THE LABOR MARKET,

Chapter 7| UNEMPLOYMENT AND INFLATION

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Chapter Outline and Learning Objectives

 Unemployment
Explain how unemployment is measured.

 Inflation and Deflation

Describe the tools used to measure
inflation and discuss the costs and effects
of inflation.

 Long-Run Growth
Discuss the components and implications
of long-run growth.

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Unemployment, Inflation, and Long-
7
Run Growth

 The unemployment rate and inflation are key

macroeconomic variables.
 The Malaysia Statistical Department announces the
previous month’s unemployment rate and the consumer
price index (CPI).
 Although much of macroeconomics is concerned with
business cycles (short-term), long-run growth is also a
major concern.

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Unemployment

Measuring Unemployment
Employed Any person 16 years old or older (1) who works for
pay, either for someone else or in his or her own business for 1
or more hours per week, (2) who works without pay for 15 or
more hours per week in a family enterprise, or (3) who has a job
but has been temporarily absent with or without pay.

Unemployed A person 16 years old or older who is not

working, is available for work, and has made specific efforts to
find work during the previous 4 weeks.
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Measuring Unemployment (1 of 2)

Not in the labor force A person who is not looking for work
because he or she does not want a job or has given up looking.
Labor force The number of people employed plus the
number of unemployed.

Labor force = Employed + Unemployed

Population = Labor force + Not in labor force

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Measuring Unemployment (2 of 2)

Unemployment rate The ratio of the number of people

unemployed to the total number of people in the labor force.

Labor force participation rate The ratio of the labor force

to the total population 16 years old or older.

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 TABLE 7.1 Employed, Unemployed, and the Labor Force,
1982–2014
(1) (2) (3) (4) (5) (6)

Population Labor Employed Unemployed Labor Force Unemployment

16 Years Force (Millions) (Millions) Participation Rate
Old or Over (Millions) Rate (Percentage
(Millions) (Percentage Points)
Points)

1982 8381.79 5431.4 5249.0 182.4 64.8 3.4

1990 7000.2 6685.0 315.2 66.5 4.5
1995 7893.1 7645.0 248.1 64.7 3.1
1999 9151.5 8837.8 313.7 64.2 3.4
2000 9556.1 9269.2 286.9 65.4 3.0
2005 10413.4 10045.4 368.1 63.3 3.5
2010 12303.9 11,899.5 404.4 63.7 3.3
2014 13913.6 13,532.1 399.5 67.5 2.9
Source: Malaysian statistical department, 2016.

** Unemployment rate (2015) = 3.1%

** Unemployment rate (as at June, 2016) = 3.4%

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ECONOMICS IN PRACTICE 7
Youth Unemployment

Research shows that the youth suffered more from

economic slowdown across the world. Data
compiled by the ILO indicates that youth are
three times more likely to be unemployed then
older groups.
As of 2015, an estimated 73 million young people
are looking for work worldwide.
The variation of the degrees of youth
unemployment across European countries, might
be attributed to structural differences in labor
policy and the education system.

THINKING PRACTICALLY

1. What measures could you think of could reduce youth unemployment while not risking
increase the unemployment of other demographic groups?
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 7
Components of the Unemployment
Rate (1 of 3)

Discouraged-worker effect
The decline in the measured
unemployment rate that results
when people who want to
work but cannot find jobs
grow discouraged and stop
looking, thus dropping out of
the ranks of the unemployed
and the labor force.

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Components of the Unemployment
Rate (3 of 3)

Discouraged-Worker Effects
If a BLS survey respondent cites inability to find employment as the sole reason
for not searching for work, that person might be classified as a discouraged
worker.
Discouraged workers are not counted as unemployed
Some economists argue that including the number of discouraged workers as
unemployed gives a better picture of the unemployment situation.

Part-time worker
Involuntary part-time workers counted as if full-time - Part time workers are counted
as “employed” even if they really want full-time work.

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** BLS is Bureau of Labor Statistics in US.
ECONOMICS IN PRACTICE 7
Female Labor Force Participation and Economic Development

There is evidence of positive correlations

between the increased presence of women in
labor markets and accelerated economic
growth.
Economic growth, rising wages, decline in
fertility and improvement in health are factors
that help increase female labor force
participation.
Despite the presence of these factors, this trend
has not been observed in urban India over the
past thirty years. It is an example that highlights
some of the challenges associated with efforts
to boost female labor force participation.

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The Costs of Unemployment (1 of 4)

There are three categories of unemployment:

 Frictional unemployment
 Structural unemployment
 Cyclical unemployment

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The Costs of Unemployment (2 of 4)

Frictional unemployment
The portion of unemployment that is as a result of
the normal turnover in the labor market; used to
denote short-run job/skill-matching problems.

Structural unemployment 
The portion of unemployment that is as a result of
changes in the structure of the economy that result in a
significant loss of jobs in certain industries.

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The Costs of Unemployment (3 of 4)

 Cyclical unemployment The increase in unemployment that occurs

during recessions and depressions.

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The Costs of Unemployment (4 of 4)

 Natural rate of unemployment

The unemployment rate that occurs as a normal part of the functioning of the
economy. Sometimes taken as the sum of the frictional unemployment rate and
the structural unemployment rate.
 Factor affecting NRU:

 Demographic changes
 Changing job search methods
 Public policy changes

**Actual unemployment can be above or fall below the NRU.

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Definition of Full Employment

 Full employment does not mean zero unemployment, but it does mean that cyclical
unemployment is zero.

 The full employment-unemployment rate is equal to the total frictional and structural
unemployment because these types of unemployment are always occurring and are a natural
part of our economy.

 The full employment rate of unemployment is also referred to as the natural rate of
unemployment.

 The natural rate is achieved when labor markets are in-balance; the number of job seekers
equals the number of job vacancies.

 The natural rate of unemployment is not fixed but depends on the demographic makeup of the
labor force and the laws and customs of the nation.
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The Classical View of the Labor Market

 Classical economists assumed that the wage rate adjusts to equate the quantity
demanded with the quantity supplied, thereby implying that unemployment does
not exist.

 Labor demand curve A graph that illustrates the amount of labor that firms
want to employ at each given wage rate.

 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

 The classical economists saw the workings of the labor market – the behavior of labor supply
and labor demand – as optimal from the standpoint of both individual households and firms
and from the standpoint of society.

 If households want more output than is currently produced, output demand will increase,
output prices will rise, the demand for labor will increase, the wage rate will rise, and more
workers will be drawn into the labor force.

 At equilibrium, prices and wages reflect a trade-off between the value of households place on
output and the value of time spent in leisure and nonmarket work.

 At equilibrium, the people who are not working have chosen not to work at that market wage.
There is always full employment in this sense.

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 7
The Classical View of the 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.

The classical idea that wages

adjust to clear the labor market
is consistent with the view that
wages respond quickly to price
changes.

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 STICKY WAGES
7
• One explanation for unemployment (above and beyond normal frictional & structural
unemployment) is that wages are “sticky” on the downward side.

• That is, the equilibrium wage gets stuck at a particular level and does not fall when demand for
labor falls.

• Thus, unemployment of amount L0 − L1, where L0 is the quantity of labor that households want
to supply at wage rate W0 and L1 is the amount of labor that firms want to hire at wage rate
W0.

• L0 − L1 is the number of workers who would like to work at W0 but cannot find jobs.

WHY UNEMPLOYMENT EXIST?

 SOCIAL, OR IMPLICIT, CONTRACTS
7
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 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.

WHY UNEMPLOYMENT EXIST?

 EXPLICIT CONTRACTS 7
explicit contracts Employment contracts that stipulate workers’ wages,
usually for a period of 1 to 3 years. Wages set in this way do not fluctuate with
economic conditions, either upward and downward.

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. COLAs thus protect workers from unexpected inflation.

WHY UNEMPLOYMENT EXIST?

 EFFICIENCY WAGE THEORY
7
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.

**Firms can benefits from lower turnover, improved morale, and reduced
“shirking” of work.

WHY UNEMPLOYMENT EXIST?

 IMPERFECT INFORMATION
7
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 wrong—
wages that do not clear the labor market.

If a firm sets its wages too high, more workers will want to work for that firm than the
firm wants to employ, and some potential workers will turned away. Thus, the result is
unemployment.

WHY UNEMPLOYMENT EXIST?

 MINIMUM WAGE LAWS
7
Minimum wage laws - Laws that set a floor for wage rates—that is, a minimum
hourly rate for any kind of labor.

WHY UNEMPLOYMENT EXIST?

The Short-Run Relationship between the
Unemployment Rate and Inflation
7
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.
The relationship between aggregate output
and the overall price level is positive:
When P increases, Y increases, and when
P decreases, Y decreases.

The AS curve shows a positive relationship

between the price level (P) and aggregate
 FIGURE 7.1 The Aggregate
output (income) (Y). Supply Curve
The Short-Run Relationship between the
Unemployment Rate and Inflation
7
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 economy’s moving
closer and closer to capacity output, the
price level rises more and more.

 FIGURE 7.2 The Relationship

between the Price Level and the
Unemployment Rate
PHILIP CURVE AND INFLATION RATE 7
Inflation rate The percentage change in the price level.

Phillips Curve A curve showing

the relationship between the
inflation rate and the
unemployment rate.

The Phillips Curve shows the

relationship between the inflation
rate and the unemployment rate.

 FIGURE 7.3 The Phillips Curve

Aggregate Supply and Aggregate Demand Analysis and
the Phillips Curve 7

 FIGURE 7.4 Changes in the Price Level and Aggregate Output Depend on Shifts in
Both Aggregate Demand and Aggregate Supply
Expectations and the Phillips Curve
7
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

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 rate—that is, from the Phillips Curve.
The Long-Run Aggregate Supply Curve,
Potential Output, and the Natural Rate of 7
Unemployment

 FIGURE 7.5 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 unemployment
—that 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.
The Nonaccelerating
Unemployment (NAIRU)
Inflation Rate of
7
To the left of the NAIRU, the  FIGURE 7.6 The NAIRU Diagram
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
rate (no change in the inflation
rate).
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REVIEW TERMS AND
CONCEPTS (1 of 2)
 consumer price index (CPI)  unemployment rate
 cyclical unemployment Equations:
 discouraged-worker effect  labor force = employed +
 employed unemployed
 population = labor force + not in
 frictional unemployment
labor force
 labor force
 labor force participation rate
 natural rate of unemployment
 not in the labor force
 structural unemployment
 unemployed
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REFERENCES 7

McConnell, Brue & Fynn (2016), Economics: principles, Problems and Policies,
Global Ed,New York: McGraw-Hill, UK.

Karl E. Case & Ray C. Fair (2016), Principles of Economics, 12th Ed., Pearson
International Education

Malaysian Statistical Department

Ministry of Finance

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