L16 - Unemployment Flashcards
What is the Natural rate of Unemployment?
- The origin of the concept is due to Milton Friedman, and is used in his 1968 article “The Role of Monetary Policy”,
- drew on Knut Wicksell work who used it in the context of describing the “natural rate of interest”
- The average rate of unemployment around which the economy fluctuates –> actual unemployment rises above this level during a recession and falls in a boom
- One of the important features of the natural rate of unemployment is that it is unobserved.
- We do not measure it directly (in the same way that we are able to collect statistics on the rate of unemployment), and economists have to use statistical and econometric methods to estimate its value across different points in time.
Is the natural rate of unemployment constant?
- no it adjusts in response to changes in, for instance, labour market legislation and supply-side factors.
- However, even then, it is expected to change very slowly over time.
- A closely related concept, which is distinct from the “natural rate of unemployment” is the “NAIRU” – that is, the non-accelerating inflation rate of unemployment.
How is the NAIRU different from the natural rate of unemployment?
- This concept has different theoretical underpinnings to the “natural rate” concept.
- The natural rate hypothesis assumes perfectly competitive markets (characterised by market clearing, where the labour market is in equilibrium).
- In contrast, the NAIRU assumes that the labour market is imperfectly competitive due to the presence of trade unions who have the power to bargain the wage rate with firms.
- In this sense, the price of labour (i.e., the wage rate) is determined in a way that is not purely competitive
What is the NAIRU?
- he non-accelerating inflation rate of unemployment (NAIRU) is the specific level of unemployment that is evident in an economy that does not cause inflation to increase.
- The NAIRU is consistent with the presence of involuntary unemployment, whereas the natural rate is not.
- All worker who is unemployed in a “natural rate” model chooses to be unemployed, as, by construction, they are not prepared to accept the wage determined in a competitive market.
How is the natural rate of unemployment calculated?
- Whereas the actual unemployment rate for each quarter is an average of the three-monthly unemployment rates in that quarter, the natural unemployment rate in a given quarter is estimated by averaging all unemployment rates from 10 years earlier to 10 years later; future unemployment rates are set at 5.5%.
- (Therefore, estimates of the natural rate may become less accurate toward the end of the sample period.)
Why is it important to policymakers to accurately measure the natural rate of unemployment?
- Policymakers, such as central bankers, may be interested in knowing for sure at what point unemployment has fallen to the point where wages are about to go up (i.e., if unemployment falls below its natural rate, the economy may be susceptible to overheating).
- Having the correct measure of the natural rate (or, NAIRU) is important for precisely for this reason: policymakers can identify when it is necessary to tighten monetary policy to stave off inflationary pressure and avoid overshooting, for instance, an inflation target
What other macroeconomic theories is the natural rate related to?
- Consider the Barro and Gordon (1983) model, in which policymakers target a rate of unemployment which is below its natural rate (think of the k parameter).
- Here, the policymaker is assumed to have perfect knowledge of what the natural rate is, and through generating an inflationary surprise, the policymaker acts opportunistically to reduce the rate of unemployment (which would ultimately manifest itself in a higher level of output – think of Okun’s law).
- The notion of a ‘natural’ rate of unemployment is central to their theoretical model.
What can Policymaker also use the natural rate of unemployment?
- Further, in addition to estimates of the natural rate of unemployment being uncertain, its use as a benchmark against which policy can be determined may be undermined if, for instance, if the relationship between unemployment and other economic variables weakens.
- For instance, the rise in unemployment during the 2008-9 financial crisis did not lead to an (expected) sizable and persistent decline in inflation in the United States; further, the recent decline in the unemployment rate to a 50-year low in 2018 did not induce a dramatic increase in inflation (see: https://www.brookings.edu/blog/up-front/2019/03/06/what-is-u/).
- In this regard, using deviations of unemployment from its natural rate as an indicator of inflationary pressure may be limited.
What is the notation needed for the simply model of the natural rate?
L = # of workers in labor force
E = # of employed workers
U = # of unemployed
U/L = unemployment rate
- The sum of workers in these different states – E +U – equals the total number of workers in the labour force, L. In other words, L= E +U.
- This implies that the unemployment rate (expressed as a %) can be calculated by using the formula U / L.
- This implies that for a fixed level of L, changes in U will lead to fluctuations in the rate of unemployment. In fact, we assume that L is fixed (and thus exogenous in our model): it is not a function of any other parameters in the model.
What are the assumptions of the simple model of the natural rate?
- L is exogenously fixed.
- During any given month,
- s = rate of job separations, the fraction of employed workers that become separated from their jobs (lose or leave them)
- f = rate of job finding, the fraction of unemployed workers that find jobs
- s and f are exogenous
- We also assume that f and s have values which are bound between zero and one. (representing a percentage value)
How do you calculate the transition between employment and unemployment?
- What we observe here is that at any point (or period) in time, employed individuals will become unemployed at rate s, as denoted by the arrow from “Employed” to “Unemployed”.
- Here, the total number of employed workers entering unemployment will be given by s x E. At the same time, other individuals who were previously unemployed will be entering the employment.
- The fraction of individuals leaving unemployment will be given by f x U
What is the steady-state condition of the simple model of the natural rate?
- We can think about the labour market being in a steady state, which can be though of as a long-run equilibrium (i.e., where there is no tendency for the unemployment rate to change). equilibrium (i.e., where there is no tendency for the unemployment rate to change). For the unemployment rate to be constant, the number of people who become unemployed in each month must equal the number of formerly unemployed people who find jobs.
s x E = f x U
- All we then have to do is manipulate this equation, drawing on the relationship that L=E+U.
How do you calculate the equilibrium unemployment rate in the simple model?
Manipulate the formula L = E + U
- Our aim is to find the rate of unemployment that is constant. This is why the solution is expressed as U/L – it captures the proportion of individuals in the total labour force who are unemployed; that is, the unemployment rate.
- Remember, s and f are exogenous variables. We can also ask what happens when, for, example s and f change. If governments can affect s and f using economic policy, it will clearly have implications for the unemployment rate.
- In fact, this solution is akin to the natural rate of unemployment. Intuitively, the basis for our manipulations is that there is no change in both unemployment and employment
- . This is consistent with us setting f x U = s x E: the number of individuals leaving employment must be identical to individuals gaining employment. Therefore, U and E remain unchanged.
What are the policy implications of the simple model?
Clearly, if we assume that government can affect (lower) s and (raise) f through government policy (which is a realistic assumption), it can influence the unemployment rate. In what follows, we discuss the type of policies that might affect s and f.
Why is there unemployment?
§If job finding was instantaneous (f = 1),
then all spells of unemployment would be brief, and the natural rate would be near zero.
There are two reasons why f < 1:
- job search - that it takes time to search for a job (e.g., if one leaves a job, but does not have another job to move to immediately).
- wage rigidity - wage rigidities may keep the wage rate above the market-clearing level, which leads to structural unemployment. It may be the case that individuals who are prepared to work for the market-clearing wage might not be able to find a job.
What is frictional unemployment?
- caused by the time it takes workers to search for a job
- it on the notion that once a person becomes unemployed, they might not find a job instantaneously.
- occurs even when wages are flexible and there are enough jobs to go around
- Even when there are jobs out there, workers might not be matched suitable work immediately.
- The notion that it takes time to find a suitable job has led to the development of “search and match theory”.
- These models assume that the more time and energy required to find a new job, the lower the likelihood that workers will match with good firms and earn good wages.
Hows does wage rigidity cause unemployment?
- we see that a second reason for unemployment is wage rigidity —the failure of wages to adjust to a level at which labour supply equals labour demand.
- As wages are not always flexible (i.e., the labour market does not clear), the real wage can be stuck above the market-clearing level.
- In this example, the amount of labour demanded by firms is greater than the amount of labour willing to work, which leads to structural unemployment.
- Jobs are therefore rationed, and not all individuals would be willing to work are able to find jobs. This sort of unemployment is purely about numbers: too many people are chasing too few jobs.
When does unemployment typical rise?
This chart plots the median duration of unemployment in the United States. We see that it typically rises during recessions, shown as the shaded
areas here, but its spike upward during the recession of 2008–2009 was unprecedented.
Recessions are indicated by shaded areas. The figure shows that the duration of unemployment typically rises during recessions. Whilst the huge increase during the recession of 2008–2009, was at the time without precedent in modern US history, the effects of the Covid-19 pandemic may be far worse and more far reaching.
What has been the Trend of the natural rate from 1960-2010?
The purpose of this slide is to establish the trend behavior of the natural rate (red smooth line) in recent decades: rising until the early 80s, then falling from the mid-80s through the early 2000s.
The natural rate data used in this graph were estimated as the average of unemployment rates from 10 years before to 10 years after each date, with future unemployment rates set at 5.5 percent.
The following slides will show that the theories in this lecture are (mostly) consistent with the trend behavior of the natural rate.
How was the minimum wage led to the trend in the natural rate?
This chart shows that for the United States, the trend in the real minimum wage rises until the mid-to-late 1970s, then falls. The real minimum wage takes inflation into account (note that we see the minimum wage in current dollars rise continually over time; it rises in discrete increments because changes are due to changes in legislation). Its trend is fairly similar to the trend of the natural rate of unemployment (not depicted in this chart).
How has sectoral shifts explained the trend in the natural rate?
- E One would expect that a decrease in the frequency and magnitude of sectoral shifts would be associated with fewer job separations, less frictional unemployment, and a lower natural rate of unemployment.
- Unfortunately, there is no single “index of sectoral shifts.” However, we know that large changes in oil prices are one important source of sectoral shifts. Consider the United states.
- A significant fall in the price of oil causes a decrease in demand for workers at oil fields in Oklahoma and Texas, and an increase in dem
- and for workers at factories that produce SUVs. A significant increase in oil prices would do the opposite.
Conversely, an increase in the price of oil may cause the demand for labour to rise in oil-producing states such as Oklahoma and Texas, but because expensive oil means expensive gasoline, it makes driving less attractive and may decrease the demand for labour in auto-producing states.
The graph shows data on the price of oil since 1965.
•During 1970-1985, the real price of oil fluctuated between $20 and $100.
Also during this time, the natural rate of unemployment was rising.
•During 1986-2002, the real price of oil was in the $20-40 range except for a brief spike during the Gulf War. Also during this time, the natural rate of unemployment was falling.
The data are roughly consistent with the notion that sectoral shifts contribute to the natural rate.
Note the increase in oil prices from about $22 to $70 during 2002-2006:
- This represents a sectoral shift and may contribute to an increase in the natural rate of unemployment. Or maybe not, as oil consumption per dollar of GDP is lower today than in the 1970s and 1980s.
What has been the trend in unemployment in Europe 1960-2012?
This figure shows the unemployment rate in the four largest nations in Europe between 1970 and 2010. The figure shows that the European unemployment rate rose substantially across all countries. However, there is still variation across countries, which may be due to each country’s economic structure, employment law, the degree of unionization, access to unemployment benefits, and so on. One take-home from the data is that the lines are all highly correlated. This illustrates the interconnectedness of economies around the world.
