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Chapter 6 of Macroeconomics,
Olivier Blanchard and David R. Johnson
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How the labour market conditions that involve unemployment
rates and different policies can affect the wage bargainingpowers of employees/workers and firms.
The wage setting and price setting.
Why natural unemployment occurs where the wage setting
and price setting equate.
How different policies or events can affect the natural
unemployment rate.
How we can use the wage setting and price setting to derive
(graphically) the labour supply and labour demand respectively
How we can derive the Short run Aggregate Supply curve fromthe algebras.
Short Run, Medium Run and Long Run
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The noninstitutional civilian population (NIP) are the
number of people potentially available for civilian employment.
The civilian labor force (LF) is the sum of those either working
or looking for work. Those who are neither working nor looking
for work are out of the labor force.
The participation rate is the ratio of the labor force to the
noninstitutional civilian population. (= LF/NIP)
The unemployment rate (u) is the ratio of the unemployed to
the labor force.
Seperations refer to movements from being employed to
being unemployed or being out of labour force.
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Popu lation, Labo r Force,
Employment, and
Unemploym ent in the
United States (in
m il l ions ), 2010
Figure 6 - 1
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The Large Flows of Workers
An unemployment rate may reflect two very differentrealities.
It may reflect an active labor market, with many
separations and many hires, or it may reflect asclerotic labor market, with few separations, few
hires, and a stagnant unemployment pool.
The Current Population Survey (CPS) producesemployment data, including the movements of
workers.
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The Large Flows of Workers
(1) The flows of workers in and
out of employment are large.
(2) The flows in and out of
unemployment are large
relative to the number of
unemployed. (3) There are also
large flows in and out of the
labor force, much of it directly
to and from employment.
Average Monthly Flow s
between Employment,
Unemploym ent, and
Nonpart ic ipat ion in the
Unit ed States, 1994 to
2011 (mill ion s)
Figure 6 - 2
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Since 1948, the average
yearly U.S. unemployment
rate has fluctuated between
3% and 10%.
Movements in the U.S.
Unemployment Rate
Sin ce 1948-2010
Figure 6 - 3
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How fluctuations in the aggregate unemployment rate
affect individual workers is important because the
answer determines two effects:
The effect of movements in the aggregateunemployment rate on the welfare of individual
workers
The effect of the aggregate unemployment rate on
wages
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During recessions, there are labor marketadjustments. There are implications for both
employed and unemployed workers:
If the adjustment takes place through fewer hires,the chance that an unemployed worker will find a
job diminishes. Equivalently, they can expect to
remain unemployed for a longer time.
If the adjustment takes place instead through
higher layoffs, then employed workers are at a
greater risk of losing their jobs.
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When unemployment is
high, the proportion ofunemployed finding jobs is
low. Note that the scale on
the right is an inverse scale.
The Unemploym ent Rate
and the Propo rt ion of
Unemployed Finding
Jobs, 19942010
Figure 6 - 4
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When unemployment is high, a
higher proportion of workers lose
their jobs.
The Unemploym ent Rate
and the MonthlySeparat ion Rate from
Emplo yment, 19942010
Figure 6 - 5
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Collective bargaining is bargaining between firms
and unions.Common forces at work in the determination of
wages include:
Workers are typically paid a wage that exceedstheir reservation wage, the wage that would
make them indifferent between working or being
unemployed.
Wages typically depend on labor market
conditions. The lower the unemployment rate,
the higher the wages.
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How much bargaining power a worker has depends ontwo factors.
How costly it would be for the firm to replace him
the nature of the job.
How hard it would be for him to find another job
labor market conditions.
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Economists call the theories that link theproductivityor
the efficiencyof workers to the wage they are paid
efficiency wage theories.
These theories also suggest that wages depend on both
the nature of the job and on labor-market conditions:
Firms that see employee morale and commitment as
essential to the quality of their work, will pay more than
firms in sectors where workers activities are moreroutine.
Labor market conditions will affect the wage.
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Wage
determination
High
unemployment
FIRM
Anything/Policiesin favour of
workers
Z
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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 W/P.
Firms do not care about the nominal wages they pay but
about the nominal wages, W, they pay relative to the price ofthe goods they sell, P. They also care about W/P.
How real wage is related to employm ent out look
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As we see in the slide 17, there are two factors that
affect the real wage (W/P) that the workers request
for:
Unemployment rate: If we think of wages as beingdetermined 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.
All factors or policies that give higher bargaining power to
the workers (eg. unemployment benefits).
How real wage is related to employment out look
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To capture the effects of the two factors on the real wage,we can assume the following relationship.
( , )
= , (1)
This equation tells us of the workers behaviour (i.e. their
real wage request in response to the labour market
conditions that involve unemployment rate, u and the
catchall variable, z).
How real wage is related to employment out look
Therefore, if the people know u, z andprice level P, they
would request for nominal wage equal to W (as shown in
(1) )
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RealWage,W
/P
WS
Unemployment Rate, u
Real wage & unemploym ent
=
This red graph is drawn to
show that the real wagerequested by the workers is
negatively related to the
unemployment rate.
Intuition: as theunemployment rate goes up,
the bargaining power of the
workers falls; so they are
willing to accept lower real
wage.
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Suppose that the economy is at where u = . Suppose alsothat the corresponding real wage that the workers request is
equal to .
However, the workers cannot possibly know the price level of
the whole economy (reasonable assumption?).
So, they have to form expectation of price level, Pe . Then
hypothetically, they could form this thinking process: With
this unemployment rate, and this catchall variable z, and our
expectation that the price would be Pe, we want to have a
nominal income, W, so that our expected real wage is W/Pe
(which is equal to = )
Previous g raph explained
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That is, at a given state of the economy whereunemployment rate is equal to u, catchall variable is equal
to z and if the expected p rice level is equal to Pe , the
workers would request for (or accept) W as nominal wage.
Note: a catchall variable, z, that stands for all othervariables that may affect, in favor of the workers, the
outcome of wage setting, given the expected price level
and the unemployment rate.
Then at a given u and z, we have:
= , = , (2)
( , )
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Y= output
N = employment
A = labor productivity, or output per worker
Further, assuming that one worker produces one unitof outputso thatA = 1, then, the production
function becomes:
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 labor, theproduction function can be written as:
=
=
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Marginal productivity of labour = MPL
One unit of labour
produces A units of
goods
Nominalmarginal cost of labour= W; so the nominal
marginal cost, which is the cost of producing one unit of
goods is:
= = 1
= / =
26
One unit of labour costs $W; one unit of labour can
produce A units of goodsCost of producing one unit of
goods = W/A
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Suppose that the firm has some market power suchthat it can set the price above the marginal cost:
Where m is the markup of price over the nominal
marginal cost
If all markets were perfectly competitive, m = 0, and
P = W.
= 1 +
= 1 +
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This relation between the real wage and the
rate of unemploymentwage-setting relation.
W
PF u z ( , )
( , )
Recall that we have the equation (1):
This equation illustrates the workers behaviour in
response to the labour market conditions
captured in u an z.
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The price-determination equation is:
If we divide both sides by W, we get:
To state this equation in terms of the wage rate,
we invert both sides:
The price-setting
relation
= 1 +
= 1 +
=
1
1 +
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RealWage,
W/
P
A PS
WS
un Unemployment Rate, u
At equilibrium, where two
curves meet, we have
unemployment rate =
natural unemployment rate
The natural rate of
unemployment is
the unemployment
rate such that the
real wage chosen
in wage setting isequal to the real
wage implied by
price setting.
Wages , Pric es,
and the Natural
Rate of
Unemployment
Figure 6 - 6
Graph 1
1
1 +
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Medium-run equilibrium:
Medium run is when Pe = P. This is because when the
expected price is equal to the actual price, there is no longer
a need to adjust the expectation. (We will explain more in
detail in next lecture)
Pe = P happens when WS meets PS. (why?)
We can also manipulate to get:
So un here is affected by A, z and m.
, =
1 + =
1
1 +
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RealWa
ge,
W/P
A PS
WS
un Unemployment Rate, u
=
1
1 +
=
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The positions of the wage-setting and price-setting curves,
and thus the medium run equilibrium unemployment rate,
depend on both z and m.
At a given unemployment rate, higher unemployment
benefits lead to a higher real wage. A higherunemployment rate is needed to bring the real wage back
to what firms are willing to pay. (Graph 2)
By letting firms increase their prices given the wage, lessstringent enforcement of antitrust legislation leads to a
decrease in the real wage. (Graph 3a-3b)
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RealWage,
W/
P
1
1+m( )
A PS
WS
un Unemployment Rate, u
Example: Unemployment benefits ,
causing WS to shift up higher un.
This is because? : Prospect of
unemployment is less painful (whohas more bargaining power?)
A
un
IF z
WS
B
Graph 2
Unemploym ent Benef i ts
and th e Natural Rate of
Unemployment
Figure 6 - 7
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Higher z higher bargaining power for workers for the
same u, workers demand for higher real wage. So WS shifts
up. If the unemployment rate is still at un, the workers would
demand higher real wage (point B)
But the firms are not willing because it does not correspond
to their price setting
Thus, firms would respond not by not hiring those who insist
on higher nominal wage. These workers are willing to wait for
better job (because it is less costly to wait now)
which causes higher unemployment.
The economy will be at point A where natural rate of
unemployment is higher.
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RealWage,
W/P
A PS
WS
un Unemployment Rate, u
Graph 3a
Markups and the Natural
Rate of Unemp loyment
Figure 6 - 8
Here, the economy is in
medium run equilibrium with
un and we have priceexpectation, Pe to be equal to
the actual price level, P.
=
1
1 +
=
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Re
alWage,
W/P
A PS
WS
un Unemployment Rate, u
Example: less stringent
enforcement of antitrust
legislation, causing PS toshift down
IF m
PS
Graph 3b
Markups and the Natural
Rate of Unemp loyment
Figure 6 - 8
= 1
1 +
=
=
1
1 +
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RealWage,W
/P
A PS
WS
un Unemployment Rate, u
PS
Graph 3c
Markups and the Natural
Rate of Unemp loyment
Figure 6 - 8
=
1
1 +
=
1
1 +
At the moment (in short run), the workers do
not know of price level change. So, they still
maintain the same expectation of price
level. And they still want to provide labour
level where unemployment rate is equal to un
In fact, the price level
has changed. Nominal
wage is still the same 39
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RealWage,
W/P
A PS
WS
un Unemployment Rate, u
A
un
PS
Graph 3d
Markups and the Natural
Rate of Unemp loyment
Figure 6 - 8
=
1
1 +
After some time, the workers realize that the
price has increased. So they update their
expectation of price to match with the new
actual price level. But the unemployment rate
has increased because some workers refuse towork at this real wage level
Pe = P
=
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Now, the price level has gone up because mark-up is
higher In the short run, workers are not aware of the price level
change, they still think the real wage is at point A.
After a while, workers find out that price level has gone
up (this means that now, they know that their realwageis lower).
They then update their price expectation to matchwith the new actual price level set by firms.
With the new expected price level, the real wage issmaller (W/Pe). The response from the workers is thatsome would not choose to work but to wait. So, theunemployment rate goes up.
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Associated with unemployment is employment:
Employment then is:
Natural level of employment Nn is:
=
=
= 1
= (1 )
= (1 )
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RealWage,
W/
P
1
1+m( )
A PS
WS
un Unemployment Rate, u
Graph 4
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RealWage,
W/
P
1
1+m( )
APS
WS
NnEmployment,N
L
N U
Equivalent to
Labour Supply
Equivalent to
Labor demand:
Why is it flat?
Graph 5
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If we have a production function as follows:
where 0 <
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Natural output is associated with natural employmentand thus also with natural unemployment rate:
So, the natural output will satisfy the following:
= = 1 = (1 )
1
, =
1 + 1
, =
1
1 +
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We have the following two relations:
And:
In the short-run, the workers would not know what is the
price level so they form expectation of the price level. Theywould demand the nominal wage, W, according to the price
level that they form in their minds or expectand the
labour market conditions, captured in variables u and z
= (,)
= 1 +
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First Step, we combine two equations:
Second Step:
Definition of
unemployment
rate
Definition of
unemployment
Math
manipulationSpecification
of production
function Y=AN
= 1 + (, )
=
=
= 1
= 1
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So then we have:
We can have:
This is our Short Run Aggregate Supply (simply
call it Aggregate Supply) curve which showsthe relationship between P and Y (P also
depends clearly on Pe and m, A, L and z)
= 1
= 1
= 1 + 1
,
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To draw the AS curve, let us find the special point onthe P-Y plane.
Recall: If P=Pe, then the unemployment rate would be
the natural unemployment rate, un (refer back to slide31). If we have u = un, corresponding output would be
Yn (refer back to slide 49)
Hence, AS will go through a special point, which is(Yn, P
e), on P-Y plane.
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= 1 + 1
,
If Y increases, then 1
, increases. Then, for a
given Pe and m, we should have P to increase.
So the AS curve would be a upward-sloping curve that goes
through the point (Pe
, Yn).
52
Graph 6
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PriceLevel,P
A
AS
Y=Yn Output, Y
When Y=Yn
then
P=Pe
Graph 6
= 1 + 1
,
(Yn, Pe)
=
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Thus, we can say The first property isthat, given the expected price level, an
increase in output leads to an increase in
the price level Rationale: (see graph 6)
Y requires higher employment
u, which leads to W (why?),Which in turn leads to P (why?)
54
Graph 7
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Price
Level,P
A
AS (for a given Pe)
Y=Yn Output, Y
AS (for Pe > Pe)Graph 7
A
=
=
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Also, given unemployment, an increase in Pe
leads to one-to-one increase in actual price
level Medium-Run Equilibrium
Rationale: (See graph 7)
Wage setters expected Pe, they push firms for higher
W, causing Labor Cost to rise. Therefore, firms would
push up prices to match the higher labour cost, leading to
higher actualPrice level (P).
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SHORT RUN: Year-to-year movements inoutput are primarily driven by
movements in demand
How Consumption and Investment behavemovements in demand (responsive to
current events)
Consumer confidence and other factors thatleads to Y or
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MEDIUM RUN: Economy tends to returns to the level of output
determined by the supply factors (potential
production, Yn): Productions depend on capital
stock, level of technology (captured in variable A)
and the amount of labor which can potentially be
employed, Nn.
At the medium run, expected price level is equalto actual price level. This is intuitive because when
Pe = P, there is no more adjustment in price or
expectation of price.58
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LONG RUN: When we have technological
progress that increases the variable A. This
will push the Yn higherWe have growth
of potential output.
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Concerns with shocks,
especially demand shocks
with consumptions and
investments
reactionary policies
Economy will settle
down at the potential
or natural state; with Ynand un and P = P
e
Innovations, technological
breakthrough higher
potential, right shift of LRAS,
A
SR MR LR