PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

The Labor Market In the Macroeconomy Prepared by: Fernando & Yvonn Quijano

14 11 The Labor Market In the Macroeconomy PART III THE CORE OF MACROECONOMIC THEORY 14 11 CHAPTER OUTLINE The Labor Market: Basic Concepts The Classical View of the Labor Market The Classical Labor Market and the Aggregate Supply Curve The Unemployment Rate and the Classical View Explaining the Existence of Unemployment Sticky Wages Efficiency Wage Theory Imperfect Information Minimum Wage Laws An Open Question The Short-Run Relationship Between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve Expectations and the Phillips Curve Is There a Short-Run Trade-Off between Inflation and Unemployment? The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU) Looking Ahead

Unemployment rate = U/LF 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. Unemployment rate = U/LF

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. 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.

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

The Classical View of the Labor Market  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.

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. 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.

The Classical View of the Labor Market 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 measured unemployment rate may sometimes seem high even though the labor market is working well.

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 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.

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.

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.

Graduate School Applications in Recessions Explaining the Existence of Unemployment Sticky Wages Explicit Contracts Graduate School Applications in Recessions Graduate School Offers Relief During Economic Recession Oklahoma Daily (U. Oklahoma)

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.

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 set wages wrong—wages that do not clear the labor market.

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 The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment.

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.  FIGURE 14.3 The Aggregate Supply Curve The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).

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 economy’s moving closer and closer to capacity output, the price level rises more and more.

The Short-Run Relationship Between the Unemployment Rate and Inflation inflation rate The percentage change in the price level. Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate.

The Short-Run Relationship Between the Unemployment Rate and Inflation  FIGURE 14.5 The Phillips Curve The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

The Short-Run Relationship Between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective  FIGURE 14.6 Unemployment and Inflation, 1960–1969 During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off.

The Short-Run Relationship Between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective  FIGURE 14.7 Unemployment and Inflation, 1970–2007 From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

The Short-Run Relationship Between the Unemployment Rate and Inflation Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve  FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply

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  FIGURE 14.9 The Price of Imports, 1960 I–2007 IV

The Short-Run Relationship Between the Unemployment Rate and Inflation 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. Inflationary expectations shift the Phillips Curve to the right.

The Short-Run Relationship Between the Unemployment Rate and Inflation Is There a Short-Run Trade-Off between Inflation and Unemployment? There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves more than simply choosing a point along a nice smooth curve.

The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment  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 unemployment—that 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.

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.

The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU) NAIRU The nonaccelerating inflation rate of unemployment.  FIGURE 14.11 The NAIRU Diagram 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). 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).

REVIEW TERMS AND CONCEPTS cost-of-living adjustments (COLAs) cyclical unemployment efficient wage theory explicit contracts frictional unemployment inflation rate labor demand curve labor supply curve minimum wage laws NAIRU natural rate of unemployment Phillips Curve relative-wage explanation of unemployment social, or implicit, contracts sticky wages structural unemployment unemployment rate

Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics PART IV FURTHER MACROECONOMICS ISSUES 19 CHAPTER OUTLINE Keynesian Economics Monetarism The Velocity of Money The Quantity Theory of Money Inflation as a Purely Monetary Phenomenon The Keynesian/Monetarist Debate New Classical Macroeconomics The Development of New Classical Macroeconomics Rational Expectations Evaluating Rational-Expectations Theory Real Business Cycle Theory Supply-Side Economics Evaluating Supply-Side Economics Testing Alternative Macroeconomic Models

Keynesian Economics In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy. Two major schools decidedly against government intervention developed: monetarism and new classical economics.

Monetarism The main message of monetarists is that money matters. Monetarism, however, is usually considered to go beyond the notion that money matters.

Monetarism The Velocity of Money velocity of money The number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money. The income velocity of money (V) is the ratio of nominal GDP to the stock of money (M):

Monetarism The Velocity of Money We can expand this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P): Through substitution: or

Monetarism The Velocity of Money quantity theory of money The theory based on the identity M × V ≡ P × Y and the assumption that the velocity of money (V) is constant (or virtually constant).

Monetarism The Quantity Theory of Money The key assumption of the quantity theory of money is that the velocity of money is constant (or virtually constant) over time. If we let V denote the constant value of V, the equation for the quantity theory can be written as follows:

Monetarism The Quantity Theory of Money Testing the Quantity Theory of Money  FIGURE 18.1 The Velocity of Money, 1960 I–2007 IV Velocity has not been constant over the period from 1960 to 2007. There is a long-term trend—velocity has been rising. There are also fluctuations, some of them quite large.

Monetarism Inflation as a Purely Monetary Phenomenon Inflation is always a monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the “strict monetarist” view. Almost all economists agree that sustained inflation is purely a monetary phenomenon. Inflation cannot continue indefinitely without increases in the money supply.

Monetarism The Keynesian/Monetarist Debate Milton Friedman has been the leading spokesman for monetarism over the last few decades. Most monetarists do not advocate an activist monetary policy stabilization. Monetarists advocate a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y). Keynesianism and monetarism are at odds with each other.

New Classical Macroeconomics The challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics. Like monetarism and Keynesianism, this term is vague. No two new classical macroeconomists think exactly alike, and no single model completely represents this school.

New Classical Macroeconomics The Development of New Classical Macroeconomics On the theoretical level, new classical macroeconomists argue that traditional models have assumed that expectations are formed in naive ways. Naive expectations are inconsistent with the assumptions of microeconomics. If people are out to maximize utility and profits, they should form their expectations in a smarter way. New classical theories were an attempt to explain the apparent breakdown in the1970s of the simple inflation-unemployment trade-off predicted by the Phillips Curve.

New Classical Macroeconomics Rational Expectations rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future.

New Classical Macroeconomics Rational Expectations Rational Expectations and Market Clearing If firms have rational expectations and if they set prices and wages on this basis, then, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets.

New Classical Macroeconomics Rational Expectations The Lucas Supply Function Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. price surprise Actual price level minus expected price level.

How Are Expectations Formed? New Classical Macroeconomics Rational Expectations How Are Expectations Formed? The Lucas Supply Function How are expectations in fact formed? Are expectations rational, as some macro- economists believe, reflecting an accurate understanding of how the economy works? Or are they formed in simpler, more mechanical ways? A recent research paper by Ronnie Driver and Richard Windram from the Bank of England sheds some light on this issue.

New Classical Macroeconomics Rational Expectations Policy Implications of the Lucas Supply Function Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

New Classical Macroeconomics Evaluating Rational-Expectations Theory If expectations are not rational, there are likely to be unexploited profit opportunities—most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it required households and firms to know too much. People must know the true model (or at least a good approximation of the true model) to form rational expectations, and this knowledge is a lot to expect.

New Classical Macroeconomics Real Business Cycle Theory real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.

Supply-Side Economics Orthodox macro theory consists of demand-oriented theories that failed to explain the stagflation of the 1970s. Supply-side economists believe that the real problem was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.

Supply-Side Economics The Laffer Curve  FIGURE 18.2 The Laffer Curve The Laffer curve shows that the amount of revenue the government collects is a function of the tax rate. It shows that when tax rates are very high, an increase in the tax rate could cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise.

Supply-Side Economics The Laffer Curve Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate.

Supply-Side Economics Evaluating Supply-Side Economics Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. When households receive a higher after-tax wage, they might have an incentive to work more, but they may also choose to work less.

Testing Alternative Macroeconomic Models Models differ in ways that are hard to standardize. If people have rational expectations, they are using the true model, but there is no way to know what model is in fact the true one. There is only a small amount of data available to test macroeconomic hypotheses—only eight business cycles since 1950.

REVIEW TERMS AND CONCEPTS Laffer Curve Lucas supply function price surprise quantity theory of money rational-expectations hypothesis real business cycle theory velocity of money