Finance, Monetary Policy and the Institutional Foundations of the Phillips Curve

Abstract

The purpose of this paper is to examine the influence of financial commitments on the short-run Phillips curve, under different institutional structures of the labour and product market, degrees of euphoria and ratios of firms' to workers' outstanding debt. We develop a Post-Keynesian conflicting-claims model that explicitly incorporates the impact of workers' and firms' financial commitments on distribution conflict and inflation. We propose different versions of the short-run Phillips curve for a debt-financed economy. We explore the impact of monetary policy on the shape and the position of the Phillips curve. We show that the inflation effects of monetary policy cannot be identified without prior knowledge about the institutional and financial structures of the economy, as well as about borrowers' desired margins of safety.

Acknowledgements

The authors wish to thank two anonymous referees for useful comments. Yannis Dafermos gratefully acknowledges the partial financial support from the A.G. Leventis Foundation.

Notes

¹The simple Kaleckian price-setting formula used in this paper, equation (6), implies that workers' and firms' income shares depend solely on the mark-up. Moreover, the mark-up is, for simplicity, set independently of wages (see equations (12) and (13) below). Thus, wages do not explicitly affect income shares in our model. However, it is assumed that workers and firms act as if they were in an environment in which wages affect income shares. Arguably, this is in line with the fact that in real-world economies income shares are a function of wages since changes in the mark-up are not independent of wage growth, and prices do not instantaneously adjust to wage changes. Adopting the aforementioned assumption, workers and firms are portrayed in equation (8) as using wage negotiations to achieve their target income shares.

²For similar arguments in the conventional literature, including some empirical evidence, see Bronars & Deere (1991), Matsa (2010), Monacelli et al. (2011) and Nickell & Nicolitsas (1999).

³Since our model refers to aggregate variables, it is implicitly assumed that workers are postulated with the aggregate burden of debt. Thus, when the aggregate burden of debt becomes higher due to a decline in employment, workers are postulated to pursue a rise in the wage rate to bring the aggregate burden of debt back down to an acceptable level. For an individual worker who has accumulated debt and whose employment status is adversely affected by this decline in aggregate employment, a rise in the wage rate is likely to counter the generated deterioration in her financial position when: (a) she had more than one job and keeps working in one of them; (b) she becomes unemployed but belongs to a household in which other members work; or (c) the decline in her employment takes the form of a fall in her working hours. Obviously, a more detailed examination of this issue would require the disaggregation of workers' households into various groups according to their composition and their members' employment status, an investigation that is beyond the scope of this paper.

⁴For some empirical evidence see Barth & Ramey (2001), Chowdhury et al. (2006), Gaiotti & Secchi (2006), Hülsewig et al. (2009), Ravenna & Walsh (2006), Sen & Vaidya (1995) and Tillmann (2008).

⁵Note that the association of firms' burden of debt (and not just of the interest rate) with firms' target profit share and the mark-up is in line with the empirical finding of Barth & Ramey (2001, pp. 229–230), who have documented a positive correlation between the price/wage ratio and the interest expense as a fraction of net sales.

⁶Note that the term captures the impact of demand on wages via the influence that it has on the rate of employment and, hence, on workers' bargaining power.

⁷The degree of flexibility depends, inter alia, on the legislation about job protection, the strength of trade unions, the level of minimum wages and the unemployment benefit system.

⁸This may not always be the case, especially when the propensity to consume out of interest income is high and the responsiveness of investment to the interest rate is low (see for example Hein, 2007). However, it is the most likely outcome in a debt-financed economy and it is the scenario that is proposed by the conventional approach to monetary policy (Clarida et al., 1999; Galí & Gertler, 2007; Romer, 2000).