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Unemployment Fluctuations and The NAIRU

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34 views

Unemployment Fluctuations and The NAIRU

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aamitabh3
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 31

Unemployment
Fluctuations
and the NAIRU

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.


In this chapter you will learn to

1. Describe how employment and unemployment change


over the short and long runs.

2. Describe the difference between the New Classical and


New Keynesian views of unemployment fluctuations.

3. Describe the causes of frictional and structural


unemployment.
4. Explain why the NAIRU can change.
5. Describe policies that might be used to reduce
unemployment.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-2
Employment and Unemployment

Changes in Employment

The long run:


- changes in employment roughly match changes in
the labor force

The short run:


- employment and unemployment fluctuate
considerably
- the labor force is more stable

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-3


Changes in Unemployment

Unemployment usually falls during booms and rises during


“slowdowns”:
- short-run fluctuations

Over longer periods, unemployment changes more due to


structural changes in the labour force.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-4


Flows in the Labor Market

The focus on job creation and job destruction can often


lead us to the conclusion that few changes are occurring in
the labor market when in fact the truth is exactly the
opposite.

The level of activity in the labor market may be better shown


by the flows into and out of unemployment:

- a million of workers flow in both directions each month!

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-5


Consequences of Unemployment

Two important costs associated with unemployment are:

1. Lost output and income


- a waste of resources

2. Personal costs
- loss of self-esteem and dislocation of families

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-6


Unemployment Fluctuations

Cyclical unemployment:
- the difference between actual unemployment and the
amount that would exist when Y = Y*

When Y = Y*, there is still some unemployment:


- frictional
- structural

Central question: What causes unemployment fluctuations?

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-7


Figure 31.1 U.S. Unemployment
Rate, 1976–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-8


Labor Market Stocks and Flows

APPLYING ECONOMIC CONCEPTS 31.1


Stocks and Flows in the Labor
Market

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-9


New Classical Theories

According to New Classical theories, shocks to technology


and tastes can explain unemployment fluctuations.

Two major characteristics of New Classical theories:


1. agents continuously optimize
2. markets continuously clear
- wage and price flexibility plays a leading role

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-10


New Classical Theories

New Classical explanations therefore look for reasons why


employment fluctuates.

Any unemployment that may exist is voluntary.

EXTENSIONS IN THEORY 31.1


A Closer Look at New Classical
Theory

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-11


Figure 31.2 Employment and Wages
in a New Classical Labor Market

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-12


Figure 31.3 Unemployment and Sticky
Wages in a New Keynesian Labor Market

Wages are sticky and


the market does not
clear

 involuntary
unemployment or labor
shortages

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-13


Four different explanations for
wage “stickiness”:

1. Long-Term Relationships

In labor markets in which long-term relationships are


important, the wage rate does not fluctuate to
continuously clear the market.

2. Menu Costs and Wage Contracts


Continuously changing prices and wages are costly. Many
firms change them only occasionally.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-14


Four different explanations for
wage “stickiness”:

3. Efficiency Wages
Firms may find it profitable to pay higher-than-market-
clearing wages so that workers put forth greater effort.

4. Union Bargaining
Wages may be more influenced by “insiders” than by
“outsiders” — this may keep wages high, even in the face of
declining demand.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-15


Convergence of Theories?

Both theories predict that in the long run, the unemployment


rate comes back to U* (NAIRU).

But they differ strongly in the short run:


- New Classical models predict U is always U*
 SR is no different than LR
- New Keynesian models have U away from U* until LR
 clear distinction between SR and LR

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-16


Table 31.1 Summary of New Classical
and New Keynesian Theories

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-17


What Determines the NAIRU?

Frictional Unemployment
Frictional unemployment is caused by the time required for
labor to move from one job to another:
- search behavior is important
- voluntary or involuntary?

EXTENSIONS IN THEORY 31.2


Voluntary versus Involuntary Unemployment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-18


Structural Unemployment

Structural unemployment is due to a mismatch between what


employers want and what workers have:
- regional mismatches
- occupational or industrial mismatches

Structural unemployment will rise if:


- there is a greater pace of structural change in
economy
- some government policies restrict mobility

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-19


Figure 31.4 Unemployment Rates
in Selected OECD Countries, 2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-20


The Frictional-Structural Distinction

Common characteristic:
- both suggest that there are as many unfilled
vacancies as there are unemployed persons

Despite different conceptual meanings, it is often difficult to


clearly distinguish the two types of unemployment.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-21


Why Does the NAIRU Change?

1. Demographic shifts
- greater labour-force participation by groups with high
unemployment rates increases NAIRU
- youths (15-24) tend to have much higher unemployment
rates than “prime age” (25-65) individuals

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-22


Figure 31.5 Unemployment Rates
by Demographic Groups, 2007

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-23


Why Does the NAIRU Change?

2. Hysteresis

In some models, the level of NAIRU can be influenced by


the level of the actual rate of unemployment
- this effect is called hysteresis
- the unemployed might become “unemployable” as
their skills wear out
- the “insiders” may keep wages high following a
negative shock

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-24


Why Does the NAIRU Change?

3. Globalization and Structural Change

If the pace of structural change increases, the NAIRU will


rise.
- trade liberalization might have this effect

4. Policies

Any government policy that reduces labor-market flexibility


is likely to increase the NAIRU.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-25


Reducing Unemployment

Cyclical Unemployment
There is debate over how much government can and should
do to reduce cyclical unemployment.

Advocates of stabilization policy call for expansionary fiscal


and monetary policies to reduce persistent recessionary gaps.
Advocates of the hands-off approach rely on normal market
adjustments to remove recessionary gaps.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-26


Frictional Unemployment

Increasing firms’ and workers’ knowledge about market


opportunities may reduce frictional unemployment.

But such measures are costly, and they must be balanced


against the benefits.

Employment insurance is one important policy:


• it permits valuable searching for good matches
• but it also might encourage “too much” job searching

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-27


Structural Unemployment

There is a social interest in reallocating resources to where


they are most valuable:
- often conflicts with entrenched private interests
Two policy approaches to reduce structural unemployment:
1. Resisting Change
− maintaining employment levels in declining industries
2. Assisting Adjustment
- increase retaining
- improve the flow of labor-market information
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-28
Conclusion

Government policy has generally followed a middle route


between those who believe that unemployment is a sign of
deep, systemic flaws in the market system and those who
argue that it is a necessary evil of the market system.

In an era of global competition, countries will be increasingly


challenged to balance the need to cooperate with change and
the need to provide a humane social welfare system.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 31-29

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