Unemployment Chapter 11

Economic Concepts Labor force Frictional unemployment Structural unemployment Cyclical unemployment Unemployment rate Marginal propensity to consume Marginal propensity to save Investment multiplier Aggregate supply and demand Leakages and injections

Costs of Unemployment Economic costs Non-economic costs Loss in income Decrease in consumption and saving Inefficient production (operation inside of the PPF) Opportunity cost of reducing unemployment is zero (but beware of inflation!) Non-economic costs Stability of the family Danger of social unrest Drug abuse Divorce Crime

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

Labor Force Institutionalization: jails, prisons, mental hospitals, nursing establishments Minimum legal age Both unemployed and employed are included in the labor force

Defining Unemployment Being without work does not mean being unemployed You are not unemployed if you are a discouraged worker (i.e. not actively seeking employment)

Unemployment in a Competitive Market

Two Solutions for Unemployment Expand labor demand Rely on market forces to bring wages down

Types of Unemployment Frictional unemployment Structural unemployment Brief, transitional, normally as a result of people changing and searching for new jobs Not a serious economic problem Structural unemployment Long-run in nature, result of fundamental changes in demand for labor Examples: technological change, change in consumer preferences Cyclical unemployment Caused by economic fluctuations (recessions in particular) Typical for unemployment rates above 6% Object of government policy

Full-Employment Rate of Unemployment Defined for policy purposes as an unemployment rate of 4%-6% Below that range, they talk about frictional or structural unemployment Above that range, it is cyclical unemployment Full-employment unemployment rate is consistent with price stability Lower rates of natural (full-employment) unemployment rates will increase inflation

Evolution of Unemployment Rates

Unemployment Rates Over Time 1960-1961 recession->high unemployment rates 1966-1969 expansion->below natural unemployment rates 1981-1982 contraction->high unemployment rates In general: recession brings about higher than natural rates of unemployment, while expansion reduces the extent of unemployment

Production and Income Flows

Circular Flow of Economic Activity Two markets are at work: a resource market and a product market Resource and product markets are interrelated: demand for goods creates a demand for resources used to produce those goods Two circular flows are involved: flow of goods/services and flow of money Unemployment has two sides: the demand side and the supply side

Aggregate Demand Aggregate Demand is a schedule showing output demanded at different price levels: we are talking about aggregate quantities and aggregate prices Output demanded=Consumer spending + Investment spending + Government spending + Net exports(exports-imports)

Aggregate Demand

Factors Determining Consumer Spending Income (+) Wealth (+) Interest rates (-) Tastes and preferences (+/-)

Marginal Propensity to Consume Marginal propensity to consume is the change in consumption divided by the change in income (e.g. MPC=80% means with each increase of income by $1, consumers will spend 80% of this one dollar, or 80 cents) Marginal propensity to save is the change in saving divided by the change in income (e.g. in the previous example, the MPS will equal 20% Psychological law of consumption: when income changes, consumption changes, but by less than the change in income (meaning you save some money)

Investment Spending Mainly purchases of new equipment and plants Determined by the rate of interest and expected return on investment When expected return on investment exceeds current interest rates, investment spending increases When expected return on investment falls short of the current interest rates, investment spending goes down Expectations are of strategic importance: e.g. currently rising prices of apartments will most likely lead to drop of real estate returns in the future

Investment Multiplier Investment multiplier represents the combined effect of a $1 increase in investment spending on income or output demanded Spending $100 million on constructing a new factory will increase total spending by more than $100 million due to a chain reaction of consumer spending (for example, construction workers will buy consumer goods) Investment multiplier is the reciprocal of MPS or the reciprocal of (1-MPC) Example: for MPC=80%, investment multiplier will be 1/20%=1/(1-80%)=5 Investment multiplier times change in investment equals change in income (for example, for investment multiplier equal to 5, each additional dollar of investment spending will increase income by five dollars)

Government Purchases An increase in government purchases (G) produces a multiplying effect on income, similarly to the increase in investment spending Government transfer payments do not increase the demand for output directly, this is why a $1 increase in transfer payments will command a lower multiplier compared to a $1 increase in government purchases The transfer payment multiplier is typically smaller than the regular investment multiplier by 1

Exports and Imports Exports increase output demanded Imports decrease output demanded Net effect of international trade on output can be measured by the difference between exports and imports Trade surplus (net exports positive) increases output, while trade deficit (net exports negative) decreases output

Aggregate Supply Aggregate supply is a schedule showing the output supplied at different price levels Determinants of aggregate supply Resource prices (-) Techniques of production (-)

Aggregate Supply and Full Employment Output

Aggregate Demand and Supply

Aggregate Demand And Supply DD-SS equilibrium: unemployment rate above the natural rate Greater aggregate demand (D2D2) allows to reach the natural rate of unemployment with a higher price level (p2) An outward shift of aggregate supply (to S1S1) would result in reaching the natural rate of unemployment and a lower price level DD-SS is a deficient (inefficient) situation: what can be done?

Reasons for Deficient Aggregate Demand Inadequate level of consumer spending (e.g. higher interest rates, change in taste etc) Decrease in investment spending due to a fall in expected return on investment Reductions in government purchases and/or increase in taxes High level of imports relative to exports Breaks in the circular flow: leakages and injections Leakages: savings (people are not spending part of their income) Injections: investment Savings should equal investment for no breaks to occur Full employment saving is higher than full employment investment, aggregate demand is deficient unless sufficient injections occur An example of leakage: government taxes reducing private spending therefore reducing aggregate demand Imports are a leakage, exports are an injection

Leakages and Injections

Reasons for Weak Aggregate Supply If incentives to save are seriously reduced (e.g. by taxes) saving would fail to finance investment Higher taxes may reduce incentives to work

Real Wages, MPRL and Employment

Combating Unemployment Aggregate demand policies Stabilize aggregate demand over the business cycle Increase government spending and cut taxes when private spending is contracting Increase taxes and decrease government spending if private spending is on the increase Keep the demand at the full-employment (or natural) unemployment level Danger of high inflation rates that come along with low rates of unemployment

Combating Unemployment Aggregate supply policies Reduce resource prices Increase productivity in the economy

Summary Unemployment has both economic and social effects 3 types of unemployment: frictional, structural and cyclical We need aggregate demand and aggregate supply theories to understand why people lose their jobs The best approach to combat unemployment is to pursue both aggregate demand and supply policies