CHAPTER
14
The Labor Market,
Unemployment, and Inflation
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Labor Market: Basic Concepts
• The unemployment rate is the ratio
of the number of people unemployed
to the total number of people in the
labor force.
• Cyclical unemployment is the
increase in unemployment that
occurs during recessions and
depressions.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Labor Market: Basic Concepts
• Frictional unemployment is the
portion of unemployment that is due
to the normal working of the labor
market; used to denote short-run
job/skill matching problems.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Labor Market: Basic Concepts
• Structural unemployment is the
portion of unemployment that is due
to changes in the structure of the
economy that result in a significant
loss of jobs in certain industries.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Classical View
of the Labor Market
• According to classical economists,
the quantity of labor demanded and
supplied are brought into equilibrium
by rising and falling wage rates.
There should be no persistent
unemployment above the frictional
and structural amount.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Classical View
of the Labor Market
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• The labor supply curve
illustrates the amount of
labor that households
want to supply at each
given wage rate.
• The labor demand
curve illustrates the
amount of labor that
firms want to employ at
each given wage rate.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Classical View
of the Labor Market
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• Classical economists
believe that the labor
market always clears.
• If labor demand
decreases, the
equilibrium wage will fall.
• Anyone who wants a job
at W1 will have one.
There is always full
employment in this
sense.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Classical Labor Market
and the Aggregate Supply Curve
• The classical idea that wages adjust
to clear the labor market is consistent
with the view that wages respond
quickly to price changes. This means
that the AS curve is vertical.
• When the AS curve is vertical,
monetary and fiscal policy cannot
affect the level of output and
employment in the economy.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Unemployment
Rate and the Classical View
• The unemployment rate is not
necessarily an accurate indicator of
whether the labor market is working
properly.
• The unemployment rate may
sometimes seem high even though
the labor market is working well.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• The fact that people are willing to
work at a wage higher than the
current wage does not mean that the
labor market is not working.
• The term sticky wages refers to the
downward rigidity of wages as an
explanation for the existence of
unemployment.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
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• If wages “stick” at W0
rather than fall to the
new equilibrium wage
of W* following a shift
of demand, the result
will be unemployment
equal to
L 0 – L 1.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• One explanation for downwardly
sticky wages is that firms enter into
social, or implicit, contracts.
These contracts are unspoken
agreements between workers and
firms that firms will not cut wages.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• The relative-wage explanation of
unemployment holds that workers
are concerned about their wages
relative to the wages of other
workers in other firms and industries.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• Explicit contracts are employment
contracts that stipulate workers’
wages, usually for a period of one to
three years. Wages set in this way
do not fluctuate with economic
conditions.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• Cost of living adjustments
(COLAs) are contract provisions that
tie wages to changes in the cost of
living. The greater the inflation rate,
the more wages are raised.
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Karl Case, Ray Fair
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• The efficiency wage theory is an
explanation for unemployment that
holds that the productivity of workers
increases with the wage rate. If this
is so, firms may have an incentive to
pay wages above the marketclearing rate.
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Karl Case, Ray Fair
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• If firms have imperfect
information, they may simply
set wages wrong—wages that
do not clear the labor market.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Explaining the
Existence of Unemployment
• Minimum wage laws set a
floor for wage rates, and
explain at least a fraction of
unemployment.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Short-Run Relationship Between
the Unemployment Rate and Inflation
• In the short run, the
unemployment rate (U) and
aggregate output (income) (Y)
are negatively related.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Short-Run Relationship Between
the Unemployment Rate and Inflation
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• As depicted by this short
run AS curve, the
relationship between Y and
the price level (P) is
positive.
• The relationship between U
and P is negative. As U
declines in response to the
economy moving closer and
closer to capacity output, the
overall price level rises more
and more.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Phillips Curve
• The inflation rate is the
percentage change in the price
level.
• The Phillips Curve shows the
relationship between the
inflation rate and the
unemployment rate.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Phillips Curve
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• There is a trade-off
between inflation and
unemployment. To
lower the inflation rate,
we must accept a
higher unemployment
rate.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Phillips Curve:
A Historical Perspective
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• In the 1960s and early
1970s, inflation
appeared to respond
in a fairly predictable
way to changes in the
unemployment rate.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Phillips Curve:
A Historical Perspective
© 2004 Prentice Hall Business Publishing
• But in the 1970s and
1980s, the Phillips
Curve broke down.
• The points on this
figure show no
particular relationship
between inflation and
unemployment.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Aggregate Supply and Aggregate
Demand Analysis and the Phillips Curve
• When AS shifts with no
shifts in AD, there is a
negative relationship
between P and Y.
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• When AD shifts with no
shifts in AS, there is a
positive relationship
between P and Y.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Aggregate Supply and Aggregate
Demand Analysis and the Phillips Curve
© 2004 Prentice Hall Business Publishing
• If both AD and AS are
shifting, there is no
systematic relationship
between P and Y and
thus no systematic
relationship between
the unemployment rate
and the inflation rate.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Role of Import Prices
• The AS curve shifts when input
prices change, and input prices are
affected by the price of imports.
• There were no large shifts in the AS
curve in the 1960s due to changes in
the price of imports.
• The price of imports increased
considerably in the 1970s. This led to
large shifts in the AS curve during the
decade.
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Karl Case, Ray Fair
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Price of Imports, 1960 I-2003 II
• The price of imports changed very little in the
1960s and early 1970s. It increased substantially
in 1974 and again in 1979–1980. Since 1981,
the price of imports has changed very little.
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Karl Case, Ray Fair
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Expectations and the Phillips Curve
• Expectations are self-fulfilling. This
means that wage inflation is affected
by expectations of future price
inflation.
• Price expectations that affect wage
contracts eventually affect prices
themselves.
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Karl Case, Ray Fair
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Expectations and the Phillips Curve
• Inflationary expectations shift the
Phillips curve to the right.
• Inflationary expectations were stable
in the 1950s and 1960s, but
increased in the 1970s.
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Karl Case, Ray Fair
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Long-Run AS curve, Potential GDP,
and the Natural Rate of Unemployment
• When output is pushed
above potential GDP (Y0),
there is upward pressure
on costs. Rising costs
push the short-run AS
curve to the left. The
quantity supplied will end
up back at Y0.
• If the AS curve is vertical in the long run, so
is the Phillips Curve.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Long-Run AS curve, Potential GDP,
and the Natural Rate of Unemployment
© 2004 Prentice Hall Business Publishing
• In the long run, the Phillips
Curve corresponds to the
natural rate of
unemployment.
• The natural rate of
unemployment (U*) is the
unemployment rate that is
consistent with the notion
of a fixed long-run output at
potential GDP.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The NAIRU—The Nonaccelerating
Inflation Rate of Unemployment
• Many economists believe
the relationship between the
change in the inflation rate
and the unemployment rate
is as depicted by the PP
curve in this figure.
• Only when the unemployment rate is equal to
the NAIRU is the price level changing at a
constant rate (no change in the inflation rate).
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
© 2004 Prentice Hall Business Publishing
• To the left of the NAIRU the
price level is accelerating
(positive changes in the
inflation rate).
• To the right of the NAIRU
the price level is
decelerating (negative
changes in the inflation
rate).
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
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• A favorable shift of the
PP curve is to the left
because the PP curve
crosses zero at a lower
unemployment rate.
• A possible recent source of
favorable shifts is increased
foreign competition, which
may have kept both wage
costs and other input costs
down.
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C H A P T E R 14: The Labor Market, Unemployment, and Inflation
Review Terms and Concepts
cost-of-living adjustments
(COLAs)
cyclical unemployment
efficiency wage theory
explicit contracts
minimum wage laws
NAIRU
natural rate of unemployment
Phillips Curve
frictional unemployment
relative-wage explanation of
unemployment
inflation rate
social, or implicit, contracts
labor demand curve
sticky wages
labor supply curve
structural unemployment
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unemployment rate
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