Chapter 6 of Macroeconomics,

Olivier Blanchard and David R. Johnson

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• How the labour market conditions that involve unemployment
rates and different policies can affect the wage bargaining
powers of employees/workers and firms.
• The wage setting and price setting.
• Why natural unemployment occurs where the wage setting
and price setting equate.
• How different policies or events can affect the natural
unemployment rate.
• How we can use the wage setting and price setting to derive
(graphically) the labour supply and labour demand respectively
• How we can derive the Short run Aggregate Supply curve from
the algebras.
• Short Run, Medium Run and Long Run
• The noninstitutional civilian population (NIP) are the
number of people potentially available for civilian employment.

• The civilian labor force (LF) is the sum of those either working
or looking for work. Those who are neither working nor looking
for work are out of the labor force.

• The participation rate is the ratio of the labor force to the

noninstitutional civilian population. (= LF/NIP)

• The unemployment rate (u) is the ratio of the unemployed to

the labor force.

• Seperations refer to movements from being employed to

being unemployed or being out of labour force.
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 Figure 6 - 1
Population, Labor Force,
Employment, and
Unemployment in the
United States (in
millions), 2010

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The Large Flows of Workers
An unemployment rate may reflect two very different
realities.

It may reflect an active labor market, with many

separations and many hires, or it may reflect a
sclerotic labor market, with few separations, few
hires, and a stagnant unemployment pool.

The Current Population Survey (CPS) produces

employment data, including the movements of
workers.

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The Large Flows of Workers

Figure 6 - 2
Average Monthly Flows
between Employment,
Unemployment, and
Nonparticipation in the
United States, 1994 to
2011 (millions)
(1) The flows of workers in and
out of employment are large.
(2) The flows in and out of
unemployment are large
relative to the number of
unemployed. (3) There are also
large flows in and out of the
labor force, much of it directly
to and from employment.

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 Figure 6 - 3
Movements in the U.S.
Unemployment Rate
Since 1948-2010
Since 1948, the average
yearly U.S. unemployment
rate has fluctuated between
3% and 10%.

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How fluctuations in the aggregate unemployment rate
affect individual workers is important because the
answer determines two effects:
 The effect of movements in the aggregate
unemployment rate on the welfare of individual
workers
 The effect of the aggregate unemployment rate on
wages

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During recessions, there are labor market
adjustments. There are implications for both
employed and unemployed workers:

 If the adjustment takes place through fewer hires,

the chance that an unemployed worker will find a
job diminishes. Equivalently, they can expect to
remain unemployed for a longer time.

 If the adjustment takes place instead through

higher layoffs, then employed workers are at a
greater risk of losing their jobs.

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 Figure 6 - 4 When unemployment is
The Unemployment Rate high, the proportion of
and the Proportion of unemployed finding jobs is
Unemployed Finding low. Note that the scale on
Jobs, 1994–2010 the right is an inverse scale.

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 Figure 6 - 5
When unemployment is high, a
The Unemployment Rate higher proportion of workers lose
and the Monthly
Separation Rate from
their jobs.
Employment, 1994–2010

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12
13
Collective bargaining is bargaining between firms
and unions.

Common forces at work in the determination of

wages include:

 Workers are typically paid a wage that exceeds

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.
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How much bargaining power a worker has depends on
two factors.

 How costly it would be for the firm to replace him—

the nature of the job.

 How hard it would be for him to find another job—

labor market conditions.

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Economists call the theories that link the productivity or
the efficiency of workers to the wage they are paid
efficiency wage theories.

These theories also suggest that wages depend on both

the nature of the job and on labor-market conditions:

 Firms that see employee morale and commitment as

essential to the quality of their work, will pay more than
firms in sectors where workers’ activities are more
routine.
 Labor market conditions will affect the wage.

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 High
unemployment

Wage
determination FIRM

Anything/Policies Z
in favour of
workers

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How real wage is related to employment outlook

Both workers and firms care about real wages (W/P), not
nominal wages (W).

Workers do not care about how many dollars they receive

but about how many goods they can buy with those dollars.
They care about W/P.

Firms do not care about the nominal wages they pay but
about the nominal wages, W, they pay relative to the price of
the goods they sell, P. They also care about W/P.

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How real wage is related to employment outlook

• As we see in the slide 17, there are two factors that

affect the real wage (W/P) that the workers request
for:
– Unemployment rate: If we think of wages as being
determined by bargaining, then higher unemployment
weakens workers’ bargaining power, forcing them to
accept lower wages. Higher unemployment allows firms to
pay lower wages and still keep workers willing to work.

– All factors or policies that give higher bargaining power to

the workers (eg. unemployment benefits).
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How real wage is related to employment outlook
To capture the effects of the two factors on the real wage,
we can assume the following relationship.
𝑊
= 𝐹 𝑢, 𝑧 (1)
𝑃 (  , )
This equation tells us of the workers’ behaviour (i.e. their
real wage request in response to the labour market
conditions that involve unemployment rate, u and the
catchall variable, z).
Therefore, if the people know u, z and price level P, they
would request for nominal wage equal to W (as shown in
(1) )
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Real wage & unemployment
Real Wage, W/P This red graph is drawn to
show that the real wage
requested by the workers is
negatively related to the
unemployment rate.
Intuition: as the
𝑊 unemployment rate goes up,
=𝜃
𝑃 𝑒 the bargaining power of the
workers falls; so they are
willing to accept lower real
wage.
WS

𝑢 Unemployment Rate, u 21
Previous graph explained

• Suppose that the economy is at where u = 𝑢. Suppose also

that the corresponding real wage that the workers request is
equal to 𝜃.

• However, the workers cannot possibly know the price level of

the whole economy (reasonable assumption?).

• So, they have to form expectation of price level, Pe . Then

hypothetically, they could form this thinking process: “With
this unemployment rate, and this catchall variable z, and our
expectation that the price would be Pe, we want to have a
nominal income, W, so that our expected real wage is W/Pe
(which is equal to = 𝜃) ”

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• Then at a given u and z, we have:

𝑊
𝑒
= 𝐹 𝑢, 𝑧 𝑊 = 𝑃𝑒 𝐹 𝑢, 𝑧 (2)
𝑃 (  , )
That is, at a given state of the economy where
unemployment rate is equal to u, catchall variable is equal
to z and if the expected price level is equal to Pe , the
workers would request for (or accept) W as nominal wage.
Note: a catchall variable, z, that stands for all other
variables that may affect, in favor of the workers, the
outcome of wage setting, given the expected price level
and the unemployment rate.
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24
•The production function is the relation between the inputs
used in production and the quantity of output produced.
•Assuming that firms produce goods using only labor, the
production function can be written as:
𝑌 = 𝐴𝑁
Y = output
N = employment
A = labor productivity, or output per worker

Further, assuming that one worker produces one unit

of output—so that A = 1, then, the production
function becomes:
𝑌=𝑁
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• Marginal productivity of labour = MPL
One unit of labour
𝑀𝑃𝐿 = 𝐴 = 1 produces A units of
goods

• Nominal marginal cost of labour = W; so the nominal

marginal cost, which is the cost of producing one unit of
goods is:

𝑀𝐶 = 𝑊/𝐴 = 𝑊
One unit of labour costs $W; one unit of labour can
produce A units of goods  Cost of producing one unit of
goods = W/A 26
• Suppose that the firm has some market power such
that it can set the price above the marginal cost:
1+𝑚 𝑊
𝑃= = 1+𝑚 𝑊
𝐴
• Where m is the markup of price over the nominal
marginal cost
• If all markets were perfectly competitive, m = 0, and
P = W.

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28
Recall that we have the equation (1):

W
 F ( u, z )
P (  , )

This equation illustrates the worker’s behaviour in

response to the labour market conditions –
captured in u an z.

This relation between the real wage and the

rate of unemployment—wage-setting relation.

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•The price-determination equation is:
𝑃 = 1+𝑚 𝑊
If we divide both sides by W, we get:
𝑃
=1+𝑚
𝑊
To state this equation in terms of the wage rate,
we invert both sides:
𝑊 1
= The price-setting
𝑃 1+𝑚 relation

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 Real Wage, W/P
Figure 6 - 6
At equilibrium, where two
Graph 1
curves meet, we have
Wages, Prices, unemployment rate =
and the Natural natural unemployment rate
Rate of
Unemployment

The natural rate of 1 A PS

unemployment is 1+𝑚
the unemployment
rate such that the
real wage chosen
in wage setting is
equal to the real WS
wage implied by
price setting.
un Unemployment Rate, u
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• Medium-run equilibrium:
– Medium run is when Pe = P. This is because when the
expected price is equal to the actual price, there is no longer
a need to adjust the expectation. (We will explain more in
detail in next lecture)
– Pe = P happens when WS meets PS. (why?)
• We can also manipulate to get:
𝐴 1
𝐹 𝑢𝑛 , 𝑧 = =
1+𝑚 1+𝑚
• So un here is affected by A, z and m.

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 Real Wage, W/P

𝑊 𝑊 1 A PS
𝑒
= =
𝑃 𝑃 1+𝑚

WS

un Unemployment Rate, u

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• The positions of the wage-setting and price-setting curves,
and thus the medium run equilibrium unemployment rate,
depend on both z and m.

– At a given unemployment rate, higher unemployment

benefits lead to a higher real wage. A higher
unemployment rate is needed to bring the real wage back
to what firms are willing to pay. (Graph 2)

– By letting firms increase their prices given the wage, less

stringent enforcement of antitrust legislation leads to a
decrease in the real wage. (Graph 3a-3b)

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 Figure 6 - 7 Graph 2
Unemployment Benefits Example: Unemployment benefits ↑,
and the Natural Rate of causing WS to shift up  higher un.
Unemployment
This is because? : Prospect of
unemployment is less painful (who
has more bargaining power?)
IF z↑
B
Real Wage, W/P

1 A A’ PS
(1+ m)

WS’
WS

un u’n Unemployment Rate, u

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• Higher z  higher bargaining power for workers  for the
same u, workers demand for higher real wage. So WS shifts
up. If the unemployment rate is still at un, the workers would
demand higher real wage (point B)
• But the firms are not willing because it does not correspond
to their price setting
• Thus, firms would respond not by not hiring those who insist
on higher nominal wage. These workers are willing to wait for
better job (because it is less costly to wait now)
 which causes higher unemployment.
• The economy will be at point A’ where natural rate of
unemployment is higher.

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 Figure 6 - 8 Graph 3a
Markups and the Natural Here, the economy is in
Rate of Unemployment
medium run equilibrium with
un and we have price

Real Wage, W/P

expectation, Pe to be equal to
the actual price level, P.

𝑊 𝑊 1 A PS
= =
𝑃𝑒 𝑃 1 + 𝑚

WS

un Unemployment Rate, u
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 Figure 6 - 8 Graph 3b
Markups and the Natural Example: less stringent
Rate of Unemployment enforcement of antitrust
IF m↑ legislation, causing PS to
shift down

Real Wage, W/P

𝑊 𝑊 1 A PS
𝑒
= =
𝑃 𝑃 1+𝑚
𝑊 1 PS’
=
𝑃′ 1 + 𝑚′

WS

un Unemployment Rate, u
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 Figure 6 - 8 Graph 3c
Markups and the Natural
Rate of Unemployment
Real Wage, W/P
At the moment (in short run), the workers do
not know of price level change. So, they still
maintain the same expectation of price
level. And they still want to provide labour
level where unemployment rate is equal to un

𝑊 1 A PS
=
𝑃𝑒 1 + 𝑚
𝑊 1 PS’
=
𝑃′ 1 + 𝑚′

WS

In fact, the price level un Unemployment Rate, u

has changed. Nominal
wage is still the same 39
 Figure 6 - 8 Graph 3d
Markups and the Natural
Rate of Unemployment
After some time, the workers realize that the
price has increased. So they “update” their
expectation of price to match with the new
actual price level. But the unemployment rate
has increased because some workers refuse to

Real Wage, W/P

work at this real wage level

A PS

𝑊 𝑊 1 PS’
= =
𝑃′𝑒 𝑃′ 1 + 𝑚′ A’
WS

un u’n Unemployment Rate, u

P’e = P’
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• Now, the price level has gone up because mark-up is
higher
• In the short run, workers are not aware of the price level
change, they still think the real wage is at point A.
• After a while, workers find out that price level has gone
up (this means that now, they know that their real wage
is lower).
• They then “update” their price expectation to match
with the new actual price level set by firms.
• With the new expected price level, the real wage is
smaller (W/P’e). The response from the workers is that
some would not choose to work but to wait. So, the
unemployment rate goes up.
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• Associated with unemployment is employment:
𝑈 𝐿−𝑁 𝑁
𝑢= = =1−
𝐿 𝐿 𝐿
• Employment then is:

𝑁 = 𝐿(1 − 𝑢)

• Natural level of employment Nn is:

𝑁𝑛 = 𝐿(1 − 𝑢𝑛 )

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Graph 4
Real Wage, W/P

1 A PS
(1+ m)

WS

un Unemployment Rate, u
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Graph 5
Equivalent to
Labour Supply
WS
Real Wage, W/P

1 A PS Equivalent to
(1+ m) Labor demand:
Why is it flat?

N U

Employment,N
Nn L
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• If we have a production function as follows:

𝛼
𝑌 = 𝐴𝑁
where 0 < α <1, how would PS curve and the
labor demand curve look like?

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• Natural output is associated with natural employment
and thus also with natural unemployment rate:

𝑌𝑛 = 𝐴𝑁𝑛 = 𝐴𝐿 1 − 𝑢𝑛 = 𝐿(1 − 𝑢𝑛 )
• So, the natural output will satisfy the following:

𝑌𝑛 𝐴 𝑌𝑛 1
𝐹 1− ,𝑧 = 𝐹 1 − ,𝑧 =
𝐴𝐿 1+𝑚 𝐿 1+𝑚

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47
• We have the following two relations:

𝑊 = 𝑃𝑒 𝐹(𝑢, 𝑧)
• And:

𝐴𝑃 = 1 + 𝑚 𝑊

In the short-run, the workers would not know what is the

price level so they form expectation of the price level. They
would demand the nominal wage, W, according to the price
level that they “form in their minds” or “expect” and the
labour market conditions, captured in variables u and z

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 • First Step, we combine two equations:
𝑃 = 𝑃𝑒 1 + 𝑚 𝐹(𝑢, 𝑧)
• Second Step:

𝑈 𝐿−𝑁 𝑁 𝑌
𝑢= = =1− =1−
𝐿 𝐿 𝐿 𝐴𝐿

Definition of
Definition of Math Specification
unemployment
unemployment manipulation of production
rate
function Y=AN
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 𝑌 𝑌
• So then we have: 𝑢 =1− =1−
𝐴𝐿 𝐿
• We can have:
𝑒
𝑌
𝑃 = 𝑃 1+𝑚 𝐹 1 − ,𝑧
𝐿
• This is our Short Run Aggregate Supply (simply
call it Aggregate Supply) curve which shows
the relationship between P and Y (P also
depends clearly on Pe and m, A, L and z)
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• To draw the AS curve, let us find the special point on
the P-Y plane.

• Recall: If P=Pe, then the unemployment rate would be

the natural unemployment rate, un (refer back to slide
31). If we have u = un, corresponding output would be
Yn (refer back to slide 49)

• Hence, AS will go through a special point, which is

(Yn, Pe), on P-Y plane.

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 𝑌
𝑃= 𝑃𝑒 1 + 𝑚 𝐹 1 − ,𝑧
𝐿
𝑌
• If Y increases, then 𝐹 1 − ,𝑧 increases. Then, for a
𝐿
given Pe and m, we should have P to increase.

• So the AS curve would be a upward-sloping curve that goes

through the point (Pe, Yn).

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Graph 6
Price Level, P
𝑌
𝑃= 𝑃𝑒 1 + 𝑚 𝐹 1 − ,𝑧
AS 𝐿

(Yn, Pe)
𝑃 = 𝑃𝑒 A

When Y=Yn then

P=Pe

Y=Yn Output, Y
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• Thus, we can say “The first property is
that, given the expected price level, an
increase in output leads to an increase in
the price level”
– Rationale: (see graph 6)
• Y↑ requires higher employment
u↓, which leads to W↑ (why?),
Which in turn leads to P↑ (why?)

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Graph 7
AS’ (for Pe’ > Pe)

Price Level, P AS (for a given Pe)

𝑃 = 𝑃𝑒′ A’

𝑃 = 𝑃𝑒 A

Y=Yn Output, Y
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• Also, “given unemployment, an increase in Pe
leads to one-to-one increase in actual price
level Medium-Run Equilibrium”
– Rationale: (See graph 7)
• Wage setters expected Pe↑, they push firms for higher
W, causing Labor Cost to rise. Therefore, firms would
push up prices to match the higher labour cost, leading to
higher actual Price level (P).

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• SHORT RUN: Year-to-year movements in
output are primarily driven by
movements in demand
– How Consumption and Investment behave
 movements in demand (responsive to
current events)
– Consumer confidence and other factors that
leads to Y↓ or ↑

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• MEDIUM RUN:
– Economy tends to returns to the level of output
determined by the supply factors (potential
production, Yn): Productions depend on capital
stock, level of technology (captured in variable A)
and the amount of labor which can potentially be
employed, Nn.
– At the medium run, expected price level is equal
to actual price level. This is intuitive because when
Pe = P, there is no more adjustment in price or
expectation of price.
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LONG RUN: When we have technological
progress that increases the variable A. This
will push the Yn higher  We have growth
of potential output.

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 Economy will “settle
down” at the potential
or natural state; with Yn
and un and P = Pe

SR MR LR

Innovations, technological
breakthrough  higher
Concerns with shocks, potential, right shift of LRAS,
especially demand shocks A↑
with consumptions and
investments 
“reactionary policies”

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