Cyclical Unemployment

Today we're going to look at cyclical unemployment -- unemployment correlated with the ups and downs of the business cycle. Using our friend, the FRED database, it's easy to see that unemployment increases during a recession when the economy is shrinking or growing only very slowly. Indeed, low growth and high unemployment -- that's part of what defines a recession. Lower growth is usually accompanied by high unemployment for two reasons.

First, and most obviously, when GDP is falling or growing more slowly than expected, firms often lay off workers, which generates unemployment. The second reason is slightly more subtle. Higher unemployment means that fewer workers are producing goods and services, and when workers are sitting idle, it's likely that capital is also sitting idle. And an economy with idle labor and capital, well, it can't be maximizing growth. Although unemployment is clearly correlated with the business cycle, the exact reasons why are debated by economists.

To see some of the issues, notice, for example, that unemployment typically spikes quickly when growth declines. But then it returns to more normal levels only slowly. The unemployment rate spiked in 2008, for example, as the economy declined. By 2010, the economy was actually growing at a slow but steady rate of around 2% per year. But unemployment didn't return to pre-recession levels for another five years. Why did it take so long for the unemployment rate to return to more normal levels? Think about a typical market, say the market for apples. Unemployed apples in this case would be apples that aren't being bought.

Now in a situation with high apple unemployment, you'd have a higher quantity supplied than the quantity demanded at the current price. So, what would you expect to happen in this situation? Well ordinarily, the price of apples would drop until the quantity supplied of apples equaled the quantity demanded and the market cleared. However, people are more complicated than apples. And labor markets -- they don't seem to behave in quite this way. Even when there are lots of unemployed workers, that is a higher quantity supplied of workers than the quantity demanded, wages seem to fall more slowly than you would expect. Economists say that wages are “sticky.” Sticky wages reduce the incentives to hire more workers and they slow the adjustment process.

Now sticky wages are puzzling and economists have a number of theories for why wages might be sticky. Probably the most important reason is that human beings get very upset when their wages fall, especially if a fall in wages is obvious and appears to be caused by a person, easily identifiable, like an employer. Imagine that your employer cut your wages. You’d probably be pretty upset. You might even retaliate by working less hard or even by disrupting your work place. Because of the fear of reducing morale, employers are very reluctant to reduce nominal wages.

This graph, for example, shows the distribution of non-zero wage changes. Small increases in wages are common, but small decreases in wages are very rare. Now even in a growing economy, we'd expect to see wages to fluctuate, like other prices, with lots of small wage decreases as well as wage increases. Supply and demand are constantly changing. But that's not what we see. Wages go up much more often than they go down. If nominal wages are sticky in the downward direction, it's going to take a long time to adjust to a shock that requires wages to fall, especially if the inflation rate is low -- a point which we will return to in a later video.

Unemployed workers may also take time to learn or to accept that their wages have fallen. And workers may also be afraid to accept a low-quality job for fear of being branded a low-quality worker. If you're a computer programmer, you might not want to take a job at Starbucks, even if you could get one -- or at least you might not want to put it on your resume. So, workers may want to search for a long time before they take a new job. Minimum wages and union contracts can also slow the adjustment of wages, as they put legal or contractual limits on how low wages can go. All of these mechanisms can lengthen the amount of time that it takes for unemployed workers to be rehired.

Okay -- one final concept -- the natural rate of unemployment. The natural rate is defined as the rate of unemployment that would occur if there were no cyclical unemployment. In other words, it's the rate of frictional plus structural unemployment. Now why do we care about the natural rate? We care because economists think that under some conditions the government can reduce cyclical unemployment through fiscal and monetary policies -- things like spending more money, cutting taxes, or increasing the money supply. These policies, however, are unlikely to change frictional or structural unemployment.

So, when the unemployment rate is close to the natural rate, that suggests that the scope for monetary and fiscal policy is diminished. Now unfortunately, we can only estimate the natural rate of unemployment. It's not something that we observe. This figure shows one estimate of the natural rate alongside the actual unemployment rate. Notice that by 2015 the actual unemployment rate was close to the natural rate. So, by this estimate, the time for fiscal and monetary policy had passed. Other estimates of the natural rate might suggest more room for policy.

Clearly, theories of cyclical unemployment are closely tied to theories of the business cycle. Why does an economy have booms and busts? And to theories about how the government might use fiscal and monetary policy to smooth the business cycle. So, we will be revisiting all of these issues in future videos.