The Medium Run
United States - 2006
A Tour of the Labor
Market
 The noninstitutional civilian population is the number of
people potentially available for civilian employment.
 The civilian labor force is the sum of those either
working or looking for work.
 Those who are neither working nor looking for work are
out of the labor force.
 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.
U.S. Participation Rate
U.S. Participation Rate
Participation Rates
The Large Flows of Workers
 On the extremes, the unemployment rate may
reflect two very different realities:
– An active labor market, with many separations and
many hires (very short duration of unemployment)
– A sclerotic labor market, with few separations, few
hires, and a stagnant unemployment pool (long
expected duration of unemployment)
The Flows of Workers
The Flows of Workers
The flows in and out of unemployment are
large in relation to the number of
unemployed.

The average duration of unemployment
was less than three months (2000) and is
higher now.
Movements in
Unemployment
 Fluctuations in the aggregate
unemployment rate affect:
– The welfare of the unemployed
– Wages of those employed
– Higher layoffs = higher risk of losing their
jobs
– A decrease in hires = more difficult to find
jobs
Movements in Unemployment
U.S.Unemployment Rate by Race, 1960-2003
Movements in Unemployment
Unemployment Rate in Europe, 1960-2003
U.S. production and employment 2000-2003
Other Labor Market Issues
 How many employed are working parttime only? How many of those want to
work full time?
 How many are employed as temporary
workers (temps)?
 Do temps (and others) have any job
security? Do they want job security?
 Nominal vs. real wages. Other benefits.
Outsourcing and Insourcing
Wages
 Real wages in
different countries
are….different.
Wage Determination
 Common forces at work in the
determination of wages (within a
specific labor market) include:
 A tendency for the wage to exceed the
reservation wage, or the wage that make
them indifferent between working or
becoming unemployed.
 Dependency of wages on labor-market
and firm-specific conditions.
Individual Bargaining
 How much bargaining power a worker
has depends on:
1. How costly it would be for the firm to replace
him—the nature of the job.
2. How hard it would be for him to find another
job—labor market conditions.
Efficiency Wages
 Efficiency wage theories - 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.
Wages, Prices, and Unemployment
W  P e F (u, z)
(  , )
 The aggregate nominal wage, W, depends on
three factors:
1. The expected price level, Pe
2. The unemployment rate, u
3. A catchall variable, z, that catches all other
variables that may affect the worker’s bargaining
position (labor market conditions).
Wages, Prices, and
Unemployment
1. Both workers and firms care about real
wages (W/P), not nominal wages (W).
2. Higher unemployment weakens workers’
bargaining power.
3. Safety nets:
1. Unemployment insurance
2. Minimum wages
3. Employment protection
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 simplest production function can be
written as:
Y  AN
Y = output
N = employment
A = labor productivity, or output per worker
Price Determination
 Firms set their price according to:
P  (1  )W
The term  is the markup of the price over the
cost of production. If all markets were perfectly
competitive,  = 0, and P = W.
The Natural Rate of 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.
The Wage-Setting Relation
 Earlier, we stated that the nominal wage rate was
determined as follows:
W  P e F (u, z)
(  , )
W  PF (u, z)
 Dividing both sides by P, then:
W
The wage-setting
 F ( u, z )
P
relation
(  , )
The Price-Setting Relation
 The price-determination equation is:
P  (1  )W
P
 (1   )
W
 To state this equation in terms of the
wage rate, we invert both sides:
W
1
The price-setting

relation
P (1  )
Equilibrium Real Wages
and Unemployment
1
F ( un , z ) 
1 
Equilibrium Real Wages and
Unemployment
An increase in
unemployment
benefits leads
to an increase
in the natural
rate of
unemployment.
Equilibrium Real Wages
and Unemployment
An increase in
markups
decreases the
real wage, and
leads to an
increase in the
natural rate of
unemployment.
The Price of Oil
From Employment to Output
 Associated with the natural level of employment
is a natural level of output, (and since Y=N,
then,)
Yn  N n  L(1  un )
 The natural level of output satisfies the following:
Yn 
1

F 1 
, z 

L  1 
The Natural Rate of Unemployment
The Natural Rate of Output