CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 47 PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 47

14 PART III THE CORE OF MACROECONOMIC THEORY © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster The Labor Market In the Macroeconomy Fernando & Yvonn Quijano Prepared by:

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4 of The Labor Market: Basic ConceptsThe Classical View of the Labor MarketThe Classical Labor Market and the Aggregate Supply Curve The Unemployment Rate and the Classical ViewExplaining the Existence of UnemploymentSticky WagesEfficiency Wage TheoryImperfect InformationMinimum Wage LawsAn Open QuestionThe Short-Run Relationship Between theUnemployment Rate and InflationThe Phillips Curve: A Historical PerspectiveAggregate Supply and Aggregate Demand Analysis and the Phillips Curve Expectations and the Phillips CurveIs There a Short-Run Trade-Off between Inflation and Unemployment? The Long-Run Aggregate Supply Curve,Potential Output, and the Natural Rate ofUnemploymentThe Nonaccelerating Inflation Rate of Unemployment (NAIRU) Looking Ahead CHAPTER OUTLINE The Labor Market In the Macroeconomy 14 PART III THE CORE OF MACROECONOMIC THEORY

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 5 of 47 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 6 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 7 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 of 47 The Classical View of the Labor Market 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 10 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 11 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 13 of 47 Explaining the Existence of Unemployment Sticky Wages 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 14 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 15 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 16 of 47 Explaining the Existence of Unemployment Sticky Wages social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. Social, or Implicit, Contracts 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 17 of 47 Explaining the Existence of Unemployment Sticky Wages explicit contracts Employment contracts that stipulate workers’ wages, usually for a period of 1 to 3 years. Explicit Contracts 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 18 of 47 Explaining the Existence of Unemployment Sticky Wages Explicit Contracts Graduate SchoolApplications inRecessions Graduate School Offers Relief During Economic Recession Oklahoma Daily (U. Oklahoma)

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 19 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 20 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 21 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 22 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 23 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 24 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 25 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 26 of 47 The Short-Run Relationship Between the Unemployment Rate and Inflation The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).  FIGURE 14.3 The Aggregate Supply Curve In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 27 of 47 The Short-Run Relationship Between the Unemployment Rate and Inflation 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 28 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 29 of 47 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 30 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 31 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 32 of 47 The Short-Run Relationship Between the Unemployment Rate and Inflation 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 Phillips Curve: A Historical Perspective

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 33 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 34 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 35 of 47 The Short-Run Relationship Between the Unemployment Rate and Inflation From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.  FIGURE 14.7 Unemployment and Inflation, 1970–2007 The Phillips Curve: A Historical Perspective

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 36 of 47 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 37 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 38 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 39 of 47 The Short-Run Relationship Between the Unemployment Rate and Inflation Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve  FIGURE 14.9 The Price of Imports, 1960 I–2007 IV The Role of Import Prices

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 40 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 41 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 42 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 43 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 44 of 47 The Long-Run Aggregate Supply Curve, Potential Output, and 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.  FIGURE The Long-Run Phillips Curve: The Natural Rate of Unemployment

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 45 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 46 of 47 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. 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

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 47 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 48 of 47 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.

CHAPTER 14 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 49 of 47 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 REVIEW TERMS AND CONCEPTS NAIRU natural rate of unemployment Phillips Curve relative-wage explanation of unemployment social, or implicit, contracts sticky wages structural unemployment unemployment rate