The Labor Market, Unemployment, and Inflation
(Part A)
by
Charles Lamson
In previous posts we stressed the three broadly defined markets in which households, firms, and government, and the rest of the world interact: (1) the goods market, (2) the money market, and (3) the labor market. We described some of the features of the U.S. labor market and explained how the unemployment rate is measured. Then, we considered the labor market briefly in our discussion of the aggregate supply curve. Because labor is an input (any resource used to create goods and services), what goes on in the labor market affects the shape of the aggregate supply (AS) curve. If wages and other input costs lag price increases, the AS curve will be upward-sloping; if wages and other input costs are completely flexible and rise every time prices rise by the same percentage, the AS curve will be vertical.
In the next several posts we look further at the labor market's role in the economy. First, we consider the classical view, which holds that wages always adjust to clear the labor market (Market clearing is the process by which the supply of whatever traded is equated to the demand so that there is no leftover supply or demand.) We then consider why the labor market may not always clear and why unemployment may exist. Finally, we discuss the relationship between inflation and unemployment. The Labor Market: Basic Concepts Let us review briefly what the unemployment rate measures. The unemployment rate is the number of people unemployed as a percentage of the labor force. To be unemployed a person must be out of a job and actively looking for work. When a person stops looking for work, he or she is considered out of the labor force and is no longer counted as unemployed. It is important to realize that even if the economy is running at or near full capacity, the unemployment rate will never be zero. The economy is dynamic. Students graduate from schools and training programs; some businesses make profits and grow, while others suffer losses and go out of business; people move in and out of the labor force and change careers. It takes time for people to find the right job and for employers to match the right worker with the jobs they have. This frictional (Frictional unemployment exists in any economy due to people being in the process of moving from one job to another.) and structural (form of involuntary unemployment caused by a mismatch between the skills that workers in the economy can offer, and the skills demanded of workers by employers) unemployment is inevitable and in many ways desirable.  In the next several posts, we are concerned with cyclical unemployment, the increase in unemployment that occurs during recessions and depressions. When the economy contracts, the number of people unemployed and the unemployment rate rise. The United States has experienced several periods of high unemployment. During the Great Depression, the unemployment rate remained over 17 percent for nearly a decade. In December of 1982, more than 12 million people were unemployed, putting the unemployment rate at 10.8 percent (Case & Fair, 2004). In one sense, the reason employment falls when the economy experiences a downturn is obvious. When firms cut back on production, they need fewer workers, so people get laid off. Employment tends to fall when aggregate output falls and rise when aggregate output rises. Nevertheless, a decline in the demand for labor does not necessarily mean that unemployment will rise. If markets work as described in earlier posts, a decline in the demand for labor will initially create an excess supply of labor. As a result, the wage rate will fall until the quantity of labor supplied again equals the quantity of labor demanded, restoring equilibrium in the labor market. At the new lower wage rate, everyone who wants a job will have one.
If the quantity of labor demanded and the quantity of labor supplied are brought into equilibrium by the rising and falling wage rates, there should be no persistent unemployment above the frictional and structural amount. This was the view held by the classical economists who preceded Keynes, and it is still the view of a number of economist's today. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 557-558* end |
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