Chapter Six: Lecture Notes -- Unemployment

The unemployment rate is the percentage of the labor force that is unemployed.
Unemployment is perhaps the most serious of all economic problems. If someone is unemployed, her ability to provide for herself and her family are compromised. Martin Luther King, Jr. argued that government has a fundamental responsibility to provide a job for all its citizens. Though the United States has yet to achieve that goal, the government and the Federal Reserve do a number of things to reduce unemployment. Since the Great Depression, the federal government has assumed political responsibility for the state of the economy, and it has put in place a number of programs that attempt to stabilize the economy during a downturn to mitigate the effects of unemployment. We discuss these policies in detail in Chapter 12, Fiscal Policy & Supply-Side Economics.

Unemployment in the U.S. follows a counter-cyclical pattern, rising when the economy's GDP is declining, and falling when the economy recovers. The unemployment rate is a lagging indicator. The rate tends to rise only after the recession has begun, and it peaks well after the recession is officially over. The 2001 U.S. recession, for example, ended in November of 2001, but the unemployment rate peaked at 6.3 percent in June, 2003, more than a year after the end of the recession.

Despite some misperceptions, unemployment in the United States is not getting constantly worse. In fact, unemployment rates were relatively low in the 1990s, reaching a low of 3.8 percent in April 2000. Despite the recession begun in March 2001, the unemployment rate was just 6 percent in 2003, and it dropped to 5.1 percent in 2005 as the economy recovered. As we will see, part of the reason for the relatively low unemployment rates following the 2001 recession was the massive fiscal and monetary policy pursued by the goverment and the Federal Reserve, respectively. The figure titled "U.S. Unemployment Rates" plots unemployment rates from 1970 through 2006. Observe the counter-cyclical pattern in the series.

Each month, the Bureau of Labor Statistics (BLS) reports the unemployment rate for the United States economy. In July 2006, for example, the unemployment rate was 4.8 percent. This means that 4.8 percent of the labor force was unsuccessfully looking for work. In order to fully understand what this statistic means, we have to understand how it is calculated.

Measuring Unemployment

The Bureau of Labor Statistics has a set of frequently asked questions in which they explain in more detail how to measure unemployment. This site describes the statistical techniques and economic assumptions used in calculating the national unemployment figures. We summarize the main steps below.

Each month the Bureau of Labor Statistics polls over 50,000 households either in person or by phone. The respondents of the survey are classified into one of three categories: unemployed, employed, or not in the labor force. Those are the only three options. The labor force consists of all those employed and unemployed.

To be counted as employed, a person must have worked at a job for pay or profit during the survey week (the week that contains the 12th of the month), or she must have worked without pay for more than 15 hours for a family business.

Persons are classified as unemployed if they do not have a job, have actively looked for work in the prior four weeks, and are currently available for work.

If a person has no job and has not actively looked for work in the prior four weeks or is currently unavailable for work except for a temporary illness, then he is classified as not in the labor force. All those who work for less than 15 hours per week in a family business but receive no pay are also classified as not in the labor force.

The unemployment rate is the percentage of the labor force that is unemployed, or

The Federal Reserve Bank of St. Louis has a record going back to 1948 of historical U.S. unemployment rates.

Calculating Unemployment Rates: An Example

Labor Force Data
Full-time students150
Those wanting work50
*Note: Of those classified as "wanting work", 22 have not actively sought work in the prior four weeks.

Table 1 provides labor force information from a survey of 800 individuals regarding their employment status. To calculate the unemployment rate, we must determine the number unemployed and the number in the labor force. There are 50 who claim that they would want to work, but 22 of them have not actively sought work in the prior four weeks. The BLS, therefore, counts only 28 (50 - 22) of them as officially unemployed.

There are two approaches to calculate the labor force. First, we can add the employed (420) to the officially unemployed (28), for a total of 448. Second, we can subtract from the sample population (800) all those not in the labor force: the retired (180), students (150), and those "unofficially" unemployed but not actively looking for a job (22). This approach also yields a labor force of 448. The unemployment rate is then 28/448 * 100 = 6.25%.

The unemployment survey may give misleading information about the true unemployment situation.

Criticisms of the Unemployment Rate

Despite the care taken in calculating unemployment, there are three common criticisms of the survey that are said to give misleading information about the true unemployment situation. These criticisms are:

  1. The survey does not count discouraged workers as unemployed. Discouraged workers are individuals who indicate that they currently want a job, have looked for work in the last 12 months, are available for work, and are not currently looking for work either because they believe that no work is available in their line of work or area, they had previously been unable to find work, they lack necessary schooling, training, skills or experience, employers think they are too young or old, or they face some other type of discrimination. In other words, they have given up looking for work because they could not find a job or thought that they could not find a job. Many people think that discouraged workers are the "hard-core" unemployed. Because the unemployment rate does not include discouraged workers, it tends to understate unemployment.

  2. The survey does not account for hidden unemployment. Hidden unemployment includes those who are working part-time but wish to have a full-time job and those who are grossly overqualified for their positions, the underemployed. This omission also makes the unemployment rate seem lower than it otherwise would be. Failure to account for hidden unemployment understates the unemployment problem.

  3. The surveyor does not check the accuracy of the response to an active job search. To be unemployed, a survey respondent must only "say" that he has actively sought work. The respondent may state, for example, that he has called several potential employers or gone on a job interview when in fact he has not done so. When people lie about their job search behavior, they are classified as unemployed instead of not in the labor force. This effect tends to overstate the unemployment rate.

The BLS has a response to each of these criticisms. First, why should it count as unemployed those that do not take an initiative to find a job? One cannot find a job without looking. Second, the unemployment rate is not intended to capture information about part-time employment. Other reports can provide information about this aspect of the labor market. Third, any survey is only as good as the honesty of those who answer it.

Given the large sample size and the detailed questions asked of participants, the unemployment rate remains a reliable gauge of economic performance in the United States. Moreover, as long as the survey is carried out consistently each month, the variation in unemployment rates through time still gives meaningful information about the relative performance of the economy from month to month.

Unemployment consists of frictional, structural, and cyclical unemployment.

The natural rate of unemployment is estimated to be between 5 percent and 5.5 percent.

Types of Unemployment

An important goal of stabilization policy is a low unemployment rate. How low of a rate should the economy have? The ideal unemployment rate is far from zero because a modest amount of unemployment occurs naturally in any dynamic economy. Economists classify unemployment into three broad categories listed below.

  1. Frictional unemployment: Frictional unemployment is unemployment that is due to the natural movements in and out of labor force. Every day, people quit their jobs in search of new ones. College students graduate and enter the work force. Trailing spouses must looking for new jobs in new cities. In a dynamic economy this frictional unemployment is healthy. It shows that people are in transition between jobs and careers. Frictional unemployment tends to be short-term and voluntary.

  2. Structural unemployment: Structural unemployment is unemployment that is typically due to changes in technology or international competitiveness. This type of unemployment is the result of some fundamental shift in the economy. For example, historically the United States dominated the production of steel. Over time, competition from Mexico, Japan, and South Korea eroded this advantage. The result was thousands of unemployed U.S. steel workers. These workers' skills are less in demand than they once were. It is difficult for steel workers to retrain quickly and re-enter the labor force in a different occupation. The same may be true of any worker whose skills are made obsolete by new technology. People who specialized in the production of manual typewriters, for example, had to retrain with the rise of the personal computer. Because of the difficulty in retraining workers with specific skill sets, structural unemployment tends to be long term and involuntary.

  3. Cyclical unemployment: Cyclical unemployment is unemployment that is due to a downturn in the business cycle. As we observe in the unemployment chart, unemployment rates are counter-cyclical. A primary goal of stabilization policy is to achieve zero cyclical unemployment.

Frictional and structural unemployment are unavoidable in a dynamic economy. These two combined are called the natural rate of unemployment, or the full-employment rate of unemployment. There is nothing that macroeconomic policy can do to reduce or eliminate frictional and structural unemployment. Many economists estimate the U.S. natural rate of unemployment to be between 5 percent and 5.5 percent. Unemployment rates below this level may lead to an increase in the inflation rate. (See Chapter 16, The Phillips Curve.) Policy makers are reluctant, therefore, to push the unemployment rate much below this natural rate.

The economic cost of unemployment is the difference between potential output and actual output.

Costs of Unemployment

There are many social and psychological costs of unemployment that range from poverty to depression. These costs are real and important but difficult to quantify. From an economic point of view, the measurable cost of unemployment is the lost output and, hence, lost consumption. What would the economy have produced if labor were fully employed? The economic costs of unemployment are the goods and services that might have been produced and consumed that are lost forever.

To measure these costs, we take the difference between potential and actual output.

where potential output is the level of GDP the economy would attain if all resources were fully employed. During recessions when unemployment is high, some labor is sitting idle and that lost work can not be made up. The higher the rate of unemployment, the higher the costs of unemployment.

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