UnemploymentUnemployment

Chapter 11Chapter 11

Economic ConceptsEconomic Concepts

Labor forceLabor force Frictional unemploymentFrictional unemployment Structural unemploymentStructural unemployment Cyclical unemploymentCyclical unemployment Unemployment rateUnemployment rate Marginal propensity to consumeMarginal propensity to consume Marginal propensity to saveMarginal propensity to save Investment multiplierInvestment multiplier Aggregate supply and demandAggregate supply and demand Leakages and injectionsLeakages and injections

Costs of UnemploymentCosts of Unemployment

Economic costsEconomic costs Loss in incomeLoss in income Decrease in consumption and savingDecrease in consumption and saving Inefficient production (operation inside of the PPF)Inefficient production (operation inside of the PPF) Opportunity cost of reducing unemployment is zero (but Opportunity cost of reducing unemployment is zero (but

beware of inflation!)beware of inflation!)

Non-economic costsNon-economic costs Stability of the familyStability of the family Danger of social unrestDanger of social unrest Drug abuseDrug abuse DivorceDivorce CrimeCrime

Labor ForceLabor Force

Labor force consists of all non-Labor force consists of all non-institutionalized individuals 16 years institutionalized individuals 16 years of age and older who are employed of age and older who are employed for pay, actively seeking for pay, actively seeking employment, or awaiting recall from employment, or awaiting recall from a temporary layoffa temporary layoff

Labor ForceLabor Force

Institutionalization: jails, prisons, mental Institutionalization: jails, prisons, mental hospitals, nursing establishmentshospitals, nursing establishments

Minimum legal ageMinimum legal age

Both Both unemployedunemployed and and employedemployed are are included in the labor forceincluded in the labor force

Defining UnemploymentDefining Unemployment

Being without work does not mean Being without work does not mean being unemployedbeing unemployed

You are not unemployed if you are a You are not unemployed if you are a discouraged worker discouraged worker (i.e. not (i.e. not actively actively seeking employmentseeking employment))

Unemployment in a Unemployment in a Competitive MarketCompetitive Market

Two Solutions for Two Solutions for UnemploymentUnemployment

Expand labor demandExpand labor demand

Rely on market forces to bring wages Rely on market forces to bring wages downdown

Types of UnemploymentTypes of Unemployment Frictional unemploymentFrictional unemployment

Brief, transitional, normally as a result of people Brief, transitional, normally as a result of people changing and searching for new jobschanging and searching for new jobs

Not a serious economic problemNot a serious economic problem Structural unemploymentStructural unemployment

Long-run in nature, result of fundamental changes in Long-run in nature, result of fundamental changes in demand for labordemand for labor

Examples: technological change, change in consumer Examples: technological change, change in consumer preferencespreferences

Cyclical unemploymentCyclical unemployment Caused by economic fluctuations (recessions in Caused by economic fluctuations (recessions in

particular)particular) Typical for unemployment rates above 6%Typical for unemployment rates above 6% Object of government policyObject of government policy

Full-Employment Rate of Full-Employment Rate of UnemploymentUnemployment

Defined for Defined for policy purposespolicy purposes as an unemployment rate of as an unemployment rate of 4%-6%4%-6%

Below that range, they talk about frictional or structural Below that range, they talk about frictional or structural unemploymentunemployment

Above that range, it is cyclical unemploymentAbove that range, it is cyclical unemployment

Full-employment unemployment rate is consistent with Full-employment unemployment rate is consistent with priprice ce stabilitystability

Lower rates of Lower rates of naturalnatural (full-employment) unemployment (full-employment) unemployment rates will increase inflationrates will increase inflation

Evolution of Unemployment Evolution of Unemployment RatesRates

Unemployment Rates Over Unemployment Rates Over TimeTime

1960-1961 recession->high unemployment rates1960-1961 recession->high unemployment rates

1966-1969 expansion->below natural 1966-1969 expansion->below natural unemployment ratesunemployment rates

1981-1982 contraction->high unemployment 1981-1982 contraction->high unemployment ratesrates

In general: recession brings about higher than In general: recession brings about higher than natural rates of unemployment, while expansion natural rates of unemployment, while expansion reduces the extent of unemploymentreduces the extent of unemployment

Production and Income Production and Income FlowsFlows

Circular Flow of Economic Circular Flow of Economic ActivityActivity

Two markets are at work: a resource market and Two markets are at work: a resource market and a product marketa product market

Resource and product markets are interrelated: Resource and product markets are interrelated: demand for goods creates a demand for demand for goods creates a demand for resources used to produce those goodsresources used to produce those goods

Two circular flows are involved: flow of Two circular flows are involved: flow of goods/services and flow of moneygoods/services and flow of money

Unemployment has two sides: the demand side Unemployment has two sides: the demand side and the supply sideand the supply side

Aggregate DemandAggregate Demand

Aggregate DemandAggregate Demand is a schedule showing output is a schedule showing output demanded at different price levels: we are talking demanded at different price levels: we are talking about aggregate quantities and aggregate pricesabout aggregate quantities and aggregate prices

Output demanded=Output demanded=Consumer spending + InvestConsumer spending + Investment spending + Government spending + Net exment spending + Government spending + Net exports(exports-imports)ports(exports-imports)

Aggregate DemandAggregate Demand

Factors Determining Factors Determining Consumer SpendingConsumer Spending

Income (+)Income (+)

Wealth (+)Wealth (+)

Interest rates (-)Interest rates (-)

Tastes and preferences (+/-)Tastes and preferences (+/-)

Marginal Propensity to Marginal Propensity to ConsumeConsume

Marginal propensity to consumeMarginal propensity to consume is the change in is the change in consumption divided by the change in income (e.g. consumption divided by the change in income (e.g. MPC=80% means with each increase of income by $1, MPC=80% means with each increase of income by $1, consumers will spend 80% of this one dollar, or 80 cents)consumers will spend 80% of this one dollar, or 80 cents)

Marginal propensity to saveMarginal propensity to save is the change in saving divided is the change in saving divided by the change in income (e.g. in the previous example, the by the change in income (e.g. in the previous example, the MPS will equal 20%MPS will equal 20%

Psychological law of consumptionPsychological law of consumption: when income changes, : when income changes, consumption changes, but by less than the change in consumption changes, but by less than the change in income (meaning you save some money)income (meaning you save some money)

Investment SpendingInvestment Spending

Mainly purchases of new equipment and plantsMainly purchases of new equipment and plants

Determined by the rate of interest and Determined by the rate of interest and expected expected return on investmentreturn on investment When expected return on investment exceeds current When expected return on investment exceeds current

interest rates, investment spending increasesinterest rates, investment spending increases When expected return on investment falls short of the When expected return on investment falls short of the

current interest rates, investment spending goes downcurrent interest rates, investment spending goes down

Expectations are of strategic importance: e.g. Expectations are of strategic importance: e.g. currently rising prices of apartments will most currently rising prices of apartments will most likely lead to drop of real estate returns in the likely lead to drop of real estate returns in the future future

Investment MultiplierInvestment Multiplier

Investment multiplierInvestment multiplier represents the combined effect of a $1 represents the combined effect of a $1 increase in investment spending on income or output increase in investment spending on income or output demandeddemanded

Spending $100 million on constructing a new factory will Spending $100 million on constructing a new factory will increase total spending by more than $100 million due to a increase total spending by more than $100 million due to a chain reaction of consumer spending (for example, chain reaction of consumer spending (for example, construction workers will buy consumer goods)construction workers will buy consumer goods)

Investment multiplier is the Investment multiplier is the reciprocal of MPSreciprocal of MPS or the or the reciprocal of (1-MPC)reciprocal of (1-MPC) Example: for MPC=80%, investment multiplier will be Example: for MPC=80%, investment multiplier will be

1/20%=1/(1-80%)=51/20%=1/(1-80%)=5 Investment multiplier times change in investment equals change Investment multiplier times change in investment equals change

in income (for example, for investment multiplier equal to 5, each in income (for example, for investment multiplier equal to 5, each additional dollar of investment spending will increase income by additional dollar of investment spending will increase income by fivefive dollars) dollars)

Government PurchasesGovernment Purchases

An increase in government purchases (G) produces An increase in government purchases (G) produces a multiplying effect on income, similarly to the a multiplying effect on income, similarly to the increase in investment spendingincrease in investment spending

Government Government transfer paymentstransfer payments do not increase the do not increase the demand for output directly, this is why a $1 demand for output directly, this is why a $1 increase in transfer payments will command a increase in transfer payments will command a lower multiplier compared to a $1 increase in lower multiplier compared to a $1 increase in government government purchasespurchases

The transfer payment multiplier is typically smaller The transfer payment multiplier is typically smaller than the regular investment multiplier by 1than the regular investment multiplier by 1

Exports and ImportsExports and Imports

Exports increase output demandedExports increase output demanded

Imports decrease output demandedImports decrease output demanded

Net effect of international trade on output can be Net effect of international trade on output can be measured by the difference between exports and measured by the difference between exports and importsimports

Trade surplus (net exports positive) increases Trade surplus (net exports positive) increases output, while trade deficit (net exports negative) output, while trade deficit (net exports negative) decreases outputdecreases output

Aggregate SupplyAggregate Supply

Aggregate supply is a schedule Aggregate supply is a schedule showing the output supplied at showing the output supplied at different price levelsdifferent price levels

Determinants of aggregate supplyDeterminants of aggregate supply Resource prices (-)Resource prices (-) Techniques of production (-)Techniques of production (-)

Aggregate Supply and Full Aggregate Supply and Full Employment OutputEmployment Output

Aggregate Demand and Aggregate Demand and SupplySupply

Aggregate Demand And Aggregate Demand And SupplySupply

DD-SS equilibrium: unemployment rate above the natural DD-SS equilibrium: unemployment rate above the natural raterate

Greater aggregate demand (D2D2) allows to reach the Greater aggregate demand (D2D2) allows to reach the natural rate of unemployment with a higher price level (p2)natural rate of unemployment with a higher price level (p2)

An outward shift of aggregate supply (to S1S1) would result An outward shift of aggregate supply (to S1S1) would result in reaching the natural rate of unemployment in reaching the natural rate of unemployment andand a lower a lower price levelprice level

DD-SS is a deficient (inefficient) situation: what can be DD-SS is a deficient (inefficient) situation: what can be done?done?

Reasons for DeficientReasons for DeficientAggregate DemandAggregate Demand

Inadequate level of consumer spending (e.g. higher interest Inadequate level of consumer spending (e.g. higher interest rates, change in taste etc)rates, change in taste etc)

Decrease in investment spending due to a fall in expected Decrease in investment spending due to a fall in expected return on investmentreturn on investment

Reductions in government purchases and/or increase in Reductions in government purchases and/or increase in taxestaxes

High level of imports relative to exportsHigh level of imports relative to exports Breaks in the circular flow: Breaks in the circular flow: leakagesleakages and and injectionsinjections

LeakagesLeakages: savings (people are not spending part of their : savings (people are not spending part of their income)income)

Injections: Injections: investmentinvestment Savings should equal investment for no breaks to occurSavings should equal investment for no breaks to occur

Full employment saving is higher than full employment investment, Full employment saving is higher than full employment investment, aggregate demand is deficient unless sufficient injections occuraggregate demand is deficient unless sufficient injections occur

An example of leakage: government taxes reducing private An example of leakage: government taxes reducing private spending therefore reducing aggregate demandspending therefore reducing aggregate demand

Imports are a leakage, exports are an injectionImports are a leakage, exports are an injection

Leakages and InjectionsLeakages and Injections

Reasons for Weak Reasons for Weak Aggregate SupplyAggregate Supply

If incentives to save are seriously If incentives to save are seriously reduced (e.g. by taxes) saving would reduced (e.g. by taxes) saving would fail to finance investmentfail to finance investment

Higher taxes may reduce incentives Higher taxes may reduce incentives to workto work

Real Wages, MPRL and Real Wages, MPRL and EmploymentEmployment

Combating Combating UnemploymentUnemployment

Aggregate demand policiesAggregate demand policies Stabilize aggregate demand over the business Stabilize aggregate demand over the business

cyclecycle Increase government spending and cut taxes when Increase government spending and cut taxes when

private spending is contractingprivate spending is contracting Increase taxes and decrease government spending if Increase taxes and decrease government spending if

private spending is on the increaseprivate spending is on the increase Keep the demand at the full-employment (or Keep the demand at the full-employment (or

natural) unemployment levelnatural) unemployment level Danger of high inflation rates that come along Danger of high inflation rates that come along

with low rates of unemploymentwith low rates of unemployment

Combating Combating UnemploymentUnemployment

Aggregate supply policiesAggregate supply policies Reduce resource pricesReduce resource prices Increase productivity in the economyIncrease productivity in the economy

SummarySummary

Unemployment has both economic and social effectsUnemployment has both economic and social effects

3 types of unemployment: frictional, structural and 3 types of unemployment: frictional, structural and cyclicalcyclical

We need aggregate demand and aggregate supply We need aggregate demand and aggregate supply theories to understand why people lose their jobstheories to understand why people lose their jobs

The best approach to combat unemployment is to The best approach to combat unemployment is to pursue both aggregate demand and supply policiespursue both aggregate demand and supply policies