Week 4: The Medium Run [Labour Market, Phillips Curve]

Question 1

Unemployment criteria:

Answer 1

1 Without a job, have been actively seeking work in the past four weeks and are available to start work in the next two weeks;
2 Out of work, have found a job and are waiting to start it in the next two weeks;

Question 2

u as a capacity utilization measure

Answer 2

■ When u is low, more (labour) resources are used;
■ Conversely, when it is high, less of an economy’s productive capacity is used;

Question 3

What creates labour flows?

Answer 3

• Separation rate s – the share of employed losing jobs
• Less productive firms are competed out by their rivals (firm
  churning), temporary contracts expire; On average, s ≈ 1.3% in the UK;
• Finding rate f – the share of unemployed finding jobs
• Finding a job involves searching, applying, being interviewed, and
  all those take time (search frictions); On average, f ≈ 50.1% in the UK;

Question 4

Unemployment rate converges

Answer 4

U= s/(s+f)

Question 5

Efficiency wages

Answer 5

■ There is a minimum wage acceptable for workers (e.g. no-one will work for a wage below unemployment benefits plus the compensation for the disutility of working);
■ This minimum level is called reservation wage;
■ At this wage, demand from labour from producers would be at
the highest level and the labour market would clear;
■ Why is this wage not offered?
■ Having the reservation wage might be detrimental to workers’ performance, and so firms pay more;
■ The link between wages and workers’ performance is explored by several efficiency wage theories;

Question 6

Shapiro-Stieglitz interpretation

Answer 6

■ Working hard requires the inconvenience of exerting extra effort, and so employees are prone to shirk;
■ They are sacked if caught shirking, and upon that start receiving unemployment benefits;
■ If the wage is higher than the benefit, it can act as a disciplining tool (workers do not shirk because otherwise they will lose their wage);
■ If, however, the wage is at the reservation level, a worker has nothing to lose, and so firms are deprived of their leverage;

■ Naturally, having a higher reservation wage implies a higher wage (wage has to stay attractive enough to still act as a disciplining tool);
■ A higher unemployment rate drives wages down (higher unemployment rate would raise the prospect of staying out of work for longer for workers, and thus strengthens the firms’ position);

Question 7

Bargaining

Answer 7

■ Finally, wages are not pushed all the way down to the reservation level because workers have a degree of bargaining power;
■ One source of power is the set of skills a worker possesses;
■ More unique skills make for a less substitutable employee;
■ The bargaining power also depends on the situation in the labour market: if unemployment is low, a worker can easily find another job if needed, while it would be difficult for the firm to find a replacement;

Question 8

Labour market - quick summary

Answer 8

■ Labour markets are characterised by the degree to which labour resources are employed;
■ This degree is always below 100%, as reflected by the positivity of the unemployment rate;
■ A larger degree of utilisation is associated with moving above an economy’s trend;

Question 9

Wage setting equation

Answer 9

■Equivalently, we can think of the WS equation in real terms W/ Pe =1−αu+z
■ W/ Pe is the expected real wage;
■ Workers and firms care about the wage not in monetary terms, but rather how much could be bought for it;

Question 10

Price setting equation

Answer 10

■ Wages are a component of firms’ costs, and so deciding upon wages has bearing on firms’ prices;
■ To formalise, suppose output is produced according to a very simple technology
Y=N
■ Each single extra worker can create 1 unit of output;
■ The price of 1 worker’s labour is W;
■ Thus the marginal cost of 1 unit of output for a firm is exactly W;

Suppose the price is formed by charging mark-up m over a firm’s marginal cost W
P = (1 + m) W
■ m measures by how much (in percentage terms) the price
exceeds the marginal cost;
■ As an example, if the wage rate is 5 and the mark-up is 20%,
thepriceishigherthanW by20%:P =5·(1+0.2)=6;

Question 11

Price-setting equation - real wage

Answer 11

■ Equivalently, we can think of the price-setting equation in terms of the real wage W/P
W/P=1/1+m
■ Charging a higher mark-up reduces the real wage: if every product costs now more, less can be bought for one wage;

Question 12

Labour market in the medium run

Answer 12

■ We know that there is always some unemployment;
■ Let us first characterise it in the medium run;
■ We will express this by positing that P = Pe: informally, there is far less jumping around in the medium run, and so we can make accurate forecasts

Question 13

Wage and price-setting together

Answer 13

■ Considering the WS and the PS relationship together allows us to pin down u in the medium run as the outcome of pricing decisions in the markets for goods and labour;
■ That medium run level of unemployment is denoted as un;
■ It is commonly called the natural rate of unemployment;
■ We will term it the structural rate of unemployment, as it depends on an economy’s structural features (which are not exactly ‘natural’, more on that in a moment)

Question 14

the impact of higher unemployment benefits in words

Answer 14

■ If benefits increase, workers demand higher wages;
■ But their real wages are determined by the PS condition,
which is outside the labour market;
■ Thus, their bargaining power needs to decrease so that the equilibrium is achieved;
■ The only way for this to happen is through a higher equilibrium unemployment rate un;

Question 15

Phillips curve

Answer 15

■ The first version of the Phillips curve was derived in 1958 by A.W.H. Phillips;
■ It connected unemployment with the growth rate of wages;
■ We are going to focus instead on unemployment and inflatio

(1/1+m)P = Pe(1-αu+z)

Final form:

■ Critically, the Phillips curve (PC) connects inflation, expected inflation and unemployment (capacity utilisation)

π = πe + (m + z) − αu

■ Lower u implies higher π: from WS, with a lower unemployment, workers demand higher wages, and those lead to higher prices;
■ Higher πe implies higher π: from WS, if higher prices are expected, workers demand higher wages to cover extra costs;

Question 16

Inflation expectations in the medium run

Answer 16

This is to say, in the medium run expected inflation equals inflation (we do not commit systematic errors of prediction);
■ Additionally, target inflation is constant π = π ̄;
■ We can therefore define the medium run unemployment
rate un through the PC as
π=πe =π ̄⇒π ̄=π ̄+(m+z)−αun
un = m + z / α

Question 17

PC as an indicator of an economy’s current position

Answer 17

Plugging un into the PC equation yields us a very convenient
indicator tool for macro policy
π = πe + α m + z − αu = πe + αun − αu α
(1) π−πe =−α(u−un)

■ Whenever the unemployment rate is below its medium run level un, inflation is above its expected (and so medium run) value;

■ Thus if inflation is staying above its medium run rate, it is an indication that an economy is above the trend (is overheating);

■ Naturally, if the unemployment rate is at un = m+z/α, inflation
is at its (constant) medium run level;
■ For this reason, un is also called the non-accelerating inflation unemployment rate (NAIRU);

Question 18

Inflation in the medium run

Answer 18

It should not be high!
■ Inflation distorts price signals (if others crank prices up and I am facing more demand, should I produce more or follow suit?);
■ Large inflation ⇒ large swings in it and in the real rate ⇒ high risks for borrowers and lenders;
■ Menu costs;
■ Losses for everyone whose nominal income cannot be renegotiated (declining real income, ‘shoe leather costs’);

It should be positive!
■ Positive inflation allows the conventional monetary policy to reach further below zero (in terms of r);
■ Observed inflation includes quality growth (e.g., computers are more expensive but pack much more computing power

Question 19

Output and spending in the medium run

Answer 19

Overall idea – connecting output with resources (L) and degree of utilisation u, in general first and then in the medium run;
■ Labour is the only production factor, the volume utilised is u = U/L = L − N/ L = 1 − N/L ⇒ N = L (1 − u)
■ Remember that a worker produces 1 piece of GDP Y=N
■ Combining the two expressions together yields
Y =L(1−u)

Question 20

Y into PC - potential output

Answer 20

■ Thus we can determine output through the stock of resources an economy possesses (labour force L) and the degree of their utilisation (u)
Y= L(1-u)
■ Naturally, we can define the level of output corresponding to the normal degree of utilisation un as potential output – a point on the trend line
Yn= L(1-un)
■ Equilibrium spending in the medium run equals potential output Yn – in the medium run spending is driven by output!

Question 21

Key notions: labour volumes

Answer 21

Employed – individuals working for at least 1 hour per week and receiving remuneration, which is not directly dependent on the revenue of the unit where they work (salary);
■ Unemployed – individuals without a job, who satisfy either of the two criteria:
1 They have been actively seeking employment (this includes registering with employment services; seeking the assistance of friends, relatives and other intermediaries; applying to employers directly; placing or answering job advertisements in print or online; placing or updating CVs) or preparing to establish a business within 4 weeks and are available to start work within the
next 2 weeks;
2 They are starting a job within a short period of time, or they
participate in skill training, or they are migrating abroad to work and seeking opportunity to leave;

■ Working age population – people within a certain age bracket, which makes them potentially part of the labour force (depending on the methodology, the age bracket can vary: between 16 and 64 or just above 16 for the UK, or between 15 and 64 according to the OECD definition);
■ Labour force (economically active) – the combined total of all employed and unemployed persons of working age;

Question 22

Key notions - Labour market characteristics

Answer 22

■ Participation rate – the share of labour force in the working age population;
■ Employment rate – the share of the employed in the working age population. It is a measure of extent to which an economy’s potential labour resources are engaged;
■ Unemployment rate – the share of the unemployed in the labour force. It is an inverse measure of labour utilisation (i.e., a lower unemployment rate corresponds to a higher degree of utilisation);
■ Reservation wage – the minimum wage at which employment is no less attractive than unemployment. It comprises the unemployment benefits and the compensation for the disutility of work;
■ Job finding rate – the share of the unemployed who find a job within a given period of time (month/quarter/year);
■ Job separation rate – the share of the employed who lose a job within a given period of time (month/quarter/year);