Labor Market Economics

name: labor-markets description: Labor market economics — unemployment, wages, Phillips Curve. Cover NAIRU, Phillips Curve, Okun's law.

When to Activate

• Analyzing unemployment dynamics (structural, cyclical, frictional)
• Estimating the NAIRU and its implications for monetary policy
• Applying the Phillips Curve to assess inflation-unemployment trade-offs
• Using Okun's Law to relate output gaps to unemployment
• Evaluating wage growth dynamics and labor share of income
• Assessing labor market tightness and its implications for inflation
• Analyzing minimum wage effects on employment and welfare
• Evaluating labor market policies (active vs passive measures)
• Comparing labor market institutions across countries

Core Concepts

Types of Unemployment

Type	Definition	Duration	Policy Response
Frictional	Workers transitioning between jobs; normal search process	Short-term	Improve information, matching platforms
Structural	Mismatch between worker skills and job requirements	Long-term	Retraining, education, relocation support
Cyclical	Demand-deficient unemployment during recessions	Varies with cycle	Fiscal/monetary stimulus
Seasonal	Predictable fluctuations (tourism, agriculture, construction)	Recurring	Seasonal adjustment in data

Measurement:

Unemployment rate = Unemployed / Labor Force x 100%
Labor force = Employed + Unemployed (actively seeking work)
Participation rate = Labor Force / Working-age Population x 100%
Employment rate = Employed / Working-age Population x 100%

Broader measures:
  U-3: Official unemployment rate (ILO definition)
  U-6: Includes marginally attached workers and involuntary part-time
       (better measure of labor market slack)

Beveridge Curve: Relationship between vacancy rate and unemployment rate
  - Outward shift = increased mismatch (structural unemployment rising)
  - Movement along curve = cyclical changes

NAIRU (Non-Accelerating Inflation Rate of Unemployment)

The unemployment rate consistent with stable inflation. Below NAIRU, inflation accelerates; above NAIRU, inflation decelerates.

NAIRU estimation approaches:
  1. Phillips Curve estimation: Extract NAIRU as the unemployment rate
     where inflation is stable (inflation expectations = actual inflation)
  2. Kalman filter / state-space models: Estimate time-varying NAIRU
  3. Structural models: Based on wage-setting and price-setting equations
  4. Reduced-form: HP filter or similar statistical decomposition

Typical NAIRU estimates (as of mid-2020s):
  US:          ~4.0-4.5%
  Eurozone:    ~6.5-7.0%
  Germany:     ~3.0-3.5%
  UK:          ~4.0-4.5%
  Japan:       ~2.5-3.0%

NAIRU is NOT constant — it shifts due to:
  - Labor market reforms (flexibility, matching efficiency)
  - Demographic changes (aging workforce)
  - Globalization and trade openness
  - Hysteresis effects (prolonged unemployment raises NAIRU)
  - Technology and automation

Policy significance: Central banks use NAIRU estimates to gauge labor market slack and calibrate monetary policy. If unemployment < NAIRU, expect inflationary pressure. Wide uncertainty bands around NAIRU estimates limit its precision as a policy guide.

Phillips Curve

Original Phillips Curve (1958): Negative relationship between wage growth and unemployment.

Expectations-Augmented Phillips Curve (Friedman-Phelps):

pi = pi_e - beta * (u - u*) + supply_shock

pi     = actual inflation
pi_e   = expected inflation
u      = actual unemployment rate
u*     = NAIRU
beta   = slope parameter (sensitivity of inflation to unemployment gap)
supply_shock = cost-push factors (oil prices, exchange rate, etc.)

When u < u*: inflation exceeds expectations (economy overheating)
When u > u*: inflation falls below expectations (slack in economy)
When u = u*: inflation equals expectations (stable)

New Keynesian Phillips Curve:

pi_t = beta * E[pi_t+1] + kappa * x_t

pi_t      = current inflation
E[pi_t+1] = expected future inflation (forward-looking)
x_t       = output gap (or real marginal cost)
kappa     = slope (sensitivity to the output gap)

Key feature: Forward-looking expectations (rational expectations),
not backward-looking (adaptive expectations)

Phillips Curve flattening: Since the 1990s, the Phillips Curve has appeared flatter in many economies — inflation is less responsive to unemployment changes. Explanations:

• Better-anchored inflation expectations
• Globalization (global slack matters, not just domestic)
• Gig economy and labor market flexibility
• Measurement issues (output gap uncertainty)
• Non-linear: Curve may steepen at very low unemployment rates

Okun's Law

Relationship between output gap and unemployment gap:

u - u* = -beta * (Y - Y*) / Y*

Typical beta: ~0.4-0.5 for the US
  → A 1 percentage point increase in unemployment corresponds to
    roughly 2-2.5% decline in GDP relative to potential

Alternative (growth rate form):
  Change in u = -beta * (g - g*)

  g   = actual GDP growth
  g*  = potential GDP growth (typically ~2% for advanced economies)
  beta = ~0.4-0.5

  → If GDP growth is 1pp below potential, unemployment rises ~0.4-0.5pp

Limitations:

• Relationship varies across countries (labor market flexibility matters)
• Asymmetric: Unemployment rises faster in downturns than it falls in recoveries
• Structural breaks possible (post-crisis periods may shift the relationship)
• Labor hoarding in some countries dampens the response

Wage Determination

Wage-setting frameworks:

• Marginal productivity theory: Wages = marginal product of labor in competitive markets
• Efficiency wages: Firms pay above market-clearing wages to reduce turnover, increase effort, and attract better workers
• Insider-outsider theory: Employed workers (insiders) have bargaining power; unemployed (outsiders) cannot underbid them due to hiring/firing costs
• Collective bargaining: Wages set through negotiations between unions and employers. Wage outcomes depend on union density, bargaining coverage, and coordination

Wage Phillips Curve:

Nominal wage growth = Inflation expectations + Productivity growth - beta * (u - u*)

Real wage growth should track productivity growth in equilibrium.
If real wages grow faster than productivity → unit labor costs rise → inflationary
If real wages grow slower than productivity → labor share of income falls

Labor share of income:

• Labor share = Total compensation / GDP
• Declining trend in many advanced economies since the 1980s
• Drivers: Globalization, automation, declining union power, superstar firms, capital-biased technical change

Labor Market Institutions

Institution	Effect on NAIRU	Effect on Resilience
Employment protection (strict)	Raises NAIRU (slower adjustment)	Dampens cyclical fluctuations
Unemployment benefits (generous)	Raises NAIRU (higher reservation wage)	Provides automatic stabilization
Active labor market policies	Lowers NAIRU (better matching)	Supports reallocation
Minimum wage (moderate)	Ambiguous (depends on level)	Floor on wages, may reduce inequality
Collective bargaining (coordinated)	Lowers NAIRU (wage moderation)	Facilitates adjustment
Flexible contracts (widespread)	Lowers NAIRU (easier hiring)	Increases volatility (dual labor market)

Methodology

1. Labor market slack assessment: Compare unemployment rate to NAIRU estimate; examine U-6, participation rate, and vacancy-unemployment (Beveridge Curve) data
2. Phillips Curve estimation: Estimate the relationship between inflation and unemployment using appropriate specification (expectations-augmented or New Keynesian)
3. Okun's Law application: Estimate the output gap implied by unemployment data, or vice versa
4. Wage dynamics analysis: Decompose wage growth into productivity, inflation expectations, and labor market tightness components
5. Policy evaluation: Assess impact of labor market reforms on NAIRU, employment, and welfare
6. Cross-country comparison: Compare labor market outcomes relative to institutional frameworks

Templates

Labor Market Dashboard

Country: __________    Period: __________

Employment Indicators:
  Unemployment rate (U-3):        ____%    (NAIRU estimate: ____%)
  Unemployment rate (U-6):        ____%
  Labor force participation:      ____%
  Employment rate:                ____%
  Vacancy rate:                   ____%
  V/U ratio:                     _____

Wage Indicators:
  Nominal wage growth (YoY):      ____%
  Real wage growth (YoY):         ____%
  Productivity growth (YoY):      ____%
  Unit labor cost growth (YoY):   ____%
  Labor share of GDP:             ____%

Phillips Curve Assessment:
  Unemployment gap (u - u*):      ____%
  Implied inflation pressure:     [ ] Disinflationary  [ ] Neutral  [ ] Inflationary

Okun's Law Implied:
  Output gap from unemployment:   ____%
  Consistent with GDP growth:     ____%

Quality Gate

• Unemployment decomposed by type (frictional, structural, cyclical)
• NAIRU estimate used with explicit uncertainty range acknowledged
• Phillips Curve specification appropriate (expectations-augmented or NK)
• Phillips Curve flattening considered when interpreting slope estimates
• Okun's Law coefficient appropriate for the country analyzed
• Wage growth decomposed into productivity, expectations, and slack components
• Broader measures of slack considered (U-6, participation, underemployment)
• Labor market institutions accounted for in cross-country comparisons
• Beveridge Curve shifts assessed for structural change in matching efficiency
• Distributional effects of labor market conditions analyzed (by skill, age, region)