Global insights from local research

Wanting to understand the problem of persistent unemployment was the inspiration for groundbreaking research by Ian McDonald from the Faculty of Business and Economics at the University of Melbourne. A study published from that research has been examined with interest across the world, and is recognised as one of a handful of studies that created the highly influential field of new Keynesian economics.

But the author of the most cited social science article in the history of the University of Melbourne never planned to be an academic.

Professor McDonald, who joined the Faculty of Business and Economics in 1974, says it was only when he got to university and found a world of ideas and people interested in ideas that he knew he was where he wanted to be. “I also found I had an aptitude for economics,” he says.

For thirty-eight years he has been teaching and researching at the University of Melbourne, making a sizeable imprint in the field of macroeconomics.

Throughout his career Professor McDonald’s main research interest has been seeking to understand why unemployment and inequality happen, and what policy-makers can do about those problems. In the 1970s the topic of the causes of unemployment came to the fore as the rate of unemployment in most industrialised economies increased rapidly to two or three times the level of the 1950s and 1960s.

Professor McDonald was unsatisfied with what was at that time the conventional theory for unemployment, espoused by Milton Friedman and Edmund Phelps, which attributed fluctuations in the rate of unemployment to workers making mistakes about the rate of inflation. According to the Friedman-Phelps theory, in any country there was a unique equilibrium rate of unemployment to which the economy would always tend. Short-term fluctuations to lower or higher rates of unemployment would only happen when workers mistakenly believed that their real wages were higher or lower than was really the case. Professor McDonald saw this theory as unable to explain the reality of unemployment.

“In my view, this ‘mistakes’ theory of unemployment had little to do with the occurrence of high unemployment in the real world. Most notably, the persistence of very high unemployment in the 1930s was a clear affront to the mistakes theory. It is implausible that so many people could be mistaken for such a long period of time,” he says.

Instead, Professor McDonald thought that rigidity in wages was a more likely explanation for the large increases in unemployment that had happened in the 1970s. His research taking this approach soon developed into a collaboration with Nobel prize winning American economist, Professor Robert Solow. Together they would produce a paper that has gone on to become the most cited social science paper in the history of the University of Melbourne. This paper ‘Wage bargaining and employment’ was published in the American Economic Review in 1981. It has been ISI (Institute for Scientific Information) cited 495 times and reprinted in seven international volumes of collected papers on economics.

The paper demonstrates how wage rigidity can happen through the process of bargaining by a trade union and a firm over employment conditions for workers, and how this implies that increases and decreases in aggregate demand will then translate purely into fluctuations in the rate of unemployment.

Professor Jeff Borland, a student at the time and now a colleague of Professor McDonald in the Department of Economics, says the paper was a huge achievement.

“Every year in economics there are probably only two or three research papers published that would have the impact of Ian and Robert Solow’s article,” he says. “It is such an important paper because it provided a new way of understanding and responding to the problem of high unemployment. But also, it was one of a group of papers that initiated a whole new approach to Keynesian macro-economics. Its legacy is enormous.”

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