1 of 29 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft CASE FAIR OSTER P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N

2 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall

3 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER OUTLINE 14 The Labor Market in the Macroeconomy 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 Inflation and Aggregate Demand The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU) Looking Ahead

4 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Labor Market: Basic Concepts

5 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Labor Market: Basic Concepts

6 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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

7 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Classical economists believe that the labor market always clears. If the demand for labor shifts from D 0 to D 1, the equilibrium wage will fall from W 0 to W 1. Anyone who wants a job at W 1 will have one.  FIGURE 14.1 The Classical Labor Market The Classical View of the Labor Market

8 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The classical view of the unemployment market is consistent with the following idea: a.The wage rate adjusts to equate the quantity of labor demanded with the quantity of labor supplied; therefore, persistent unemployment above the frictional and structural amount is unlikely. b.If the wage rate in the labor market is too low, people will work for themselves. c.The amount of labor that a firm hires depends on the value of the output that workers produce. d. All of the above.

9 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The classical view of the unemployment market is consistent with the following idea: a.The wage rate adjusts to equate the quantity of labor demanded with the quantity of labor supplied; therefore, persistent unemployment above the frictional and structural amount is unlikely. b.If the wage rate in the labor market is too low, people will work for themselves. c.The amount of labor that a firm hires depends on the value of the output that workers produce. d. All of the above.

10 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Indeed, in this view, there is no unemployment problem to be solved! The Classical View of the Labor Market The Classical Labor Market and the Aggregate Supply Curve

11 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Classical View of the Labor Market The Unemployment Rate and the Classical View

12 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. If wages “stick” at W 0 instead of falling to the new equilibrium wage of W* following a shift of demand from D 0 to D 1, the result will be unemployment equal to L 0 − L 1.  FIGURE 14.2 Sticky Wages Explaining the Existence of Unemployment Sticky Wages

13 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the graph below. The meaning of “sticky wages” in this graph refers to: a.The decrease in the equilibrium wage that results after the decrease in demand. b.The failure of the wage rate to fall after the decrease in demand. c.The tendency for the wage rate to rise above W0 after the decrease in demand. d.The decrease in unemployment that results after the decrease in demand.

14 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the graph below. The meaning of “sticky wages” in this graph refers to: a.The decrease in the equilibrium wage that results after the decrease in demand. b.The failure of the wage rate to fall after the decrease in demand. c.The tendency for the wage rate to rise above W0 after the decrease in demand. d.The decrease in unemployment that results after the decrease in demand.

15 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Social, or Implicit, Contracts

16 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Explaining the Existence of Unemployment Sticky Wages Explicit Contracts

17 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Efficiency Wage Theory Among some potential benefits that firms receive from paying workers more than the market-clearing wage are:  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.

18 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The efficiency wage is among the theories of unemployment that explain why: a.Firms tend to pay wages above the wage at which the quantity of labor demanded equals the quantity supplied. b.Firms tend to pay wages below the wage at which the quantity of labor demanded equals the quantity supplied. c.Firms prefer to pay the wage at which quantity supplied equals quantity demanded in the labor market. d.There is only one level of the wage rate at which quantity supplied equals quantity demanded, called the efficiency wage rate.

19 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The efficiency wage is among the theories of unemployment that explain why: a.Firms tend to pay wages above the wage at which the quantity of labor demanded equals the quantity supplied. b.Firms tend to pay wages below the wage at which the quantity of labor demanded equals the quantity supplied. c.Firms prefer to pay the wage at which quantity supplied equals quantity demanded in the labor market. d.There is only one level of the wage rate at which quantity supplied equals quantity demanded, called the efficiency wage rate.

20 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Does Unemployment Insurance Increase Unemployment or Only Protect the Unemployed? E C O N O M I C S I N P R A C T I C E Long Recession Ignites Debate on Jobless Benefits The Wall Street Journal In the summer of 2010 Congress considered an expansion of the program of unemployment insurance. One of the debates around this program was whether the existence of such programs actually fueled unemployment. There is a considerable debate about the benefit of jobless benefits.

21 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 wrong—wages that do not clear the labor market. Explaining the Existence of Unemployment Imperfect Information

22 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall minimum wage laws Laws that set a floor for wage rates— that is, a minimum hourly rate for any kind of labor. 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. Explaining the Existence of Unemployment Minimum Wage Laws An Open Question

23 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the figure below. What happens in this labor market if the minimum wage (W 0 ) is abolished? a.Unemployment will rise. b.Unemployment will fall. c.The quantity of labor demanded falls. d.The quantity of labor supplied rises.

24 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the figure below. What happens in this labor market if the minimum wage (W 0 ) is abolished? a.Unemployment will rise. b.Unemployment will fall. c.The quantity of labor demanded falls. d.The quantity of labor supplied rises.

25 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).  FIGURE 14.3 The Aggregate Supply Curve 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. The Short-Run Relationship between the Unemployment Rate and Inflation

26 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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.  FIGURE 14.4 The Relationship between the Price Level and the Unemployment Rate The Short-Run Relationship between the Unemployment Rate and Inflation

27 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.  FIGURE 14.5 The Phillips Curve

28 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Which of the following relationships is correct? a.There is a positive relationship between unemployment and output. b.There is a negative relationship between output and the overall price level. c.There is a negative relationship between the unemployment rate and the price level. d.There is a negative relationship between output and employment.

29 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Which of the following relationships is correct? a.There is a positive relationship between unemployment and output. b.There is a negative relationship between output and the overall price level. c.There is a negative relationship between the unemployment rate and the price level. d.There is a negative relationship between output and employment.

30 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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.  FIGURE 14.6 Unemployment and Inflation, 1960–1969 The Short-Run Relationship between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective

31 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Policy discussions in the 1960s concerning the Phillips Curve revolved around the issue of: a.What point to choose along a smooth Phillips Curve. b.What to do about a highly unstable Phillips Curve. c.How to maintain low inflation and at the same time lower the unemployment rate. d.How to maintain low unemployment and at the same time lower the inflation rate.

32 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Policy discussions in the 1960s concerning the Phillips Curve revolved around the issue of: a.What point to choose along a smooth Phillips Curve. b.What to do about a highly unstable Phillips Curve. c.How to maintain low inflation and at the same time lower the unemployment rate. d.How to maintain low unemployment and at the same time lower the inflation rate.

33 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.  FIGURE 14.7 Unemployment and Inflation, 1970–2009 The Short-Run Relationship between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective

34 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  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

35 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall If there is no systematic relationship between inflation and unemployment, it is because: a.The aggregate demand curve shifts, without a shift in the aggregate supply curve. b.Both the aggregate demand and the aggregate supply curve shift simultaneously. c.Neither the aggregate demand nor the aggregate supply curves shift. d.Government policies have effectively eradicated inflation and unemployment.

36 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall If there is no systematic relationship between inflation and unemployment, it is because: a.The aggregate demand curve shifts, without a shift in the aggregate supply curve. b.Both the aggregate demand and the aggregate supply curve shift simultaneously. c.Neither the aggregate demand nor the aggregate supply curves shift. d.Government policies have effectively eradicated inflation and unemployment.

37 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 14.9 The Price of Imports, 1960 I–2010 I 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 The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in Between 1981 and 2002, the price of imports changed very little. It generally rose between 2003 and 2008, with some falloff in 2009.

38 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Short-Run Relationship between the Unemployment Rate and Inflation Expectations and the Phillips Curve 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 rate—that is, from the Phillips Curve. Inflation and Aggregate Demand

39 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the graph below. The impact of higher inflationary expectations on this Phillips curve is reflected by the move: a.From a to b. b.From a to c. c.From a to d. d. None of the above. Inflationary expectations do not affect the Phillips curve.

40 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the graph below. The impact of higher inflationary expectations on this Phillips curve is reflected by the move: a.From a to b. b.From a to c. c.From a to d. d. None of the above. Inflationary expectations do not affect the Phillips curve.

41 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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.  FIGURE The Long-Run Phillips Curve: The Natural Rate of Unemployment The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment

42 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 NAIRU The nonaccelerating inflation rate of unemployment. The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

43 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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).  FIGURE The NAIRU Diagram The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

44 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the figure below. Which of the following causes a leftward shift in the PP curve? a.A positive change in the rate of inflation. b.A negative change in the rate of inflation. c.An adverse change in input prices. d.A favorable change in input prices.

45 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Refer to the figure below. Which of the following causes a leftward shift in the PP curve? a.A positive change in the rate of inflation. b.A negative change in the rate of inflation. c.An adverse change in input prices. d.A favorable change in input prices.

46 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Looking Ahead This chapter concludes our basic analysis of how the macroeconomy works. In the preceding seven chapters, we have examined how households and firms behave in the three market arenas—the goods market, the money market, and the labor market. We have seen how aggregate output (income), the interest rate, and the price level are determined in the economy, and we have examined the relationship between two of the most important macroeconomic variables, the inflation rate and the unemployment rate. In the next chapter, we use everything we have learned up to this point to examine a number of important policy issues.

47 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall cost-of-living adjustments (COLAs) cyclical unemployment efficiency 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 R E V I E W T E R M S A N D C O N C E P T S