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Chapter 31

ECON 102 Chapter Notes - Chapter 31: Classical Economics, Labour Market Flexibility, Longrun

Course Code
ECON 102
Robert Gateman

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Economics 102: Principles of Macroeconomics
Chapter 31
31.1 Employment and Unemployment
Changes in Employment:
Rising population, increased labour force participation and net immigration has expanded
the labour force
Net increase in employment: difference between jobs created and jobs lost
Changes in Unemployment:
During periods of rapid economic growth, the unemployment rate usually falls
During recessions or periods of slow growth, the unemployment rate usually rises
Flows in the Labour Market:
The amount of activity in the labour market is better reflected by the flows into and out of
unemployment than by the overall unemployment rate
o The unemployment rate may stay near constant must job creation may be changing
Consequences of Unemployment:
Some unemployment is socially desirable as it reflects the necessary time spent searching
to make appropriate matched between firms and workers
Lost Output:
The unemployed are valuable resources who are currently not producing output
o The output not being produced, but potentially could be, is a loss for society
o The loss of output accompanied by unemployment is forever lost
Personal Costs:
Those effected by long-term unemployment, in terms of disillusioned who have given up
trying to make it within the system, contribute to social unrest
o Loss of self-esteem and dislocation of families are results of prolonged
31.2 Unemployment Fluctuations
New Keynesians distinguish unemployment when Y*=Y and when there are output gaps
Cyclical unemployment: unemployment not due to frictional or structural factors
o Due to deviations of GDP from Y*
New Classical economists believe real wages adjust immediately to clear labour markets
and as a result real GDP is always equal to Y*
o Unemployment rate changes but only because of changes in the amount of frictional
or structural unemployment (no cyclical unemployment)
New Classical Theories:
Agents continuously optimize and markets continuously clear
Believe unemployment is the outcome of voluntary decisions made by individuals who are
choosing to do what they do, including spending some time out of employment

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Economics 102: Principles of Macroeconomics
Changes in technology that affect the marginal product of labour will lead to changes in
labour demand
o Positive and negative technological shocks lead to fluctuations in the level of
o Flexibility of real wages results in a clearing of the labour market
o Whatever unemployment exists must be either frictional or structural (NAIRU)
New Keynesian Theories:
Most people, despite reading market signals correctly, react in ways that do not cause
markets to clear at all times
People are involuntarily unemployed in the sense that they would accept an offer of work
in jobs for which they are trained, at the going wage rate, if such as offer were made
If wages do not respond quickly to shifts in supply/demand in labour markets, QS and QD
may not be equated for extended periods of time
Unemployed wait to be needed, rather than seek out employment for lower real wages
Long-Term Employment Relationships:
Firms and workers care about things in addition to the wage rate, and wages are somewhat
insensitive to fluctuations in current economic conditions
Wages are regular payments over the long-term rather than supply/demand devices
Menu Costs and Wage Contracts:
Changing prices and wages in response to every minor fluctuation in demand is a costly
and time consuming
Firms often react to small changes in demand by holding prices constant and responding
with changes in output and employment
o If many firms react this way, output and employment will respond to changes in AD
o The amount of involuntary unemployment will fluctuate over the business cycle
New Keynesians believe that sticky prices are a result of firms' optimal responses to
adjustment costs
Inflexibility of wages implied that changes in AD and AS will tend to cause changes in the
amount of involuntary employment
Efficiency Wages:
Employers may find they receive more efficient workforces if they pay more than the
minimum amount
Firms may choose to pay a wage premium (efficiency wage) to worker, in excess of the
wage that the workers will get elsewhere in the labour market
o Workers will be less likely to neglect work because if they get laid off, they lose
premium wages
o QS of labour may exceed QD by firms (creating involuntary unemployment)
o Wages do not fall to clear the labour market because firms would rather pay a high
wage to motivate workers than a lower wage to workers who neglect their duties
Union Bargaining:
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