Forex Educational Library

Labor Market and its Implications


One of the aspects that matter most to people about economics is the labor market. It is of special interest because much of the population is active in this market, so it is important to analyze how it behaves, which variables are more important to determine wages. In addition, what problems imply some policies that in the first instance try to protect workers, but end up affecting it as it is the minimum wage. Likewise, unions represent certain frictions in the labor market that, consequently, have undesirable negative effects.



The labor market in the economy is one of the most important issues in the economy. To analyze how the job market behaves some concepts must be clear

  • Active population: Sum of people who are working or looking for work.
  • Inactive population: People who do not work and do not seek work.
  • Activity Rate: Active population/working-age population. In Europe, as well as most developed countries the rate of activity has increased over time due to the inclusion in women’s labor market, although this fact does not occur in all countries.
  • Unemployment rate: unemployed/active population. The unemployment rate can reflect two different realities. It can reflect an active labor market where there are large numbers of layoffs, but also of hiring. Or it can reflect a stagnant job market where there is little movement. To find out what is behind the aggregate unemployment rate, workers ‘ movements need to be analyzed and this data can be obtained from quarterly surveys conducted in the countries.

The following charts show the rates of participation of men and women respectively in the labor market

Labor market and its implications

Graph 15. Labor force participation rate, male. Data taken from the World Bank

Labor force participation rate female


Graph 16. Labor force participation rate, female. Data taken from the World Bank.

It’s important to keep in mind that many times the surveys carried out and the numbers given by the media do not reflect the reality, because in some cases people looking for work stop looking because they do not find and take these people as an inactive population and this reduces the unemployment rate which politicians use to say that the economy has a good performance which is not true. So, to have a complete picture of job creation and destruction and to know if it is true the unemployment rate is better to review workers ‘ movement surveys.

The job market like any other market has a price variable, which is the salary. Salaries are determined in many ways, sometimes they are determined by collective bargaining between companies and workers, but these negotiations do not cover all workers. Some negotiations are bilateral between a businessman and a private worker. Although in each country differs in the way wages are adjusted, a theory can be developed to explain how the salaries are determined.

According to economic theory, workers usually receive a higher salary than their reserve salary which is the minimum level at which workers are indifferent between working or not. That is, most people receive a salary that at least encourages them to work. Moreover, salaries depend on the situation of the labor market. When the unemployment rate decreases the wages increase because there are fewer job offers. Even when there is no collective bargaining between employers and workers, workers have some bargaining power that they can use to get better wages than their reserve wages

Some companies can pay higher salaries than others to encourage their employees or attract more skilled workers. In the negotiations the companies consider the costs of hiring an employee, the costs of firing him and how much it would cost him to maintain these. The more expensive it is for a company to replace its workers, it will be willing to pay more to keep them. But this is not the only reason to pay better salaries some companies want their workers to be more comfortable in their work and have better performance, so they decide to pay salaries that are called efficiency wages.

As previously mentioned the labor market situation also influences wages. When the unemployment rate is low it is harder to find skilled workers, so wages increase. The following charts show the unemployment rate of several countries and the growth of production.

Unemployment rate

Graph 17. Unemployment rate. Data taken from the World Bank


Gross Domestic Product


Graph 18. Gross Domestic Product. Data taken from the World Bank

Now it will be analyzed some variables that affect the wage negotiation. On the one hand, workers do not care about the level of nominal wages, but they do care about real wages as this indicates how many goods can be bought. On the other hand, companies do not care how much the salary they pay, but they care about the relationship between the salary they pay and the price of the goods they sell. As these variables are those that come into the decisions of the agents, this article must analyze what happens when they change. For example, if the price level increases in a certain proportion, workers will ask for an increase of at least the magnitude of the price increase as their purchasing power is reduced. Companies will be willing to increase maximum wages in the magnitude that increased the prices. But the decision to set wages will depend primarily on the bargaining power of each agent

Given the above, the existence of trade unions are important as they have more bargaining power than people individually. If there are unions, they will ask that the wage increase be at least the magnitude of the inflation. But if companies are the ones with the decision-making power, they will make the decision to raise wages less than inflation, as they earn a higher income by having better sales margins. Likewise, the existence of a minimum wage or unemployment insurance would alter the labor market.

If there is unemployment insurance in an economy, people will have a higher reserve salary because when they are unemployed they will have an income for a certain amount of time, so it will be harder for them to work for a low salary. This gives a little bit of bargaining power to the workers because if they don’t feel motivated by a company they will decide to quit and be unemployed for a while until they find a job that motivates them enough. Efficiency wages will also have to be higher because it is not so expensive to be unemployed for people.

Another variable affecting wage fixing is the existence of a minimum wage or protection of workers as it may be in some cases that the minimum wage is higher than the reserve salary of the people so that it will be positive for the workers but for companies will be a contracting barrier and in some cases it can increase the unemployment rate in the countries because if the minimum wage level is above the productivity of the workers and is greater than their reserve salary will be very expensive for companies to hire and decide to hire less or use machines that lower their production.

Now it will analyze the aggregate supply of goods and their relationship with the labor market. An increase in production causes an increase in employment. The increase in employment causes a decrease in unemployment and therefore in the unemployment rate, which causes nominal wages to rise as well since it is more difficult for companies to replace their workers. The rise in nominal wages causes prices to rise on the part of companies. These effects also affect the agent’s expectations if prices are expected to increase in a certain proportion in the future in the negotiations, the salary will be asked to increase in the same way.

In the demand when there is an increase in the price level this causes a reduction in production as it decreases the real quantity of the amount of money which leads to an increase in the interest rate which in turn leads to a decrease in the demand for goods and services. Production depends negatively on taxes and positively on the real amount of money in the economy and on public spending.

In some situations, in the short term, production is higher than the natural level of the economy, that is, the economy is producing beyond its capabilities. When this happens, the price level increases which leads to higher expected inflation and this ends up impacting wage negotiations. The above effect concludes with a decrease in the real amount of money which generates an increase in the nominal interest rate and this reduces the levels of production taking it to its natural level. It is normal that in the short term the growth of production is above or below the natural level, but in the long term, these imbalances are eliminated.

After analyzing the aggregate demand, the short and medium-term effects of an expansionary monetary policy will be analyzed. In principle, when a central bank emits more money to the economy, the amount of real money increases and therefore production does so in the short term. This leads to an increase in the price level which affects the price expectations. The effect of monetary expansion dissipates when production returns to its natural level thanks to the fact that price expectations adjust to this new scenario leading to higher wages in the short term.

On the other hand, inflation also affects the supply and aggregate demand for goods. An increase in expected inflation causes an increase in effective inflation since there are several channels of transmission of these expectations. A channel is the negotiation of contracts because if they expect a higher price level in the future they will set higher nominal wages, which in effect leads to higher prices in the future. Inflation is also related to unemployment since when there is an increase in the unemployment rate this causes a decrease in inflation. This occurs because an increase in unemployment causes a reduction in nominal wages, which directly leads to a reduction in the price level.

In conclusion, the labor market is very important for people because they are constantly involved in it. In some countries, there are rigidities in this market that end up affecting the whole economy as we saw in this article because it ends up affecting inflation and production. Unemployment insurance, a high degree of employee protection, forms of wage negotiations and the minimum wage are some of the rigidities that the labor market faces. When the inflation rate reaches a high level, inflation tends to be more variable and consequently, the agents of the economy are more reluctant to sign long-term contracts that are not flexible. That is why salary negotiations are done every year or even for shorter periods of time.

In the medium term, the growth of production is equal to the normal rate of growth, unemployment is equal to its natural rate and both variables are independent of the growth of the nominal amount of money. The growth of the nominal amount of money only affects inflation. That is, inflation is always a purely monetary phenomenon since, in the presence of other factors such as monopolies, unions, and strikes, fiscal deficits do not affect inflation unless they affect the nominal amount of money.




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