The Labor Market

An important macroeconomic variable is the total amount of labor that is used in a certain time period. The amount of labor and the amount of capital are important explanatory variables for production and GDP. Another reason for the importance of the amount of labor is that it is related to the unemployment rate – a macroeconomic variable which is clearly important.

Unemployment classification

Economists sometimes distinguish between different types of unemployment. There are many different ways of classifying unemployment but the following is quite common.

  • Frictional unemployment. Individuals that are temporarily unemployed while transiting between jobs or just entering the labor market. This kind is typically short in duration but always present in a market economy.
  • Structural unemployment. Individuals that are unemployed because their skills are no longer in demand where they live. This kind typically leads to longer spells and may require the unemployed to acquire training or to move.
  • Cyclical unemployment. Unemployment due to a recession.
  • Classical unemployment. Unemployment due to real wages being too high (for example through minimum wage laws).

All unemployed individuals are assumed to belong to exactly one of these categories so that if we sum the unemployment from each category we will get the total unemployment. We define the unemployment rate for the above categories e.g. we define the frictional unemployment rate as the frictional unemployment divided by the total labor force, and similarly for the other categories. Obviously, it is often difficult to determine exactly which category an unemployed individual belongs to and official measures of the unemployment in each category do not exist.

Notwithstanding, this classification is very useful in economics. If unemployment increases in a particular city due to a firm relocating production, it is structural unemployment that increases (initially, part of it is frictional), and if unemployment increases due to a recession, it is the cyclical unemployment that has increased. Knowing what type of unemployment is currently present is important when considering what type of measures to take to lower unemployment.

Full employment

The natural rate of unemployment is defined as the sum of the rates of frictional, structural, and classical unemployment (excluding cyclical unemployment). The natural rate of unemployment is sometimes called voluntary unemployment and is assumed to be much more stable than the total unemployment rate.

Since the cyclical unemployment is zero in a boom, the natural rate of unemployment is equal to the observed unemployment rate in a boom. In a recession, the observed unemployment rate exceeds the natural rate by the cyclical unemployment rate.

We say that we have full employment when the unemployment rate is equal to the natural rate (and cyclical unemployment is zero). Remember that full employment does not imply that the unemployment rate is zero.

Different kinds of unemployment

Figure 5.3: Different kinds of unemployment.


Nominal wages

The nominal wage is the wage per unit of time in the currency used in the country– what we typically just call wage. When we refer to wage in macroeconomics we almost always mean gross wage, that is, the wage before income taxes but after employment taxes paid by the employer. Wage is a flow that we typically measure in units of currency per hour.

Wages and income

Remember that by wage we typically mean what you receive for working one hour, while income is the total revenue from all sources over a longer time period (such as a month). Your income depends on the wage but also on the number of hours you work. An individual may have a very high wage but a low income (say $1000 per hour but only working 1 hour per month) or a low wage but a high income (for example by owning stocks or bonds). Do not confuse wages with income.

Nominal wage level

In macroeconomics, we are normally not interested in the wage for a particular individual but in the average wage for all employed individuals. This average is called the wage level but since we typically only care about the wage level, we will almost always use wage when we actually mean the wage level. Thus, a statement such as “wages increase” should not be interpreted as all wages increasing, but rather that the average is increasing.

Real wage

Consider the following scenario. You work full time and during January 2008 you make 2000 euros after tax. A particular basket of goods and services costs 100 euro in January, which means that your salary will buy you 20 such baskets. In February, you receive a 10% wage increase and you make 2200 euro after tax. Does this imply that you can buy 10% more baskets – that is 22 – in February? Well, not necessarily.

The number of baskets that you can buy in February depends on the possible changes in prices as well. If the price of a basket increases by 3% to 103 euro your 2200 will buy you 2200/103 = 21.36 baskets of 7% more than in January. Even though your wage has increased by 10%, you can only increase your consumption of baskets by 7%. We say that the real wage has increased by 7%.

Formally, we define the real wage as the nominal wage divided by a price index (typically CPI). In the example above, your real wage was 20 in January and 21.36 in February if we use the price of the basket as a price index. Remember that the nominal wage will tell you your wage in units of currency, while the real wage will tell you your wage in baskets of goods and services and this is more important to us.

Therefore, we care about increases in real wages, not in nominal wages. If you found out that Ken, who works in another country, got a 50% increase in his wage each year, you may initially be quite happy for Ken. If you then found out that inflation in the country where Ken works is 70%, you should actually feel sorry for him. His real wage is 1.5/1.7 = 88% of his real wage the year before – a real wage cut by 12%.

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