Powerpoint class 2 International Macroeconomics

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International macroeconomics
Thomas Lagoarde-Segot, PhD, HDR
The labour market: wages, prices and unemployment
Introduction
Understanding the labour market
3. The determination of wages
4. The determination of prices
5. Wages, prices and equilibrium unemployment
Equilibrium unemployment and production
Reference: O.Blanchard, Macroeconomics (Pearson), chapter 7
When firms respond to a positive shock in aggregate demand by increasing their output, this leads to an increased labour demand 
But a higher labour demand exerts a positive pressure on wages, which increases production costs and final prices
In turn, higher prices leads trade unions to negotiate higher wages, which generates additional inflation…
The objective of this session is to study the links uniting unemployment, production, wages and prices 
Introduction
5
The unemployment rate (u) is defined as the ratio of unemployed workers (U) over total active population (L):
Total active population (L) is the sum of number of employed and unemployed workers:
The unemployment rate depends on the number of unemployed workers, and hence on the definition of unemployment
Definition
According to the international definition adopted in 1982 by the International Labour Office (www.ilo.org), an unemployed person is a person of working age (above 15) who meets three conditions:
Being without employment, meaning having not worked for at least one hour during the reference week ;
Being available to take up employment within two weeks ; 
Having actively looked for a job in the previous month or having found one starting within the next three months
https://www.insee.fr/fr/statistiques/serie/001688526?idbank=001688526#Graphique
http://www.ilo.org/global/statistics-and-databases/lang--en/index.htm
Definition
A lower unemployment rate may reflect:
A higher level of employment
A lower participation rate (i.e. a lower number of workers searching for a job) All unemployment statistics are biased by hidden unemployment: many agents declare to be not searching for a job but would actually accept one if offered
The fast development of part-time precarious jobs (as in the UK or Germany). It only takes a 1 hour job a week to be counted as employed according to the ILO definition.
The classical definition of unemployment hides inequalities in the labour market (e.g. gender inequalities and inequalities linked to the development of part time jobs)
In the end the statistical definition of unemployment is a political issue.
Problems
The rate of ‘non full time employment’ which measures the proportion of individuals that are not employed (or self-employed) as a proportion of the population in working age (that is both active and inactive population)
This indicator has the advantage of taking into account individuals not actively searching for a job (i.e. discouraged workers, stay home parents, etc…)
This indicator also corrects for partial employment (which mostly affects women and low skilled workers) – which the ILO definition doesn’t
For instance in the second quarter of 2017, 65.1% of French individuals aged 25-59 had a full time employment and 13.7% had a part time employment. The rate of non employment is therefore 1-(65.1%+13.7%)= 27.1%; Given the hours worked in part time jobs are 56% of those of full time jobs, the « rate of non employment » was: 1-(65.1%+13.7%*56%)= 27.2%
The rate of non employment
https://www.alternatives-economiques.fr/non-emploi-france-moyenne-europeenne-0109201780276.html
A given unemployment rate may reflect different situations (i.e. a high job market turnover or long run permanent unemployment)
To get additional insight, one needs to look at quarterly labour market flows:
Interpretation: on average, in 2016, about 60% of unemployed workers remain unemployed at the next quarter
The labour market
Destination: quarter t+1 (France, 2016average)
Quarter t
Employed
Unemployed
Inactiveseekingemployment
Inactive notseekingemployment
Total
Employed
95.9
2
0.4
1.7
100
Unemployed
20.3
59.6
13
7.1
100
Inactiveseekingemployment
11.5
28.1
33.7
26.7
100
Inactive notseekingemployment
3.0
2.4
3.6
90.9
100
Source: https://www.insee.fr/fr/statistiques/2891763?sommaire=2891780
Unemployment does not correspond to a permanent stock of unemployed workers: 
 Workers enter and exit firms, individuals enter/exit the active population
In France, 4% of workers employed at a given quarter do not have a job at the next quarter, and 40% of unemployed workers at a given quarter are not unemployed at the next quarter
The labour market
Source: INSEE
Destination: quarter t+1 (France, 2016average)
Quarter t
Employed
Unemployed
Inactiveseekingemployment
Inactive notseekingemployment
Total
Employed
95.9
2
0.4
1.7
100
Unemployed
20.3
59.6
13
7.1
100
Inactiveseekingemployment
11.5
28.1
33.7
26.7
100
Inactive notseekingemployment
3.0
2.4
3.6
90.9
100
http://ec.europa.eu/eurostat/web/experimental-statistics/labour-market-transitions/database
The labour market
For international data on labour market transitions see:
The WS/PS model
The determination of wages
There are many ways by which wages are determined across countries and sectors:
Collective negotiation between employers and trade unions (e.g. continental Europe)
Direct negotiation between the employer and the worker. In this case, the negotiation power of the worker increases with his level of qualification (e.g. football stars versus Uber drivers)
Unilateral, ‘take or leave’ by the employer (e.g. “Mac jobs”)
Two consistent stylized facts are observed across countries:
Paid wages are always higher than the worker’s reservation wage (i.e. the wage for which a worker finds it equivalent to stay unemployed and look for a better paid job, or to accept the job offer)
 Paid wages must be high enough to convince workers to leave their former job or to stop searching for employment
Paid wages are a negative function of the unemployment rate
https://www.stlouisfed.org/on-the-economy/2014/december/are-wages-and-the-unemployment-rate-correlated
Economists have explained these stylized facts through the worker’s negotiation power theory and the efficient wage theory
 
The determination of wages
The worker’s negotiation power depends upon on two factors:
How hard it would be to find another job
The worker’s negotiating power decreases with the time it would take him to find another job
2. The ease with which the employer may replace him
The worker’s negotiating power increases with his skills
Therefore the workers’ negotiation power :
Decreases with the macroeconomic unemployment rate
Increases with the worker’s level of human capital
 
#1The worker’s negotiation power
Employers have an interest in paying good wages (regardless of the worker’s negotiation power) given that higher wages tend to increase worker productivity
In jobs where there is a significant high training period, an employer wants to keep its employees. One
way to keep employees is to pay a wage that it significantly superior to the reservation wage. Doing so
Decreases employee turnover and increases productivity, as better paid employees tend to show higher productivity level.
For example, in 1914, Henry Ford decided to double wages and to decrease working hours for his employees (from 2.34 dollars for a 9 hour shift, to 5 dollar for a 8 hour shift). The impact on employee productivity and job turnover were spectacular:
 
#2 The efficient wage theory
1913
1914
1915
Jobturnover (%)
370
54
16
Firingrate (%)
62
7
0.1
Source: Raff and Summers (1986)
The two theories can be summarized through the following equation:
Where the aggregate nominal wage (W) depends upon three factors:
The expected price level Pe
The unemploymentrate u
A composite variable, z, representing all the other factors affecting the determination of wages
Let us analyze each of these factors
 
The determination of wages
(1)
Expected prices affect wages given that workers care about real wages rather than nominal wages:
Workers do not care about how many euros they earn, but about how many goods they can purchase with their wage.
 It is the wage is expressed in terms of goods (W/P), not in euros, that matter to them.
2. Reciprocally, employers care about the real cost of wages
If workers and employers expect prices to double over the next period, they would double the wage. If Pe is multiplied by 2, then W is also multiplied by 2:
The higher the employee’s negotiation power, the longer the estimation horizon for nominal wages
 
The expected price level Pe
An increase in unemployment rate decreases the workers’ negotiation power – hence the negative sign under the variable ‘u’:
In cases where wages are negotiated between trade unions and employers, higher unemployment rate leads trade unions to accept lower wages
In cases where wages are negotiated between workers and employers, higher unemployment rate allows employers to pay lower wages without risking of losing their employees 
The unemployment rate u
The variable z corresponds to all the other factors affecting wages for a given level of price and unemployment. These are defined such as they have a positive impact on wages:
Examples include:
Unemployment benefits: higher benefits increases the workers’ reservation wage and negotiating power, leading to higher wages
The rate of economic structural change. For instance, if the economy is going through a period of technological change where there is simultaneously job destruction but also job creation, some of the workers’ negotiating power and wages increase in spite of higher unemployment
Other factors z
The determination of prices
Prices depend on production costs, which are represented with the production function. The latter gives the relation between factors used to produce a given quantity. 
Assuming that labour is the only production factor : 
 (2)
Where Y is production, N employment and A labour productivity (assumed to be constant i.e. A=1)
This means that producing an additional unit implies to hire an additional worker, for a wage W
Final prices can then be defined as the sum of wages (production costs) and of the firms mark-up µ (which would be equal to zero under perfect competition):
 
 (3)
The determination of prices
Linking wages, prices and the unemployment level
One key hypothesis: we assume that the negotiating parties make accurate forecasts about future prices (i.e Pe=P). Equation (1) becomes:
 (1.1)
Dividing both sides of the equation by P we get real wages:
(4)
Equation (4) highlights a negative relationship between real wages and unemployment: the higher the unemployment rate, the lower the real wage. This is explained by the workers’ loss of negotiating power.
This relationship is expressed as the WS (wage-setting) curve
The WS curve
The WS curve
WS
(real wage determined by the workers negotiation power)
Unemployment rate, u
Real wage, W/P
Dividing equation (3) by nominal wages W yields:
 (5)
Which can be rewritten as follows:
(6)
Equation (6) shows that when employers increases their mark ups (u), final prices increase, implying lower real wages
This gives us the PS (price-setting) curve
The PS curve
The PS curve
PS
(real wage determined by the determination of prices)
Unemployment rate, u
Real wage, W/P
Combining WS (equation 4) and PS (equation 6), yields the following:
 (7)
The equilibrium unemployment rate un is the unemployment rate which equalizes the real wage as determined by worker-employer negotiation (the left hand term of equation 7) with the real wage as determined by the determination of prices (the right hand term of equation 7)
As there can only be one macroeconomic real wage, the economy always converges towards un
The equilibrium unemployment rate (also called ‘structural unemployment rate’) can be obtained by plotting WS and PS in the same unemployment – real wage diagram
The equilibrium unemployment rate
The WS/PS framework and equilibrium unemployment
PS
WS
(relationship between real wages and unemployment)
Unemployment rate, u
Real wage, W/P
Real wages as determined negotiation are a negative function of the unemployment rate. Real wages as determined by prices are independent from the unemployment level. The equilibrium unemployment rate is the rate which equalizes the real wage as determined by negotiation (WS) with the real wage as determined by the price setting behaviour of firms (PS)
The level of the equilibrium unemployment rate depends on the relative position of the WS and the PS curve.
The equilibrium unemployment rate is hence related to wages and prices, which depend on several policy parameters. Consider the following two examples:
An increase in unemployment benefits. This corresponds to an increase in z: the workers’ negotiating power increases. This increases the level of wages for a given rate of unemployment
Lower competition between firms. This allows firms to increase their mark-ups u. This induces lower real wages and higher unemployment
Therefore the impact of variations of real wages on the equilibrium unemployment rate depends on whether the effect is driven by WS or PS
Real wages, employment and equilibrium unemployment
Higher unemployment benefits increases equilibrium unemployment
PS
WS
Unemployment rate, u
Real wage, W/P
WS’
Lower competition (higher margins) increase unemployment
PS
WS
Unemployment rate, u
Real wage, W/P
PS’
Increased margins (µ’>µ)
Equilibrium unemployment and production
The equilibrium unemployment rate yields and equilibrium employment level N. 
Letting U be unemployment, N employment and L the active population, we have:
For instance, if the active population is 100 million (L=100) and the equilibrium unemployment is 5% (u=5%), then the equilibrium employment level (N) is 95 million.
This equilibrium employment level determines an equilibrium production level, given the production function Y = AN (equation 2)
Unemployment and production
We have observed the following facts:
A negative correlation between wages and unemployment
A positive correlation between wages and prices
A positive correlation between prices and corporate mark-ups
A negative correlation between real wages and mark-ups
Assuming perfect expectations (Pe=P), we then demonstrated that:
The equilibrium unemployment rate equalizes real wages as determined by labour negotiation (WS) with real wages as determined by price setting relationship (PS)
The equilibrium unemployment rate simultaneously determines the level of employment and the level of production
Summary
However, the WS/PS model rests on the hypothesis that Pe = P (see equation 1.1): it is assumed that workers and employersalways make perfect price forecasts
There is no a priori reason for this hypothesis to hold in the short run: agents do make expectation errors.
Economists thus believe that in the short run, the unemployment rate always deviates from the equilibrium rate
It is determined by the factors affecting production levels (i.e. budgetary policy, trade, exchange rates, etc...)
In the middle run and long run, however, expectations are accurate and unemployment converges towards its equilibrium level
Conclusion
Assignment