Macroeconomic Labor Market

The macroeconomic labor market represents the demand and supply for all labor in the economy.
The y-axis represents the average real wage rate (W), adjusted for inflation.
The x-axis shows the number of workers (Q).
Aggregate Demand for labor (AD) slopes downwards: lower real wages encourage producers to hire more labor; higher wages cause firms to reduce labor, possibly using more capital.
AD depends on aggregate demand in the economy: increased AD means increased labor demand and vice versa.
Aggregate Supply of labor (AS) slopes upwards: higher average wage rates encourage more people to work.
Equilibrium is where AD equals AS.
The equilibrium wage for the economy is established by this interaction of AD and AS, and is shown on the diagram as W_e.

Cyclical unemployment arises from a downturn in economic activity.
A fall in demand leads to a reduction in demand for labor.
Assume that the initial level of economic activity results in demand for labor at AD1 and an equilibrium wage of W1.
If the economy slows, the demand for labor falls from AD1 to AD2.
Labor markets may not function perfectly where wages are flexible downwards.
Wage "stickiness" is likely to lead to disequilibrium and unemployment.
Firms and trade unions may resist wage cuts.
At wage W_1, the aggregate demand for labor is now at point a, indicating unemployment.
This type of unemployment is called cyclical unemployment.