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

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

4. 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

5. 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

6. 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.

7. 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.

8. The Classical View of the Labor Market
 FIGURE 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.

9. 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.

10. 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.

11. Explaining the Existence of Unemployment
Sticky Wages
sticky wages The downward rigidity of wages as an explanation for the existence of unemployment.
 FIGURE 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.

12. 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.

13. 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.

14. 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)

15. 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.

16. 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.

17. 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.

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

19. The Short-Run Relationship Between the Unemployment Rate and Inflation
 FIGURE 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.

20. 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.

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

22. The Short-Run Relationship Between the Unemployment Rate and Inflation
The Phillips Curve: A Historical Perspective
 FIGURE 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.

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

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

25. 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 The Price of Imports, 1960 I–2007 IV

26. 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.

27. 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.

28. The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment
 FIGURE 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.

29. 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.

30. 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 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).

31. 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

32. 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

33. 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.

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

35. 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):

36. 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

37. 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).

38. 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:

39. 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 There is a long-term trend—velocity has been rising. There are also fluctuations, some of them quite large.

40. 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.

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. 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.

50. 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.

51. 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.

52. 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.

53. 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.

54. 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.

55. 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.

56. 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