1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 14 Chapter The Labor Market, Unemployment, and Inflation

2. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 49 Chapter Outline 14 The Labor Market, Unemployment, and Inflation 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 GDP, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU) Looking Ahead

3. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 49 THE LABOR MARKET: BASIC CONCEPTS unemployment rate The number of people unemployed as a percentage of the labor force. The labor force (LF) is the number of employed plus unemployed: LF = E + U Unemployment rate = U/LF

4. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 49 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.

5. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 49 THE LABOR MARKET: BASIC CONCEPTS cyclical unemployment The increase in unemployment that occurs during recessions and depressions. Employment tends to fall when aggregate output falls and to rise when aggregate output rises. A decline in the demand for labor does not necessarily mean that unemployment will rise.

6. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 49 THE CLASSICAL VIEW OF THE LABOR MARKET FIGURE 14.1 The Classical Labor Market

7. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 49 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.

8. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 49 THE CLASSICAL VIEW OF THE LABOR MARKET labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate.

10. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 49 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.

11. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 49 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.

12. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 49 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT STICKY WAGES sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. FIGURE 14.2 Sticky Wages

13. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 49 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT 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.

16. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 49 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT 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.

17. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 49 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT 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. EFFICIENCY WAGE THEORY

18. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 49 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT 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. IMPERFECT INFORMATION

21. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 49 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.

22. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 49 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.

23. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 49 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT AN OPEN QUESTION The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment.

25. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises. In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related

26. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.3 The Aggregate Supply Curve This curve represents the positive relationship between Y and the overall price level (P).

27. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.4 The Relationship Between the Price Level and the Unemployment Rate There is a negative relationship between the unemployment rate and the price level. As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the overall price level rises more and more, as shown in Figure 14.4.

28. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.5 The Phillips Curve

29. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 49 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. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 49 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.

31. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION inflation rate The percentage change in the price level. Phillips Curve A graph showing the relationship between the inflation rate and the unemployment rate.

32. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION THE PHILLIPS CURVE: A HISTORICAL PERSPECTIVE FIGURE 14.6 Unemployment and Inflation, 1960–1969

33. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 49 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.

34. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 49 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.

35. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.7 Unemployment and Inflation, 1970—2004

36. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply AGGREGATE SUPPLY AND AGGREGATE DEMAND ANALYSIS AND THE PHILLIPS CURVE

37. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 49 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.

38. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 49 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.

39. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 49 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.9 The Price of Imports, 1960 I–2005 II The Role of Import Prices

40. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 40 of 49 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.

41. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 41 of 49 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.

42. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 42 of 49 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.

43. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 43 of 49 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 much more than simply choosing a point along a nice, smooth curve.

44. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 44 of 49 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, AND THE NATURAL RATE OF UNEMPLOYMENT FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment

45. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 45 of 49 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, 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.

46. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 46 of 49 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, AND THE NATURAL RATE OF UNEMPLOYMENT NAIRU The nonaccelerating inflation rate of unemployment. THE NONACCELERATING INFLATION RATE OF UNEMPLOYMENT (NAIRU) FIGURE 14.11 The Long-Run Phillips Curve: The Natural Rate of Unemployment

47. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 47 of 49 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.

48. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 48 of 49 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.

49. CHAPTER 14: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 49 of 49 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