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Required Knowledge: Inflation, Labour Market (Micro)

Someone is economically defined as unemployed if they are actively seeking a job but are not currently employed. Unemployment does not include members of the population who are not part of the workforce (e.g. students or the retired elderly), nor those disillusioned people who have given up looking for a job but aren't in employment. Reducing unemployment is seen as the predominant purpose a government exists and is thus an important macroeconomic target.
Unemployment can be considered a lagging indicator of the economic situation. We cannot determine whether the economy is growing or declining based on new unemployment figures. For example when a recession begins it might take a few months for people to be made redundant, or firms to go bankrupt. The reason for this is that managers aren’t sure how long the recession will last and so are apprehensive about sacking their workforce, which is expensive to do, only to have to rehire them. Costs of training the new workforce also have to be taken into account, meaning that cutting back a workforce is expensive and therefore is something a firm wouldn't do until it was sure that demand would be suppressed for the next few years and that the firm would have spare capacity (i.e. is able to supply future predicted demand) for the foreseeable future.
The labour force participation rate is the percentage of the adult population that are in employment or are actively seeking employment but are currently unemployed. It can be given as: (Labour Force/Adult Population)*100.
The unemployment rate is only those who are in the labour force (i.e. actively seeking and available for work) and can be calculated as: (unemployed/labour force)*100; where the labour force = the number of employed + the number of unemployed.

Unemployment doesn't include those who are recently out of work and are in the transition period to starting a new job, or for people who have left a job and have only just recently started looking for a job. People who fall into this category are known as frictionally unemployed.

The official unemployment rate includes those who are employed, but aren't doing as many hours as they would ideally like, i.e. part timers who are looking for full terms work are classified as employed. This can lead to underemployment, whereby the unemployment rate may look low, but this is because it doesn't show the full picture of many people working only a few hours a week who are classified as employed even though they may not be earning enough money to sustain their household. This can make the economic picture look better than it truly is.

There are two ways to measure unemployment; the claimant count and the ILO (International Labour Organisation) rate.

Claimant Count - is a measure of the rate of unemployment obtained from the number of people claiming JSA (job seekers allowance) which is a government benefit for the unemployed. Claimants have to declare that they are out of work, capable of and actively seeking work; whenever they claim their benefit. However some claimants may not actually be seeking work and so technically aren't a member of the labour force but are included in the unemployment rate. It also omits some people who would like to work and are looking for a job but are not eligible for the unemployment benefit such as women returning to the labour force after child birth.

ILO rate - is a measure of the percentage of the workforce who are without jobs and are available, willing to work and looking for a job based on the Labour Force Survey. It includes people who have actively sought work in the last 4 weeks and are available to start work within the next 2 weeks or people who have found a new job and are waiting to start it in the next 2 weeks.

A major difference between the 2 measures is that the claimant count is a full count on those claiming benefits whereas the ILO measure is based on a sample.

Generally, the claimant count rate of unemployment is lower than the ILO rate of unemployment. The difference between the 2 measures is narrower when unemployment is relatively high and wider when unemployment is falling. This may be because low unemployment encourages more people who are not eligible for unemployment benefits to look for jobs whereas they may withdraw from the workforce when unemployment rises and they perceive that finding a job will be difficult.

Officially the ILO rate has superseded the claimant count as it is considered more accurate, however both figures are still produced and are in the public domain, and can both be used to tell a different picture of the economy. The claimant count can also be used to judge the value of benefits (however this is only one benefit of social security, there are others for different situations) the government is responsible for paying.

Real wage (aka classical) unemployment occurs when demand and supply aren’t equal. Therefore it is a disequilibria issue. This can occur if the wages demanded by the labour force are higher than the amount that industry is willing to pay. Hence classical unemployment can occur through government intervention (by establishing minimum prices; in the UK the national minimum wage is an example of a policy which can lead to classical unemployment), trade unions bargaining for higher wages or reserve wages (a limit set by employees as to how much they wish to earn to accept a job offer). If workers refuse employment because they aren’t offered their reserve wage then they are considered to be voluntarily unemployed
Cyclical unemployment occurs because labour is a derived demand, if there is a deficiency in aggregate demand then the derived demand for the production of goods and services will fall, leading firms to make redundancies. Labour is a lagging economic indicator because during cyclical unemployment firms won’t immediately reduce their work force in spite of a fall in demand. This is because they don’t know how long the downturn will last and it is costly to fire a workforce, to simply rehire one and have to train the up a few weeks later (if that is the case), therefore managers hold on to their trained and experienced workers until they are sure that demand is going to be suppressed for a great period of time. During this period they are likely to build up stocks of unsold goods until they eventually make redundancies. Some firms may even decide to keep on their workforce during a period of time of suppressed demand if they can afford to do so and the workforce is suitable trained and experienced to make themselves vital for the firm. During the upturn firms may have large stores of unsold stock and hence may sell this before they hire more workers to increase production, they do this to ensure that the upturn is permanent (and not just a positive quarter) and to make room in warehouses for more goods.
Seasonal unemployment could also come under this heading; it occurs when workers are only required during certain periods of the year/business cycle, for example retail workers may be required during the busy trading period of Christmas, or some farmers may only be needed during harvest to help collect the produce.
Frictional unemployment always occurs and happens when workers leave a job, and are technically unemployed, whilst they search for another job. They may decide to leave for personal reasons, or because they want to find a better job with higher pay/perks, or it may be because they have been laid off, also new workers entering the labour force are considered frictionally unemployed whilst they come to terms with the labour market. Imperfect information can increase frictional unemployment if unemployed members of the labour force are unaware of the existence of jobs. 
Structural unemployment can occur due to capital-labour substitution (workers are replaced by machines, hence they are no longer needed) or due to a long run (permanent) decline in demand in the sector in which they work. This can be a problem of occupational and geographical immobility; workers may not be in the place where the jobs are, or may not have the skills and training to do the required work. 

Okun's Law shows the negative relationship between unemployment and GDP. It is named after the American economist Arthur Okun who studied it. We would expect the relationship between unemployment and GDP to be negative - employed workers produce goods which contribute to GDP, whereas unemployed workers do not. Hence we would expect a rise in unemployment to result in a negative change in GDP.
An empirical study has proven that unemployment is largely inversely related to the rise in GDP growth (economic growth) as shown in the graph to the left. The data provided is for the US between 1990 and 2011 and is shown as a scatterplot.  
Studies have shown that Percentage Change in Real GDP = 3% - 2*(Change in the Unemployment Rate). (For the US). 
If the unemployment rate remains constant (it doesn't increase - note, this doesn't mean there are no changes in the number of unemployed, just that the overall rate which takes into account the number of unemployed and the number of employed remains the same) then GDP grows at about 3% according to Okun. The reason this growth occurs is due to the increase in the labour force (which increases at the same rate as demand for workers), capital accumulation due to investment and through technological advancements. 
It is considered a rule of thumb, for every 1% rise in a countries unemployment rate, real GDP (taking into account inflation) will be operating at 2% below potential GDP. 
Jobless growth occurs when there is economic growth but employment levels continue to fall or at least remain constant. Proposed reasons are increased productivity – this can lead to higher output without the need to increase employment – and automation, leading to growth without the need for increased employment.

Tax and Benefits
The government looses out to high unemployment as they will receive fewer taxes and will have to pay more benefits (providing the government has a welfare net for the unemployed). Fewer taxes will be received as there are fewer workers paying income tax and other contributions. Firms may also pay less in tax if they higher fewer people. Meanwhile, higher unemployment is likely to result in higher benefit payouts as job-seekers 'sign on' to receive benefits whilst they look for a new job.

Civil Unrest
High unemployment (particularly high youth unemployment) may result in riots and protests as people are discontented that their government cannot provide them with jobs. The provision of employment is seen as a basic necessity that the government should be able to provide (or encourage the private sector to provide). If the government cannot complete this task then civil unrest may follow. The government may also be ousted and another party voted in.

Economic Inefficiency
Unemployment (not including frictional) means that an economy is not operating on the PPF curve (this also means that the economy isn't working at full-employment) and hence isn't using its factors of production to their full potential. 

Psychological Effects
There are many psychological effects resulting from not being employed. These costs aren't solely felt by the person that is unemployed but also by their family and dependent's. Children may be deterred from looking for jobs and entering the workforce if they see that their parent/s are unemployed. Fellow family members may have to work longer hours in order to increase the household income due to a member of the family being unemployed. This can increase stress and lower productivity in the workplace. 

There are also negative psychological effects for the unemployed person themselves, who may feel useless as they can't provide for themselves and/or their family. There may also exist a stigma in certain countries for being on benefits, this may result in unemployed people from claiming benefits, instead existing on a lower wage (which may effect their health if they decide to reduce food consumption or not take non-emergency medical treatment) or depleting savings. Alternatively if they do accept benefits then they may be perceived negatively within society thus effecting their self image and potentially resulting in them exiting the workforce all together.

Crime rates may increase as a result of civil unrest and the negative psychological effects that unemployment entails. Crime does not necessarily rise as thefts increase in order to make money (although thefts may increase for this reason), empirically crime can be seen to rise across the board rises due to unemployment.

Few job opportunities and high unemployment in a country may cause citizens to emigrate from a country in search for work abroad. Although this reduces the cost on society (less benefits, healthcare education etc are needed for a smaller population) it also reduces the benefits that workers bring. Notably taxes, but also other benefits including the ability to produce goods and services and the knowledge (which may have been paid for by the government) they possess. 

Hysteresis is the theory that a period of high unemployment (usually caused by demand deficiency) can lead to an increase in the value of NAIRU. That is high unemployment now, can cause high unemployment in the future. The reason for this is that unemployment has long term effects (as well as the short term effect of not having an income other than unemployment benefits) in that workers forget their skills and as they aren’t practising them they may deteriorate or at least not improve at the rate they would have done had they been in employment. Furthermore some people may become so disillusioned with the labour market that they leave it completely and remain unemployed perpetually. 
Additionally hysteresis can also occur because after a negative shock, there are fewer workers, who may decide to collectively bargain (in the form of a union) for higher wages. Because firms have few workers to choose from (skills wise, and considering that some people would have exited the job market), they may (at least in the short term) have to give in to the unions' demands. These higher wages will then keep out new workers in the future as the firm has less money to spend on new workers. In the long run however, firms may decide to move production abroad, or make production more capital intensive as a result of higher wages. These higher wages may alternatively be passed on to consumers in the form of higher prices, leading to inflation.
Another way hysteresis can occur is through the reduction in a business network resulting from unemployment. During periods of unemployment, workers loose touch of old colleagues and associates who form a valuable network which may help them get a job, or who without which may not be able to 'stay in the loop'.
High unemployment means workers are likely to have less disposable income (as they are depleting savings, becoming dependent on other relatives' income, or are on benefits) and may reduce their consumption. This results in less aggregate demand and may worsen the situation of cyclical unemployment (lower AD may cause higher, cyclical, unemployment). A result of lower aggregate demand may be that firms decide to lower their prices in order to sell more goods, this potentially could lead to deflation.

Hysteresis is a theory developed by the Keynesians to explain why laissez-faire economic policy may be damaging in the long run. Neoclassicalists would argue that during an economic downturn, when an external shock causes demand to fall, wages should be allowed to fall which would increase the international competitiveness of the economy so that exports can grow to increase demand and provide a boost to the economy fueling further growth until the economy is out of the slump and growing again. Even if we ignore the Keynesian argument that lower wages will further reduce consumption (because people have less money to spend and save instead - the paradox of thrift - for fear that they may lose their job in the future) and possibly investment (because there is lower demand which means reduced future profitability and "animal spirits" may be weak) we still have to consider the short-term effects that the economic downturn causes. Hysteresis is the argument that these short-term effects manifest themselves into long term problems which inhibit growth and make it difficult to return to pre-recession growth trends as the neoclassicalists presume.
These hysteresis channels are: skills atrophy, signalling effects, cognitive dissonance, capital depreciation and beachhead effects/trade penetration.
Skills Atrophy - unemployed workers will begin to forget their skills or at the very least lose productive efficiency as they forget particular ways of producing goods and services. This may mean that education is needed before output can expand, in some cases some skills may permanently be lost (perhaps not completely relevant to this discussion, but consider in Britain how many workers remain with textile skills, this is despite the UK being a world-lead in textiles only 30/40 years ago).
Signalling Effects - normally firms would hire workers who have had a steady employment history, as this is a useful signalling effect to show that they are reliable and skilled workers. During a recession workers may be put out of work, - made redundant - not due to their own failings but due to insufficient demand. Some workers may be employed by many firms during the course of a recession, with short periods of employment as firms only have limited amounts of work. To a firm hiring after the recession this could be a negative signalling effect, implying that the worker isn't reliable. Therefore it becomes difficult for a firm to hire additional workers, they may need to expend greater effort into hiring decisions to consider whether a worker was unemployed due to his own deficiency, or due to the economic situation. This may explain why long term unemployment remains low, but shouldn't be too great an obstacle if the economy is expanding quickly.
Cognitive Dissonance - simply stated this is when unemployed workers become so disillusioned with the labour force - and the fact that they are unable to find work - that they exit the labour market completely. This could manifest itself in a number of ways, it could be that some workers decide to emigrate and find work elsewhere: it is likely these workers would be lost forever, or at the very least would be difficult to get back. Some workers may decide to have a family, and thus exit the workforce for X period of time. Older workers may decide to take an early retirement, permanently exiting the labour market. Some may simply give up looking for a job, and thus are no longer statistically considered as unemployed but as not in the workforce. Fortunately these workers are easier to return to the labour market, as they may start looking for jobs when the economy speeds up and thus won't significantly, or irreversibly, shift the LRAS curve left.
Capital Depreciation - over time capital goods (factories, machinery and equipment) depreciate: that is their condition is deteriorated through wear and tear. For example, factories may begin to crumble, IT equipment becomes outdated and tools begin to rust. This happens because during an economic downturn there is little incentive for firms to invest in replacing and fixing capital - demand is low so they don't need to produce as much output. As a result, the long run aggregate supply curve has shifted left and even when output begins to pick up again, unemployment will persist because it will take time for firms to purchase new equipment and fix other capital to allow for a larger workforce.
Trade Effects - sometimes called trade penetration or a beachhead effect, this is when a downturn means that domestic producers lose ground to foreign competition. This could occur because domestic producers focus on the domestic market, perhaps they increase foreign prices to maintain profitability, fail to reduce prices significantly domestically and lose out to competition or fail to invest in R+D so they don't develop the latest consumer products. Perhaps significant numbers of firms go bankrupt, such that foreign competition gets a stronghold. Whatever the cause, foreign competition erodes at domestic exporters and attacks domestic producers through cheaper imports. The result is that the foreign firm is selling more output and so may gain from economies of scale allowing it to produce even cheaper than competition and thus expand further. The effect of this is that domestic firms lose output share and thus lose economies of scale, hence making it more expensive to produce so eroding the price competitiveness of the firm. If domestic firms fail then it may be the case that unemployment rises, although presumably foreign firms would need to have some production/offices in the domestic economy which would mitigate job losses. In short, an economic downturn means domestic firms temporarily lose export and import market share to foreign competition, which means they lose economies of scale and are thus permanently at a disadvantage.
However, during an economic downturn we would expect the domestic exchange rate to depreciate which would make imports more expensive and exports cheaper. This could ameliorate the situation and prevent foreign competition from expanding output shares and gaining from economies of scale.
In short, these channels mean that unemployment could be persistently high even for a period after the external shock. It can be seen as a leftward shift of the long run aggregate supply curve meaning that the economy has permanently lost a chunk of output and that more resources will need to be expended to try and return the economy to its previous position and then expand further to increase living standards. This gives Keynesian's an argument for government spending during economic downturns to restore aggregate output and prevent the hysteresis channels from taking effect.

Page last updated on 03/11/15