26 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business...

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Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Labor Market, Unemployment, and Inflation

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2 of 36© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Labor Market: Basic Concepts

• The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force.

• Cyclical unemployment is the increase in unemployment that occurs during recessions and depressions.

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

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• Structural unemployment is 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.

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The Classical Viewof the Labor Market

• According to classical economists, the quantity of labor demanded and supplied are brought into equilibrium by rising and falling wage rates. There should be no persistent unemployment above the frictional and structural amount.

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

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

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• If labor demand decreases, the equilibrium wage will fall.

• Anyone who wants a job at W1 will have one. There is always full employment in this sense.

• Classical economists believe that the labor market always clears.

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The Classical Labor Marketand 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. This means that the AS curve is vertical.

• When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.

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The Unemployment Rate and the Classical View

• The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly.

• The unemployment rate may sometimes seem high even though the labor market is working well.

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Explaining the Existence of Unemployment

• The fact that people are willing to work at a wage higher than the current wage does not mean that the labor market is not working.

• The term sticky wages refers to the downward rigidity of wages as an explanation for the existence of unemployment.

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• If wages “stick” at W0 rather than fall to the new equilibrium wage of W* following a shift of demand, the result will be unemployment equal toL0 – L1.

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• One explanation for downwardly sticky wages is that firms enter into social, or implicit, contracts. These contracts are unspoken agreements between workers and firms that firms will not cut wages.

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• The relative-wage explanation of unemployment holds that workers are concerned about their wages relative to the wages of other workers in other firms and industries.

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• Explicit contracts are employment contracts that stipulate workers’ wages, usually for a period of one to three years. Wages set in this way do not fluctuate with economic conditions.

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• Cost of living adjustments (COLAs) are 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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• The efficiency wage theory is 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.

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• If firms have imperfect information, they may simply set wages wrong—wages that do not clear the labor market.

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• Minimum wage laws set a floor for wage rates, and explain at least a fraction of unemployment.

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The Short-Run Relationship Between the Unemployment Rate and Inflation

• In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.

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The Short-Run Relationship Between the Unemployment Rate and Inflation

• The relationship between U and P is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more.

• As depicted by this short run AS curve, the relationship between Y and the price level (P) is positive.

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The Phillips Curve

• The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

• The inflation rate is the percentage change in the price level.

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The Phillips Curve

• There is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate.

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The Phillips Curve:A Historical Perspective

• In the 1960s and early 1970s, inflation appeared to respond in a fairly predictable way to changes in the unemployment rate.

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The Phillips Curve:A Historical Perspective

• But in the 1970s and 1980s, the Phillips Curve broke down.

• The points on this figure show no particular relationship between inflation and unemployment.

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Aggregate Supply and AggregateDemand Analysis and the Phillips Curve

• When AS shifts with no shifts in AD, there is a negative relationship between P and Y.

• When AD shifts with no shifts in AS, there is a positive relationship between P and Y.

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Aggregate Supply and AggregateDemand Analysis and the Phillips Curve

• If both AD and AS are shifting, there is no systematic relationship between P and Y and thus no systematic relationship between the unemployment rate and the inflation rate.

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The Role of Import Prices

• The AS curve shifts when input prices change, and input prices are affected by the price of imports.

• There were no large shifts in the AS curve in the 1960s due to changes in the price of imports.

• The price of imports increased considerably in the 1970s. This led to large shifts in the AS curve during the decade.

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The Price of Imports, 1960 I-2003 II

• The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in 1979–1980. Since 1981, the price of imports has changed very little.

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Expectations and the Phillips Curve

• Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation.

• Price expectations that affect wage contracts eventually affect prices themselves.

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Expectations and the Phillips Curve

• Inflationary expectations shift the Phillips curve to the right.

• Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s.

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The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment

• When output is pushed above potential GDP (Y0), there is upward pressure on costs. Rising costs push the short-run AS curve to the left. The quantity supplied will end up back at Y0.

• If the AS curve is vertical in the long run, so is the Phillips Curve.

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The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment

• In the long run, the Phillips Curve corresponds to the natural rate of unemployment.

• The natural rate of unemployment (U*) is the unemployment rate that is consistent with the notion of a fixed long-run output at potential GDP.

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The NAIRU—The Nonaccelerating Inflation Rate of Unemployment

• Many economists believe the relationship between the change in the inflation rate and the unemployment rate is as depicted by the PP curve in this figure.

• Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate).

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The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

• To the left of the NAIRU the price level is accelerating (positive changes in the inflation rate).

• To the right of the NAIRU the price level is decelerating (negative changes in the inflation rate).

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The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

• A favorable shift of the PP curve is to the left because the PP curve crosses zero at a lower unemployment rate.

• A possible recent source of favorable shifts is increased foreign competition, which may have kept both wage costs and other input costs down.

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Review Terms and Concepts

cost-of-living adjustments (COLAs)

cyclical unemploymentcyclical unemployment

efficiency wage theoryefficiency wage theory

explicit contractsexplicit contracts

frictional unemploymentfrictional unemployment

inflation rateinflation rate

labor demand curvelabor demand curve

labor supply curvelabor supply curve

minimum wage lawsminimum wage laws

NAIRUNAIRU

natural rate of unemploymentnatural rate of unemployment

Phillips CurvePhillips Curve

relative-wage explanation of relative-wage explanation of unemploymentunemployment

social, or implicit, contractssocial, or implicit, contracts

sticky wagessticky wages

structural unemploymentstructural unemployment

unemployment rateunemployment rate

26 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business...

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