The Labor Market, Unemployment, and Inflation: Fernando & Yvonn Quijano

Chapter
27
The Labor Market,
Unemployment,
and Inflation
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
The Labor Market,
Unemployment,
and Inflation 27
Chapter Outline
The Labor Market: Basic Concepts
The Classical View of the Labor Market
The Classical Labor Market and the Aggregate
Supply Curve
The Unemployment Rate and the Classical View
Explaining the Existence of Unemployment
Sticky Wages
Efficiency Wage Theory
Imperfect Information
Minimum Wage Laws
An Open Question
The Short-Run Relationship Between the
Unemployment Rate and Inflation
The Phillips Curve: A Historical Perspective
Aggregate Supply and Aggregate Demand Analysis
and the Phillips Curve
Expectations and the Phillips Curve
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Is There a Short-Run Trade-Off Between Inflation

and Unemployment?
The Long-Run Aggregate Supply Curve,
Potential GDP, and the Natural Rate of
Unemployment
The Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
HC
Looking Ahead
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 31
THE LABOR MARKET: BASIC CONCEPTS
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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HC
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
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certain industries.
HC
cyclical unemployment The increase

in unemployment that occurs during
recessions and depressions.
Employment tends to fall when aggregate output falls and to rise when aggregate output
rises.
A decline in the demand for labor does not

necessarily mean that unemployment will rise.
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HC
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THE CLASSICAL VIEW OF THE LABOR MARKET
FIGURE 14.1 The Classical Labor Market

HC
labor supply curve A graph that

illustrates the amount of labor that
households want to supply at each given
wage rate.
labor demand curve A graph that

illustrates the amount of labor that firms
want to employ at each given wage rate.
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HC
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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HC
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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HC
EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
STICKY WAGES
sticky wages The downward rigidity
of wages as an explanation for the
existence of unemployment.
FIGURE 14.2 Sticky Wages

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HC
UNEMPLOYMENT
Social, or Implicit, Contracts
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
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a wage cut unless they know that all other

workers are receiving similar cuts.
HC
UNEMPLOYMENT
Explicit Contracts
explicit contracts Employment

contracts that stipulate workers’ wages,
usually for a period of 1 to 3 years.
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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HC
UNEMPLOYMENT
EFFICIENCY WAGE THEORY
efficiency wage theory 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.
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HC
UNEMPLOYMENT
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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HC
UNEMPLOYMENT
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.
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HC
UNEMPLOYMENT
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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HC
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
When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises.
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HC
This curve represents the

positive relationship
between Y and the overall
price level (P).
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FIGURE 14.3 The Aggregate Supply Curve

HC
There is a negative relationship between the

unemployment rate and the price level. As
the unemployment rate declines in response
to the economy’s moving closer and closer
to capacity output, the overall price level
rises more and more, as shown in Figure
14.4.
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FIGURE 14.4 The Relationship Between the Price Level

and the Unemployment Rate
HC
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FIGURE 14.5 The Phillips Curve

HC
inflation rate The percentage change in

the price level.
Phillips Curve A graph showing the

relationship between the inflation rate
and the unemployment rate.
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HC
THE PHILLIPS CURVE: A HISTORICAL
PERSPECTIVE
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FIGURE 14.6 Unemployment and Inflation, 1960–1969

HC
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FIGURE 14.7 Unemployment and Inflation, 1970—2004

HC
AGGREGATE SUPPLY AND AGGREGATE DEMAND ANALYSIS
AND THE PHILLIPS CURVE
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FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on
Shifts in Both Aggregate Demand and Aggregate Supply
HC
The Role of Import Prices

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FIGURE 14.9 The Price of Imports, 1960 I–2005 II

HC
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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HC
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 much more than simply choosing
a point along a nice, smooth curve.
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HC
THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL
GDP, AND THE NATURAL RATE OF UNEMPLOYMENT
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FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment
HC
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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HC
THE NONACCELERATING INFLATION RATE OF

UNEMPLOYMENT (NAIRU)
NAIRU
The nonaccelerating
inflation rate of
unemployment.
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FIGURE 14.11 The Long-Run Phillips Curve:

The Natural Rate of Unemployment
HC
REVIEW TERMS AND CONCEPTS
cost-of-living adjustments NAIRU

(COLAs) natural rate of unemployment
cyclical unemployment Phillips Curve
efficient wage theory relative-wage explanation of
explicit contracts unemployment
frictional unemployment social, or implicit, contracts
inflation rate sticky wages
labor demand curve structural unemployment
labor supply curve unemployment rate
minimum wage laws
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HC

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Chapter

Fernando & Yvonn Quijano

Is There a Short-Run Trade-Off Between Inflation

The labor force (LF) is the number of employed

unemployment rate The number of

Unemployment rate = U/LF

frictional unemployment The portion of

structural unemployment The portion

cyclical unemployment The increase

A decline in the demand for labor does not

FIGURE 14.1 The Classical Labor Market

labor supply curve A graph that

labor demand curve A graph that

THE CLASSICAL LABOR MARKET AND THE

The classical idea that wages adjust to clear

When the AS curve is vertical, monetary and

THE UNEMPLOYMENT RATE AND THE

The unemployment rate is not necessarily an

The measured unemployment rate may

FIGURE 14.2 Sticky Wages

Social, or Implicit, Contracts

social, or implicit, contracts

a wage cut unless they know that all other

explicit contracts Employment

cost-of-living adjustments (COLAs)

EFFICIENCY WAGE THEORY

efficiency wage theory An explanation

Firms may not have enough information at their

If firms have imperfect or incomplete information,

MINIMUM WAGE LAWS

minimum wage laws Laws that set a

The aggregate labor market is very complicated,

In the short run, the unemployment rate (U) and

This curve represents the

FIGURE 14.3 The Aggregate Supply Curve

There is a negative relationship between the

FIGURE 14.4 The Relationship Between the Price Level

FIGURE 14.5 The Phillips Curve

inflation rate The percentage change in

Phillips Curve A graph showing the

FIGURE 14.6 Unemployment and Inflation, 1960–1969

FIGURE 14.7 Unemployment and Inflation, 1970—2004

The Role of Import Prices

FIGURE 14.9 The Price of Imports, 1960 I–2005 II

EXPECTATIONS AND THE PHILLIPS CURVE

Expectations are self-fulfilling. This means that

Price expectations that affect wage contracts

Inflationary expectations shift the Phillips Curve

IS THERE A SHORT-RUN TRADE-OFF BETWEEN

natural rate of unemployment The

THE NONACCELERATING INFLATION RATE OF

FIGURE 14.11 The Long-Run Phillips Curve:

cost-of-living adjustments NAIRU

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