©McGraw-Hill Companies, 2010 Chapter 23 Unemployment ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Some key terms Unemployment rate the percentage of the labour force without a job but registered as being willing and available for work Labour force those people holding a job or registered as being willing and available for work. Participation rate the percentage of the population of working age declaring themselves to be in the labour force ©McGraw-Hill Companies, 2010 2

Unemployment: Selected countries ©McGraw-Hill Companies, 2010

Labour market flows LABOUR FORCE Working Unemployed Non-participants It is tempting to see the labour market in static terms. LABOUR FORCE Working Unemployed Non-participants but... ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 Labour market flows LABOUR FORCE Working New hires Recalls Unemployed Job-losers Lay-offs Quits Taking a job Retiring Temporarily leaving Discouraged workers Re-entrants New entrants Non-participants ©McGraw-Hill Companies, 2010 5

More on labour market flows The size of these flows is surprisingly high. At October 2009, the stock of unemployed people claiming jobseekers’ allowance was 1.7 million in the UK. A much larger number, around 4.2 million people had flowed into and out of unemployment during the previous 12 months. ©McGraw-Hill Companies, 2010 6

©McGraw-Hill Companies, 2010 Types of unemployment Frictional the irreducible minimum level of unemployment in a dynamic society people between jobs the ‘almost unemployable’ Structural unemployment arising from a mismatch of skills and job opportunities when the pattern of demand and production changes it takes time for ex-coal miners to retrain with other skills ©McGraw-Hill Companies, 2010 7

Types of unemployment (2) Demand-deficient unemployment occurs when output is below full capacity ‘Keynesian’ unemployment occurs in the transitional period before wages and prices have fully adjusted Classical unemployment created when the wage is deliberately maintained above the level at which labour supply and labour demand schedules intersect ©McGraw-Hill Companies, 2010 8

Keynesian unemployment Beginning at E, suppose labour demand falls to LD’. A LD’ AJ LF With sticky wages and prices in the short run, the economy will move to equilibrium at A Real wage E F w* and there will be unemployment of AF. Of which EF will be voluntary and AE will be involuntary (i.e. Keynesian). w2 H If labour demand remains at LD’, the new equilibrium when wages and prices have fully adjusted will be at G. G LD Number of workers LD – Labour demand; LF – Labour force; AJ – those willing to work ©McGraw-Hill Companies, 2010 9

Classical unemployment w2 Suppose that union power succeeds in maintaining a real wage of w2. AJ LF A N2 Equilibrium is at A B of which BC is voluntary C and unemployment is AC, Real wage and AB is involuntary. w* To the extent that this unemployment reflects a conscious decision by unions to restrict employment, it is all voluntary unemployment. LD N* N1 Number of workers ©McGraw-Hill Companies, 2010 10

A ‘modern’ view of unemployment Modern analysis stresses the difference between voluntary and involuntary unemployment. Voluntary unemployment when a worker chooses not to accept a job at the going wage rate Involuntary unemployment when a worker would be willing to accept a job at the going wage but cannot get an offer ©McGraw-Hill Companies, 2010 11

The natural rate of unemployment The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium. This is entirely voluntary. It includes: frictional unemployment structural unemployment ©McGraw-Hill Companies, 2010 12

The natural rate of unemployment LD: labour demand AJ AJ: the number of workers prepared to accept jobs LF LF: size of labour force Real wage LD AJ is to the left of LF because some members of the labour force are between jobs, others are waiting for better offers. w* N* N1 Equilibrium is at w*,N*. The distance EF is the natural rate of unemployment. E F Number of workers It is determined by normal labour market turnover, structural mismatch, union power and incentives in the labour market. ©McGraw-Hill Companies, 2010 13

UK equilibrium unemployment 3 periods in which involuntary unemployment became important the Thatcher squeeze in the early 1980s, the Major squeeze in the early 1990s the aftermath of the financial crash Sources: R. Layard, S. Nickell and R. Jackman, Unemployment, Oxford University Press, 1991; S. Nickell, ‘Inflation and the UK Labour Market’, in T. Jenkinson, Readings in Macroeconomics, Oxford University Press, 1996; authors’ estimates ©McGraw-Hill Companies, 2010 14

Supply-side economics entails the use of microeconomic incentives to alter the level of full employment the level of potential output the natural rate of unemployment In the long run, the performance of the economy can only be changed by affecting the level of full employment and the corresponding level of potential output. ©McGraw-Hill Companies, 2010 15

Tax cuts and unemployment w1 Firms pay a gross wage of w1 AJ Real wage w3 w1 > w3 (the take-home net pay of workers). LF AB is the amount of tax A B N1 Equilibrium is at N1 w2 N2 E Without tax, equilibrium is at E. F Unemployment is now EF. Unemployment is BC C LD EF < BC i.e. unemployment is reduced. Number of workers ©McGraw-Hill Companies, 2010 16

Other supply-side policies Trade union reform reducing the power of trade unions may limit distortions in the labour market Other labour supply policies training and retraining measures improving the efficiency of the labour market Reducing the replacement ratio such measures may affect frictional and structural unemployment ©McGraw-Hill Companies, 2010 17

Annual fraction of workers hired or fired (%) Countries with greater job stability are probably slower to experience initial unemployment, but, when unemployment does increase, they are also less successful at helping people out of unemployment back into work. Source : OECD Employment Outlook, 2009 In the medium run the fiscal burden of unemployment benefits is likely to be greater in countries with less flexible labour markets. ©McGraw-Hill Companies, 2010 18

©McGraw-Hill Companies, 2010 Hysteresis The idea that a (short-run) fall in aggregate demand can lead to a persistence of unemployment even when the fall in aggregate demand has been reversed. This could help to explain high and persistent unemployment in Europe in the 1980s. ©McGraw-Hill Companies, 2010 19

Hysteresis (continued) Four channels: Insider-outsider distinction only those in work take part in wage bargaining & they protect their own positions Discouraged workers people stop looking for jobs Search and mismatch firms and workers get used to low search Capital stock low levels of investment in recession lead to permanently low capital stock levels ©McGraw-Hill Companies, 2010 20