Download natural rate of unemployment

The medium term I
The labor market
From the Short to the Medium
Run
How is the unemployement rate
determined in the Medium Run?
The Short Run: The IS-LM model
• The economy responds increasing production to match demand.
• A higher production increases employment
• Higher employment usually reduces unemployment
• So far we assume that all prices remain constant (except the interest
rate)
• That makes sense when the economy has spare production capacity and
only in the short term.
The Medium Run: Prices, Wages and Employment
•
Production increases employment.
•
When employment increases (usually) unemployment is reduced.
•
A lower unemployment rate push wages up
•
Higher wages mean a higher production cost and higher prices of final goods and
services.
•
Higher prices reduce wage purchasing power and lead workers to ask for higher
nominal wages
•
Different from the IS-LM model: in the medium run, prices and wages do not
remain stable when output grows or decreases.
Introduction III: Objective of this unit
Understanding how is the unemployment rate
determined in the medium run.
In the medium run, unemployment rate tends to return
to the so called natural rate. This rate is determined by
equilibrium in the labor market when the expected
price level equals the actual price level.
Conditional on price level expectations, equilibrium in
the labor market occurs when:
•
•
The real wage –implied by wage setting behaviour (influenced by the
relative bargaining power of workers and firms)equals the real wage implied by price setting behavior (influenced by the
degree of competition in the goods market).
Intruduction IV: Labor market
What is it? The place where the main productive factor (labor) is traded
in exchange of a wage.
The conventional labor supply and demand competitive model is not
realistic:
1. Wages are set by a bargain proces between workers and firms
2. Firms do not take prices as given; they have the ability to fix them, given their
costs (imperfect competition or oligopoly)
3. Unemployment is not voluntary but involuntary
In this model we develop an alternative model which uses wage and
price curves, instead of supply and demand curves
Introduction V: Labor market theory
• Wage curve and price curve interaction determines employment and
unemployment levels (usually called “natural” or “equilibrium” rates) and
also prices and wages.
• From these levels we can establish a relation between production and
prices level, which we will name aggregate supply curve; we will use it
to complete the IS-LM model studied before.
Labor market
We use to pay attention in labor market analysis
to total population situation relative to
employment; this is usually the main source
of income for families.
However, in some countries (such as Spain or
Italy), there is a relevant percentage of
workers who work by themselves. Does it
have sense to speak about wage or
employment of any of this workers?
Labor market II: the groups
• Total population of a country is the total amount of people who live in a
country at a given time, usually the first or the last the of a year.
• Total population variation during a period of time, a year for example,
depends on births and deaths in that year and on the difference between
immigrants and emigrants in that year.
• Noninstitutional civilian population are the number of people
potentially available for civilian employment (over 16 years; or between 1664 years). Is the sum of labor force and out of the labor force.
• Active Population (Labor force) is that inside labor market,
composed by employed people and unemployed people.
Labor market III: participation and
unemployment rates
The participation rate is the ratio of the labor force to the
noninstitutional civilian population.
The unemployment rate is the ratio of the unemployed to the
labor force.
Labor market IV: Spain
SPAIN: EPA, fourth quarter, 2006
Population over 16 years
Labor force
Employed
Unemployed
Participation rate
Unemployment rate
Participation rate (16-64)
Unemployment rate (16-64)
Employment rate (16-64)
Total
Men
Women
37.235,5
21.812,4
20.001,8
1.810,6
58,6
8,3
72,2
8,3
66,2
18.255,0
12.595,1
11.831,3
763,8
69,0
6,1
82,4
6,1
77,4
18.980,5
9.217,3
8.170,5
1.046,8
48,6
11,4
61,8
11,4
54,8
Labor market V: Evolution
Participation, employment and unemployment in
Spain, 1976-2006 (EPA)
Labor market V: Evolution
Participation, employment and unemployment in
Spain, 1976-2006 (EPA)
Labor market V: Flujos
Participation rates of men and women, by age groups,
1976 and 2001 (Source: EPA)
100
90
Percentages
80
70
60
50
40
30
20
10
0
16-19
20-24
25-29
30-34
35-39
40-44
45-49
50-54
Year
1976-VARONES
2001-VARONES
1976-MUJERES
2001-MUJERES
55-59
60-64
65-69
70 y+
Labor market V: Flujos
Example: USA average flows, 1994-1999
Employment
93,8 millones
1,0
Out of the labor force
57,3 millones
Unemployment
6,5 millones
0,8
Labor market V: Flows in Spain
Unemployment rate and the proportion of unemployed who find a job each
quarter
Labor market V: Flows
Spain: Proportion of employed workers fired each quarter
Wage determination Theories:
A. Bargaining
Wages are bargained individually (between employers and employees) or
collectivelly (between unions and firms) not defined by a competitive
market..
The output of this bargain depends on how the labor market is
organized in the economy and on the relative bargaining power of
the implied parts.
How much bargaining power a worker has depends on two
factors:
 How costly it would be for the firm to replace him—the nature
of the job.
 How hard it would be for him to find another job—labor
market conditions.
Wage determination Theories:
B. Efficiency Wages
Efficiency wage theories are theories that link the
productivity or the efficiency of workers to the wage they
are paid.
These theories also suggest that wages depend on both
the nature of the job and on labor-market conditions:
 Firms that see employee morale and commitment as
essential to the quality of their work, will pay more
than firms in sectors where workers’ activities are
more routine.
 Labor market conditions will affect the wage.
The Expected Price Level
Both workers and firms care about real wages
(W/P), not nominal wages (W):
 Workers do not care about how many dollars
they receive but about how many goods they
can buy with those dollars. They care about
W/P.
 Firms do not care about the nominal wages
they pay but about the nominal wages (W)
they pay relative to the price of the goods
they sell (P). They also care about W/P.
The Unemployment Rate
Also affecting the aggregate wage is the
unemployment rate u.
If we think of wages as being determined by
bargaining, then higher unemployment weakens
workers bargaining power, forcing them to accept
lower wages. Higher unemployment also allows
firms to pay lower wages and still keep workers
willing to work.
The Other Factors
The third variable, Z, is a catchall variable that
stands for all the factors that affect wages given
the expected price level and the unemployment
rate.
Unemployment insurance is the payment of
unemployment benefits to workers who lose their
jobs.
Price Determination
The production function is the relation between
the inputs used in production and the quantity of
output produced.
Assuming that firms produce goods using only
labor, the production function can be written as:
Y  AN
Y = output
N = employment
A = labor productivity, or output per worker
Further, assuming that one worker produces one
unit of output—so that A = 1, then, the production
function becomes:
Y N
Price Determination
Firms set their price according to:
P  (1  )W
The term  is the markup of the price over the
cost of production. If all markets were perfectly
competitive,  = 0, and P = W.
The Natural Rate
of Unemployment
This section looks at the implications of wage
and price determination for unemployment.
We assume that Pe = P, and that nominal wages
depends on the actual price level, P, rather than
on the expected price level, Pe.
Wage setting and price setting determine the
equilibrium rate of unemployment.
The Wage-Setting Relation
Earlier, we stated that the nominal wage rate was
determined as follows:
W  P F (u, z)
e
(  , )
Now, since Pe = P, then:
W  PF (u, z)
Dividing both sides by P, then:
W
 F ( u, z )
P
(  , )
The wage-setting
relation
This relation between the real wage and the rate of
unemployment is called the wage-setting relation.
The Price-Setting Relation
The price-determination equation is:
P  (1  )W
If we divide both sides by W, we get:
P
 (1   )
W
To state this equation in terms of the wage rate,
we invert both sides:
W
1

P (1  )
The price-setting
relation
The Price-Setting Relation
Wages, Prices, and the
Natural Rate of
Unemployment
Ecuación de precios
(PS)
1/(1+μ)
Real wage, W/P
The natural rate of
unemployment is the
unemployment rate such that
the real wage chosen in
wage setting is equal to the
real wage implied by price
setting.
Ecuación de salarios
(WS)
u
Unemployment rate, u
The Price-Setting Relation
The price-setting relation is drawn as the
horizontal line PS (for price setting) in Figure 6-6.
The real wage implied by price setting is
1/(1 = µ); it does not depend on the
unemployment rate.
Equilibrium Real Wages
and Unemployment
Eliminating W/P from the wage-setting and the
price-setting relations, we can obtain the
equilibrium unemployment rate, or natural rate of
unemployment, un:
1
F (un , z) 
1 
The equilibrium unemployment rate (un) is called
the natural rate of unemployment.
Equilibrium Real Wages
and Unemployment
The positions of the wage-setting and pricesetting curves, and thus the equilibrium
unemployment rate, depend on both z and u.
 At a given unemployment rate, higher
unemployment benefits lead to a higher real
wage. A higher unemployment rate is needed
to bring the real wage back to what firms are
willing to pay.
 By letting firms increase their prices given the
wage, less stringent enforcement of antitrust
legislation leads to a decrease in the real
wage.
Equilibrium Real Wages
and Unemployment
Unemployment
Benefits and the
Natural Rate of
Unemployment
A
A’
Real wage, W/P
An increase in
unemployment
benefits leads to an
increase in the natural
rate of unemployment.
1/(1+μ)
PS
WS
u
u’
Unemployment rate, u
Equilibrium Real Wages
and Unemployment
Markups and the
Natural Rate of
Unemployment
Real wage, W/P
An increase in
markups decreases
the real wage, and
leads to an increase in
the natural rate of
unemployment.
1/(1+μ)
A
A’
u
u’
1/(1+μ’)
Unemployment rate, u
Equilibrium Real Wages
and Unemployment
Because the equilibrium rate of unemployment
reflects the structure of the economy, a better
name for the natural rate of unemployment is the
structural rate of unemployment.
From Unemployment to Employment
Associated with the natural rate of unemployment
is a natural level of employment.
U L N
N
u

 1
L
L
L
Employment in terms of the labor force and the
unemployment rate equals:
N  L(1  u)
The natural level of employment, Nn, is given by:
N n  L(1  un )
From Employment to Output
Associated with the natural level of employment
is a natural level of output, (and since Y=N,
then,)
Yn  N n  L(1  un )
The natural level of output satisfies the following:
Yn 
1

F 1 
, z 

L  1 
In words, the natural level of output is such
Yn
that, at the associated rate of unemployment, un  1  ,
L
the real wage chosen in wage setting is equal to
the real wage implied by price setting.
Where are we going to
In the short run • Effective price level can be different than
expected.
• Unemployment rate can differ from its natural
rate.
• Production can differ from its natural level.
In the medium
run
• Effective price level must be equal to expected
price level (expectations can’t be permanently
wrong).
•Employment returns to its natural rate.
•Production returns to its natural level.