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5.5.5 Microeconomic policies to increase aggregate supply

The next policy implication of the new classical approach we consider concerns

what policies the authorities should pursue if they wish to increase

output/reduce unemployment permanently (the role of monetary policy is not

to try to reduce unemployment permanently but to keep inflation low and

stable). As we have already seen, microeconomic policies to reduce distortions

in the labour market have been recommended as the ‘first-best’ solution

to the inflation bias problem identified by Kydland and Prescott (1977).

Unemployment is regarded as an equilibrium outcome reflecting the optimal

decisions of workers who substitute work/leisure in response to movements

in current and expected future real wages. The labour market continuously

clears, so that anyone wanting to work at the current real wage can do so.

Those who are unemployed voluntarily choose not to work at the current real

wage (Lucas, 1978a). Changes in output and employment are held to reflect

the equilibrium supply decisions of firms and workers, given their perceptions

of relative prices. It follows from this view that the appropriate policy

measures to increase output/reduce unemployment are those that increase the

microeconomic incentives for firms and workers to supply more output and

labour (examples of the wide range of often highly controversial supply-side

policies which have been pursued over recent years can be found in Chapter

4, section 4.3.2; see also Minford et al., 1985; Minford, 1991). The importance

of supply-side reforms has recently been taken up by Lucas. In his

Presidential Address to the American Economic Association in January 2003,

Lucas focused on ‘Macroeconomic Priorities’ (Lucas, 2003). In an analysis

using US performance over the last 50 years as a benchmark, Lucas concluded

that the potential for welfare gains from better long-run, supply-side

policies far exceeds the potential gains to be had from further improvements

in short-run stabilization policies.

To some economists the unemployment problem in Europe is not fundamentally

a monetary policy issue but a suppy-side problem, often referred to as

‘Eurosclerosis’. During the 1950s and 1960s the European ‘welfare state’ OECD

economies experienced lower unemployment on average than that experienced

in the USA. Since around 1980 this experience has been reversed. Many

economists have attributed the poor labour market performance in Europe to

various institutional changes which have adversely affected the flexibility of

the labour market, in particular measures relating to the amount and duration of

unemployment benefit, housing policies which limit mobility, minimum wage

legislation, job protection legislation which increases hiring and firing costs,

the ‘tax wedge’ between the cost of labour to firms (production wage) and the

net income to workers (consumption wage), and ‘insider’ power (Siebert, 1997;

Nickell, 1997). In the face of an increasingly turbulent economic environment,

economies require ongoing restructuring. Ljungqvist and Sargent (1998) argue

that the generous entitlement programmes in the European OECD welfare

states have generated ‘a virtual time bomb waiting to explode’ . That explosion

arrives when large economic shocks occur more frequently. The welfare state

programmes hinder the necessary restructuring of the economy and this shows

up as high and prolonged rates of unemployment.

While accepting the validity of some of the supply-side arguments, Solow

(1998) and Modigliani (1996) see a significant part of the rise in European

unemployment as having its origin in the tight anti-inflationary monetary

policies which have been a characteristic of the past two decades. The solution

to the unemployment problem in Europe therefore requires micro-oriented

supply-side policies combined with more expansionary aggregate demand

policies.