Cyclical Unemployment

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

unemployment correlated
with the ups and downs

of the business cycle.

Using our friend,
the FRED database,

it's easy to see that
unemployment increases

during a recession
when the economy is shrinking

or growing only very slowly.

Indeed, low growth
and high unemployment --

that's part of what defines
a recession.

Lower growth is usually accompanied

by high unemployment
for two reasons.

First, and most obviously,
when GDP is falling

or growing more slowly
than expected,

firms often lay off workers,
which generates unemployment.

The second reason
is slightly more subtle.

Higher unemployment means

that fewer workers are producing
goods and services,

and when workers are sitting idle,

it's likely that capital
is also sitting idle.

And an economy
with idle labor and capital,

well, it can't
be maximizing growth.

Although unemployment
is clearly correlated

with the business cycle,

the exact reasons why
are debated by economists.

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

that unemployment
typically spikes quickly

when growth declines.

But then it returns to more
normal levels only slowly.

The unemployment rate
spiked in 2008,

for example,
as the economy declined.

By 2010, the economy
was actually growing

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

But unemployment didn't return
to pre-recession levels

for another five years.

Why did it take so long
for the unemployment rate

to return to more normal levels?

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

Unemployed apples
in this case would be apples

that aren't being bought.

Now in a situation
with high apple unemployment,

you'd have
a higher quantity supplied

than the quantity demanded
at the current price.

So what would you expect
to happen in this situation?

Well ordinarily, the price
of apples would drop

until the quantity
supplied of apples

equaled the quantity demanded
and the market cleared.

However, people are
more complicated than apples.

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

Even when there are lots
of unemployed workers,

that is a higher quantity
supplied of workers

than the quantity demanded,

wages seem to fall more slowly
than you would expect.

Economists say
that wages are “sticky.”

Sticky wages reduce the incentives
to hire more workers

and they slow
the adjustment process.

Now sticky wages are puzzling

and economists
have a number of theories

for why wages might be sticky.

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

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

and appears to be caused
by a person,

easily identifiable,
like an employer.

Imagine that your employer
cut your wages.

You’d probably be pretty upset.

You might even retaliate
by working less hard

or even by disrupting
your work place.

Because of the fear
of reducing morale,

employers are very reluctant
to reduce nominal wages.

This graph, for example,
shows the distribution

of non-zero wage changes.

Small increases in wages
are common,

but small decreases in wages
are very rare.

Now even in a growing economy,

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

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

Supply and demand
are constantly changing.

But that's not what we see.

Wages go up much more often
than they go down.

If nominal wages are sticky
in the downward direction,

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

that requires wages to fall,

especially
if the inflation rate is low --

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

Unemployed workers
may also take time to learn

or to accept
that their wages have fallen.

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

for fear of being branded
a low-quality worker.

If you're a computer programmer,

you might not want
to take a job at Starbucks,

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

to put it on your resume.

So workers may want
to search for a long time

before they take a new job.

Minimum wages and union contracts
can also slow the adjustment

of wages, as they put legal
or contractual limits

on how low wages can go.

All of these mechanisms
can lengthen the amount of time

that it takes for unemployed
workers to be rehired.

Okay -- one final concept --

the natural rate of unemployment.

The natural rate is defined as
the rate of unemployment

that would occur if there were
no cyclical unemployment.

In other words, it's the rate

of frictional plus
structural unemployment.

Now why do we care
about the natural rate?

We care because economists think
that under some conditions

the government can reduce
cyclical unemployment

through fiscal
and monetary policies --

things like spending more money,
cutting taxes,

or increasing the money supply.

These policies, however,
are unlikely to change

frictional
or structural unemployment.

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

that suggests that
the scope for monetary

and fiscal policy is diminished.

Now unfortunately,
we can only estimate

the natural rate of unemployment.

It's not something that we observe.

This figure shows one estimate
of the natural rate

alongside the actual
unemployment rate.

Notice that by 2015
the actual unemployment rate

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

the time for fiscal
and monetary policy had passed.

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

Clearly, theories
of cyclical unemployment

are closely tied to theories
of the business cycle.

Why does an economy
have booms and busts?

And to theories about
how the government might use

fiscal and monetary policy
to smooth the business cycle.

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

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