1. Unemployment
Chapter 11

2. 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

3. 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

4. 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

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

6. 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)

7. Unemployment in a Competitive Market

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

9. 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

10. 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

11. Evolution of Unemployment Rates

12. Unemployment Rates Over Time
recession->high unemployment rates
expansion->below natural unemployment rates
contraction->high unemployment rates
In general: recession brings about higher than natural rates of unemployment, while expansion reduces the extent of unemployment

13. Production and Income Flows

14. 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

15. 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)

16. Aggregate Demand

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

18. 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)

19. 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

20. 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)

21. 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

22. 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

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

24. Aggregate Supply and Full Employment Output

25. Aggregate Demand and Supply

26. 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?

27. 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

28. Leakages and Injections

29. 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

30. Real Wages, MPRL and Employment

31. 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

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

33. 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