KRUGMAN_WELLS_MACRO_CHAPTER15

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Unformatted text preview: chapter 1 5 >> Labor Markets, Unemployment, and Inflation M T W O PAT H S T O U N E M P L O Y M E N T ICHAEL WATSON, A SOFTWARE sending out between 50 and 75 résumés, he has had few bites to date. In North Carolina, there are more jobs than there were a few years ago, but manufacturing and engineering jobs are still hard to come by. Because both Watson and Patterson are currently jobless and actively seeking employment, they are considered to be unemployed. Both are in professions on the decline or stagnating in their given locations, but each is hesitant to move his family to a new city in search of work. So both men continue to search actively for permanent employment that’s a good match for their skills and ambitions. At any given point in time, millions of Americans are actively pursuing employment but have not found the right match. Others have recently been laid off, and still others have just entered the workforce but haven’t yet found jobs. This “natural” churning of the labor force means that at any given point in time some fraction of the population is developer in Colorado Springs, has been moving in and out of unemployment for three years. Ever since his high-tech employer closed its doors in July 2002, Watson has been without a permanent job, instead traveling to places as far-flung as Virginia and Djibouti to do temporary contract work. He isn’t alone: Colorado Springs, home to many high-tech workers, lost nearly 20% of its high-tech jobs between 2000 and 2004. Some workers who lost their jobs have since found new ones in Colorado Springs, others have left the area, and others—like Watson—are still looking for permanent work. The economy in North Carolina, where textile engineer Tommy Patterson lives, is booming relative to that in the rest of the country. But Patterson, who lost his job at a Charlotte textile mill in November 2004, is still looking for work as a process engineer in the chemical industry. Still, despite What you will learn in this chapter: ® The meaning of the natural rate of unemployment, and why it isn’t zero Why cyclical unemployment changes over the business cycle How factors such as a minimum wage and efficiency wages can lead to structural unemployment The reasons that unemployment can be higher or lower than the natural rate for extended periods The existence of a short-run trade-off between unemployment and inflation, called the shortrun Phillips curve, that disappears in the long run Why the NAIRU, the nonaccelerating inflation rate of unemployment, is an important measure for policy-making ® ® ® ® ® 368 Job loss strikes many kinds of workers, from computer programmers like Michael Watson to textile engineers like Tommy Patterson. These two, like the millions of other workers who lose jobs in any given year, would like to see themselves as pictured above: employed again. IT Stock/AgeFotostock Samuel Ashfield/Taxi/Getty Images unemployed. But the size of that fraction depends on the state of the economy: there are more people in Watson’s and Patterson’s situation when the economy is depressed than when the economy is booming. In this chapter, we look more closely at the nature of unemployment, why the unemployment rate goes up and down over time, and what economic policy can and cannot do about it. The Nature of Unemployment U.S. government statistics count as unemployed a worker who is actively looking for a job but hasn’t found one. Recall from Chapter 6 that the unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force who are either currently working or looking for jobs. If everyone who wanted a job had one, the unemployment rate would be 0%. But American public policy considers “full employment,” which you might think means that everyone who wants to work can, to be a number well above 0%. Indeed, as explained in For Inquiring Minds, a famous piece of legislation known as the Humphrey–Hawkins bill, passed by Congress in 1978, called on the government to seek full employment—but defined full employment to be an unemployment rate of 4%. Although 4% unemployment may seem like a large number—after all, this implies that even with “full employment” millions of Americans looking for work would be jobless—at the time Humphrey–Hawkins was passed the vast majority of economists considered this target to be unrealistic. In fact, the Congressional Budget Office currently calculates the cyclically adjusted budget balance, the budget balance if the economy were at potential output and, hence, at full employment, under the assumption that full employment means 5.2% unemployment. To understand why there are so many unemployed workers at full employment, we need to look at the realities of the labor market. FOR INQUIRING MINDS F U L L E M P L O Y M E N T : I T ’ S T H E L AW ! Is there a law requiring the U.S. government to ensure full employment? No, and there never was. But the Full Employment and Balanced Growth Act of 1978, usually referred to as the Humphrey– Hawkins bill, did call on the U.S. government to achieve an unemployment rate of 4% or less. Nothing in the bill specified penalties for government officials who failed to achieve these goals, and policy makers began ignoring the unemployment target from the start. The only provision that really had teeth was the requirement that the chairman of the Federal Reserve Board of Governors testify about monetary policy before Congress twice a year, a tradition that continues to this day. That testimony is still often referred to as the “Humphrey–Hawkins testimony,” even though the 1978 bill was allowed to lapse in 2000. Despite the fact that Humphrey–Hawkins never had much direct effect on policy, it came to have symbolic importance. A 4% unemployment rate became the seemingly unattainable goal of economic policy. In late 1998, when the unemployment rate finally (and briefly) dropped toward the elusive goal, columnist Walter Shapiro asked in the online magazine Slate, “Where are the ticker-tape parades, the patriotic speeches, the red-white-and-blue fireworks, and the photographs of beautiful women embracing exuberant economists in Times Square?” Job Creation and Job Destruction At any given time, most Americans know someone who has lost his or her job recently. On average, about one worker in seven loses his or her job (in some cases because of leaving voluntarily) even in good years. 369 370 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N 15un02 FPO There are many reasons for such job loss. One is that industries rise and fall as new technologies emerge and consumers’ tastes change. For example, employment in high-tech industries such as telecommunications surged in the late 1990s but slumped severely after 2000. That’s a major reason that Watson, the software developer, lost his job in 2002 and has had difficulty finding another. Another reason is that individual companies do well or badly depending on the quality of their management or simply depending on luck: in 2005 General Motors announced plans to close a number of auto plants even as Japanese companies such as Toyota announced plans to open new plants in North America. In addition, individual workers are constantly leaving jobs for personal reasons—family moves, dissatisfaction, better job prospects elsewhere. This constant churning of the workforce is an inevitable feature of the modern economy. It is also one main reason that there is a considerable amount of unemployment even when the economy is at full employment. Frictional Unemployment Workers who spend time looking for employment are engaged in job search. When a worker loses a job—or a young worker enters the job market for the first time—he or she often doesn’t take the first new job offered. For example, suppose a Frictional unemployment is unemployskilled programmer, laid off because her company’s product line was unsuccessful, ment due to the time workers spend in sees a help-wanted sign in the window of a shop. She might well be able to walk in job search. and get the job—but that would usually be foolish. Instead, she should take the time to look for a job that takes advantage of her skills and pays accordingly. Figure 15-1 Economists say that workers who spend time looking for employment are engaged in job search. If all workers and all jobs were Distribution of the Unemployed alike, job search wouldn’t be necessary; if information about jobs by Duration of Unemployment, 2000 and workers were perfect, job search would be very quick. In practice, however, it’s normal for a worker who loses a job (or a young worker seeking a first job) to spend at least a few weeks searching. 27 weeks Frictional unemployment is unemployment due to the time and over workers spend in job search. A certain amount of frictional un15 to 11% employment is inevitable, for two reasons. One is the constant 26 weeks process of job creation and job destruction, which we have just 12% Less than 5 weeks described. The other is the fact that new workers are always enter45% ing the job market. For example, in July 2005, out of 7.8 million 5 to 14 workers counted as unemployed, 882,000 were new entrants to weeks the workforce. 32% A limited amount of frictional unemployment is relatively harmless and may even be a good thing. The economy is more productive if workers take the time to find jobs that are well matched to their skills, and workers who are unemployed for a brief period while searching for the right job don’t experience In years when the unemployment rate is low, most ungreat hardship. In fact, when there is a low unemployment rate, employed workers are unemployed for only a short peperiods of unemployment tend to be quite short, suggesting that riod. In 2000, a year of low unemployment, 45% of the much of the unemployment is frictional. Figure 15-1 shows the unemployed had been unemployed for less than 5 composition of unemployment in 2000, when the unemployweeks and 77% for less than 15 weeks. The short duration of unemployment for most workers suggests that ment rate was only 4%. Forty-five percent of the unemployed had most unemployment in 2000 was at this time frictional. been unemployed for less than 5 weeks and only 23% had been Source: Bureau of Labor Statistics. unemployed for 15 or more weeks. Just 11% were considered to be “long-term unemployed”—unemployed for 27 or more weeks. CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 371 In periods of higher unemployment, however, workers tend to be jobless for longer periods of time, suggesting that a smaller share of unemployment is frictional. By 2003, for instance, the fraction of workers considered “long-term unemployed” had jumped to 22%. Structural Unemployment Frictional unemployment exists even when the number of people seeking jobs is equal to the number of jobs being offered—that is, frictional unemployment doesn’t signal a surplus of labor. Sometimes, however, there is a persistent surplus of jobseekers in a particular labor market. For example, there may be more workers with a particular skill than there are jobs available using that skill, or there may be more workers in a particular geographic region than there are jobs available in that region. Structural unemployment is unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage. The supply and demand model tells us that the price of a good, service, or factor of production tends to move toward an equilibrium level that matches the quantity supplied with the quantity demanded. This is equally true, in general, of labor markets. Figure 15-2 shows a typical market for labor. The labor demand curve indicates that when the price of labor—the wage rate—increases, employers demand less labor. The labor supply curve indicates that when the price of labor increases, more workers will be willing to supply labor at the prevailing wage. These two forces coincide to lead to an equilibrium wage rate for any given type of labor in a particular location. That equilibrium wage rate is shown as WE. Structural unemployment is unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage. Figure 15-2 Wage rate Labor supply Structural unemployment The Effect of a Minimum Wage on the Labor Market When the government sets a minimum wage, WF , that exceeds the market equilibrium wage rate, WE , the number of workers, QS , who would like to work at that minimum wage, is greater than the number of workers, QD , demanded at that wage. This surplus of labor is considered structural unemployment. WF Minimum wage WE E Labor demand QD QE QS Quantity of labor Even at the equilibrium wage WE , there will still be some frictional unemployment. That’s because there will always be some workers engaged in job search even when the number of jobs available is equal to the number of workers seeking jobs. But there wouldn’t be any structural employment in this labor market. Structural unemployment occurs when the wage rate is, for some reason, persistently above WE. There are several factors that can lead to a wage rate in excess of WE , the most important being minimum wages, labor unions, efficiency wages, and the side effects of government policies. 372 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N Minimum Wages As we learned in Chapter 4, a minimum wage is a government-mandated floor on the price of labor. In the United States, the national minimum wage in 2005 was $5.15 an hour. For many types of labor, the minimum wage is irrelevant; the market equilibrium wage is well above this price floor. But for some types of labor, the minimum wage may be binding—it affects the wages that people are actually paid. Figure 15-2 shows just such a situation. In this market, there is a legal floor on wages, WF, which is above the equilibrium wage rate, WE. This leads to a persistent surplus in the job market: the quantity of labor supplied, QS, is larger than the quantity demanded, QD. In other words, more people want to work than can find jobs at the minimum wage, leading to structural unemployment. Given that minimum wages—at least, binding minimum wages—generally lead to structural unemployment, you might be wondering why governments impose them. The rationale is to help ensure that people who work can earn enough income to have at least a minimally comfortable lifestyle. However, this comes at a cost, because it forecloses the opportunity to work for some workers who would have willingly worked for lower wages. As illustrated in Figure 15-2, not only are there more sellers of labor than there are buyers, but there are also fewer people working at a minimum wage (QD) than there would have been with no minimum wage at all (QE). We should note, however, that although economists broadly agree that a high minimum wage has the employment-reducing effects shown in Figure 15-2, there is some question about whether this is a good description of how the minimum wage works in the United States. As a percentage of average wages, the minimum wage in the United States is quite low by international standards. (See the Economics in Action that follows this section.) Some researchers have produced evidence that increases in the minimum wage actually leads to higher employment when the minimum wage is low compared with average wages. They argue that firms that employ low-skilled workers sometimes restrict their hiring in order to keep wages low and that, as a result, the minimum wage can sometimes be increased without any loss of jobs. Most economists, however, agree that a sufficiently high minimum wage does lead to structural unemployment. Labor Unions The actions of labor unions can have effects similar to those of minimum wages, leading to structural unemployment. By bargaining for all a firm’s workers collectively, unions can often win higher wages from employers than the market would have otherwise provided when workers bargained individually. This process, known as collective bargaining, is intended to tip the scales of bargaining power more to workers and away from employers. Labor unions exercise bargaining power by threatening firms with a labor strike, a collective refusal to work. The threat of a strike can be very serious for firms that would have difficulty replacing striking workers. In such cases, workers acting collectively can exercise more power than they could if they acted independently. When workers have greater bargaining power, they tend to demand and receive higher wages. Unions also bargain over benefits, such as health care and retirement benefits, which we can think of as additional wages. Indeed, economists who study the effects of unions on wages find that unionized workers earn higher wages and benefits than non-union workers with similar skills. The result of these increased wages is the same as the result of a minimum wage: labor unions push the wage that workers receive above the equilibrium wage. Consequently, there are more people willing to work at the wage being paid than there are jobs available. Like a binding minimum wage, this leads to structural unemployment. Another way in which labor unions lead to unemployment involves the ways in which the labor contracts that result from collective bargaining are structured. Union members tend to have Unions are one reason why wages are sometimes higher than long-term contracts of two or three years. Independent of the inthe level that matches the supply and demand for labor. Darren McCollester/Getty Images CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 373 creased wages associated with unions, these long-term contracts could also lead to structural unemployment. If the demand for labor is falling but employers and employees have previously agreed to a higher wage rate, this has the same effect as a floor on wages—leading to more workers being willing to work for the negotiated wage than there are jobs available at that wage. If non-unionized firms also commit to a given advertised wage for a period of time, the same effects could occur even without labor unions. The fact that some firms are on a different timetable for negotiating their labor contracts than other firms—a phenomenon known as wage staggering—leads the labor market to move slowly from one equilibrium to another when the demand for labor changes. In the meantime, while the labor market is out of equilibrium, structural unemployment can occur. We will turn to this topic again later in this chapter when we explore in more detail why the labor market moves slowly from one equilibrium to another. Actions by firms may also contribute to structural unemployment in the absence of labor unions and wage staggering. Firms may choose to pay efficiency wages—wages that employers set above the equilibrium wage rate as an incentive for better performance. Employers may do this for several reasons. One is that workers know more about their other work opportunities than do their employers. An employer that pays as little as possible risks losing its better workers and retaining more of its lower-quality workers—the ones who wouldn’t be able to find better work elsewhere. This is less likely to happen if the firm pays a wage above the equilibrium wage rate. In such a situation, high-quality workers will be less likely to move to a different employer. Employers may also pay above-market wages in order to ensure a higher degree of worker effort. Employees receiving these higher wages are more likely to maintain a higher level of effort to ensure that they do not suffer a wage reduction by being fired. If many firms pay wages that are above the market equilibrium wage rate, this will result in a pool of workers who want higher-paying jobs but can’t find them. So the use of efficiency wages by firms leads to structural unemployment. Efficiency Wages Efficiency wages are wages that employers set above the equilibrium wage rate as an incentive for better performance. Side Effects of Public Policy In addition, public policy designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect. Most economically advanced countries provide benefits to laid-off workers as a way to tide them over until they find a new job. In the United States, these benefits typically replace only a small fraction of a worker’s income and expire after 26 weeks. In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces a worker’s incentive to seek a new job. Generous unemployment benefits are widely believed to be one of the main causes of “Eurosclerosis,” described in the forthcoming Economics in Action. The Natural Rate of Unemployment We can now return to the question of why national goals for unemployment are so modest. Why settle for an unemployment rate of 4% or more? Because some frictional unemployment is inevitable and many economies also suffer from structural unemployment, a certain amount of unemployment is normal, or “natural,” although actual unemployment fluctuates around this normal level. The natural rate of unemployment is the normal unemployment rate around which the actual unemployment rate fluctuates. It is the rate of unemployment that arises from the effects of frictional plus structural unemployment. Deviations in the actual rate of unemployment from the natural rate are called cyclical unemployment. As the name suggests, cyclical unemployment is unemployment that arises from the business cycle. We’ll see later in this chapter that public policy cannot keep the unemployment rate persistently below the natural rate without leading to accelerating inflation. Actual unemployment is the sum of natural unemployment (that is, frictional plus structural unemployment) and cyclical unemployment. The natural rate of unemployment is the normal unemployment rate around which the actual unemployment rate fluctuates. Cyclical unemployment is a deviation in the actual rate of unemployment from the natural rate. 374 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N Perhaps because of its name, people often imagine that the natural rate of unemployment is a constant that doesn’t change over time and can’t be affected by policy. Neither proposition is true. Let’s take a moment to stress two facts: the natural rate of unemployment changes over time, and it can be affected by economic policies. Changes in the Natural Rate of Unemployment Both private-sector economists and government agencies need estimates of the natural rate of unemployment for forecasts and policy analyses. Almost all these estimates show the U.S. natural rate rising and falling over time. For example, the Congressional Budget Office believes that the natural rate was 5.3% in 1950, rose to 6.3% by the end of the 1970s, then fell to 5.2% by the end of the 1990s. The United States is not alone in its changes in the natural rate of unemployment over time. In fact, Europe has experienced even larger swings in the natural rate of unemployment. What causes the natural rate of unemployment to change? The most important factors are changes in the characteristics of the labor force, changes in labor market institutions, changes in government policies, and changes in productivity. Let’s look briefly at each factor. Changes in Labor Force Characteristics: In 2000, as we’ve seen, the overall rate of unemployment in the United States was 4%. Young workers, however, had much higher unemployment rates: 13% for teenagers and 7% for workers aged 20 to 24. Workers over 25 had an unemployment rate of only 3%. In general, unemployment rates tend to be lower for experienced workers than for inexperienced workers. Because experienced workers tend to stay in a given job longer than do inexperienced workers, they have lower frictional unemployment. Also, because older workers are more likely than young workers to be family breadwinners, they have a stronger incentive to find and keep jobs. One reason the natural rate of unemployment rose during the 1970s was a large rise in the number of new workers—children of the post World War II baby boom entered the labor force, as did a rising percentage of married women. As Figure 15-3 shows, both the percentage of the labor force less than 25 years old and the percentage of women in the labor force surged in the 1970s. By the end of the 1990s, however, the share of women in the labor force had leveled off, and the percentage of Figure 15-3 Percent of labor force 50% The Changing Makeup of the U.S. Labor Force In the 1970s the percentage of the labor force consisting of women rose rapidly, as did the percentage under age 25. These changes reflected the entry of large numbers of women into the paid labor force for the first time and the fact that baby boomers were reaching working age. The natural rate of unemployment may have risen because many of these workers were relatively inexperienced. Today, the labor force is much more experienced, which is one possible reason the natural rate has fallen since the 1970s. Source: Bureau of Labor Statistics 40 Women 30 20 Under 25 10 60 70 80 90 00 20 19 19 19 19 Year 20 04 CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 375 workers under 25 had fallen sharply. This meant that the labor force as a whole is more experienced today than it had been in the 1970s, one likely reason that the natural rate of unemployment is lower today than in the 1970s. Changes in Labor Market Institutions: As we pointed out earlier, unions that negotiate wages above the equilibrium level can be a source of structural unemployment. Some economists believe that strong labor unions are one reason for the high natural rate of unemployment in Europe, discussed below. In the United States, the sharp fall in union membership after 1980 may have been one reason the natural rate of unemployment fell between the 1970s and the 1990s. Other institutional changes may also be at work. For example, some labor economists believe that temporary employment agencies, which have proliferated in recent years, have reduced frictional unemployment by helping match workers to jobs. Technological change, coupled with labor market institutions, can also play a role in affecting the natural rate of unemployment. Technological change probably leads to an increase in the demand for skilled workers who are familiar with the technology and a reduction in the demand for unskilled workers. Economic theory predicts that wages should increase for skilled workers and decrease for unskilled workers. But if wages for unskilled workers cannot go down, say due to a binding minimum wage, increased structural unemployment, and hence a higher rate of natural unemployment, will result. Changes in Government Policies: A high minimum wage can cause structural unemployment. Generous unemployment benefits can increase both structural and frictional unemployment. So government policies intended to help workers can have the undesirable side effect of raising the natural rate of unemployment. Some government policies, however, may reduce the natural rate. Two examples are job training and employment subsidies. Job-training programs are supposed to provide unemployed workers with skills that widen the range of jobs they can perform. Employment subsidies are payments either to workers or to employers that provide a financial incentive to offer or accept jobs. Changes in Productivity: Another explanation for changes over time in the natural rate of unemployment involves changes in labor force productivity. Productivity changes are an attractive explanation for the changes in the natural rate of unemployment because it’s consistent with the timing of actual events. The rise in the natural rate of unemployment in the 1970s came at the same time as a slowdown in productivity growth, and a fall in the natural rate of unemployment in the 1990s came at the same time as an acceleration in productivity growth. That said, it is now easy to explain why higher productivity growth should reduce the natural rate of unemployment, as opposed to simply raising real wages. Suppose, for example, there is an acceleration in productivity growth. If workers do not immediately recognize that productivity is rising faster than before, they will be slow to demand wage increases that reflect their productivity gains. Until wages catch up with productivity gains, hiring an additional worker will be profitable for employers. For a while, then, increases in productivity growth can translate into lower unemployment rates. Alternatively, suppose there is a slowdown in productivity growth. If workers do not immediately recognize that productivity is growing more slowly, they may continue to demand higher wage increases that were consistent with an earlier, higher rate of productivity growth. Until wage demands diminish, an employer will be better off not hiring, and sometimes firing, workers. As a result, a persistent surplus of labor may develop. For a while, then, a productivity slowdown can translate into higher unemployment rates. In the end, a number of factors can be proposed to explain the patterns in the natural rate of unemployment experienced over the past 30 years. Although each of these explanations seems reasonable, none can be considered solely responsible for the 376 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N changes over time in the natural rate of unemployment. Different elements have been at work at different times, and there are surely other determinants of the natural rate of unemployment that have yet to be fully understood. economics in action Eurosclerosis Unemployment rates in Western Europe are normally higher than in the United States. Most estimates suggest that the natural rate of unemployment in France and Germany is currently above 8%, compared with somewhere between 5% and 5.5% in the U.S. today. It wasn’t always that way. In fact, in the early 1970s the natural rate of unemployment seemed to be lower in France and Germany than in the United States. As you can see from Figure 15-4, the unemployment rate was lower in France than in the United States, but the situation reversed in the 1980s. Why is the natural rate in Europe so high today? The answer of many (but not all) economists is that high European natural rates of unemployment are an unUnemployment Rates Figure 15-4 intended side-effect of government policies. This is often over Time in France referred to as Eurosclerosis. and the United States The Eurosclerosis hypothesis says that persistently high Unemployment European unemployment is the result of policies intended rate to help workers. One such set of policies involves the gen14% France erous benefits to unemployed workers. In many European 12 countries, there is no limit to the amount of time that the 10 unemployed can collect benefits, and the benefits that the unemployed collect at any given point in time tends to be 8 considerably greater than in the United States. For exam6 ple, benefits replace 48% of the earnings of a typical 4 United States French worker, compared with only 14% for the typical 2 U.S. worker. The importance of the European “welfare state” in explaining unemployment differences between Europe and the United States has further increased as the demand for Year unskilled workers has fallen. If unskilled wages continue to fall, the benefit to these workers of taking a job—as Until the mid-1970s France, like other compared to collecting benefits—also falls. These workers European countries, typically had a lower unemployment rate than the United States. are increasingly likely to choose unemployment as a longToday, the French unemployment rate substanterm option. tially exceeds the U.S. unemployment rate. In addition, many European countries have high miniSource: OECD. mum-wage rates. For example, as of 1999 the minimum wage in France was 47% of the average wage rate, compared with only 34% in the United States. Union membership is greater in many European countries than in the United States as well, and unions seem to have strong bargaining power even in European countries such as France that have relatively low union membership. Both of these factors could also contribute to higher unemployment rates in Europe than in the United States. If the Eurosclerosis explanation of high European unemployment is correct, a European country that moved its policies in an “American” direction—such as by reducing unemployment benefits and limiting the power of unions—should reduce its natural rate of unemployment. In fact, this seems to have happened in the United Kingdom, which had one of the highest unemployment rates in Europe in the early 1980s. Britain undertook a number of economic reforms under Prime Minister Margaret Thatcher and today typically has an unemployment rate of around 5%. 19 70 19 90 60 80 19 19 20 00 20 04 15 CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 377 It should be noted, however, that an “Americanization” of European policies would come at a cost: Reducing welfare benefits would probably reduce unemployment by encouraging individuals to take low-wage jobs. But at the same time it would make many workers worse off, increasing the inequities that were the motivation for the creation of the European social welfare systems. I ®® ® QUICK REVIEW ® >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 15-1 ® 1. Explain the following: a. Why frictional unemployment is inevitable in a modern economy. b. Why frictional unemployment accounts for a larger share of total unemployment when the unemployment rate is low. 2. Why does collective bargaining have the same general effect on unemployment as a minimum wage? Illustrate with a diagram. 3. Suppose the United States dramatically increases benefits for unemployed workers. Explain what will happen to the natural rate of unemployment. Solutions appear at back of book. ® Unemployment and the Business Cycle Although the natural rate of unemployment can change over time, it changes only gradually. The actual rate of unemployment, however, fluctuates around the natural rate, reflecting changes in cyclical unemployment. Panel (a) of Figure 15-5 on page 378 illustrates these fluctuations, showing both the actual unemployment rate and Congressional Budget Office (CBO) estimates of the natural rate of unemployment from 1959 to 2004. (We’ll explain later in the chapter how the CBO arrives at these estimates.) Fluctuations of the actual unemployment rate around the natural rate reflect fluctuations in output over the course of the business cycle: the unemployment rate normally rises during recessions and falls during expansions. To understand why, and to understand the exceptions to this rule, we need to look at the links between changes in output and the unemployment rate. Due to job search, some portion of unemployment—called frictional unemployment—is inevitable. A variety of factors—minimum wages, unions, and efficiency wages, and the side effects of public policy— lead to structural unemployment. Frictional and structural unemployment result in a natural rate of unemployment. In contrast, cyclical unemployment changes with the business cycle. Actual unemployment is equal to the sum of natural unemployment (frictional plus structural) plus cyclical unemployment. The natural rate of unemployment can shift over time, due to changes in labor force characteristics and institutions. It can also be affected by government policies. In particular, policies designed to help workers are believed to be one reason for high natural rates of unemployment in Europe. The Output Gap and the Unemployment Rate In Chapter 10 we introduced the concept of potential output, the level of real GDP that the economy would produce once all prices had adjusted. Potential output typically grows steadily over time, reflecting long-run growth. However, as we learned in the Aggregate Supply-Aggregate Demand Model, actual output fluctuates around potential output in the short run: a recessionary gap arises when actual output falls short of potential output; an inflationary gap arises when actual output exceeds potential output. In either case, the percentage difference between the actual level of real GDP and potential output is called the output gap. A positive or negative output gap occurs when an economy is producing more than or less than what would be “expected” because all prices have not yet adjusted. And wages, as we’ve learned, are the prices in the labor market. This realization implies a straightforward relationship between the unemployment rate and the output gap. This relationship consists of two rules: I The percentage difference between the actual level of real GDP and potential output is the output gap. When actual output is equal to potential output, the actual unemployment rate is equal to the natural rate of unemployment. When the output gap is positive (an inflationary gap), the unemployment rate is below the natural rate. When the output gap is negative (a recessionary gap), the unemployment rate is above the natural rate. I In other words, fluctuations of aggregate output around the long-run trend in potential output correspond to fluctuations of the unemployment rate around the natural rate. 378 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N Figure 15-5 Unemployment rate 12% 10 8 6 4 Cyclical Unemployment and the Output Gap Panel (a) shows the actual U.S. unemployment rate from 1959 to 2004, together with the Congressional Budget Office estimate of the natural rate of unemployment. The actual rate fluctuates around the natural rate, often for extended periods. Panel (b) shows cyclical unemployment—the difference between the actual unemployment rate and the natural rate—and the output gap, also estimated by the CBO. The output gap is shown with an inverted scale, so that it moves in the same direction as the unemployment rate: when the output gap is positive, the actual unemployment rate is below the natural rate; when the output gap is negative, actual unemployment is above the natural rate. Sources: Congressional Budget Office; Bureau of Labor Statistics. (a) The Actual Unemployment Rate Fluctuates Around the Natural Rate . . . Actual unemployment rate Natural rate of unemployment 2 19 70 19 90 80 19 59 20 00 20 04 19 Year (b) . . . and These Fluctuations Correspond to the Output Gap. Cyclical unemployment rate 10% 8 6 4 2 0 –2 –4 –6 –8 0 195 197 Output gap Output gap Cyclical unemployment –10% –8 –6 –4 –2 0 2 4 6 8 00 20 80 0 Year This makes sense. When the economy is producing less than potential output— when the output gap is negative—it is not making full use of its productive resources. Among the resources that are not fully utilized is labor, the economy’s most important resource. So we would expect a negative output gap to be associated with unusually high unemployment. Conversely, when the economy is producing more than potential output, it is temporarily using resources at more than normal rates. With this positive output gap, we would expect to see lower-than-normal unemployment. Figure 15-5 confirms this rule. Panel (a) shows the actual and natural rates of unemployment. Panel (b) shows two series. One is cyclical unemployment: the difference between the actual unemployment rate and the CBO estimate of the natural rate of unemployment. The other is the CBO estimate of the output gap. To make the relationship clearer, the output gap series is “inverted”—shown upside down—so that the line goes down if actual output rises above potential output and up if actual output falls below potential output. As you can see, the two series move together: years of high cyclical unemployment, like 1982 or 1992, were also years of a strongly negative output gap. Years of low cyclical unemployment, like the late 1960s or 2000, were also years of a strongly positive output gap. You may notice something else, however: although cyclical unemployment and the output gap move together, cyclical unemployment seems to move less than the output gap. For example, the output gap reached −8% in 1982, but cyclical unemployment reached only 4%. This observation is the basis of an important relationship known as Okun’s law. 20 19 19 04 CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 379 Okun’s Law In the early 1960s Arthur Okun, who was John F. Kennedy’s chief economic adviser, pointed out an important fact about the relationship between aggregate output and the unemployment rate. Although the ups and downs of the unemployment rate correspond closely to fluctuations in real GDP around its long-run trend, fluctuations in the unemployment rate are normally much smaller than the corresponding changes in the output gap. Okun originally estimated that a rise in real GDP of 1 percentage point would lead to a fall in the unemployment rate of only 1⁄3 of a percentage point. Today, estimates of Okun’s law—the negative relationship between the output gap and the unemployment rate—typically find that a rise in the output gap of 1 percentage point reduces the unemployment rate by about 1⁄2 of a percentage point. That is, a modern version of Okun’s law reads According to Okun’s law, each additional percentage point of output gap reduces the unemployment rate by less than 1 percentage point. (15-1) Unemployment rate = Natural rate of unemployment − (0.5 × Output gap) For example, suppose that the natural rate of unemployment is 5.2% and that the economy is currently producing only 98% of potential output. In that case, the output gap is −2%, and Okun’s law predicts an unemployment rate of 5.2% − (0.5 × (−2%)) = 6.2%. You should be aware that the “0.5” coefficient in Okun’s law is an estimate, rather than a physical property, and this relationship can change over time. Indeed, there have been numerous estimates of this coefficient, which varies depending on the time period considered and the context in which it is estimated. Importantly, however, the estimates of the Okun’s law coefficient all tend to be considerably less than 1. You might have expected this coefficient to be 1—that is, to see a one-to-one relationship between the output gap and unemployment. Doesn’t a 1% rise in output require a 1% increase in employment? And shouldn’t that take 1% off the unemployment rate? PITFALLS There are two well-understood reasons for the relationship between changes in the output gap and changes in the unemployment rate to be when is a “law” not a law? less than one-to-one. The first is that companies often meet changes in Economists occasionally refer to a generally obdemand in part by changing the number of hours their existing employserved and accepted pattern of behavior as a ees work. For example, a company that experiences a sudden increase in “law.” The term law brings to mind unalterable physical properties or formulaic explanations of demand for its products may cope by asking (or requiring) its workers to the ways in which the world operates. In some put in longer hours, rather than by hiring more workers. Conversely, a cases in economics, such as the law of demand, company that sees sales drop will often reduce workers’ hours rather the economic theory has been so consistent with than lay off employees. This behavior dampens the effect of output flucexperience that it approaches the certainty that tuations on the number of workers employed. you may associate with chemical or physical The second reason is that the number of workers looking for jobs is aflaws. fected by the availability of jobs. Suppose that the number of jobs falls by Economics, however, is a study of human be1 million. Often, measured unemployment will rise by less than 1 milings, and human behavior is difficult to predict. lion because some unemployed workers become discouraged and give up We may know that the quantity demanded of a actively looking for work. (Recall from Chapter 7 that workers aren’t given product falls when its price rises, but the counted as unemployed unless they are actively seeking work.) Conlaw of demand does not tell us by how much the quantity demanded will fall. versely, if the economy adds 1 million jobs, some people who haven’t The same holds true for Okun’s law. Okun’s been actively looking for work will begin doing so; as a result, measured law is based on estimates that can and do unemployment will fall by less than 1 million. This behavior dampens change over time and in different settings. The the effect of output fluctuations on the measured unemployment rate. constant feature of these estimates is not preIn addition to these well-understood factors, the rate of growth of cisely how much the unemployment rate falls labor productivity generally accelerates during booms (when actual outwhen the output gap increases, but that the put is growing faster than potential output) and slows down or even unemployment rate falls less at a ratio of less turns negative during busts (when actual output is growing more slowly than 1:1 with increases in the output gap. than potential output). The reasons for this phenomenon are the subject Okun’s law says not that this relationship is, for of some dispute among economists. The consequence, however, is that example, 1:3 or 1:2 but that this relationship is the effects of booms and busts on the unemployment rate are dampened. less than 1:1. 380 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N Figure Unemployment rate 8% 15-6 Jobless Recoveries economics in action Jobless Recoveries Our explanation of the relationship between the output gap and the unemployment rate is slightly more complex 7 than a statement that the unemployment rate falls when the economy is expanding and rises when the economy is 6 contracting. A good way to see the subtlety is to look at those occasions when the economy expands but unem5 ployment nonetheless rises. 4 Figure 15-6 shows the U.S. unemployment rate from Jobless recoveries 1985 to 2004. It also shows, as shaded areas, the periods of recession, according to the National Bureau of Economic Research, which dates U.S. business cycles. Officially, the Year U.S. economy went into recession in July 1990 and began an expansion in March 1991. But tell that to workers: the The graph shows the unemployment rate in the unemployment rate continued rising and didn’t turn United States from 1985 to 2004. The shaded downward until July 1992. The same thing happened after areas show official periods of recession. In the the next recession, 11 years later. The recession that began recessions of 1990–1991 and 2001, unemployin March 2001 officially ended in November 2001, but the ment rose sharply. In both cases, however, unemployment rate didn’t turn downward until July 2003. unemployment continued to rise for a time Both recessions, in other words, were followed by periods after, even though the economy was officially of jobless recovery. recovering. Why do jobless recoveries happen? The unemployment Sources: Bureau of Labor Statistics; National Bureau of Economic Research. rate reflects the output gap: the unemployment rate only falls if the output gap becomes more positive, which happens when real GDP is growing faster than potential GDP. If real GDP is growing more slowly than potential GDP—as it did in both ®® Q U I C K R E V I E W 1991–1992 and 2001–2003—the output gap continues to widen even though the economy is officially considered to be expanding. And this widening output gap ® When aggregate output is equal to leads to rising, not falling, unemployment. I potential output, the unemploy95 19 9 19 0 91 20 2000 01 19 19 ment rate is equal to the natural rate of unemployment. When the output gap is positive, the unemployment rate is below the natural rate. When the output gap is negative, the unemployment rate is above the natural rate. Okun’s law says that each additional percentage point of output gap reduces the unemployment rate by less than 1 percentage point. Modern estimates indicate that a point of output gap reduces the unemployment rate by about 1/2 percentage point. Recessions <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 15-2 1. Examine panel (a) of Figure 15-5. In which years would you expect the output largest positive gap? How does your expectation compare with the reality of panel (b)? 8 7 6 ® ® 2. Suppose the United States imposes strict limits on the number of hours that employees can work in a week. How would this policy affect the relationship between the output gap and the unemployment rate? 5 4 3 20 04 85 Solutions appear at back of book. Why Doesn’t the Labor Market Move Quickly to Equilibrium? We’ve now seen that the unemployment rate fluctuates around the natural rate of unemployment. A look back at Figure 15-5 shows that these fluctuations can last for long periods. For example, the actual unemployment rate was above the natural rate from 1980 to 1987. One way to think about the natural rate of unemployment is that it is an equilibrium rate, the rate of unemployment that the labor market achieves when employers and workers have had time to adjust. Deviations from the natural rate, then, are situations in which the labor market is out of equilibrium. What we have learned is that the labor market often remains out of equilibrium for long stretches of time. CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 381 Yet in most economic analyses we assume that markets move quickly to equilibrium. Why is the labor market different? One compelling answer is that wages behave differently from the prices of many goods and services. Wages do not fall quickly in the face of labor surpluses or rise quickly in the face of shortages. Almost all macroeconomists agree that wages adjust slowly to surpluses or shortages of labor. There is, however, some dispute about why wages adjust slowly. Broadly speaking, there are two main theories: misperceptions and sticky wages. Misperceptions: Some macroeconomists believe that an important source of slow wage adjustment is that workers are slow to realize that the equilibrium wage rate has changed. For example, a worker searching for a new job may have expectations based on last year’s wage rate. If wage rates have dropped, that worker may spend a long time looking for a job with an unrealistically high wage rate. When workers take longer to find jobs because they are holding out for a wage that may no longer be appropriate, this contributes not only to slow wage adjustment but also to an increased unemployment rate. Misperceptions by firms can also contribute to slow wage adjustment. Firms, especially those that hire infrequently, may base their wage decisions on old information; this, in turn, causes wages to change slowly. If a firm sets its wages below the marketclearing wage, it will have difficulty hiring workers but may be slow to realize this fact and respond to it. If a firm sets its wages above the market-clearing price, it will turn away excess job applicants—and perhaps also contribute to worker misperceptions about the market-clearing wage. You might wonder why firms and workers would not quickly realize when their perceptions about wages are out of line with the reality of market-clearing wages. One reason labor markets may clear more slowly than other markets is that they are so complex. Market-clearing wages are constantly changing as demand conditions change, and firms and workers are collectively responding to ever-changing perceptions about these wages. As a result, when conditions change in the labor market, it may take quite some time before the labor market returns to equilibrium. Sticky Wages: Economists say that sticky wages occur when employers are slow to reduce wage rates in the face of a surplus of labor, even when everyone understands that wages are above equilibrium levels. Wages may be sticky for several reasons. Some wages are governed by long-term contracts, which set the wage rate a year or more in advance and don’t reflect changes in the labor market after the contract has been signed. In other cases there is no formal contract, but there is an implicit agreement between workers and their employers not to change wage rates too often. Workers and employers are often concerned about relative wages—how the wages of one group of workers compare with those of other workers. Companies believe that the productivity or morale of workers will suffer—or even that they will go on strike— if wages are cut compared with those paid by other companies. As a result, each company is reluctant to reduce wages until other companies do the same, making wages as a whole slow to adjust. Concerns about relative wages can interact with explicit or implicit contracts to slow down wage adjustment. Even if a worker’s contract has just expired, the employer will be cautious about reducing his or her wage rate compared with that of other workers who are still covered by contracts signed in the past. Economists have shown that if employers are concerned about relative wages and contracts are staggered over time, even short contracts—such as contracts that set wages one year ahead—can cause the adjustment of the average wage rate to its equilibrium level to take a number of years. Wages tend to be stickier when equilibrium wages are falling than when they are rising. When wages are rising, workers may put pressure on firms to renegotiate Sticky wages occur when employers are slow to reduce wages in the face of a surplus of labor. 382 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N Menu costs are small costs associated with the act of changing prices. wages to reflect the new wage reality. This pressure could occur either through negotiation or through worker departure, as competing firms bid up wages. But when wages are falling, firms may be contractually unable to lower wages in response to prevailing market conditions—and even if they are able to lower wages, it may not be in their best interest to do so. Recall the discussion of efficiency wages earlier in this chapter: firms may pay above-market wages to improve worker productivity and boost morale. Although this discussion has focused only on the slow adjustment of wages, prices of some goods and services also seem to adjust slowly. Because it is time-consuming and costly to constantly devise new sets of prices, firms may change prices infrequently even if the market-clearing prices change frequently. An influential economic theory says that these small costs associated with the act of changing prices—known as menu costs—can have a surprisingly large effect in postponing price adjustment to surpluses and shortages. (This term derives from the fact that it costs time and money for restaurants to print new menus and that, as a result, restaurants rarely change their prices.) Sticky prices can interact with sticky wages to slow the adjustment of prices and wages in the economy as a whole. For our purposes, the distinctions between different theories of slow wage and price adjustment don’t matter very much. The important point is that wages move toward their equilibrium level, but only slowly. economics in action Sticky Wages During the Great Depression QUICK REVIEW History’s most extreme example of disequilibrium in the labor market is the Great Depression, the era of high unemployment between 1929 and World War II. At its peak in 1933, the U.S. unemployment rate exceeded 25%. The Depression also provides the clearest illustration of the sluggish adjustment of wages, which plays a crucial role in our understanding of aggregate supply. Recent analyses suggest that during the 1930s manufacturing wages in particular were sticky. Nominal hourly wages in manufacturing—wages in dollar amounts— remained almost unchanged during the first two years of the Great Depression. Since prices of almost all goods and services fell during the early years of the Depression, the real wages of manufacturing workers—their nominal wages divided by the price level—actually rose even though there was a massive surplus of labor. I ®® ® ® ® Prolonged deviations from the natural rate of unemployment show that the labor market, unlike the markets for many goods and services, does not move quickly to equilibrium. The majority of economists agree that wages adjust slowly to surpluses or shortages of labor, due to either misperceptions or sticky wages. Several factors, including staggered contracts, concern for relative wages, and menu costs, may explain why wages and other prices are sticky. <<<<<<<<<<<<<<<<<< >>CHECK YOUR UNDERSTANDING 15-3 1. The country of Willovia has a tradition of three-year labor contracts, but Malavia has a tradition of one-year labor contracts. In which country would you expect the labor market to move more quickly to equilibrium when demand conditions change? Explain your answer. 2. Why might workers misperceive changes in the market-clearing wage rate? Suppose the marketclearing rate is rising but workers are slow to recognize this growth. What does this misperception imply about unemployment in the short run? Solutions appear at back of book. Unemployment and Inflation: The Phillips Curve Earlier in this chapter we saw that in 1978, when the Humphrey–Hawkins bill set a target unemployment rate of 4%, many economists were concerned: they feared an attempt to achieve that target would lead to high and accelerating inflation. What was the basis for these concerns? CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 383 We’ve seen part of the answer: 4% was well below estimates of the natural rate of unemployment. But what’s wrong with trying to keep unemployment below the natural rate? To answer that question we need to look at the relationship between unemployment and inflation. The Short-Run Phillips Curve In a famous 1958 paper the New Zealand–born economist A. W. H. Phillips found that historical data for the United Kingdom showed that when the unemployment rate is high, the wage rate tends to fall, and when the unemployment rate is low, the wage rate tends to rise. Using data from Britain, the United States, and elsewhere, other economists soon found similar patterns between the unemployment rate and the rate of inflation—that is, the rate of change in the overall price level. The negative short-run relationship between the unemployment rate and the inflation rate is called the short-run Phillips curve, or SRPC. (We’ll explain the difference between the short run and the long run in a little while.) Figure 15-7 shows a hypothetical short-run Phillips curve. Why is there a negative short-run relationship between the unemployment rate and the inflation rate? Recall the short-run aggregate supply curve from earlier chapters. The SRAS curve shows that when a rightward shift of the aggregate demand curve leads to an increase in the aggregate price level, real GDP increases as well. In other words, there is a positive relationship between the aggregate price level and real GDP. But how does this relate to unemployment? Remember that there is a negative relationship between real GDP and the unemployment rate: Okun’s law tells us that when real GDP is higher than potential output, the unemployment rate will be lower than when real GDP is below potential output. So increases in the aggregate price level are associated with increases in real GDP, which in turn tend to lead to lower unemployment rates. The relationship between the short-run Phillips curve and the short-run aggregate supply curve is a bit trickier than presented here. Specifically, this discussion describes a relationship between changes in the unemployment rate and inflation; the short-run Phillips curve, however, describes a relationship between the level of the unemployment rate and inflation. For Inquiring Minds on page 384 explains the relationship between the two concepts in more detail. The short-run Phillips curve is the negative short-run relationship between the unemployment rate and the inflation rate. Figure 15-7 Inflation rate The Short-Run Phillips Curve The short-run Phillips curve, SRPC, is downward-sloping because the relationship between the unemployment rate and the inflation rate is negative. When the unemployment rate is low, inflation is high. 0 When the unemployment rate is high, inflation is low. Short-run Phillips curve, SRPC Unemployment rate 384 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N FOR INQUIRING MINDS T H E A G G R E G AT E S U P P LY C U R V E A N D T H E S H O R T - R U N P H I L L I P S C U R V E In earlier chapters we made extensive use of the AS–AD model, in which the short-run aggregate supply curve—a relationship between real GDP and the price level—plays a central role. Now we’ve introduced the concept of the short-run Phillips curve, a relationship between the unemployment rate and the rate of inflation. How do these two concepts fit together? We can get a partial answer to this question by looking at panel (a) of Figure 15-8, which shows how changes in the price level and the output gap depend on changes in aggregate demand. Assume that in year 1 the aggregate demand curve is AD1, the long-run aggregate supply curve is LRAS, and the short-run aggregate supply curve is SRAS. The initial equilibrium is at E1, where the price level is 100 and real GDP is $10 trillion. Notice that at E1 real GDP is equal to potential output, so the output gap is zero. Now consider two possible paths for the economy over the next year. One is that aggregate demand remains unchanged and the economy stays at E1. The other is that aggregate demand shifts out to AD2 and the economy moves to E2. At E2, real GDP is $10.4 trillion, $0.4 trillion more than potential output—a 4% output gap. Meanwhile, at E2 the aggregate price level is 102—a 2% increase. So panel (a) tells us that in this example a zero output gap is associated with zero inflation and a 4% output gap is associated with 2% inflation. Panel (b) shows what this implies for the relationship between unemployment and inflation. Assume that the natural rate of unemployment is 6%, and that a rise of 1 percentage point in the output gap causes a fall of 1⁄2 of a percentage point in the unemployment rate. In that case, the two cases shown in panel (a)—aggregate demand either staying put or rising—correspond to the two points in panel (b). At E1, the unemployment rate is 6% and the inflation rate is 0%. At E2, the unemployment rate is 4%, because an output gap of 4% reduces the unemployment rate by 4% × 0.5 = 2%—and the inflation rate is 2%. So there is a negative relationship between unemployment and inflation. So does the aggregate supply curve say exactly the same thing as the Phillips curve? Not quite. The short-run aggregate supply curve seems to imply a relationship between the change in the unemployment rate and the inflation rate, but the Phillips curve shows a relationship between the level of the unemployment rate and the inflation rate. Reconciling these views completely would go beyond the scope of this book. The important point is that the Phillips curve is a concept that is closely related, though not identical, to the aggregate supply curve. Figure 15-8 The AS–AD Model and the Short-Run Phillips Curve (b) . . . Leads to Both Inflation and to a Fall in the Unemployment Rate (a) An Increase in Aggregate Demand . . . Aggregate price level LRAS SRAS E2 Inflation rate 102 100 2% E2 E1 4 6% E1 0 AD2 AD1 Potential output $10 10.4 Real GDP (trillions of dollars) Unemployment rate The short-run Phillips curve is closely related to the short-run aggregate supply curve. In panel (a), the economy is initially in equilibrium at E1, with the aggregate price level at 100 and aggregate output at $10 trillion, which we assume is potential output. Now consider two possibilities. If the aggregate demand curve remains at AD1, there is a zero output gap and 0% inflation. If the aggregate demand curve shifts out to AD2, there is an output gap of 4% and 2% inflation, as shown in panel (b). The implication for unemployment and inflation: if aggregate demand does not increase, 6% unemployment and 0 inflation will result; if aggregate demand does increase, 4% unemployment and 2% inflation will result. The short-run Phillips curve relationship itself, however, is very intuitive. In general, a low rate of unemployment corresponds to an economy in which there are shortages of labor and other resources, leading to rising prices. But when unemployment is high, the economy is far from capacity. When there are surpluses of labor and other resources, prices will fall. CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 385 Early estimates of the Phillips curve for the United States were very simple: they showed a relationship between the unemployment rate and the inflation rate, without taking account of any other variables. During the 1960s this simple approach seemed, for a while, to be adequate. Figure 15-9 plots average annual rates of unemployment and inflation from 1961 to 1969. The data look a lot like a simple Phillips curve. Figure 15-9 Inflation rate 6% 5 4 1966 1968 1969 Unemployment and Inflation in the 1960s Each point shows the combination of unemployment and inflation for one year from 1961 to 1969 in the U.S. During the 1960s there seemed to be a simple relationship between unemployment and inflation, corresponding to the short-run Phillips curve. Source: Bureau of Labor Statistics. 3 2 1 0 3 1967 1963 1964 1962 1961 1965 4 5 6 7 8% Unemployment rate Even at the time, however, some economists argued that a more accurate Phillips curve would include other factors. In Chapter 10 we discussed the effect of supply shocks, such as sudden changes in the price of oil, which shift the aggregate supply curve. Such shocks also shift the Phillips curve: surging oil prices were an important factor in the inflation of the 1970s and also played an important role in the acceleration of inflation in early 2004. But supply shocks are not the only factors that could change the inflation rate. In the early 1960s, Americans had little experience with inflation: inflation rates had been low for decades. But by the late 1960s, after inflation had been steadily increasing for a while, they had probably started to expect future inflation. In 1968 two economists—Milton Friedman of the University of Chicago and Edmund Phelps of Columbia University—independently set forth a crucial hypothesis that expectations about future inflation directly affect the present inflation rate. Today most economists accept that the expected inflation rate—the rate of inflation that employers and workers expect in the near future—is the most important factor affecting inflation other than the unemployment rate. Inflation Expectations and the Short-Run Phillips Curve The expected rate of inflation is the rate of inflation that employers and workers expect in the near future. One of the crucial discoveries of modern macroeconomics is that the expected rate of inflation affects the short-run trade-off between unemployment and inflation. Why does expected inflation affect the short-run Phillips curve? The answer lies in part with the fact that wages are sticky, as discussed earlier in this chapter. Put yourself in the position of a worker or employer about to sign a contract setting the worker’s wages over the next year. For a number of reasons, the wage rate they agree to will be higher if everyone expects high inflation (including rising wages) than if The expected rate of inflation is the rate of inflation that employers and workers expect in the near future. 386 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N everyone expects prices to be stable. The worker will want a wage rate that takes into account future declines in the purchasing power of earnings. He or she will also want a wage rate that won’t fall behind the wages of other workers. And the employer will be more willing to agree to a wage increase now if hiring workers later will be even more expensive. Also, rising prices will make paying a higher wage rate more affordable for the employer. For these reasons, an increase in expected inflation shifts the short-run Phillips curve upward: the actual rate of inflation at any given unemployment rate is higher when the expected inflation rate is higher. In fact, macroeconomists believe that the relationship between expected inflation and actual inflation is one-for-one. That is, when the expected inflation rate increases, the actual inflation rate at any given unemployment rate will increase by the same amount. When the expected inflation rate falls, the actual inflation rate at any given level of unemployment will fall by the same amount. Figure 15-10 shows how the expected rate of inflation affects the short-run Phillips curve. First, suppose that the expected rate of inflation is 0%: people expect 0% inflation in the near future. SRPC0 in Figure 15-10 is the short-run Phillips curve when the public expects 0% inflation. According to SRPC0, the actual inflation rate will be 0% if the unemployment rate is 6%; it will be 2% if the unemployment rate is 4%. Alternatively, suppose the expected rate of inflation is 2%. In that case, employers and workers will build this expectation into wages and prices: at any given unemployment rate, the actual inflation rate will be 2 percentage points higher than it would be if people expected 0% inflation. SRPC2, which shows the Phillips curve when the expected inflation rate is 2%, is SRPC0, shifted upward by 2 percentage points at any given level of unemployment. According to SRPC2, the actual inflation rate will be 2% if the unemployment rate is 6%; it will be 4% if the unemployment rate is 4%. What determines the expected rate of inflation? In general, people base their expectations about inflation on experience. If the inflation rate has hovered around 0% in the last few years, people will expect it to be around 0% in the near future. But if the inflation rate has averaged around 5% lately, people will expect inflation to be around 5% in the near future. Since expected inflation is an important part of the modern Phillips curve discussion, you might wonder why it was not in the original formulation of the Phillips curve. But think back to what we said about the early 1960s: at that point, people Figure 15-10 Inflation rate 6% 5 4 3 2 1 0 –1 –2 –3 Unemployment rate Expected Inflation and the Short-Run Phillips Curve Expected inflation shifts the short-run Phillips curve up. SRPC0 is the Phillips curve with an expected inflation rate of 0%; SRPC2 is the Phillips curve with an expected inflation rate of of 2%. Each percentage point of expected inflation raises the actual inflation rate at any given unemployment rate by 1 percentage point. SRPC shifts up the same amount as an increase in expected inflation. SRPC2 3 4 5 6 7 8% SRPC0 CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 387 were accustomed to low inflation rates and reasonably expected that future inflation rates would also be modest. It was only after 1965 that persistent inflation became a fact of life. So it was only at that point that it became clear that expected inflation would play an important role in price-setting. The Long-Run Phillips Curve We can now explain why economists were skeptical of the 4% target for unemployment contained in the Humphrey–Hawkins bill, and believed that an attempt to achieve that target would lead to high and accelerating inflation. Figure 15-11 reproduces the two short-run Phillips curves from Figure 15-10, SRPC0 and SRPC2. It also adds an additional short-run Phillips curve, SRPC4, representing a 4% expected rate of inflation. We’ll explain why these are short-run curves in a moment, and we’ll also explain the significance of the vertical line long-run Phillips curve, LRPC. Suppose that the economy has, in the past, had a 0% inflation rate. In that case the current Phillips curve will reflect a 0% expected inflation rate, so it will be SRPC0. If the unemployment rate is 6%, the actual inflation rate will be 0%. Also suppose that policy makers decide to take Humphrey–Hawkins seriously and try to trade off lower unemployment for a higher rate of inflation. They use monetary policy, fiscal policy, or both to drive the unemployment rate down to 4%. This puts the economy at point A on SRPC0, leading to an actual inflation rate of 2%. Over time, the public will come to expect a 2% inflation rate. This will shift the short-run Phillips curve upward to SRPC2. Now, when the unemployment rate is 6%, the actual inflation rate will be 2%. Given this new short-run Phillips curve, keeping the unemployment rate at 4% will lead to a 4% actual inflation rate—point B on SRPC2—rather than 2%. Eventually, this 4% inflation rate gets built into expectations, and the short-run Phillips curve shifts upward again, to SRPC4. To keep the unemployment rate at 4% would now require accepting a 6% actual inflation rate, and so on. In short, a persistent attempt to trade off lower unemployment for higher inflation leads to accelerating inflation over time. Figure 15-11 Inflation rate 8% 7 6 5 4 3 2 1 0 –1 –2 –3 3 4 5 6 Long-run Phillips curve, LRPC The NAIRU and the Long-Run Phillips Curve SRPC0 is the short-run Phillips curve when the expected inflation rate is 0%. At a 4% unemployment rate, the economy is at point A with an inflation rate of 2%. The higher inflation rate will get built into expectations, and the SPRC will shift upward to SRPC2. If the unemployment rate remains at 4%, the economy will be at B and the inflation rate will rise to 4%. Inflationary expectations will be revised again, and SPRC will shift upward to SRPC4. At a 4% unemployment rate, the economy will be at C, and the inflation rate will rise to 6%. Here, 6% is the NAIRU, or non-accelerating-inflation rate of unemployment. As long as unemployment is at the NAIRU, the inflation rate will match expectations and remain constant. An unemployment rate below 6% requires everaccelerating inflation. The long-run Phillips curve, LRPC, which passes through E0, E2, and E4, is vertical: no long-run trade-off between unemployment and inflation exists. C B A Non-accelerating-inflation rate of unemployment, NAIRU E4 E2 E0 7 SRPC4 SRPC2 8% SRPC0 Unemployment rate 388 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N The nonaccelerating inflation rate of unemployment, or NAIRU, is the unemployment rate at which inflation does not change over time. The long-run Phillips curve shows the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience. To avoid accelerating inflation over time, the unemployment rate must be high enough so that the actual rate of inflation matches the expected rate of inflation. This is the situation at E0 on SRPC0: when the expected inflation rate is 0% and the unemployment rate is 6%, the actual inflation rate is 0%. It is also the situation at E2 on SRPC2: when the expected inflation rate is 2% and the unemployment rate is 6%, the actual inflation rate is 2%. And it is the situation at E4 on SRPC4: when the expected inflation rate is 4% and the unemployment rate is 6%, the actual inflation rate is 4%. The unemployment rate at which inflation does not change over time—6% in Figure 15-11—is known as the nonaccelerating inflation rate of unemployment, or NAIRU for short. Unemployment rates below the NAIRU lead to ever-accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long-run trade-off between unemployment and inflation. We can now explain the significance of the vertical line LRPC. It is the long-run Phillips curve, the relationship between unemployment and inflation in the long run, after expectations of inflation have had time to adjust to experience. It is vertical because any unemployment rate below the NAIRU leads to ever-accelerating inflation (and, a point we have not yet emphasized, any unemployment rate above the NAIRU leads to decelerating inflation). In other words, it shows that an unemployment rate below the NAIRU cannot be maintained in the long run. The Natural Rate, Revisited Earlier in this chapter, we introduced the concept of the natural rate of unemployment, the normal rate of unemployment around which the actual unemployment rate fluctuates. Now we have introduced the concept of the NAIRU. How do these two concepts relate to each other? The answer is that the NAIRU is another name for the natural rate. The level of unemployment the economy “needs” in order to avoid accelerating inflation is equal to the sum of frictional unemployment plus structural unemployment. In fact, economists estimate the natural rate of unemployment by looking for evidence about the NAIRU. For example, the way European countries learned, to their dismay, that their natural rates of unemployment were 9% or more was through unpleasant experience: in the late 1980s, and again in the late 1990s, European inflation began to accelerate as the unemployment rates in major economies, which had been above 9%, began to fall, approaching 8%. Earlier in this chapter we used Congressional Budget Office estimates of the U.S. natural rate of unemployment. The CBO has a model that predicts changes in the inflation rate based on the deviation of the actual unemployment rate from the natural rate. Given data on actual unemployment and inflation, this model can be used to deduce estimates of the natural rate—and that’s where the CBO numbers come from. economics in action From the Scary Seventies to the Nifty Nineties Earlier we saw that experience during the 1960s seemed to show the existence of a short-run Phillips curve for the U.S. economy, with a short-run trade-off between unemployment and inflation. After 1969, however, that apparent relationship fell apart. Figure 15-12 plots the track of the unemployment and inflation rates from 1961 to 1990. The track looks more like a tangled piece of yarn than like a smooth curve. Through much of the 1970s and early 1980s, the economy suffered from a combination of above-average unemployment rates coupled with inflation rates unprecedented in modern American history. This condition came to be known as “stagflation”—for stagnation combined with inflation. In the late 1990s, by contrast, CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 389 Figure 15-12 Inflation rate 14% 12 10 1973 8 6 4 2 0 3 4 5 1971 1961 6 1969 1990 1975 1979 Unemployment and Inflation, 1961–1990 During the 1970s, the short-run Phillips curve relationship that seemed to work in the 1960s broke down as the economy experienced a combination of high unemployment and high inflation. Economists believe this was the result both of adverse supply shocks and a buildup of expected inflation. Inflation came down during the 1980s, and the 1990s were a time of both low unemployment and low inflation. Source: Bureau of Labor Statistics. 1982 7 8 9 10% Unemployment rate the economy was experiencing a blissful combination of low unemployment and low inflation. What explains these developments? Part of the answer lies in the role of supply shocks. During the 1970s the economy suffered a series of adverse supply shocks. The price of oil, in particular, soared as wars and revolutions in the Middle East led to a reduction in oil supplies and as oil exporting countries deliberately curbed production to drive up prices. There was also a slowdown in labor productivity growth, which may have contributed to the poor performance. During the 1990s, by contrast, supply shocks were positive. Prices of oil and other raw materials were generally falling, and productivity growth accelerated. Equally important, however, was the role of expected inflation. As mentioned earlier in the chapter, inflation accelerated during the 1960s as the result of an economic boom. During the 1970s the public came to expect high inflation, and this got built into the short-run Phillips curve. It took a sustained and costly effort during the 1980s to get inflation back down. We’ll describe that effort in Chapter 16. The result, however, was that expected inflation was very low by the late 1990s, allowing actual inflation to be low even with low rates of unemployment. I ®® ® QUICK REVIEW ® ® >>>>>>>>>>>>>>>>>>>> >>CHECK YOUR UNDERSTANDING 15-4 1. How can the short-run Phillips curve can be thought of as the relationship between cyclical unemployment and the inflation rate above and beyond the expected inflation rate? 2. Why is there no long-run trade-off between unemployment and inflation? Solutions appear at back of book. The Phillips curve illustrates the negative relationship between unemployment and inflation. An increase in the expected rate of inflation pushes the short-run Phillips curve upward: each additional percentage point of expected inflation pushes the actual inflation rate at any given unemployment rate up by 1 percentage point. Any unemployment rate below the NAIRU leads to ever-accelerating inflation. The long-run Phillips curve is vertical because there is no longrun trade-off between unemployment and inflation. 14 12 9 6 3 0 3 4 6 • A LOOK AHEAD • Few economists now believe that government policy can trade off higher inflation for lower unemployment except in the short run. Nonetheless, the United States and other economies have had periods of substantial inflation; in some times and places, the inflation rate has gone into the thousands of percent. In contrast, in some other countries deflation—falling prices—has become a concern. In Chapter 16 we’ll look at why inflation occurs and the harm that it can do if not managed well. We’ll also look at why inflation can be hard to eliminate once the public comes to expect it. We’ll also explore the flip-side of the coin—the perils of deflation. 390 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N SUMMARY 1. There is always a positive amount of unemployment in the economy: job search leads to frictional unemployment. There is also structural unemployment, which is the result of factors that include minimum wages, unions, efficiency wages, and side effects of government policies. 2. Frictional plus structural unemployment leads to a natural level of unemployment and the natural rate of unemployment. It’s a rate that can and does shift over time. At any given time, the actual unemployment rate fluctuates around the natural rate because of the business cycle. Cyclical unemployment is linked to the output gap: when the output gap is positive, cyclical unemployment is negative; when the output gap is negative, cyclical unemployment is positive. Swings in cyclical unemployment are, however, smaller than swings in the output gap, a fact captured by Okun’s law. 3. Unlike many markets, the labor market doesn’t move quickly to equilibrium. This may, in part, reflect misperceptions on the part of workers and employers about the state of the market. Sticky wages also appear to play a role, slowing the adjustment of wages even in the absence of misperceptions. Prices (including wages) are also slow to adjust in some cases, in part reflecting the menu costs of changing prices. 4. The short-run Phillips curve shows a negative relationship between the unemployment rate and inflation rate. The short-run Phillips curve is related to, but not the same thing as, the short-run aggregate supply curve. Today, macroeconomists believe that the short-run Phillips curve shifts with changes in the expected rate of inflation. Because expectations change with experience, attempts to keep the unemployment rate persistently low lead not only to high inflation but also to constantly accelerating inflation. The nonaccelerating inflation rate of unemployment, or NAIRU, is the rate of unemployment at which inflation is stable. It is equal to the natural rate of unemployment. The long-run Phillips curve is vertical because there is no trade-off between the unemployment rate and the inflation rate in the long run. KEY TERMS Job search, p. 370 Frictional unemployment, p. 370 Structural unemployment, p. 371 Efficiency wages, p. 373 Natural rate of unemployment, p. 373 Cyclical unemployment, p. 373 Output gap, p. 377 Okun’s law, p. 379 Sticky wages, p. 381 Menu costs, p. 382 Short-run Phillips curve, p. 383 Expected rate of inflation, p. 385 Nonaccelerating inflation rate of unemployment, or NAIRU, p. 388 Long-run Phillips curve, p. 388 PROBLEMS 1. In each of the following situations, what type of unemployment is Melanie facing? Labor Statistics home page, click on the unemployment rate, choose the Employment Situation Summary, and then click on the table titled “Unemployed persons by duration of unemployment.” Use the seasonally adjusted numbers for your answers to the following questions. a. After completing a complex programming project, Melanie is laid off. Her prospects for a new job requiring similar skills is good, and she has signed up with a programmer placement service. She has passed up low-paying job offers. a. How many workers were unemployed less than 5 weeks? What percentage of all unemployed workers do these workers represent? How do these numbers compare to the previous month’s data? b. When Melanie and her co-workers refused to accept pay cuts, her employer outsourced her programming tasks for workers in another country. This phenomenon is occurring throughout the programming industry. b. How many workers were unemployed 27 or more weeks? What percentage of all unemployed workers do these workers represent? How do these numbers compare to the previous month’s data? c. Due to the current slump in investment spending, Melanie has been laid off from her programming job. Her employer promises to re-hire her when business picks up. 2. Each month, usually on the first Friday of the month, the Bureau of Labor Statistics releases the Employment Situation Summary for the previous month. Part of the information released concerns how long individuals have been unemployed. Go to www.bls.gov to find the latest report. On the Bureau of c. How long has the average worker been unemployed (average duration, in weeks)? How does this compare to the average for the previous month’s data? d. Comparing the latest month for which there is data with the previous month, has the problem of long-term unemployment improved or deteriorated? CHAPTER 15 L A B O R M A R K E T S, U N E M P L O Y M E N T, A N D I N F L AT I O N 391 3. There is only one labor market in Profunctia. All workers have the same skills and all firms hire workers with these skills. Use the accompanying plot, which shows the supply of and demand for labor, to answer the following questions. Wage rate $20 S 7. With its tradition of a job for life for most citizens, Japan once had a much lower unemployment rate than that of the United States; from 1960 to 1995, the unemployment rate in Japan exceeded 3% only once. However, since the crash of its stock market in 1989 and slow economic growth in the 1990s, the job-for-life system has broken down and unemployment has risen to more than 5% in 2003. Explain the likely effect of these recent changes in Japan on the Japanese natural rate of unemployment. 8. The accompanying scatterplot shows the relationship between the unemployment rate and the output gap in the United States from 1990 to 2004. Draw a straight line through the scatter of dots in the figure. Assume that this line represents Okun’s law: Unemployment rate = b − (m × Output gap) Unemployment rate 8% 7 6 5 4 3 2 1 –4 –3 –2 –1 0 1 2 3 4% Output gap 10 0 D 50 100 Quantity of labor (thousands) a. What is the equilibrium wage rate in Profunctia? At this wage rate, what is the level of employment, the size of the labor force, and the unemployment rate? b. If the government of Profunctia sets a minimum wage equal to $12, what will be the level of employment, the size of the labor force, and the unemployment rate? c. If unions bargain with the firms in Profunctia and set a wage rate equal to $14, what will be the level of employment, the size of the labor force, and the unemployment rate? d. If the concern for retaining workers and encouraging high quality work leads firms to set a wage rate equal to $16, what will be the level of employment, the size of the labor force, and the unemployment rate? 4. In Northlandia, there are no labor contracts; that is, wage rates can be renegotiated at any time. But in Southlandia, wage rates are set at the beginning of each odd year and last for two years. Why would equal-sized falls in aggregate output due to a fall in aggregate demand have different effects on the magnitude and duration of unemployment in these two economies? 5. In which of the following cases is it more likely for efficiency wages to exist? Why? What is the unemployment rate when aggregate output equals potential output? What would the unemployment rate be if the output gap were 2%? What if the output gap were −3%? What do these results tell us about the coefficient m in Okun’s law? 9. After experiencing a recession for the past two years, the residents of Albernia were looking forward to a decrease in the unemployment rate. Yet after six months of positive economic growth, the unemployment rate remains the same as it was at the end of the recession. How can you explain why the unemployment rate did not fall although the economy was experiencing economic growth? 10. Due to historical differences, countries often differ in how quickly a change in actual inflation is incorporated into a change in expected inflation. In a country such as Japan that has had very little inflation or deflation in recent memory, it will take longer for a change in the actual inflation rate to be reflected in a corresponding change in the expected inflation rate. In contrast, in a country such as Argentina, one that has recently had very high inflation, a change in the actual inflation rate will immediately reflected in a corresponding change in the expected inflation rate. What does this imply about the short-run and long-run Phillips curves in these two types of countries? What does this imply about the effectiveness of monetary and fiscal policy to reduce the unemployment rate? a. Jane and her boss work as a team selling ice cream. b. Jane sells ice cream without any direct supervision by her boss. c. Jane speaks Korean and sells ice cream in a neighborhood in which Korean is the primary language. Is it difficult to find another worker who speaks Korean. 6. How will the following changes affect the natural rate of unemployment? a. The government reduces the time during which an unemployed worker can receive benefits. b. More teenagers focus on their studies and do not look for jobs until after college. c. Greater access to the Internet leads both potential employers and potential employees to use the Internet to list and find jobs. d. Union membership declines. 392 PA R T 6 T H E S U P P LY- S I D E A N D T H E M E D I U M R U N 11. The accompanying table shows data for the average annual rates of unemployment and inflation for the economy of Britannia from 1995 to 2004. Use it to construct a scatterplot similar to Figure 15-9. Are the data consistent with a short-run Phillips curve? If the government pursues expansionary monetary policies in the future to keep the unemployment rate below the natural rate of unemployment, how effective will such a policy be? Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Unemployment rate 4.0% 2.0% 10.0% 8.0% 5.0% 2.5% 6.0% 1.0% 3.0% 7.0% Inflation rate 2.5% 5.0% 1.0% 1.3% 2.0% 4.0% 1.7% 10.0% 3.0% 1.5% >web... To continue your study and review of concepts in this chapter, please visit the Krugman/Wells website for quizzes, animated graph tutorials, web links to helpful resources, and more. www.worthpublishers.com/krugmanwells ...
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This note was uploaded on 03/18/2009 for the course ECON 102 taught by Professor Erus during the Spring '09 term at Boğaziçi University.

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