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Chapter 6 of Macroeconomics

Olivier Blanchard and David R. Johnson


• How the labour market conditions that involve unemployment
rates and different policies can affect the wage bargaining
powers of employees/workers and firms.
• The wage setting and price setting.
• Why natural unemployment occurs where the wage setting
and price setting equate.
• How different policies or events can affect the natural
unemployment rate.
• How we can use the wage setting and price setting to derive
(graphically) the labour supply and labour demand respectively
• How we can derive the Short run Aggregate Supply curve from
the algebras.
• Short Run, Medium Run and Long Run

• The noninstitutional civilian population (NIP) are the
number of people potentially available for civilian employment.
• The civilian labor force (LF) is the sum of those either working
or looking for work. Those who are neither working nor looking
for work are out of the labor force.
• The participation rate is the ratio of the labor force to the
noninstitutional civilian population. (= LF/NIP)
• The unemployment rate (u) is the ratio of the unemployed to
the labor force.
• Seperations refer to movements from being employed to
being unemployed or being out of labour force.

2010 4 .Figure 6 . and Unemployment in the United States (in millions). Employment.1 Population. Labor Force.

The Large Flows of Workers An unemployment rate may reflect two very different realities. and a stagnant unemployment pool. with few separations. including the movements of workers. few hires. or it may reflect a sclerotic labor market. The Current Population Survey (CPS) produces employment data. It may reflect an active labor market. with many separations and many hires. 5 .

6 . Unemployment. much of it directly to and from employment. and Nonparticipation in the United States. (3) There are also large flows in and out of the labor force.2 Average Monthly Flows between Employment. (2) The flows in and out of unemployment are large relative to the number of unemployed. 1994 to 2011 (millions) (1) The flows of workers in and out of employment are large.The Large Flows of Workers Figure 6 .

the average yearly U. Unemployment Rate Since 1948-2010 Since 1948.S.3 Movements in the U.S. unemployment rate has fluctuated between 3% and 10%.Figure 6 . 7 .

How fluctuations in the aggregate unemployment rate affect individual workers is important because the answer determines two effects:  The effect of movements in the aggregate unemployment rate on the welfare of individual workers  The effect of the aggregate unemployment rate on wages 8 .

the chance that an unemployed worker will find a job diminishes. then employed workers are at a greater risk of losing their jobs.During recessions. Equivalently. there are labor market adjustments. 9 . they can expect to remain unemployed for a longer time. There are implications for both employed and unemployed workers:  If the adjustment takes place through fewer hires.  If the adjustment takes place instead through higher layoffs.

4 The Unemployment Rate and the Proportion of Unemployed Finding Jobs.Figure 6 . 1994–2010 When unemployment is high. the proportion of unemployed finding jobs is low. Note that the scale on the right is an inverse scale. 10 .

1994–2010 When unemployment is high.5 The Unemployment Rate and the Monthly Separation Rate from Employment. 11 .Figure 6 . a higher proportion of workers lose their jobs.

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Collective bargaining is bargaining between firms and unions. 14 . The lower the unemployment rate.  Wages typically depend on labor market conditions. the higher the wages. Common forces at work in the determination of wages include:  Workers are typically paid a wage that exceeds their reservation wage. the wage that would make them indifferent between working or being unemployed.

 How costly it would be for the firm to replace him— the nature of the job.  How hard it would be for him to find another job— labor market conditions.How much bargaining power a worker has depends on two factors. 15 .

16 . will pay more than firms in sectors where workers’ activities are more routine.  Labor market conditions will affect the wage.Economists call the theories that link the productivity or the efficiency of workers to the wage they are paid efficiency wage theories. These theories also suggest that wages depend on both the nature of the job and on labor-market conditions:  Firms that see employee morale and commitment as essential to the quality of their work.


in favour of




How real wage is related to employment outlook

Both workers and firms care about real wages (W/P), not
nominal wages (W).
Workers do not care about how many dollars they receive
but about how many goods they can buy with those dollars.
They care about W/P.
Firms do not care about the nominal wages they pay but
about the nominal wages, W, they pay relative to the price of
the goods they sell, P. They also care about W/P.


How real wage is related to employment outlook

• As we see in the slide 17, there are two factors that
affect the real wage (W/P) that the workers request
– Unemployment rate: If we think of wages as being
determined by bargaining, then higher unemployment
weakens workers’ bargaining power, forcing them to
accept lower wages. Higher unemployment allows firms to
pay lower wages and still keep workers willing to work.
– All factors or policies that give higher bargaining power to
the workers (eg. unemployment benefits).

we can assume the following relationship. ) (1) This equation tells us of the workers’ behaviour (i. their real wage request in response to the labour market conditions that involve unemployment rate. 𝑊 = 𝐹 𝑢. 𝑧 𝑃 (  .e. z).How real wage is related to employment outlook To capture the effects of the two factors on the real wage. they would request for nominal wage equal to W (as shown in (1) ) 20 . z and price level P. if the people know u. u and the catchall variable. Therefore.

u 21 .Real wage & unemployment Real Wage. so they are willing to accept lower real wage. Intuition: as the unemployment rate goes up. the bargaining power of the workers falls. W/P This red graph is drawn to show that the real wage requested by the workers is negatively related to the unemployment rate. 𝑊 =𝜃 𝑒 𝑃 WS 𝑢 Unemployment Rate.

we want to have a nominal income.Previous graph explained • Suppose that the economy is at where u = 𝑢. and our expectation that the price would be Pe. so that our expected real wage is W/Pe (which is equal to = 𝜃) ” 22 . Then hypothetically. Suppose also that the corresponding real wage that the workers request is equal to 𝜃. W. • So. they have to form expectation of price level. and this catchall variable z. • However. they could form this thinking process: “With this unemployment rate. Pe . the workers cannot possibly know the price level of the whole economy (reasonable assumption?).

the outcome of wage setting.• Then at a given u and z. the workers would request for (or accept) W as nominal wage. we have: 𝑊 = 𝐹 𝑢. that stands for all other variables that may affect. 23 . given the expected price level and the unemployment rate. ) (2) That is. z. Note: a catchall variable. at a given state of the economy where unemployment rate is equal to u. 𝑧 𝑒 𝑃 𝑊 = 𝑃𝑒 𝐹 𝑢. catchall variable is equal to z and if the expected price level is equal to Pe . in favor of the workers. 𝑧 (  .

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or output per worker Further. the production function can be written as: 𝑌 = 𝐴𝑁 Y = output N = employment A = labor productivity. the production function becomes: 𝑌=𝑁 25 . then. •Assuming that firms produce goods using only labor. assuming that one worker produces one unit of output—so that A = 1.•The production function is the relation between the inputs used in production and the quantity of output produced.

• Marginal productivity of labour = MPL 𝑀𝑃𝐿 = 𝐴 = 1 One unit of labour produces A units of goods • Nominal marginal cost of labour = W. which is the cost of producing one unit of goods is: 𝑀𝐶 = 𝑊/𝐴 = 𝑊 One unit of labour costs $W. one unit of labour can produce A units of goods  Cost of producing one unit of goods = W/A 26 . so the nominal marginal cost.

and P = W. m = 0. 27 .• Suppose that the firm has some market power such that it can set the price above the marginal cost: 1+𝑚 𝑊 𝑃= = 1+𝑚 𝑊 𝐴 • Where m is the markup of price over the nominal marginal cost • If all markets were perfectly competitive.

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Recall that we have the equation (1): W  F ( u. This relation between the real wage and the rate of unemployment—wage-setting relation. ) This equation illustrates the worker’s behaviour in response to the labour market conditions – captured in u an z. 29 . z ) P (  .

we invert both sides: 𝑊 1 = 𝑃 1+𝑚 The price-setting relation 30 . we get: 𝑃 =1+𝑚 𝑊 To state this equation in terms of the wage rate.•The price-determination equation is: 𝑃 = 1+𝑚 𝑊 If we divide both sides by W.

we have unemployment rate = natural unemployment rate A PS WS un Unemployment Rate.6 1 1+𝑚 At equilibrium. Real Wage.Graph 1 Wages. and the Natural Rate of Unemployment The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting. W/P Figure 6 . u 31 . Prices. where two curves meet.

This is because when the expected price is equal to the actual price. 𝑧 = = 1+𝑚 1+𝑚 • So un here is affected by A. (why?) • We can also manipulate to get: 𝐴 1 𝐹 𝑢𝑛 . (We will explain more in detail in next lecture) – Pe = P happens when WS meets PS. 32 . there is no longer a need to adjust the expectation.• Medium-run equilibrium: – Medium run is when Pe = P. z and m.

Real Wage. W/P 1 𝑊 𝑊 = = 𝑒 𝑃 1+𝑚 𝑃 A PS WS un Unemployment Rate. u 33 .

less stringent enforcement of antitrust legislation leads to a decrease in the real wage. – At a given unemployment rate. and thus the medium run equilibrium unemployment rate. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay. depend on both z and m. (Graph 3a-3b) 34 . higher unemployment benefits lead to a higher real wage. (Graph 2) – By letting firms increase their prices given the wage.• The positions of the wage-setting and price-setting curves.

Figure 6 . This is because? : Prospect of unemployment is less painful (who has more bargaining power?) Unemployment Benefits and the Natural Rate of Unemployment Real Wage. causing WS to shift up  higher un. u 35 .7 Graph 2 Example: Unemployment benefits ↑. W/P IF z↑ 1 (1+ m) B A PS A’ WS’ WS un u’n Unemployment Rate.

• The economy will be at point A’ where natural rate of unemployment is higher.• Higher z  higher bargaining power for workers  for the same u. firms would respond not by not hiring those who insist on higher nominal wage. If the unemployment rate is still at un. These workers are willing to wait for better job (because it is less costly to wait now)  which causes higher unemployment. workers demand for higher real wage. 36 . the workers would demand higher real wage (point B) • But the firms are not willing because it does not correspond to their price setting • Thus. So WS shifts up.

Pe to be equal to the actual price level. u 37 .Figure 6 . W/P Markups and the Natural Rate of Unemployment 𝑊 𝑊 1 = = 𝑃𝑒 𝑃 1 + 𝑚 PS A WS un Unemployment Rate. the economy is in medium run equilibrium with un and we have price expectation. P. Real Wage.8 Graph 3a Here.

u 38 .8 Graph 3b Markups and the Natural Rate of Unemployment Real Wage. causing PS to shift down A PS 𝑊 1 = 𝑃′ 1 + 𝑚′ PS’ WS un Unemployment Rate. W/P IF m↑ 𝑊 𝑊 1 = = 𝑒 𝑃 𝑃 1+𝑚 Example: less stringent enforcement of antitrust legislation.Figure 6 .

And they still want to provide labour level where unemployment rate is equal to un PS A 𝑊 1 = 𝑃′ 1 + 𝑚′ PS’ WS In fact. they still maintain the same expectation of price level. the workers do not know of price level change. u 39 . the price level has changed. W/P Markups and the Natural Rate of Unemployment 𝑊 1 = 𝑃𝑒 1 + 𝑚 At the moment (in short run).8 Graph 3c Real Wage. So. Nominal wage is still the same un Unemployment Rate.Figure 6 .

After some time. But the unemployment rate has increased because some workers refuse to work at this real wage level Figure 6 . W/P Markups and the Natural Rate of Unemployment PS A 𝑊 𝑊 1 = = 𝑃′𝑒 𝑃′ 1 + 𝑚′ PS’ A’ WS P’e = P’ un u’n Unemployment Rate. u 40 . the workers realize that the price has increased.8 Graph 3d Real Wage. So they “update” their expectation of price to match with the new actual price level.

• They then “update” their price expectation to match with the new actual price level set by firms. the real wage is smaller (W/P’e). the price level has gone up because mark-up is higher • In the short run. workers find out that price level has gone up (this means that now. • After a while. • With the new expected price level. 41 . So. they still think the real wage is at point A. The response from the workers is that some would not choose to work but to wait.• Now. they know that their real wage is lower). the unemployment rate goes up. workers are not aware of the price level change.

• Associated with unemployment is employment: 𝑈 𝐿−𝑁 𝑁 𝑢= = =1− 𝐿 𝐿 𝐿 • Employment then is: 𝑁 = 𝐿(1 − 𝑢) • Natural level of employment Nn is: 𝑁𝑛 = 𝐿(1 − 𝑢𝑛 ) 42 .

u 43 .Real Wage. W/P Graph 4 1 (1+ m) A PS WS un Unemployment Rate.

N 44 .Graph 5 Equivalent to Labour Supply Real Wage. W/P WS A 1 (1+ m) PS Equivalent to Labor demand: Why is it flat? U N Nn L Employment.

• If we have a production function as follows: 𝑌 = 𝐴𝑁 𝛼 where 0 < α <1. how would PS curve and the labor demand curve look like? 45 .

• Natural output is associated with natural employment and thus also with natural unemployment rate: 𝑌𝑛 = 𝐴𝑁𝑛 = 𝐴𝐿 1 − 𝑢𝑛 = 𝐿(1 − 𝑢𝑛 ) • So. the natural output will satisfy the following: 𝑌𝑛 𝐴 𝐹 1− .𝑧 = 𝐴𝐿 1+𝑚 𝑌𝑛 1 𝐹 1 − .𝑧 = 𝐿 1+𝑚 46 .

47 .

captured in variables u and z 48 .• We have the following two relations: • And: 𝑊 = 𝑃𝑒 𝐹(𝑢. They would demand the nominal wage. according to the price level that they “form in their minds” or “expect” and the labour market conditions. 𝑧) 𝐴𝑃 = 1 + 𝑚 𝑊 In the short-run. the workers would not know what is the price level so they form expectation of the price level. W.

𝑧) • Second Step: 𝑈 𝐿−𝑁 𝑁 𝑌 𝑢= = =1− =1− 𝐿 𝐿 𝐿 𝐴𝐿 Definition of unemployment rate Definition of unemployment Math manipulation Specification of production function Y=AN 49 .• First Step. we combine two equations: 𝑃 = 𝑃𝑒 1 + 𝑚 𝐹(𝑢.

A. L and z) 50 .• So then we have: 𝑌 𝑌 𝑢 =1− =1− 𝐴𝐿 𝐿 • We can have: 𝑌 𝑃 = 𝑃 1+𝑚 𝐹 1 − .𝑧 𝐿 𝑒 • This is our Short Run Aggregate Supply (simply call it Aggregate Supply) curve which shows the relationship between P and Y (P also depends clearly on Pe and m.

which is (Yn.• To draw the AS curve. on P-Y plane. If we have u = un. • Recall: If P=Pe. 51 . un (refer back to slide 31). corresponding output would be Yn (refer back to slide 49) • Hence. Pe). AS will go through a special point. let us find the special point on the P-Y plane. then the unemployment rate would be the natural unemployment rate.

𝑧 𝐿 𝑌 . Then.𝑧 𝐿 • If Y increases. then 𝐹 1 − increases. • So the AS curve would be a upward-sloping curve that goes through the point (Pe. Yn). 52 . for a given Pe and m.𝑃= 𝑃𝑒 𝑌 1 + 𝑚 𝐹 1 − . we should have P to increase.

𝑧 𝐿 (Yn. P Graph 6 𝑃 = 𝑃𝑒 AS 𝑃= 𝑃𝑒 𝑌 1 + 𝑚 𝐹 1 − . Pe) A When Y=Yn then P=Pe Y=Yn Output. Y 53 .Price Level.

an increase in output leads to an increase in the price level” – Rationale: (see graph 6) • Y↑ requires higher employment u↓. Which in turn leads to P↑ (why?) 54 . given the expected price level. we can say “The first property is that.• Thus. which leads to W↑ (why?).

P AS’ (for Pe’ > Pe) 𝑃 = 𝑃𝑒′ 𝑃 = 𝑃𝑒 AS (for a given Pe) A’ A Y=Yn Output. Y 55 .Graph 7 Price Level.

“given unemployment.• Also. Therefore. an increase in Pe leads to one-to-one increase in actual price level Medium-Run Equilibrium” – Rationale: (See graph 7) • Wage setters expected Pe↑. leading to higher actual Price level (P). 56 . causing Labor Cost to rise. firms would push up prices to match the higher labour cost. they push firms for higher W.

• SHORT RUN: Year-to-year movements in output are primarily driven by movements in demand – How Consumption and Investment behave  movements in demand (responsive to current events) – Consumer confidence and other factors that leads to Y↓ or ↑ 57 .

Nn.• MEDIUM RUN: – Economy tends to returns to the level of output determined by the supply factors (potential production. – At the medium run. expected price level is equal to actual price level. 58 . there is no more adjustment in price or expectation of price. Yn): Productions depend on capital stock. level of technology (captured in variable A) and the amount of labor which can potentially be employed. This is intuitive because when Pe = P.

LONG RUN: When we have technological progress that increases the variable A. 59 . This will push the Yn higher  We have growth of potential output.

A↑ 60 . with Yn and un and P = Pe SR Concerns with shocks. technological breakthrough  higher potential. especially demand shocks with consumptions and investments  “reactionary policies” MR LR Innovations. right shift of LRAS.Economy will “settle down” at the potential or natural state.