployment bene�ts and black market income. It tends tolower the level of e¤ort.27 Workers want to be valued more than someone who re-ceives bene�ts or does not have a legal job. bt is linked both to past real wages andpast productivity in the private sector, where Yt denotes private sector output. Thismay re�ect both the structure of bene�ts and the manner in which the black market islinked to the o¢ cial economy. Productivity also has a direct e¤ect on morale and ef-fort as employees desire their due share of the companies�success. Unions might playa role in this to the extent that they instil a sense of entitlement among employees.The employer takes this relationship into account when setting the wage, as will

be discussed further below.

7.2 Cost Minimisation and E¢ ciency Wages

The production technology is a Cobb Douglas production function,

Yt(i) = AKt(i)�(TFPtet(i) (nt(i)� n))1��

where the output of �rm i Yt(i) depends on the capital stock of �rm i Kt(i), thee¢ ciency of its workers et(i) and the number of non-overhead workers nt(i) � n: Inthe Danthine and Kurman model (2004), in a �rst stage the �rm minimises its cost ofproducing a given amount of output. Capital and labour are hired in economy widefactor market. However, the �rm does not take the real wage as given but sets ittaking into account the relationship between e¤ort and wages given by (27).28 Hencethe �rm�s problem is:

minKt(i);nt(i);wt(i);et(i)

rktKt(i)+wt(i)(nt(i)�n)s:t:Yt(i) = AKt(i)�(TFPtet(i) (nt(i)� n))1��

and et(i) = �0 + �1 logwt(i) + �2 (nt � n) + �3 logwt

+�4 logwt�1 � �5 log bt � �8 (Yt�1= (nt�1 � n� ns))

The �rst order conditions for capital and labour are

rkt = �mct (i)Yt(i)

Kt(i)(28)

wt(i) = (1� �)mct (i)Yt(i)

nt(i)� n(29)

27Danthine and Kurman (2007) introduce the bene�t level as a factor which, ceteris paribus,reduces e¤ort.28See Danthine and Kurman (2004), pp. 114-115.

29

where mct(i) and rkt refer to real marginal costs of �rm i and the capital rentalrate. It will be shown below that even though all �rms set the wage individually,�rms will �nd it optimal to set the same wage and the same e¢ ciency level. Dividingthe two �rst order conditions gives Kt(i)

nt(i)�n =�1��

wtrkt: Thus the capital labour ratio is

the same across �rms. It is then easily shown using the production function that thesame holds for the output-capital ratio and the output-labour ratio. Hence we have

rkt = �mctYtKt

(30)

wt = (1� �)mctYt

nt � ns � n(31)

This then means that the capital to (productive) labour ratio, the output per unit ofproductive labour ratio and marginal costs are the same in all �rms, as can be easilyveri�ed by dividing the two �rst order conditions. This gives the capital to productivelabour ratio as Kt(i)

nt(i)�n =�1��

wtrkt: Substituting this back into equation (30) yields an

equation formct(i) containing only labour augmenting technological progress and thefactor price, implying that marginal costs are the same across all �rms:

mct =

�rkt��w1��t

A��(1� �)1��(�1TFPt)1�� (32)

We now turn to wage setting. The �rst order conditions with respect to e¤ort andthe real wage are

nt(i)� n =�t�1wt(i)

(33)

�t = (1� �)mctYt(i)

et(i)

Combining those with the �rst order condition with respect to labour yields anoptimal e¤ort level of �1. Substituting this back into the e¤ort function (27), we notethat, as the �rm�s wage depends only on aggregate variables which are the same forall �rms, it must indeed hold that wt(i) = wt . Substituting for log bt and rearrangingthen yields

(�1 + �3) logwt = (�5 (1� �6)� �4) logwt�1 + �1 � �0 + �5�7 � �2 (nt � n)

� (�5�6 + �8) log

�1=

�Yt�1

nt�1 � n� ns

��Subtracting (�5�6 + (1� �5)) logwt�1 on both sides and dividing by (�1 + �3) thenyields

30

logwt =�1 � �0 + �5�7

�1 + �3� �2�1 + �3

(nt � n) +�5 + �8 � �4�1 + �3

logwt�1 (34)

�(�5�6 + �8)

�1 + �3log

�wt�1 (nt�1 � n� ns)

Yt�1

�

Hence with the coe¢ cient restrictions imposed above, the wage depends positivelyon the past real wage and non managerial employment. It will be above its marketclearing level and thus there is unemployment in the economy.Note that the last term in brackets is in fact the private sector labour share.

If this were constant in the steady state, as it would be at a constant employmentlevel, equation (34) could be solved for a long run real wage if �5+�8��4

�1+�3< 1: As

mentioned above however, in our model, Danthine and Kurmann�s, is a growth model.Therefore the real wage must be growing in the steady state. Thus a wage settingfunction simply relating the wage level to employment would not be consistent witha stable employment level. The easiest way to deal with the issue therefore is to set�5+�8��4�1+�3

= 1. This does not seem too restrictive: It simply says that an increase inthe log of the time t real wage in the economy (including �rm i) has in absolute valuethe same net e¤ect on e¤ort (remember we have �1 + �3 > 0) as an increase in theexogenous reference as represented by logwt�1, log bt and log (Yt�1= (nt�1 � n� ns)) :Thus we arrive at a real wage Phillips Curve with a labour share term:

logwt � logwt�1 = a+ b � (nt � n) + c log

�wt�1 (nt�1 � n� ns)

Yt�1

�;

with a =�0 � �1 + �5�7

�1 + �3, b = � �2

�1 + �3> 0 and c = �(�5�6 + �8)

�1 + �3< 0 (35)

Equation (35) is a real wage Phillips Curve plus an "error correction term" rep-resented by the log of the labour share. Note that if there is no e¤ect of productivityon e¤ort and (�8 = 0) and no e¤ect of productivity on bene�ts (�6 = 0) we havec = 0:It remains to determine the size of the overhead labour force. Following Rotemberg

and Woodford (1999), we assume that in the steady state, all economic pro�t gener-ated by employing productive labour and capital goes to the overhead sta¤. Hencethe �rm ends up with zero pro�ts.29 This is justi�ed because setting up productionis impossible without overhead labour and the �rms pro�t is thus essentially equal tothe collective marginal product of its overhead sta¤. We assume that the overheadsta¤ splits this pro�t equally. We assume the amount of overhead workers required toenable production is such that the real wage for overhead and non-overhead workers

29See Rotemberg and Woodford (2004), pp. 15-16.

31

will be exactly the same in the steady state. These assumptions allow for a straight-forward way to determine the amount of overhead and non-overhead workers as afunction of total employment. Zero pro�t requires

�� 1�

Yt � wtn = 0

where ��1�is the share of �rms pro�ts in output. Substituting wt = (1� �) 1

�Yt

n�ns�ngives, after some manipulation

�� 11� �

=n

n� ns � n� s

This is the ratio of overhead labour to productive labour, which we call s: Solving forn then gives

n =s

1 + s(n� ns)

7.3 Price Setting and Nominal Rigidities

Each �rm produces one of the variants of the output good in the CES basket. House-holds spread their expenditures across the di¤erent varieties in the basket in a costminimising fashion. Assuming that investment expenditure stretches over these vari-ants in precisely the same way as consumption demand, we can write the demand

for variant j as yt+i(j) = Yt+i

�pt+i(j)Pt+i

���. Following Rotemberg (1983) we assume

that the representative �rm faces quadratic costs if it alters its individual price in-�ation from a reference level � � 1. This is the steady state level of in�ation in theeconomy. These cost arise because frequent price changes are bad for the reputationof the company. Convincing customers to remain with the company nevertheless iscostly. Additional costs arise because deviating from the "standard" level of in�ationrequires the �rm to engage in a costly re-optimisation process. This has to be carriedout by high paid marketing professionals, while price changes close to average in�a-tion can be decided by lower paid "frontline" sta¤. Both kinds of costs are likely toincrease in the �rms output as well. We assume the following functional form:

ACt+i(j) ='

2(pt+i(j)

pt+i�1(j)� �)2yt+i(j) (36)

The �rm j chooses its price pt+i(j) in order to maximise

1Xi=0

Et

��t;t+i

�pt+i(j)

Pt+iyt+i(j)�mct+iyt+i(j)� ACt+i(j)

��(37)

where �t;t+i denotes the discount factor used to discount real pro�ts earned in periodt+i back to period t. Note that because households own the �rms, we have �t;t+i =

32

�i u0(Ct+i)u0(Ct)

: Di¤erentiating with respect to pt(j) and noting that, as all �rms are thesame, pt(j) = Pt holds ex post, yields

(1� �) + �mct � '

�PtPt�1

� ��

PtPt�1

+ �'

2(PtPt�1

� �)2

+Et

��t;t+1'

Yt+1Yt

�Pt+1Pt

� ��Pt+1Pt

�= 0 (38)

which is a nonlinear version of the standard New Keynesian Phillips curve. It is, how-ever, a consistent feature of empirical estimations of Phillips curves that speci�cationswhich include lagged in�ation as well ("hybrid" Phillips curves") perform better thanpurely forward looking Phillips Curves. This is because in�ation has inertia.30 Back-ward looking elements are easily introduced into the price setting considerations ofthe �rm by assuming that the reference level of in�ation does not remain constantover time. Instead, we assume that it equals last periods in�ation, i.e. �t =

Pt�1Pt�2

:If the in�ation rate becomes higher for several periods, �rms will mandate frontlinesta¤ to handle price increases of that size in order to keep costs low. Customers willget used to the di¤erent pace of price changes as well, making a higher rate of pricechange less costly for the individual �rm. Hence we have

(1� �) + �mct � '

�PtPt�1

� Pt�1Pt�2

�PtPt�1

+ �'

2(PtPt�1

� Pt�1Pt�2

)2

+Et

��t;t+1'

Yt+1Yt

�Pt+1Pt

� PtPt�1

�Pt+1Pt

�= 0 (39)

The experiment we want to conduct later is a disin�ation. In�ation is brought intothe economy by a so called "cost-push shock" ut widely used in the New Keynesianliterature.31 This shock increases current in�ation, holding the values of past in�ationand marginal costs constant, and is added directly to the Phillip�s curve equation:

(1� �) + �mct � '

��PtPt�1

� ut

�� Pt�1Pt�2

��PtPt�1

� ut

�(40)

+�'

2(

�PtPt�1

� ut

�� Pt�1Pt�2

) + Et

��t;t+1'

Yt+1Yt

�Pt+1Pt

��

PtPt�1

� ut

��Pt+1Pt

�= 0

It is easily shown that up to �rst order, this Phillips Curve resembles very closelyspeci�cations which are obtained by Woodford (2003) under the assumption of Calvocontracts and full indexation of the prices of those �rms which can not re-optimiseprices to past in�ation.32 It is a forward looking accelerationist Phillips Curve. Ifpresent and future marginal costs are at their steady state level and present and futurevalues of cost push shock are zero, in�ation will remain constant. It will accelerateor decelerate otherwise. Hence the model has a well de�ned NAIRU.30See for instance Gali and Gertler (2000).31See for instance Clarida et al (1999), pages 1665 and 1667.32See Woodford (2003), p. 215. In fact, the coe¢ cients on expected future in�ation and the

coe¢ cient on lagged in�ation exactly match Woodfords�results.

33

7.4 De�nition of the Output Gap

The output gap is the percentage deviation of total output, i.e. private sector plusthe output of government employees, from its natural level. We calculate the outputof government employees by simply adding up their wages, following the conventionof national accounts. We assume that government employees earn the same wage asin the private sector. For total output, we then have Yt + wtn

s, while total naturaloutput is given by Y n

t +wnt n

s. wnt and Ynt denote the wage rate and the private sector

output level consistent with natural employment, or the NAIRU. Thus we have

gpt =Yt + wtn

s � Y nt � wnt n

s

Y nt + wnt n

s(41)

Y nt denotes the private sector output level which would set marginal costs equal to

its long run level ��1; given the capital stock and the previous period�s real wage. Ascan be obtained from equation (40), this would ensure that in the absence of cost pushshocks, in�ation is neither rising nor falling. The employment level corresponding tothis output level will be referred to as "natural employment" nnt . The natural levelsof output and employment are derived by substituting the equation for the rental oncapital (30) and the wage setting equation (35) into (32) and setting mct = ��1: Thenatural levels of output, employment and the real wage are then given by the valuesof Y n

t nnt and wnt solving

��1 =(nnt � ns � n)�wnt

A (1� �) (�1TFPt)1��K�

t

logwnt � logwt�1 = a+ b � (nnt � n) + c log

�wt�1 (nt�1 � n� ns)

Yt�1

�Y nt = AKt

�(TFPt�1 (nnt � ns � n))1�� (42)

Note that given the past real wage, the capital stock has a positive e¤ect onnatural employment given the past real wage. This e¤ect works through the negativee¤ect of a higher capital stock on the capital rental. This tends to lower marginalcosts and thus accommodates a higher real wage given the mark-up. This allows theemployer to meet the demands of wage setters associated with higher employment.

7.5 Introducing Endogenous Growth

The basic idea in the knowledge spill-over model of Romer (1986) is to start o¤with astandard neoclassical production function with labour augmenting technical progressas above.33 An additional feature is that labour augmenting technological progressmight be �rm speci�c. Thus the output of �rm i is given by

Yt(i) = F (Kt(i); TFPt (i)nt(i)) (43)

33The exposition here follows Barro and Sala-i-Martin (2004), pp.212-222.

34

Romer then makes two crucial assumptions:

� Increasing it�s physical capital simultaneously teaches the �rm how to producemore e¢ ciently. This idea was �rst suggested by Arrow (1962). For simplicity,in the Romer setup, TFPt (i) is simply proportional to the �rm�s capital stock.

� Knowledge is a public good. Hence each �rm�s knowledge is in fact proportionalto the aggregate capital stock rather than to its own.34 However, the impact ofthe �rm�s capital stock on the aggregate capital stock is so small that they canbe neglected. Thus the production function of �rm i becomes

Yt(i) = F (Kt(i); Ktnt(i)) (44)

This implies that there are now constant returns to capital at the economy widelevel, allowing per capita output to grow. However, there are still decreasing returnsto capital at the �rm level. In the Romer model, this leads to a growth rate which isine¢ ciently low. This is because saving is to low as the individual return on capitalfalls short of the social return on capital.Thus we set TFPt = Kt in the equations derived in the previous section. The

marginal cost equation (32) and the aggregate production function become

mct =

�rkt��w1��t

A��(1� �)1��(�1Kt)1��(45)

Yt = AKt(�1 (nt � ns � n))1�� (46)

To arrive at from the production function (5) ; after setting TFPt = Kt, we divide bynt(i) � n: As the capital labour ratio and the output per unit of productive labourratio are the same across all �rms, we arrive at (46) :The capital stock now has a stronger e¤ect on both marginal costs and output than

in the JLN economy. An increase in the capital stock by 1% for a given employmentlevel (implying that output expands at the same rate) reduces marginal costs by1%: In the absence of endogenous growth the e¤ect is only �% This can be see bysubstituting the capital rental out of equations (32) and (45) and then substitutingYtKtusing the respective production functions.Accordingly, the capital stock also has a greater e¤ect on natural employment and

the NAIRU. The equivalents of equations (42) are

��1 =(nnt � ns � n)�wntA (1� �) (�1)

1��Kt

logwnt � logwt�1 = a+ b � (nnt � n) + c log

�wt�1 (nt�1 � n� ns)

Yt�1

�Y nt = AKt(�1 (n

nt � ns � n))1�� (47)

34See Barro/ Sala-i-Martin (2004), pp.21-22.

35

Clearly, an increase in the capital stock now accommodates a larger increase innatural employment than in (42) :

8 Appendix B : Normalised Version of the New

Growth Model

As we are dealing with two growth models, we have to stationarise all variables whichwould otherwise be trended in order to be able to solve the model. This appendixapplies this normalisation to the New Growth model. The resulting equations arethose which have been solved and simulated. We de�ne Ct

Kt; habt�1

Kt

Yt+wtns

Kt; ItKtand wt

Kt

as Dt; Habt�1; Ft; Rt and Ht; while the gross capital stock growth rateKt+1

Kt� 1 is

de�ned as gkt+1:We directly apply the normalisation to the equations of the aggregate demand

block:

Ft = Dt +Rt +'

2(�t � �t�1)

2 (Ft �Htns) +Htn

s (48)

Consumption (remember habt�1 = jCt�1; thus Habt�1 = jDt�11+gkt

1= (Dt �Habt�1) = �Et�(1 + it) =

�(1 + �t+1) (Dt+1 �Habt)

�1 + gkt+1

���(49)

Habt = jDt

1 + gkt+1(50)

Investment:

�Et

1

(Dt+1 �Habt)�1 + gKt+1

� �rkt+1 + qt+1 (1� �)�!

=1

Dt �Habt�1qt(51)

1

Dt �Habt�1qt

" 1� �

2

�RtRt�1

�1 + gkt

�� (1 + g)

�2!� RtRt�1

�

�RtRt�1

�1 + gkt

�� (1 + g)

�#(52)

+�Et

"1

Dt+1 �Habtqt+1

�Rt+1Rt

�1 + gkt+1

��2�

�Rt+1Rt

�1 + gkt+1

�� (1 + g)

�#=

1

Dt �Habt�1

From (3) we have

gkt+1 = �� +Rt

1� �

2

�RtRt�1

�1 + gkt

�� (1 + g)

�2!(53)

36

The rental on capital becomes:

rkt = �mct (Ft �Htns) (54)

Substituting (54) into (32) and multiplying by K�

1��t

K�

1��t

yields

mct =(Ft �Htn

s)�

1�� Ht

X(55)

where X = A1

1�� (1� �)�1.

The wage setting function lnwt = lnwt�1+a+ b (nt � n)+ c log�wt�1(nt�1�n�ns)

Yt�1

�can be rewritten as (using equation (31)) lnHt = a+ b (nt � n) + ln

�wt�1

Kt�1(1+gkt )

�+

c log ((1� �)mct�1) = a+ b (nt � n) + ln

�Ht�1

(1+gkt )

�+ c log ((1� �)mct�1)

Ht = exp(a+ b (nt � n))Ht�1�1 + gkt

� ((1� �)mct�1)c (56)

Employment: from Outputt = AKt((nt � n� ns)�1)1�� + wtn

s; we have

Ft = A((nt � n� ns)�1)1�� +Htn

s (57)

The Phillips Curve and the Policy rule do not contain any trended variables andtherefore does not need to be normalised. However, we will substitute the real pro�tsstochastic discount factor by its de�nition, i.e. �t;t+1 = � u

0(Ct+1�Habt)u0(Habt�1)

= � Ct�Habt�1Ct+1�Habt ;

which gives

(1� �) + �mct � '

��PtPt�1

� ut

�� Pt�1Pt�2

��PtPt�1

� ut

�+ �

'

2(

�PtPt�1

� ut

�� Pt�1Pt�2

)2

(58)

+�Dt �Habt�1

Ft'Et

�Ft+1

Dt+1 �Habt

�Pt+1Pt

��

PtPt�1

� ut

��Pt+1Pt

�= 0 (59)

Replacing Pt+iPt�1+i

= 1 + �t+i gives

(1� �) + �mct � ' ((�t � ut)� �t�1) (1 + �t � ut) + �'

2((�t � ut)� �t�1)

2 (60)

+�Dt �Habt�1

Ft'Et

�Ft+1

Dt+1 �Habt(�t+1 � (�t � ut)) (1 + �t+1)

�= 0 (61)

37

For natural output, natural employment and the natural real wage from equation

��1 =(F nt )

�1�� Hn

t

X(62)

F nt = At((nnt � n� ns)�1)

1�� + nsHnt

Hnt = exp(a+ b (nnt � n))

Ht�1�1 + gkt

� ((1� �)mct�1)c (63)

given last periods wage/ capital ratio Ht�1 and this periods capital stock growthrate gkt (which was also determined in the t-1 by the then investment decision). Theoutput gap gpt is then calculated as

gpt =Outputt �Outputnt

Outputnt

�Kt

Kt

�=Ft � F ntF nt

(64)

9 Appendix C: Steady State Relations

This Appendix shows how to calculate the steady state values for the system devel-oped in Appendix B. We will �rst derive a steady state relation between the level ofemployment and the steady state growth rate for the New Growth Economy.First apply the fact that in the steady state, gKt = g to (52) which yields q = 1:

We then apply this to (51) which yields

��rkt+1 + (1� �)

�= (1 + g) (65)

In the New Growth economy, we now replace the capital rental with equation (54)and, after using (57) and noting that in the steady state we have mc = ��1; arrive at

g =���(1� �) + ���1A((n� n� ns)�1)

1����� 1 (66)

This is the steady state growth rate which is borne out by the marginal productof capital in the endogenous growth economy. It is easily veri�ed that it is increasingand concave in employment. It is straightforward to show that in the steady state,the real wage implied by the desired mark-up grows at the same rate as output andthe capital stock by using mct = ��1 and rkt = rk on (45). This yields

wt = Kt�1

���1A��(1� �)1��

(rk)�

�1=(1��)(67)

Hence in the steady state, the real wage has to grow at the same rate as the capitalstock. This means that equation (67) actually the dynamic, endogenous growthversion of the familiar macroeconomic textbook price setting function: It gives thereal wage growth rate compatible with marginal costs remaining constant and at it�s

38

long run level. Unlike the textbook price setting function, this real wage growth rateis not constant but increases in employment: A higher steady state employment levelimplies a higher marginal product of capital, which triggers higher investment andthus faster capital stock- and thus productivity growth. Accordingly, the steady statelevels of employment an the growth rate are determined by the intersection of (66)with the wage setting function (35), (making again use of the fact that mc = ��1 inthe steady state).In practice, we choose a desired steady state employment rate (here 0.96) and

then compute the wage setting function intercept a to support this value, given g, band � and n:Having determined g and n; the determination of the steady state values of

Ft; Dt; Rt; Ht; rkt and it is now straightforward. For F we have

F = A((n� n� ns)�1)1�� (68)

from the production function. ForRt; we have from the capital accumulation equationin (53)

R = g + � (69)

D can then be determined as a residual via

D = F �R (70)

H is computed using the cost-minimisation �rst order condition for labour (31)

H = (1� �)��1F

n� n� ns(71)

rk is computed viark = ���1A((n� n� ns)�1)

1�� (72)

The steady state value of it is computed from (49)

i =1 + g

�� 1 (73)

Note that this is also the intercept of the interest rate rule i of the central bank.

10 Appendix D: Normalised Version of the JLNEconomy

Most of the equations from Appendix B just carry over to the JLN economy. However,there are a few changes related to the production function and the marginal cost equa-tion. The aggregate production function is nowOutputt = AK�

t (TFPt�1 (nt � n� ns))1��+wtn

s: Dividing both sides by Kt gives

Ft = (lt�1 (nt � n� ns))1�� +Htns (74)

39

where lt is de�ned as TFPtKt. This variable evolves according to

lt =1 + gTFP1 + gKt

lt�1 (75)

In the JLN model, it convenient to normalise the real wage with respect to TFPtrather than with respect to Kt, while all the remaining normalisations carry over tothe JLN model. Denoting wt

TFPtas Hnc

t ; we have from (10) ; after making use of (8)

mct =F(�=(1��))t Hnc

t

A1=(1��) (1� �)�1(76)

Concerning the capital rental, we employ the JLN expression for Ft to have

rkt = �mctAl1��t ((nt � n� ns)�1)

1�� (77)

The normalised wage setting equation becomes

Hnct = exp(a+ b (nt � n))

Hnct�1

(1 + gTFP )((1� �)mct�1)

c (78)

All the remaining equations are just the same as in the New Growth version. Thecomputation of the steady state values in the neoclassical model is slightly di¤erent.The steady state growth rate (of output, consumption, the capital stock, the realwage) is now given by the parameter gTFP rather than being endogenously deter-mined, which means we have g = gTFP : Hence we can compute the steady state realinterest rate from 73, while we compute rk from (65). From (78), we have the steadystate employment rate. Setting mct = ��1in (77) then gives the steady state valuefor lt as

l =1

(nt � n� ns)�1

�rk�

�A

�1=(1��)(79)

which allows us to compute F from (74). Rearranging (76) then yields Hnc:

11 Appendix E: Estimation of the Wage SettingFunction

We estimate the real wage growth function using German data ranging from 1970Q1to 2000Q4. Our dataset includes Western German data up to 1991Q4 and followingthat data for the uni�ed country. All data is taken from a publication of the German"Statistisches Bundesamt", all of which has been seasonally adjusted.35 When esti-mating the function, we replace the employment rate with one minus the unemploy-ment rate. As a measure for labour costs, we use the "Arbeitnehmerentgeld" per hour35See Statistisches Bundesamt (2006a) and Statistisches Bundesamt (2007a).

40

worked, which is employee compensation including the full tax wedge. This is de�atedusing the GDP price index. The labour share is given by total nominal compensation(i.e. total "Arbeitnehmerentgeld") divided by total nominal GDP. Denoting the un-employment rate as U, we then estimate � logwt = a+ b�Ut+ c log (LSt�1)+d92Q1;where LSt�1 denotes the previous periods labour share in GDP, d92Q1 denotes anintercept dummy equalling one in 1992Q1 and zero everywhere else. The later is toaccount for reuni�cation. We use two stage least squares to account for the possi-ble endogeneity of employment. As instruments, we choose � log realwaget�1; Ut�1(following Danthine and Kurman (2004)); c and d92Q1:36

Note that we use Newey-West Standard Errors serial correlation consistent stan-dard errors because the Breusch-Godfrey LM test for serial correlation rejects thehypotheses of no serial correlation at the 5% level. The result is reported in table E1,where WG denotes the change in log real wages and U denotes the unemploymentrate.Table E1Dependent Variable: WGMethod: Two-Stage Least SquaresDate: 06/03/08 Time: 12:27Sample (adjusted): 1970Q3 2000Q4Included observations: 122 after adjustmentsNewey-West HAC Standard Errors & Covariance (lag truncation=4)Instrument list: WG(-1) C U(-1) LOG(LS(-2)) D92Q1Variable Coe¢ cient Std. Error t-Statistic Prob.C -0.042273 0.018893 -2.237531 0.0271U -0.120587 0.046582 -2.588689 0.0108LOG(LS(-1)) -0.089599 0.032530 -2.754342 0.0068D92Q1 -0.112300 0.002188 -51.33630 0.0000R-squared 0.574362 Mean dependent var 0.005890Adjusted R-squared 0.563541 S.D. dependent var 0.014077S.E. of regression 0.009300 Sum squared resid 0.010205F-statistic 52.46032 Durbin-Watson stat 2.535359Prob(F-statistic) 0.000000Note that our calibrated value of b is lower than the point estimate of 0.12. How-

ever, it is not statistically di¤erent from 0.12 with any reasonable level of con�dence,in fact it is less than one standard deviation away from the point estimate. The rea-son for this choice is that while it is possible to preserve the results of this paper inface of higher wage �exibility, this calibration has certain undesirable features. If weaim to achieve a steady growth rate of GDP in the order of magnitude of a reasonableorder of magnitude (and one that makes lifetime utility converge), we would have tochoose either relatively high depreciation rates or a lower individual discount factor

36See Danthine and Kurman (2004), p. 121.

41

�, the later implying a very high steady state risk less rate. We think that theseconsiderations justify the choice of a value smaller than the point estimate.The reason why the coe¢ cient of the labour share c also falls short of the calibrated

coe¢ cient, though the distance is again less than one standard deviation. This is dueto the fact that we have experimented with di¤erent computations of the labourshare in GDP. The alternative computation was based on real values of GDP andemployee compensation. The later computations methods generated a value of -0.12than the -0.1 we use in the simulations. It is not a priori clear which measure is moreappropriate. In fact to is common to interpret the labour share term as real wagesdivided by productivity (i.e. real GDP/hour or real GDP/ employee) and enter thesevariables separately.37 Furthermore, a reduction of c by 0.01 has only small e¤ects onour simulation results.

References

[1] Abowd, John M., Kramarz, F., Margolis, D.N. (2001), The relative Importanceof Employer and Employee E¤ects on Compensation: A Comparison of Franceand the United States, in: Journal of the Japanese and international Economies15, pp. 419-436.

[2] Baker, D./ Glyn, A./ Howell, D./ Schmitt, J. (2002), Labor Market Institu-tions and Unemployment: A Critical Assessment of the Cross-Country Evidence,CEPA Working Paper 2002-17, CEPA.

[3] Ball, L. (1996), Disin�ation and the NAIRU, NBER Working Paper 5520.

[4] Ball, L. (1999), Aggregate Demand and Long-Run Unemployment, in: BrookingsPapers on Economic Activity, Vol. 199, No. 2, pp. 189-251.

[5] Ball, L./ Mo¢ tt, R. (2001), Productivity Growth and the Phillips Curve, NBERWorking Paper 8421.

[6] Barro, R.J./ Sala-i-Martin, X. (2004), Economic Growth, MIT Press.

[7] Bewley, T. F. (1998), Why not cut pay?, in: European Economic Review 42(1998), pp. 459-490.

[8] Bewley, T. F. (2004), Fairness, Reciprocity, and Wage Rigidity, IZA DiscussionPaper No. 1137.

[9] Belot, M./ van Ours, J. (2004), Does the recent success of some OECD countriesin lowering their unemployment lie in the clever design of their labor marketreforms?, in: Oxford Economic Papers 56, pp. 621-642.

37Cahuc and Zylberberg (2004), p. 486 and OECD (1997), p. 21.

42

[10] Blanchard, O. (2007), A Review of Layard, Nickell and Jackmann�s Unemploy-ment, in: Journal of Economic Literature, Vol. 65, No. 2, pp. 410-418.

[11] Blanchard, O./ Katz, L.F. (1997), What We Know and Do Not Know Aboutthe Natural Rate of Unemployment, in: The Journal of Economic Perspectives,Vol. 11, No. 1, pp. 51-72

[12] Blanchard, O./ Katz, L.F. (1999), Wage Dynamics: Reconciling Theory andEvidence, in: The American Economic Review, Vol. 89.

[13] Blanchard, O./ Wolfers, J. (2000), The Role of Shocks and Institutions in theRise of European Unemployment: The Aggregate Evidence, in: The EconomicJournal, Vol. 110, No. 462, Conference Papers, pp. C1-C33.

[14] Blanchard, O./ Summers, L. H. (1986), Hysteresis and the European Unemploy-ment Problem, in: NBER Macroeconomics Annual, Vol. 1, pp. 15-78.

[15] Cahuc, P./ Zylberberg, A. (2004), Labor Economics, MIT Press.

[16] Christiano, Eichenbaum and Evans (2005), Nominal Rigidity and the DynamicE¤ects of a Shock to Monetary Policy, in: Journal of Political Economy, Vol.113, No. 1.

[17] Clarida, R./ Gali, J., Gertler, M. (1998), Monetary Policy in Practice. Someinternational Evidence, in: European Economic Review, pp. 1033-1067.

[18] Clausen, J. R/ Meier, C. P. (2003), Did the Bundesbank follow a Taylor Rule?An Analysis based on Real-Time Data, IWP Discussion Paer No. 2003/2.

[19] Danthine, J.-P./ Kurmann, A. (2004), Fair Wages in a New Keynesian model ofthe business cycle, in: Review of Economic Dynamics 7, pp. 107-142.

[20] Danthine, J.-P., Kurmann, A. (2007), The Macroeconomic Consequences of Reci-procity in Labor Relations, in: Scandinavian Journal of Economics, pp. 557-881.

[21] Elmeskov, J./ Martin, J./ Scarpetta, S. (1998), Key Lessons for Labor MarketReforms, in: Swedish Economic Policy Review 5, pp. 205-252.

[22] European Commission Directorate General for Economic and FinancialA¤airs (DG ECFIN) (2008), Annual Macro-Economic Database (AMECO),http://ec.europa.eu/economy_�nance/db_indicators/db_indicators8646_en.htm

[23] Fitoussi, J. P./ Jestaz, D./ Phelps, E. S./ Zoega, G. (2000), Roots of the RecentRecoveries: Labor Reforms or Private Sector Forces?, in: Brookings Papers onEconomic Activity 1:2000, pp. 237-311.

43

[24] Gali, J. (2001) New Perspectives on Monetary Policy, In�ation, and the BusinessCycle, NBER Working paper 8767, http://www.nber.org/papers/w8767.

[25] Gali, J./ Gertler, M. (1999), In�ation Dynamics: A structural EconometricAnalysis, in: Journal of Monetary Economics 44, pp. 195-222.

[26] IMF (2003), Unemployment and Labour Market Institutions: Why Reforms payo¤, in: World Economic Outlook 2003, pp. 129-150.

[27] Jackman, R./ Layard, R./ Nickell, S. (1991), Unemployment. MacroeconomicPerformance and the Labour Market, Oxford University Press.

[28] Juillard, M. (1996), Dynare: A program for the resolution of and simulation ofdynamic models with forward variables through the use of relaxation algorithm,CEPREMAP.

[29] Jondeau, E./ Bihan, H. (2005), Testing for the New Keynesian Phillips Curve.Additional international Evidence, in: Economic Modelling 22, pp. 521-550.

[30] Layard, R./ Nickell, S./ Jackman, R. (1991), Unemployment. MacroeconomicPerformance and the Labour Market, Oxford University Press.

[31] Leslie, D. (1993), Advanced Macroeconomics. Beyond IS/LM, McGraw-Hill,London.

[32] Lubik, T.A./ Marzo, M. (2007), in: International Review of Economics andFinance 16, pp. 15-36.

[33] Nickel, S/ Nunziata, L./ Ochel, W. (2005), Unemployment in the OECD sincethe 1960s. What do we know?, in: The Economic Journal, 115, pp. 1-27.

[34] Nickel, S./ Nunziata, L./ Ochel, W./ Quintini, G. (2002), The Beveridge Curve,Unemployment and Wages in the OECD from the 1960s to the 1990s, Centre forEconomic Performance, London School of Economics.

[35] Nolan, C./ Thoenissen, C. (2005), Labour Markets and Firm-Speci�c Capitalin New Keynesian General Equilibrium Models, Centre for Dynamic Macroeco-nomic Analysis Working Paper Series, 05/01.

[36] OECD (1997), OECD Employment Outlook 1997, Chapter 1.

[37] Pissarides, C./ Vallanti, G. (2005), The Impact of TFP Growth on Steady StateUnemployment, CEPR Discussion Paper No. 5002.

[38] Rannenberg, A. (2009), Disin�ation and the NAIRU in a New-Keynesian New-Growth Model (Extended Version), http://mpra.ub.uni-muenchen.de/13610/1/MPRA_paper_13610.pdf

44

[39] Rodrik, D. (1998), Why do more open Economies have bigger Governments?, in:The Journal of Political Economy, Vol. 106, No. 5 pp. 997-1032.

[40] Romer, P.M. (1986), Increasing Returns and Long-Run Growth, in: The Journalof Political Economy, Vol. 94, No. 5, pp. 1002-1037.

[41] Rotemberg, J.J. (1983), Monetary Policy and Costs of Price Adjustment, in:Journal of Economic Dynamics and Control 5, pp. 267-288.

[42] Rotemberg, J. J./ Woodford, M. (1999), The Cyclical Behavior of Prices andCosts, in: NBER Working Paper No. 6909, National Bureau of Economic Re-search.

[43] Sargent, T./ Ljungqvist, L (1998), The European Unemployment Dilemma, in:The Jorunal of Political Economy, Vol. 106, No. 3.

[44] Sargent, T./ Ljungqvist, L (2007), Understanding European unemployment withmatching and search-island models, in: The Journal of Monetary Economics 54,pp. 2139-2179.

[45] Schmittt-Grohe, S./ Uribe, M. (2004), Solving dynamic general equilibriummod-els using a second order approximation to the policy Function, in: Journal ofEconomic Dynamics & Control, pp. 755-775.

[46] Schmitt Grohe, S./ Uribe, M. (2005), Optimal In�ation Stabilization in aMedium Scale Macroeconomic Model, NBER Working Paper 11854.

[47] Skozylas, L./ Tisso, B. (2005), Revisiting recent Productivity Developmentsacross OECD Countries, in: BIS Working Paper No. 182, BIS.

[48] Smets, F./ Wouters, R. (2002), An estimated Stochastic Dynamic General Equi-librium Model of the Euro Area, in: ECB Working Paper No. 171.

[49] Statistisches Bundesamt Wiesbaden (2006a), Volkswirtschaftliche Gesamtrech-nungen. Inlandsproduktberechnung. Revidierte Saisonbereinigte Vierteljahre-sergebnisse nach Census-X-12-ARIMA und BV4.1. 1970-1991, Statistisches Bun-desamt Wiesbaden.

[50] Statistisches Bundesamt Wiesbaden (2006b), Volkswirtschaftliche Gesamtrech-nungen. Inlandsproduktberechnung. Revidierte Jahresergebnisse 1970 bis 1991,Statistisches Bundesamt, Wiesbaden.

[51] Statistisches Bundesamt Wiesbaden (2007a), Volkswirtschaftliche Gesamtrech-nungen. Inlandsproduktberechnung. Revidierte Saisonbereinigte Vierteljahre-sergebnisse nach Census-X-12-ARIMA und BV4.1. 2.Vierteljahr 2007, Statis-tisches Bundesamt Wiesbaden.

45

[52] Statistisches Bundesamt Wiesbaden (2007b), Volkswirtschaftliche Gesamtrech-nungen. Inlandsproduktberechnung. Revidierte Jahresergebnisse 1991 bis 2006,Statistisches Bundesamt, Wiesbaden.

[53] Woodford, M. (2003), Interest and Prices. Foundations of a Theory of MonetaryPolicy. Princeton University Press, Princeton, New Jersey.

46

www.st-and.ac.uk/cdma

ABOUT THE CDMA

The Centre for Dynamic Macroeconomic Analysis was established by a direct grant from theUniversity of St Andrews in 2003. The Centre funds PhD students and facilitates a programme ofresearch centred on macroeconomic theory and policy. The Centre has research interests in areas such as:characterising the key stylised facts of the business cycle; constructing theoretical models that can matchthese business cycles; using theoretical models to understand the normative and positive aspects of themacroeconomic policymakers' stabilisation problem, in both open and closed economies; understandingthe conduct of monetary/macroeconomic policy in the UK and other countries; analyzing the impact ofglobalization and policy reform on the macroeconomy; and analyzing the impact of financial factors onthe long-run growth of the UK economy, from both an historical and a theoretical perspective. TheCentre also has interests in developing numerical techniques for analyzing dynamic stochastic generalequilibrium models. Its affiliated members are Faculty members at St Andrews and elsewhere withinterests in the broad area of dynamic macroeconomics. Its international Advisory Board comprises agroup of leading macroeconomists and, ex officio, the University's Principal.

Affiliated Members of the School

Dr Fabio Aricò.Dr Arnab Bhattacharjee.Dr Tatiana Damjanovic.Dr Vladislav Damjanovic.Prof George Evans.Dr Gonzalo Forgue-Puccio.Dr Laurence Lasselle.Dr Peter Macmillan.Prof Rod McCrorie.Prof Kaushik Mitra.Prof Charles Nolan (Director).Dr Geetha Selvaretnam.Dr Ozge Senay.Dr Gary Shea.Prof Alan Sutherland.Dr Kannika Thampanishvong.Dr Christoph Thoenissen.Dr Alex Trew.

Senior Research Fellow

Prof Andrew Hughes Hallett, Professor of Economics,Vanderbilt University.

Research Affiliates

Prof Keith Blackburn, Manchester University.Prof David Cobham, Heriot-Watt University.Dr Luisa Corrado, Università degli Studi di Roma.Prof Huw Dixon, Cardiff University.Dr Anthony Garratt, Birkbeck College London.Dr Sugata Ghosh, Brunel University.Dr Aditya Goenka, Essex University.Prof Campbell Leith, Glasgow University.Prof Paul Levine, University of Surrey.Dr Richard Mash, New College, Oxford.Prof Patrick Minford, Cardiff Business School.Dr Gulcin Ozkan, York University.Prof Joe Pearlman, London Metropolitan University.

Prof Neil Rankin, Warwick University.Prof Lucio Sarno, Warwick University.Prof Eric Schaling, South African Reserve Bank and

Tilburg University.Prof Peter N. Smith, York University.Dr Frank Smets, European Central Bank.Prof Robert Sollis, Newcastle University.Prof Peter Tinsley, Birkbeck College, London.Dr Mark Weder, University of Adelaide.

Research Associates

Mr Nikola Bokan.Mr Farid Boumediene.Mr Johannes Geissler.Mr Michal Horvath.Ms Elisa Newby.Mr Ansgar Rannenberg.Mr Qi Sun.

Advisory Board

Prof Sumru Altug, Koç University.Prof V V Chari, Minnesota University.Prof John Driffill, Birkbeck College London.Dr Sean Holly, Director of the Department of Applied

Economics, Cambridge University.Prof Seppo Honkapohja, Bank of Finland and

Cambridge University.Dr Brian Lang, Principal of St Andrews University.Prof Anton Muscatelli, Heriot-Watt University.Prof Charles Nolan, St Andrews University.Prof Peter Sinclair, Birmingham University and Bank of

England.Prof Stephen J Turnovsky, Washington University.Dr Martin Weale, CBE, Director of the National

Institute of Economic and Social Research.Prof Michael Wickens, York University.Prof Simon Wren-Lewis, Oxford University.

www.st-and.ac.uk/cdmaRECENT WORKING PAPERS FROM THE

CENTRE FOR DYNAMIC MACROECONOMIC ANALYSIS

Number Title Author(s)

CDMA07/10 Optimal Sovereign Debt Write-downs Sayantan Ghosal (Warwick) andKannika Thampanishvong (StAndrews)

CDMA07/11 Bargaining, Moral Hazard and SovereignDebt Crisis

Syantan Ghosal (Warwick) andKannika Thampanishvong (StAndrews)

CDMA07/12 Efficiency, Depth and Growth:Quantitative Implications of Financeand Growth Theory

Alex Trew (St Andrews)

CDMA07/13 Macroeconomic Conditions andBusiness Exit: Determinants of Failuresand Acquisitions of UK Firms

Arnab Bhattacharjee (St Andrews),Chris Higson (London BusinessSchool), Sean Holly (Cambridge),Paul Kattuman (Cambridge).

CDMA07/14 Regulation of Reserves and InterestRates in a Model of Bank Runs

Geethanjali Selvaretnam (StAndrews).

CDMA07/15 Interest Rate Rules and Welfare in OpenEconomies

Ozge Senay (St Andrews).

CDMA07/16 Arbitrage and Simple Financial MarketEfficiency during the South Sea Bubble:A Comparative Study of the RoyalAfrican and South Sea CompaniesSubscription Share Issues

Gary S. Shea (St Andrews).

CDMA07/17 Anticipated Fiscal Policy and AdaptiveLearning

George Evans (Oregon and StAndrews), Seppo Honkapohja(Cambridge) and Kaushik Mitra (StAndrews)

CDMA07/18 The Millennium Development Goalsand Sovereign Debt Write-downs

Sayantan Ghosal (Warwick),Kannika Thampanishvong (StAndrews)

CDMA07/19 Robust Learning Stability withOperational Monetary Policy Rules

George Evans (Oregon and StAndrews), Seppo Honkapohja(Cambridge)

CDMA07/20 Can macroeconomic variables explainlong term stock market movements? Acomparison of the US and Japan

Andreas Humpe (St Andrews) andPeter Macmillan (St Andrews)

www.st-and.ac.uk/cdmaCDMA07/21 Unconditionally Optimal Monetary

PolicyTatiana Damjanovic (St Andrews),Vladislav Damjanovic (St Andrews)and Charles Nolan (St Andrews)

CDMA07/22 Estimating DSGE Models under PartialInformation

Paul Levine (Surrey), JosephPearlman (London Metropolitan) andGeorge Perendia (LondonMetropolitan)

CDMA08/01 Simple Monetary-Fiscal Targeting Rules Michal Horvath (St Andrews)

CDMA08/02 Expectations, Learning and MonetaryPolicy: An Overview of Recent Research

George Evans (Oregon and StAndrews), Seppo Honkapohja (Bankof Finland and Cambridge)

CDMA08/03 Exchange rate dynamics, asset marketstructure and the role of the tradeelasticity

Christoph Thoenissen (St Andrews)

CDMA08/04 Linear-Quadratic Approximation toUnconditionally Optimal Policy: TheDistorted Steady-State

Tatiana Damjanovic (St Andrews),Vladislav Damjanovic (St Andrews)and Charles Nolan (St Andrews)

CDMA08/05 Does Government Spending OptimallyCrowd in Private Consumption?

Michal Horvath (St Andrews)

CDMA08/06 Long-Term Growth and Short-TermVolatility: The Labour Market Nexus

Barbara Annicchiarico (Rome), LuisaCorrado (Cambridge and Rome) andAlessandra Pelloni (Rome)

CDMA08/07 Seignioprage-maximizing inflation Tatiana Damjanovic (St Andrews)and Charles Nolan (St Andrews)

CDMA08/08 Productivity, Preferences and UIPdeviations in an Open EconomyBusiness Cycle Model

Arnab Bhattacharjee (St Andrews),Jagjit S. Chadha (Canterbury) and QiSun (St Andrews)

CDMA08/09 Infrastructure Finance and IndustrialTakeoff in the United Kingdom

Alex Trew (St Andrews)

..

For information or copies of working papers in this series, or to subscribe to email notification, contact:

Johannes GeisslerCastlecliffe, School of Economics and FinanceUniversity of St AndrewsFife, UK, KY16 9ALEmail: jg374@at-andrews.ac.uk; Phone: +44 (0)1334 462445; Fax: +44 (0)1334 462444.