CHAPTER 25

The Labor Market,

Unemployment, and Inflation

Prepared by: Fernando

Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Labor Market: Basic Concepts

The unemployment rate is the ratio of the

number of people unemployed to the total
number of people in the labor force.
Frictional unemployment is the portion of
unemployment that is due to the normal
working of the labor market; used to
denote short-run job/skill matching
problems.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Labor Market: Basic Concepts

Structural unemployment is 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 is the increase in
unemployment that occurs during
recessions and depressions. Employment
tends to fall when aggregate output falls
and rise when aggregate output rises.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Classical View of the Labor Market

The view of classical economists was that

if the quantity of labor demanded and the
quantity of labor supplied are brought into
equilibrium by rising and falling wage
rates, there should be no persistent
unemployment above the frictional and
structural amount.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Classical View of the Labor Market

The labor supply

curve illustrates the
amount of labor that
households want to
supply at the particular
wage rate.
The labor demand
curve illustrates the
amount of labor that
firms want to employ
at the particular wage
rate.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Classical View of the Labor Market

Classical economists
believe that the labor
market always clears.
If labor demand
decreases, the
equilibrium wage will
fall. Everyone who
wants a job at W* will
have one. There is
always full employment
in this sense.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.
Therefore, monetary and fiscal policy
cannot affect the level of output and
employment in the economy.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Unemployment Rate and the
Classical View
The unemployment rate as measured by the
government is not necessarily an accurate
indicator of whether the labor market is
working properly.
The unemployment rate may sometimes
seem high even though the labor market is
working well.
The fact that people are willing to work at a
wage higher than the current wage does not
mean that the labor market is not working.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Explaining the Existence
of Unemployment
The term sticky wages refers to the
downward rigidity of wages as an explanation
for the existence of unemployment.
If wages stick at W0
rather than fall to the
new equilibrium wage
of W* following a shift
of demand, the result
will be unemployment
equal to L0 L1.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Explaining the Existence
of Unemployment
One explanation for downwardly
sticky wages is that firms enter into
social, or implicit, contracts.
These contracts are unspoken
agreements between workers and
firms that firms will not cut wages.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Explaining the Existence
of Unemployment
The relative-wage explanation of
unemployment holds that workers
are concerned about their wages
relative to the wages of other
workers in other firms and industries.
They may be unwilling to accept
wage cuts unless they know other
workers are receiving similar cuts.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Explaining the Existence
of Unemployment
Explicit contracts are employment
contracts that stipulate workers
wages, usually for a period of one to
three years. Wages set in this way
do not fluctuate with economic
conditions.
Cost of living adjustments
(COLAs) are contract provisions that
tie wages to changes in the cost of
living. The greater the inflation rate,
the more wages are raised.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Explaining the Existence
of Unemployment
The efficiency wage theory is 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Explaining the Existence
of Unemployment
If firms have imperfect information,
they may simply set wages wrong
wages that do not clear the labor
market.
Minimum wage laws set a floor for
wage rates, and explain at least a
fraction of unemployment.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Short-Run Relationship Between
the Unemployment Rate and Inflation
The unemployment rate (U) and aggregate output
(income) (Y) are negatively related.
The relationship between Y and
the price level (P) is positive, as
depicted by the AS curve.

The relationship between U and P

is negative. As U declines in
response to the economy moving
closer and closer to capacity
output, the overall price level rises
more and more.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Phillips Curve

The Phillips curve shows the relationship between

the inflation rate and the unemployment rate.

2002 Prentice Hall Business Publishing
This macroeconomic
relationship has been
widely studied.
It shows that there is a
trade-off between inflation
and unemployment. To
lower the inflation rate,
we must accept a higher
unemployment rate.
Principles of Economics, 6/e Karl Case, Ray Fair
 The Phillips Curve:
A Historical Perspective
In the 1960s and
early 1970s,
inflation appeared
to respond in a
fairly predictable
way to changes in
the unemployment
rate.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Phillips Curve:
A Historical Perspective
But in the 1970s
and 1980s, the
Phillips Curve broke
down.
The points on this
figure show no
particular
relationship
between inflation
and unemployment.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Aggregate Supply and Aggregate Demand
Analysis and the Phillips Curve

When AS shifts with no When AD shifts with no

shifts in AD, there is a shifts in AS, there is a
negative relationship positive relationship
between P and Y. between P and Y.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Aggregate Supply and Aggregate Demand
Analysis and the Phillips Curve

If both AD and AS are shifting, there is no

systematic relationship between P and Y and thus
no systematic relationship between the
unemployment rate and the inflation rate.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Role of Import Prices

The AS curve shifts when input prices

change, and input prices are affected by
the price of imports. There were no large
shifts in the AS curve in the 1960s due to
changes in the price of imports.
The price of imports increased
considerably in the 1970s. This led to
large shifts in the AS curve during the
decade.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Role of Import Prices

The price of imports changed very little in the 1960s

and early 1970s. It increased substantially in 1974 and
again in 19791980. Since 1981, the price of imports
has changed very little.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Expectations and the Phillips Curve

Expectations are self-fulfilling. 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.
Inflationary expectations were stable in the
1950s and 1960s, but increased in the
1970s.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Long-Run AS curve, Potential GDP, and
the Natural Rate of Unemployment

When output is pushed

above potential GDP (Y0),
there is upward pressure on
costs. Rising costs push
the short-run AS curve to
the left. The quantity
supplied will end up back at
Y0 .
If the AS curve is vertical in
the long run, so is the
Phillips Curve.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Long-Run AS curve, Potential GDP, and
the Natural Rate of Unemployment

In the long run, the Phillips

Curve corresponds to the
natural rate of
unemployment.

The natural rate of

unemployment (U*) is the
unemployment rate that is
consistent with the notion
of a fixed long-run output at
potential GDP.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The NAIRUThe Nonaccelerating
Inflation Rate of Unemployment
Many economists
believe the relationship
between the change in
the inflation rate and
the unemployment rate
is as depicted by the
PP curve in this figure.

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).

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The NAIRUThe 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).

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The NAIRUThe Nonaccelerating
Inflation Rate of Unemployment
A favorable shift of the
PP curve is to the left
because the PP curve
crosses zero at a lower
unemployment rate.
A possible recent source of
favorable shifts is
increased foreign
competition, which may
have kept both wage costs
and other input costs down.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Inflation and Unemployment
Around the World, 1997 to 2000
Inflation and Unemployment Around the World, 1997 to 2000
UNEMPLOYMENT RATE INFLATION RATE
1997 2000 1997 2000
Canada 9.5 6.6 0.3 3.6
Australia 8.8 6.7 0.7 3.6
France 12.5 9.8 1.4 2.5
United Kingdom 5.8 5.7 4.2 6.4
Italy 12.2 10.7 1.5 2.9
United States 4.8 4.1 1.3 4.6
Netherlands 5.8 2.9 3.6 6.2
Sweden 7.8 4.1 0.1 1.4
Germany 11.4 9.1 1.7 1.5
Japan 3.5 4.6 5.4 0.8
Sources:
Sources: Economic Indicators, The Economist,
Economist, July 5 11, 1997; July 8 14, 2000. Reprinted by permission.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair