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Economics 3rd ch06


By John B. Taylor
Stanford University

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Chapter 20 (Macro 7)
Unemployment and
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• Unemployment arises in both the growth and the

cyclical parts of macroeconomics. Any contemporary
account of unemployment must therefore attempt to
define and explain each of these sources. So the natural
rate or, alternatively, frictional and structural
unemployment are due to the enduring features of an
economy in normal times, while cyclical unemployment
is a consequence of economic fluctuations. Due to the
close connection between cyclical unemployment and
economic fluctuations, detailed discussion of the
underlying connections is deferred until the model of
economic fluctuations is introduced and developed in
later chapters.

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Teaching Objectives
• Develop a clear set of definitions of
unemployment and employment that is consistent
with government reports of these data.
• Use the demand and supply model as it applies to
the labor market in the determination of real
wages, employment, and unemployment.
• Discuss the policy implications of the demand and
supply for labor model.

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1. Employment and Unemployment Trends
• The labor force consists of all people who are 16 or
over, employed or unemployed. The current population
survey is the source of this number.
• The distinction between employed and unemployed
depends on whether the person is paid or not. The labor
force consists of the employed plus the unemployed,

the latter consisting of those in the labor force but not
employed. Discouraged workers are not in the labor
force and so are not counted as unemployed.
• Part-time workers (1 to 34 hours per week) are counted
as employed. See Figure 21.2.

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Three indicators of labor market conditions

• The unemployment rate, or unemployed/labor
force. Figure 20.1 makes clear the relation
between unemployment and real GDP.
• The labor force participation rate, or labor
force/working-age population. It fluctuates with
real GDP as does unemployment.
• The employment-to-population ratio, or
employed/working-age population. These ratios
are given in Figure 20.3.

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Figure 20.1 (Macro 7)
The Unemployment Rate

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Figure 20.2
(Macro 7)
How to Find Labor
Market Indicators

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Figure 20.3
(Macro 7)
Employment-to-Population Ratio for Men, Women, and Everyone

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• Because the labor force is composed of both fulltime workers and a significant number of part-time
workers, the number employed needs to be
supplemented by other measures that reflect this
fact. Aggregate hours = (average hours per
worker) x (labor force participation) x (workingage population).

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Unemployment and GDP
• Increases in unemployment reduce real
GDP as the labor input to production falls
because fewer workers are employed. So an
increase in the natural rate reduces potential
real GDP, provided there are no
accompanying changes in productivity to be
accounted for.

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2. The Nature of Unemployment
• People become unemployed because they are job
losers, job leavers, or new entrants. See Figure
• Job losers are unemployed because of the
dynamism of the economy: As jobs are created and
destroyed, workers are often left unemployed in
the process. As a consequence, job vacancies and
unemployment exist at the same time, a reflection
of this dynamism. However, job losers increase
during recessions and decline during booms, as
seen in Figure 20.4.
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Figure 20.4
(Macro 7)
Job Losers, Job
Leavers, New
Entrants and
(January 2000)

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• Job leavers, or quits, are relatively constant over the
cycle due to the opposing forces of reduced quits and
fewer job vacancies in a recession.
• New entrants are a large fraction of the unemployed,
especially on a seasonal basis.
• Most of the unemployed (85 percent) are unemployed
for less than 6 months. See Figure 20.5. However, the
long-term unemployed (the other 15 percent) increase
during recessions and decrease during booms.
• The rate of unemployment varies dramatically across
groups in society, with very high unemployment rates
among minority teenagers.
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Figure 20.10
(Macro 7)
Unemployment Rates for Young Adults
(ages 20-24)

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Figure 20.11
(Macro 7)
Percentage of 20-24-year-olds Still
Living with Parents

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Figure 20.5
(Macro 7)
Unemployment by
Duration (January

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3. Determination of Employment and Unemployment
• The relationship between labor demand and supply
is given in Figure 20.6, determining the equilibrium
quantity of full-employment labor and the real wage.
• Two broad trends in labor are the general increase in
real wages and employment. This is associated with
a shift in the demand for labor, as seen in Figure
20.7, due in part to the growth of service industries,
which hire more women. Women are quite sensitive
to changes in real wages, so the increased demand in
service industries probably explains the higher
participation rate by women.

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Figure 20.6 (Macro 7)
Labor Supply, Labor Demand, and Equilibrium Employment

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Figure 20.7 (Macro 7)
Explaining the Increase in the Employment-to-Population Ratio

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Other Explanations for Unemployment
• In order to account for unemployment in a model such
as Figure 20.6, it is necessary to introduce some
explanation outside of equilibrium. Two complementary
explanations are job rationing and job search.
• Job rationing is depicted in Figure 21.8 in terms of
excess supply that is always present, not allowing for
the normal downward price (real wage) adjustment due
to: (1) the minimum wage law and its effect on teenage
unemployment; (2) insiders sometimes preventing
outsiders from being employed; (3) employers paying
efficiency wages.

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Figure 20.8 (Macro 7)
Excess Supply of Labor and Unemployment

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Figure 20.9
(Macro 7)
Labor Market Flows

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Policy implications of the demand and supply
model of the labor market
• The policy implications of the demand and supply
model of the labor market are discussed in terms
of the effect on employment and the natural rate of
• Taxes such as a payroll tax affect the demand for
labor, as seen in Figure 20.13. For example, an
increase in the social security tax will reduce the
demand for labor by the amount of the tax,
reducing the real wage and employment.

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Figure 20.13 (Macro 7)
Effects of a Tax on Wages

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