The Labour Market & the Macro-economy

The Macro-Economics of European EconomiesMSc in Economic Policy StudiesJohn FitzGerald, February 2015

Course Outline

1. How does an economy work? JF 16-1-2015

2. The genesis of macroeconomics AM 23-1-2015

3. Modern macroeconomics AM 30-1-2015

4. Banks and financial markets AM 6-2-2015

5. The recent crisis AM 13-2-2015

6. The labour market JF 20-2-2015

7. Fiscal Policy and forecasting JF 6-3-2015

8. Trade JF 13-3-2015

9. The economics of global warming JF 20-3-2015

10. The future of the Irish economy AM and JF 27-3-2015

Outline of Lecture

• Theory• Demographic factors, exogenous in short run• Labour Supply• Labour Demand• Wage Determination, Market Clearing and Unemployment• Interaction with macro-economy

• Applied - examples covering a range of EU economies• Human Capital and the labour market• Labour Market Disequilibria in EU economies

Demography and the Labour Market

• Population• Nt=Nt-1-Dt+Bt+Mt

• Where: N=population; D=deaths; B=births; M=immigration

• Education• Affects participation, migration, employability and productivity

• Working age population• Participation rates

• Affected by economic circumstances

• Migration• Drivers of migration – economic differences and other factors

Demography and the economy

(inverse) Ratio

Dependency

1564

RateionParticipat

1564

RateEmployment

tyProductivi

capitaper GDP

Pop

Pop

Pop

LForce

LForce

Emp

Emp

GDP

Pop

GDP

The Role of Education

• Rising educational attainment – differs by country and by age• Affects productivity which, in turn:

• Affects wage rates – in perfect competition labour paid the marginal product• Affects participation because higher wages v costs of working• Affects employability and numbers unemployed

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1921-25 1931-35 1941-45 1951-55 1961-65 1971-75 1981-85

Birth Cohort

EU15, Educational Attainment

Tertiary

High School

Lower Secondary

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1921-25 1931-35 1941-45 1951-55 1961-65 1971-75 1981-85

Birth Cohort

USA, Educational Attainment

Tertiary

High School

Lower Secondary

Labour supply

• L=f(W, N, M, UR, welfare, unions, T)• Where: W=wage rate; UR= unemployment rate; T= other factors, e.g. culture

• Migration = f(UR, URw, W, Ww , T)• Where subscript w signifies the rest of the world• Sensitive to wage rates in Ireland – much less sensitive elsewhere

• Female labour supply= f(demographics, education, W, costs, culture)• Fairly elastic – sensitive to wage rates

• Male labour supply= f(demographics, education, W, costs, culture)• Fairly inelastic – what is inelastic?

• Shape of labour supply curve?• How elastic – what is elastic?

Elastic Labour Supply

DL

S1L

W

L

W1

L2

Wage Rates

Employment

Inelastic Labour Supply

DL

S1L

W

L

W1

L2

Wage Rates

Employment

Totally Inelastic Labour Supply

DL

S1LW

L

W1

L2

Wage Rates

Employment

Skilled v Unskilled

• Two kinds of labour: skilled (high education) & unskilled (low education)• Are they substitutable?• Unskilled labour may be less employable• While the skilled labour market may clear the unskilled may not• Focus on:

• Educational attainment of labour force• Returns to education

• Migration – skilled or unskilled? Different effects

Labour Demand

• L=f(Q,W,Pk,Pm,T)• Where L=employment; Q=output; W= wage rate; Pk=price of capital; Pm=price of materials

and other inputs; T=technical progress• Firms choose the mix of inputs (labour etc.) so as to minimise the cost of producing a given

output Q

• Q=f(Qw,c,cw,T)• Where c= unit cost of production; subscript w signifies the rest of the world• World output is located based on the cost of production in different countries

• Hence wage rates affect employment through two channels1. Substitution of capital and materials for labour and vice versa2. Substitution of foreign for domestic output and vice versa

• Shape of Labour demand curve? How elastic?

Market Clearing: Wage Rates

• Market clearing? How can there be unemployment?• Speed of adjustment• Structural unemployment• Hysteresis

• Bargaining• Philips curve• The tax wedge• Minimum wages• Efficiency wages

Speed of adjustment

• Employers may be slow to adjust employment• Want to hold on to firm specific skills – e.g. Germany• Costs of hiring and firing• Labour laws – if hire may not be able to fire

• Employees slow to adjust reservation wage• Expectations• Don’t have requisite skills• Problems with nominal wage cuts v real wage cuts• Market wage < welfare etc.

• Result: market may remain out of equilibrium for a long time

Structural Unemployment

• Where skills of the unemployed don’t match needs of employers• Where labour market laws may interfere with market clearing

• Reasons for laws may mean that some unemployment is acceptable?

• Hysteresis. A shock to the system shakes out labour that may not be re-employed in a recovery – e.g. because of skills mismatch

• Move from a full employment equilibrium to an unemployment equilibrium

• Policy Options?• Measures to increase demand?• Measures to reduce / transform supply?

Bargaining

• One “model” of the labour market:• Employees bargain in terms of after tax wages• Employers take the wage and set employment

• Bargaining power of employees may be affected by• Legislation• Unions• Insiders v Outsiders

Philips Curve

• Wage rates (or the level of wages) may be affected by unemployment• With high unemployment employees anxious to hold jobs

• More willing to take a pay cut or not to look for an increase• With high unemployment more competition for jobs

• May result in wage rates lower than would otherwise be the case• With low unemployment labour is scarce and employers have to pay more

• If unemployment affects wage inflation• At what level of unemployment is the effect on wage inflation zero?

• If higher unemployment – then real wage rates will tend to fall, leading to higher employment and lower unemployment

• Similarly if unemployment below this level wages will tend to rise affect unemployment• The non-accelerating wage rate of inflation (NAWRU) is the stable equilibrium

• Explains why market clears at a significant rate of unemployment• What happens if infinite labour supply? No Philips curve

Wage Rates

• The tax wedge:• Employers pay W*(1+te); Employees get W*(1-tp)• Where te=employers taxes (rate) and tp=employees taxes (rate)• The higher the tax wedge the bigger the difference between the 2 wage rates

• Who pays the taxes on labour – where is the incidence?• Depends on the shape of the labour supply and demand curves

Tax incidence: affected by labour supply & demand

• Impose a tax on labour of W1-W3. • Labour bargains in terms of after tax wages

• Labour supply moves from S1 to S2

• Labour demand downward sloping• Employment falls from L2 to L1• Wage rates rise from W1 to W2 – that share of the tax is paid by employer• The part of the tax W2-W3 is paid by the employee

• The flatter – more elastic – labour supply the bigger the share of the tax is paid by employers – increasing the employment effect

• Partnership in Ireland 1987 – trade off tax cuts for wage moderation• This reflected the behaviour of the market with an elastic labour supply

• Other countries – labour supply less elastic because limited migration

Elastic Labour Supply

DL

S1L

W

L

W1

L2

Wage Rates

Employment

Elastic Labour Supply

DL

S1L

W

L

W1

L1

W2

L2

Wage Rates

Employment

S2L

W3

Replacement Rate or Minimum Wage• Sets a floor on wage rates• Does it lead to unemployment?• Consider the distribution of wage rates

• If there are many at the bottom of the distribution ….• If there are few at the bottom of the distribution ….

• Social considerations:• Higher pay – welfare gain, less welfare payments; offset by lost employment?• Protection of the weak e.g. immigrants

Unskilled Labour

S1L

U

L2

DL

L1

S=W

L

W

Wage Rates

EmploymentL3

Efficiency Wage

• Employers do not know the productivity of a new hire• Pay a premium to ensure that they get the best • High pay may affect morale and productivity of workers• Result: may pay more than market clearing wage rate

Labour Market and the Macro-Economy• Demand for goods and, hence, labour determined in goods market• Wage rate feeds back into prices, competitiveness etc.• Employment, unemployment and wage rates affects public finances

• Tax revenue• Welfare payments• Cost of goods and services

Examples

• Education and skills• How does education affect labour supply?

• Productivity, participation, employability

• Examples of Labour market adjustments• Finland – Crisis 1990• Germany – Unification 1990 and Labour market reforms 2004• Ireland, Spain, Portugal – 25 years of labour market adjustment

• Migration: example of Ireland• Labour market policies

Education – cohort of 1931-5

Education – cohort of 1951-5

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Educational Attainment, birth cohort 1951-55

Lower Secondary High School Tertiary

Education – cohort of 1981-5

Returns to education: lower secondary relative to upper secondary

Men Women2000/1 2011/2 2000/1 2011/2

Belgium 93 92 83 84Chile 64 65Denmark 87 79 90 82Estonia 89 91Germany 81 87 74 82Ireland 82 80 64 70Portugal 68 69Spain 81 80 69 74UK 74 67 69 69USA 65 64 66 62EU 82 78 78 77

Returns to education: tertiary relative to upper secondary

Men Women2000/1 2011/2 2000/1 2011/2

Belgium 128 129 133 134Chile 271 262Denmark 132 138 124 126Estonia 137 160Germany 143 171 141 172Ireland 135 169 161 190Portugal 173 172Spain 125 136 143 155United Kingdom 152 151 176 178United States 181 182 169 177EU21 average 160 165 153 162

80

85

90

95

100

105

110

115

120

125

130

Human Capital Index, 2010, Population 20-64, OECD average returns to education

Investment in Human Capital, 2010

0.8

0.9

1

1.1

1.2

1.3

1.4

Ratio 25-29 to 55-59

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

Unemployment rate by level of education, 2010

Lower secondary Upper secondary Tertiary education

0

5

10

15

20

25

% o

f lab

our f

orce

Unemployment Rate by level of education, 2010

Lower secondary Upper secondary Tertiary education

-0.5

0

0.5

1

1.5

2

2.5

%

Contribution of Rising Educational Attainment to Growth, annual average

Employment rate Labour Force Participation Productivity

20000

25000

30000

35000

40000

45000

50000

55000

60000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

tho

usa

nd

s

EU 15, Labour Market, Lower Secondary Education

Labour supply Employment

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

tho

us

an

ds

EU15, High School

Labour supply Employment

20000

25000

30000

35000

40000

45000

50000

55000

60000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Th

ou

san

ds

EU15, Tertiary Education

Labour supply Employment

Examples of Labour Market Adjustment• Finland – Crisis 1990• Germany – Unification 1990 and Labour market reforms 2004• Ireland, Spain, Portugal – 25 years of labour market adjustment• Migration: example of Ireland

Finland – Unemployment Rate

0

2

4

6

8

10

12

14

16

18

20

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Unemployment rate

Finland – Unemployment Rate by Education

0

2

4

6

8

10

12

14

16

18

20

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Chart Title

Lower Secondary Upper Secondary Tertiary

Finnish wage rates relative to EU 15

0.85

0.90

0.95

1.00

1.05

1.10

1.15

90 92 94 96 98 00 02 04 06 08 10 12 14

RX_FIN*W_FIN/(W_EU15)

Germany – Unemployment Rate

0

2

4

6

8

10

12

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Unemployment Rate

Germany – Unemployment Rate by Education

0

5

10

15

20

25

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Chart Title

Lower Secondary Upper Secondary Tertiary

German wage rates relative to EU15

0.88

0.92

0.96

1.00

1.04

1.08

1.12

90 92 94 96 98 00 02 04 06 08 10 12 14

RX_DEU*W_DEU/(W_EU15)

Labour market adjustment: Ireland, Spain Portugal• Ireland – post 1980s crisis slow to fall

• Hysteresis post 1990 why?• Today?

• Spain – pre-crisis – very high, though had been falling• Labour market rigidities?• Today?

• Portugal – appears fairly flexible – till the crisis• Today?

Unemployment Rate

0

4

8

12

16

20

24

28

90 92 94 96 98 00 02 04 06 08 10 12 14

Spain Ireland Portugal

Ireland: unemployment rate by education

0

5

10

15

20

25

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Chart Title

Lower Secondary Upper Secondary Tertiary

Spain: unemployment rate by education

0

5

10

15

20

25

30

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Chart Title

Lower Secondary Upper Secondary Tertiary

Portugal: unemployment rate by education

0

2

4

6

8

10

12

14

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Chart Title

Lower Secondary Upper Secondary Tertiary

0

5

10

15

20

25

% o

f lab

our f

orce

Unemployment Rate by level of education, 2010

Lower secondary Upper secondary Tertiary education

Wage rates relative to EU15

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

90 92 94 96 98 00 02 04 06 08 10 12 14

Spain Ireland Portugal

Migration

• Driven by:• Potential earnings differentials• Employment opportunities• Cultural factors

• Differences between labour markets – inflows and outflows• Impact of migration on:

• Receiving labour markets• Origin labour markets

Ireland v UK, Wage Rates

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011

Wage Rates, Manufacturing: Ireland relative to UK

Ireland: Net emigration, % of population

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1927 1937 1947 1957 1967 1977 1987 1997 2007

Net emigration

Unemployment: Implications for Policy?• Largely a national responsibility

• However a European fiscal policy would have helped in the crisis

• How to make European labour markets work• Europe v US

• Supply side measures• Education and training• Activation etc.

• Demand side measures• Costs of employment• Flexibility

AMECO Database

• Many annual variables for EU economies, US, Japan etc.• Don’t assume that the data are always right!• Where available, runs from 1960. Includes EU forecasts to 2016• Be careful that 2014 onwards are EU forecasts!

• Two approaches to accessing it:1. Online: http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfm

2. Excel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheet

• House prices from BIS datatbase:• Online: http://www.bis.org/statistics/pp_detailed.htm#selected

Other Data Used in this Lecture

• Eurostat Labour Force Survey• OECD Economic Outlook• CSO

Presentations

1. The origins and resolution of the current crisis in Estonia, Bulgaria, and Greece (20th February)• What were the origins? How is it resolving? Look at disequilibria in markets

2. The origins and resolution of the current crisis in Latvia, Portugal, and Italy (20th February)• What were the origins? How is it resolving? Look at disequilibria in markets

3. The crisis in Scandinavia (Finland, Sweden, Denmark) 1988-1995 (6th March)• What were the origins? How was it resolved? Look at disequilibria in markets

Reading for this lecture

• Basic text:• Blanchard etc. Probably more theory than you need, but provides the basics

• Chapters 7 and 9

• The rest of the reading discusses real economic situations. • The objective is to evaluate whether labour markets are out of equilibrium

and if so why? How are they adjusting or how have they adjusted? What are the problems?

• In addition to previous reading• http://

www.oecd.org/g20/topics/employment-and-social-policy/G20-labour-markets-outlook-key-challenges-and-policy-responses.pdf

• On Spain http://www.oecd.org/els/emp/SpainLabourMarketReform-Report.pdf• On labour market reforms http://www.oecd.org/site/sgemrh/46190166.pdf

Reading for this lecture

• As mentioned previously:• FitzGerald, J., 2013 “Financial crisis, economic adjustment and a return to growth in the EU”, Revue de l’OFCE -

Debates and policies, No.127 pp. 277-302 http://www.ofce.sciences-po.fr/pdf/revue/127/revue-127.pdfLook at one or two of these publications for the EU and its component economies• IMF World Economic Outlook, October 2014. http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/text.pdf• OECD Economic Outlook, November 2014,

http://www.oecd.org/eco/outlook/General-assessment-of-the-macroeconomic-situation.pdf• National Institute Economic Review, November 2014, http://ner.sagepub.com/content/230/1.toc• European Commission: European Economic Forecast, Winter 2014 http://

ec.europa.eu/economy_finance/publications/european_economy/2014/pdf/ee2_en.pdf• See http://www.oecd.org/eco/surveys/ for surveys of individual countries. They don’t do Bulgaria and Latvia