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Most governments have the key macroeconomic objective of achieving low levels of unemployment.
Not being employed does not necessarily mean being unemployed. Unemployment occurs when a person who is actively searching for employment is unable to find work.
Stay at home mothers and fathers, the retired, students and prisoners are all people who are not working, but neither are they actively seeking work – these people would not figure in the unemployment rate for a country or region.
Unemployment is often used as a measure of the health of the economy. The most frequently measure of unemployment is the unemployment rate, which is the number of unemployed people divided by the number of people in the labour force.
The labour force is defined simply as the people who are willing and able to work – they are either working or actively seeking work.
The percentage of the working-age population (15-64 years of age) working or actively seeking work is the labour force participation rate.
The size of the labour force is used to determine the unemployment rate:
1. Calculating the unemployment rate: worked example:
Country A’s labour force = 40 million people (i.e., either working or actively seeking work).
The total number of those that are unemployed = 6 million people (i.e., not in employment and actively seeking employment).
The calculation is as follows:
Labour force and unemployment
What is unemployment?
labour force participation rate
2. Calculating the size of the labour force: worked example:
Determine the size of the labour force when the rate of unemployment is 8% and total unemployment = 12 million people.
The calculation is as follows:
3. Calculate the number of unemployed: worked example:
Determine the number of unemployed when the rate of unemployment is 5% and the labour force = 8 million people.
The calculation is as follows:
Essential statement: Unemployment can be unequally distributed between geographic regions, ages, ethnic groups and genders
Difficulties in measuring unemployment
Difficulties in measuring unemployment – hidden unemployment:
Economic costs of unemployment
Essential statement: There are private and external costs (negative externalities) that are caused by unemployment. There is a decrease in tax revenues and an increase in government expenditure causing the government budget to worsen (i.e., a reduced surplus, increased deficit or moving from surplus to deficit).
Structural Unemployment: Structural unemployment occurs due to the structural changes within an economy. This type of unemployment occurs when there is a mismatch of skilled workers and occupational vacancies in the labour market. Some of the causes of the structural unemployment are geographical immobility (difficulty in moving to a new work location), occupational immobility (difficulty in learning a new skill) and technological change (introduction of new techniques and technologies that need less labour force). Structural unemployment depends upon the growth rate of an economy and also on the structure of an industry.
Seasonal unemployment occurs when people are unemployed at certain times of the year, because they work in industries where they are not needed all year round. Examples of industries where demand, production and employment are seasonal include tourism and leisure, farming, construction and retailing.
For example, in a Ski resort unemployment is likely to be higher in the summer when there is no snow.
Often unemployment falls around Christmas time because extra jobs are available (e.g. Royal Mail taking on extra workers for mail delivery).
The government often produce seasonally adjusted unemployment statistics to take into account these seasonal variations.
In tourist areas, seasonal unemployment could be a big problem because work is only available for a few months a year.
Four types of unemployment in the AS/AD model
Frictional unemployment is transitional unemployment due to people moving between jobs e.g. new entrants to the labour market. There are always hundreds of thousands of job vacancies in modern economies such as the UK, so a degree of frictional unemployment is both unavoidable and (to an extent) desirable so that jab vacancies can be filled.
This is unemployment that occurs from the inevitable time delays in finding new employment in a free market. It may also be called ‘search unemployment as it relates to the time taken to search for new employment.
For example, if you graduate from university, you can’t necessarily expect to find a job straight away which matches your skills. This period of searching for a job is known as frictional unemployment.
Frictional unemployment will also occur when people are switching between jobs, either because they have been made redundant or are looking for new employment.
Frictional unemployment would generally be classed as voluntary unemployment because workers are choosing to remain unemployed rather than get the first job that comes along.
The concept of full employment would acknowledge the existence of some frictional unemployment. For example, if frictional unemployment accounts for 2% of workforce; an unemployment rate of 2% would be considered to be ‘full employment’.
Cyclical (demand-deficient) unemployment
Cyclical unemployment is involuntary unemployment due to a lack of demand for goods and services. This is also known as Keynesian unemployment or demand-deficient unemployment.
When there is a recession or a steep slowdown in growth, we see a rising unemployment because of plant closures, business failures and an increase in worker lay-offs and redundancies. This is due to a fall in demand leading to a contraction in output across many industries.
Firms are likely to reduce employment to cut costs and/or maintain profits – this is called “labour shedding" or “down-sizing"
The economy does not have to go into recession for cyclical unemployment to start rising. Many jobs can be lost even in a slowdown phase and one reason for this is because of rising productivity. Say for example that a country's GDP is expanding at 1 per cent a year but output per worker is growing by 3 per cent. This means that the same national output can be produced using fewer workers.
Cyclical unemployment has been a major problem for a number of European Union economies who have suffered from a deep and persistent recession in recent years.
Cyclical unemployment is most likely to occur when there is a negative output gap.
Evaluating government unemployment policies
Policies for cyclical (DEMAND DEFICIENT) unemployment
Low levels of aggregate demand is the cause of cyclical (demand-deficient) unemployment. The government can attempt to boost levels of aggregate demand in the economy through running an expansionary fiscal policy.
Fiscal policy: The use of government revenue collection (mainly taxes) and expenditure (spending) to influence the level of economic activity.
Expansionary fiscal policy is an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease.
Increased government spending and/or decreased taxes increases aggregate demand.
Governments can run a budget deficit to boost aggregate demand in the economy and shift the level of employment closer to Y1, the full employment level of output. A budget deficit is when government expenditures are greater than government revenues. A budget deficit acts as an injection into the circular flow of income and expenditure because the government is in effect borrowing to increase its spending or to finance the short fall of revenue that results from tax cuts.
Government spending is a core component of aggregate demand and increases in government spending will increase aggregate demand and reduce the amount of cyclical (demand-deficient) unemployment in the economy. The mechanisms through which aggregate demand increase with an expansionary fiscal policy include:
Decreased interest rates increase aggregate demand, and increased aggregate demand shifts the economy closer to the full employment level of output and decreases unemployment.
Monetary policy: The process by which the monetary authority of a country, like the central bank, controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability.
Central bank: A national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.
Independent central banks can set interest rates to influence levels of employment or unemployment in the economy. For example, in the US the Federal Reserve (America’s central bank) has the objective of maximum employment. If the central bank has an unemployment objective and unemployment looks likely to increase in the short-to-medium term, it will decrease interest rates in the economy.
Lower interest rates have various economic effects:
Therefore, lower interest rates will tend to increase consumer spending and investment. This will lead to an increase in aggregate demand: increaseAD = increaseC + increaseI + G + increase(X – M).
Higher AD causes:
Expansionary monetary policy: The central bank decreases the base interest rate in an economy causing borrowing for consumption and investment to become relatively less expensive and the exchange rate to depreciate.
This is the opposite of contractionary monetary policy, which has the opposite effect – increasing unemployment (usually in an effort to maintain price stability in the face of rising average prices).
Contractionary monetary policy: The central bank increases the base interest rate in an economy causing borrowing for consumption and investment to become relatively more expensive and the exchange rate to appreciate (results in increased unemployment).
Supply-side policies to reduce structural unemployment
Supply side policies are government policies which seek to increase the productivity and efficiency of the economy.
Supply side policies aim to increase long term competitiveness and productivity. For example, it was hoped that privatisation and deregulation would make firms more productive and competitive. Therefore, in the long run supply side policies can help increase the level of employment in an economy as firms expand and grow. However, supply side policies work very much in the long term; they cannot be used to reduce sudden increases in the unemployment rate. Also, there is no guarantee government supply side policies will be successful in reducing unemployment.
Supply-side policies can involve interventionist supply side policies (e.g. government spending on education) or free market supply side policies (e.g. reduce government legislation)
The main macro-economic objectives of the government include:
To achieve all objectives simultaneously it is essential to improve the supply side of the economy. If the government can increase productivity and shift AS to the right, it can enable employment to grow and unemployment to fall without the inflationary pressures associated with increasing aggregate demand.
To attain rates of low unemployment, supply side policies can help reduce costs and increase productivity. For example, privatisation and deregulation can help reduce costs, lower costs increase the profitability of firms which, in turn, increase the supply of goods and services and employ more workers to do so.
Suggested supply side policies to reduce unemployment:
Demand-deficient unemployment. Supply side policies will not reduce unemployment caused by a fall in aggregate demand (demand-deficient unemployment). They can only reduce long term structural unemployment (i.e., the natural rate of unemployment).
However, in maintaining a low level of unemployment, the most significant factor in the short-run is the use of monetary policy and controlling AD through interest rates. Supply side policies will take a long time to have any effect on reducing unemployment.
Supply side policies can be very beneficial. However, in practise it is not always so easy to increase productivity. Also, there is a limit to how much benefit they can give, it is often more appropriate to use demand side policies.
An Evaluation of government policies
Advantages of monetary policy in setting interest rates:
Limitations of the monetary policy’s effectiveness:
In sum, monetary policy has done a good job so far in developed countries. However the real test may come when there is a rise in structural unemployment caused by global instability, the continued automation of jobs and globalisation.
Supply-side policies to attain low unemployment. Supply side policies can help reduce costs and increase productivity. For example, privatisation and deregulation can help reduce costs. However, in the control of unemployment, the most significant factors depend on the type of unemployment.
Natural Rate of Unemployment
The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium.
It is the difference between those who would like a job at the current wage rate and those who are willing and able to take a job.
The natural rate of unemployment will therefore include:
The natural rate of unemployment will have zero cyclical (demand-deficient) unemployment and the economy will be operating at YF – the full employment level of output.
The natural rate of unemployment is unemployment caused by supply side factors rather than demand side factors.
NAIRU is an acronym for non-accelerating inflation rate of unemployment, and refers to a level of unemployment below which inflation rises.
the Four Types of unemployment
In theory the government can increase spending and/or decrease taxes to reduce aggregate demand. As aggregate demand increases there is more demand from firms for the factors of production, especially labour. Any increase in aggregate demand is going to be associated with decreased demand-deficient unemployment. However, there is also going to be an inflationary affect from the government stimulating aggregate demand.
In fact, the monetarist theory of aggregate demand and supply states that any attempt by the government to increase aggregate demand is only going to lead to a long-term increase in the price level.
There is a trade-off faced here between inflation and unemployment, but only in the short-run. There is no trade-off between inflation and unemployment in the long-run.
The monetarist theory of AD/AS states that in the long-run the economy will automatically return to the full employment level of output.
Increases in aggregate demand cause wage rates to rise (as labour becomes scarce) and SRAS shifts left as costs of production increase.
Monetarists thus conclude that there is no long-term trade-off between inflation and unemployment.
Consider the diagram below. If, for example, aggregate demand increases because the exchange rate depreciates making exports relatively more profitable and imports relatively more expensive: increaseAD = C + I + G + (increaseX – decreaseM), then the following sequence of events occur:
Increased government spending and/or decreased taxation revenues worsens the government’s fiscal position. Budget deficits add to the national debt. However, there are some automatic stabilisers.
As aggregate demand increases, tax revenues increase and government expenditure on transfer payments (e.g., unemployment benefits) and education and training programmes decrease. Higher tax revenues and lower government spending will increase a budget surplus, decrease a budget deficit or close an existing budget deficit, depending on how the government’s books were balanced prior to an expansionary fiscal policy being implemented.
Incentives of tax cuts. Decreasing taxes to increase AD may cause added incentives to work because households will have higher disposable incomes. If this occurs there will be a rise in productivity and AS could increase. However lower taxes do not necessarily increase incentives to work if the income effect dominates.
Other issues associated with a contractionary fiscal policy:
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