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Midterm logistics Midterm: Next Wednesday, Oct 10, 11:35-12:50. Closed book, no electronic anything. Room for midterm is Davies Auditorium. Coverage: through labor (not investment). Gradation of questions from easy to hard. Three parts. Last year’s will be posted (but different coverage, so just for structure). Review sessions: - Special sections by TFs TBA - Omnibus sessions 6-9 on Mon and Tues pm; room WLH

Macro theory of unemployment 3 IS-MP Y Potential output = AF(K,L) Y pot u

Some key empirical regularities of the labor market Okun’s Law: unemployment moves inversely with Y Beveridge Curve: Unemployment moves inversely with vacancy rate (later) Phillips Curve: Inflation moves inversely with unemployment 4

Unemployment driven by changes in output 5 Δu = (8/16)(Δ %gap) = ½ (Δ%gap)

6 The Current Population Survey (CPS) Source of data for monthly unemployment, employment, labor force data. Overview of the survey 60,000 households surveyed monthly “scientifically selected to represent the civilian non-institutional population” provides estimates of employment, unemployment, earnings, hours of work, and other indicators Definitions: Employed = worked for pay or absent from job for cause Unemployed = not working plus actively looking for work Labor force = E + U For further information, see

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10 Alternative Measures of Unemployment (corrected)

Unemployment by age 11

Why is there unemployment? Is it indeed a central flaw in modern capitalism? 12

How do labor markets function? This is a major issue in modern macro Alternative mechanisms for balancing supply and demand: -Auctions (financial markets, stock markets, …) -Firms post prices or wages (union contracts, Yale tuition, …) -Buyers and sellers bargain (houses, baseball players,…) 13

How do wages respond to a glut of workers? 14 Wages tend to display “nominal stickiness” and “downward rigidity.”

Flexible oil prices v. sticky wages 15

16 The Issue of Wage-Price Flexibility The single most important issue in labor and inflation theory revolves around the question of the flexibility of wages and prices. This in turn mainly concerns the flexibility of wages Major historical developments: 1. Nominal wage change became much less volatile. 2. Nominal wages became downwardly rigid.

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18 Distribution of wage increases (nominal, percent year over year)

19 Why are wages rigid?* 1.Rise of unionization and worker representation 2.Rise of multi-year nominal contracts 3.Social norms against nominal wage reductions 4.Money illusion on nominal wage reductions From an microeconomic point of view, wages are sticky because it is costly for employers to adjust them rapidly (“menu costs” in “New Keynesian macroeconomics”) The result is a fundamentally different macroeconomic dynamics from a flexible-wage-price economy! * Warning: This is very controversial area in macro.

20 Why is there unemployment? Market-clearing (auction-Walrasian): not really relevant Wages move to clear supply and demand Workers would be on supply curves; unemployment would be “voluntary” Non-market-clearing (non-Walrasian): Wages are determined in a decentralized manner: In modern search theories, workers search and “matching” with firms, but can have unemployment and vacancies when matching is not perfect. (Discussed today) In other case, firms have wage structure (say union bargain). Firms determine employment (are on their demand schedules), and workers may be off curves and jobs rationed.

Why are so many people unemployed at the same time that there are a large number of job openings? How can economic policy affect unemployment? … On many markets, buyers and sellers do not always make contact with one another immediately. This concerns, for example, employers who are looking for employees and workers who are trying to find jobs. Since the search process requires time and resources, it creates frictions in the market. On such search markets, the demands of some buyers will not be met, while some sellers cannot sell as much as they would wish. Simultaneously, there are both job vacancies and unemployment on the labor market. [From Nobel citation.] 21

22 Search Models of the Labor Market Search models: Unemployment arises from “search” and “labor market frictions” (Mortensen-Pissarides model is standard) Heterogeneous firms and workers are like molecules, bouncing around looking for jobs or workers. When they meet, and if there is surplus*, they match and bargain for a wage. Have job creation and destruction by economic forces This leads to equilibrium “frictional” unemployment and vacancies depending on various parameters. This generates a “Beveridge curve” over the cycle. A change in the structure may shift the Beveridge curve out or in. But search models have not yet been successful in predicting the cyclical pattern of wages and employment changes. *I.e., potential net gains from trade.

23 Vacancy = Unemployment = Match =

Basics of search models of labor market [From Nobel reading on reading list.] Labor force, L Unemployment = uL Vacancies = vL φ = exogenous rate of job destruction Labor market “tightness” = θ = v/u = slope of Beveridge curve Unemployed workers find jobs at rate of α = α(θ), α'(θ) > 0 Firms fill vacancies at rate q = q(θ), q' (θ) < 0 In steady state, job creation (αuL) equals job destruction (φ(1-u)L). Steady state unemployment when flows are in equilibrium: (1) 24

Derivation of Beveridge curve (1) which yields a negative relationship between u and v. 25

Search model continued Steady state unemployment when flows are in equilibrium: (1) Notes: Eq (1) shows the (u,v) pairs that are consistent with the search equilibrium and is the Beveridge curve. We need another equation to close the system. The other equation might be aggregate demand or productivity. Changes in φ or α will shift the Beveridge curve. Note that if the matching function deteriorates, then the Beveridge curve shifts out. 26

27 Note the shift from 1960s to 1980s. Probably due to increase in structural change. Source: FRBSF Economic Letter, ; April 21, 2006, Job Matching: Evidence from the Beveridge Curve

How much are the unemployed searching 28 Alan B. Krueger and Andreas Mueller, “The Lot of the Unemployed: A Time Use Perspective”. “Min” are minutes per day.

What happens in recessions and booms? In recessions, the rate of job destruction increases. This leads to high u, lower v, and a movement along the Beveridge curve. So far, the models have not matched the dynamics quite right, probably because the wage determination is misspecified. 29 recession boom

30 Bureau of Labor Statistics U.S. Beveridge curve Has the Beveridge curve shifted out in Great Recession? Very worrisome for the level of full employment (NAIRU/natural rate). Is it temporary or permanent?

Final Thoughts on Unemployment Unemployment exists because of frictions in labor markets as people and firms try to find good matches. Unemployment rises in recessions as jobs are destroyed because output rises less rapidly than potential output (for Keynesian reasons) Equilibrium (full employment) unemployment can be affected by labor-market policies that improve matching, searching, skills, and the like … but these will not help in deep recessions where the constraint is inadequate aggregate demand. People are worried today about the impact of the long recession on the level of mismatch. 31