Macroeconomics I Lecture 9. October 2, 2007 Robert TCHAIDZE

October 2, 2007 MACROECONOMICS I 2 Unemployment  NAIRU – Non-Accelerating Inflation Rate of Unemployment  Natural rate of unemployment: The average rate of unemployment around which the economy fluctuates.  In a recession, the actual unemployment rate rises above the natural rate.  In a boom, the actual unemployment rate falls below the natural rate.

October 2, 2007MACROECONOMICS I3 Actual and natural rates of unemployment in the U.S., Percent of labor force Unemployment rate Natural rate of unemployment

October 2, 2007 MACROECONOMICS I 4 Simple Model of NRU  L – labor force  E – employed  U – unemployed  s – fraction of employed workers that become separated from their jobs in any given month (rate of job separations)  f – fraction of unemployed workers that find jobs in any given month (rate of job finding)  L, s, f are exogenously given

October 2, 2007 MACROECONOMICS I 5 Steady State (LR equilibrium) Unemployment f U = s E f U = s (L – U) f U / L = s (1 – U / L) U / L = s / (s + f) = 1 / (1 + f/s) To lower NRU, one must affect s or f.

October 2, 2007 MACROECONOMICS I 6 Example:  1% of employed workers lose their jobs (s = 0.01). Average job lasts 100 months or 8 years.  20% of unemployed workers find jobs (f = 0.20). Spell of unemployment lasts 5 months on average.  NRU: U / L = 0.01 / ( ) = ≈ 5%

October 2, 2007 MACROECONOMICS I 7 Why there is unemployment  An implicit assumption: all workers are identical and all jobs are identical.  Two reasons for unemployment (for why f<1): job search and wage rigidity.

October 2, 2007 MACROECONOMICS I 8 Job search & frictional unemployment  Frictional unemployment: caused by the time it takes workers to search for a job.  Occurs even when wages are flexible and there are enough jobs to go around.  Occurs because: –workers have different abilities, preferences –jobs have different skill requirements –geographic mobility of workers not instantaneous –flow of information about vacancies and job candidates is imperfect –sectoral shifts

October 2, 2007 MACROECONOMICS I 9 Sectoral Shifts  Changes in the composition of demand among industries or regions.  Example: Technological change more jobs repairing computers, fewer jobs repairing typewriters  Example: A new international trade agreement labor demand increases in export sectors, decreases in import-competing sectors  Late 1800s: decline of agriculture, increase in manufacturing  Late 1900s: relative decline of manufacturing, increase in service sector  1970s: energy crisis caused a shift in demand away from gas guzzlers toward smaller cars.

October 2, 2007MACROECONOMICS I10 CASE STUDY: Structural change over the long run

October 2, 2007 MACROECONOMICS I 11 Public Policy affecting job search  Employment agencies that disseminate info about job openings to better match workers & jobs.  Public job training programs that help workers displaced from declining industries get skills needed for jobs in growing industries.  Unemployment insurance that pays part of a worker’s former wages for a limited time after losing his/her job.

October 2, 2007 MACROECONOMICS I 12 Unemployment insurance (UI)  UI increases search unemployment, because it reduces –the opportunity cost of being unemployed –the urgency of finding work  Studies show that the longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.  Benefit: by allowing workers more time to search, UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes.

October 2, 2007MACROECONOMICS I13 Unemployment from real wage rigidity Labor Real wage Supply Demand Unemployment Rigid real wage Amount of labor willing to work Amount of labor hired If real wage is stuck above its equilibrium level, then there aren’t enough jobs to go around.

October 2, 2007MACROECONOMICS I14 Unemployment from real wage rigidity Then, firms must ration the scarce jobs among workers. Structural unemployment: The unemployment resulting from real wage rigidity and job rationing. If real wage is stuck above its equilibrium level, then there aren’t enough jobs to go around.

October 2, 2007 MACROECONOMICS I 15 Reasons for wage rigidity: Minimum Wage  The minimum wage may exceed the equilibrium wage of unskilled workers, especially teenagers.  Studies: a 10% increase in minimum wage reduces teen unemployment by 1- 3%  But, the minimum wage cannot explain the majority of the natural rate of unemployment, as most workers’ wages are well above the minimum wage.

October 2, 2007 MACROECONOMICS I 16 Reasons for wage rigidity: Labor Unions  Unions exercise monopoly power to secure higher wages for their members.  When the union wage exceeds the equilibrium wage, unemployment results.  Insiders: Employed union workers whose interest is to keep wages high.  Outsiders: Unemployed non-union workers who prefer equilibrium wages, so there would be enough jobs for them.

October 2, 2007 MACROECONOMICS I 17 Reasons for wage rigidity: Efficiency Wages  Firms willingly pay above-equilibrium wages to raise productivity.  Theories in which higher wages increase worker productivity by: –attracting higher quality job applicants –increasing worker effort –reducing turnover, which is costly to firms –improving health of workers (in developing countries)

October 2, 2007 MACROECONOMICS I 18 Caveats  Variations among demographic groups – race, gender, age.  Trends: an increase in 1970s and 1980s with a decline in 1990s –Baby-boom generation born in 50s, entered labor force in 1970s –Sectoral shifts caused by oil price volatility –Productivity decline in 1970s and an increase in 1990s  Europe vs U.S. –Generous benefits –Fall in demand for low skilled workers

October 2, 2007 MACROECONOMICS I 19 Denmark: Flexicurity  Flexibility + Security  Flexible labor market  Generous unemployment benefits  Active labor market policies  Unemployment much lower than in other European countries  Hidden unemployment?  Very costly. High income taxes

October 2, 2007 MACROECONOMICS I 20 Homework:  Chapter 6, problem 2  Chapter 6, problem 4  Chapter 6, problem 6  Due next Tuesday at 9.00 a.m. Logistics  New website for the course: → M.A. in Economics → Teaching Forum → Macroeconomics  You need password to access some of the materials