Labor Market and AS-AD Model PDF

Labor market and the AS-AD model Introduction Importance of the Labor Market The labor market is central to macroeconomic analysis because it directly influences output, inflation, and overall economic growth. Understanding how wages and employment levels are determined helps policymak...

Labor market and the AS-AD model Introduction Importance of the Labor Market The labor market is central to macroeconomic analysis because it directly influences output, inflation, and overall economic growth. Understanding how wages and employment levels are determined helps policymakers design effective fiscal and monetary policies to achieve macroeconomic stability. Additionally, the labor market's functioning impacts social welfare, influencing income distribution and poverty levels. Key Concepts in the Labor Market The Labor Force The labor force comprises individuals aged 16 and over who are either employed or actively seeking employment. The labor force participation rate, which measures the proportion of the working-age population that is part of the labor force, is an indicator of economic health. A high participation rate suggests that a large portion of the population is engaged in productive activities, while a low rate may indicate economic distress or demographic challenges. Unemployment Unemployment refers to the situation where individuals who are willing and able to work cannot find jobs. The unemployment rate, a key macroeconomic indicator, measures the proportion of the labor force that is unemployed. Unemployment Rate The percentage of the labor force that is unemployed and actively seeking work. It reflects the health of the labor market. Determined by the ratio of the number of people who are unemployed and the number of people who are currently in the labor force.  Blanchard explains that the unemployment rate indicates two different labor market conditions, an active market with frequent job changes, hires, and separations, or a sclerotic market with few job changes and a stagnant pool of unemployed workers. CPS To understand the underlying dynamics of unemployment, it is essential to analyze the movement of workers within the labor market. In the US, data on these movements is collected through the monthly Current Population Survey (CPS), which provides detailed insights into the flow of workers in and out of employment Wage Determination Wages are primarily determined by the bargaining process between workers and employers. This process is influenced by factors such as productivity, labor market conditions, and institutional settings (e.g., minimum wage laws, unionization). High wages can reduce employment if they exceed the productivity of workers, while low wages may increase employment but at the cost of workers' living standards. Bargaining A worker's bargaining power depends on two factors: the cost of replacing them and the ease of finding another job. If it's costly to replace a worker and easy for them to find another job, they have more bargaining power. This means highly skilled workers with unique knowledge are more likely to negotiate higher wages, while low-skilled workers with easily replaceable skills have less bargaining power. Additionally, labor market conditions play a role. When unemployment is low, workers have more leverage, while high unemployment weakens their bargaining position. Nominal Wages The amount of money workers earn per unit of time (e.g., per hour or per year). It's called "nominal" because it doesn't adjust for inflation. Real Wages The purchasing power of nominal wages, calculated by adjusting for the price level. Real wages indicate how much goods and services workers can actually buy with their earnings. W = Nominal Wage P = Price Level Efficiency Wages Theory Efficiency wages refer to the practice of paying workers more than their reservation wage to boost productivity and reduce turnover. Firms adopt this approach to make jobs more attractive, encouraging employees to remain in their positions and work more effectively. If workers are only paid their minimum acceptable wage, they may feel indifferent about staying, leading to higher turnover and lower efficiency. By paying a higher wage, firms aim to foster employee satisfaction, which in turn promotes better performance and commitment. Efficiency wage theory suggests that wages are tied to worker productivity, and the strategy is often employed in sectors where the quality of work is crucial, such as high-tech industries. Additionally, labor-market conditions play a role, as lower unemployment rates may compel firms to raise wages to retain workers, while higher unemployment allows firms to offer lower wages. Example: Efficiency wages can be seen in the transformation of airport security jobs after September 11, 2001, where higher wages were offered to attract more motivated and competent workers in a critical field. Wage-Setting The wage-setting equation represents the relationship between wages, unemployment, and other factors like productivity and institutional settings. Wages are set through bargaining processes where workers and employers negotiate based on labor market conditions. Higher unemployment tends to reduce workers' bargaining power, leading to lower wages, while lower unemployment strengthens workers' position, pushing wages upward. Additionally, factors like unemployment benefits, labor laws, and the overall economic environment can influence the wage-setting process. W = Nominal wage P^e = Expected price level - How does P^e affect wages? - Workers care about W/P - How much their wage can buy goods and services - If Price level increase then Wage Increases u = Unemployment rate - High Unemployment leads to Lower Wages - You know competition for a job is high therefore you ask for a lower wage z = Other factors affecting wages (e.g., unemployment benefits, minimum wage laws) - By convention, Define z so that an increase in z implies an increase in the wage F (u,z) = A function representing how wages respond to unemployment and other factors Price-Setting The price-setting equation explains how firms determine the prices of goods and services based on the wages they pay and the productivity of labor. Firms set prices to cover their costs, including wages, while aiming to achieve a certain profit margin. The firm’s costs depend on the nature of production. Production Cost or Production Function is written as follows: Y = output  A = labor productivity N = employment We assume that A is a constant then we can simplify the equation to be Which means one worker produces one unit of output. This implies that the cost of producing an additional unit of output, or the marginal cost, is equal to the wage W Firms add a markup (m) to their costs, including wages, to determine the prices of goods and services. Higher wages, other things being equal, lead to higher prices. In perfectly competitive markets, prices would equal the marginal cost (P = W) However, since many markets are not perfectly competitive, firms add a markup m, The markup reflects the market power of firms, with m = 0 in perfectly competitive markets and positive values in markets with less competition. P = Price level m = Markup over costs (reflecting the firm’s profit margin) - Higher Markup leads to Higher Prices W = Marginal Cost of Production - Higher wages (Higher costs for firms) lead to higher prices Wage-setting relation Wage-setting relation describes how the real wage (W/P) is determined by the unemployment rate (u). When the unemployment rate is high, workers have weaker bargaining power, leading to lower real wages. This relation is represented by the downward-sloping curve WS in the graph. Price-setting relation Price-setting relation describes how firms set prices based on their costs (including wages) and markup. A higher markup leads to higher prices, which means a lower real wage for workers. This relation is represented by a horizontal line in the graph, as the real wage is determined solely by the markup. Equilibrium Unemployment  It occurs when the real wage chosen by workers in the wage-setting process equals the real wage implied by firms' price-setting decisions. This equilibrium point is represented by point A in the graph. This balance determines the equilibrium unemployment rate, known as the "natural rate of unemployment" (denoted as 𝑢𝑛). While the term "natural" suggests an unchanging rate, the natural unemployment rate can be influenced by factors like institutions and policy changes. The position of the wage-setting and price-setting curves influences this equilibrium. Furthermore, This rate can be influenced by factors such as unemployment benefits and antitrust legislation. For example, An increase in unemployment benefits leads to an increase in the natural rate of unemployment. This is because higher benefits make workers less willing to accept low-paying jobs, shifting the wage-setting curve upward. Another example: Antitrust enforcement can allow firms to increase their market power, leading to lower wages. Ultimately, these factors can affect the equilibrium level of unemployment. -An increase in markups leads to a decrease in the real wage that firms are willing to pay. -This decrease in the real wage shifts the price-setting curve downward. Natural Level of Employment The natural level of employment is the level of employment that occurs when unemployment is at its natural rate. Nn = Natural level of Employment L = Labor Force Un =Natural rate of Unemployment For example, if the labor force is 150 million and the natural rate of unemployment is 5%, then the natural level of employment is 142.5 million. Natural Level of Output The natural level of output is the level of production that occurs when employment is at its natural rate. It can be calculated using the production function and the natural level of employment. Yn = Natural level of Output Nn = Natural level of Employment L = Labor Force Un =Natural rate of Unemployment  AS-AD Model Aggregate Supply Relation Aggregate Supply ○ Aggregate supply is the relationship between the overall price level in the economy and the amount of output that will be supplied. As output goes up, prices will be higher. Derivation of AS CURVE ○ The AS curve is derived from the behavior of wages and prices. It uses the wage-setting equation: ○ The price-setting equation is given by: ○ By combining these equations and eliminating 𝑾, the AS relation is derived: ○ The price level P depends on the expected price level Pe and the level of output Y (and also on the markup m, the catchall variable z, and the labor force L, which we all take as constant here). Key Properties of AS Curve ○ The first property is that, given the expected price level, an increase in output leads to an increase in the price level. This is the result of four underlying steps: 1. An increase in output leads to an increase in employment.  2. The increase in employment leads to a decrease in unemployment and therefore to a decrease in the unemployment rate. 3. The lower unemployment rate leads to an increase in the nominal wage. 4. The increase in the nominal wage leads to an increase in the prices set by firms and therefore to an increase in the price level. ○ The second property is that, given unemployment, an increase in the expected price level leads, one for one, to an increase in the actual price level. For example, if the expected price level doubles, then the price level will also double. This effect works through wages: 1. If wage setters expect the price level to be higher, they set a higher nominal wage. 2. The increase in the nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level. Graphical Representation Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.  This property that the price level equals the expected price level when output is equal to the natural level of output has two straightforward implications: ○ When output is above the natural level of output, the price level turns out to be higher than expected. ○ When output is below the natural level of output, the price level turns to be lower than expected. An increase in the expected price level P^e shifts the aggregate supply curve up. Conversely: A decrease in the expected price level shifts the aggregate supply curve down. Aggregate Demand Relation Definition of Aggregate Demand (AD) ○ The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium conditions in the goods and financial markets. Derivation of AD Curve ○ It is derived from the equilibrium conditions in the goods and financial markets we described in Chapter 5. In Chapter 5, we derived the following equation for goods-market equilibrium ○ ○ IS Relation: Represents equilibrium in the goods market, where output (Y) equals the total demand for goods. This demand is composed of consumption (C), investment (I), and government spending (G), adjusted for taxes (T). ○ ○ LM Relation: This represents equilibrium in the financial markets, where the money supply (M) divided by the price level (P) equals the demand for real money balances, which depends on output (Y) and the interest rate (i). ○ Key Properties of AD Curve The AD curve slopes downward, showing a negative relationship between the price level and output. Changes in fiscal or monetary policy can shift the AD curve. For example, increased government spending shifts the AD curve to the right, while a contraction in the money supply shifts it to the left ○ The increase in the price level leads to a decrease in the real money stock. This monetary contraction leads to an increase in the interest rate, which leads in turn to a lower demand for goods and lower output.  ○ Money Supply (M): An increase in the money supply shifts the AD curve to the right. This is because more money in the economy reduces interest rates, encouraging investment and consumption, which increases overall demand. Government Spending (G): An increase in government spending also shifts the AD curve to the right, as government purchases directly increase demand for goods and services in the economy. Taxes (T): An increase in taxes shifts the AD curve to the left, as higher taxes reduce consumer spending and investment due to lower disposable income. Equilibrium Output in Short Run and Medium Run The next step is to put the AS and the AD relations together. From Sections 7-1 and 7-2, the two relations are given The equilibrium depends on the value of Pe. The value of Pe determines the position of the aggregate supply curve, and the position of the aggregate supply curve affects the equilibrium. In The Short Run Aggregate Supply (AS): This is the total supply of goods and services that businesses in an economy are willing to produce at different price levels. In the short run, this curve slopes upward, meaning that as prices rise, businesses are willing to produce more. Aggregate Demand (AD): This is the total demand for goods and services in the economy at different price levels. The curve slopes downward, meaning that as the price level falls, people demand more goods and services. Equilibrium Point (A): The point where the AS curve and the AD curve intersect is called the equilibrium. At this point, the quantity of goods and services supplied equals the quantity demanded. This balance ensures that all markets (labor, financial, goods) are in equilibrium. ○ In the short run, there is no reason why output should equal the natural level of output. Whether it does depends on the specific values of the expected price level and the values of the variables affecting the position of aggregate demand. From the Short Run to the Medium Run Wage setters are likely to continue to revise upwards their expectation of the price level. This means that as long as the equilibrium output exceeds the natural level of output Yn, the expected price level increases, shifting the AS curve upward. So long as output exceeds the natural output level, the price level turns out to be higher than expected. This leads wage setters to revise their expectations of the price level upward, leading to an increase in the price level. The adjustment ends once wage setters no longer have a reason to change their expectations. In the medium run, output returns to the natural level of output. To summarize: In the short run, output can be above or below the natural level of output. Changes in any of the variables that enter either the aggregate supply relation or the aggregate demand relation lead to changes in output and to changes in the price level. In the medium run, output eventually returns to the natural level of output. The adjustment works through changes in the price level. When output is above the natural level of output, the price level increases. The higher price level decreases demand and output. When output is below the natural level of output, the price level decreases, increasing demand and output. Dynamic Effects of Monetary Policy  1. What is Monetary Policy: ○ Monetary policy involves changes in the nominal money supply (M) by central banks to influence economic conditions like inflation, output, and interest rates. In the AS-AD model, monetary policy typically involves increasing or decreasing the money supply to shift the aggregate demand (AD) curve. 2. Impact of Monetary Policy: ○ Changes in monetary policy affect the real money stock (M/P), which influences interest rates and the overall demand for goods and services. An increase in the money supply lowers interest rates, stimulating output, while a reduction in the money supply has the opposite effect. 3. Short-Run Effects: ○ In the short run, an increase in nominal money shifts the AD curve to the right, raising output and reducing interest rates. The price level may rise slightly, but most of the initial effect falls on output. However, as prices adjust, the impact on output diminishes. 4. Medium-Run Effects: ○ In the medium run, the price level increases further, offsetting the effects of the initial monetary expansion. Output returns to its natural level, and the real money stock (M/P) returns to its initial value. Thus, in the medium run, monetary policy is neutral, having no long-term effect on output or the interest rate. Dynamic Effects of Fiscal Policy 1. What is Fiscal Policy: ○ Fiscal policy refers to government actions related to taxation (T) and spending (G) to influence economic conditions. In the AS-AD model, changes in fiscal policy primarily affect aggregate demand (AD) by shifting the IS curve. 2. Impact of Fiscal Policy: ○ A decrease in government spending shifts the AD curve to the left, reducing output. This is a form of fiscal contraction, which initially lowers aggregate demand and output. In contrast, fiscal expansion (increased government spending or tax cuts) increases aggregate demand and boosts output. 3. Short-Run Effects: ○ In the short run, a reduction in government spending leads to a decrease in output and, in some cases, a decrease in investment. The price level may fall slightly due to reduced  demand. However, a proper mix of monetary and fiscal policies can help mitigate the short-run adverse effects. 4. Medium-Run Effects: ○ In the medium run, output returns to its natural level as prices adjust downward. The interest rate decreases further, and investment increases. A fiscal contraction reduces the interest rate, stimulating investment in the medium run.