PRINCIPLES OF

MACROECONOMICS
TENTH EDITION
PART III The Core of Macroeconomic Theory

CASE FAIR OSTER

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PART III The Core of Macroeconomic Theory

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 The Labor Market in
the Macroeconomy 14
CHAPTER OUTLINE
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
PART III The Core of Macroeconomic Theory

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
Inflation and Aggregate Demand
The Long-Run Aggregate Supply Curve, Potential
Output, and the Natural Rate of Unemployment
The Nonaccelerating Inflation Rate of Unemployment
(NAIRU)
Looking Ahead
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 The Labor Market: Basic Concepts

The labor force (LF) is the number of employed plus unemployed:

LF = E + U

unemployment rate The number of people

unemployed as a percentage of the labor force.

U
PART III The Core of Macroeconomic Theory

unemployment rate
LF

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 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.
PART III The Core of Macroeconomic Theory

cyclical unemployment The increase in unemployment

that occurs during recessions and depressions.

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 The Classical View of the Labor Market

labor demand curve A graph that illustrates the amount of

labor that firms want to employ at each given wage rate.
PART III The Core of Macroeconomic Theory

labor supply curve A graph that illustrates the amount of

labor that households want to supply at each given wage rate.

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 The Classical View of the Labor Market
PART III The Core of Macroeconomic Theory

FIGURE 14.1 The Classical Labor Market

Classical economists believe that the labor market always clears.
If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1.
Anyone who wants a job at W1 will have one.
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 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.

In the absence of sticky wages, the AS curve will be vertical.

In this case, monetary and fiscal policy will have no effect on real
output.

Indeed, in this view, there is no unemployment problem to be solved!

PART III The Core of Macroeconomic Theory

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 The Classical View of the Labor Market

The Unemployment Rate and the Classical View

Some economists argue that the unemployment rate is not a good

measure of whether the labor market is working well. The economy is
dynamic and at any given time some industries are expanding and
some are contracting.

A positive unemployment rate as measured by the government does

not necessarily indicate that the labor market is working poorly. The
measured unemployment rate may sometimes seem high even though
the labor market is working well.
PART III The Core of Macroeconomic Theory

Economists who view unemployment this way do not see it as a major

problem. There are other views of unemployment, as we will now see.

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 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

If wages stick at W0 instead of
falling to the new equilibrium
wage of W* following a shift of
demand from D0 to D1, the result
will be unemployment equal to L0
PART III The Core of Macroeconomic Theory

L1.

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 Explaining the Existence of Unemployment

Sticky Wages

Social, or Implicit, Contracts

social, or implicit, contracts Unspoken agreements

between workers and firms that firms will not cut wages.

relative-wage explanation of unemployment An

explanation for sticky wages (and therefore unemployment):
If workers are concerned about their wages relative to other
PART III The Core of Macroeconomic Theory

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.

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 Explaining the Existence of Unemployment

Sticky Wages

Explicit Contracts

explicit contracts Employment contracts that

stipulate workers wages, usually for a period of 1 to 3 years.

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.
PART III The Core of Macroeconomic Theory

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 Explaining the Existence of Unemployment

Efficiency Wage Theory

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.

Among some potential benefits that firms receive from paying workers
more than the market-clearing wage are:
PART III The Core of Macroeconomic Theory

Lower turnover.
Improved morale.
Reduced shirking of work.

Even though the efficiency wage theory predicts some unemployment,

the behavior it is describing is unlikely to account for much of the
observed large cyclical fluctuations in unemployment over time.

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 E C O N O M I C S I N PRACTI C E

Does Unemployment Insurance Increase Unemployment or Only

Protect the Unemployed?
In the summer of 2010
Congress considered an
expansion of the
program of
unemployment
insurance.
One of the debates
around this program was
whether the existence of
PART III The Core of Macroeconomic Theory

such programs actually

fueled unemployment.
There is a considerable
debate about the benefit of jobless benefits.

Long Recession Ignites Debate on Jobless Benefits

The Wall Street Journal
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 Explaining the Existence of Unemployment

Imperfect Information

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 simply set

wages wrongwages that do not clear the labor market.
PART III The Core of Macroeconomic Theory

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 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.

An Open Question
PART III The Core of Macroeconomic Theory

The aggregate labor market is very complicated, and there are no

simple answers to why there is unemployment. Which argument or
arguments will win out in the end is an open question.

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 The Short-Run Relationship between the Unemployment Rate and Inflation

The unemployment rate (U) and aggregate output (income) (Y) are negatively
related: when Y rises, the unemployment rate falls, and when Y falls, the
unemployment rate rises.

FIGURE 14.3 The Aggregate Supply Curve

The AS curve shows a positive
relationship between the price level (P)
and aggregate output (income) (Y).
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 The Short-Run Relationship between the Unemployment Rate and Inflation

FIGURE 14.4 The Relationship between

the Price Level and the Unemployment Rate
This curve shows a negative
relationship between the price level (P)
and the unemployment rate (U).
As the unemployment rate declines in
response to the economys moving
closer and closer to capacity output,
the price level rises more and more.
PART III The Core of Macroeconomic Theory

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 The Short-Run Relationship between the Unemployment Rate and Inflation

inflation rate The percentage change in the price level.

FIGURE 14.5 The Phillips Curve

The Phillips Curve shows the
relationship between the
inflation rate and the
unemployment rate.
PART III The Core of Macroeconomic Theory

Phillips Curve A curve showing the relationship

between the inflation rate and the unemployment rate.
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 The Short-Run Relationship between the Unemployment Rate and Inflation

The Phillips Curve: A Historical Perspective

FIGURE 14.6 Unemployment and

Inflation, 19601969
During the 1960s, there seemed
to be an obvious trade-off
between inflation and
unemployment.
Policy debates during the period
revolved around this apparent
trade-off.
PART III The Core of Macroeconomic Theory

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 The Short-Run Relationship between the Unemployment Rate and Inflation

The Phillips Curve: A Historical Perspective

FIGURE 14.7 Unemployment

and Inflation, 19702009
From the 1970s on, it
became clear that the
relationship between
unemployment and inflation
was anything but simple.
PART III The Core of Macroeconomic Theory

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 The Short-Run Relationship between the Unemployment Rate and Inflation

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve
PART III The Core of Macroeconomic Theory

FIGURE 14.8 Changes in the Price Level and Aggregate Output

Depend on Shifts in Both Aggregate Demand and Aggregate Supply

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 The Short-Run Relationship between the Unemployment Rate and Inflation

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

The Role of Import Prices

PART III The Core of Macroeconomic Theory

FIGURE 14.9 The Price of Imports, 1960 I2010 I

The price of imports changed very little in the 1960s and early 1970s.
It increased substantially in 1974 and again in 1979-1980.
Between 1981 and 2002, the price of imports changed very little.
It generally rose between 2003 and 2008, with some falloff in 2009.

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 The Short-Run Relationship between the Unemployment Rate and Inflation

Expectations and the Phillips Curve

If inflationary expectations increase, the result will be an increase in the rate

of inflation even though the unemployment rate may not have changed. In
this case, the Phillips Curve will shift to the right.

If inflationary expectations decrease, the Phillips Curve will shift to the left
there will be less inflation at any given level of the unemployment rate.

Inflation and Aggregate Demand

PART III The Core of Macroeconomic Theory

Inflation is affected by more than just aggregate demand. Where inflation

depends on both the unemployment rate and cost variables, there will be no
stable Phillips Curve unless the cost variables are not changing.

Therefore, the unemployment rate can have an important effect on inflation

even though this will not be evident from a plot of inflation against the
unemployment ratethat is, from the Phillips Curve.
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 The Long-Run Aggregate Supply Curve, Potential Output, and the
Natural Rate of Unemployment
PART III The Core of Macroeconomic Theory

FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment
If the AS curve is vertical in the long run, so is the Phillips Curve.
In the long run, the Phillips Curve corresponds to the natural rate of unemploymentthat is, the
unemployment rate that is consistent with the notion of a fixed long-run output at potential
output.
U* is the natural rate of unemployment.
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 The Long-Run Aggregate Supply Curve, Potential Output, 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.

The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

PART III The Core of Macroeconomic Theory

NAIRU The nonaccelerating inflation rate of unemployment.

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 The Long-Run Aggregate Supply Curve, Potential Output, and the
Natural Rate of Unemployment
The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

FIGURE 14.11 The NAIRU Diagram

To the left of the NAIRU, the price
level is accelerating (positive
changes in the inflation rate);
To the right of the NAIRU, the
price level is decelerating
(negative changes in the inflation
rate).
Only when the unemployment
rate is equal to the NAIRU is the
price level changing at a constant
PART III The Core of Macroeconomic Theory

rate (no change in the inflation

rate).

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 Looking Ahead

This chapter concludes our basic analysis of how the macroeconomy works.

In the preceding seven chapters, we have examined how households and firms
behave in the three market arenasthe goods market, the money market, and
the labor market.

We have seen how aggregate output (income), the interest rate, and the price
level are determined in the economy, and we have examined the relationship
between two of the most important macroeconomic variables, the inflation rate
PART III The Core of Macroeconomic Theory

and the unemployment rate.

In the next chapter, we use everything we have learned up to this point to

examine a number of important policy issues.

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 REVIEW TERMS AND CONCEPTS

cost-of-living adjustments (COLAs) NAIRU

cyclical unemployment natural rate of unemployment

efficiency wage theory Phillips Curve

explicit contracts relative-wage explanation of unemployment

frictional unemployment social, or implicit, contracts

inflation rate sticky wages

PART III The Core of Macroeconomic Theory

labor demand curve structural unemployment

labor supply curve unemployment rate

minimum wage laws

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