© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 27 Chapter The Labor Market, Unemployment, and Inflation

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 31 Chapter Outline 27 The Labor Market, Unemployment, and Inflation The Labor Market: Basic Concepts The Classical View of the Labor Market The Classical Labor Market and the Aggregate Supply Curve The Unemployment Rate and the Classical View Explaining the Existence of Unemployment Sticky Wages Efficiency Wage Theory Imperfect Information Minimum Wage Laws An Open Question The Short-Run Relationship Between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve Expectations and the Phillips Curve Is There a Short-Run Trade-Off Between Inflation and Unemployment? The Long-Run Aggregate Supply Curve, Potential GDP, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU) Looking Ahead

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 31 THE LABOR MARKET: BASIC CONCEPTS unemployment rate The number of people unemployed as a percentage of the labor force. The labor force (LF) is the number of employed plus unemployed: LF = E + U Unemployment rate = U/LF

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 31 THE LABOR MARKET: BASIC CONCEPTS frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems. structural unemployment 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.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 31 THE LABOR MARKET: BASIC CONCEPTS cyclical unemployment The increase in unemployment that occurs during recessions and depressions. Employment tends to fall when aggregate output falls and to rise when aggregate output rises. A decline in the demand for labor does not necessarily mean that unemployment will rise.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 31 THE CLASSICAL VIEW OF THE LABOR MARKET FIGURE 14.1 The Classical Labor Market

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 31 THE CLASSICAL VIEW OF THE LABOR MARKET labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 31 THE CLASSICAL VIEW OF THE LABOR MARKET 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. When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 31 THE CLASSICAL VIEW OF THE LABOR MARKET THE UNEMPLOYMENT RATE AND THE CLASSICAL VIEW The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly. The measured unemployment rate may sometimes seem high even though the labor market is working well.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT STICKY WAGES sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. FIGURE 14.2 Sticky Wages

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. Social, or Implicit, Contracts relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT explicit contracts Employment contracts that stipulate workers’ wages, usually for a period of 1 to 3 years. Explicit Contracts cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT efficiency wage theory 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. EFFICIENCY WAGE THEORY

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information. If firms have imperfect or incomplete information, they may set wages wrong—wages that do not clear the labor market. IMPERFECT INFORMATION

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT MINIMUM WAGE LAWS minimum wage laws Laws that set a floor for wage rates—that is, a minimum hourly rate for any kind of labor.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 31 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT AN OPEN QUESTION The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises. In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.3 The Aggregate Supply Curve This curve represents the positive relationship between Y and the overall price level (P).

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.4 The Relationship Between the Price Level and the Unemployment Rate There is a negative relationship between the unemployment rate and the price level. As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the overall price level rises more and more, as shown in Figure 14.4.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.5 The Phillips Curve

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION inflation rate The percentage change in the price level. Phillips Curve A graph showing the relationship between the inflation rate and the unemployment rate.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION THE PHILLIPS CURVE: A HISTORICAL PERSPECTIVE FIGURE 14.6 Unemployment and Inflation, 1960–1969

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.7 Unemployment and Inflation, 1970—2004

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply AGGREGATE SUPPLY AND AGGREGATE DEMAND ANALYSIS AND THE PHILLIPS CURVE

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION FIGURE 14.9 The Price of Imports, 1960 I–2005 II The Role of Import Prices

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION EXPECTATIONS AND THE PHILLIPS CURVE Expectations are self-fulfilling. This means that 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.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 31 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION IS THERE A SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT? There is a short-run trade off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves much more than simply choosing a point along a nice, smooth curve.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 31 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, AND THE NATURAL RATE OF UNEMPLOYMENT FIGURE The Long-Run Phillips Curve: The Natural Rate of Unemployment

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 31 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, AND THE NATURAL RATE OF UNEMPLOYMENT natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment.

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 31 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, AND THE NATURAL RATE OF UNEMPLOYMENT NAIRU The nonaccelerating inflation rate of unemployment. THE NONACCELERATING INFLATION RATE OF UNEMPLOYMENT (NAIRU) FIGURE The Long-Run Phillips Curve: The Natural Rate of Unemployment

CHAPTER 27: The Labor Market, Unemployment, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 31 cost-of-living adjustments (COLAs) cyclical unemployment efficient wage theory explicit contracts frictional unemployment inflation rate labor demand curve labor supply curve minimum wage laws REVIEW TERMS AND CONCEPTS NAIRU natural rate of unemployment Phillips Curve relative-wage explanation of unemployment social, or implicit, contracts sticky wages structural unemployment unemployment rate