Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 31 Unemployment Fluctuations...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 31

Unemployment Fluctuations and the NAIRU

31-2Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to

5. Describe policies that might be used to reduce unemployment.

1. Describe how employment and unemployment change over the short and long runs.

2. Describe the difference between the New Classical and New Keynesian views of unemployment fluctuations.

4. Explain why the NAIRU can change.

3. Describe the causes of frictional and structural unemployment.


Changes in Employment

Employment and Unemployment

The long run: - changes in employment roughly match changes in the labor force

The short run: - employment and unemployment fluctuate considerably- the labor force is more stable


Changes in Unemployment

Unemployment usually falls during booms and rises during “slowdowns”:

- short-run fluctuations

Over longer periods, unemployment changes more due to structural changes in the labour force.


The level of activity in the labor market may be better shown by the flows into and out of unemployment:

- a million of workers flow in both directions each month!

Flows in the Labor Market

The focus on job creation and job destruction can oftenlead us to the conclusion that few changes are occurring in the labor market when in fact the truth is exactly the opposite.


Consequences of Unemployment

1. Lost output and income

- a waste of resources

2. Personal costs

- loss of self-esteem and dislocation of families

Two important costs associated with unemployment are:


Unemployment Fluctuations

Cyclical unemployment:

- the difference between actual unemployment and the amount that would exist when Y = Y*

When Y = Y*, there is still some unemployment:

- frictional

- structural

Central question: What causes unemployment fluctuations?


Figure 31.1 U.S. Unemployment Rate, 1976–2006


APPLYING ECONOMIC CONCEPTS 31.1

Stocks and Flows in the LaborMarket

Labor Market Stocks and Flows


New Classical Theories

According to New Classical theories, shocks to technology and tastes can explain unemployment fluctuations.

Two major characteristics of New Classical theories:

1. agents continuously optimize

2. markets continuously clear

- wage and price flexibility plays a leading role


New Classical explanations therefore look for reasons why employment fluctuates.

Any unemployment that may exist is voluntary.

EXTENSIONS IN THEORY 31.1

A Closer Look at New Classical Theory

New Classical Theories


Figure 31.2 Employment and Wages in a New Classical Labor Market


Figure 31.3 Unemployment and Sticky Wages in a New Keynesian Labor Market

Wages are sticky and the market does not clear

involuntary unemployment or labor shortages


2. Menu Costs and Wage Contracts

Continuously changing prices and wages are costly. Many firms change them only occasionally.

Four different explanations for wage “stickiness”:

1. Long-Term Relationships

In labor markets in which long-term relationships are important, the wage rate does not fluctuate to continuously clear the market.


3. Efficiency Wages

Firms may find it profitable to pay higher-than-market-clearing wages so that workers put forth greater effort.

4. Union Bargaining

Wages may be more influenced by “insiders” than by “outsiders” — this may keep wages high, even in the face of declining demand.

Four different explanations for wage “stickiness”:


Convergence of Theories?

Both theories predict that in the long run, the unemployment rate comes back to U* (NAIRU).

But they differ strongly in the short run:

- New Classical models predict U is always U*

SR is no different than LR

- New Keynesian models have U away from U* until LR

clear distinction between SR and LR


Table 31.1 Summary of New Classical and New Keynesian Theories


What Determines the NAIRU?

Frictional Unemployment

Frictional unemployment is caused by the time required for labor to move from one job to another:

- search behavior is important

- voluntary or involuntary?

EXTENSIONS IN THEORY 31.2

Voluntary versus Involuntary Unemployment


Structural Unemployment

Structural unemployment is due to a mismatch between what employers want and what workers have:

- regional mismatches

- occupational or industrial mismatches

Structural unemployment will rise if:

- there is a greater pace of structural change in economy

- some government policies restrict mobility


Figure 31.4 Unemployment Rates in Selected OECD Countries, 2006


The Frictional-Structural Distinction

Common characteristic:

- both suggest that there are as many unfilled vacancies as there are unemployed persons

Despite different conceptual meanings, it is often difficult to clearly distinguish the two types of unemployment.


Why Does the NAIRU Change?

1. Demographic shifts

- greater labour-force participation by groups with high unemployment rates increases NAIRU

- youths (15-24) tend to have much higher unemployment rates than “prime age” (25-65) individuals


Figure 31.5 Unemployment Rates by Demographic Groups, 2007


2. Hysteresis

In some models, the level of NAIRU can be influenced by the level of the actual rate of unemployment

- this effect is called hysteresis

- the unemployed might become “unemployable” as their skills wear out

- the “insiders” may keep wages high following a negative shock



3. Globalization and Structural Change

If the pace of structural change increases, the NAIRU will rise.

- trade liberalization might have this effect

4. Policies

Any government policy that reduces labor-market flexibility is likely to increase the NAIRU.



Reducing Unemployment

Cyclical Unemployment

There is debate over how much government can and should do to reduce cyclical unemployment.

Advocates of stabilization policy call for expansionary fiscal and monetary policies to reduce persistent recessionary gaps.

Advocates of the hands-off approach rely on normal market adjustments to remove recessionary gaps.


Frictional Unemployment

Increasing firms’ and workers’ knowledge about market opportunities may reduce frictional unemployment.

Employment insurance is one important policy:

• it permits valuable searching for good matches

• but it also might encourage “too much” job searching

But such measures are costly, and they must be balanced against the benefits.


Structural Unemployment

There is a social interest in reallocating resources to where they are most valuable:

- often conflicts with entrenched private interests

Two policy approaches to reduce structural unemployment:

1. Resisting Change

− maintaining employment levels in declining industries

2. Assisting Adjustment

- increase retaining

- improve the flow of labor-market information


Conclusion

Government policy has generally followed a middle route between those who believe that unemployment is a sign of deep, systemic flaws in the market system and those who argue that it is a necessary evil of the market system.

In an era of global competition, countries will be increasingly challenged to balance the need to cooperate with change and the need to provide a humane social welfare system.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 31 Unemployment Fluctuations...

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