Macroeconomics & The global economy

Ace Institute of Management

Chapter 6: Unemployment

InstructorSandeep Basnyat

Sandeep_basnyat@yahoo.com9841 892281

Unemployment- Major Macroeconomic Issue

• Major concern for all government• Develop policies to curb unemployment

or increase employment rate.• However…

U.S. Unemployment, 1958-2002

2

3

4

5

6

7

8

9

10

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1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Per

cen

t o

f la

bo

r fo

rce

Unemployment rate Natural rate of unemployment

What determines the natural rate of unemployment?

Natural Rate of Unemployment• Natural rate of unemployment:

the average rate of unemployment around which the economy fluctuates.

• In a recession, the actual unemployment rate rises above the natural rate.

• In a boom, the actual unemployment rate falls below the natural rate.

A first model of the natural rate

Notation:

L = # of workers in labor force

E = # of employed workers

U = # of unemployed

U/L = unemployment rate

L = E+U or E = L – U or U = L - E

Assumptions:1. L is exogenously fixed.

2. During any given month,

s = fraction of employed workers that become separated from their jobs,

f = fraction of unemployed workers that find jobs.

s = rate of job separations

f = rate of job finding

(both exogenous)

The steady state condition• Definition: the labor market is in

steady state, or long-run equilibrium, if the unemployment rate is constant.

• The steady-state condition is:s E = f U

# of employed people who lose or leave their jobs

# of unemployed people who find jobs

The transitions between employment and unemployment

Employed Unemployed

f U

s E

Solving for the “equilibrium” U rate f U = s E

= s (L –U )

= s L – s U

f xU + sU = s L

or, (f + s)U = s L

so,

Or,

Example:

• Each month, 1% of employed workers lose their jobs (s = 0.01)

• Each month, 19% of unemployed workers find jobs (f = 0.19)

• Find the natural rate of unemployment:

0.010.05, or 5%

0.01 0.19U sL s f

Policy implication

• A policy that aims to reduce the natural rate of unemployment will succeed only if it lowers s or increases f.

Why is there unemployment?

• There are two reasons:1. Job search

2. Wage rigidity

Job Search & Frictional Unemployment

• frictional unemployment: caused by the time it takes workers to search for a job

• occurs even when wages are flexible and there are enough jobs to go around

• occurs because workers have different abilities, preferences jobs have different skill requirements geographic mobility of workers not

instantaneous flow of information about vacancies and job

candidates is imperfect

Sectoral shifts• def: changes in the composition of demand among

industries or regions

• example: Technological change increases demand for computer repair persons, decreases demand for typewriter repair persons

• example: A new international trade agreement causes greater demand for workers in the export sectors and less demand for workers in import-competing sectors.

• It takes time for workers to change sectors, so sectoral shifts cause frictional unemployment.

Industry shares in U.S. GDP, 1960

4.2%28.0%

9.9%

57.9%

Agriculture

Manufacturing

Other industry

Services

Source: World Development Indicators, World Bank

Industry shares in U.S. GDP, 1997

1.7%17.8%

8.5%

72.0%

Agriculture

Manufacturing

Other industry

Services

Source: World Development Indicators, World Bank

Even the “tiny” category of agriculture drops by more than half : from 4.2% to 1.7% of GDP.

Sectoral shifts abound

• more examples: Late 1800s: decline of agriculture, increase in

manufacturing Late 1900s: relative decline of manufacturing,

increase in service sector 1970s energy crisis caused a shift in demand away

from huge gas guzzlers toward smaller cars.

• Sectoral shifts occur frequently, contributing to frictional unemployment.

For your information

Assess the trend in sectoral shift in the industrial sectors in:1.Nepal2.India3.China4.Japan5.South Korea6.Taiwan7.Malaysia, and8.Vietnam

Public Policy and Job Search

Govt programs affecting unemployment Govt employment agencies:

disseminate info about job openings to better match workers & jobs

Public job training programs:help workers displaced from declining industries get skills needed for jobs in growing industries

Unemployment insurance (UI)

• UI pays part of a worker’s former wages for a limited time after losing his/her job.

• UI increases search unemployment, because it:– reduces the opportunity cost of being

unemployed– reduces the urgency of finding work– hence, reduces f

• Studies: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.

Benefits of UI• By allowing workers more time to

search,UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes.

Why is there unemployment?

• There are two reasons:1. job search

2. wage rigidity

DONE Next

Unemployment from real wage rigidity

Labor

Real wage

Supply

Demand

Unemployment

Rigid real wage

Amount of labor willing to work

Amount of labor hired

If the real wage is stuck above the eq’m level, then there aren’t enough jobs to go around.

Unemployment from real wage rigidity

If the real wage is stuck above the eq’m level, then there aren’t enough jobs to go around.

Then, firms must ration the scarce jobs among workers.

Structural unemployment: the unemployment resulting from real wage rigidity and job rationing.

Reasons for wage rigidity1. Minimum wage laws

2. Labor unions

3. Efficiency wages (employers offer high wage as incentive for worker productivity and loyalty)

The minimum wage : US Case Study

• In Sept 1996, the minimum wage was raised from $4.25 to $4.75. Here’s what happened:

Unemployment rates, before & after

3rd Q 1996 1st Q 1997

Teenagers 16.6% 17.0%

Single mothers

8.5% 9.1%

All workers 5.3% 5.3%

Other studies: A 10% increase in the minimum wage increases teenage unemployment by 1-3%.

Labor unions• Unions exercise monopoly power to

secure higher wages for their members. • When the union wage exceeds the eq’m

wage, unemployment results. • Employed union workers are insiders

whose interest is to keep wages high. • Unemployed non-union workers are

outsiders and would prefer wages to be lower (so that labor demand would be high enough for them to get jobs).

Efficiency Wage Theory• Theories in which high wages increase worker

productivity: – attract higher quality job applicants – increase worker effort and reduce “shirking”– reduce turnover, which is costly – improve health of workers

(in developing countries)

• The increased productivity justifies the cost of paying above-equilibrium wages.

• The result: unemployment

Wage Inflation and UnemploymentWage Inflation and Unemployment

• In 1958, economist A W Philips, through empirical study of Britain’s economy, concluded that there exists inverse relationship between wage Inflation and Unemployment

• It shows the trade-off between wage inflation and unemployment.

Logic:1. When Labour demand is high, most of the labour get

employed and labour market is in shortage of labour or tight.

2. Labour unions find opportunities to bargain with employers or they have high bargaining power for increasing wage rates faster.

3. So, Lower the unemployment rate, higher the wage rate.

Relationship Between Inflation and Unemployment

1. Faster increase in wage rates will result in faster increase in disposable income of the labour causing higher increase in price level or inflation.

2. Conclusion: Higher the employment rate or Lower the Unemployment rate, higher the inflation rate.

The Phillips CurveThe Phillips CurveThe Phillips curve shows the relationship between the

inflation rate and the unemployment rate.

• This macroeconomic relationship has been widely studied.

• It shows that there is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate.

Unemployment and GrowthUnemployment and Growth

• In 1960s, Arthur Okun, through empirical study, concluded that there exists inverse relationship between unemployment and economic growth

• He concluded that one percent decrease in unemployment will increase the output by 2.5 percent in the short run.

• This law is known as Okun’s Law• This relation can be used to deduce inflationary

pressure curve, which along with Phillips curve gives the short run rate of inflation and unemployment

Criticism of Phillip Curve-Non Trade offCriticism of Phillip Curve-Non Trade off

Milton Friedman:• Downward sloping curve is a short run and in

the long run Phillips curve become vertical line– In the long run, Phillips curve shifts constantly due

to improvement in economic situations (such as labour market reform, labours wanting stability, increased competition in labour market etc. )

– Regardless of the rate of inflation, there is only one rate of unemployment in the long run, that is natural rate: NAIRU (Non Accelerating Rate of Unemployment).

Criticism of Phillip Curve-Non Trade offCriticism of Phillip Curve-Non Trade off

A

B C

Inflation Rate

Unemployment RateInitial SR Phillips Curve

New SR Phillips Curve

For further info: Macroeconomic Analysis, Edward ShapiroMacroeconomics, Theory and Policy, D.N. Dwivedi

Thank You