Inflation and unemployment (topic 7) Flashcards
Focus: the natural rate of unemployment is the rate at which the wage demands of workers are consistent with the price decisions of firms. Medium run. Low unemployment puts upward pressure on inflation, but the form of the relation depends on how people and firms form expectations.
When is inflation and unemployment taken into account?
in the medium run.
Explain the relations between demand, production, employment/unemployment and costs.
An increase in demand is seen-> production increases -> higher production = higher employment -> decrease in unemployment -> lower unemployment = higher bargaining power to the workers -> higher wages -> higher wages = higher production costs -> firms increase their product prices -> higher prices = workers asking for higher wages -> higher wages = higher prices -> etc.
What is the labor force?
the sum of people looking for work or working.
Explain the participation rate.
the ratio of the labor force to the total population.
Explain the unemployment rate.
Unemployment rate = the ratio of unemployed to the labor force.
When unemployment is high workers have a lower probability for becoming employed/stay unemployed for a longer time and employed workers have a higher probability of becoming unemployed.
A low unemployment rate makes it more attractive for workers to quit their jobs if they are not satisfied with their wage, as it will be easy to find a new job.
Explain the employment rate.
Employment rate = ratio of employment to the population available for work.
high unemployment = low employment.
low unemployment = high employment.
What factors does bargaining power depend on?
How much will it cost the firm to find other workers as replacement?
- A highly skilled worker who knows how the firm operates can be hard to replace, both economically and operationally.
How hard is it for the workers to find another job?
- When unemployment is low, it can be more difficult for firms to find replacement workers, but it will at the same time be easier for workers to find other jobs and they won’t necessarily accept a low wage.
Explain the wage setting relation.
W / P^e = F(u,z)
P^e= expected price level
The expected price level is used because wages are set in nominal terms, meaning that when they are set, the relevant price level is not known yet (wage levels are often set a couple of years ahead, so if prices suddenly go up, these are typically not readjusted).
u= unemployment rate
There is a negative relation between the unemployment rate and wages, indicates that an increase in unemployment leads to a decrease in wages.
z= all other variables that may affect the outcome of wage setting
An increase in z leads to an increase in W (positive relation).
Factors could be e.g., unemployment insurance, increase in minimum wage which would lead to an increase in the average wage, increase in employment protection, etc.
How do you determine real wage?
W / P
wages relative to the products that are sold.
Explain the price setting relation.
W / P^e = 1 / (1+m)
m = mark-up of the price over the cost.
This relation shows that many goods markets are not competitive and that firms can charge a higher price than their marginal cost (P will exceed W (the costs) by a factor = (1+m)).
What does prices depend on?
Prices depend on firm’s costs, which depend on the nature of the production function.
Production function = the relation between inputs used in the production and the prices of these and the quantity of output produced. (Y=N)
N = employment
Implies that the cost of producing one more unit of output is the cost of employing one more worker at wage W (marginal cost = W)
What is the natural rate of unemployment?
the equilibrium rate of unemployment.
Explain the real wage and unemployment equilibrium graphically.
On the Y-axis: real wage W/P.
On the X-axis: unemployment rate u.
Wage setting relation is a downward sloping curve (negative relation between real wage and unemployment rate)
Price setting relation is a horizontal line.
Equilibrium: WS = PS <=> F (un,z) = 1 / (1 + m)
Explain the graphical effect on the wages and unemployment equilibrium when there’s and increase in z.
increase in unemployment benefits (z), increases the wage set by wage setters at a given unemployment rate.
The WS curve will be shifted upwards.
Movement along the PS line to the right and the natural rate of unemployment increases.
The increase in unemployment rate brings the real wage back to what firms are willing pay.
Explain the graphical effects on equilibrium (WS = PS) when there’s an increase in m.
Increase in m:
Decrease in real wage paid by firms.
PS line shifts downwards.
Movement downward on the WS curve.
Natural unemployment rate increases.
