Review of the previous lecture

1. Key results from Solow model with tech progress steady state growth rate of income per person depends solely on

the exogenous rate of tech progress the U.S. has much less capital than the Golden Rule steady state

2. Ways to increase the saving rate increase public saving (reduce budget deficit) tax incentives for private saving

Review of the previous lecture

3. Productivity slowdown & “new economy” Early 1970s: productivity growth fell in the U.S. and other

countries. Mid 1990s: productivity growth increased, probably because of

advances in I.T.

4. Empirical studies Solow model explains balanced growth, conditional convergence Cross-country variation in living standards

due to differences in cap. accumulation and in production efficiency

Lecture 9

UnemploymentInstructor: Prof.Dr.Qaisar Abbas

Lecture Outline

1. Natural rate of unemployment

2. Why is there unemployment?

3. Job search

4. Wage rigidity

Natural rate of unemploymentNatural rate of unemployment •the average rate of unemployment around which the economy fluctuates. •In a recession, the actual unemployment rate rises above the natural rate. •In a boom, the actual unemployment rate falls below the natural rate.

A first model of the natural rateA first model of the natural rateNotation:

L = # of workers in labor forceE = # of employed workersU = # of unemployedU/L = unemployment rate

AssumptionsAssumptions1. L is exogenously fixed. 2. During any given month,

s = fraction of employed workers that become separated from their jobs,

f = fraction of unemployed workers that find jobs.

Natural rate of unemployments = rate of job separations

f = rate of job finding(both exogenous)

The transitions between employment and unemploymentThe transitions between employment and unemployment

The steady state condition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant. The steady-state condition is:

Solving for the “equilibrium” U rate

f U = s E = s (L –U )= s L – s U

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

Natural rate of unemployment

Natural rate of unemployment

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

Policy implication

•A policy that aims to reduce the natural rate of unemployment will succeed only if it lowers s or increases f.

0.010.05, or 5%

0.01 0.19U sL s f

How Is Unemployment Measured?•Based on the answers to the survey questions, each adult is placed into one of three categories:

EmployedUnemployed

Not in the labor force

•The BLS considers a person an adult if he or she is over 16 years old.

• A person is considered employed if he or she has spent most of the previous week working at a paid job.

•A person is unemployed if he or she is on temporary layoff, is looking for a job, or is waiting for the start date of a new job.

•A person who fits neither of these categories, such as a full-time student, homemaker, or retiree, is not in the labor force.

How Is Unemployment Measured?Labor Force

• The labor force is the total number of workers, including both the employed and the unemployed.

• The BLS defines the labor force as the sum of the employed and the unemployed.

The Breakdown of the Population

How Is Unemployment Measured?•The unemployment rate is calculated as the percentage of the labor force that is unemployed.

•The labor-force participation rate is the percentage of the adult population that is in the labor force.

U n em p lo y m en t ra te =N u m b er u n em p lo y ed

L ab o r fo rce 1 0 0

L ab o r fo rce p artic ip a tio n ra te

L ab o r fo rce

A d u lt p o p u la tio n 1 0 0

Why is there unemployment?If job finding were 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 < 1:1. job search2. wage rigidity

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 not instantaneous

• flow of information about vacancies and job candidates is imperfect

Sectoral shiftsdef: changes in the composition of demand among industries or regions

example: Technological change increases demand for computer repair persons, decreases demand for typewriter repair persons

example: A new international trade agreement causes greater demand for workers in the export sectors and less demand for workers in import-competing sectors.It takes time for workers to change sectors, so sectoral shifts cause frictional unemployment.

more examples:Late 1800s: decline of agriculture, increase in manufacturing

Late 1900s: relative decline of manufacturing, increase in service sector1970s energy crisis caused a shift in demand away from huge gas

guzzlers toward smaller cars.

In our dynamic economy, smaller (though still significant) sectoral shifts occur frequently, contributing to frictional unemployment.

Why is there unemployment?

Public Policy and Job SearchGovt programs affecting unemployment

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

Unemployment insurance (UI)• UI pays part of a worker’s former wages for a limited time after losing his/her job.•UI increases search unemployment, because it:reduces the opportunity cost of being unemployed, reduces the urgency of finding work hence, reduces f.•The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.

Benefits of UIBy 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.

Wage rigidityUnemployment from real wage rigidity

Wage rigidityReasons for wage rigidity1.Minimum wage laws

2.Labor unions

3.Efficiency wages (employers offer high wage as incentive for worker productivity and loyalty)

The minimum wage• The minimum wage is well below the eq’m wage for most workers, so it

cannot explain the majority of natural rate unemployment.

• However, the minimum wage may exceed the eq’m wage of unskilled workers, especially teenagers.

• If so, then we would expect that increases in the minimum wage would increase unemployment among these groups.

Wage rigidity

Labor unions

•Unions exercise monopoly power to secure higher wages for their members.

•When the union wage exceeds the eq’m wage, unemployment results.

•Employed union workers are insiders whose interest is to keep wages high.

•Unemployed non-union workers are outsiders and would prefer wages to be lower (so that labor demand would be high enough for them to get jobs).

The duration of unemployment

• More spells of unemployment are short-term than medium-term or long-term.

• Yet, most of the total time spent unemployed is attributable to the long-term unemployed.

•This long-term unemployment is probably structural and/or due to sectoral shifts among vastly different industries.

•Knowing this is important because it can help us craft policies that are more likely to succeed.

# of weeks unemployed

# of unemployed persons as % of

total # of unemployed

amount of time these workers spent unemployed

as % of total time all workers spent unemployed

1-4 39% 6.5%

5-14 31% 20.5%

15 or more 30% 73.0%

Summary

• The natural rate of unemployment the long-run average or “steady state” rate of unemployment depends on the rates of job separation and job finding

• Frictional unemployment due to the time it takes to match workers with jobs may be increased by unemployment insurance

• Structural unemployment results from wage rigidity - the real wage remains above the equilibrium

level causes: minimum wage, unions, efficiency wages

Summary

• Duration of unemployment most spells are short term but most weeks of unemployment are attributable to a small number of

long-term unemployed persons