Unemployment Full employment means maintaining a high and stable level of employment in the economy while keeping unemployment low. This is because employment provides people with incomes and wealth to spend on goods and services, whereas unemployment is a waste of productive resources such as the welfare payments made by the government for the unemployed. Governments therefore pay attention to: Labour force: The total number of people of working age willing and able to work, whether they are in work or actively seeking it. Labour force participation rate: The labour force as a proportion of the total working-age population, calculated as the labour force divided by the total working-age population. Employment by industrial sector: The amount of people working in each different sector, specifically in agriculture and manufacturing relative to services. Employment status: The number of people employed full-time, part-time, or temporary work. Unemployment: The number of people registered as being without work as a proportion of the total labour force. Unemployment rate is the percentage of people in the labor force without work and recorded as unemployed, calculated by: (unemployed / labour force) x 100 Labor force participation The labor force is the working, economically active population of a country consisting of people of working age who are able and willing to work. It forms the total supply of labor in a country including those employed by private sector firms, public sector organizations, are self-employed, are in the armed forces, are on government training programmes, and the unemployed who are looking for work. Those not counted economically active are students, retired people, stay-at-home parents, people in prison, and those unwilling to work. They are the dependent population as they depend on the labor force to supply the goods and services they need and want. The labor force participation rate measures the percentage of the working-age population that is working or seeking work, and therefore able to produce goods and services. Trends in participation rates can be explained by: ➔ Poverty, so more people seeking formal paid employment (formal: included in GDP and taxes) ➔ Rising cost of living, thus more people are forced into work to maintain the living standrads of their families ➔ Social attitudes have changed to make it more acceptable for women to work ➔ Availability of part-time jobs has increased ➔ Shrinking of industries and a higher proportion of employment in the tertiary sector ➔ Decline in the proportion employed in the public sector as a country moves towards a market economy. Employment by industrial sector As an economy develops, it undergoes a structural change as output and employment shifts from the primary sector in agriculture to the secondary sector in manufacturing, and then to the tertiary sector in services. Developed economies employ most of its labor force to work in services, whereas low-income economies employ most of its labor force in agriculture. However, the loss of jobs from agriculture, mining, and manufacturing industries in developed economies may increase unemployment. The decline of unemployment in agriculture and the expansion of jobs in industry and services means that more people will move from rural areas into urban areas, but the rapid growth of densely populated urban areas causes problems including an increase in demand for energy, rising car use, and overcrowding. Measuring unemployment ● Claimant count: Unemployed people can file for unemployment claims including social welfare payments or unemployment benefits. The government can count the total number of unemployment claims made in the economy to measure unemployment. However, this may be inaccurate as benefits in some countries may only be paid for a short amount of time. In addition, some people who want to work may not receive financial payments from the government, such as the old and disables, stay-at-home mothers, students willing to work but in education, and people who work a few hours each week but want to work for longer. ● Labour surveys: economies conduct surveys among the entire labour force to collect data about it, including data on the number of people unemployed. The highest unemployment rates may be observed in the least developed economies, where there are low levels of education and skills among the labor force and a lack of paid employment opportunities, causing problems for economic development. Types of unemployment: Frictional unemployment This describes a situation when people are between two jobs, as they leave one job and spend time looking for a new one. This type of unemployment is short-lived. Seasonal unemployment This describes a situation where people are unemployed in specific seasons due to seasonal consumer demand for goods and services. For example, a strawberry pickers being unemployed during the winter. This type of unemployment is short-lived. Cyclical unemployment Cyclical unemployment occurs when there is a lack of aggregate demand for goods and services in the economy during an economic recession. This means spending will be reduced and stocks of unsold products will accumulate, so firms will cut their production in response and therefore workers may become unemployed. Aggregate demand includes consumer expenditure, investment by firms, government spending, and spending on exports by overseas consumers. When AD is changed, it can have widespread effects in an economy known as the multiplier effect whereby a small change in total expenditure can cause much larger changes in income, output, and employment. Structural unemployment Structural unemployment arises from long-term, changes in the structure of an economy. Workers are made unemployed since they are occupationally immobile as they lack the skills modern industries want. It is long-lived. It can be split into two types: ● Technological unemployment: As technology advances and firms move into more capital-intensive production processes, industrial robots and computerized machinery will substitute labor. ● Sectoral unemployment: As a sector or industry declines, its workers become unemployed. For example, in many developed economies people are now employed in services, whereas many years ago far more people were employed in agriculture than in manufacturing industries. Labor market barriers Labor market is a market for labor, referring to the demand for labor by firms and supply of labor by people. Barriers to entry in the labor market are: ● Lack of information and difficulty finding jobs ● Lack of skills and education ● Lack of financial resources to cover application costs ● Mobility constraints, including occupational (inability of workers to move easily between different occupations due to a lack of transferable skills) and geographic (unable or unwilling to move to another geographic area for a job) ● Criminal record ● More capital-intensive production, thus skills are not needed ● Government regulations, such as the banning of an industry ● Unemployment benefits reduce the incentive to work as they might be too generous What decreases the demand for labor? 1. Powerful trade unions forcing up wages without improving their labor productivity, thus employers will not be able to employ as many workers and the demand for labor contracts 2. Minimum wage legislation may reduce labor demand as they raise the market wage rates of the lowest paid workers, but in some cases they are too high, reducing demand for labor 3. Lack of demand for the good or service, thus there is no demand for labor as the demand for labor is a derived demand, meaning it is dependent on the demand for the product Consequences of unemployment ● Deskilling: People will lose their working skills if they remain unemployed for long periods of time and therefore may find it even harder to find suitable jobs. Labor losing skills is also detrimental to firms who may employ these people in the future, since they will have to retrain these workers. ● Living standards will fall: As people remain unemployed, their incomes will decrease, and thus living standards will fall. ● Illnesses: Unemployment increases susceptibility to malnutrition, illness, mental stress, and loss of self-esteem leading to depression while fear of job loss can cause psychological anxiety ● Rise in crime rates: Unemployment will lead to poverty and homelessness, encouraging people to steal and commit other crimes in order to live, leading to civil unrest ● Higher average costs: Firms will have to pay redundancy payments to workers they unemploy, raising costs. In addition, as firms lay off workers, they will be left with spare capacity, including unutilised machinery and factory spaces, leading to higher average costs. ● Burden on tax-payers rises: People will need to rely on government unemployment benefits to support themselves, and these benefits are provided from tax revenue. However, as incomes have fallen tax revenue will also fall. This means that people remaining in work will have to pay more of their income as tax so that it can be distributed as unemployment benefits to the unemployed. ● Opportunity cost: Public expenditure on other projects such as schools, roads etc. will have to be cut down to be able to pay benefits. ● Loss of output: Since labor is a resource and it is not being used, the economy doesn’t reach its maximum productive capacity, therefore it is economically inefficient on the PPC. The economy loses output. ● Deflation: Due to low incomes, people’s purchasing power/consumption will fall, causing demand to fall. Due to lack of consumption, aggregate demand shifts inwards, decreasing prices. Policies to reduce unemployment Demand-side policies Fiscal and monetary policies can be used as a short-term boost in aggregate demand during an economic recession, reducing cyclical unemployment. An economic recovery will always create new jobs as demand rises, but will not reduce unemployment if it has been caused by other factors such as structural unemployment. ● Fiscal policy stimulus may include tax cuts to increase disposable income, therefore increasing consumer expenditure. It may also include an increase in public spending for example on welfare payments and capital projects to create new jobs, such as the building of public infrastructure ● Monetary policy stimulus involves reducing interest rates to make borrowing money cheaper. In a deep, prolonged recession, a government may increase the money supply in the economy However, if aggregate demand is overstimulated and increases for too long and it exceeds growth in the aggregate supply of goods and services in an economy, inflation is likely to accelerate. Thus, it is important for demand-side policies to be combined with supply-side policies that aim to boost the long-run productive capacity of the economy. Supply-side policies Supply-side policy instruments aim to correct or overcome problems that reduce people’s ability to find new jobs, incentive to find work, and the firm’s incentive to employ them. These measures are long-term and may take several years to have their full effect. ➔ Measures to reduce the occupational immobility of labor reduce structural employment by: ◆ Providing government training to teach the unemployed new skills they need to find new jobs in new, growing industries ◆ Raising the school leaving age so young people spend longer in education learning a range of skills and acquiring the qualifications they need to increase their chances of being employed ➔ Regional subsidies can be offered to firms to locate themselves in areas where old industries hve declined in order to reduce regional concentrations of structural unemployment. However, this is expensive and may take a long time to achieve. Alternatively, subsidies could be offered to unemployed workers to move to areas where there are jobs, helping to reduce geographical immobility ➔ Emplpyment subsidies can be paid to firms to employ people who have been unemployed for a long time while also cutting payroll taxes. However, this may encourage firms to ➔ ➔ ➔ ➔ unemploy their existing workers and hire from the pool of unemployed to benefit from the subsidies and tax breaks. Labor market reforms: ◆ Restricting the power of trade unions to prevent firms in employing non-unionized workers and to use strikes and other industrial actions in an attempt to bargain for wage increases that are not matched by improvements in the productivity of union members ◆ Reducing minimum wages if they have been set at too high a level and have therefore reduced the demand for low paid workers ◆ Cutting the marginal rate of income tax on low incomes would increase the financial reward from working relative to unemployment benefits, as some people may be better off receiving unemployment benefits than accepting a low paying job ◆ Reducing unemployment benefits in amount and in the length of time people are able to claim them when they are out of work Depreciate the exchange rate: as the currency depreciates, the country’s exports will become cheaper and so export demand from abroad will increase, helping boost production and employment in the export industries. Restricting imports and encourage exports: A lot of unemployment occurs when good quality and cheaper foreign products put domestic industries out of business. Controlling imports using import tariffs and quotas will encourage domestic firms to emerge and increase production and thus increase employment. Provide information: Frictional unemployment can be eliminated to an extent by making information available about job vacancies to the unemployed through job centres, newspapers, government websites etc. Inflation and deflation What is inflation? Inflation refers to the general and sustained rise in the level of prices of goods and services. It is expressed as a rate of change per period of time, usually per year. Hyperinflation refers to a type of runaway inflation during which prices rise at phenomenal rates rapidly and uncontrollably, causing money to become almost worthless. Governments aim to keep inflation in their economies at 2-3% per year. Measurement of inflation Inflation is measured using consumer prices index (CPI), which includes tracking the prices of a selection of goods and services or ‘basket’. It is often considered to provide a cost-of-living index, but it simply indicates the amount that would need to be spent to purchase the same things bought in an earlier period. The base year is the average price of the basket of products of the first calculation, and is what the following years are compared to. The consumer price index is calculated in this way: ● A selection of goods and services normally purchased by a typical family or household is identified. The prices of these ‘basket of goods and services’ will then be monitored at a number of different retail outlets across the area. ● The average price of the basket in the first year or ‘base year’ is given a value of 100. ● The average change in price of these goods and services over the year is calculated. For example, if it rises by an average of 25%, the new index is 125% x 100 = 125%. If in the next year there is a further average increase of 10%, the price index is 110% x 125 = 137.5%. The average inflation rate over the two years is thus 137.5 – 100 = 37.5% CPI = (weighted average price in a year / weighted average price in base year) x 100 Weighted average price in a year = (proportion of weekly expenditure in a category / 100) x average price of goods and services in that category. Then, add all the results from categories together. $25 in this case is the base year. Next year, when this calculation is used again, you will divide the new price of the basket by 25 and multiply that by 100. Therefore, 27/25 x 100 = 108, so CPI in year 1 is 108. Why do we use price indices? 1. As an economic indicator: CPI is widely used as a measure of price inflation, and therefore as a measure of changes in the cost of living. Governments will try to control price inflation using macroeconomic policies. 2. As a price deflator: CPI is used to deflate various economic series to calculate their real values without inflation, because rising prices reduce the purchasing power/real value of money. This includes wages, profits, pensions, savings, and more economic variables. For example, if annual earnings have increased by 10% but price inflation has increased by 15%, then the real value of earnings has fallen by 5% as the purchasing power of the payments have reduced. 3. Indexation: Indexation means tying certain payments to the rate of increase in price inflation to keep their real value constant, for example public pensions paid to retired people by the government may be indexed so they increase by the rate of inflation each year. Problems with price indices. 1. Consumers change their consumption patterns over time in comparison with the base years. This is due to changes in tastes and fashion, the introduction of new goods and services, and the changing composition of the population and households (due to migration, change in death and birth rates, later marriages) 2. Changes in the quality of products is not taken into account, as product quality may improve over time 3. There may be regional variations in price for which CPI cannot account for 4. CPI does not account for an increase in the use of discount stores and sales, as it takes the retail prices of goods and services 5. International comparisons of CPI inflation are difficult to make as household composition and spending patterns can differ significantly by country Causes of inflation Monetary factors affect the rate of inflation. This is because an increase in the supply of money wil cause inflation to accelerate if there is no growth in real output, as people will increase their spending on goods and services at a faster rate than producers can expand the supply of goods and services. This causes an excess of aggregate demand, forcing the general price levels up. A government allows the money supply to expand: ● To increase AD in an economy during a recession to decrease unemployment ● In response to worker’s demand for higher wages, or a rise in other costs of production The monetary rule a government must follow if it wants to keep inflation low and stable in the economy is that it should only allow the supply of money to expand at the same rate as the increase in output or real GDP over time. Stagflation has occurred in the past due to: Governments allowed their money supplies to expand faster than growth in output in an effort to boost AD and reduce unemployment. In response, firms took on more resources and employed more people to increase the production of goods and services. This provided people with more income to spend, causing inflation to rise as aggregate demand grew faster than output. The high inflation reduced the purchasing power of incomes, thus AD fell. Workers would demand higher wages to keep up with the cost of living, but as wages increased firms reduced their demand for labor, increasing unemployment once more. This caused a situation where inflation and unemployment were both high and rising together. Demand-pull inflation Demand-pull inflation is inflation caused by an increase in aggregate demand. An increase in AD causes market prices to increase and inflation to rise if firms are unable to supply goods and services at the same rate as demand. To finance an increase in aggregate demand, consumers and firms may borrow more from banks if there are lower interest rates and the government can issue more notes and coins, which both involve increasing the supply of money in the economy. Therefore, the monetary rule a government must follow if it wants to keep inflation low and stable in the economy is that it should only allow the supply of money to expand at the same rate as the increase in output or real GDP over time. Cost-push inflation Inflation caused by rising production costs is cost-push inflation. Rising production costs could be due to higher taxes, higher wages, higher cost of raw materials, higher interest rates on capital, etc. Aggregate supply shifts inwards, pushing up general price levels, and less labor is needed as output is reduced which causes people to become unemployed. To compensate for higher prices, workers may ask for an increase in wages, adding to the costs of production. However, this will cause prices to rise even further, further prompting higher wage demands (this is called wage-price spiral). To prevent a rise in unemployment, the goverment can expand the supply of money to boost aggregate demand. Wage-price inflation: As wages rise, the cost of production rises thus the general price level of goods and services rises. As prices rise, workers demand higher wages, and an inflationary spiral begins. Imported inflation Rising prices in one country causes its import prices in another country to rise, causing imported inflation as it is more expensive to import goods into the country than before. Also, a fall in the value of the national currency against the currencies of other countries will mean imports become more expensive. Benefits of low and stable inflation Governments aim to keep inflation in their economies at 2-3% per year because low inflation can be beneficial in these ways: ★ Encourages consumers to buy goods and services sooner rather than later as delaying means that they will have to pay more for the same product ★ During periods of low inflation, interest rates are low, making it more appealing to borrow money. In addition, the real cost of loan repayments are low. This can boost economic growth, for example as firms are more optimistic to borrow money they will invest in new plant and machinery ★ Exports from a country with low inflation will become more competitive than rival products from overseas producers on international markets, helping boost demand for exports, creating additional incomes and employment opportunities in the low inflation country ★ Expectations that inflation will be low helps in reducing demands for higher wages by workers. Therefore if wages rise by less than the inflation rate each year, the real cost of employing workers will fall for firms and may encourage them to increase their demand for labor, decreasing unemployment Consequences of inflation ● Inflation erodes the purchasing power of money and reduces real incomes: People will be able to buy less with the same amount of money than they did before. For example, if inflation was 5% per year, a dollar will be worth 78 cents 5 years from then and 61 cents ten years after. Those on fixed incomes will be affected most as they are unable to increase their real incomes at the same rate as price inflation, therefore their living standards will fall. ● Savers and lenders: Those who saved or lent money will be negatively affected as the interest rates received will be lower than the rate of price inflation, thus the real value of their money will fall. Those who borrowed will benefit as the real value of the interest rates they pay will fall. ● Imposes additional costs on firms, especially during a cost-push inflation: All types of inflation involve ‘menu costs’, referring to all types of inconveniences that firms and ● ● ● individuals can fave as prices continue to rise. For example, firms will have to change price labels and consumers will have to pay surcharges on goods and services they have already paid for, like additional charges on holidays to cover higher fuel costs. Reduces the competitiveness of exports: If prices continue to rise in an exporting country at a faster rate than prices in rival countries, exports from that country will become less competitive in international markets and demand for those exports from overseas consumers may fall. This has a negative impact on employment in exporting industries and the balance of payments, causing a deficit. Economic uncertainty is created: Consumers, firms, and the government are uncertain about their future costs and the impact inflation will have on their incomes and revenues. Firms may become reluctant to invest in new plant and equipment while consumers may be reluctant to spend, reducing economic growth. Effect on currency: If inflation is very volatile and turns into hyperinflation, people may lose all confidence in theur currency as a medium of exchange and store of value. Policies to control inflation Announcing a long-term inflation target By announcing an inflation target, people will believe their government will keep their rate of inflation low and stable in their economy, therefore they are less likely to demand big wage increases each year. This helps in reducing the rate at which costs of production rise and therefore reduces pressure on firms to increase their prices. Demand-side policies If there is demand-pull inflation caused by aggregate demand exceeding growth in aggregate supply, demand-side policies can be used: ➔ Contractionary fiscal policy: Reducing public expenditure and raising direct taxes, e.g. cutting welfare payments and raising taxes on incomes to reduce real disposable incomes and consumer spending. This is an unpopular policy only employed when inflation is severe, as raising taxes will cause hardship for many people and cutting public spending on capital projects will damage the long-term productive potential of the economy. ➔ Contractionary monetary policy: Increasing interest rates to reduce borrowing, discouraging spending and investing. This may also cause the foreign exchange rate to appreciate, resulting in a reduction in the imported price of goods and services purchased from producers overseas. However, there is a considerable time lag for this policy to take effect. However, these will be ineffective if the main cause of rising prices are due to external or global factors like rising food and energy prices. Supply-side policies Expanding the productive capacity and total output of an economy can reduce inflationary pressures caused by rising total demand and rising production costs. If the aggregate supply of goods and services in an economy is able to expand at the same rate as total demand, cost and price inflation would not accelerate. Policies to achieve this include: ● Increased public sector support for training workers in new and more advanced skills to boost their mobility and productivity ● Cutting taxes on profits to encourage entrepreneurs to start up and invest in more firms ● Financial support to encourage firms to invest more in the research and development of new, innovative products and efficient production processes These are effective long-term policies helping to keep the long-term inflation rate stable, so sudden surges in inflation cannot be addressed using supply-side policies as they take longer to work than demand-side policies. They are more effective in the long-term as they allow incomes and demand in the economy to grow over time without creating additional inflationary pressures. Direct controls ● Capping the rate at which public sector wages can increase each year below the rate of inflation or freezing them altogether in order to reduce disposable income and purchasing power of public sector workers. However, limits on public sector wages will reduce the attraction of public sector jobs. It will be increasingly difficult for hospitals, schools, social services, the police force, and other public sector organizations to recruit people, thus the delivery and quality of many public sector services may suffer as a result ● Capping the prices firms can charge in markets regulated by the government, including markets for essential goods and services like electricity and water supplies. However, capping the prices of private sector firms in regulated markets for too long will squeeze their profits and reduce their incentives to invest in new equipment and service improvements. Their effect is limited and can cause significant problems in the long-run. Deflation Deflation refers to the continuous decline in the general price levels of goods and services in an economy. This is due to: ● Aggregate supply increasing relative to demand ● Competition between firms to supply has increased ● Labour productivity rises, increasing output and reducing average costs ● Technological advancements has allowed for more efficient production at lower costs ● Demand has fallen in the economy during a recession, causing general prices to fall Disinflation refers to a slow down in the rate at which prices are rising in general. How is deflation measured? Deflation is measured in the same way as inflation, using CPI. However, instead of showing figures above 100, it will show an index below 100 denoting a deflation. For example, if a drop in the average prices of the basket of goods in a year is 10%, deflation will be 10%. Consequences during malign deflation 1. Consumers will dellay many spending decisions as they wait for prices to fall further, decreasing aggregate demand 2. Stocks of unsold goods accumulate so firms cut their prices, reducing their profits and incentive to invest 3. Firms cut their production and reduce the size of their workforce 4. Household income falls as unemployment rises, further reducing demand for goods and services 5. Value of debts held by people and firms rises in real value, increasing the burden of loan repayments 6. Firms stop investing in new plant and machinery as demand falls and the cost of borrowing rises, reducing future growth in the economy 7. The real cost of public spending rises but tax revenues fall as economic activity slumps and people become uenmployed, meaning the government must borrow more money despite the rising real cost of borrowing 8. The economy eventually goes into a deep recession as demand, output, demand for labor, and incomes continue to fall. Policies to control deflation Deflation leads to more deflation as consumers continue to delay their spending further, causing many firms to go out of businesses as they are unable to make a profit. It is therefore hard to break out of the downard spiral that can occur in a malign deflation, requiring a major boost to aggregate demand and confidence. ● Expansionary monetary policy to revive demand: Cutting interest rates will encourage more spending and investment in the economy which will stimulate prices to rise. However, this might cause a liquidity trap, meaning if interest rate is already at a very low point where decreasing it any further won’t increase spending as people would still prefer to save some money, then cutting interest rates will have no effect on spending as monetary policy is ineffective in this case. This is because as prices fall real interest rates will be rising, even if nominal interest rate is zero. ● Expansionary fiscal policy to revive demand: Increasing government spending in the economy to fund projects can draw more people back into employment, such as in infrastructure, along with cuts in direct taxes on incomes to boost demand. The money for this expenditure can be created via quantitative easing (selling government bonds to the public). ● Devaluation: Devaluing the currency, for example by increasing the money supply, will cause export prices to fall resulting in higher demand overseas which encourages production of exports in the economy, while also increasing prices of imported products which will raise costs and prices for products in the economy. ● Change inflation expectations: When a deflation is expected, businesses won’t increase wages and consumers won’t pay higher prices because they expect prices to fall in the future. This will cause the deflation they expected. But if the monetary authorities indicate that they expect higher inflation, firms will pay their workers more and consumer will spend more now, avoiding a deflation.
