Chapter

27
The Labor Market,
Unemployment,
and Inflation

Prepared by:

Fernando & Yvonn Quijano

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 27: The Labor Market, Unemployment,

The Labor Market,

Unemployment,
and Inflation 27
Chapter Outline
The Labor Market: Basic Concepts
The Classical View of the Labor Market
The Classical Labor Market and the Aggregate
Supply Curve
and Inflation

The Unemployment Rate and the Classical View

Explaining the Existence of Unemployment
Sticky Wages
Efficiency Wage Theory
Imperfect Information
Minimum Wage Laws
An Open Question
The Short-Run Relationship Between the
Unemployment Rate and Inflation
The Phillips Curve: A Historical Perspective
Aggregate Supply and Aggregate Demand Analysis
and the Phillips Curve
Expectations and the Phillips Curve
Is There a Short-Run Trade-Off Between Inflation
and Unemployment?
The Long-Run Aggregate Supply Curve,
Potential GDP, and the Natural Rate of
Unemployment
The Nonaccelerating Inflation Rate of
Unemployment (NAIRU)
Looking Ahead
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 THE LABOR MARKET: BASIC CONCEPTS
CHAPTER 27: The Labor Market, Unemployment,

The labor force (LF) is the number of employed

plus unemployed:

LF = E + U
and Inflation

unemployment rate The number of

people unemployed as a percentage of
the labor force.

Unemployment rate = U/LF

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 THE LABOR MARKET: BASIC CONCEPTS
CHAPTER 27: The Labor Market, Unemployment,

frictional unemployment The portion of

unemployment that is due to the normal
working of the labor market; used to
denote short-run job/skill matching
and Inflation

problems.

structural unemployment The portion

of unemployment that is due to changes
in the structure of the economy that
result in a significant loss of jobs in
certain industries.

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 THE LABOR MARKET: BASIC CONCEPTS
CHAPTER 27: The Labor Market, Unemployment,

cyclical unemployment The increase

in unemployment that occurs during
recessions and depressions.
and Inflation

Employment tends to fall when aggregate output falls and to rise when aggregate output
rises.

A decline in the demand for labor does not

necessarily mean that unemployment will rise.

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 THE CLASSICAL VIEW OF THE LABOR
MARKET
CHAPTER 27: The Labor Market, Unemployment,
and Inflation

FIGURE 14.1 The Classical Labor Market

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 THE CLASSICAL VIEW OF THE LABOR
MARKET
CHAPTER 27: The Labor Market, Unemployment,

labor supply curve A graph that

illustrates the amount of labor that
households want to supply at each given
wage rate.
and Inflation

labor demand curve A graph that

illustrates the amount of labor that firms
want to employ at each given wage rate.

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 THE CLASSICAL VIEW OF THE LABOR
MARKET
CHAPTER 27: The Labor Market, Unemployment,

THE CLASSICAL LABOR MARKET AND THE

AGGREGATE SUPPLY CURVE

The classical idea that wages adjust to clear

the labor market is consistent with the view that
wages respond quickly to price changes. This
and Inflation

means that the AS curve is vertical.

When the AS curve is vertical, monetary and

fiscal policy cannot affect the level of output and
employment in the economy.

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 THE CLASSICAL VIEW OF THE LABOR
MARKET
CHAPTER 27: The Labor Market, Unemployment,

THE UNEMPLOYMENT RATE AND THE

CLASSICAL VIEW

The unemployment rate is not necessarily an

accurate indicator of whether the labor market
is working properly.
and Inflation

The measured unemployment rate may

sometimes seem high even though the labor
market is working well.

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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

STICKY WAGES
sticky wages The downward rigidity
of wages as an explanation for the
existence of unemployment.
and Inflation

FIGURE 14.2 Sticky Wages

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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

Social, or Implicit, Contracts

social, or implicit, contracts

Unspoken agreements between workers
and firms that firms will not cut wages.
and Inflation

relative-wage explanation of
unemployment An explanation for sticky
wages (and therefore unemployment): If
workers are concerned about their wages
relative to other workers in other firms and
industries, they may be unwilling to accept
a wage cut unless they know that all other
workers are receiving similar cuts.
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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

Explicit Contracts

explicit contracts Employment

contracts that stipulate workers’ wages,
usually for a period of 1 to 3 years.
and Inflation

cost-of-living adjustments (COLAs)

Contract provisions that tie wages to
changes in the cost of living. The greater
the inflation rate, the more wages are
raised.

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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

EFFICIENCY WAGE THEORY

efficiency wage theory An explanation

for unemployment that holds that the
productivity of workers increases with the
wage rate. If this is so, firms may have
and Inflation

an incentive to pay wages above the

market-clearing rate.

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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

IMPERFECT INFORMATION

Firms may not have enough information at their

disposal to know what the market-clearing wage
is. In this case, firms are said to have imperfect
information.
and Inflation

If firms have imperfect or incomplete information,

they may set wages wrong—wages that do not
clear the labor market.

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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

MINIMUM WAGE LAWS

minimum wage laws Laws that set a

floor for wage rates—that is, a minimum
hourly rate for any kind of labor.
and Inflation

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 EXPLAINING THE EXISTENCE OF
UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

AN OPEN QUESTION

The aggregate labor market is very complicated,

and there are no simple answers to why there is
unemployment.
and Inflation

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

In the short run, the unemployment rate (U) and

aggregate output (income) (Y) are negatively
related
and Inflation

When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises.

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

This curve represents the

positive relationship
between Y and the overall
and Inflation

price level (P).

FIGURE 14.3 The Aggregate Supply Curve

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

There is a negative relationship between the

unemployment rate and the price level. As
the unemployment rate declines in response
to the economy’s moving closer and closer
to capacity output, the overall price level
rises more and more, as shown in Figure
14.4.
and Inflation

FIGURE 14.4 The Relationship Between the Price Level

and the Unemployment Rate
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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,
and Inflation

FIGURE 14.5 The Phillips Curve

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

inflation rate The percentage change in

the price level.
and Inflation

Phillips Curve A graph showing the

relationship between the inflation rate
and the unemployment rate.

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

THE PHILLIPS CURVE: A HISTORICAL

PERSPECTIVE
and Inflation

FIGURE 14.6 Unemployment and Inflation, 1960–1969

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,
and Inflation

FIGURE 14.7 Unemployment and Inflation, 1970—2004

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

AGGREGATE SUPPLY AND AGGREGATE DEMAND

ANALYSIS AND THE PHILLIPS CURVE
and Inflation

FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on
Shifts in Both Aggregate Demand and Aggregate Supply

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

The Role of Import Prices

and Inflation

FIGURE 14.9 The Price of Imports, 1960 I–2005 II

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

EXPECTATIONS AND THE PHILLIPS CURVE

Expectations are self-fulfilling. This means that

wage inflation is affected by expectations of
future price inflation.
and Inflation

Price expectations that affect wage contracts

eventually affect prices themselves.

Inflationary expectations shift the Phillips Curve

to the right.

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 THE SHORT-RUN RELATIONSHIP BETWEEN
THE UNEMPLOYMENT RATE AND INFLATION
CHAPTER 27: The Labor Market, Unemployment,

IS THERE A SHORT-RUN TRADE-OFF BETWEEN

INFLATION AND UNEMPLOYMENT?

There is a short-run trade off between inflation and unemployment, but other factors
and Inflation

besides unemployment affect inflation. Policy involves much more than simply choosing
a point along a nice, smooth curve.

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 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL
GDP, AND THE NATURAL RATE OF UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,
and Inflation

FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment

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 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL
GDP, AND THE NATURAL RATE OF UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

natural rate of unemployment The

unemployment that occurs as a normal
part of the functioning of the economy.
Sometimes taken as the sum of frictional
and Inflation

unemployment and structural

unemployment.

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 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL
GDP, AND THE NATURAL RATE OF UNEMPLOYMENT
CHAPTER 27: The Labor Market, Unemployment,

THE NONACCELERATING INFLATION RATE OF

UNEMPLOYMENT (NAIRU)
NAIRU
The nonaccelerating
inflation rate of
unemployment.
and Inflation

FIGURE 14.11 The Long-Run Phillips Curve:

The Natural Rate of Unemployment

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 REVIEW TERMS AND CONCEPTS
CHAPTER 27: The Labor Market, Unemployment,

cost-of-living adjustments NAIRU

(COLAs) natural rate of unemployment
cyclical unemployment Phillips Curve
efficient wage theory relative-wage explanation of
explicit contracts unemployment
and Inflation

frictional unemployment social, or implicit, contracts

inflation rate sticky wages
labor demand curve structural unemployment
labor supply curve unemployment rate
minimum wage laws

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