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[Alex] Today we're going to look
at cyclical unemployment --

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unemployment correlated
with the ups and downs

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of the business cycle.

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Using our friend,
the FRED database,

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it's easy to see that
unemployment increases

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during a recession
when the economy is shrinking

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or growing only very slowly.

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Indeed, low growth
and high unemployment --

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that's part of what defines
a recession.

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Lower growth is usually accompanied

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by high unemployment
for two reasons.

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First, and most obviously,
when GDP is falling

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or growing more slowly
than expected,

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firms often lay off workers,
which generates unemployment.

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The second reason
is slightly more subtle.

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Higher unemployment means

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that fewer workers are producing
goods and services,

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and when workers are sitting idle,

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it's likely that capital
is also sitting idle.

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And an economy
with idle labor and capital,

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well, it can't
be maximizing growth.

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Although unemployment
is clearly correlated

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with the business cycle,

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the exact reasons why
are debated by economists.

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To see some of the issues,
notice, for example,

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that unemployment
typically spikes quickly

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when growth declines.

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But then it returns to more
normal levels only slowly.

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The unemployment rate
spiked in 2008,

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for example,
as the economy declined.

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By 2010, the economy
was actually growing

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at a slow but steady rate
of around 2% per year.

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But unemployment didn't return
to pre-recession levels

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for another five years.

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Why did it take so long
for the unemployment rate

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to return to more normal levels?

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Think about a typical market,
say the market for apples.

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Unemployed apples
in this case would be apples

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that aren't being bought.

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Now in a situation
with high apple unemployment,

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you'd have
a higher quantity supplied

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than the quantity demanded
at the current price.

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So what would you expect
to happen in this situation?

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Well ordinarily, the price
of apples would drop

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until the quantity
supplied of apples

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equaled the quantity demanded
and the market cleared.

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However, people are
more complicated than apples.

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And labor markets -- they don't
seem to behave in quite this way.

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Even when there are lots
of unemployed workers,

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that is a higher quantity
supplied of workers

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than the quantity demanded,

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wages seem to fall more slowly
than you would expect.

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Economists say
that wages are “sticky.”

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Sticky wages reduce the incentives
to hire more workers

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and they slow
the adjustment process.

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Now sticky wages are puzzling

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and economists
have a number of theories

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for why wages might be sticky.

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Probably the most important reason
is that human beings get very upset

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when their wages fall, especially
if a fall in wages is obvious

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and appears to be caused
by a person,

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easily identifiable,
like an employer.

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Imagine that your employer
cut your wages.

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You’d probably be pretty upset.

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You might even retaliate
by working less hard

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or even by disrupting
your work place.

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Because of the fear
of reducing morale,

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employers are very reluctant
to reduce nominal wages.

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This graph, for example,
shows the distribution

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of non-zero wage changes.

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Small increases in wages
are common,

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but small decreases in wages
are very rare.

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Now even in a growing economy,

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we'd expect to see wages
to fluctuate, like other prices,

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with lots of small wage decreases
as well as wage increases.

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Supply and demand
are constantly changing.

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But that's not what we see.

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Wages go up much more often
than they go down.

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If nominal wages are sticky
in the downward direction,

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it's going to take a long time
to adjust to a shock

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that requires wages to fall,

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especially
if the inflation rate is low --

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a point which we will return to
in a later video.

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Unemployed workers
may also take time to learn

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or to accept
that their wages have fallen.

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And workers may also be afraid
to accept a low-quality job

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for fear of being branded
a low-quality worker.

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If you're a computer programmer,

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you might not want
to take a job at Starbucks,

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even if you could get one --
or at least you might not want

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to put it on your resume.

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So workers may want
to search for a long time

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before they take a new job.

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Minimum wages and union contracts
can also slow the adjustment

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of wages, as they put legal
or contractual limits

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on how low wages can go.

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All of these mechanisms
can lengthen the amount of time

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that it takes for unemployed
workers to be rehired.

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Okay -- one final concept --

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the natural rate of unemployment.

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The natural rate is defined as
the rate of unemployment

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that would occur if there were
no cyclical unemployment.

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In other words, it's the rate

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of frictional plus
structural unemployment.

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Now why do we care
about the natural rate?

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We care because economists think
that under some conditions

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the government can reduce
cyclical unemployment

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through fiscal
and monetary policies --

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things like spending more money,
cutting taxes,

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or increasing the money supply.

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These policies, however,
are unlikely to change

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frictional
or structural unemployment.

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So when the unemployment rate
is close to the natural rate,

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that suggests that
the scope for monetary

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and fiscal policy is diminished.

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Now unfortunately,
we can only estimate

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the natural rate of unemployment.

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It's not something that we observe.

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This figure shows one estimate
of the natural rate

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alongside the actual
unemployment rate.

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Notice that by 2015
the actual unemployment rate

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was close to the natural rate.
So by this estimate,

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the time for fiscal
and monetary policy had passed.

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Other estimates of the natural rate
might suggest more room for policy.

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Clearly, theories
of cyclical unemployment

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are closely tied to theories
of the business cycle.

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Why does an economy
have booms and busts?

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And to theories about
how the government might use

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fiscal and monetary policy
to smooth the business cycle.

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So we will be revisiting all
of these issues in future videos.

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[Narrator] If you want
to test yourself,

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click "Practice Questions."

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