UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
1
LABORMARKET
ξ Noninstitutionalcivilianpopulationisthenumberofpeoplepotentiallyavailableforcivilianemployment=Laborforce+Outofthelaborforce
ξ Laborforce=eitherworking+lookingforwork
ξ Outofthelaborforce=neitherworkingnorlookingforwork–workingathomeorhousewivesetc.
ξ Therefore,participationrate=LaborForceLaborforce+Outofthelaborforce
ξ Laborforce=employed+unemployed
A. MovementsinUnemployment
ξ Theeffectofmovementsintheaggregateunemploymentrateonthewelfareofindividualworkers
ξ Theeffectoftheaggregateunemploymentrateonwages.
ξ Periodsofhigherunemploymentareassociatedwithmuchlowerproportionsofunemployedworkersfindingjobs
o Sinceemployedworkersfaceahigherprobabilityoflosingtheirjobs
o Unemployedworkersfacealowerprobabilityoffindingjobs;equivalently,theycanexpecttoremainunemployedforalongertime.
B. WageDetermination–Workersbased
ξ Workersaretypicallypaidawagethatexceedstheirreservationwage.
o Thisisthewagethatwouldmakethemindifferentbetweenworkingorbeingunemployed.Inotherwords,mostworkersarepaidahighenoughwagethattheypreferbeingemployedtobeingunemployed.
ξ Wagestypicallydependonlabormarketconditions.
o Unemploymentrate Wages
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
2
Alowerunemploymentratewouldmeanthatfirmswouldfinditdifficulttofindacceptablereplacementworkers.
Atthesametime,itiseasierforworkerstofindotherjobs.
• Therefore,workershaveastrongbargainingpowerandcanaskforhigherwages
o Unemploymentrate Wages
Ahigherunemploymentratewouldmeanthatfirmswouldfinditeasytofindacceptablereplacementworkers.
Atthesametime,itisdifficultforworkerstofindotherjobs.
• Therefore,workershaveaweakbargainingpowerandcanaskforlowerwages
o NatureoftheJob
Therequiredskillscanbehighorlowlevel.Iftrainingcostareminimumreplacementwouldbeeasierandbargainingpowerofworkersbecomeweaker.Example:McDonaldscrewversusMicrosoftprogrammers
C. EfficiencyWages–Firmbased
ξ Ifworkersarepaidonlytheirreservationwage,theywillbeindifferenttostayingorleaving.Inthiscase,manyofthemwillquit,andtheturnoverratewillbehigh.
o WagesTurnover&productivity
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
3
1. WAGES,PRICESANDUNEMPLOYMENT
ξ TheexpectedpricelevelPe
ξ Theunemploymentrateu.
ξ Catchallvariablezthatstandsforallothervariablethatmayaffecttheoutcomeofwagesettings
A. ExpectedPriceLevel
ξ Firmsandworkerscareaboutrealwages,notnominalwages
o Ifworkersexpectthepricelevel–thepriceofthegoodstheybuy–todouble,theywillaskforadoublingoftheirnominalwage.
o Iffirmsexpectthepricelevel–priceofthegoodstheysell–todouble,theywillbewillingtodoublethenominalwage.
Therefore,anincreaseintheexpectedpricelevelleadstoanincreaseinthenominalwage,inthesameproportion.
ξ Thereasonwhywagesdependontheexpectedpricelevel,Pe, ratherthanonactualpricelevelisbecausewagesaresetinnominalterms,andwhentheyareset,therelevantpricelevelisnotyetknown.
B. Unemploymentrate
ξ Theminus(‐)signunderuindicatesthatanincreaseintheunemploymentratedecreaseswages.
W=Pe * F(u,z) (‐,+)
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
4
C. Otherfactors
ξ Unemploymentinsuranceorunemploymentbenefitsincreasethereservationwageofunemployedworkersandsotheywouldholdoutforhigherwages.
o Unemploymentbenefits,zwages
2. PRICEDETERMINATION
ξ WhereYisoutput
ξ Nisunemployment
ξ Aislaborproductivity
o AssumptionthatoutputperworkerisconstantandequaltoA.Therefore,A=1
ξ TheproductionfunctionY=N,implies the cost of producing one more unit of output is the cost of employment one more worker, at wage, W.
ξ The marginal cost of production – the cost of producing one more unit of output – is equal to W.
ξ However, the price of that unit of output would not be equal to the marginal cost (not perfectly competitive). Therefore, the equation is adjusted to give;
ξ (1+µ)isthemarkupofthepriceovercost
Y=AN
Y=N
P=(1+µ)W
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
5
3. STRUCTURALRATEOFUNEMPLOYMENT
A. WageSettingRelation
Dividebothsidesbythepricelevel
ξ Wagedeterminationimpliesanegativerelationbetweenrealwage,W/P,andtheunemploymentrate,u.
o UnemploymentrateRealWagesChosenbywagesetters
Higherunemploymentweakerthebargainingpowerofworkers
B. PriceSettingRelation
Invertbothsides
W=P * F(u,z) (‐,+)
W=F(u,z)P (‐,+)
P=(1+µ)W
W=.1.P(1+µ)
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
6
ξ Thefirmwantsincreasemarkup,µ.Yourrealwagedoesnotchangemuch.Youarestillpaidthesamenominalwage,andtheproductproducedbythefirmis,atmost,asmallpartofyourconsumptionbasket.
ξ IfALLfirmsincreasemarkupConstantnominalwagerealwage
ξ Note:therealwageimpliedbypricesettingis1/(1+µ);itdoesnotdependontheunemploymentrate.
WS
PSPrice‐Settingrelation
Wage‐Settingrelation
Unemploymentrate,u
RealWage,W/P
Un
.1.(1+µ)
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
7
4. EQUILIBRIUMREALWAGESANDUNEMPLOYMENT
ξ Equilibriumunemploymentrateiscalledthenaturalrateofunemployment.However,thepositionsofthewage‐settingandprice–settingcurves,dependonbothzandu.
ξ Increaseinunemploymentbenefits,z
o Thiswouldshiftthewagesettingcurveupandtheeconomymovesalongtheprice‐settingcurve.
o Therefore,atagivenunemploymentrate,higherunemploymentbenefitsrealwage.
Resultingin:
F(un,z)=.1.(1+µ)
RealWage,W/P
PS
Wage‐Settingrelation
UnUnemploymentrate,u
WS
A A’ Price‐Settingrelation
WS’
Un’
.1.(1+µ)
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
8
Unemploymentrateisneededtobringtherealwagebacktowhattheformsarewillingtopay
• Economistscallthisthedisciplinedevice
ξ Alessstringentenforcementofexistinganti‐trustlegislation
o Markupshiftstheprice‐settingcurveandtheeconomymovesalongthewage‐settingcurve
Therefore,equilibriumunemployment;
o FirmsincreasetheirpricesgiventhewageRealwageunemploymentisrequiredtomakeworkersacceptthislowerrealwagenaturalrateofunemployment
WS
Unemploymentrate,u
RealWage,W/P
Un
PSPrice‐Settingrelation
Wage‐Settingrelation
.1.(1+µ)
PS’
Un’
.1.(1+µ)’
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
9
5. FROMUNEMPLOYMENTTOEMPLOYMENT
ξ Thelevelofunemployment,U,equalsthelaborforce,L,minusemploymentN
ξ L=N+UU=L‐U
ξ Rearrangingthis:
ξ Thereforethenaturallevelrateofunemploymentis
ξ Sinceweknowthat(Y=N)frombefore
ξ Thereforesinceun=1‐Yn
L
U=U=L–N=1‐NLLL
N=L(1–u)
Nn=L(1–un)
Yn=Nn=L(1–un)
F(1–Yn,z)=1.L1+µ
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
10
Assumethattheexpectedpricelevelisequaltotheactualpricelevel
1. Therealwagechoseninwagesettingisadecreasingfunctionoftheunemploymentrate
2. Therealwageimpliedbypricesettingisconstant
3. Equilibriuminthelabormarketrequiredthattherealwagechoseninwagesettingtobeequaltotherealwageimpliedbypricesetting.Thisdeterminestheunemploymentrate
4. Thisequilibriumunemploymentrateisknownasthenaturalrateofunemployment
5. Associatedwiththenaturalrateofunemploymentisanaturalrateofemploymentandanaturallevelofoutput.
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
11
6. AGGREGATESUPPLY
ξ Thedifferenceinthischapteristhatwedonotimposethisadditionalassumptioni.e.pricelevelisequaltotheexpectedpricelevelinthemediumrunbutwilltypicallynotbeequaltotheexpectpricelevelintheshortrun
ξ SinceN=Yfromabove
ξ Therefore;
P=Pe*(1+µ)F(u,z)
U=U=L–N=1–N=1‐YLLLL
u=1–YL
P=Pe*(1+µ)*F(1–Y,z)L
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
12
Output pricelevel
1. Anincreaseinoutputleadstoanincreaseinemployment‐YN
2. Theincreaseinemploymentleadstoadecreaseinunemploymentand,therefore,toadecreaseintheunemploymentrate‐N‐u
3. Thelowerunemploymentrateleadstoanincreaseinthenominalwage‐uW
4. Theincreaseinthenominalwageleadstoanincreaseinthepricessetbythefirmsandtherefore,toanincreaseinthepricelevel‐W‐P
Expectedpricelevel actualpricelevel
1. ifwagesettersexpectthepriceleveltobehigher,theysetahighernominalwage‐Pe‐W
2. Thenominalwagesleadstocosts,whichleadstopricessetbyfirmsandahigherpricelevel–W‐P
AggregateSupplyCurve
ξ Whenoutputisabovethenaturallevelofoutput,thepriceishigherthanexpected;
o IfYistotherightofYn,PishigherthanPe.
A
A’
AS’
ASForexpectedprice
LevelPe
P’e>Pe
P=P’e
P=Pe
PriceLevel,P
Output,YYn
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
13
ξ Whenoutputisbelowthenaturallevelofoutput,thepricelevelislowerthanexpected
o IfYistotheleftofYn,PislowerthanPe.
ξ SupposetheexpectedpricelevelincreasefromPetoP’e.
o Atagivenlevelofoutput,Ynandcorrespondinggivenunemploymentrate,theincreaseintheexpectedpricelevelsleads
W‐P
Soatanylevelofoutput,pricesarehigher–AggregatesupplycurveshiftsfromAStoAS’
7. AGGREGATEDEMAND
ISrelation
LMRelation
Y=C(Y–T)+I(Y,i)+G
M=Y*L(i)P
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
14
Output,YY‘Y
InterestRate,i
LM(ForP)
LM’(forP’>P)
IS
Output,YY’Y
PriceLevel,P
ADP’
P
A’A
i’
i
A
A’
Note:Equilibriuminfinancialmarketsrequiresthatthesupplyofmoneyequalthedemandformoney–LMrelation
ξ Changesintherealmoneystockthatcamefromchangesinnominalmoneysupply,M,madebytheFed.
ξ ChangesintherealmoneystockM/PcanalsocomefromchangesinthepricelevelP.
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
15
o 10%increaseinpricelevelP(increasesbottom‐decreasesM/P)hasthesameeffectontherealstockasa10%decreaseinthestockofnominalmoneyM(decreasetop‐decreasesM/P)
Bothleadstoadecreaseinrealmoneystock
ξ ISCurveisdrawnforgivenvaluesofG&T.
o Anincreaseintheinterestrateleadstodecreaseinoutputasthediagramaboveshows–i–i’leadstodecreasefromYn–Y’
o Note:LMcurveisdrawnforagivenvalueofM/P–anychangesinMorPwouldresultintheLMcurvetoshift
Therefore,pricelevelfromP–P’M/PLMcurveshiftsup
• NOTE:Amonetarycontractionnominalstock,MandM/PBUTitwouldshifttheADtotheleftunlikeprice,whichmerelymakestheeconomy,movealongthecurrentADcurve.
Now,atgivenlevelofoutput,thelowerrealmoneystockleadstoanincreaseintheinterestrate.TheeconomymovesfromAtoA’.theinterestrateincreasefromitoi’,andoutputdecreasesfromYtoY’.
AnyvariableotherthanthepricelevelshiftseitherIScurveortheLMcurvealsoshiftstheaggregatedemandrelation.
ξ Examplewouldbeadecrease/increaseingovernmentspending–decreaseinoutputasaresultofashiftofADtotheleft.
ξ Contractionarymonetarypolicy–decreasenominalmoney–decreaseoutputasaresultofashift
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
16
AggregateRelation
Note:OutputincreasewithincreasesinM/PandGovernmentspendinganddecreaseswithT.
A. EquilibriumintheShortRun
ASRelation
ADRelation
Note:EquilibriumdependsonvaluePe–sincePedeterminesthepositionofAScurve.
Y=Y(M,G,T)P(+,+,‐)
P=Pe*(1+µ)*F(1–Y,z)L
Y=Y(M,G,T)P(+,+,‐)
BAD
AS
A
Output,YYn Y
P
Pe
PriceLevel,P
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
17
ξ TheequilibriumistheintersectionofASandADcurvesatpointA.Thereisnoreasonwhy,equilibriumoutput,Yshouldbeequaltothenaturallevelofoutput.
B. EquilibriumintheMediumrun
ξ AsOutputexceedsthenaturallevelofoutput–theexpectedpricelevelwouldbelowerthanthecurrentpricelevel–thepricelevelwagesetterswouldexpecthighernominalwages(Pe–P’e).ThisresultsinASshiftingtoAS’
ξ ThismovementwouldcontinuetilloutputreachesYnwhereP=Pe–sincethereisnoreasonnowtochangewagesettersexpectationsofthepricelevel.
AS(forPe)
AS’’AS’(forP’e>Pe)
PriceLevel,P
ADA
Output,YYn Y
P
Pe
Y’
A’
A’’
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
18
8. SENARIOS
1. Monetaryexpansion
DynamicsofAdjustment
ξ Ifpriceleveldidnotchange,theincreaseinnominalmoneywouldshifttheLMcurvedowntoLM’’.So,ifthepriceleveldidnotchange–aswasoutassumption–theequilibriumwouldbetheintersectionofISandLM’’,orpointB.
A(andA’’)
BIS
LM’’
LM’
LM
A’
Yn Y Output,Y
AD’(forM’>M)
AD(forNominalmoneyM)
AS
A’
A’’
A
Yn Y Output,Y
Pricelevel,P
P’
P
Interestrate,i
i
i’
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
19
ξ However,duetochangeinpriceintheshortrun,PtoP’.theincreaseinpriceshiftstheLMcurveupwardsfromLM’’toLM’,partiallyoffsettingtheeffectoftheincreaseinnominalmoney
ξ Theneteffect:
o Increaseinnominalmoney–pushLMtoLM’’
o Increaseinpricelevel–pushLM”’toLM’
Therefore,theequilibriumisA’intheshortrunandfinallyendsupatAinthemediumrunasillustratedabovetopricewagesettersexpectationsincreasingpricestillcurveshiftsbacktoLM.
Note:ThisiswhatiscalledtheNeutralityofmoney
• Intheshortrun,amonetaryexpansionleadstoanincreaseinoutputandadecreaseininterestrateandincreaseinpricelevel
• Inthemediumrun,inincreaseinnominalmoneyisreflectedentirelyinaproportionalincreaseinpricelevelTheincreaseinnominalmoneyhasnoeffectonoutorontheinterestrate.
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
20
2. Adecreaseinthebudgetdeficit
ξ GovernmentisrunningabudgetdeficitanddecidestoreduceitbydecreasingitsspendingfromGtoG’,whileleavingtaxes,T,unchanged.
ξ ThiswouldshiftaggregatedemandfromADtoADOutputYnY’
ξ Intheshortrun:
o TheequilibriummovesfromAtoA’;outputdecreasesandpriceleveldecreasefromPtoP’.
ξ IntheMediumRun:
o Aslongasoutputisbelownaturallevelofoutput,AScurvewouldkeeponshiftingdown.Therefore,ASwouldmovetoAS’’andtheeconomyreachespointA’’–outputYn
ξ Note:Likeaincreaseinnominalmoney,areductioninthebudgetdeficitdoesnotaffectoutputforever.Eventually,theoutputreturnstoitsnaturallevel.However,atpointA’’‐Price&interestrate
AS
AS’’
AD
AD’(G’<G)
Output,YY’ Yn
A
A’’
A’
Pricelevel,P
PP’
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
21
ξ ThereductioninbudgetdeficitIScurvetoshifttoIS’andeconomymovesfromAtoB–pricesheldconstant.
ξ Intheshortrun:
ξ However,sincepricesdochangeinresponsetodecreaseinoutput–pricesRealmoneystock(M/P)andtheLMcurveshiftstoLM’.andeconomymovesfromBtoA’–
o Note:Nowoutputandinterestarebothlowerthanbeforethefiscalcontractionbutinvestmentmayormaynotincreaseintheshortrunasoutputinvestmentbutinterestrateinvestment
AS
ADAD’(G’>G)
A
A’’A’
YnY’ Output,Y
PP’
LM
i’
IS’
i
Yn Output,YY’
i’’
LM’’
LM’
IS
A
A’’
A’
B
PriceLevel,P
Interestrate,i
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
22
ξ Inthemediumrun:
o Asoutputremainsbelowthenaturallevelofoutput,thepricelevelcontinuestodecline,ladingtofurtherincreaseinrealmoneystockandshiftingLMtilloutputreturntoYnoreconomyequilibriumisA’’.
EffectontheYn=C(Yn–T)+I(Yn,i)+G
ξ Incomeandtaxesareunchanged–consumptionisnotaffected
ξ Governmentspendingislowerthanbefore
ξ InvestmentishigherthanbeforethedeficitbyexactlytheamountofthedecreaseinG
o Note:mediumrun,reductioninbudgetdeficitunambiguouslyleadstoadecreaseintheinterestrateandanincreaseininvestment
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
23
3. ChangesinthePriceofOil
Theeffectonthenaturalrateofunemploymentwhenthepriceofoilincreases
ξ Theprice‐settingrelationisrepresentedbythehorizontallineatW/P=1/(1+µ).
ξ TheinitialnaturalemploymentrateisUn.Anincreaseinthemarkupleadstoadownwardshiftoftheprice‐settingline,fromPStoPS’.
Markuprealwageimpliedbypricesetting
EquilibriummovesfromAtoA’–Realwageislowerandnaturalunemploymentishighersincegettingworkerstoacceptrealwagerequiresanunemployment
Unemploymentemploymentoutput(assumeY=N–fromabove)
WS
PS’(forµ’>µ
PS
UnemploymentRate,uUn Un’
RealWage,
W/P
1.1+µ1.1+µ’
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
24
ShortRun–aggregateSupplyrelation
ξ Intheshortrun:
o Theincreaseinthepriceofoilshowsupasanincreaseinthemarkupµ.
o ThisleadsfirmstoincreasepricelevelatanylevelofoutputandhenceAScurveshiftsup.ThenewequilibriumisBfromA,outputislowerequalthenewlowernaturallevelofoutputY’nandpricelevelequalstheexpectedpricelevel,Pe.
o IntheshortrunonlytheASshiftsasADremainsconstantduetothebalancingouteffectoftheincreasesanddecreasesofconsumption&investmentareaffectedbyincreasingoilprices.
ξ Inthemediumrun
o Althoughoutputhasfallen,naturallevelofoutputhasfallenevenmore.
o AtpointA’,outputA’isstillabovethenewnaturallevelofoutput,Y’n,soAS’shiftstoAS’’andequilibriumatA’’.
AS
AS’AS’’
AD
A
A’
A’’
B
PriceLevel,P
Pe
Yn’ Y’ Yn Output,Y
P=Pe*(1+µ)*F(1–Y,z)L
UshanPremaratne
BSP2001–Macroeconomics–LaborMarket–AS/AD
25
o Note:theendresultisanoutputisatalowerlevelthanbeforetheoilpriceincreasesbutatanewnaturallevelofoutput,Y’natahigherpricelevelthanbefore.
9. SHORTRUNVERSUSTHEMEDIUMRUN
SHORTRUN MEDIUMRUN
OutputLevel
InterestRate
PriceLevel OutputLevel
InterestRate
PriceLevel
MonetaryPolicy
Increase Decrease Increase(small)
Nochange Nochange Increase
Deficitreduction
Decrease Decrease Decrease(Small)
NoChange Decrease Decrease
Increaseinoilprice
Decrease Increase Increase Decrease Increase Increase
