Macroeconomics II Unemployment

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1 Macroeconomics II Unemployment Vahagn Jerbashian Ch. 6 from Mankiw (2003; 2010) Spring 2018

2 Where we are and where we are heading to Macroeconomics I covers the IS-LM Model which delivers Aggregate Demand curve While discussing Consumption and Investment Theories we have looked at Microeconomics behind the Aggregate Demand curve We will proceed now to setting up the Aggregate Supply curve

3 Where we are and where we are heading to So far it was usually assumed that the factors of production (L, K) are (1) given/fixed, and (2) fully utilized. Therefore, aggregate supply (output) was constant and there was no unemployment We will now relax the second assumption for labor force and discuss in more details what is unemployment and where it comes from The unemployment is a serious issue in macroeconomics. The loss of jobs can reduce the standard of living of the majority of population

4 Unemployed and unemployment rate - A reminder Economy s labor force is equal to the sum of employed and unemployed people, where the unemployed are those who are (1) more than, e.g., 16; (2) not employed; (3) ready to work; and (4) looking for a job The unemployment rate is the percentage of unemployed people (out of labor force), Unemployment rate = Number of unemployed Labor force

5 Unemployment - The neoclassical (Walrasian) view In the neoclassical setting factors are fully utilized Real wage clears the labor market Everyone who wants to work is employed at the market wage Wages are determined from demand and supply of labor

Unemployment rate in the US Unemployment in the US, 1950-2006 Note: Natural

6 Unemployment rate in the US Unemployment in the US, Note: Natural unemployment is the average of unemployment rates from ten years earlier to ten years later.

7 Unemployment rate in Spain

8 Unemployment rate in EU 17

9 The questions that we ll try to address 1. Why do we observe above zero natural unemployment? 2. What are its causes and consequences?

10 A model for natural unemployment This model tries to address the first question In an economy, let E and U be the number of employed and unemployed, respectively L be the total labor force, i.e., L = E + U u be the unemployment rate, i.e., u = U L s be the rate of job separation (layoff, firing, quitting), i.e., in each period se number of employees become unemployed f be the rate of job finding, i.e., in each period fu number of unemployed become employed

11 A model for natural unemployment - Steady state In the steady state the number of workers who lose their job equals to the number of unemployed who find a job (i.e., there are no compositional changes in the labor force) se = fu s(l U) = fu (L U) s = f U L L u = s s + f

12 A model for natural unemployment - Steady state In the steady state the natural rate of unemployment depends on the rates of job finding and job separation Higher job finding rate implies lower unemployment, u f Higher job separation rate implies higher unemployment, u s If the f is very high, i.e., a person can always find a job quickly (back to neoclassical setting), then u is close to zero for a given s

13 Where do f and s come from? So far we have shown why there can be non zero natural unemployment (low f ). Now we will discuss how it can happen In neoclassical setting f is very large number ( f = + ) In order to have low f (i.e., f << + ) we need to have departures from neoclassical setting

14 Where do f and s come from? In neoclassical setting there is no labor force immobility everyone knows everything the prices (as well as wages) are fully flexible no one sets prices

15 Reasons to have low f - Frictional unemployment Frictional unemployment is one of the reasons to observe low f Searching for a job may be time consuming because it is hard to find a match (e.g., skills don t match with the job requirements) the flow of information about job vacancies is not perfect the geographic mobility of workers is not instantaneous Some frictional unemployment might be inevitable due to, for example, sectoral changes

16 Public policies can affect frictional unemployment There are several public policies which can affect the frictional unemployment Government employment agencies with retraining programs and/or disseminating information on job vacancies increase the job finding rate Unemployment benefit/insurance aims to mitigate the economic impact of unemployment; thus, it has a positive side decreases the time pressure of finding new job longer time of search (lower f )

17 Reasons to have low f - Wage rigidity Real wage rigidity can reduce f Definition: Real wages are rigit (or there is real wage rigidity) if real wages do not adjust to equilibrate demand and supply of labor (clear the labor market) Real wages can be stuck above the equilibrium level This will create/increase unemployment since firms will hire less labor This can decrease f since there will be workers who would accept a job with lower wage, but cannot find such a job Unemployment arising from real wage rigidity is often called Structural Unemployment

18 The Microeconomics behind - The demand for labor The demand for labor L D is given from firms profit maximization problem { max π = K α L 1 α wl rk } L,K where α (0, 1)

19 The Microeconomics behind - The demand for labor The demand for labor L D is given by first order condition L π = 0, which is equivalent to w = ( ) K α (1 α) L L D = ( ) 1 1 α α K w Therefore, higher wage rate w implies lower demand for labor

20 The Microeconomics behind - The supply of labor The supply of labor is given from workers /consumers utility maximization problem where max {U (C, H) = ln C + γ ln H} C,H s.t. C = rk + wl L + H = 24 H is leisure (holidays) and γ 0 The first equation is budget constraint where rk is income from lending capital The second equation is time constraint: In a day, time can be allocated either to labor or leisure

21 The Microeconomics behind - The supply of labor To derive the supply of labor substitute H = 24 L and C = rk + wl into utility function and take the first order condition L U = 0: L S = γ γ rk 1 + γ w Therefore, labor suply is non-decreasing in wage rate w In case γ > 0 it is increasing with w: elastic labor supply In case γ = 0 it does not depend on w: inelastic labor supply

22 The Microeconomics behind - Supply and demand together For simplicity, suppose that γ = 0. In such a case equilibrating/market clearing wage w is such that L D = L S : ( ) 1 1 α α 24 = K w If, wage rate w is somehow fixed above equilibrating wage rate then demand falls short of supply and unemployment arises

23 Supply and demand of labor

24 Reasons for real wage rigidity - Minimum wage laws One of the reasons behind real wage rigidity are minimum wage laws Minimum wage laws prevent firms from cutting wages below certain level called minimum wage

25 Minimum wage laws Positive: Minimum wage laws are implemented to secure a minimal income and reduce the bargaining power of the firms Neutral: Minimum wage is lower than the market clearing wage for the majority of the workers therefore, it cannot explain a significant part of natural rate of unemployment Negative: Minimum wage may exceed the market clearing wage of low earners (e.g., unskilled and inexperienced workers) within this group we may expect that higher minimum wage would increase the unemployment

26 Reasons for real wage rigidity - Labor unions Labor Unions and collective bargaining also can raise real wage rate above the equilibrating rate Labor unions and collective bargaining increase the bargaining power of union members (insiders) It is in the interests of the union members to keep their wages high and job separation low This reduces employment The unemployed non-union workers (outsiders) might want to accept lower wages so that they get jobs

5.2 Demand and Supply in the Labour Market

Summary - Chapter 5 Labour Markets and Unemployment 5.2 Demand and Supply in the Labour Market 5.2.1 Labour Supply and the Consumption Leisure Trade-off - The consumption leisure trade-off is the fundamental