Chapter 3: Unemployment

Determination of the natural rate of

unemployment (long term)
Causes of unemployment
Policies to tackle unemployment

Natural rate of unemployment

(NRU)
Natural rate of unemployment:
The average rate of unemployment around
which the economy fluctuates (given labor market
imperfections impeding workers to find jobs)

How a recession affect the actual unemployment

rate ?

How a boom affect the actual unemployment

rate ?

CHAPTER 6

Unemployment

Natural rate of unemployment

(NRU)
Natural rate of unemployment:
The average rate of unemployment around
which the economy fluctuates (given labor market
imperfections impeding workers to find jobs)

In a recession, the actual unemployment rate

rises above the natural rate.

In a boom, the actual unemployment rate falls

below the natural rate.

CHAPTER 6

Unemployment

Actual and natural rates of unemployment,

U.S., 1960-2010
Percent of labor force

12

10

Unemployment rate

Natural rate of
unemployment

0
CHAPTER
Unemployment
1960 61965
1970 1975 1980

1985

1990

1995

2000

2005

2010 4

Job loss, Job Finding and NRU

What determines the natural rate of unemployment ?
Model of labor-force dynamic
Notation:
L = workers in labor force
E = employed workers
U = unemployed workers
U/L = unemployment rate
CHAPTER 6

Unemployment

Assumptions:
1. L is exogenously fixed.
2. During any given month,
s = rate of job separations,
the fraction of employed workers
that become separated from their jobs
f = rate of job finding,
fraction of unemployed workers
that find jobs
s and f are exogenous

CHAPTER 6

Unemployment

The transitions between

employment and unemployment
s E

Employed

Unemploye
d

f U
CHAPTER 6

Unemployment

Finding the equilibrium U rate

If the unemployment rate is neither rising nor falling

f U ( job finders) = s E (job losers)

= s (L U )
= s L s U
Solve for U/L:
(f + s) U = s L
so,
CHAPTER 6

Unemployment

U
s

L sf

Example:
Each month,
1% of employed workers lose their jobs
(s = 0.01)
19% of unemployed workers find jobs
(f = 0.19)

Find the natural rate of unemployment ?

CHAPTER 6

Unemployment

Example:
Each month,
1% of employed workers lose their jobs
(s = 0.01)
19% of unemployed workers find jobs
(f = 0.19)

Find the natural rate of unemployment:

U
s
0.01

0.05, or 5%
L s f
0.01 0.19
CHAPTER 6

Unemployment

10

Policy implication
From

We get

Question: What kind of policy can reduce

the unemployment rate ?
CHAPTER 6

Unemployment

11

Policy implication

A policy will reduce the natural rate of

unemployment only:
if it lowers s : the rate of job
separation
or if it increases f : the rate of job
finding

CHAPTER 6

Unemployment

12

Why is there unemployment in

the first place ?
If job finding were instantaneous (f = 1),
then the natural rate of unemployment would be
near zero.

There are two reasons why f < 1: ??

CHAPTER 6

Unemployment

13

Why is there unemployment in

the first place ?
If job finding were instantaneous (f = 1),
then the natural rate of unemployment would be
near zero.

There are two reasons why f < 1:

1. job search
2. wage rigidity

CHAPTER 6

Unemployment

14

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 is not
instantaneous
flow of information about vacancies and job
candidates is imperfect
CHAPTER 6

Unemployment

15

Sectoral shifts and

unemployment (I)

The demand for goods and services vary

over time..

. So How does it affect the labor market ?

CHAPTER 6

Unemployment

16

Sectoral shifts and

unemployment (I)

The demand for goods and services vary

over time..

. So does the demand for labor that

produces these goods

CHAPTER 6

Unemployment

17

Sectoral shifts and unemployment

(II)
Def: Changes in the composition of demand
among industries or regions.

example: Technological change

more jobs repairing computers,
fewer jobs repairing typewriters

example: A new international trade agreement

labor demand increases in export sectors,
decreases in import-competing sectors
These scenarios result in frictional
unemployment
CHAPTER 6

Unemployment

18

CASE STUDY:

Structural change over the long

run

CHAPTER 6

Unemployment

19

More examples of sectoral shifts

Industrial revolution (1800s):
agriculture declines, manufacturing soars

Energy crisis (1970s):

demand shifts from larger cars to smaller ones

In
In our
our dynamic
dynamic economy,
economy,
smaller
smaller sectoral
sectoral shifts
shifts occur
occur frequently,
frequently,
contributing
contributing to
to frictional
frictional unemployment.
unemployment.

CHAPTER 6

Unemployment

20

Public policy and job search

Question:
What can governments do to tackle
frictional unemployment ?

CHAPTER 6

Unemployment

21

Public policy and job search

Govt programs affecting unemployment include:
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.

CHAPTER 6

Unemployment

22

Case study Unemployment insurance

(UI)
UI pays part of a workers former wages for a
limited time after losing his/her job.

Studies: (Woodbury et al.(1987)):

- The longer a worker is eligible for UI,
the longer the duration of the average spell of
unemployment
- The probability of a person finding a job more
than double when its benefits run out

Why ??
CHAPTER 6

Unemployment

23

Case study Unemployment insurance

(UI)

UI increases unemployment because it

reduces
the opportunity cost of being unemployed
the urgency of finding work

CHAPTER 6

Unemployment

24

What are the Benefits of

UI ?

CHAPTER 6

Unemployment

25

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

CHAPTER 6

Unemployment

26

Why is there unemployment?

The natural rate of unemployment:

U
s

L s f

Two reasons why f < 1:

1. job search
2. wage rigidity

CHAPTER 6

Unemployment

27

Unemployment from real wage

rigidity
If real wage is
stuck above
its eqm level,
then there
arent enough
jobs to go
around.

Real
wage

Supply
Unemployment

Rigid
real
wage

Demand
Labor

Amount of
labor hired
CHAPTER 6

Unemployment

Amount of labor
willing to work
28

Unemployment from real wage

rigidity
If real wage is
stuck above
its eqm level,
then there
arent enough
jobs to go
around.

CHAPTER 6

Then,
Then, firms
firms must
must ration
ration the
the
scarce
scarce jobs
jobs among
among workers.
workers.

Structural
Structural unemployment:
unemployment:
The
The unemployment
unemployment resulting
resulting
from
from real
real wage
wage rigidity
rigidity and
and
job
job rationing.
rationing.

Unemployment

29

Reasons for wage rigidity

1.

Minimum wage laws

2.

Efficiency wages

3.

Unions power

CHAPTER 6

Unemployment

30

1. The minimum wage

The min. wage may exceed the equilibrium
wage of unskilled workers, especially teenagers.

Studies (Brown (1988), Journal of Economic

Perspective): a 10% increase in min. wage
reduces teen employment by 1-3%

But !!! the min. wage cannot explain the

majority of the natural rate of employment,
as most workers wages are well above
the min. wage
CHAPTER 6

Unemployment

31

Effect of Minimum Wage

232

2. Efficiency wage theory

Theory in which higher wages increase worker
productivity
Idea: A firm operates more efficiently if it pays its
workers a high wage
Efficiency wage theory

CHAPTER 6

Unemployment

33

2. Efficiency wage theory

Theory in which higher wages increase worker
productivity
How ? By which mechanisms ?

CHAPTER 6

Unemployment

34

2. Efficiency wage theory

Theory in which higher wages increase worker
productivity by:
attracting higher quality job applicants
increasing worker effort, reducing shirking
reducing turnover (workers leave because wages are

low), which is costly to firms

improving health of workers
(in developing countries)

Firms are willing to pay above

equilibrium wages to raise productivity
Structural unemployment !!
CHAPTER 6

Unemployment

35

CHAPTER 6

Unemployment

36

TREND: The natural rate rises over 1960-

84, then falls over 1985-2005

Percent of labor force

9
8
7
6
5
4
3
37
CHAPTER
The Science
of Macroeconomics
19601 1965
1970 1975
1980 1985 1990 1995 2000 2005 2010

EXPLAINING THE TREND:

The minimum wage

$9

The
The real
real minimum
minimum wage
wage
and
and natural
natural u-rate
u-rate have
have
similar
similar trends.
trends.

Dollars per hour

$8
$7
$6
$5

minimum wage
in 2009 dollars

$4
$3
$2
$1

$0
38
19501 1955
1965of1970
1975 1980 1985 1990 1995 2000 2005 2010
CHAPTER
The 1960
Science
Macroeconomics

EXPLAINING THE TREND:

Sectoral shifts

1986-2005:
1986-2005: oil
oil prices
prices less
less
140
volatile,
volatile, so
so fewer
fewer sectoral
sectoral shifts
shifts
1970-1986:
volatile
oil
prices
1970-1986:
volatile
oil
prices
120
create
create jarring
jarring sectoral
sectoral shifts
shifts
100
80

Price per
barrel of oil,

60
40

in 2009
dollars

20
0
CHAPTER
19651

The
Macroeconomics
1970 Science
1975 of
1980
1985
1990
1995

2000

2005

39
2010

EXPLAINING THE TREND:

Union membership
Union membership
selected years

year

percent of labor force

1930

12%

1945

35%

1954

35%

1970

27%

1983

20.1%

2008

12.3%

CHAPTER 6

Unemployment

Since
Since early
early 1980s,
1980s,
the
the natural
natural rate
rate
and
and union
union
membership
membership
have
have both
both fallen.
fallen.
But,
But, from
from 1950s
1950s
to
to about
about 1980,
1980,
the
the natural
natural rate
rate
rose
rose while
while union
union
membership
membership fell.
fell.

40

Unemployment in Europe, 1960-2009

Percent of labor force

12
10
8
6
4

France
Germany

Italy
0
1970 6 1975
1980
1985
CHAPTER
Unemployment

1990

1995

2000

2005

201041

Why unemployment rose in Europe

but not the U.S.
Shock
Technological progress has shifted labor demand
from unskilled to skilled workers in recent
decades.
Effect in United States
An increase in the skill premium the wage gap
between skilled and unskilled workers.
Effect in Europe
Higher unemployment: Why ?
CHAPTER 6

Unemployment

42

Why unemployment rose in Europe

but not the U.S.
Shock
Technological progress has shifted labor demand
from unskilled to skilled workers in recent
decades.
Effect in United States
An increase in the skill premium the wage gap
between skilled and unskilled workers.
Effect in Europe
Higher unemployment, due to generous govt
benefits for unemployed workers and strong union
presence and minimum wage laws (France)
CHAPTER 6

Unemployment

43

Percent of workers covered by collective

bargaining, selected countries

CHAPTER 6

United States

18%

United Kingdom

47

Switzerland

53

Spain

68

Sweden

83

Germany

90

France

92

Austria

98

Unemployment

44

CHAPTER 6

Unemployment

45

Case study
Minimum wage: a poor way to reduce poverty,
Cato Institute

CHAPTER 6

Unemployment

47