Introduction to Macroeconomics: The Labour Market

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1 Introduction to Macroeconomics: The Labour Market (based on Chapter 6 of the textbook by Olivier Blanchard) Ulrich Gunter Department of Economics, University of Vienna Summer Term / 31

2 Organisational Matters Instructor: Ulrich Gunter, Oesterreichische Nationalbank and University of Vienna Oce hours: 24/7 by or shortly before/after the lecture in person Time and location: Wednesdays (HS 3 at BWZ) and Thursdays (HS 5 at BWZ) from 18:00 sharp until 19:30 NO lectures on: Thu, June 2; Wed, June 15; Thu, June 23 2 / 31

3 Agenda for the Rest of this Course The Labour Market (Chapter 6 of Blanchard) The Phillips Curve (Chapter 8 of Blanchard) Ination, Output, and Nominal Money Growth (Chapter 9 of Blanchard) The Open Economy An Introduction (Chapter 18 of Blanchard) The Goods Market in an Open Economy (Chapter 19 of Blanchard) 3 / 31

4 Motivation In the IS-LM model (short-run analysis) we have assumed a constant price level For a medium run analysis this assumption is not feasible anymore since prices (incl. wages) adjust over time Thus, studying prices is a necessary prerequisite for a medium run analysis of the economy Central to our study of prices is the labour market 4 / 31

5 What is the Labour Market? In the labour market, rms buy (demand) and individuals sell (supply) labour The price of labour is called wage The labour market is central to our study of prices because there is a close relation between 1. the wage at which rms buy labour and the price at which they sell their goods 2. the wage at which workers sell labour and the price at which they buy goods 5 / 31

6 Labour Market Denitions Noninstitutional civilian population: number of people potentially available for civilian employment (i.e. total population excluding children, people in the armed forces etc.) Labour force: people either working or looking for work (i.e. employed and unemployed people) Out of the labour force: sum of those neither working in the market place nor looking for work (e.g. retirees, housewives/househusbands, discouraged workers, rich inheritors etc.) Unemployment rate: ratio of unemployed to the labour force Participation rate: ratio of the labour force to the noninstitutional civilian population 6 / 31

7 Movements in the Labour Market The unemployment rate can reect an active (i.e. many separations and hires) or a sclerotic (i.e. stagnant pool of unemployed) labour market 7 / 31

8 Unemployment Rates over Time Figure: Yearly unemployment rates of Austria, Germany, and the US since 1980; IMF WEO, April / 31

9 Wage Determination Stylized Facts Typically wages exceed the so-called reservation wage, i.e. the wage at which a worker is indierent between working and being unemployed Reasons: 1. Workers have bargaining power (on an individual and/or a collective level) 2. Sometimes rms have an interest to pay more than the reservation wage 9 / 31

10 Wage Determination Stylized Facts (cont.) ad 1) bargaining power depends on three factors: conditions on the labour market (e.g. low unemployment makes it dicult for rms to nd replacement workers) nature of the job (e.g. high skilled workers are relatively dicult to replace) rate of unionisation combined with importance of trade unions in wage negotiations ad 2) eciency wage theories: a higher wage increases worker productivity (and decreases employee turnover) 10 / 31

11 Wage Determination Formal Analysis Formalisation of the previous discussion: W = P e F (u, z), F (u, z)/ u < 0, F (u, z)/ z > 0 W... nominal wage P e... expected price level u... unemployment rate z... catchall variable (other factors aecting wages, e.g. level of unemployment benets as reservation wage or "alternative income", negotiated and/or minimum wages, employment protection) F... a function (decreasing in u and increasing in z) 11 / 31

12 Wage Determination Formal Analysis (cont.) We use the expected price level P e because the relevant prices in the future are not known when nominal wages are set Workers and rms care about real rather than nominal wages: workers because they do not care about how much money they get but how many goods they can buy with their money rms because they need to know how much they have to pay relative to the prices of the goods they sell If workers expect the price level to double, for instance, they will ask for a doubling of their nominal wage (in order to hold real wages constant) 12 / 31

13 The Wage-Setting Relation If we assume that P = P e (reasonable in medium run only) then we can write W = PF (u, z) W P = F (u, z) (1) Equation (1) implies that the real wage asked for by workers is decreasing in the unemployment rate u and increasing in z The relation between the real wage and the unemployment rate described by (1) is called wage-setting relation 13 / 31

14 Wage-Setting Relation Graphical Representation Figure: The WS-curve 14 / 31

15 Price Determination Formal Analysis Prices set by rms depend on the costs of production and thus on the production technology We will assume that labour is the sole input factor to this technology: Y = AN Y... aggregate output N... employment (i.e. number of workers) A... labour productivity (i.e. output per worker) 15 / 31

16 Price Determination Formal Analysis (cont.) If a worker gets wage W and he produces A units of output then the wage costs per unit of output are equal to W /A So the costs of producing one more unit of output, i.e. the marginal costs of production, are equal to W /A In a perfectly competitive market, price equals marginal costs, i.e. P = W /A 16 / 31

17 Price Determination Formal Analysis (cont.) We will not assume perfect competition (rms as price takers); instead we assume that rms have some market power and charge a positive markup µ (rms as price setters, monopolistic competition) Therefore rms set prices according to P = (1 + µ)(w /A) Since price P exceeds production costs W /A rms make prots 17 / 31

18 The Price-Setting Relation Rewriting the relation between the price level P and nominal wages W yields W P = A (2) 1 + µ Equation (2) implies that the real wage oered by rms is decreasing in the markup µ and increasing in productivity A The relation is called price-setting relation In the graphical representation, the price-setting relation is a horizontal line, i.e. the real wage implied by price setting is independent of the unemployment rate 18 / 31

19 Price-Setting Relation Graphical Representation Figure: The PS-curve 19 / 31

20 Labour Market Equilibrium Equilibrium in the labour market requires that the real wage asked for by workers equals the real wage oered by rms Formally, denoting the equilibrium unemployment rate by u n (natural rate of unemployment), the equilibrium is given by F (u n, z) = A 1 + µ In the graphical representation, the equilibrium is given by the intersection of the WS-curve (wage-setting relation) and the PS-curve (price-setting relation) 20 / 31

21 Labour Market Equilibrium Graphical Representation Figure: Equilibrium in the Labour Market 21 / 31

22 Determinants of Labour Market Equilibrium From the equilibrium condition F (u n, z) = A/(1 + µ) we see that u n is determined by the markup µ, the catchall variable z and the productivity A In graphical terms: the positions of the wage-setting curve (WS) and the price-setting curve (PS), and therefore the labour market equilibrium, depend on µ, z and A What happens if unemployment benets increase, i.e. an increase in z? From the wage-setting relation we know that if z increases the real wage W /P goes up for any unemployment rate. Thus the WS-curve shifts up 22 / 31

23 Increase in Unemployment Benets Graphical Representation Figure: A Shift of the WS-curve 23 / 31

24 Increase in Unemployment Benets Intuition The shift of the WS-curve implies that the equilibrium moves from point A to A. Therefore the natural rate of unemployment u n increases if unemployment benets increase Intuition: if unemployment benets increase, rms would have to pay higher real wages (because the reservation wage of workers increases and the prospect of becoming unemployed is less distressing); if rms are not willing to pay higher wages, unemployment will go up; unemployment will increase until the real wage asked for by workers is equal to the real wage oered by rms 24 / 31

25 Relaxation of Antitrust Regulation Next consider a less stringent enforcement of existing antitrust legislation This is likely to result in more market power for rms (e.g. collusion) and thus a higher markup µ From the price-setting relation we know that if µ increases the real wage W /P goes down for any unemployment rate. Thus the PS-curve shifts down 25 / 31

26 Relaxation of Antitrust Regulation Graphical Representation Figure: A Shift of the PS-curve 26 / 31

27 Relaxation of Antitrust Regulation Intuition The shift of the PS-curve implies that the equilibrium moves from point A to A. Therefore the natural rate of unemployment u n increases if antitrust regulation is relaxed Intuition: given nominal wages W an increase in the markup µ leads to higher prices and therefore to lower real wages W /P; the bargaining power of workers has to decrease so that they accept these real wages; this adjustment occurs through the unemployment rate; unemployment increases until real wages asked for by workers are equal to real wages oered by rms 27 / 31

28 The Natural Level of Output The natural rate of unemployment u n is associated with a natural level of output In the following, U denotes unemployment, N employment and L the labour force u U L = L N L = 1 N L (3) Rearranging (3) yields N = L(1 u) 28 / 31

29 The Natural Level of Output Recall that the production function was given by Y = AN Therefore the natural level of output is given by Y n = AL(1 u n ) Solving for the natural rate of unemployment yields u n = 1 Y n /AL Substituting this into our labour market equilibrium condition we get F ( 1 Y ) n AL, z = A 1 + µ 29 / 31

30 Summary Equilibrium in the labour market requires that the real wage asked for by workers is equal to the real wage oered by rms The main assumption in this respect is that the price level equals the expected price level, i.e. P = P e In the short run, however, this assumption might not be true and therefore u u n Since expectations are unlikely to be systematically wrong, in the medium run P = P e will hold and u = u n 30 / 31

040035/1 UK Introductory Macroeconomics Einführung in die Makroökonomie

Chapter 6 040035/1 UK Introductory Macroeconomics Einführung in die Makroökonomie Wolfgang Schwarzbauer IHS Contents Labour Market Basics Movements in Unemployment Wage Determination Price Determination