8.3 What Causes Changes in Unemployment over the Short Run
4 min read•june 24, 2024
are like a rollercoaster ride for the job market. During good times, businesses hire more workers to meet growing demand. But when the economy slows, companies cut jobs, leading to higher unemployment.
complicate this process. Even when the economy dips, wages don't always drop quickly to match. This can force businesses to lay off workers instead of lowering pay, making unemployment worse during tough times.
Economic Cycles and Unemployment
Economic cycles and unemployment
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- Economic cycles, also known as , are fluctuations in economic activity over time characterized by periods of expansion (economic growth, rising GDP, increasing employment) and contraction (, declining economic activity, falling GDP, rising unemployment)
- During expansionary phases, businesses experience increased demand for their goods and services leading to hiring more workers to meet the growing demand resulting in lower unemployment rates (e.g., the late 1990s dot-com boom)
- During contractionary phases (recessions), businesses face reduced demand for their products leading to layoffs and hiring freezes to cut costs resulting in higher unemployment rates (e.g., the 2008 financial crisis)
- is the portion of unemployment directly related to economic cycles, rising during recessions and falling during expansions (construction workers, manufacturing employees)
Sticky Wages and Unemployment
Sticky wages and employment
- Sticky wages refer to the tendency of wages to remain constant or adjust slowly, even in the face of changing economic conditions due to factors such as long-term contracts, minimum wage laws, and (where employers pay higher wages to maintain productivity and reduce turnover)
- During a recession, the demand for labor decreases as businesses experience reduced demand for their goods and services
- In a perfectly flexible , wages would decrease to reach a new equilibrium level
- However, due to sticky wages, the adjustment process is slower, and wages remain higher than the equilibrium level
- Consequences of sticky wages during a recession include:
- Businesses unable to lower wages quickly to match the reduced demand for labor
- Higher labor costs leading to businesses laying off workers or reducing hiring
- Higher unemployment levels than would occur with flexible wages (e.g., the slow recovery in employment after the 2008 financial crisis)
Supply and Demand Analysis of Unemployment
Supply and demand of labor
- The labor market can be analyzed using the supply and demand framework, where the supply of labor is the number of workers willing and able to work at various wage levels and the demand for labor is the number of workers that businesses are willing to hire at various wage levels
- Equilibrium in the labor market occurs when the quantity of labor supplied equals the quantity of labor demanded, with the () being the wage at which this occurs and the equilibrium level of employment () being the number of workers employed at
- Shifts in and demand can lead to changes in the equilibrium wage and employment levels
- An increase in (due to economic growth) shifts the demand curve to the right, leading to higher wages and employment (e.g., the tech industry in the 2010s)
- A decrease in labor demand (during a recession) shifts the demand curve to the left, leading to lower wages and employment (e.g., the hospitality industry during the COVID-19 pandemic)
- Sticky wages can prevent the labor market from reaching equilibrium
- If wages remain above the equilibrium level during a recession, the quantity of labor supplied will exceed the quantity of labor demanded
- This results in unemployment, as there are more workers seeking jobs than there are available positions at the prevailing wage rate (e.g., the persistent high unemployment rates in some European countries with strong labor protections)
Policy Responses and Types of Unemployment
Government interventions and unemployment types
- Policymakers use various tools to address unemployment during economic downturns:
- : Central banks may lower interest rates to stimulate borrowing and investment, potentially increasing and employment
- : Governments can increase spending or cut taxes to boost economic activity and create jobs
- Different types of unemployment require different policy approaches:
- Cyclical unemployment is addressed through demand-side policies that stimulate aggregate demand
- occurs when there's a mismatch between workers' skills and job requirements, often requiring long-term solutions like education and training programs
- is a natural part of the job search process and is less influenced by short-term economic policies
Key Terms to Review (16)
Aggregate Demand: Aggregate demand (AD) is the total demand for all final goods and services in an economy at a given time and price level. It represents the sum of four key components: consumer spending, business investment, government spending, and net exports. The concept of aggregate demand is central to understanding macroeconomic phenomena such as economic growth, unemployment, and inflation.
Business Cycles: Business cycles refer to the periodic fluctuations in economic activity, characterized by alternating periods of expansion and contraction in various economic indicators such as GDP, employment, and consumer spending. These cycles are a fundamental feature of market economies and have significant implications for microeconomics, macroeconomics, and the overall well-being of society.
Cyclical Unemployment: Cyclical unemployment refers to the fluctuations in the unemployment rate that occur due to changes in the business cycle. It is the component of unemployment that rises during economic downturns and falls during periods of economic growth and expansion.
Economic Cycles: Economic cycles refer to the fluctuations in economic activity over time, characterized by periods of growth, recession, and recovery. These cyclical patterns are a fundamental feature of market-based economies and have significant implications for employment, production, and overall economic well-being.
Efficiency Wage Theory: Efficiency wage theory is an economic concept that explains why employers may choose to pay workers more than the market-clearing wage. The theory suggests that higher wages can lead to increased worker productivity and reduced labor turnover, ultimately benefiting the employer through greater efficiency and profitability.
Equilibrium Wage Rate: The equilibrium wage rate is the market-clearing wage at which the quantity of labor demanded equals the quantity of labor supplied. It represents the point where the labor market is in balance, with no shortage or surplus of workers.
Fiscal Policy: Fiscal policy refers to the use of government spending, taxation, and borrowing to influence the overall level of economic activity. It is a macroeconomic tool employed by policymakers to manage the economy and achieve desired outcomes, such as promoting economic growth, reducing unemployment, and controlling inflation.
Frictional Unemployment: Frictional unemployment refers to the temporary unemployment experienced by individuals who are in the process of transitioning between jobs or entering the labor force for the first time. It occurs due to the time it takes for workers to find suitable employment opportunities that match their skills and preferences.
Labor Demand: Labor demand refers to the quantity of labor that employers are willing to hire at different wage rates. It is a derived demand, meaning it is dependent on the demand for the goods and services produced by workers. The labor demand is a crucial factor in understanding economic issues, the functioning of labor markets, and changes in unemployment over the short run.
Labor Market: The labor market is the market in which workers find paid employment and employers find the labor they need. It is where the supply of labor from workers and the demand for labor from employers interact to determine the wages and other employment conditions.
Labor Supply: Labor supply refers to the availability and willingness of individuals to provide their time and effort towards productive economic activities in exchange for compensation. It is a fundamental concept in labor economics that explores the factors influencing the quantity and quality of labor available in the market.
Monetary Policy: Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve in the United States, to influence the money supply and interest rates in an economy. It is a macroeconomic tool used to promote economic growth, stability, and full employment, as well as to manage inflation.
Recession: A recession is a significant decline in economic activity that lasts for a prolonged period, typically characterized by a drop in gross domestic product (GDP), increased unemployment, and reduced consumer spending. It is a key macroeconomic concept that is closely tied to the overall health and performance of an economy.
Recessions can have far-reaching impacts on various aspects of the economy, including the size of the economy, the labor market, monetary policy, and fiscal policy. Understanding the causes, characteristics, and implications of recessions is crucial for policymakers, businesses, and individuals to navigate economic challenges and make informed decisions.
Sticky Wages: Sticky wages refer to the phenomenon where wages in the labor market are slow to adjust to changes in economic conditions, remaining relatively fixed or 'sticky' even when supply and demand would suggest they should change. This concept is crucial in understanding the causes of changes in unemployment over the short run, the Keynesian perspective on market forces, and the balance between Keynesian and neoclassical models.
Structural Unemployment: Structural unemployment refers to a mismatch between the skills and qualifications of workers and the skills required by available jobs in the labor market. This type of unemployment is caused by fundamental shifts in the economy, such as technological advancements, changes in consumer demand, or the decline of certain industries, which can render some workers' skills obsolete or no longer in demand.
Unemployment Rate: The unemployment rate is a measure of the prevalence of unemployment and is calculated as the percentage of the total labor force that is unemployed but actively seeking employment and willing to work. It is a key economic indicator that provides insights into the health and performance of the labor market.