1. Lecture 15: Unemployment and the Business Cycle L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.9 25 February 2010

2. Introduction Last time: – Expanded model to incorporate supply of capital over the business cycle to match data Today – Try to explain unemployment within the model – Develop a model of job separation and job search

3. Why is this a Problem? Equilibrium Business Cycle model has no unemployment – If labour market clears than labour supply = labour demand – No-one who wants to work is without a job – All unemployment is voluntary – if people wanted to work at the going wage they could

4. Explanations for Unemployment To explain unemployment, some appeal to excess supply of labour – i.e. labour demand falls in recessions but wages are somehow held above equilibrium – Minimum wages, Union bargaining, Wage Contracts More modern theories appeal to search and matching, which we develop today

5. Basics of the Model Workers looking for jobs dont immediately find a job which pays their MPL=w/P – Search around looking for the best offer possible – Searching is much more easily done while unemployed – Income while unemployed is some minimum paid by the government, ω – Job offers taken from some distribution of possible wages above ω

6. Distribution of w/P Small chance of getting a high-paid job, more likely get a job close to workers MPL – So when job offer comes along, have to make a decision – Do you take the offer and forego the chance of a better offer? – Certainly will not take any offer below ω (unemployment benefit) paid by government

7. Reservation Wage Will take a job at some reservation wage (w/P) depending on preferences – Certainly wont take any job paying below ω – Have to make a judgement about what offer would be taken – This decision results in the individual deciding on their reservation wage

8. Dynamics and the Labour Force Data shows that the labour force is very steady over the cycle – So patterns in employment and unemployment not caused by changes in labour force – Instead, caused by job-separations: workers leave current job to find another / firms find workers have MPL less than anticipated – And by job-findings: workers find an acceptable wage offer above reservation wage and take job

9. Model Setup So growth of employment depends on : Critical issue is determinants of σ and – Do these vary over the business cycle? growth in employment = (job finding rate x no. people unemployed) - (job separation rate x no. people employed)

10. Equilibrium Unemployment Employment is unchanged when Denote overall labour force F U/F is natural unemployment rate, denoted by u n

11. Factors affecting u n Variation in explained by factors which shift either job-separation of job-finding rate – Unemployment insurance: which lowers job- finding rate – Search technology (e.g. internet) which raises job- finding rate – Generally, job-finding rate more likely to change compared with job-separation rate

12. Fluctuations and Employment Positive technology shock raises prospective MPL of workers – Increases recruitment by firms – For a given ω, increases likelihood of worker taking an advertised position – So job-finding rate increases and u n falls. – Converse is true when negative shocks lower MPL, job-finding rate falls and u n rises.

13. Advertising and Unemployment If this is true, should find greater job- advertising when unemployment is low – Firms demand for workers reflected in more job- adverts – More jobs ease ability of workers to find a good matching job – Unemployment rate falls – Known as the Beveridge Curve

14. Recap Why does unemployment rise in recessions – Because lower MPL reduces wage offers and advertising by firms – Lower wage offer reduces likelihood that workers will take jobs (for a given ω) – Job-finding rate falls, so natural unemployment rate increases – So unemployment is counter-cyclical: high when output is falling, and vice-versa

15. Summary Unemployment is possible, and counter- cyclical in the modified model – Arises because of friction in the labour market between rate at which individuals separate from jobs and find new jobs – Data suggests this is a plausible model Next time: introduce a new topic, money, and consider role of money in our economy