Macroeconomic Objectives: Low Unemployment - Detailed Notes

Macroeconomic Objectives: Low Unemployment

Causes of Unemployment

Four main types of unemployment:
1. Cyclical (Demand-Deficient) Unemployment
2. Structural Unemployment
3. Frictional Unemployment
4. Seasonal Unemployment

Cyclical (Demand-Deficient) Unemployment

Associated with economic downturns (business cycle).
As the economy slows down or enters a recession, aggregate demand (AD) falls because consumers spend less.
A fall in consumer spending leads to a fall in demand for labor.
Firms cut back production and require fewer factors of production, including labor.
Figure 19.3(a) illustrates a decrease in AD; Figure 19.3(b) shows the corresponding fall in demand for labor.
Initially, the economy operates at a high level of economic activity (Y₁) with aggregate demand for labor at AD₀ resulting in equilibrium wage W₀ for Q₀ workers.
If the economy slows, AD falls from AD₀ to AD₁.
Firms reduce their demand for labor from AD₀ to AD₁.
In a perfect labor market, the average real wage would fall to W₁.
However, wages are "sticky downwards," meaning they don't easily fall.
- Firms fear discontent and reduced motivation among workers if wages are cut.
- Labor contracts and trade union power may prevent wage reductions.
Because wages remain "stuck" at W₀, the aggregate supply of labor exceeds the aggregate demand, creating unemployment of a - b.
Also known as Keynesian Unemployment.
- Keynes observed that the economy could operate below full employment, leading to high unemployment.

Curing Demand-Deficient Unemployment

The solution involves increasing aggregate demand through fiscal or monetary policies (Keynesian demand management policies).
Fiscal Policy:
- Increase government spending to directly increase AD.
- Lower direct and indirect taxes to indirectly increase consumption and investment.
Monetary Policy:
- Decrease interest rates.
- Increase the money supply.
Exercise 19.2: Using an AD/AS diagram, explain how fiscal policy can reduce demand-deficient unemployment.

Structural Unemployment

A result of the changing structure of an economy.
Considered the worst type of unemployment.

Forms of Structural Unemployment

Permanent Fall in Demand for a Particular Type of Labor
- Occurs naturally in a growing economy.
- New jobs are created (e.g., software engineers, financial advisors), while others disappear (e.g., coal mining).
- Leads to long-term unemployment because people lack the skills for newly created jobs (occupational immobility).
- Jobs may be created in one part of the country, while the unemployed live in another (geographic immobility).
- Causes include:
  - Technological Change: Mechanization and robots lead to job cuts (technological unemployment).
  - Globalization: Companies set up operations in countries with lower labor costs and less strict regulations, reducing demand for labor in developed countries. Increased trade from countries with lower production costs impacts higher-cost labor markets. For example, manufacturing unemployment in developed countries is blamed on imports from China.
  - Changes in Consumer Taste: Concerns about negative externalities (e.g., coal production) lead to a fall in demand for certain types of labor. For example, coal miners become structurally unemployed.
- Figure 19.4 illustrates a fall in demand for manufacturing labor in Canada due to lower costs in emerging economies.
  - Demand falls from D₁ to D₂.
  - Employment decreases from Q₁ to Q₂.
  - Wage falls from $16 to $12 per hour.
  - Increase in unemployment of the amount Q₁ - Q₂.
Change in the Institutional Framework of the Economy
- Changes in laws governing the labor market and trade unions.
  - Laws Governing the Labor Market: Laws that make it difficult to fire workers may discourage firms from hiring, reducing labor demand.
  - Minimum Wage Legislation: A minimum wage (e.g., $12 per hour for fast-food workers, as shown in Figure 19.5) can lead to unemployment.
    - Before the minimum wage, Q workers are employed at $10 per hour.
    - With the minimum wage enforced, labor demand falls to Q₁ workers, increasing unemployment by Q - Q₁.
    - The supply of labor increases from Q to Q₂ due to the higher wage.
  - Laws Governing Trade Unions: Unions may prevent firms from hiring non-union members, contributing to unemployment.
    *Important Distinction: Demand-deficient unemployment is caused by an overall (temporary) fall in demand for all labour in the economy as a result of a slowdown in economic growth or a recession While Structural unemployment is caused by a permanent fall in the demand for one type of labour and requires a different set of solutions.
- Demand deficient unemployment caused by a lengthy period of economic activity could result in structural unemployment.

Curing Structural Unemployment

Best addressed through supply-side policies.

Interventionist Policies
- Enhance the occupational mobility of people.
  - Education System: Train people to be more occupationally flexible.
  - Adult Upskilling/Retraining Programmes: Help people acquire skills for available jobs.
  - Subsidies to Firms: Encourage firms to provide training.
  - Subsidies/Tax Breaks for Relocation: Encourage people to move to areas with available jobs (enhance geographic mobility).
  - Apprenticeship Programmes: Like those in Germany and Austria.
  - Job Centres: Provide information about job vacancies, training, and interview skills.
- Disadvantages:
  - High opportunity cost.
  - Effective only in the longer term.
Market-Based Policies
- Lower unemployment benefits to encourage unemployed workers to take available jobs.
- Deregulation of labor markets: Reduce legislation on hiring, firing, and employment practices to increase "labor market flexibility".
- Burden of such policies:
  - Lower living standards for those losing unemployment benefits, thus increasing inequity.
  - Worse working conditions due to reduced labor market regulations which guarantee certain conditions of work, such as working time, holidays and safety at work. This can contribute to inequity in the economy

Frictional Unemployment

Short-term unemployment when people are between jobs or leaving education to find their first job.
Not generally seen as negative in a dynamic economy.
People move to jobs where they can be more productive.

Reducing Frictional Unemployment

Reduce unemployment benefits (market-based solution).
Improve the flow of information from employers to job seekers (interventionist approach).
- Internet job sites, newspapers, job centers, and employment counselors.

Seasonal Unemployment

Demand for certain workers falls at certain times of the year.
Examples: Construction workers in winter, ski instructors in summer.

Reducing Seasonal Unemployment

Encourage people to take different jobs in their "off-season".
Reduce unemployment benefits.
Improve the flow of information.

Natural Rate of Unemployment

The labor market may be in equilibrium with no demand-deficient unemployment, but unemployment still exists.
The number of job vacancies equals the number of people looking for work.
Some workers are unwilling or unable to take available jobs.
Unemployment greater than the equilibrium level. The full employment level of output, is known as the natural rate of unemployment
Comprises structural, frictional, and seasonal unemployment.
Workers may be unable to take jobs due to: occupational immobility, geographical immobility, or institutional framework limitations.
Formula: NATURAL_RATE_OF_UNEMPLOYMENT = Structural_unemployment + frictional_unemployment + seasonal_unemployment

Demand-Side vs. Supply-Side Policies for Reducing Unemployment

Solutions depend on the type of unemployment.
Demand-deficient unemployment requires demand-management policies.
- Concerns with demand-side policies like expansionary fiscal policy:
  - Budget deficits.
  - No guarantee people will spend extra disposable income.
  - Time lags before effects are realized.
Natural unemployment requires supply-side policies, using demand management policies will be unsucessful.
At full employment, increases in aggregate demand cause inflationary pressure.

Fiscal Policy: Discretionary vs. Automatic Stabilizers

Discretionary Fiscal Policy: Deliberate changes to government policy to manage aggregate demand.
- Example: Increasing infrastructure spending or reducing healthcare spending.
Automatic Stabilizers: Do not require deliberate policy changes.
- Affect government revenue and expenditure.
- High unemployment leads to lower tax revenues and increased transfer payments (unemployment benefits).
Automatic stabilizers control fluctuating economic activity without political decision-making or time lags.

Combining Policies

It is difficult to distinguish between types of unemployment.
Economies may suffer from multiple types of unemployment.
Governments commonly use a mix of demand-side and supply-side policies.
Demand-side policies narrow business cycle fluctuations and reduce output gaps.
Supply-side policies ensure labor is skilled and flexible, shifting the LRAS to the right.

Crowding Out (Higher Level)

When governments run budget deficits to stimulate the economy, they borrow money.
Governments sell bonds to financial institutions, increasing demand for savings or loanable funds.
Increased demand for loanable funds raises the interest rate.
Figure 19.6 illustrates the crowding-out effect.
Increased government borrowing (QLF2-QLF3) increases the interest rate from i₁ to i₂.
Higher interest rates reduce private business investment (borrowing falls from QLF1 to QLF2).
*. Whether the increase in government spending outweighs the fall in private investment is not known so the final effect on aggregate demand is also unknown.
Keynesian economists believe crowding out will not occur at less than full employment.
New classical economists argue crowding out is a significant problem.

Extreme New Classical View

The supply of loanable funds is fixed (perfectly inelastic).
Any increase in government spending leads only to an increase in interest rates.
Figure 19.7 illustrates this extreme view.
Interest rates increase from i₁ to i₂ with no increase in total borrowing (QFL1).
Private business borrowing falls to QLF2 which is less than the moderate view. This is even greater crowding out occurs than in the moderate view.

Exercise 19.3

Create a table showing types of unemployment, their causes, and their cures.