1. Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281
Macroeconomics & The global economy Ace Institute of Management Chapter 6: Unemployment
Instructor
Sandeep Basnyat

2. Unemployment- Major Macroeconomic Issue
Major concern for all government
Develop policies to curb unemployment or increase employment rate.
However…

3. U.S. Unemployment,
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?

4. 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.

5. 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

6. 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)

7. 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

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

9. 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,

10. 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:

11. Policy implication
A policy that aims to reduce the natural rate of unemployment will succeed only if it lowers s or increases f.

12. Why is there unemployment?
There are two reasons:
1. Job search
2. Wage rigidity

13. 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

14. 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.”

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

16. 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

17. 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.

18. For your information
Assess the trend in sectoral shift in the industrial sectors in:
Nepal
India
China
Japan
South Korea
Taiwan
Malaysia, and
Vietnam

19. 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

20. 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.

21. 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.

22. Why is there unemployment?
There are two reasons:
1. job search
2. wage rigidity
DONE 
Next 

23. 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

24. 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.

25. 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)

26. The minimum wage : US Case Study
In Sept 1996, the minimum wage was raised from $4.25 to $ 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%.

27. 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).

28. 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

29. 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.

30. 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.

31. 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.

32. 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

33. 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).

34. 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

35. Thank You