Advanced Macroeconomics
Lecture 5: The Labor Market
Yeqing Zhang
Central University of Finance and Economics
October 29, 2021
Schedule (tentative)
Week Date Content
2 24-Sep Introduction
3 1-Oct No Class
4 8-Oct The Short Run: The Goods Market
5 15-Oct The Short Run: Financial Markets
6 22-Oct The Short Run: The IS–LM Model
7 29-Oct The Medium Run: The Labor Market
8 5-Nov The Medium Run: The AS-AD Model
9 12-Nov The Medium Run: The Phillips-Curve
10 19-Nov The Long Run: Basic Solow Model
11 26-Nov The Long Run: Solow Model with Technology
12 3-Dec The Long Run: Ramsey Model
13 10-Dec The Long Run: Cass-Koopmans Model
14 17-Dec The Long Run: Other Neoclassical Growth Models
15 24-Dec Chinese Economy
16 31-Dec Chinese Economy
17 7-Jan Frontiers in Macroeconomics (if possible)
Recap
Focused on short-run assuming constant Pt in the IS–LM model
Limited our discussion to short run, assumed a flat aggregate supply
curve
I Equilibrium was only a matter of the demand side
Also ignored the labor market
I Flat aggregate supply: labor market satisfies any level of output demanded
I Any changes in labor market passive responses to changes in aggregate
demand
Recap
What supported our assumption of a flat aggregate supply curve in the
short run
I In the short run, firms may prefer to keep price (Pt ) fixed (to avoid menu
costs, or price contracts unable to adjust nominal prices within a certain
period)
Nominal wages (Wt ) quite likely to be fixed in the short run: horizontal
labor supply curve
I Because existed nominal wage contracts
No change to real wages ( W
Pt )
t
I Little incentive (room) to re-negotiate to adjust nominal wages
Roadmap
How things are likely to change in the medium run
I Workers have chances (bargaining power) to re-negotiate nominal wages
based on up-to-date market conditions (Labor supply curve no longer flat)
I When money wages Wt (cost of production) adjusted, firms likely to adjust
prices Pt (to maintain the rate of profit; aggregate supply curve would not
be flat, either)
Roadmap
How things are likely to change in the medium run
I If change in Pt exceeds change in Wt so real wage W
Pt
t
is hurt. Another
Wt
round Wt − Pt adjustments, until Pt restored original level
I If workers forward-looking, may request Wt to be adjusted as P e
I Firms also forward-looking when consider real cost of hiring labor. This
gives rise to the role of expectations in medium-run analyses.
This Lecture: The Labor Market
We turn to the medium run: How prices and wages determined
How prices and wages adjust over time – affect output
I The labor market – which determines the supply side of the economy
1 How equilibrium wage, unemployment determined in labor market
2 Summarize the full supply-side schedule
Movements in Unemployment
When unemployment is high, workers are worse off
I Employed workers: higher probability of losing job
I Unemployed workers: lower probability of finding job (should expect to
remain unemployed for a longer time)
Collective Bargaining
Sometimes wages set by collective bargaining (between unions and firms)
Higher required skills, bargaining is likely
Collective bargaining important in many countries
Reservation Wage
Workers are typically paid a wage exceeding their reservation wage—the
wage that would make them indifferent between working or being
unemployed.
Wages typically depend on labor-market conditions: The lower the
unemployment rate, the higher the wages.
Workers’ bargaining power depends on
I How costly for the firm to find other workers
I How hard for workers to find another job if they were to leave the firm
Efficiency Wage Theory
Link the productivity of the efficiency of workers to the wage they are
paid.
Firms pay a wage above the reservation wage to decrease workers’
turnover and increase productivity.
Firms that see employee morale and commitment as essential will pay
more than those whose activities are routine.
When unemployment is low, firms that want to avoid an increase in quits
will increase wages to induce workers to stay with the firms.
Aggregate Nominal Wage
W depends on
W = P e F (u, z)
−+
I Expected price level P e
I Unemployment rate u
I Catch-all variable z
Real Wage
Both workers and firms care about real wages ( W
P ), not nominal wages.
The nominal wage (W ) depends on the expected price level P e (rather
than the actual price P ) because when nominal wages are set, the
relevant price levels are not yet known.
Unemployment and Wages
An increase in the unemployment rate decreases wages.
I weakens worker’ bargaining power
I allows firms to pay lower wages W and still keep workers willing to work
z stands for all the factors that affect wages given the expected price level
and the unemployment rate
I unemployment insurance as the payment of unemployment benefits to
workers who lose their jobs
I employment protection makes it more expensive for firms to lay off workers
Production Function
The prices set by firms depend on their costs, which in turn depends on
the nature of the production function
The production function is the relation between the inputs used in
production and the quantity of output produced
Y = AN
where Y is output, N is employment, and A is labor productivity (output
per worker).
Price and Markup
Assume A constant (A = 1)
Y =N
the cost of producing one more unit of output M C is the cost of
employing one more worker W
Firms set their price according to a markup m over the cost
P = (1+m)W
+
Real Wage – Wage Setters
Assume W depends on P rather than P e
W = P e F (u, z)
−+
W
= F (u, z)
P
−+
Higher unemployment rate, lower real wage chosen by wage setters
Wage-setting relation between real wage and unemployment rate
Real Wage – Wage Setters
P = (1 + m)W
P
=1+m
W
Inverting both sides gives the implied real wage, or the price-setting
relation
W 1
=
P 1+m
Price-setting decisions determine the real wage paid by firms.
Natural Rate of Unemployment
Unemployment rate such that the
real wage chosen in wage setting is
equal to the real wage implied by
price setting
Wage-setting
W
= F (u, z)
P
−+
Price-setting
W 1
=
P 1+m
Equilibrium unemployment rate
un can be derived by eliminating
W
P between equations
Natural Rate of Unemployment
1
F (un , z) =
1+m
un is natural rate of unemployment
un depends on z (+) and m (+)
Change in z
An increase in unemployment
benefits leads to an increase in the
natural rate of unemployment un
Wage-setting
W
= F (u, z)
P
−+
Price-setting
W 1
=
P 1+m
Change in m
An increase in the markup leads
to an increase in the natural rate
of unemployment un
Wage-setting
W
= F (u, z)
P
−+
Price-setting
W 1
=
P 1+m
Excercise
Suppose that the markup of the prices of products over wage cost is 10%
and z is 10%, and that the wage-setting equiation is
W = P (1 − 2u + z)
where u is the unemployment rate and z is the unemployment
benefit/minimum wage.
a. What is the real wage, as determined by the price-setting equation?
b. Solve for the natural rate of unemployment
c. What happens to the natural rate of unemployment if z falls from 10% to
5%? Explain your answer.
Excercise
Suppose that the markup of the prices of products over wage cost is 10%
and z is 10%, and that the wage-setting equiation is
W = P (1 − 2u + z)
where u is the unemployment rate and z is the unemployment
benefit/minimum wage.
a. What is the real wage, as determined by the price-setting equation?
W 1
I Answer: P
= 1+m
Excercise
Suppose that the markup of the prices of products over wage cost is 10%
and z is 10%, and that the wage-setting equiation is
W = P (1 − 2u + z)
where u is the unemployment rate and z is the unemployment
benefit/minimum wage.
b. Solve for the natural rate of unemployment
I Answer:
(1) Price-setting: W
P
1
= 1+m
(2) Wage-setting: WP
= 1 − 2u + z
1
(3) 1+m = 1 − 2u + z
1
(4) 1+10% = 1 − 2u + 10%
(5) u = 0.095
Excercise
Suppose that the markup of the prices of products over wage cost is 10%
and z is 10%, and that the wage-setting equiation is
W = P (1 − 2u + z)
where u is the unemployment rate and z is the unemployment
benefit/minimum wage.
c. What happens to the natural rate of unemployment if z falls from 10% to
5%? Explain your answer.
I Answer:
(1) Price-setting: W
P
1
= 1+m
W
(2) Wage-setting: P = 1 − 2u + z
1
(3) 1+m = 1 − 2u + z
1
(4) 1+10% = 1 − 2u + 5%
(5) u = 0.070
The decrease in unemployment benefits/minimum wage causes a fall in the
natural rate of unemployment. A decrease in z reduces wages for any given
level of unemployment, thereby reducing the equilibrium level of
unemployment.
Short Run vs. Medium Run
We assume P equal to P e
In the short run, the price level P may turn out to be different from what
is expected when nominal wages W are set
Unemployment u is not necessarily equal to the natural rate un or output
equal to its natural level.
In the medium run, output tends to return to its natural level. Because
expectations are unlikely to be systematically wrong
Wage- and Price-Setting Relations
W
Draw P against employment N
Unemployment is the labor force
minus employment U = L − N
The wage-setting relation is now
upward sloping: Higher
employment implies a higher real
wage.
Next Lecture
Date: 5-Nov
Lecture 6: The AS–AD Model
Reading: Chapter 5&6, Macroeconomics by Dornbusch, Fischer, and
Startz (13th ed)
Thanks for your time
