The Labour Market & the Macro-economy The Macro-Economics of European Economies MSc in Economic Policy Studies John FitzGerald, February 2015

Course Outline 1.How does an economy work? JF The genesis of macroeconomics AM Modern macroeconomics AM Banks and financial markets AM The recent crisis AM The labour market JF Fiscal Policy and forecasting JF Trade JF The economics of global warming JF The future of the Irish economy AM and JF

Outline of Lecture Theory Demographic factors, exogenous in short run Labour Supply Labour Demand Wage Determination, Market Clearing and Unemployment Interaction with macro-economy Applied - examples covering a range of EU economies Human Capital and the labour market Labour Market Disequilibria in EU economies

Demography and the Labour Market Population N t =N t-1 -D t +B t +M t Where: N=population; D=deaths; B=births; M=immigration Education Affects participation, migration, employability and productivity Working age population Participation rates Affected by economic circumstances Migration Drivers of migration – economic differences and other factors

Demography and the economy

The Role of Education Rising educational attainment – differs by country and by age Affects productivity which, in turn: Affects wage rates – in perfect competition labour paid the marginal product Affects participation because higher wages v costs of working Affects employability and numbers unemployed

Labour supply L=f(W, N, M, UR, welfare, unions, T) Where: W=wage rate; UR= unemployment rate; T= other factors, e.g. culture Migration = f(UR, UR w, W, W w, T) Where subscript w signifies the rest of the world Sensitive to wage rates in Ireland – much less sensitive elsewhere Female labour supply= f(demographics, education, W, costs, culture) Fairly elastic – sensitive to wage rates Male labour supply= f(demographics, education, W, costs, culture) Fairly inelastic – what is inelastic? Shape of labour supply curve? How elastic – what is elastic?

Elastic Labour Supply DLDLDLDL S1LS1LS1LS1L W L W1W1W1W1 L2L2L2L2 Wage Rates Employment

Inelastic Labour Supply DLDLDLDL S1LS1LS1LS1L W L W1W1W1W1 L2L2L2L2 Wage Rates Employment

Totally Inelastic Labour Supply DLDLDLDL S1LS1LS1LS1L W L W1W1W1W1 L2L2L2L2 Wage Rates Employment

Skilled v Unskilled Two kinds of labour: skilled (high education) & unskilled (low education) Are they substitutable? Unskilled labour may be less employable While the skilled labour market may clear the unskilled may not Focus on: Educational attainment of labour force Returns to education Migration – skilled or unskilled? Different effects

Labour Demand L=f(Q,W,P k,P m,T) Where L=employment; Q=output; W= wage rate; P k =price of capital; P m =price of materials and other inputs; T=technical progress Firms choose the mix of inputs (labour etc.) so as to minimise the cost of producing a given output Q Q=f(Q w,c,c w,T) Where c= unit cost of production; subscript w signifies the rest of the world World output is located based on the cost of production in different countries Hence wage rates affect employment through two channels 1.Substitution of capital and materials for labour and vice versa 2.Substitution of foreign for domestic output and vice versa Shape of Labour demand curve? How elastic?

Market Clearing: Wage Rates Market clearing? How can there be unemployment? Speed of adjustment Structural unemployment Hysteresis Bargaining Philips curve The tax wedge Minimum wages Efficiency wages

Speed of adjustment Employers may be slow to adjust employment Want to hold on to firm specific skills – e.g. Germany Costs of hiring and firing Labour laws – if hire may not be able to fire Employees slow to adjust reservation wage Expectations Don’t have requisite skills Problems with nominal wage cuts v real wage cuts Market wage < welfare etc. Result: market may remain out of equilibrium for a long time

Structural Unemployment Where skills of the unemployed don’t match needs of employers Where labour market laws may interfere with market clearing Reasons for laws may mean that some unemployment is acceptable? Hysteresis. A shock to the system shakes out labour that may not be re-employed in a recovery – e.g. because of skills mismatch Move from a full employment equilibrium to an unemployment equilibrium Policy Options? Measures to increase demand? Measures to reduce / transform supply?

Bargaining One “model” of the labour market: Employees bargain in terms of after tax wages Employers take the wage and set employment Bargaining power of employees may be affected by Legislation Unions Insiders v Outsiders

Philips Curve Wage rates (or the level of wages) may be affected by unemployment With high unemployment employees anxious to hold jobs More willing to take a pay cut or not to look for an increase With high unemployment more competition for jobs May result in wage rates lower than would otherwise be the case With low unemployment labour is scarce and employers have to pay more If unemployment affects wage inflation At what level of unemployment is the effect on wage inflation zero? If higher unemployment – then real wage rates will tend to fall, leading to higher employment and lower unemployment Similarly if unemployment below this level wages will tend to rise affect unemployment The non-accelerating wage rate of inflation (NAWRU) is the stable equilibrium Explains why market clears at a significant rate of unemployment What happens if infinite labour supply? No Philips curve

Wage Rates The tax wedge: Employers pay W*(1+t e ); Employees get W*(1-t p ) Where t e =employers taxes (rate) and t p =employees taxes (rate) The higher the tax wedge the bigger the difference between the 2 wage rates Who pays the taxes on labour – where is the incidence? Depends on the shape of the labour supply and demand curves

Tax incidence: affected by labour supply & demand Impose a tax on labour of W1-W3. Labour bargains in terms of after tax wages Labour supply moves from S1 to S2 Labour demand downward sloping Employment falls from L2 to L1 Wage rates rise from W1 to W2 – that share of the tax is paid by employer The part of the tax W2-W3 is paid by the employee The flatter – more elastic – labour supply the bigger the share of the tax is paid by employers – increasing the employment effect Partnership in Ireland 1987 – trade off tax cuts for wage moderation This reflected the behaviour of the market with an elastic labour supply Other countries – labour supply less elastic because limited migration

Elastic Labour Supply DLDLDLDL S1LS1LS1LS1L W L W1W1W1W1 L2L2L2L2 Wage Rates Employment

Elastic Labour Supply DLDLDLDL S1LS1LS1LS1L W L W1W1W1W1 L1L1L1L1 W2W2W2W2 L2L2L2L2 Wage Rates Employment S2LS2LS2LS2L W3W3W3W3

Replacement Rate or Minimum Wage Sets a floor on wage rates Does it lead to unemployment? Consider the distribution of wage rates If there are many at the bottom of the distribution …. If there are few at the bottom of the distribution …. Social considerations: Higher pay – welfare gain, less welfare payments; offset by lost employment? Protection of the weak e.g. immigrants

Unskilled Labour S1LS1LS1LS1L U L2L2L2L2 DLDLDLDL L1L1L1L1 S=W L W Wage Rates Employment L3L3L3L3

Efficiency Wage Employers do not know the productivity of a new hire Pay a premium to ensure that they get the best High pay may affect morale and productivity of workers Result: may pay more than market clearing wage rate

Labour Market and the Macro-Economy Demand for goods and, hence, labour determined in goods market Wage rate feeds back into prices, competitiveness etc. Employment, unemployment and wage rates affects public finances Tax revenue Welfare payments Cost of goods and services

Examples Education and skills How does education affect labour supply? Productivity, participation, employability Examples of Labour market adjustments Finland – Crisis 1990 Germany – Unification 1990 and Labour market reforms 2004 Ireland, Spain, Portugal – 25 years of labour market adjustment Migration: example of Ireland Labour market policies

Education – cohort of

Education – cohort of

Education – cohort of

Returns to education: lower secondary relative to upper secondary

Returns to education: tertiary relative to upper secondary MenWomen 2000/12011/22000/12011/2 Belgium Chile Denmark Estonia Germany Ireland Portugal Spain United Kingdom United States EU21 average

Investment in Human Capital, 2010

Examples of Labour Market Adjustment Finland – Crisis 1990 Germany – Unification 1990 and Labour market reforms 2004 Ireland, Spain, Portugal – 25 years of labour market adjustment Migration: example of Ireland

Finland – Unemployment Rate

Finland – Unemployment Rate by Education

Finnish wage rates relative to EU 15

Germany – Unemployment Rate

Germany – Unemployment Rate by Education

German wage rates relative to EU15

Labour market adjustment: Ireland, Spain Portugal Ireland – post 1980s crisis slow to fall Hysteresis post 1990 why? Today? Spain – pre-crisis – very high, though had been falling Labour market rigidities? Today? Portugal – appears fairly flexible – till the crisis Today?

Unemployment Rate

Ireland: unemployment rate by education

Spain: unemployment rate by education

Portugal: unemployment rate by education

Wage rates relative to EU15

Migration Driven by: Potential earnings differentials Employment opportunities Cultural factors Differences between labour markets – inflows and outflows Impact of migration on: Receiving labour markets Origin labour markets

Ireland v UK, Wage Rates

Ireland: Net emigration, % of population

Unemployment: Implications for Policy? Largely a national responsibility However a European fiscal policy would have helped in the crisis How to make European labour markets work Europe v US Supply side measures Education and training Activation etc. Demand side measures Costs of employment Flexibility

AMECO Database Many annual variables for EU economies, US, Japan etc. Don’t assume that the data are always right! Where available, runs from Includes EU forecasts to 2016 Be careful that 2014 onwards are EU forecasts! Two approaches to accessing it: 1.Online: 2.Excel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheet House prices from BIS datatbase: Online:

Other Data Used in this Lecture Eurostat Labour Force Survey OECD Economic Outlook CSO

Presentations 1.The origins and resolution of the current crisis in Estonia, Bulgaria, and Greece (20 th February) What were the origins? How is it resolving? Look at disequilibria in markets 2.The origins and resolution of the current crisis in Latvia, Portugal, and Italy (20 th February) What were the origins? How is it resolving? Look at disequilibria in markets 3.The crisis in Scandinavia (Finland, Sweden, Denmark) (6 th March) What were the origins? How was it resolved? Look at disequilibria in markets

Reading for this lecture Basic text: Blanchard etc. Probably more theory than you need, but provides the basics Chapters 7 and 9 The rest of the reading discusses real economic situations. The objective is to evaluate whether labour markets are out of equilibrium and if so why? How are they adjusting or how have they adjusted? What are the problems? In addition to previous reading policy-responses.pdf policy-responses.pdf On Spain On labour market reforms

Reading for this lecture As mentioned previously: FitzGerald, J., 2013 “Financial crisis, economic adjustment and a return to growth in the EU”, Revue de l’OFCE - Debates and policies, No.127 pp Look at one or two of these publications for the EU and its component economies IMF World Economic Outlook, October OECD Economic Outlook, November 2014, macroeconomic-situation.pdfhttp:// macroeconomic-situation.pdf National Institute Economic Review, November 2014, European Commission: European Economic Forecast, Winter See for surveys of individual countries. They don’t do Bulgaria and Latviahttp://