Dundee Discussion Papers in Economics 126:Efficiency wages, unemployment and macroeconomic policy

We provide empirical evidence from a number of European countries, which shows that unemployment and output are positively related when unemployment is low and inversely related when unemployment is high. We then construct a stylised macro-model with goods and labour market imperfections to show that the economy can rationally operate at an inefficient equilibrium in the neighbourhood of which the relationship between output and unemployment is positive. Our results suggest that circumstances exist in which market imperfections pose serious obstacles to the smooth working of expansionary and/or stabilization policies whose final aim is to improve welfare. KEYWORDS: Efficiency wages; effort supply; monopolistic competition; multiple equilibria; stability; fiscal multiplie