ECON 442:ECONOMIC THEORY II (MACRO) Lecture 7: W/C 13 ...€¦ · 3/19/2017 1 ECON 442:ECONOMIC THEORY II (MACRO) Lecture 7: W/C 13 March 2017 Medium Run I Labour Market and Aggregate

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ECON 442:ECONOMIC THEORY II (MACRO) Lecture 7: W/C 13 March 2017

Medium Run ILabour Market and Aggregate Supply

Dr Ebo Turkson

The Labor Market

Chapter 7

MEDIUM RUN I

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Chapter 7 OutlineThe Labor Market

7-1 A Tour of the Labor Market

7-2 Movements in Unemployment

7-3 Wage Determination

7-4 Price Determination

7-5 The Natural Rate of Unemployment

7-6 Where We Go from Here

APPENDIX Wage- and Price-Setting Relations versus Labor Supply and Labor Demand

The Medium Run

• In the short run, demand determines the level of output • The supply (output) adjusts to demand => AS flat

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Medium Run (Cont.)• In the medium run both AD and AS depend on the general price

level and thus AS is upward sloping

Medium Run (Cont.)• As we shall see though output will return to its natural level.

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Medium Run (Cont.)

• At natural level we would then be transitioning to the long run where we can increase the YNAT through growth.

The Labour Market (based on Blanchard et al Ch. 7)

• Focus: What determines unemployment rate in the medium run?

• Approach: Study the labour mkt. in isolation.

• Assumptions1. Closed economy -Labour is the only factor of production 2. Firms are price setters (monopolist) -CRS technology3. The wage is bargained between firms and workers, or is

unilaterally set by firms 4. The labour force is fixed

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The Labor Market

• We have focused on the short run by assuming a constant price level in the IS-LM model.

• We now turn to the medium run and explore how prices and wages adjust over time, and how this in turn affects output.

• The labor market is the center of that sequence of events.

Medium Run (Cont.)

• Why is the AS upward Sloping in the Medium Run?

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• The working population are the number of people potentially available for employment.

• The labour force is the sum of those either working or looking for work.

• Those who are neither working nor looking for work are out of the labour force.

• The participation rate is the ratio of the labour force to the working population.

• The unemployment rate is the ratio of the unemployed to the labour force.

7-1 A Tour of the Labour Market

The Large Flows of Workers

An unemployment rate may reflect two very different realities.

It may reflect an active labour market, with many separations

and many hires, or it may reflect a sclerotic labour market, with

few separations, few hires and a stagnant unemployment pool.

The Ghana Statistical Service (GSS) produces employment

data, including the movements of workers.

7-1 A Tour of the Labour Market (Continued)

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7-1 A Tour of the Labor MarketFigure 7-1 Population, Labor Force, Employment, and Unemployment in the United States (in millions), 2014

• The unemployment rate is the ratio of the unemployed to the labor force, was 9.5/155.9 = 6.1%.

TOTAL POPULATION

24,658,823

WORKING POPULATION

15,208,425

LABOUR FORCE

10,876,470

EMPLOYED

10,243,476

UNEMPLOYED

632,994

OUT OF LABOUR FORCE

4,389,142

NON-WORKING POPULATION

9,450,398

• The unemployment rate is the ratio of the unemployed to the labor force, was 5.8%.

• Employed was 94.2%

Population, Labor Force, Employment, and Unemployment in Ghana, 2010

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Figure 7.6 Average flows between employment, unemployment and non-participation in a hypothetical country


From the employment data we conclude that:

• The flows of workers in and out of employment are large because of

Quits and layoffs, which come from changes in employment levels

across firms.

• The flows in and out of unemployment are large in relation to the number

of unemployed. The average duration of unemployment is the length

of time (months) people spend unemployed.

• Discouraged workers are classified as “out of the labour force” but they

may take a job if they find it. The non-employment rate is the ratio of

population minus employment to population.



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7-2 Movements in Unemployment

• When unemployment is high, workers are worse off in two ways:

• Employed workers face a higher probability of losing their job.

• Unemployed workers face a lower probability of finding a job; or they can expect to remain unemployed for a longer time.


• Collective bargaining is bargaining between firms and unions.

-At the firm level

- Industry level

- National level

• Unilaterally fixed by Firms

• Bilateral bargaining between firms and workers

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Common forces at work in the determination of wages include:

1. Workers are typically paid a wage that exceeds their

reservation wage, the wage that would make them indifferent

between working or being unemployed.

2. Wages typically depend on labour market conditions. The

lower the unemployment rate, the higher the wages.

How much bargaining power a worker has depends on two factors.

1. How costly it would be for the firm to replace him—the nature of the

job (Skilled vrs. Unskilled)

2. How hard it would be for him to find another job—labour market

conditions.

Bargaining

7-2 Wage Determination (Continued)

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Wages, Prices and Unemployment

The aggregate nominal wage, W, depends on

three factors:

• The expected price level, Pe

• The unemployment rate, u

• A catchall variable, z, that stands for all other variables that may affect the

outcome of wage setting.

W P F u ze ( , )( , )


Both workers and firms care about real wages (W/P), not nominal

wages (W).

• Workers do not care about how many dollars they receive

but about how many goods they can buy with those dollars. They

care about Real Wage (W/P).

• Firms do not care about the nominal wages they pay but about the

nominal wages, W, they pay relative to the price of the goods they

sell, P. They also care about W/P.

The Expected Price Level



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Also affecting the aggregate wage is the unemployment rate, u.

If we think of wages as being determined by bargaining, then;

• Higher unemployment weakens workers’ bargaining power,

forcing them to accept lower wages.

• Higher unemployment allows firms to pay lower wages and still

keep workers willing to work.

The Unemployment Rate



The third variable, z, is a catchall variable that stands for all the

factors that affect wages, given the expected price level and the

unemployment rate.

Unemployment insurance is the payment of unemployment

benefits to workers who lose their jobs.

Minimum wages

Job protection laws and regulations

The Other Factors- “catchall”



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7-3 Price Determination

• The production function is the relation between the inputs used in production and the quantity of output produced.

• Assuming that firms produce goods using only labour, the production function can be written as:

Y AN

Y = outputN = employmentA = labour productivity, or output per worker

Further, assuming that one worker produces one unit of output—so that A = 1 CRS, then, the production function becomes:

Y N

7-3 Price Determination (Continued)

Firms (monopolies) set their price according to:

P W ( )1

The term is the markup of the price over the cost of production.

If all markets were perfectly competitive, = 0, and P = W.

We can think of the mark-up as depending on the degree of

competition in the product market.

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7-4 The Natural Rate of Unemployment

• In this section we will look at the implications of wage and price determination for unemployment.

• Let’s assume that nominal wages depend on the actual

price level, P, rather than on the expected price level, .

eP

• Wage setting and price setting determine the equilibrium rate of unemployment.

Since Pe equals P, then:

W PF u z ( , )

We can divide both sides by the price level:

This relation between the real wage and the rate of unemployment—wage-setting relation.

The Wage-Setting Relation

W

PF u z ( , )

( , )

7-4 The Natural Rate of Unemployment (Continued)

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The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting.

The Wage-Setting Relation

Figure 7.12 Wages, prices and the natural rate of unemployment


The price-determination equation is:

P W ( )1

If we divide both sides by W, we get:

P

W ( )1

To state this equation in terms of the wage rate, we invert both sides:

W

P

1

1( )The price-setting relation

The Price-Setting Relation


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• The price-setting relation in equation (7.6) is drawn as the horizontal line PS (for price setting) in Figure 7.6.

• The real wage implied by price setting is1/(1 = µ); it does not depend on the unemployment rate.

The Price-Setting Relation


Eliminating W/P from the wage-setting and the price-setting relations, we can obtain the equilibrium unemployment rate, or natural rate of unemployment, un:

The equilibrium unemployment rate (un) is called the natural

rate of unemployment.

F u zn( , )

1

1

Equilibrium Real Wages and Unemployment


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The positions of the wage-setting and price-setting curves, and thus the equilibrium unemployment rate, depend on both z and μ.

• At a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay.

• By letting firms increase their prices given the wage, less stringent enforcement of antitrust legislation leads to a decrease in the real wage.

Equilibrium real wages and unemployment



Figure 7.13 Unemployment benefits and the natural rate of unemployment


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Figure 7.14 Mark-ups and the natural rate of unemploymentAn increase in mark-ups decreases the real wage and leads to an increase inthe natural rate of unemployment.

Because the equilibrium rate of unemployment reflects the structure of the economy, a better name for the natural rate of unemployment is the structural rate of unemployment.



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Associated with the natural rate of unemployment is a natural level of employment.

uU

L

L N

L

N

L

1

Employment in terms of the labour force and the unemployment rate equals:

N L u ( )1

The natural level of employment, Nn, is given by:

N L un n ( )1


From Unemployment to Employment

Associated with the natural level of employment is the natural level of output, and since (Y=N):

Y N L un n n ( )1

The natural level of output satisfies the following:

In words, the natural level of output is such that, at the associated rate of unemployment,

the real wage chosen in wage setting is equal to the real wage implied by price setting.

uY

Ln

n 1

,

From Employment to Output


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7-6 Where We Go from Here• We have assumed that the price level is equal to the expected price level.

• In the short run, the price level may well turn out to be different from what is expected when nominal wages are set, so that unemployment is not necessarily equal to the natural rate or output equal to its natural level.

• Because expectations are unlikely to be systematically wrong, in the medium run, output tends to return to its natural level.

• The next chapter will relax the assumption that the price level is equal to the expected price level.

8-1 Aggregate Supply

• The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices.

• Recall the equations for wage and price determination from Chapter 7:

W P F u ze ( , )

P W ( )1

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8-1 Aggregate Supply (Continued)

Step 1: Eliminate the nominal wage from:

W P F u ze ( , ) P W ( )1 and

then

In words, the price level depends on the expected price level and the unemployment rate. We assume that and z are constant.

P P F u ze ( ) ( , )1

Step 2: Express the unemployment rate in terms of output:

uU

L

L N

L

N

L

Y

L

1 1

Therefore, for a given labour force, the higher the output, the lower is the unemployment rate.


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Step 3: Replacing the unemployment rate in the equation obtained in step one gives us the aggregate supply relation:

In words, the price level depends on the expected price level, Pe, and the level of output, Y (and also , z, and L, but we take those as constant here).

P P FY

Lze

( ) ,1 1


The AS relation has two important properties:

An increase in output leads to an increase in the price level. This is the result of four steps:

1. .

2. .

3. .

4. .

Y N

N u

u W

W P


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The second property of the AS relation is that:

An increase in the expected price level leads, one-for-one, to an increase in the actual price level. This effect works through wages:

1. If wage setters expect the price level to be higher, they set a higher nominal wage.

2. The increase in the nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level.

P We

W P


Figure 8.1 The aggregate supply curveGiven the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level


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The AS curve has three properties that will prove useful in the

following ways:

• The AS curve is upward-sloping. Y P.

• The AS curve goes through point A, where Y = Yn and P = Pe.

• An increase in the expected price level, Pe, shifts the AS curve

up. Conversely, a decrease in the expected price level shifts

the aggregate supply curve down.


Figure 8.2 The effect of an increase in the expected price level on the aggregate supply curveAn increase in the expected price level shifts the aggregate supply curve up


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Let’s summarize:

I. Starting from wage determination and price determination in the labour market, we have derived the aggregate supply relation.

II. This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the aggregate supply curve.

III. Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down.


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ECON 442:ECONOMIC THEORY II (MACRO) Lecture 7: W/C 13 ...€¦ · 3/19/2017 1 ECON 442:ECONOMIC THEORY II (MACRO) Lecture 7: W/C 13 March 2017 Medium Run I Labour Market and Aggregate