PRINCIPLES OF

MACROECONOMICS
TENTH EDITION

PART III The Core of Macroeconomic Theory

CASE FAIR OSTER

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The Labor Market: Basic Concepts

The labor force (LF) is the number of employed plus unemployed: LF = E + U

unemployment rate The number of people unemployed as a percentage of the labor force.
PART III The Core of Macroeconomic Theory

U unemployment rate LF

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The Labor Market: Basic Concepts

frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.

PART III The Core of Macroeconomic Theory

structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

cyclical unemployment The increase in unemployment that occurs during recessions and depressions.

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The Classical View of the Labor Market

labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate.

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labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate.

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The Classical View of the Labor Market

PART III The Core of Macroeconomic Theory

FIGURE 14.1 The Classical Labor Market

Classical economists believe that the labor market always clears. If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1. Anyone who wants a job at W1 will have one.
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The Classical View of the Labor Market

The Classical Labor Market and the Aggregate Supply Curve The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. In the absence of sticky wages, the AS curve will be vertical. In this case, monetary and fiscal policy will have no effect on real output.
PART III The Core of Macroeconomic Theory

Indeed, in this view, there is no unemployment problem to be solved!

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The Classical View of the Labor Market

The Unemployment Rate and the Classical View Some economists argue that the unemployment rate is not a good measure of whether the labor market is working well. The economy is dynamic and at any given time some industries are expanding and some are contracting. A positive unemployment rate as measured by the government does not necessarily indicate that the labor market is working poorly. The measured unemployment rate may sometimes seem high even though the labor market is working well. Economists who view unemployment this way do not see it as a major problem. There are other views of unemployment, as we will now see.

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Explaining the Existence of Unemployment

Sticky Wages sticky wages The downward rigidity of wages as an explanation for the existence of unemployment.
FIGURE 14.2 Sticky Wages

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If wages stick at W0 instead of falling to the new equilibrium wage of W* following a shift of demand from D0 to D1, the result will be unemployment equal to L0 L1.

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Explaining the Existence of Unemployment

Sticky Wages Social, or Implicit, Contracts

social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages.
relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts.

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Explaining the Existence of Unemployment

Sticky Wages Explicit Contracts

explicit contracts Employment contracts that stipulate workers wages, usually for a period of 1 to 3 years.
cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.

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PART III The Core of Macroeconomic Theory

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Explaining the Existence of Unemployment

Efficiency Wage Theory efficiency wage theory An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate. Among some potential benefits that firms receive from paying workers more than the market-clearing wage are:
PART III The Core of Macroeconomic Theory

Lower turnover. Improved morale. Reduced shirking of work.

Even though the efficiency wage theory predicts some unemployment, the behavior it is describing is unlikely to account for much of the observed large cyclical fluctuations in unemployment over time.

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Explaining the Existence of Unemployment

Imperfect Information Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information. If firms have imperfect or incomplete information, they may simply set wages wrongwages that do not clear the labor market.
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Explaining the Existence of Unemployment

Minimum Wage Laws

minimum wage laws Laws that set a floor for wage rates that is, a minimum hourly rate for any kind of labor.

An Open Question
PART III The Core of Macroeconomic Theory

The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment. Which argument or arguments will win out in the end is an open question.

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The Short-Run Relationship between the Unemployment Rate and Inflation

The unemployment rate (U) and aggregate output (income) (Y) are negatively related: when Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises.
FIGURE 14.3 The Aggregate Supply Curve

The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).

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PART III The Core of Macroeconomic Theory

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The Short-Run Relationship between the Unemployment Rate and Inflation

FIGURE 14.4 The Relationship between the Price Level and the Unemployment Rate

This curve shows a negative relationship between the price level (P) and the unemployment rate (U). As the unemployment rate declines in response to the economys moving closer and closer to capacity output, the price level rises more and more.

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PART III The Core of Macroeconomic Theory

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The Short-Run Relationship between the Unemployment Rate and Inflation

inflation rate The percentage change in the price level.

FIGURE 14.5 The Phillips Curve

The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.
PART III The Core of Macroeconomic Theory

Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate.
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The Short-Run Relationship between the Unemployment Rate and Inflation

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

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FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply

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The Short-Run Relationship between the Unemployment Rate and Inflation

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve The Role of Import Prices

PART III The Core of Macroeconomic Theory

FIGURE 14.9 The Price of Imports, 1960 I2010 I

The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in 1979-1980. Between 1981 and 2002, the price of imports changed very little. It generally rose between 2003 and 2008, with some falloff in 2009.
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The Short-Run Relationship between the Unemployment Rate and Inflation

Expectations and the Phillips Curve If inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. In this case, the Phillips Curve will shift to the right. If inflationary expectations decrease, the Phillips Curve will shift to the left there will be less inflation at any given level of the unemployment rate.
PART III The Core of Macroeconomic Theory

Inflation and Aggregate Demand Inflation is affected by more than just aggregate demand. Where inflation depends on both the unemployment rate and cost variables, there will be no stable Phillips Curve unless the cost variables are not changing.

Therefore, the unemployment rate can have an important effect on inflation even though this will not be evident from a plot of inflation against the unemployment ratethat is, from the Phillips Curve.
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The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment

PART III The Core of Macroeconomic Theory

FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment

If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemploymentthat is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output. U* is the natural rate of unemployment.
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The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment
natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment.

PART III The Core of Macroeconomic Theory

The Nonaccelerating Inflation Rate of Unemployment (NAIRU): the specific level of unemployment that exists in an economy that do not cause inflation to increase NAIRU The nonaccelerating inflation rate of unemployment.

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REVIEW TERMS AND CONCEPTS

cost-of-living adjustments (COLAs) cyclical unemployment efficiency wage theory explicit contracts frictional unemployment
PART III The Core of Macroeconomic Theory

NAIRU natural rate of unemployment Phillips Curve relative-wage explanation of unemployment social, or implicit, contracts sticky wages structural unemployment unemployment rate

inflation rate labor demand curve labor supply curve minimum wage laws

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