CHAPTER 29 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 47

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

29PART V THE CORE OF MACROECONOMIC THEORY

The Labor Market In

the Macroeconomy

Fernando & Yvonn Quijano

Prepared by:

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The Labor Market: Basic Concepts

The Classical View of the Labor MarketThe Classical Labor Market and the Aggregate Supply CurveThe Unemployment Rate and the Classical View

Explaining the Existence of UnemploymentSticky WagesEfficiency Wage TheoryImperfect InformationMinimum Wage LawsAn Open Question

The Short-Run Relationship Between the Unemployment Rate and InflationThe Phillips Curve: A Historical PerspectiveAggregate Supply and Aggregate Demand Analysis and the Phillips CurveExpectations and the Phillips CurveIs There a Short-Run Trade-Off between Inflation

and Unemployment?

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

Looking Ahead

CHAPTER OUTLINE

The Labor Market In

the Macroeconomy

29PART V THE CORE OF MACROECONOMIC THEORY

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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.

Unemployment rate = U/LF

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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.

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.

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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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.

FIGURE 29.1 The Classical Labor Market

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The classical view of the unemployment market is consistent with the following idea:

a. The wage rate adjusts to equate the quantity of labor demanded with the quantity of labor supplied; therefore, persistent unemployment above the frictional and structural amount is unlikely.

b. If the wage rate in the labor market is too low, people will work for themselves.

c. The amount of labor that a firm hires depends on the value of the output that workers produce.

d. All of the above.

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The classical view of the unemployment market is consistent with the following idea:

a. The wage rate adjusts to equate the quantity of labor demanded with the quantity of labor supplied; therefore, persistent unemployment above the frictional and structural amount is unlikely.

b. If the wage rate in the labor market is too low, people will work for themselves.

c. The amount of labor that a firm hires depends on the value of the output that workers produce.

d. d. All of the above.All of the above.

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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. This means that the AS curve is vertical.

When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.

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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 measured unemployment rate may sometimes seem high even though the labor market is working well.

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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.

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 - L1.

FIGURE 29.2 Sticky Wages

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Refer to the graph below. The meaning of “sticky wages” in this graph refers to:

a. The decrease in the equilibrium wage that results after the decrease in demand.

b. The failure of the wage rate to fall after the decrease in demand.

c. The tendency for the wage rate to rise above W0 after the decrease in demand.

d. The decrease in unemployment that results after the decrease in demand.

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Refer to the graph below. The meaning of “sticky wages” in this graph refers to:

a. The decrease in the equilibrium wage that results after the decrease in demand.

b.b. The failure of the wage rate to fall after the decrease in The failure of the wage rate to fall after the decrease in demand.demand.

c. The tendency for the wage rate to rise above W0 after the decrease in demand.

d. The decrease in unemployment that results after the decrease in demand.

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Sticky Wages

social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages.

Social, or Implicit, Contracts

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.

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Sticky Wages

explicit contracts Employment contracts thatstipulate workers’ wages, usually for a period of 1 to 3 years.

Explicit Contracts

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.

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Sticky Wages

Explicit Contracts

Graduate School Applications in Recessions

Graduate School Offers Relief During Economic Recession

Oklahoma Daily (U. Oklahoma)

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Efficiency Wage Theory

efficiency wage theory An explanation forunemployment 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.

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The efficiency wage is among the theories of unemployment that explain why:

a. Firms tend to pay wages above the wage at which the quantity of labor demanded equals the quantity supplied.

b. Firms tend to pay wages below the wage at which the quantity of labor demanded equals the quantity supplied.

c. Firms prefer to pay the wage at which quantity supplied equals quantity demanded in the labor market.

d. There is only one level of the wage rate at which quantity supplied equals quantity demanded, called the efficiency wage rate.

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The efficiency wage is among the theories of unemployment that explain why:

a.a. Firms tend to pay wages above the wage at which the Firms tend to pay wages above the wage at which the quantity of labor demanded equals the quantity supplied.quantity of labor demanded equals the quantity supplied.

b. Firms tend to pay wages below the wage at which the quantity of labor demanded equals the quantity supplied.

c. Firms prefer to pay the wage at which quantity supplied equals quantity demanded in the labor market.

d. There is only one level of the wage rate at which quantity supplied equals quantity demanded, called the efficiency wage rate.

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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 set wages wrong—wages that do not clear the labor market.

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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

The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment.

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Refer to the figure below. What happens in this labor market if the minimum wage (W0) is abolished?

a. Unemployment will rise.

b. Unemployment will fall.

c. The quantity of labor demanded falls.

d. The quantity of labor supplied rises.

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Refer to the figure below. What happens in this labor market if the minimum wage (W0) is abolished?

a. Unemployment will rise.

b.b. Unemployment will fall.Unemployment will fall.

c. The quantity of labor demanded falls.

d. The quantity of labor supplied rises.

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The Short-Run Relationship Betweenthe Unemployment Rate and Inflation

The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).

FIGURE 29.3 The Aggregate Supply Curve

In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.

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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 29.4 The Relationship Between the Price Level and the Unemployment Rate

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inflation rate The percentage change in the price level.

Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate.

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The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

FIGURE 29.5 The Phillips Curve

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Which of the following relationships is correct?

a. There is a positive relationship between unemployment and output.

b. There is a negative relationship between output and the overall price level.

c. There is a negative relationship between the unemployment rate and the price level.

d. There is a negative relationship between output and employment.

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Which of the following relationships is correct?

a. There is a positive relationship between unemployment and output.

b. There is a negative relationship between output and the overall price level.

c.c. There is a negative relationship between the unemployment There is a negative relationship between the unemployment rate and the price level.rate and the price level.

d. There is a negative relationship between output and employment.

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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.

FIGURE 29.6 Unemployment and Inflation, 1960–1969

The Phillips Curve: A Historical Perspective

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Policy discussions in the 1960s concerning the Phillips Curve revolved around the issue of:

a. What point to choose along a smooth Phillips Curve.

b. What to do about a highly unstable Phillips Curve.

c. How to maintain low inflation and at the same time lower the unemployment rate.

d. How to maintain low unemployment and at the same time lower the inflation rate.

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Policy discussions in the 1960s concerning the Phillips Curve revolved around the issue of:

a.a. What point to choose along a smooth Phillips Curve.What point to choose along a smooth Phillips Curve.

b. What to do about a highly unstable Phillips Curve.

c. How to maintain low inflation and at the same time lower the unemployment rate.

d. How to maintain low unemployment and at the same time lower the inflation rate.

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From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

FIGURE 29.7 Unemployment and Inflation, 1970–2007

The Phillips Curve: A Historical Perspective

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Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

FIGURE 29.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply

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If there is no systematic relationship between inflation and unemployment, it is because:

a. The aggregate demand curve shifts, without a shift in the aggregate supply curve.

b. Both the aggregate demand and the aggregate supply curve shift simultaneously.

c. Neither the aggregate demand nor the aggregate supply curves shift.

d. Government policies have effectively eradicated inflation and unemployment.

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If there is no systematic relationship between inflation and unemployment, it is because:

a. The aggregate demand curve shifts, without a shift in the aggregate supply curve.

b.b. Both the aggregate demand and the aggregate supply curve Both the aggregate demand and the aggregate supply curve shift simultaneously.shift simultaneously.

c. Neither the aggregate demand nor the aggregate supply curves shift.

d. Government policies have effectively eradicated inflation and unemployment.

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Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

FIGURE 29.9 The Price of Imports, 1960 I–2007 IV

The Role of Import Prices

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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.

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Refer to the graph below. The impact of higher inflationary expectations on this Phillips curve is reflected by the move:

a. From a to b.

b. From a to c.

c. From a to d.

d. None of the above. Inflationary expectations do not affect the Phillips curve.

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Refer to the graph below. The impact of higher inflationary expectations on this Phillips curve is reflected by the move:

a. From a to b.

b. From a to c.

c.c. From From aa to to dd..

d. None of the above. Inflationary expectations do not affect the Phillips curve.

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Is There a Short-Run Trade-Off between Inflation and Unemployment?

There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves more than simply choosing a point along a nice smooth curve.

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The Long-Run Aggregate Supply Curve, Potential Output, and 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.

FIGURE 29.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment

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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.

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The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

NAIRU The nonaccelerating inflation rate of unemployment.

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 rate (no change in the inflation rate).

FIGURE 29.11 The NAIRU Diagram

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Refer to the figure below. Which of the following causes a leftward shift in the PP curve?

a. A positive change in the rate of inflation.

b. A negative change in the rate of inflation.

c. An adverse change in input prices.

d. A favorable change in input prices.

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Refer to the figure below. Which of the following causes a leftward shift in the PP curve?

a. A positive change in the rate of inflation.

b. A negative change in the rate of inflation.

c. An adverse change in input prices.

d.d. A favorable change in input prices.A favorable change in input prices.

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cost-of-living adjustments (COLAs)

cyclical unemployment

efficient wage theory

explicit contracts

frictional unemployment

inflation rate

labor demand curve

labor supply curve

minimum wage laws

REVIEW TERMS AND CONCEPTS

NAIRU

natural rate of unemployment

Phillips Curve

relative-wage explanation of unemployment

social, or implicit, contracts

sticky wages

structural unemployment

unemployment rate

Documents

CHAPTER 29 The Labor Market In the Macroeconomy © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and