�Labour Market Institutions�& Inflation, monetary policy and unemployment

Structure of lecture

• Macroeconomic modelling of the Labour Market
• (From Core Unit 9)
• Inflation unemployment and monetary policy
• (Unit 15 of CORE)

What is the ILO’s technical definition of unemployment?

• A person is unemployed, if they were:
• without work during a reference period (usually four weeks),
• not in paid employment or self-employment
• available for work
• seeking work, which means they had taken specific steps in that period to seek paid employment or self-employment

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Participation rate =

labour force/population of working age

Unemployment rate =

unemployed/ labour force

Employment rate / Absorption Rate =

employed/population of working age

SOUTH AFRICA

Very high unemployment rate, very low participation rate and very low employment rate. And many out of labour force as unemployment is long-term and structural

South Africa’s Labour Market�The official unemployment rate in Q2:2021 was calculated as 7,8m divided by 22,7m.

Participation and absorption rates

Types of employment

Graduates have the lowest rate of unemployment

Macroeconomic modelling of the Labour Market

• The outcome of the wage-setting process across all firms in the economy is the wage-setting curve, which shows the wage associated with each unemployment rate.
• The outcome of the price-setting process across all firms is the price setting curve, which gives the value of the real wage that is consistent with a firm’s profit-maximizing markup over production costs.
• Excess supply of labour (involuntary unemployment) is a feature of labour markets, even in equilibrium.
• If economy-wide demand for goods and services is too low, unemployment will be higher than its equilibrium level and may persist.
• Unions and public policies can affect labour market equilibrium.

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The workings of the labour market

• Firms and employees
• In order to motivate employees to work hard and well, firms must set the wage sufficiently high so that the worker receives an employment rent.
• If the worker is very likely to find alternative work if she is fired, i.e. if the level of employment is high, she will need a higher wage to work hard.
• Firms and customers
• In setting the price of the good they sell, firms face a trade-off between selling more goods and setting a higher price, due to the demand curve they face.
• To determine the price to set, the firm finds the markup over their production cost that balances the gains from a higher price against the losses from lower sales.
• This profit maximizing markup determines the division of the firm’s revenues between profits and wages.
• Think about this in two stages:
• First, each firm decides what wage to pay, what price to charge for its products, and how many people to hire.
• Second, adding up all of these decisions across all firms gives the total employment in the economy and the real wage.

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WS and PS curves

• To understand how the real wage and employment are jointly determined:
• The wage-setting curve (WS curve): This gives the real wage necessary at each level of economy-wide employment to provide workers with incentives to work hard and well.
• The price-setting curve (PS curve) : This gives the real wage paid when firms choose their profit-maximizing price.
• All firms in the economy make their wage and price (markup) decisions
• The output per worker in the economy is divided into the real wage that a worker receives and the real profits that the owner receives
• A higher real wage (W/P) means a lower markup (1 − (W/P)).

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WS Curve (The wage setting curve - supply of labour)

• At 12% unemployment in the economy, employees put in a high level of effort for a relatively low wage.
• The firm’s profit-maximizing wage is therefore low (wL).
• At 5% unemployment in the economy, the employees will not put in much effort unless the wage is higher.
• The firm’s profit-maximizing wage is therefore higher (wH)

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The wage-setting curve: The wage level required to make employees work rather than shirk

• Above WS curve shows a feasible wage / a wage acceptable wage to employees, for each level of employment
• Below WS curve the wage is not feasible wage or acceptable wage to employees, for each level of employment
• WS shifts upwards if union bargaining power is increased, represented by a higher wage for each level of employment

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PS Curve (firms hiring decisions – demand for labour)

• The firm’s decision about how many people to hire depends on the amount that it produces.
• The firm has only one input—labour—so the wage is the only cost.
• Assume that one hour of labour produces one unit of output (i.e. product of labour = λ = 1)
• The wage the firm pays (W) is the cost of a unit of output
• W is the nominal wage and w is the real wage.

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A firm sets price as a mark-up to its wage cost to maximise profits at B (on highest isoprofit curve)

For the economy as a whole

• When firms set prices as a mark up on the wage costs this means that the price per unit of output is split into the profit per unit and the wage cost per unit.
• For the economy as a whole: Output per worker (or the average product of labour, called lambda, λ) is split into:
• real profit per worker Π/P and
• the real wage W/P.

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Understanding the PS Curve

• PS curve shows the outcome of price-setting decision of firms in the economy as a whole
• P represents the economy-wide price level
• The top horizontal line shows firms’ revenues per worker in real terms: the average product of labour (lambda, λ)
• PS curve gives the value of the real wage at B that is consistent with the markup over costs, when all firms set their price to maximize their profits
• Point B on the price-setting curve shows the outcome of profit-maximizing price-setting behaviour of firms for the economy as a whole

Understanding the PS Curve

• At A - above the price-setting curve
• firms raise prices so real wage (W/P) falls
• firms cut employment
• the increased price will mean that fewer goods are sold, and as this is true of all firms, total employment falls.
• See A on isoprofit curve where firm will raise price to maximise profit.
• At C - below the price-setting curve
• firms lower prices so real wage (W/P) rises
• firms hire more people
• see C on isoprofit curve where firm will lower price to maximise profit
• Final Position is at B
• Given the level of demand in the economy as a whole, firms’ pricing and hiring behavior will push the economy to a point on the price-setting curve
• the level of employment and real wage will converge at B

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What determines height of PS curve?

• Many public policy factors influence the PS curve level which we will analyse in future lectures, for now focus on:
• Less Competition pushes down the PS curve:
• The less the competition, the greater the markup.
• As P rises, W/P falls
• Increased Labour productivity pushes up PS curve:
• The greater the level of labour productivity (λ), the higher the real wage that is consistent with a given markup.
• Higher labour productivity shifts PS curve upwards raising the real wage.

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Wage, profits and unemployment

• By superimposing the WS curve on the PS curve we have a picture of the two sides of the labour market.
• At point X
• The firms are offering the wage that ensures effective work from employees at least cost (that is, on the wage-setting curve)
• Employment is the highest it can be (on the price-setting curve), given the wage offered.
• In this equilibrium there are unemployed people: This is shown by the gap between the wage-setting curve and the labour supply curve

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How changes in demand for goods and services affect unemployment

• The term ‘derived demand for labour’ is used to highlight the fact that the firms’ demand for labour depends on the demand for their goods and services.
• Economists use the term aggregate—meaning added up to measure the whole, not just the parts—to describe economy-wide facts or variables.
• Aggregate demand, for example, is the sum of the demand for all of the goods and services produced in the economy, whether from consumers, firms, the government, or buyers in other countries.
• The increase in unemployment caused by the fall in aggregate demand is called ‘demand-deficient’ unemployment—or cyclical unemployment.

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Equilibrium and demand-deficient (cyclical) unemployment

• At X, unemployment is at its labour market equilibrium level.
• At B, due to cyclical demand deficiency, there are additional people looking for work who are also involuntarily unemployed
• At point B, total involuntary unemployment is given by the sum of cyclical and equilibrium unemployment.
• Move from B back to X
• From B, W/P would fall and lower wages would lower costs.
• Lower costs will lead to lower prices
• The demand curve facing the firm is downward-sloping so firms will sell more, expanding output and employment (moving back to X)

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Firm’s adjustment process from B to X

• The wage is cut lower and prices are cut to maximize profit
• Firms would move to the right along their demand curve.
• Output and employment increase from B to X
• The (lower wage) isoprofit curve passing through the original point B is now steeper than the demand curve, so the firm can do better by lowering its price and moving down the demand curve, selling more.
• It will continue doing this until it reaches a point on the demand curve where one of the new darker blue isoprofit curves is tangent to the demand curve.
• The firm maximizes profits at point X.

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The adjustment process might not be so smooth

• Worker resistance to a reduction in the nominal wage
• Firms are often reluctant to cut nominal wages because it may reduce worker morale and result in conflict with employees.
• Strikes and worker resistance such as informal ‘go slow’ tactics would disrupt the production process.
• Wage and price reductions might not lead to higher sales and employment
• Falling prices across the economy can lead to cutbacks in spending, which shift the demand curves facing firms to the left.
• Falling prices can lead households to postpone spending, as they hope to get better bargains later. The gap in spending would be exacerbated by such behaviour. Moreover, as wages fall people may spend less, reducing demand.

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The role of government policy

• The government could adopt policies to increase its own spending and expand the demand facing the firms.
• In this case, at point B firms would find that they were producing less than the profit-maximizing amount
• They will rather employ more people at X, instead of wanting to reduce wages.

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Effects of increased Labour Supply

• We use an increase in the labour supply due to immigration as an example.
• The short-run impact of immigration is bad for existing workers in that country: wages fall and the expected duration of unemployment increases.
• In the long run, however, the increased profitability of firms leads to expanded employment that eventually will restore the real wage and return the economy to its initial rate of unemployment.
• As a result, incumbent workers are no worse off.
• Immigrants are likely to be economically better off too—especially if they left their home country because it was difficult to make a living.

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Immigration pushes down the WS curve (also policies to enhance women’s employment opportunities such as subsidized childcare)

• The economy starts at point A, employing 4 million workers at a wage of $20 per hour and a labour force of 5 million.
• One million workers are unemployed - U.
• Immigrant workers join the labour force – labour force up from 5 million to 5.5 million
• The rise in unemployment to 1.5 million - U′
• The wage-setting curve shifts downward – as threat of job loss is greater and firms can secure effort from the workforce at a lower wage
• Firms lower the wage – to B on the new wage-setting curve with wage at $13 an hour and employment still at 4 million.
• The labour market moves from point B to point C as profits rise causing firms to hire more workers, wages rise along the wage-setting curve.
• At point C, employment is 4.5 million workers, the wage is $20, and unemployment has fallen back to 1 million workers, as shown by distance U″.

Measuring degree of inequality

• In labour market there 80 identical employees of 10 identical firms and there are 10 unemployed people. Each firm has a single owner.
• The economy is in equilibrium at point A, where the real wage is both sufficient to motivate workers to work and consistent with the firm’s profit-maximizing price markup over costs (w = 0.6 in this case).
• The right-hand panel shows the Lorenz curve for income in this economy and the unemployed people receive no income so the Lorenz curve begins on the horizontal axis to the right of the left-hand corner.
• The price-setting curve in the left panel indicates that total output is divided up so that workers receive a 60% share and their employers receive the rest.
• In the right panel this is shown by the second ‘kink’ in the Lorenz curve, where we see that the poorest 90 people in the population (the 10 unemployed workers and the 80 employees, shown on the horizontal axis) receive 60% of the total output (on the vertical axis).
• The size of the shaded area measures the extent of inequality.

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Inequality will increase if…

Increased competition may reduce inequality

• What would happen if there were an increase in the degree of competition faced by firms e.g. due to increased imports
• From A to B: the markup charged by firms in the market will decrease, and so the price setting curve will be higher
• At B At the new equilibrium there is a higher wage and a higher level of employment.
• Stronger competition means that firms have weaker market power: the share going to profits falls, and the share going to wages rises.
• Inequality falls

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Inflation, unemployment and monetary policy (From Unit 15 of CORE)

• Politically (what people want)
• low unemployment and low inflation

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• Economically (real constraints)
• in the short-run, when unemployment falls inflation tends to rise,
• in the short-run, when inflation falls unemployment tend to rise
• this trade off is referred to as the Phillips curve relationship
• if there are negative shocks to the economy both unemployment and inflation can rise at the same time (known as stagflation)

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What is inflation?

• Inflation is about a general rise in prices – not the relative rise in prices which provide useful price signals
• Inflation: The price level is rising
• Deflation: The price level is falling
• Disinflation: The inflation rate is falling
• Accelerating inflation: The inflation rate is rising

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What is the problem with inflation?

• For pensioners with a fixed income – if there is inflation or a rise in general prices then they are worse off as they can buy less items with their pension
• For those who lend money – of they are paid back in one year the amount that they lent it will be worth less in real terms
• For lenders to avoid this problem Fisher’s equation says that:
• Nominal interest rate = Real interest rate + Inflation rate
• Or, Real interest rate = Nominal interest rate - Inflation rate (r = i – pi)

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What are the benefits and costs of inflation?

• A moderate and stable inflation rate (say 3%) allows for easier relative price and wage adjustments that are needed for price signalling i.e. people will not normally object to a slight fall in their real wage (e.g. if nominal wage goes up by 2% and inflation is 3%), but they would object to a reduction in their nominal wage
• But if inflation rate is volatile this causes uncertainty and imposes menu costs i.e. the real cost of changing price lists (as prices have to be constantly adjusted)
• If inflation becomes too high (hyperinflation) this seriously damages economic outcomes as the currency loses its value and investment levels fall, etc

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What is the problem with deflation?

• If prices are falling households will postpone consumption (as good will be cheaper in future) leading to fall in demand, growth and jobs, etc.
• If process are falling this increases the debt burden of borrower e.g. if you borrow a R1m bond to buy a house and there is deflation
• This leads to a falling value of the house, falling wages and falling prices
• You still have to pay back R1m on the house with interest and due to deflation the amount of this repayment will be rising in real terms casing serious problems for the borrower

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Causes of inflation

• Poorly managed monetary policy can cause inflation or hyperinflation e.g. too much money chasing to few goods then in general prices will rise
• You can also trace the causes inflation to conflicts among economic actors
• As per WS-PS depiction of the Labour Market
• An increase in the bargaining power of firms over their consumers:
• This is caused by a reduction in competition increasing the firm’s pricing power, which allows firms to charge a higher markup. Represented by a downward shift of the price-setting (PS) curve (as prices P rise, real wages W/P fall)
• An increase in the bargaining power of workers over firms: This allows them to get a higher wage in return for working hard. Represented by either
• an upward shift of the wage-setting (WS) curve (e.g. if unions bargaining power increases), or
• movement along the the wage-setting (WS) curve (aka Phillips curve relationship – positive association between level of employment ↑ and inflation ↑)

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Unemployment falls

1. Owners’ power rises relative to consumers (e.g. lower competition) – medium to long run

2. Employees’ power rises relative to owners (e.g. stronger unions) –

medium to long run

3. Employees’ power rises relative to owners in a business cycle upswing –

Increased demand for goods leads to increased derived demand in the labour market in the short to medium run

Price-setting curve

Wage-Price Spiral

• A wage-spiral occurs if an initial increase in wages in the economy is followed by an increase in the price level,
• Amd this is followed by an increase in wages and so on.
• It can also begin with an initial increase in the price level.

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• If there is a recession instead of a boom, the wage-price spiral operates in reverse, and the price level falls year after year.

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Fundamentals of Phillips curve relation

• When the real wage given by the WS cure and PS curve are not equal, we say there is a bargaining gap
• At B - WS above PS - If unemployment is lower (employment is higher) than at the equilibrium: There is a positive bargaining gap and there is inflation.
• At C - PS above WS - If unemployment is higher (employment is lower) than at the equilibrium: There is a negative bargaining gap and there is disinflation.
• At A - WS = PS - If there is labour market equilibrium: The bargaining gap is zero and the price level is constant.

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Deriving the Phillips curve from WS-PS

• The Phillips curve diagram (lower frame) has inflation on the vertical axis and employment on the horizontal axis.
• If we begin with employment at the labour market equilibrium (WS =PS), and inflation of zero on the Phillips curve.
• Now consider a higher level of employment due to stronger aggregate demand. A 1% positive bargaining gap opens up.
• Firms increase wages in response to the fall in unemployment.
• The price level rises as firms put up their prices in response to the rise in their labour costs.
• If the bargaining gap is 1%, prices and wages will rise by 1%. This gives a second point on the Phillips curve at 1% inflation and higher employment

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Relating Phillips curve to AD model

• To complete the picture, we include the multiplier model beneath the labour market and Phillips diagrams to bring the short- and medium-run models together.
• This highlights that:
• At a higher level of aggregate demand (a boom) inflation is positive:
• Unemployment is lower, which means there is a positive bargaining gap, so wages and prices are rising continuously.
• At a lower level of aggregate demand (a recession), there is deflation:
• Unemployment is higher, which means there is a negative bargaining gap, so there is disinflation or deflation.

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Role of Central Bank Policy

• A key mandate of the central bank is to keep inflation under control – not too high and not too low, typically aiming to achieve a specific inflation target
• If inflation is too high:
• Central Banks raise the interest rate to dampen aggregate demand,
• Along the Phillips Curve this reduces employment (raises cyclical unemployment) and brings down inflation back toward target
• If inflation is too low (or deflation):
• Central Banks lower the interest rate to stimulate aggregate demand,
• Along the Phillips Curve this increases employment (lowers cyclical unemployment) and brings up inflation back toward target

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The Phillips curve relation is a short-term phenomenon

• In the short term (if wages are fixed) policy makers can
• increase unemployment and reduce inflation, or
• reduce unemployment and increase inflation
• But in the medium- and long-term prices and wages adjust so policy makers cannot choose permanently to reduce unemployment by having higher inflation i.e. there is not a long-term trade-off between unemployment and inflation
• Empirically: the data shows that the short-term trade-off between inflation and unemployment is not a stable over longer periods – see Phillips curve in the US from 1960 to 2014

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Milton Friedman -‘There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off,’

If a government tries to keep unemployment ‘too low’ the result will be not just higher inflation, but rising inflation as well.

This means that the Phillips curve would keep shifting upward (e.g. upward shift in Phillips Curve in the US from 1960’s, early 1970’s and late 1970’s)

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Expected inflation and the Phillips Curve

• Why does the Phillips curve shift? Why does inflation keep rising when governments try to keep unemployment too low? Because:
• People are forward-looking and expectations about the future level of inflation impact on wage and price setting
• People treat prices as messages about what will happen in the future
• If employment is above (unemployment is below) the inflation stabilising rate (i.e. employment level where WS is above PS) then inflation will continue to accelerate and the Phillips curve will continue to shift upwards

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• At A: WS = PS, stable inflation of 3% is expected and unemployment is 6%
• At B: WS > PS employment has risen and unemployment is at 3% (below 6% the inflation stabilising rate of U) so there is a bargaining gap of 2% as workers demand a (3% + 2%) 5% wage increase for that many workers to be employed at that level of output
• At C: expected inflation has risen to 5% so Phillips curve has shifted up, but in the next period workers will demand a wage increase of 7% (5% +2%) to continue to supply labour at the level where unemployment is 3%
• Conclusion: to hold unemployment at 3% will require accelerating inflation, even though workers real wages will not increase, only nominal wage will increase along with inflation

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Supply shocks and inflation

• The WS and PS curves model the Supply side of the Economy (the AD curve the demand side)
• What if there is a supply shock eg an unexpected change on the supply side of the economy, such as a rise or fall in oil prices or an improvement in technology.
• Supply shocks are represented by shifts in the PS curve and the WS curve
• If PS curve shifts down – it means that the pricing power of firms has increased, so prices rise and the Phillips curve shifts upwards
• If the WS curve shifts up – it means that the bargaining strength of workers has increased, so real wages rise and the Phillips curve shifts upwards

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Oil price shock

• The WS-PS model and the Phillips curve can explain why a one-off increase in the world oil price can lead to a combination of:
• a one-off increase in the price level (inflation) at the time of the shock, and
• rising inflation over time
• A rise in the oil price
• Shifts the PS curve down leading to a positive bargaining gap and inflation
• Shifts the Phillips curve up as expected inflation rises

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• At A: initial point
• At B: Oil price shock shifts PS curve down
• To keep the economy at A there is a positive bargaining gap and inflation will increase each year
• To keep employment at A at its pre-oil-shock level, inflation will increase every period
• Alternatively, employment falls to B and at B there is a new labour market equilibrium with increased unemployment and lower wages and stable inflation

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Monetary Policy

• Many central banks around the world have policies to target an inflation rate of 2% (South Africa’s inflation target is between 3% and 6%)
• Central banks either set this objective for themselves, or the government sets the objective for them
• when inflation is forecast to be higher or lower than this, the central bank can take action to adjust the level of aggregate demand and employment to steer the economy toward the inflation target
• Central Bank’s use the interest rate to control Aggregate Demand
• If inflation is forecast to be above target then the central bank increases the nominal inters rate, with the aim of raising the real interest rate in order to reduce aggregate demand and bring inflation back towards target

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Using interest rates to stabilise the economy

• Recession
• If there is a drop in consumption from C to C’ (move from A to B)
• A cut in interest rates can be used to lift aggregate demand
• As r is reduced to r’ investment rises (move from B to A)
• Boom
• A boom will shift the aggregate demand upwards
• The central bank must dampen demand by raising interest rates
• But why would it want to curtail a boom? From the Phillips curve, we know that a boom leads to higher inflation. High and rising inflation imposes costs on the economy.

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Other policies for influencing Aggregate Demand

• Fiscal policy
• Government’s can boost demand by increasing spending or cutting taxes
• but the budget process takes longer than monetary policy that is set every few months
• Quantitative Easing
• If interest rates are near zero and cannot be reduced further
• central banks can buy bonds and financial assets to boost demand by reducing interest rates on longer term assets

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Exchange rate channel of monetary policy

• If aggregate demand (AD) falls
• Central Bank cuts interest rate (r)
• Foreign demand for county’s bonds fall (as there is less of a return for foreign investors if r is lower)
• Currency depreciates (e.g. Rand depreciates from R16/USD to R17/USD)
• Deprecation makes SA exports more competitive and makes imported goods more expensive compared to local goods
• This boosts demand for exports and locally produced goods (X rises and M falls)
• AD is boosted as AD ↑ = C + I + G + X↑ - M ↓

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Response to recession (fall in investment)

• At C: economy before recession
• At D: economy is in recession (fall in investment) unemployment rises and inflation falls
• Stimulus to move back to C – monetary (cut r) and fiscal (cut tax and spending up)
• Move along Phillips curve to C where inflation is higher and unemployment is lower
• Even though not at X where inflation is at target of 2% and unemployment is even lower

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Reasons for Central bank independence

• To secure re-election, politicians may want to promise lower unemployment now—even if this as per the Phillips curve leads to rising inflation later (and a wage price-spiral).
• Making the central bank independent, with an explicit inflation target, makes it easier for the central bank to resist political pressure.
• The central bank is committed to keeping inflation close to the target and this, in turn, keeps the inflation rate expected by workers and firms close to target.
• Empirically from 1962 to 1990 there is a strong correlation between central bank independence and low inflation in OECD countries
• Countries with less central bank independence have higher rates of inflation

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Conclusions on Central Bank independence

• In the short run, policy makers could choose to reduce unemployment at a cost of higher inflation (move up along Phillips curve)
• But this can lead to higher inflation expectations and a wage-price spiral, which means that inflation is not just temporarily higher, but continues to rise over time (as the Phillips curve shifts upwards with rising inflation expectations)
• Central banks are mandated to target low inflation, to protect monetary policy / interest rate setting becoming part of the political business cycle.

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