From the Short to the Medium Run How is the unemployement rate determined in the Medium Run?

1. From the Short to the Medium Run How is the unemployement rate determined in the Medium Run?

2. The Short Run: The IS-LM model The economy responds increasing production to match demand. A higher production increases employment Higher employment usually reduces unemployment So far we assume that all prices remain constant (except the interest rate) That makes sense when the economy has spare production capacity and only in the short term. Production response toanincrease in aggregateddemand.

3. The Medium Run: Prices, Wages and Employment Production increases employment. When employment increases (usually) unemployment is reduced. A lower unemployment rate push wages up Higher wages mean a higher production cost and higher prices of final goods and services. Higher prices reduce wage purchasing power and lead workers to ask for higher nominal wages Different from the IS-LM model: in the medium run, prices and wages do not remain stable when output grows or decreases. Production response toanincrease in aggregateddemand.

4. Introduction III: Objective of this unit Understanding how is the unemployment rate determined in the medium run. In the medium run, unemployment rate tends to return to the so called natural rate. This rate is determined by equilibrium in the labor market when the expected price level equals the actual price level. Conditional on price level expectations, equilibrium in the labor market occurs when: The real wage –implied by wage setting behaviour (influenced by the relative bargaining power of workers and firms)- equals the real wage implied by price setting behavior (influenced by the degree of competition in the goods market).

5. Intruduction IV: Labor market What is it? The place where the main productive factor (labor) is traded in exchange of a wage. The conventional labor supply and demand competitive model is not realistic: Wages are set by a bargain proces between workers and firms Firms do not take prices as given; they have the ability to fix them, given their costs (imperfect competition or oligopoly) Unemployment is not voluntary but involuntary In this model we develop an alternative model which uses wage and price curves, instead of supply and demand curves

6. Introduction V: Labor market theory Wage curve and price curve interaction determines employment and unemployment levels (usually called “natural” or “equilibrium” rates) and also prices and wages. From these levels we can establish a relation between production and prices level, which we will name aggregate supply curve; we will use it to complete the IS-LM model studied before.

7. Labor market We use to pay attention in labor market analysis to total population situation relative to employment; this is usually the main source of income for families. However, in some countries (such as Spain or Italy), there is a relevant percentage of workers who work by themselves. Does it have sense to speak about wage or employment of any of this workers?

8. Labor market II: the groups Total population of a country is the total amount of people who live in a country at a given time, usually the first or the last the of a year. Total population variation during a period of time, a year for example, depends on births and deaths in that year and on the difference between immigrants and emigrants in that year. Noninstitutional civilian population are the number of people potentially available for civilian employment (over 16 years; or between 16-64 years). Is the sum of labor force and out of the labor force. Active Population (Labor force) is that inside labor market, composed by employed people and unemployed people.

9. Labor market III: participation and unemployment rates The participation rate is the ratio of the labor force to the noninstitutional civilian population. The unemployment rate is the ratio of the unemployed to the labor force.

10. Labor market IV: Spain SPAIN: EPA, fourth quarter, 2006

11. Labor market V: Evolution Participation, employment and unemployment in Spain, 1976-2006 (EPA)

12. Labor market V: Evolution Participation, employment and unemployment in Spain, 1976-2006 (EPA)

13. Participation rates of men and women, by age groups,1976 and 2001 (Source: EPA) Labor market V: Flujos

14. Example: USA average flows, 1994-1999 Labor market V: Flujos Employment 93,8 millones 1,3 1,5 Out of the labor force 57,3 millones Unemployment 6,5 millones 1,6 1,6 1,0 0,8

15. Unemployment rate and the proportion of unemployed who find a job each quarter Labor market V: Flows in Spain

16. Spain: Proportion of employed workers fired each quarter Labor market V: Flows

17. Wage determination Theories: A. Bargaining Wages are bargained individually (between employers and employees) or collectivelly (between unions and firms) not defined by a competitive market.. • The output of this bargain depends on how the labor market is organized in the economy and on the relative bargaining power of the implied parts. • How much bargaining power a worker has depends on two factors: • 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.

18. Wage determination Theories: B. Efficiency Wages • Efficiency wage theories are theories that link the productivity or the efficiency of workers to the wage they are paid. • 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, will pay more than firms in sectors where workers’ activities are more routine. • Labor market conditions will affect the wage.

19. The Expected Price Level 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.

20. The Unemployment Rate • Also affecting the aggregate wage is the unemployment rate u. • 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 also allows firms to pay lower wages and still keep workers willing to work.

21. The Other Factors • The third variable, Z, is a catchall variable that stands for all the factors that affect wages given the expected price level and the unemployment rate. • Unemployment insurance is the payment of unemployment benefits to workers who lose their jobs.

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

23. Price Determination • Firms set their price according to: The term  is the markup of the price over the cost of production. If all markets were perfectly competitive,  = 0, and P = W.

24. The Natural Rateof Unemployment • This section looks at the implications of wage and price determination for unemployment. • We assume that Pe = P, and that nominal wages depends on the actual price level, P, rather than on the expected price level, Pe. • Wage setting and price setting determine the equilibrium rate of unemployment.

25. The Wage-Setting Relation • Earlier, we stated that the nominal wage rate was determined as follows: Now, since Pe = P, then: Dividing both sides by P, then: This relation between the real wage and the rate of unemployment is called the wage-setting relation. The wage-setting relation

26. The Price-Setting Relation • The price-determination equation is: If we divide both sides by W, we get: To state this equation in terms of the wage rate, we invert both sides: The price-setting relation

27. The Price-Setting Relation Wages, Prices, 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. Ecuación de precios (PS) 1/(1+μ) Real wage, W/P Ecuación de salarios (WS) u Unemployment rate, u

28. The Price-Setting Relation • The price-setting relation is drawn as the horizontal line PS (for price setting) in Figure 6-6. The real wage implied by price setting is • 1/(1 = µ); it does not depend on the unemployment rate.

29. Equilibrium Real Wagesand Unemployment • Eliminating W/P from the wage-setting and the price-setting relations, we can obtain the equilibrium unemployment rate, or natural rate of unemployment, un: The equilibrium unemployment rate (un) is called the natural rate of unemployment.

30. Equilibrium Real Wagesand Unemployment • The positions of the wage-setting and price-setting curves, and thus the equilibrium unemployment rate, depend on both z and u. • At a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay. • By letting firms increase their prices given the wage, less stringent enforcement of antitrust legislation leads to a decrease in the real wage.

31. Equilibrium Real Wagesand Unemployment Unemployment Benefits and the Natural Rate of Unemployment A A’ PS 1/(1+μ) An increase in unemployment benefits leads to an increase in the natural rate of unemployment. Real wage, W/P WS u u’ Unemployment rate, u

32. Equilibrium Real Wagesand Unemployment Markups and the Natural Rate of Unemployment A A’ 1/(1+μ) An increase in markups decreases the real wage, and leads to an increase in the natural rate of unemployment. 1/(1+μ’) Real wage, W/P u u’ Unemployment rate, u

33. Equilibrium Real Wagesand Unemployment • Because the equilibrium rate of unemployment reflects the structure of the economy, a better name for the natural rate of unemployment is the structural rate of unemployment.

34. From Unemployment to Employment • Associated with the natural rate of unemployment is a natural level of employment. Employment in terms of the labor force and the unemployment rate equals: The natural level of employment, Nn, is given by:

35. From Employment to Output In words, the natural level of output is suchthat, at the associated rate of unemployment,the real wage chosen in wage setting is equal to the real wage implied by price setting. , • Associated with the natural level of employment is a natural level of output, (and since Y=N, then,) The natural level of output satisfies the following:

36. Where are we going to • Effective price level can be different than expected. • Unemployment rate can differ from its natural rate. • Production can differ from its natural level. In the short run • Effective price level must be equal to expected price level (expectations can’t be permanently wrong). • Employment returns to its natural rate. • Production returns to its natural level. In the medium run