1. Unemployment Chapter 7

2. 2 Introduction Keynes first challenged the orthodox view that the economic system tends to return quickly to full-employment equilibrium during the Great Depression. We will study a model that incorporates elements from modern unemployment theories into a framework similar to that of the classical theory.

3. 3 Explaining Unemployment Two dimensions: 1.Why there is any unemployment at all? 2.Why does unemployment move in a systematic way with other business cycle variables?

4. 4 Frictional Unemployment The classical economists recognized that equality of demand and supply in the labor market does not imply the absence of unemployment. Labor turnover  Frictional unemployment

5. 5 Figure 7.1 Flows Through the Labor Market

6. 6 Cyclical Unemployment The increased unemployment that occurs during a recession is called cyclical unemployment. Keynesian : The economy does not respond to shocks as efficiently as it should. ( Nominal Rigidity) We will amend the classical model by allowing firms to choose the wage to describe unemployment as an equilibrium phenomenon.

7. 7 Efficiency Wage Theory Firms choose to pay higher wage than the classical equilibrium wage to minimize the turnover costs. Three strands: 1.High wage may ensure the productivity of its workers. 2.Higher wages will attract high-quality applicants. 3.Firms use the wage as a device to minimize turnover costs.

8. 8 The New-Keynesian Theory The firm explicitly recognizes its pool of workers as a stock and any given stock of workers can be associated with fast or slow labor turnover. The firm minimizes the costs of maintaining a stock of employed workers by adjusting the real wage.

9. 9 The New-Keynesian Theory The stock of workers sent to the labor market by households is called the labor force. -Increasing function to the real wage. The stock of workers employed by the firm is called employment. - Decreasing function of real wage.

10. 10 Figure 7.2 The New-Keynesian Model of the Labor Market

11. 11 Turnover Cost and Efficiency Wage In the new-Keynesian model, the firm must devote resources to the search process. The firm chooses its wage to minimize its wage bill: -The wage paid to each worker. -The cost of recruiting new workers, C(w/P, L).

12. 12 Turnover Cost and Efficiency Wage We study a special case of a turnover cost function: In this case, turnover costs are proportional to the number of workers and the firm’s problem can be broken into two part: 1.Choose the efficiency wage to minimize cost per-worker. 2.Given the efficiency wage, choose L to maximize profit.

13. 13 Firm’s Problem

14. 14 Choosing the Efficiency Wage Marginal cost (1) = Marginal benefit (c’(w/P) )

15. 15 The New-Keynesian Model of the Firm Panel A

16. 16 Choosing a Stock of Workers Marginal Product = Marginal Cost

17. 17 The New-Keynesian Model of the Firm Panel B

18. 18 ©2002 South-Western College Publishing Figure 7.4 Demand and Supply in the New- Keynesian Model of the Labor Market

19. 19 A Mathematical Example Production Function: Per-worker turnover cost: Labor supply: 

20. 20 Unemployment and Economic Policy Two approaches: 1.Policies designed to control the natural rate are called structural policy and unemployment that results from poorly designed labor- market institutions is called structural unemployment. 2.The second deals with the control of cyclical unemployment as it fluctuates over the business cycle. (Chapter 8)

21. 21 ©2002 South-Western College Publishing Table 7.1

22. 22 Unemployment and Economic Policy Possible reason: Low-skill labor and labor market rigidity. Some economists have advocated reforms to make labor markets more flexible.

23. 23 Homework Question 1, 8, 10, 11

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