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Unemployment

Definition - A person is unemployed when they are out of work and actively seeking work, while not imposing any unreasonable conditions (high wages) on potential employers.

Measurements of unemployment 

  1. Claimant account – measures the amount of people claiming benefits (job seekers allowance), but open to both fraud and the issue that not everyone claims. The main reasin for people not claiming is that they feel embarassed, they don't want people to know that they are unemployed and require financial help.
  2. International labour organisation (ILO) – covers those people who have looked for work in the past month and are able to start work in the next two weeks. On average, the labour force survey has exceeded the claimant count total by about 400,000 in recent years.

Types of unemployment:

  • Frictional unemployment – This form of unemployment occurs as people move between jobs.
  • Structural unemployment – When the structure of the economy changes some people’s skills are no longer demanded and so they become unemployed. This was the case during the decline of the mining sector, miners were no longer needed and their skills were not transferable to other industries, subsequently they became unemployed.
  • Cyclical unemployment – Occurs as the economy moves through the business cycle, into a recession. During a recession consumer confidence is low as is spending and AD, leading to a rise in unemployment. Also known as demand deficient unemployment.
  • Seasonal unemployment –Some work is only available during certain seasons. For example in Britain people only go to the beach in the summer months. Anyone employed in this sector will be seasonally unemployed for the rest of the year.

Economics costs of unemployment

  • Foregone output – unemployment is a waste of resources resulting in the economy not maximising its level of output, which reduces long run growth potential.
  • Monetary costs to the government – The government not only receives less in the form of tax revenue but it also has to pay more in benefits, this often causes a rise in the governments borrowing requirement.
  • Deadweight loss of human capital – when people are unemployed not only are there skills under-utilised but the unemployed begin to lose their skills.

Social costs of unemployment

  • Social deprivation – there are links between unemployment and social problems such as divorce, crime, bad health and so on.

Solutions to unemployment

  • Cut real wages – part of the problem is that demand for high wages, has resulted in some workers pricing themselves out of a job. Reducing the real wage will mean that these workers are willing to work at the current wage rate.
  • Reduce trade union power – Despite the fact that Trade Unions improve working conditions for employees they do actually create unemployment. Unions bargain for higher wages for workers, but these higher wages reduce the demand for labour and so create unemployment.
  • Improve the quantity and quality of information - On available jobs and workers, this will reduce time spent searching for jobs. A related example is that of Sweden whereby there are nationwide job centers, which have an integrated database of jobs, employers, and available employees.
  • Reduce the supply of labour - Achieved through early retirement, work sharing and reduced migration. However, this policy is not popular among economists.
  • Improve labour employability - Improvements to education and training (increase human capital), so that the unemployed have the right skills to take up any available job opportunities. In addition to this the policies should focus on improving the occupational mobility of labour, so that unemployment isn’t concentrated in specific regions.
  • Increase the incentives for people to search and accept paid work - this may require reforms to the welfare system, ensuring that there are no disincentives to work. One possible reform is a reduction in unemployment benefits - if unemployment benefits are below the national minimum wage then the unemployed will have an incentive to get a job.
  • Sustained economic growth - this requires that high aggregate demand which will encourage businesses to expand their workforces (create jobs). The diagram below is proof that economic growth creates jobs. The red line shows economic growth and the blue line shows employment, there is a direct relationship between the two. As economic growth rises employment rises.

  • Increase Aggregate Demand - The government can also use macro-economic policies (monetary/fiscal policy) to increase the level of aggregate demand. Another opportunity is to encourage direct foreign investment into the economy from foreign multinational companies. Either way the increase in demand for output, will lead an increase in total employment.
  • Employment Subsidies - Government subsidies for those firms that take on the long-term unemployed will create an incentive for firms to increase the size of their workforce. Employment subsidies could also be made available for overseas firms locating in the UK.
  • Lower marginal tax rates – marginal tax rates are the tax rates that you face as your income rises. Lowering these marginal tax rates will encourage people to work harder because they no longer face such high tax rates on additional earnings. Put simply less money is taking by the government, your hard work is rewarded.
  • Regional policies – low business tax rates or business subsidies to encourage businesses to locate in areas of high unemployment, this will create employment opportunities.  
  • An example is the New Deal scheme whereby when a person has claimed benefits for 6 months they have to accept a job offered to them or lose the benefits.

The current unemployment situation in the UK

In the diagram above it is clear that unemployment has been falling within the UK over the last two years. The reason being, that over the last two years  output has been rising, and in order to satisfy the high demand, more people were in employed. However, with the economy currently slowing down, it is likely that unemployment will begin too rise. For more information on the ‘slow down’ refer to the page on economic growth.


Inflation

Definition: Persistent rise in the price level of goods and services in an economy.

Causes of inflation:

  • Cost push inflation – a rise in the price of costs (labour/materials/taxes), causes the aggregate supply curve to shift left. And as seen in the diagram below this causes the price to rise from P1 to P2.

  • Demand pull inflation – A shift outward in AD causes both a rise in the price level and output. This can be seen in the diagrams below.

Effects of inflation:

  • Uncertainty about future prices, this discourages investment and saving.
  • Redistribution 1) From those on fixed incomes (pensioners) to those on variable incomes (profits/wages). 2) A reduction in debt value helps debtors. 3) Governments benefit from fiscal drag whereby inflation pushes people into higher tax brackets.
  • International trade – Where there are fixed exchange rates a rise in prices will make exports more expensive and so the level of exports will fall.

Measuring inflation

Measured by the Consumer Price Index (CPI). The CPI collects two sets of data. 1) Prices - the prices of a sample of goods are collected from a sample of locations across the country. 2) Weighting - the goods are weighted in terms of expenditure, the more money is spent on a good the higher the weighting it is given. Prices are compared with the base year and an inflation rate (%) is calculated.

Controlling inflation

  • Monetary policy – the process of raising interest rates in order to a) encourage more saving b) restrict investment (loans are more costly in terms of interest repayments) c) reduce disposable incomes (larger mortgage repayments). All of this reduces AD within the economy thereby controlling inflation.
  • Fiscal policy – altering the levels of taxation and government expenditure. In the case of rising inflation the government will raise taxes, this will reduce disposable income and so reduce both investment and consumption. In addition to this the government will reduce government expenditure, the combination of all this will cause AD to shift left reducing inflation.
  • Supply side policies –the aim is to increase the productive capacity of the economy in the long run as this causes the supply curve to shift right, reducing inflation. This can be achieved through training the workforce, increasing efficiency.

The current inflation situation in the UK

As can be seen in the diagram above inflation in the UK has been slowly rising over the last two years. The reason being is that over the last two years aggregate demand and output have been rising. The UK entered what’s known as a boom in terms of the business cycle. With demand being high, demand push inflation set in. However with the economy starting to slow down in terms of economic growth it's likely that inflation will begin to slow.


The Phillips curve and the NAIRU

It may be clear from the current UK experience that unemployment and inflation move in opposite directions. In the last two years unemployment has been falling while inflation has been increasing. And there is a theory that explains this – the Phillips curve. The Phillips curve is an inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation in that economy (there is a trade off). This can be seen in the diagram below, as the unemployment rate falls from 7% to 2% the inflation rate rises from 4% to 6%.



Why is this?

As unemployment falls not only do workers seek greater wage increases, but the growing skill shortages also put an upward pressure on wages. And as wages rise, business costs rise, which in turn leads to higher prices within the economy (cost push inflation). Furthermore during periods of low unemployment clearly the majority of people are earning an income. This will obviously lead to a rise in consumption and investment, which in turn produce an outward shift in the AD curve (demand pull inflation). This has important implications for the government in that if the government wishes to lower unemployment it will have to accept that inflation will rise in the short run (a trade off).

However in the long run Milton Friedman put forward the theory that there was no relationship between unemployment and inflation. He argued that the long run Phillips curve was vertical. This led to the NAIRU (Non accelerating inflation rate of unemployment), which is the rate of unemployment at which inflationary pressures are stable. To see this consider the diagram below, the economy begins at equilibrium point 1. With the economy on the LRAS curve, the AS1 curve and the AD1 curve with the price level at P1 and output at Yn. The government then introduces a one off fiscal expansion causing an outward shift in the AD curve to AD2. In the short run there is an expansion up the AS1 curve, firms can increase output beyond the full employment level of output by paying workers over time. This generates inflation since the price level increases, but in the long run all factors are available and so workers demand a rise in wages to compensate for the higher prices. This raises costs causing an inward shift in the AS curve to AS2. Long run equilibrium means that output falls back to the full employment level at Yn. The only long run affect is a rise in prices to P2. From this it is clear as to why Friedman states the long run Phillips curve is vertical.

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