Tobin Updated

Over thirty years ago, the late James Tobin gave an address to the American Economic Association in which he offered an explanation for some of the core issues of macroeconomics. The current state of the economy provides an excellent illustration of Tobin's framework.

Think of our economy as having two job markets, one for webmasters and one for home health care assistants. 2-1/2 years ago, we had full employment in both markets, with webmasters making $35 an hour and home health care assistants making $10 an hour.

Next came the collapse of the dotcom bubble, which caused a drop in the demand for webmasters. Eventually, for equilibrium to be restored, the ratio of the webmaster wage to the home health care wage has to fall and on the margin some webmasters have to change careers to become home health care workers.

The fundamental problem of macroeconomics is how this transition takes place. In a zero-inflation environment, the webmaster wage must fall and the home health care wage must rise. In a deflation environment, both wages must fall, with the webmaster wage falling more. In an inflation environment, both wages may rise, with the health care wage rising faster, although in real (inflation-adjusted) terms, the wages of webmasters will fall.

What Tobin argued is that the the relative wage adjustment will occur most quickly in an inflationary environment. He said that it is difficult to reduce nominal wages, so that in a zero-inflation or deflationary environment wages will be sticky in the short term, leading to unemployment. Webmaster wages will remain above their market-clearing level, and unemployed webmasters will remain unemployed hoping to get jobs at those unrealistic wages, rather than taking pay cuts or changing careers.

Discussion Question. How does Tobin's model fit in with the current controversy over whether the Fed should be trying to reduce interest rates?