The Labor Market, Unemployment and Inflation
The Labor Market: Basic Concepts
The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force.
Cyclical unemployment is the increase in unemployment that occurs during recessions and depressions.
Frictional unemployment is 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 is 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.
The Classical View of the Labor Market
According to classical economists, the quantities of labor demanded and supplied are brought into equilibrium by rising and falling wage rates. There should be no persistent unemployment above the frictional and structural amount.
- labor supply curve
- labor demand curve
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 unemployment rate may sometimes seem high even though the labor market is working well.
Explaining the Existence of Unemployment
The fact that people are willing to work at a wage higher than the current wage does not mean that the labor market is not working.
The term sticky wages refers to the downward rigidity of wages as an explanation for the existence of unemployment.
If wages “stick” at W0 rather than fall to the new equilibrium wage of W* following a shift of demand, the result will be unemployment equal to L0 – L1.
One explanation for downwardly sticky wages is that firms enter into social, or implicit, contracts. These contracts are unspoken agreements between workers and firms that firms will not cut wages.
The relative-wage explanation of unemployment holds that workers are concerned about their wages relative to the wages of other workers in other firms and industries.
Explicit contracts are employment contracts that stipulate workers’ wages, usually for a period of one to three years. Wages set in this way do not fluctuate with economic conditions.
Cost of living adjustments (COLAs) are contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.
The efficiency wage theory is 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. If firms have imperfect information, they may simply set wages wrong—wages that do not clear the labor market.
Minimum wage laws set a floor for wage rates, and explain at least a fraction of unemployment.
The Short-Run Relationship between the Unemployment Rate and Inflation
In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.
As depicted by this short run AS curve, the relationship between Y and the price level (P) is positive.
The relationship between U and P is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more.
The Phillips Curve
The inflation rate is the percentage change in the price level.
The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.
There is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate.
The Role of Import Prices
The AS curve shifts when input prices change, and input prices are affected by the price of imports.
There were no large shifts in the AS curve in the 1960s due to changes in the price of imports.
The price of imports increased considerably in the 1970s. This led to large shifts in the AS curve during the decade.
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.
Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s.
The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment
When output is pushed above potential GDP (Y0), there is upward pressure on costs. Rising costs push the short-run AS curve to the left. The quantity supplied will end up back at Y0.
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.
The natural rate of unemployment (U*) is the unemployment rate that is consistent with the notion of a fixed long-run output at potential GDP.
The NAIRU—The Nonaccelerating Inflation Rate of Unemployment
Many economists believe the relationship between the change in the inflation rate and the unemployment rate is as depicted by the PP curve in this figure.
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).