CHAPTER NINE: UNEMPLOYMENT

9.0 Introduction
Just like GDP, unemployment ranks high as an indicator of economic wellbeing in any country and
unemployment rate is the most widely used indicator of the well-being of a labour market and an
important measure of the state of an economy in general. To the layman, unemployment means a state
of joblessness but economists consider it as the inability of those who are in the labour force to find a
job. It is a very serious macroeconomics problem that can influence political outcomes in any country
especially in developed countries. This study session will focus majorly on definition, causes and types
of unemployment.

Objectives of the chapter

Having successfully completed this chapter, you should be able to:

o Define the concept of unemployment.

o Determine unemployment rate.
o Explain the economic costs of unemployment.
o Distinguish different types of unemployment.
o Formulate policies to reduce unemployment.
o Explain conflict between unemployment and inflation.

9.1 Definitions
9.1.1 Definition of unemployment

Unemployment could be defined as the percentage of the labour force that is without job but is able and
willing to work. Or the unemployed people are regarded as those who are not currently employed and
who indicate by their behaviour that they want to work at prevailing wages and working conditions.
According to the ILO guidelines, a person is to be considered unemployed if he/she during the reference
period simultaneously satisfies being:

(a) ‘without work’, i.e., was not in paid employment or self-employment as specified by the
international definition;

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(b) ‘currently available for work’, i.e., was available for paid employment or self-employment during
the reference period; and

(c) ‘Seeking work’, i.e., has taken specific steps in a specified recent period to seek paid employment
or self-employment.

Generally, unemployment refers to people of working age who are actively looking for a job but who
are not employed.

9.1.2 Definition of underemployment

Under-employment occurs when someone is working part-time, but would prefer to work full-time.

9.1.3 Economic inactivity

This occurs when people are not in the labour force. They are neither working nor looking for work.
They could include categories such as early retirement and long-term sickness.

9.2 Estimating unemployment rate

The most difficult part of measuring the unemployment rate entails determining who is unemployed
versus who is out of the labour. Because of this, we will need to define some terms.

• Labour force: It is the total number of workers, both employed and unemployed. Labour Force=
Number of Employed+ Number of Unemployed.

• Employed: This category includes paid employees, both full-time and part-time, people who worked
in their own business, and those who were temporarily absent from work because of illness or vacation.

• Unemployed: This category includes people who were not employed, were available for work, and
had tried to find a job within the previous four weeks, as well as those who were temporarily laid off
and waiting to be recalled.

• Not in the Labour Force: This category includes everyone else: students, homemakers, retired people.

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For example, if the unemployment rate in an economy is 6%, this means that six out of every 100 people
in the labour force are unemployed.

Underemployment can similarly be measured as a number or as a percentage. If the underemployment

rate is 15%, this means that 15 out of every 100 people in the labour force are underemployed.

Labour force participation rate: Is the percentage of the total adult population that is in the labour
force,

Labour force participation rate =

Example:

Given the following hypothetical demographical statistics of country X, calculate the unemployment
rate and labour force participation rate for the country.

• Number of employed =139.9million.

• Number of unemployed =14.3million.
• Not in the labour force =81.7million.
• Labour force =139.9+14.3=154.2million
• Adult population =235.9 million

Solution:

Unemployment rate =14.3/154.2 x 100 = 9.3%

Labour force participation rate = {139.9 +14.3}/ {139.9 +14.3 + 81.7} = (154.2/235. 9)x 100= 65.4%

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Shortfalls in the measurement of unemployment rate

• No measure of unemployment is ever completely accurate since there are some people out of work but
looking for a job who are not picked up by the official statistics.

• Official unemployment data misses out the “hidden unemployed” - an example is discouraged workers
who have been out of work for a long time and who have stopped applying for jobs.

• Economically inactive – people who are not actively looking for work because they need to look after
elderly or infirmed relatives or some parents who are full-time carers for their children and people who
have taken early retirement.

• Under-employment: In many countries data may ignore the extent of under employment, for example
people who want full-time work but have to settle for a part-time job. In many lower-income countries,
the quality of the labour market data may be poor causing published figures to be inaccurate.

9.3 Economic costs of unemployment

• Loss of earnings for the unemployed, leading to lower living standards.
• More difficulty getting work in the future, as the unemployed lose ‘on-the-job skills’ and may become
less attractive to future employers.
• Stress and health problems of being unemployed, imposing personal costs and also costs onto the
National Health Service.
• Increased government borrowing. The government will have to spend more on unemployment and
related benefits, and will receive lower income tax revenues because fewer people are working.
• Lower GDP for the economy and possible negative multiplier effect.
• Increased social division between the unemployed and employed.

9.4 Types of unemployment

Before discussing different types of unemployment, it is pertinent to discuss the concept of natural rate of
unemployment. The natural rate of unemployment is an estimate of the unemployment rate that exists
when the economy is at full employment and this is the rate of unemployment that the economy will have
in the long run.

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The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium.
We can think of it as the average long run rate of unemployment. The major challenge is that many
countries especially the developing countries do not have the estimate of their natural rate of
unemployment. For country like the US, the natural rate of unemployment would be around 5% to 6%.
Also, a nation is considered to be operating at full employment when all unemployment is either frictional
or structural. The difference between a nation’s natural rate of unemployment and its actual unemployment
rate is referred to as cyclical unemployment.

• The natural rate is the difference between those who would like a job at the current wage rate, and those
who are willing and able to take a job.

• The natural rate of unemployment includes frictional and structural unemployment. The natural rate of
unemployment is unemployment caused by supply-side factors rather than demand-side factors.

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What determines the natural rate of unemployment?

• Availability of job information.

• Quality of education and retraining schemes, which affect levels of occupational immobilities.

• Degree of geographical labour mobility, can workers move to where jobs are available?

• Flexibility of the labour market, e.g. powerful trade unions may be able to restrict the supply of labour
to certain labour markets.

• A rise in unemployment caused by a recession may cause the natural rate of unemployment to increase.
This is because when workers are unemployed for a time period, they become deskilled and demotivated.

• Monetarists believe that unemployment is primarily due to supply-side factors — the natural rate of
unemployment. They believe demand-side unemployment will only be temporary.

1. Frictional unemployment

This is unemployment caused by people moving between jobs, e.g. graduates or people changing jobs.
There will always be some frictional unemployment, as it takes time to find a job.

2. Structural unemployment

This is unemployment due to a mismatch of skills in the labour market. It can be caused by:

• Occupational immobility. This refers to the difficulties in learning new skills applicable to a new
industry, and technological change. For example, a former manual labourer may find it hard to retrain in
a new, high-tech industry.

• Geographical immobility. This refers to the difficulty in moving regions to get a job; e.g. someone
unemployed in the Southern may find it difficult to move to Kigali, where housing is expensive. We often
see higher unemployment in depressed regions.

3. Classical or Real-Wage Unemployment

This occurs when wages in a competitive labour market are pushed above the equilibrium. This could be
caused by minimum wages or trade unions.

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In a competitive labour market, a minimum wage above the equilibrium will cause real-wage
unemployment of Q3-Q1.

• There is concern that a rapid rise in the minimum wage (to a ‘living wage’) may cause unemployment
– especially in low-paid industries, such as catering.

4. Demand-deficient or ‘Cyclical unemployment’

This occurs when there is a fall in AD, leading to a decline in national income.

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The fall in AD leads to a decline in real GDP. With less output, firms demand fewer workers.

5. Voluntary unemployment

This occurs when people turn down the opportunity to work at the going wage rate.

• For example, generous unemployment benefits may encourage people to stay on benefits rather than
take a job.

• This is opposed to involuntary unemployment, where people are unable to get a job at the going wage
rate. For example, due to structural or frictional unemployment.

6. Seasonal unemployment

In many countries, unemployment rates will be higher in certain seasons. For example, in the tourist off-
season unemployment rates will be higher. Unemployment statistics are often seasonally adjusted to take
into account lower rates during busy time periods.

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9.5 Policies to reduce unemployment

1. Fiscal and monetary policy (demand-side)

If there is demand-deficient unemployment, the government could pursue expansionary fiscal policy by
cutting income tax to boost consumer spending and aggregate demand. Higher AD should lead to higher
economic growth and should encourage firms to take on more workers.

• However, demand-side policies may cause higher rates of inflation and will not reduce supply-side
unemployment, like structural unemployment.

2. Education and training

Structural unemployment could be solved by offering retraining and new skills for the long-term
unemployed. This gives a better opportunity for the unemployed to find work in new industries.

• However, it would cost money, and it may prove difficult for some older workers to retrain in new
industries and develop new skills.

3. Better job information and interview practice

This could help reduce frictional unemployment by giving the unemployed better information about
available job vacancies, and also offering tips for the unemployed to get work.

4. Lower benefits and taxes

Lower benefits and income tax may increase the incentive for the unemployed to look for work rather
than stay on benefits. This could reduce frictional unemployment.

5. Reducing minimum wages

If the minimum wage is above the equilibrium, reducing it to the equilibrium will enable firms to employ
more workers, which reduces real-wage unemployment.

• However, demand for labour may be quite inelastic; cutting wages may just make firms more profitable.

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6. Regional grants

These can help overcome geographical unemployment by encouraging firms to set up in depressed areas,
or helping workers to move to areas of high demand.

• However, subsidies may prove ineffective for encouraging workers to move, because they may be
attached to their local community. Also, firms may have a similar reluctance to set up in depressed areas
because of a lack of infrastructure.

9.6 Conflict between unemployment and inflation

In the short term, we can often see a trade-off between unemployment and inflation.

• If the government increased spending (G), we would see an increase in AD. This leads to a rise in real
GDP (Y1 to Y2).

• As output rises, firms will hire more workers, and unemployment falls.

• But as the economy gets closer to full capacity (positive output gap), we start to see inflationary
pressures (P1 to P2).

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Therefore, after a rise in AD we go from (A) - unemployment (6%) and low inflation (2%), and move to
point (B) - unemployment (3%) and higher inflation (5%).

Temporary trade-off between unemployment and inflation

This monetarist model suggests there will only be a temporary trade-off between unemployment and
inflation.

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• In this model, the long-run Phillips curve gives a natural unemployment rate of 6%.

• Initially, we assume workers expect inflation of 2%.

• If there is an increase in AD, we get a temporary fall in unemployment to 4% (point B). At B, there is
a positive output gap.

• However, when inflation expectations adjust, the short-run Phillips Curve (SRPC) shifts to the right.

• The economy returns to full employment, we move back to point C at 6% unemployment, but at a
higher price level (3.5%), and higher inflation expectations.

• To reduce unemployment below the natural rate, we have to allow an ever-accelerating rate of inflation.

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Importance of the Phillips Curve
• If the Monetarist view is correct, it would suggest that demand-side policies to reduce unemployment
will be ineffective in the long run. Therefore, Monetarists place greater stress on supply-side policies.

• If the Keynesian view of the Phillips Curve is correct, then demand-side policies could play a role in
reducing cyclical unemployment. However, they would still have to be careful not to cause inflation.

• L-shaped curve. In some situations, e.g. deep recession, it is possible to reduce unemployment without
inflation. However, when the economy gets close to full capacity, reducing unemployment has a much
bigger impact on inflation.

Avoiding conflict between inflation and unemployment

1. Supply-side policies to reduce structural unemployment.

If the government introduced successful supply-side policies, we could see a fall in structural and
frictional unemployment. This would reduce the natural rate of unemployment and shift the Phillips
curve to the left.

There is still a trade-off between unemployment and inflation, but after the fall in the natural rate of
unemployment there is a better trade-off.

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2. Economic growth close to long-run trend rate of growth.

If the economic growth is kept close to the long-run trend rate (e.g. 2.5%), then the growth is sustainable.
In this case there will not be a positive output gap, but we will reach full employment with minimal
inflationary pressure.

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