Lecture 15: Unemployment and the Business Cycle

L11200 Introduction to Macroeconomics 2009/10

Reading: Barro Ch.925 February 2010

Introduction

• Last time:– Expanded model to incorporate supply of capital

over the business cycle to match data

• Today– Try to explain unemployment within the model– Develop a model of job separation and job search

Why is this a Problem?

• Equilibrium Business Cycle model has no unemployment– If labour market clears than labour supply = labour

demand– No-one who wants to work is without a job– All unemployment is voluntary – if people wanted

to work at the going wage they could

Explanations for Unemployment

• To explain unemployment, some appeal to excess supply of labour– i.e. labour demand falls in recessions but wages

are somehow held above equilibrium– Minimum wages, Union bargaining, Wage

Contracts

• More modern theories appeal to ‘search and matching’, which we develop today

Basics of the Model

• Workers looking for jobs don’t immediately find a job which pays their MPL=w/P– Search around looking for the best offer possible– Searching is much more easily done while

unemployed– Income while unemployed is some minimum paid

by the government, ω– Job offers taken from some distribution of

possible wages above ω

Distribution of w/P

• Small chance of getting a high-paid job, more likely get a job close to worker’s MPL– So when job offer comes along, have to make a

decision– Do you take the offer and forego the chance of a

better offer?– Certainly will not take any offer below ω

(unemployment benefit) paid by government

Reservation Wage

• Will take a job at some reservation wage (w/P)’ depending on preferences – Certainly won’t take any job paying below ω– Have to make a judgement about what offer

would be taken– This decision results in the individual deciding on

their reservation wage

Dynamics and the Labour Force

• Data shows that the labour force is very steady over the cycle– So patterns in employment and unemployment

not caused by changes in labour force– Instead, caused by job-separations: workers leave

current job to find another / firms find workers have MPL less than anticipated

– And by job-findings: workers find an acceptable wage offer above reservation wage and take job

Model Setup

• So growth of employment depends on :

• Critical issue is determinants of σ and – Do these vary over the business cycle?

L U L

growth in employment = (job finding rate x no. people unemployed) - (job separation rate x no. people employed)

‘Equilibrium’ Unemployment

• Employment is unchanged when• Denote overall labour force F

• U/F is ‘natural unemployment rate’, denoted by un

U L

( )

( )

/ ( )

/ / ( )

U F U

U F

U F

U F

Factors affecting un

• Variation in explained by factors which shift either job-separation of job-finding rate– Unemployment insurance: which lowers job-

finding rate – Search technology (e.g. internet) which raises job-

finding rate– Generally, job-finding rate more likely to change

compared with job-separation rate

/ ( )nu

Fluctuations and Employment

• Positive technology shock raises prospective MPL of workers – Increases recruitment by firms– For a given ω, increases likelihood of worker

taking an advertised position– So job-finding rate increases and un falls.– Converse is true when negative shocks lower MPL,

job-finding rate falls and un rises.

Advertising and Unemployment

• If this is true, should find greater job-advertising when unemployment is low– Firms demand for workers reflected in more job-

adverts– More jobs ease ability of workers to find a good

matching job– Unemployment rate falls– Known as the Beveridge Curve

Recap

• Why does unemployment rise in recessions– Because lower MPL reduces wage offers and

advertising by firms– Lower wage offer reduces likelihood that workers

will take jobs (for a given ω)– Job-finding rate falls, so natural unemployment

rate increases– So unemployment is counter-cyclical: high when

output is falling, and vice-versa

Summary

• Unemployment is possible, and counter-cyclical in the modified model– Arises because of friction in the labour market

between rate at which individuals separate from jobs and find new jobs

– Data suggests this is a plausible model

• Next time: introduce a new topic, money, and consider role of money in our economy