Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281 Macroeconomics & The global economy Ace Institute of Management Chapter 6: Unemployment Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 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 The actual unemployment rate fluctuates considerably over the short run: the red line: the so-called “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. The natural rate of unemployment is the “normal” unemployment rate the economy experiences when it is neither in a recession nor a boom.

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: s = rate of job separations f = rate of job finding 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 unemployed people who find jobs # of employed people who lose or leave their jobs

The transitions between employment and unemployment f U Employed Unemployed s E

Solving for the “equilibrium” U rate f U = s E = s (L –U ) = s L – s U f xU + sU = 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:

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. Sometimes the unemployment caused by sectoral shifts is severe. Due to increasing imports of cheaper foreign-made textiles, the U.S. textile industry has been in decline for years. Many workers in this industry have lost jobs. Many of these workers are in their 50s and have worked in this industry for decades. Such workers are unlikely to have the skills necessary to get jobs available in newly booming industries, and they are less likely to invest in the acquisition of the necessary skills for these jobs. Hence, such workers are at greater risk for becoming “discouraged workers.”

Industry shares in U.S. GDP, 1960 Source: World Development Indicators, World Bank

Industry shares in U.S. GDP, 1997 Even the “tiny” category of agriculture drops by more than half : from 4.2% to 1.7% of GDP. Source: World Development Indicators, World Bank

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. Sectoral shifts are distinct from recessions (which also cause unemployment). In recessions, there is a general fall in demand across industries, and the unemployment that results is cyclical. Sectoral shifts, though, are changes in the composition of demand across industries, and lead to frictional unemployment as described above.

For your information Assess the trend in sectoral shift in the industrial sectors in: Nepal India China Japan South Korea Taiwan Malaysia, and 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 Supply Labor Real wage If the real wage is stuck above the eq’m level, then there aren’t enough jobs to go around. Unemployment Demand Rigid real wage Amount of labor hired Amount of labor willing to work

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 rigidity 1. 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% Teens and single mothers are more likely to be in minimum wage jobs than workers from other demographic groups. These data show that these groups experienced higher unemployment after the minimum wage was raised in September 1996. 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 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: When Labour demand is high, most of the labour get employed and labour market is in shortage of labour or tight. Labour unions find opportunities to bargain with employers or they have high bargaining power for increasing wage rates faster. So, Lower the unemployment rate, higher the wage rate.

Relationship Between Inflation and Unemployment Faster increase in wage rates will result in faster increase in disposable income of the labour causing higher increase in price level or inflation. Conclusion: Higher the employment rate or Lower the Unemployment rate, higher the inflation rate.

The Phillips Curve The 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 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 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 off Inflation Rate B C A New SR Phillips Curve Initial SR Phillips Curve Unemployment Rate For further info: Macroeconomic Analysis, Edward Shapiro Macroeconomics, Theory and Policy, D.N. Dwivedi

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