CHAPTER 31 – UNEMPLOYMENT FLUCTUATIONS AND THE NAIRU
- How employment and unemployment change over the short and long runs
- The difference between the New Classical and New Keynesian views of unemployment
- The cause of frictional and structural unemployment
- The various forces that cause the NAIRU to change
- About policies designed to reduce unemployment
31.1 EMPLOYMENT AND UNEMPLOYMENT
Over the span of many years, increases in the labour force are more or less matched by increase in
employment. Over the short term, however, the unemployment rate fluctuates considerably because
changes in the labour force are not exactly matched by changes in employment.
Changes in Employment
Level of employment has increased dramatically over past few decades
Supply side – labour force has expanded almost every year.
- Rising population
- Increased labour force participation by various groups
- Net-immigration of working-age groups
Demand – many eliminated and created every year. Net increase – difference between jobs created and
In most years, enough new jobs are created both to replace old jobs that have been eliminated and to
provide jobs for the growing labour force. The result is a net increase in employment in most years.
Annual growth rate employment – 1.3%
Changes in Unemployment
During periods of rapid economic growth, the unemployment rate usually falls.
During recessions or periods of slow growth, the unemployment rate usually rises.
Flows in the Labour Market
New jobs eliminated and created.
Public focus tends to be on levels of employment/unemployment, not amount of job
creation/destruction. Can ignore fact that a lot of changes occur.
The amount of activity in the labour market is better reflected by the flows into and out of
unemployment than by the overall unemployment rate.
Look at gross flows – see economic activity hidden when just looking at changes in overall level of
employment and unemployment.
Stocks and Flows in the Canadian Labour Market
Focus on stock of unemployment can often hide activity that can be revealed by looking at gross flows.
Stock of unemployment – actual number of people unemployed at point in time
Monthly flow into unemployment: People losing jobs, quitting jobs to find new jobs, new entrants to
labour force looking for jobs.
Monthly flow out of unemployment: unemployed individuals finding new jobs; unemployed individuals
becoming discouraged and leaving the labour force If flows into exceeds flows out of unemployment - stock of unemployment rises. Vice versa.
1. Show tremendous amount of activity in labour market even though stock of unemployment may
not be changing significantly
2. Relationship between flows and the stock can tell us something about amount of time the
average unemployed person spends unemployed.
Average duration of unemployment spell: stock of unemployment/monthly outflow from
Consequences of Unemployment
Every person counted as unemployed is willing and able to work and is seeking a job but has not found
one. Thus valuable resources currently not producing output – loss for society. Not regained when they
do find job.
The loss of output that accompanies unemployment is lost forever. Represents serious waste of
Most spells of unemployment are short. Have access to employment insurance program.
But are problems. Long-term unemployment – disillusioned who have given up trying to make it and
contribute to social unrest. Loss of self-esteem and dislocation of families.
31.2 UNEMPLOYMENT FLUCTUATIONS
Debate over source of these fluctuations.
One group – New Keynesians – distinction between unemployment that exists when real GDP =
Y*(NAIRU) and unemployment due to deviations of real GDP from Y* (cyclical unemployment:
unemployment not due to frictional or structural factors; it is due to deviations of GDP from Y*). Argue
that cyclical unemployment exists because real wages do not quickly adjust to clear labour markets in
response to shocks of various kinds.
Other group – New Classical – real wages adjust immediately to clear labour markets, and real GDP is
always equal to Y*. unemployment rate does fluctuate, but only because of changes in amount of
frictional or structural unemployment. Do not believe in cyclical unemployment.
Central difference – regards the nature of unemployment.
New Keynesians – workers who are suffering cyclical unemployment are assumed to be involuntarily
unemployed. Want to work but cannot find appropriate jobs.
Neo Classical – all unemployment is voluntary. Choose not to work or not to accept available job offers.
New Classical Theories
- Agents continuously optimize
- Markets continuously clear
No involuntary unemployment. Explain unemployment as outcome of voluntary decisions made by
Explains fluctuations in employment and real wages as having one of two causes 1. Changes in technology that affect the marginal product of labour will lead to changes in the
demand. If they are sometimes positive and sometimes negative, they will lead to fluctuations in
employment and real wages
2. Changes in the willingness of individuals to work will lead to changes in supply of labour and
thus in fluctuations in level of employment and real wages
Flexibility of real wages results in a clearing of the labour market. All employment must be frictional or
structural, cannot be involuntary.
New Classical theory assumes that labour markets always clear. People who are not working are assume
dot have voluntarily withdrawn from the labour market for one reason or another. There is no
1. Empirical observation not consistent with fluctuations in real wages. Employment tends to be
quite volatile but real wages tend to show little cyclical variation.
2. Predicts no involuntary unemployment, also unsupported by empirical observation
A Closer Look at New Classical Theory
Attempts to explain cyclical fluctuations in context of models in which wages and prices adjust very
quickly to shocks.
If wages and prices were able to adjust instantly, output would always be equal to potential output – no
inflationary or recessionary gaps.
Key propositions and criticisms
Views short-run fluctuations in real GDP as being caused by fluctuations in potential output, Y*.
Unemployment is always equal to NAIRU and NAIRU itself fluctuates.
Cyclical fluctuations arise in New Classical models based on the role of supply shocks.
Major claims in its favour:
- It has been able to demonstrate that an economy subject to technological and taste shocks has
fluctuations that are similar to those in the actual economy
- Integrated approach to understanding cycles and growth may be appropriate, as both reflect
forces that affect Y*. makes distinction that some shocks are temporary and some are
- Provides useful insights into how shocks, regardless of their origin, spread over time to the
different sectors of the economy.
- Assumptions of individuals’ behaviour
- Sceptical about an approach that ignores monetary issues (cannot provide insight into
correlation between money and output or global recessions like the one in 08-09)
Gives no role to AD in influencing business cycles, provides no role for stabilization operating through
monetary and fiscal policies. Predict such demand-management policies can be harmful.
Heart of theory – proposition that cycles represent efficient responses to the shocks that are hitting the
Policymakers may mistakenly interpret cyclical fluctuations as deviations from potential output caused
by shifts in either the AD or the AS curves. May try to stabilize output and distort maximizing decisions
made by firms/households. Which will cause responses to real shocks to be inefficient.
Controversy over how applicable it is in short-run, but important insights for long-run. New Keynesian Theories
People are involuntarily unemployed in the sense that they would accept an offer of work in jobs for
which they are trained at the going wage rate, if such an offer were made.
Wages do not quickly adjust to eliminate involuntary unemployment.
Quantity supplied and quantity demanded may not be equated for extended periods of time.
Will display unemployment during recessions and excess demand during booms
Observation –wages do not change every time demand or supply shifts.
Long-Term Employment Relationships
Advantages to both workers and employers of relatively long-term and stable employment
relationships. Workers want job security, employers want employees with experience.
Wages somewhat insensitive to fluctuations in current economic conditions.
Employers tend to smooth income of employees by paying a steady wage and letting profits and
employment fluctuate to absorb the effects of temporary increases and decreases in demand for the
Institutions like long-term contracts, employee benefits, pay that rises with years to service.
In many labour markets in which long-term relationships are important, the wage rate does not fluctuate
to clear the market continuously
Menu Costs and Wage Contracts
Typical firms sells many products and has many types of labour.
Changing prices and wages in response to every fluctuation is costly and time-consuming.
Firms find it optimal to keep price lists/menus constant.
React to small changes in demand by holding prices constant and responding with changes in output and
Amount of involuntary unemployment will fluctuate over the business cycle.
Sluggish price adjustment by firms – ‘price stickiness’
Wages inflexible in short term because wage rates are generally set only occasionally.
Implies changing in AD and AS will tend to cause changes in the amount of involuntary unemployment.
Costs associated with ch