21-11-2023

Errol D’Souza

The Labour Market

Errol D’Souza
Suppose that individuals are only interested in the
money wage w and not the real wage w/p.

Individuals are interested in comparing their

earnings vis-à-vis the earnings of others
in the labour market.
w = MRSC ,l

Firms/employers are still making decisions in terms

of the real cost of any nominal wage they pay.

Then, w = pMPN

In this case what happens when prices rise?

Email: errol@iima.ac.in

1 2

Nominal wage Price

Errol D’Souza Errol D’Souza

w Panel A
p
Panel D
MRSC ,l So far, labour demand was always equal to labour supply
AS
in equilibrium and there is never any unemploy-
ment.
p1
p0
How do we understand unemployment?
p1MPN
Output
p0 MPN
N Y Keynes argued that in the short run the money wages
ND = NS Employment Y0 Y1 are constant till the point at which those who
Y Panel B
Y are looking for jobs get employment.
Panel C
Y = F (K , N )

Y1 After that when everyone is employed, the money

Y0 wage is flexible upwards.

Let the initial price be p0 and the money wage be w

450 Y
N
N 0 N1
Figure 7.9: Aggregate Supply (Money Wages)

3 4

1
 21-11-2023

Errol D’Souza Errol D’Souza

Panel A Panel A Unemployment
w w
p0 (MRSY ,l ) p0 (MRSY ,l )
w w

At w supply of labour
is N 0S and demand for
labour is N 0D
p0 MPN p0 MPN
N N
N 0D N 0S N 0D N 0S
Y Y = F (K , N )

Y0

Panel B

N = min N D , N S 
N
N0

5 6

Errol D’Souza Errol D’Souza

Panel A Unemployment p Panel D Panel A
p Panel D
w w p1  p 0 p1 (MRSY ,l )
p0 (MRSY ,l ) p0 (MRSY ,l )
w w

p1 E
D D
p0 p0

p1MPN
p0 MPN p0 MPN
N Y N Y
N 0D N 0S Y0 N 0D N1D N 0S Y0 Y1
Y Y = F (K , N ) Y Y Y = F (K , N ) Y
YF
Y1
Y0 Y0

Panel B Panel C Panel B Panel C


N = min N D , N S 
450 Y 450 Y
N N
N0 N0 N1

7 8

2
 21-11-2023

Errol D’Souza Errol D’Souza

Panel A Panel D
w p1 (MRSY ,l ) p
F p0 (MRSY ,l ) AS
w Lucas - Friedman’s Explanation:

p1
D
E Workers are imperfectly informed about the aggregate
p0
price of the typical basket of goods they consume.

p1MPN
p0 MPN
They thus form an estimate of the aggregate price
N D
N 1
D
N =N
D S
N S
N
Y0 Y1 YF
Y level and on this basis they supply labour.
0 0

Y Y = F (K , N ) Y
YF
w = p e MRSC ,l
Y1
Y0
Demand for labour is still given by

w = pMPN
Panel B Panel C

N.B.: If there are no expectational errors then p e = p

450 Y
N
N0 N1 NF
Diagram X: Keynesian Aggregate Supply

9 10

Errol D’Souza Errol D’Souza

Assume p0e = p0
w p (
AS p = p e )
Lucas - Friedman and Mistaken Expectations Panel A
p0e (MRSY ,l ) Panel D

w0 E
If p = p there are no expectational errors and both sides
e
p0
of the market are making decisions in real terms E/
p0 MPN

N Y
ND = NS Y2
Vertical AS Curve Y Y = F (K , N ) Y

Y* Y*
The level of employment and output produced when
expectations are realized i.e. p e = p is called the
natural rate of employment N* and output Y*
Panel B Panel C

450 Y
N
N*

11 12

3
 21-11-2023

Price increase to p1  p 0 Errol D’Souza

Price declines to p 2  p 0  p1 Errol D’Souza

w Panel A p (
AS p = p e ) w Panel A p (
AS p = p e )
p0e (MRSY ,l ) Panel D p0e (MRSY ,l ) Panel D

w1 A w1 A

w0 E w0 E
p1MPN p1 A/ p1MPN p1 A/
p0 w2 B p0
E/ p2 E/

p0 MPN p0 MPN B/
p2 MPN
N Y N Y
ND = NS Y1 ND = NS Y2 Y1
Y Y = F (K , N ) Y Y Y = F (K , N ) Y
Y1 Y1
Y* Y* Y* Y*
Y2

Panel B Panel C Panel B Panel C

450 Y 450 Y
N N
N* N1 N2 N* N1

13 14

Errol D’Souza Errol D’Souza

Higher price expectations p1e  p0e
w Panel A p (
AS p = p e ) w Panel A p (
AS p = p e )
p0e (MRSY ,l ) Panel D p0e (MRSY ,l ) Panel D
AS ( p1e  p1 )
w1 A w1 A
(
AS p0e  p0 ) (
AS p0e  p0 )

w0 E w0 E
p1MPN p1 A/ p1MPN p1 A/
w2 B p0 w2 B p0
p2 E/ p2 E/

p0 MPN B/ p0 MPN B/
p2 MPN p2 MPN
N Y N Y
ND = NS Y2 Y1 ND = NS Y2 Y1
Y Y = F (K , N ) Y Y Y = F (K , N ) Y
Y1 Y1
Y* Y* Y* Y*
Y2 Y2

Panel B Panel C Panel B Panel C

450 Y 450 Y
N N
N2 N * N1 N2 N * N1
Diagram XII: Mistaken Expectations Aggregate Supply Diagram XII: Mistaken Expectations Aggregate Supply

15 16

4
 21-11-2023

Errol D’Souza Errol D’Souza

Lower price expectations p2e  p0e
w p (
AS p = p e )
Panel A
p0e (MRSY ,l ) Panel D Mistaken Expectations Aggregate Supply Curve
AS ( p1e  p1 )
w1 A
(
AS p0e  p0 )  p 

AS ( p2e  p2 ) Y = Y *  e   0
w0 E p 
p1MPN p1 A/
w2 B p0
How do price expectations change when workers
p2 E/
B/ realize that expectations are mistaken?
p0 MPN
p2 MPN
Adaptive Expectations Hypothesis
N Y
ND = NS Y2 Y1
Y = F (K , N ) pte+1 = pte +  ( pt − pte ) 0   1
Y Y
Y1
Y*
 : Speed with which price expectations are updated
Y*
Y2 When p e  p then a fraction  of the expectational
error ( pt − pte ) is incorporated into a revision of
Panel B Panel C
the expectation in the next period
Next period then workers move to a higher AS ( p e  p )
450 Y
N curve
N2 N * N1
Diagram XII: Mistaken Expectations Aggregate Supply

17 18

Errol D’Souza Errol D’Souza

Unemployment and Output Gaps
Natural rate of unemployment = Seasonal Unemployment
Unemployed person – one who is not holding a job and is + Frictional Unemployment
searching for one. + Structural Unemployment
Four types of unemployment:
Unemployment = Natural rate of Unemployment
• Seasonal – e.g. agriculture, tourism + Cyclical Unemployment
• Frictional – when people are in transition from one
job to another or when they first enter the
labour market in search of work.
• Structural – more long term and chronic. It often
occurs in periods of economic change when
new jobs being created have different requi-
rements from old jobs being lost.
E.g.: growth of IT and demise of organized
textile work.
• Cyclical – associated with a reduction in output
during periods of recession

19 20

5
 21-11-2023

Errol D’Souza Errol D’Souza

Natural rate of unemployment = Seasonal Unemployment

+ Frictional Unemployment
+ Structural Unemployment
ഥ
Consider that the number of people in the labour force, 𝑁,
is the sum of the people employed, 𝑁, and those who are un-
employed, 𝑈.

Unemployment = Natural rate of Unemployment ഥ =𝑁+𝑈

𝑁
+ Cyclical Unemployment
Reasons why unemployment changes over time
Focus of Macroeconomics: Cyclical Unemployment • it takes time to match workers skills with vacancies
or
Cyclical Unemployment = Unemployment • the process of economic change creates new jobs
- Natural rate of unemployment and destroys old ones.
= U – U*
We can think of these as situations of workers being sep-
Full employment  Cyclical Unemployment = 0
arated from jobs that they could fit into if the match
was successful or job destruction. Think of them as
lost jobs.

21 22

Errol D’Souza Errol D’Souza

rises due to job separation or destruction,

𝑁𝑡 ∶ number of people who start out at time 𝑡 with employ- 𝜎𝑁
ത 𝑡
ment Unemployment
𝜎ത ∶ the job separation or destruction rate
declines due to successful job search or
job creation, 𝜑𝑈
ത 𝑡
ത 𝑡 : the number of people who are wanting work but who
𝜎𝑁
are out of jobs. These are lost jobs.
Change in unemployment, ∆𝑈𝑡 , then, may be written as,
Those who lose their jobs spend time searching for a job and ∆𝑈𝑡 = 𝑈𝑡+1 − 𝑈𝑡 = 𝜎𝑁
ത 𝑡 − 𝜑𝑈
ത 𝑡
apply to job vacancies at firms
In the long-run, the economy would gravitate towards the
𝜑ത ∶ probability that the time spent searching for a job results steady state where there is no change in unemployment,
in employment. This is none other the fraction of or, ∆𝑈𝑡 = 0. Then,
unemployed people, 𝑈𝑡 , who find a job.
𝑈𝑡 : number of people unemployed. Then, 𝜎𝑁
ത 𝑡 − 𝜑𝑈
ത 𝑡=0

ത 𝑡 ∶ number of jobs created.

𝜑𝑈

23 24

6
 21-11-2023

Errol D’Souza Errol D’Souza

𝜎𝑁
ത 𝑡 − 𝜑𝑈
ത 𝑡=0 𝜎ത
𝑢∗ =
𝜑ത + 𝜎ത
Since the number employed, 𝑁𝑡 , is just the size of the labour
ഥ minus the number unemployed, 𝑈𝑡 ,
force, 𝑁, In an emerging market typically 1 per cent of the employed
jobs are lost due to separation or destruction. That
ഥ − 𝑈𝑡 − 𝜑𝑈
𝜎ത 𝑁 ത 𝑡=0 is, 𝜎ത = .01.
or, ഥ − 𝜑ത + 𝜎ത 𝑈𝑡 = 0
𝜎ത 𝑁 In emerging markets people cannot afford to be unemp-
loyed for long as there is a lack of social security
The steady-state is a situation where the number unemployed
and people are willing to work for less or at a job
does not change. Hence, replace 𝑈𝑡 with 𝑈 ∗ ─
that they are unqualified or overqualified for. We
ഥ
𝜎ത 𝑁 take it that approximately 30 per cent of the un-
𝑈∗ =
𝜑ത + 𝜎ത employed find a new job, or, 𝜑ത = .30.
Unemployment rate, 𝑢 ∗ , is the fraction of the labour force The natural rate of unemployment then is 3.2%
that is unemployed, or, 𝑈 ∗ Τ𝑁.ഥ Then,
𝜎ത 𝜎ത .01
𝑢∗ = Natural rate of 𝑢∗ = = = .032
𝜑ത + 𝜎ത unemployment 𝜑ത + 𝜎ത .01 + .30

25 26

Errol D’Souza Errol D’Souza

𝜎ത Natural rate of unemployment in the US

𝑢∗ =
𝜑ത + 𝜎ത

In a steady-state the economy is neither expanding or cont-

racting and the number of people losing jobs exactly
equals the number of people finding jobs.

This is the concept of the natural rate of unemployment, or,

the unemployment that will always exist as economies
have job vacancies from job separation or destruction
and at the same time have job creation and it would be
a matter of coincidence if the two were equal.

27 28

7
 21-11-2023

Errol D’Souza Errol D’Souza

𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 − 𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡

Potential Output – that output which can be produced if 𝑂𝑢𝑡𝑝𝑢𝑡 𝑔𝑎𝑝 =
labour were fully employed at normal 𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
levels of overtime and plant and
machinery were used at their normal 𝑌−𝑌∗
rates of utilization. =
𝑌∗
Okun argued that as an economy gets out of a recession
Real Output > Potential Output
output increases by a greater percentage than the
 Individuals temporarily are putting in rise in employment and vice versa.
extra time.
𝑌−𝑌∗
This is not sustainable. = 3 𝑢 ∗ −𝑢
𝑌∗
Individuals cannot work overtime
continuously and plant and
machinery must be shut down
for maintenance.

29 30

Errol D’Souza Errol D’Souza

31 32

8
 21-11-2023

Errol D’Souza Errol D’Souza

Phillips Curve – The Static Case

N : total labour force

N: number employed

U: number unemployed

N = N +U

33 34

Errol D’Souza Errol D’Souza

Phillips Curve – The Static Case Phillips Curve – The Static Case

N : total labour force N : total labour force

N: number employed N: number employed

U: number unemployed U: number unemployed

N = N +U N = N +U
U U
U=N Everyone unemployed
All labour is employed

N N
N=N N=N

35 36

9
 21-11-2023

Errol D’Souza Nominal wage Errol D’Souza

Assume p0e = p0
w
p0e (MRSC ,l )
Panel A
Phillips Curve – The Static Case

N : total labour force

w0 E
N: number employed

U: number unemployed p0 MPN

N
N*
N = N +U Employment

U
U=N Locus of points relating
employment and unemp-
loyment – Panel B in the
next diagram

N
N=N

37 38

Nominal wage Errol D’Souza Nominal wage Price

Errol D’Souza
Assume p0e = p0 Assume p0e = p0
w w p
Panel A
p0e (MRSC ,l )
Panel A
p0e (MRSC ,l ) (
PC p = p e )
Panel D

w0 E w0 E
p0 E/

p0 MPN p0 MPN

N N U
Unemployment N* Employment Unemployment N* Employment U* Unemployment
U U
Unemployment

U=N Panel B U=N Panel B

Panel C
U* U*
U*

450 U
N N
N* N=N N* N=N U* Unemployment

39 40

10
 21-11-2023

Nominal wage  p0
Price increase to p1 Price Errol D’Souza Nominal wage  p 0  p1
Price declines to p 2Price Errol D’Souza

w p w p
Panel A
p0e (MRSC ,l ) (
PC p = p e ) Panel A
p0e (MRSC ,l ) (
PC p = p e )
A Panel D A Panel D
w1 w1

w0 E p1MPN A/ w0 E p1MPN A/
p1 p1
B p0 E/ w2 B p0 E/
B/
p2
p0 MPN p0 MPN
p2 MPN
N U N U
Unemployment N* N1 Employment U1 U* Unemployment Unemployment N2 N* N1 Employment U1 U* U2 Unemployment
U U
Unemployment

Unemployment
U=N Panel B U=N Panel B

U2
Panel C Panel C
U* U*
U* U*
U1 U1
450 U 450 U
N N
N2 N* N1 N=N U* Unemployment N2 N* N1 N=N U* Unemployment

41 42

Nominal wage Price

Errol D’Souza Nominal wage Higher price expectations
Price p1e  p0e
Errol D’Souza

w p w p
Panel A
p0e (MRSC ,l ) (
PC p = p e ) Panel A
p0e (MRSC ,l ) (
PC p = p e )
A Panel D A Panel D
w1 w1

w0 E p1MPN A/ w0 E p1MPN A/
p1 p1
w2 B p0 E/ w2 B p0 E/
B/ B/ (
PC p1e  p1 )
p2 p2
p0 MPN (
PC p0e  p0 ) p0 MPN (
PC p0e  p0 )
p2 MPN p2 MPN
N U N U
Unemployment N2 N* N1 Employment U1 U* U2 Unemployment Unemployment N2 N* N1 Employment U1 U* U2 Unemployment
U U
Unemployment

Unemployment

U=N Panel B U=N Panel B

U2 U2
Panel C Panel C
U* U*
U* U*
U1 U1
450 U 450 U
N N
N2 N* N1 N=N U* Unemployment N2 N* N1 N=N U* Unemployment

43 44

11
 21-11-2023

Nominal wage Lower price expectations

Price p2e  p0e
Errol D’Souza Errol D’Souza

w p
Panel A
p0e (MRSC ,l ) (
PC p = p e )
A Panel D
w1

w0 E p1MPN A/
p1
w2 B p0
p2
E/
B/ (
PC p1e  p1 ) Phillips Curve is the mirror image
p2 MPN
p0 MPN
(
PC p2e  p2
(
PC p0e  p0
)
)
of the Aggregate Supply Curve
N U
Unemployment N2 N* N1 Employment U1 U* U2 Unemployment
U
Unemployment

U=N Panel B

U2
Panel C
U*
U*
U1
450 U
N
N2 N* N1 N=N U* Unemployment

Figure 7.12: Static Phillips Curve

45 46

Nominal wage Errol D’Souza

Price (
AS p = p e ) Price PC p = p (
e
)
w Panel A p0e (MRSC ,l )
Figure 7.11 Figure 7.12
Panel D (
AS p0e  p0 ) Panel D
A
w1
p1 A/ p1 A/
w0 E p1MPN p0 E/ p0 E/

w2 B p2 p2
B/ B/
(
PC p0e  p0 )
p0 MPN
p2 MPN
Output Unemployment
N2 N* N1 Employment Y2 Y * Y1 U1 U * U2
Output

Panel B Panel C
Y1
Y*
Y2
Output

450 Output

N2 N * N1 Employment
Unemployment

Unemployment

Panel E Panel F

U2 U2
U*
U1
U1
450
N2 N * N1 Employment U* Unemployment

Figure 7.13: Phillips Curve as Image of Aggregate Supply Curve

47

12