12-1

Unemployment in a Market Economy (competitive labor market):

explanation of structural unemployment

Employment per unit of time

Wage rates

D

D S

S

e0 e e1

w

w1

Wage rate > equil. wage rate = q.s > q.d. = surplus of labor = unemployment

•If labor markets competitive & wages allowed to freely rise & fall, unemployment minimized & limited to time necessary to reach equilibrium

•Prevention of competitive labor markets & freely adjusting prices (reasons for above-wage equilibrium)?

•Min. wage laws(impact on low-skill/experience)

•Unions (collective bargaining)

•Efficiency wages

12-2

Full employment Unemployment rate (natural rate of unemployment)

12-3

Annual Unemployment Rate 1960-2006

• repeating cyclical pattern• relation to changes in GDP?

12-4

Circular Flow of Economic Activity

Producers Households

Flow of final goods and services

Flow of money payments (consumption)

(Aggregate Demand for goods/services)

(Aggregate Supply of goods/services)

Flow of productive services

Flow of money payments

(Aggregate Supply of resources)

(Aggregate Demand for resources)

ProductMarket Resource

Market

Observations:

•Interrelation of 2 markets: -D for goods creates D for resources to produce them -Costs of producing goods depends on prices paid/quantities of resources used to produce

•2 flows (real & $)

•2 incomes (real & $)

•Inter- dependency of variables: -income on production -production on spending -spending on income -D for resources on D for products

12-5

Long-Run Aggregate Supply “Curve”

Price level (p)

p0

q0Output supplied per year (q)

p1

S

S

0

Full Employment Output/Potential Output/Natural Rate of Output(output @ natural rate of unemployment)

Economy reaches sustainable capacity at level of full employment

In the long-run, a change in the price level doesn’t impact output– resources are already fully employed

Can maybe temporarily move past this level by over-employing resources, but in long-run, resources force output back to natural rate

12-6

The Short-Run and Long-Run Aggregate Supply Curves

Price level (p)

p0

q0Output supplied per year (q)

p1

S1

S1

0 q1

S0

S0

Can temporarily move past natural rate of output level by over-employing resources (if price level turned out to be higher than expected), but in long-run, resources force output back to natural rate, at a now-higher price level

12-7

AD, LRAS, & SRAS: Long-Run Equilibrium

Price Level

Quantity of

Output

SRASLRAS

AD

Equilibrium Price

When the economy reaches its long-run equilibrium where AD = LRAS, the expected price level will have adjusted to equal the actual price level. As a result, the SRAS curve crosses this point as well

Natural rate of output

Output & price level determined in long run by intersection of AD & LRAS curve

12-8

Aggregate Demand and Aggregate Supply: AD shift

Price level (p)

p0

q0Output supplied per year (q)

p2

S1

S1

0 q1

S0

q2

S0

D0

D0

D1

D1

D2

D2

p1

If AD is too weak, cyclical unemployment will exist– if it persists, economy will experience recession

If AD is increased, the price level increases, but so does output (to full-employment output at D1D1=LRAS)(Unemployment ↓)

If AD grows beyond natural rate of output, resource overemployment may move economy beyond sustainable level of output…

p3

Resulting in inflation (pure inflation)

But in long-run, output must fall back to natural level, with higher price level, at q1, p3 — how?

S1

Expectation change of price level… expectations catch up with new reality & expected price level rises

12-9

Contraction in AD

12-10

Circular Flow of Economic Activity

Producers Households

Flow of final goods

Consumer spending

Flow of productive services

Flow of money payments

Investment

GovernmentSpending

Exports

Savings

Taxes

Imports

LeakagesInjections

Breaks in circular flow deficient AD part of income created by production doesn’t return to producers in form of spending surpluses at market prices & employment levels unemployment

Leakages may be offset by injections (e.g., if rate of saving at full employment returns to CF through investment spending, AD may be sufficient to buy all goods/services produced)

12-11

Aggregate Demand & Aggregate Supply: SRAS Shift

Price level (p)

p0

q0Output supplied per year (q)

p1

0 q1

SRAS0

S0AD0

AD0

SRAS1

S1

Price of labor rises without productivity increase decrease in SRAS total output falls & price level rises (inflation)

LRAS

Falling output with rising prices = stagflation

If firms respond to higher price level by raising expectations of price level and setting higher nominal wages, can lead to wage-price spiral

SRAS2

p2 In long run, low output puts downward pressure on wages, production becomes more profitable, & SRAS shifts back to natural rate

12-12

SRAS & AD shift

11-13

12-14

The Phillips Curve (a side note)

Inflation rate (percent per year)

Unemployment rate (percent)

0

2

6%

4% 7

The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate in the short-run.

●

●

A

B

Phillips curve

Inflation high & unemployment low

Inflation low & unemployment high