and price inflation. The modification of the traditional AS-AD model that we shall
introduce thus treats expectations in a hybrid way, myopic perfect foresight of the current
rates of wage and price inflation on the one hand and an adaptive updating of an
economic climate expression with exponential or other weighting scheme on the other
hand.
We assume two Phillips Curves or PC’s in the place of only one. In this way we can
discuss wage and price dynamics separately from each other, in their structural forms,
both based on their own measure of demand pressure, namely Vl — Vl, Vc — Vc, in
the market for labor and for goods, respectively. We here denote by Vl the rate of
employment on the labor market and by Vl the NAIRU-Ievelof this rate, and similarly by
Vc the rate of capacity utilization of the capital stock and Vc the normal rate of capacity
utilization of firms. These demand pressure influences on wage and price dynamics, or on
the formation of wage and price inflation, w,p, are here both augmented by a weighted
average of cost-pressure terms based on forward looking myopic perfect foresight and a
backward looking measure of the prevailing inflationary climate, symbolized by πm. Cost
pressure perceived by workers is a weighted average of the currently evolving rate of price
inflation p and a medium-run concept of price inflation, πm, the inflationary climate in
which the economy is operating, which is based on past observations. Similarly, cost
pressure perceived by firms is given by a weighted average of the currently evolving
(perfectly foreseen) rate of wage inflation w and again the measure of the inflationary
climate in which the current state of the economy is embedded.
We thereby arrive at the following two Phillips Curves for wage and price inflation,
which in this core version of Keynesian AS-AD dynamics are - qualitatively seen - still
formulated in a fairly symmetric way.5 We stress that we have included forward-looking
behavior here, without the (later) need for the jump variable technique of the rational
expectations school.
Structural form of the wage-price dynamics:
w = βw 1 ( V l — V l ) — βw 2 ( ω — ωo ) + κw p) +(1 — κw ) πm,
p = βp 1 ( Vc — Vc ) + βp 2 ( ω — ωo ) + KpW + (1 — Kp ) πm.
Inflationary expectations over the medium run, πm, i.e., the inflationary climate in which
current inflation is operating, may be adaptively following the actual rate of inflation
(by use of some linear or exponential weighting scheme), may be based on a rolling
sample (with hump-shaped weighting schemes), or on other possibilities for updating
expectations. For simplicity of the exposition we shall make use of the conventional
theoretical expression of an adaptive expectations mechanism:
5 With respect to empirical estimation we could also consider the role of labor productivity growth,
which we here assume to be zero to ease the presentation of the model. This role is found to be of second
order only in the empirical estimates of the considered wage and price Phillips curves, as far as trend
terms in wage inflation are concerned. And with respect to the distinction between real wages, unit
wage costs and the wage share we shall detrend the corresponding time series such that the following
types of PC’s can still be applied. empirically, we therefore concentrate on the cyclical features of the
model by the formulation of the structural equations of the model and the choice of detrended time
series.