Macroeconomic Objectives: Low Unemployment - Detailed Notes

Macroeconomic Objectives: Low Unemployment

Causes of Unemployment

There are four main types of unemployment:

  1. Cyclical (Demand-Deficient) Unemployment
  2. Structural Unemployment
  3. Frictional Unemployment
  4. Seasonal Unemployment

Cyclical (Demand-Deficient) Unemployment

This type of unemployment is linked to economic downturns. When an economy slows down or enters a recession, aggregate demand (AD) decreases, leading to reduced consumer spending on goods and services,Illustrated in Figure 19.3(a). The fall in consumer spending leads to a fall in demand for labour. Firms reduce production and require fewer factors of production, including labour. As firms cut back on production, they will need fewer factors of production and, of course, labour is one of the factors. This is shown in Figure 19.3(b).

Assume the economy is initially operating at a high level of economic activity at Y1 in Figure 19.3(a). There is aggregate demand for labour at AD1 in 19.3(b), so the equilibrium wage will be We for Qe workers. The labour market is in equilibrium.

If the economy slows down, aggregate demand is likely to fall as shown in Figure 19.3(a). To reduce their output, firms will reduce their demand for labour from AD₁ to AD₁₁ as shown in Figure 19.3(b). If labour markets functioned perfectly, then the average real wage would fall to W_1. However, this is not the case, and we say that wages are "sticky downwards". This means that while workers' wages can easily increase, it is less likely that real wages will fall. There are several reasons for this wage "stickiness". First of all, firms realize that paying lower real wages is likely to lead to discontent and reduced motivation among workers. This may result in lower worker productivity and is undesirable

If the economy slows down, aggregate demand falls. Firms reduce their demand for labor from ADe to AD1 (Figure 19.3(b)).

In a perfect labor market, real wages would fall to W_1. However, wages are "sticky downwards," meaning they don't decrease easily. This is due to:

  • Firms fearing discontent and reduced motivation among workers if wages are lowered.
  • Labor contracts and trade union power preventing wage cuts.

Since wages remain "stuck" at W_e, the aggregate supply of labor exceeds the aggregate demand, creating unemployment of a - b.

This is also known as Keynesian unemployment, referencing Keynes' observation that economies can operate below full employment, leading to high unemployment.

Curing Demand-Deficient Unemployment

The solution is to increase aggregate demand (AD) through fiscal or monetary policies (Keynesian demand management policies).

  • Fiscal Policy: Increasing government spending or lowering direct and indirect taxes to boost consumption and investment.
  • Monetary Policy: Decreasing interest rates or increasing the money supply.

Structural Unemployment

Structural unemployment arises from significant changes in the economy's structure. Two forms exist:

  1. Permanent Fall in Demand for a Particular Type of Labor

    This occurs when certain jobs become obsolete due to economic shifts. While new jobs are created (e.g., software engineers), others disappear (e.g., coal mining), leading to long-term unemployment. Workers often lack the occupational mobility (skills) or geographic mobility to switch jobs. Causes include:

    • Technological Change: Mechanization and automation lead to job cuts (technological unemployment).
    • Globalization: Companies move operations to countries with lower labor costs and regulations, reducing demand for labor in developed countries.
    • Changes in Consumer Taste: Shifts in preferences reduce demand for certain goods and the labor associated with them (e.g., declining demand for coal due to environmental concerns).

  2. A change in the institutional framework of the economy
    Laws governing the labour market - For example, consider the case where there is a law which states that firms may not fire workers unless they give lengthy documentation and proof of inefficiency or malpractice. Most people would agree that this is a very important right that should be given to all workers. However, this law might also prevent some firms from hiring workers, as they fear the costs of dismissing them should the workers not be efficient. This would reduce the demand for labour, causing unemployment.

We can use a diagram to illustrate structural unemployment. We
can show the fall in demand for labour in a particular market or
geographical area. Consider the case of manufacturing workers
in Canada, as illustrated in Figure 19.4. Given that the cost of
employing labour in manufacturing in emerging/developing
economies is lower than in high-income countries there has been a
fall in demand (D, to D₂) for manufacturing labour in higher-wage
countries such as Canada. The consequence of this is that there are
fewer manufacturing workers employed (Q1 to Q2) and the wage
falls from $16 per hour to $12 per hour. From this diagram we can
assume that unless these workers can find other jobs there is an
increase in unemployment of the amount Q1 - Q2

Note the distinction: Demand-deficient unemployment is a temporary fall in overall labor demand due to economic slowdowns, while structural unemployment is a permanent fall in demand for specific types of labor.
Demand deficient unemployment caused by a lengthy period of economic activity could result in structural unemployment. This could occur because, as the economy picks up, it is quite possible that new forms of labour are needed, while workers who were made redundant during a recession do not have the skills needed for the changing economic climate.

Curing Structural Unemployment

Supply-side policies are the best approach:

Interventionist Policies:

  • Enhance occupational mobility through education and training.
  • Develop an education system that promotes adaptability to changing economic conditions.
  • Invest in adult upskilling and retraining programs.
  • Subsidize firms that provide worker training.
  • Provide subsidies or tax breaks to encourage geographic mobility.
  • Support apprenticeship programs.
  • Establish job centers to provide information about job vacancies and training opportunities.

Market-Based Policies:

  • Reduce unemployment benefits to incentivize job seeking.
  • Deregulate labor markets to increase "labor market flexibility."

Frictional Unemployment

This is short-term unemployment that occurs when people are between jobs or entering the workforce. It's generally not considered a major problem, as it reflects a dynamic economy where people seek more productive employment.

Reducing Frictional Unemployment

  • Reduce unemployment benefits (market-based).
  • Improve the flow of information about job vacancies through job sites, newspapers, and employment counselors (interventionist).

Seasonal Unemployment

This occurs when the demand for certain workers falls at specific times of the year (e.g., 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 about alternative job opportunities.

Natural Rate of Unemployment

Even in a labor market equilibrium (where job vacancies equal job seekers), some unemployment persists. This is the natural rate of unemployment, comprising structural, frictional, and seasonal unemployment.

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

The appropriate policies depend on the type of unemployment:

  • Demand-deficient unemployment: Demand-management policies (fiscal and monetary) are suitable.
  • Structural, frictional, and seasonal unemployment: Supply-side policies are more effective.

Fiscal Policy - Discretionary vs. Automatic Stabilizers

  • Discretionary Fiscal Policy: Deliberate changes in government policy to manage aggregate demand (e.g., increasing infrastructure spending).
  • Automatic Stabilizers: Mechanisms that automatically adjust government revenue and expenditure in response to economic fluctuations (e.g., unemployment benefits).

Crowding Out

When governments run budget deficits to stimulate the economy, they borrow money by selling government bonds. This increases the demand for loanable funds, potentially raising interest rates and reducing private business investment as Private businesses will have been "crowded out" of the market.

Keynesian economists argue that crowding out is less likely when the economy is producing below full employment. New classical economists view crowding out as a significant problem with increased government spending.

Extreme new classical economists believe the supply of loanable funds is fixed (perfectly inelastic), so increased government spending only raises interest rates without increasing total borrowing, leading to greater crowding out of private investment.