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Unemployment Notes

PPE Notes > Labour Economics: Unemployment Notes

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Trends in OECD Employment Natural Rate of Unemployment & PS/WS Framework Open Economy Theory Labour Market Institutions: o Employment Protection Legislation (EPL) o Minimum Wage o Unemployment Benefits o Trade Unions Alternative Models: o Efficiency Wage Hypothesis o Calmfors Driffel Model o Search Model Hysteresis: o A Model o Unemployment duration and hysteresis o Evidence Education & Unemployment Past essay questions Tutorial Essay Plan: Can demand shocks alter the equilibrium rate of unemployment

Trends in OECD Unemployment

1. Unemployment rates lower in Europe than in US at start of 1970s but soared in 1980s to over 10%. Less educated suffered disproportionately. US unemployment: no real trend over period though increase in dispersion (partially attributed to declining real wage in 1980s)

2. General rise in unemployment levels, especially in Europe (having been best performing in 3 decades post WWII), often attributed to less flexible labour markets.

3. UK: a. Thatcher: 1979-1981: unemployment doubled. Partially just recognising reality of natural rate. b. UK unemployment initially fell substantially post 1992 while French (and other EU countries) stayed high. Then got worst of both - rise in unemployment and inequality.

4. Increase in divergence in divergence between unemployment for educated/skilled, and uneducated/unskilled

5. Recession. a. UK: peaked at 8.4% in 2011, but fell to 7.8% in Jan 2013 b. Germany: now 5.9% (recent increase). Had been 12% in 2006, but generally kept falling throughout recession c. Spain: 26.7% (55% u25 unemployed) from 8.7% in 2006 d. France: 10.5% vs 9.5% in 2006 e. Greece: 27.7% (59% u25 unemployed) f. US: peaked 10.1% in October 2009 vs 4% in 2006!
g. Eurozone: 12.1% average in March.

6. NGDP currently estimated to be 15% below trend

7. CPI rose 1.2% in the year to April across Eurozone, slowdown from March's 1.7% rise. Natural Rate of Unemployment Natural rate: Friedman: 'the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural

characteristics of the labour and commodity markets, including market imperfections, stochastic variability in demand and supplies, the costs of gathering information about job vacancies and labour availabilities, the costs of mobility etc. NAIRU: level of unemployment consistent with stable inflation. Could be generated by wider range than Friedman's model, eg. Carlin/Soskice. Broader concept which can include Friedman concept. Equilibrium unemployment: rate of unemployment consistent with stable inflation and balanced trade. What determines it?
Nickell: Threeway trade off between:

1. Low measured unemployment

2. Stable inflation

3. Balanced current account??

For some countries trade off is relatively benign. For others is malign. Nickell claims that how benign or malign that trade off is a function of the supply side. All that demand side can do is pick a point on the trade off. If believe in hysteresis and believe it could be lingering, 3 way trade off affected by demand side.

Original Phillips curve - 1958. Regarded as menu for policy choice. Friedman 1968 questioned it - curve should be drawn for given level of price inflation expectations. Workers are surprised as don't expect prices to change; adjustment lag. (Information story from C&S: W/PE > W/P). So monetary expansion only achieves higher inflation but shame unemployment - VPC. Can only change by changing supply side. What determines the natural rate of unemployment?
WS lies below LS curve. PS lies below Ld (MPL) curve: excess of real wages on real demand curve is supernormal real profits per worker associated with IC in product market. Often assume PS horizontal. Lower elasticity pushes PS curve down (less competitive). With IC labour market, unemployment at ERU must involve some involuntary unemployment. Know this because WS curve > LS curve so at ICE real wage must be workers willing to supply labour at that wage who are not employed. Labour market imperfections necessary to generate involuntary unemployment, but product market imperfections also affect level of ERU. NB if had PS curve and competitive labour supply curve, would be no involuntary unemployment, but employment would not be the same as with competitive labour demand curve. Framework can explain differences internationally and over time. Anything shifting PS up and WS to right will reduce ERU.

WS curve wWS = b(E, zw) where z is set of wage push variables. Lies above LS curve because of labour market imperfections. The distance is the mark up per worker associated with labour market imperfections. The real wage demanded by workers rises as employment rises since the bargaining strength of workers improves. Labour market not competitive in practice:

1. Unions: wage bargaining trade unions seek high real wage for members, while recognizing too high a wage will reduce employment. Don't care about unemployed non-members in simple model.

2. Efficiency wages: firms set wages above market clearing level to retain wellqualified/productive workforce. Hard to specify exactly what a worker must do in a given job, so firm uses wage to motivate worker to perform well and to overcome adverse selection/moral hazard.

These determine the position of the WS curve. WS curve shifts closer to LS curve if:

1. Lower replacement ratio or UB duration (shifts balance towards accepting job at lower real wage at any given unemployment rate)

2. Reduced trade union power

3. Bargaining restraint - eg wage accord PS curve Perfect competition: real wage = MPL. In IC, firms set prices to maximize profits. The mark-up of prices over MC depends on the elasticity of demand: as the elasticity of demand rises, the mark-up falls until the extreme of PC holds, where elasticity is infinite. In the case of monopoly, have the standard pricing formula:

The excess of the real wage on the labour demand curve above that on the PS curve is the supernormal real profits per worker associated with IC in the product market. For simplicity, often assume PS is horizontal, but only true under certain assumptions (see macro notes). wps= lf(mu,zp) where ?u?is the mark up and z a set of price push variables which determine the PS curve position and l productivity. PS shifts closer with:

1. Fall in tax wedge. Workers care about prices in terms of consumption basket. Firms care about price they get for product. Difference between these is tax wedge - made

up of indirect taxes (eg. VAT) and direct taxes (eg income taxes and social security contributions)

2. Fall in mark up

3. Reduced employment protection

Competitive vs uncompetitive model:

Open economy theory Open economy: ERU varies with real exchange rate, so might want to also include measures of price competitiveness in empirical model of equilibrium unemployment.

The PS shifts down when the real exchange rate depreciates because import costs for firms rise, so to maintain profit margins they will only agree to a lower real wage at any given level

of employment.

Labour Market Institutions-

Tend to raise rate of unemployment over time. Eg, when someone loses their job as firms constantly restructure, go bust, get bought etc. etc they are then affected by the labour market institution - eg high replacement ratios. Interaction with shocks is important (BLANCHARD & WOLFERS 2005) Negative effects on unemployment disproportionately affect unskilled, uneducated and lower paid.

1. Employment Protection Legislation 2 most common elements:

1. Severance pay - the amount of money a worker is entitled to if made redundant (usually multiple of money wages based on length of service)

2. Advance notice requirements - have to give number of months notice and often has to engage in compulsory negotiation before redundancy can occur Varies in practice: US: no compulsory severance pay (though workers can sue for unfair dismissal) and no advance notice requirement Italy: 15 month salary for worker of 10 year service!
Greece: 10 month advance Theoretical Impact of EPL:1. Firms hire less due to larger firing costs - leads to unemployment and loss of output.

2. Reduces probability of layoff Both proven empirically (eg BLANCHARD & PORTUGAL 2001)
=> hiring and firing lower. Overall effect ambiguous a priori.

Undoing EPL effects:Can be undone by an efficient contract in theory. Assumptions: o Workers neutral o Wages flexible o EPL is the severance payment that must be paid at the end of the employment contract o 2 periods.
? Constant w each period
? Workers utility is u(w)
? S is severance payment paid to the worker
? To keep labour costs constant, employer offers worker (w - B) in first period, where B is the bond entitling the worker to S in the second period.

??-Worker is indifferent provided:

Requires that B = S/(1 + r), where r is the interest rate, ie the bond =
PV of the severance payment Usual problems with bonding apply - worker may not be able to afford it, firm may cheat

o LAZEAR (1990): examines relationship between severance pay and unemployment for 22 countries over 29 years (crossnational and intertemporal). Does find evidence:
? 1956-84 big increase in such payments (increase 250%)
? Problem: results to unemployment seem to vary.
? Finds introducing 3 months severance pay reduces employmentpopulation ratio by 1%. Argues young bear disproportionate effect of burden.
? Also finds EPL reduces work hours - because if tougher firms have incentive to switch from full-time to part-time workers where it doesn't apply, thus average hours fall
? Model varies in explanatory power - eg. Explains 59% of increase in unemployment in France, but much less elsewhere. Overall pretty mixed and not that compelling. o NICKELL (2005): time series. 1961-1995 OECD countries. No impact on unemployment. o GRIFFITHS (2007): similar approach using more recent data. Found no significant effect. o OECD (2012): no significant effect. o BLANCHARD & PORTUGAL (2000): compare Portugal and America. No impact on unemployment but does have impact on unemployment duration (increases) and job flows (reduces). o OECD index on employment laws: UK has third lowest level of protection in OECD (behind US and Canada) and third lowest of all countries examined by the OECD/World Bank. o BEECROFT report in the UK: recommended deregulation. Doesn't seem justified empirically. o Crisis: Monti reduced regulation in Italy (arbitrary 15 people distinction); Spain overhauled labour laws last year o Amable and Mayhew (2011): o Unemployment rose by less in countries which had strict employment protection legislation (excluding spain) and high collective bargaining coverage o Work-sharing also helped reduce rise in unemployment and the generosity of out of work benefit arrangements (usually involving reduced hours) o U/e: Started to rise very early - end of 2007 in Spain, Ireland and US. Magnitude v.large in Spain, the US, Iceland, Ireland, more limited for Continental European and Nordic countries and almost insignificant for Germany. o Potential reason Spain is an outlier: dual labour market system. OECD (2012): During downturn 90% of the reduction in employment occurred among workers under temporary contracts who were not protected by EPL. Explaining cross country differences: o Size of recession varied eg. Iceland -12.5% vs Italy -6%, UK -5.2%. More moderate for most continental European countries (eg -2.25% in France)

1. Extent of Employment Protection Legislation (EPL): Initial regression - not significant. BUT, Spain problematic - large increase in unemployment despite high level of employment protection. Once removed EPL very important in preventing lower unemployment o 2. Extent of collective bargaining. Ceteris paribus, higher collective bargaining = lower unemployment o 3. Willingness of country to have work sharing schemes - eg. Germany v.extensive work sharing scheme (paid for by government/companies combination). o Germany an extreme case - despite severe recession, unemployment rose only moderately and then resumed downward trend after second quarter of 2009. Reason:
? 1. Chose to maintain employment but diminish level of hours worked (fell by c.3%).
? 2. Employers had failed to hire extensively in expansion preceding it. HUNT et al (2010): didn't expect boom to last so adopted cautious attitude towards hiring. Irony: 3 things regarded as bad for employment prevented unemployment rising seem to be beneficial in very severe recessions. Interesting angle. Implications particularly important w.r.t hysteresis arguments o2.Minimum Wages-

See that topic for employment arguments. Prices low paid out of work and increase wage demands Working tax credits: Provide a credit against the tax that would be due for those on low incomes who would otherwise not find it worth working UK: Working Family Tax Credit (WFTC); Earned Income Tax Credit (EITC) in US Program works by introducing kinks in the budget constraint

WFTC causes some people to enter who otherwise wouldn't, but for those already in work impact is more ambiguous

3. Unemployment benefits: NB **should unemployment benefits change with the cycle?**Conventional theory: 2 key dimensions: o 1. Replacement ratio = the %age of previous earnings replaced by the UB. o 2. Duration. Some countries have cap or at least start to reduce RR as duration of unemployment increases.

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