Unemployment

WEEK 6

Professor Dermot McAleese

.

OUTLINE

Facts about unemployment

Supply-side approach and the market mechanism

Policies for unemployment

Keynesian approach – the importance of Aggregate Demand

UNEMPLOYMENT

The unemployed are those of working age who, in a

specified period, are without work and are both available for, and have taken specific

steps to find, work. (ILO)

Definitional Problems

• “Discouraged” workers

• Involuntary part-timers

• Long-term unemployed

• Social welfare fraud

Source: OECD

Table 1. Unemployment rates in OECD countries, 1960-2000

1960s 1970s1980s 1990s 1994 2000

North America Canada 4.7 6.6 9.3 8.1 10.4 6.8 United States 4.7 6.1 7.2 5.4 6.1 4.0

Japan 1.3 1.7 2.5 2.1 2.9 4.8

Europe France 1.7 3.8 9.0 8.9 12.3 9.8 Germany 0.6 1.9 5.7 4.9 8.4 8.5 Italy 3.8 4.7 7.5 8.2 11.2 11.0 Netherlands 0.9 4.0 9.6 7.5 7.1 2.5 Spain 2.3 4.2 17.5 15.9 24.1 14.1 United Kingdom 2.0 4.4 10.1 6.9 9.6 5.7 Austria 2.1 1.6 3.3 3.2 3.8 3.7 Finland 2.1 3.7 4.9 3.4 16.7 9.2 Norway 1.7 1.6 2.8 5.2 5.5 3.5 Sweden 1.5 1.8 2.2 1.7 9.4 7.2 Swizerland 0.1 1.2 1.5 1.1 3.8 3.9

Australia 2.0 3.9 7.5 7.0 9.7 6.7New Zealand 0.9 1.5 4.1 7.7 8.2 6.1

OECD 2.8 4.3 7.0 6.0 8.1 6.8

Averages of

ADJUSTMENT TO A FALL IN THE DEMAND FOR LABOUR

Fall in Demand

Supply exceeds demand

Unemployment

Fall in pay

Rise in demand for workers

Full employment

Pay rigidities

No decline in pay

Unemployment persists

FLEXIBLE LABOUR MARKET (A)

INFLEXIBLE LABOUR MARKET (B)

CLASSICAL LABOUR MARKET

S

S1

D1

D

L1L2L

TRE

WW1

W2

Real wage (w/p)

Quantity of labour

D1D

S

S1

LABOUR MARKET RIGIDITIES

Minimum wages

Replacement ratio

Trade union power

Employment protection legislation

Tax wedges

Rigidities in the product market

REPLACEMENT RATIO

Replacement ratio is defined as unemployment benefit entitlements as a percentage of average earnings after tax.

Average earnings after allowing for:

Income tax

Rent allowances

Medical subsidies

Travel expenses

HYSTERESIS

Hysteresis is defined as a failure of unemployment rate, that has been increased by an adverse shock, to return to its original level after that adverse shock

has been reversed

Causes human capital depletion

labour market segmentation (Insider-Outsider Theory)

physical capital depletion

IMPLICATIONS of HYSTERESIS FOR ANALYSIS OF UNEMPLOYMENT

Unemployed unable to exert downward pressure on real wage

Pro-active labour market policies needed

To prevent long-term unemployment

To re-integrate long-term unemployed

Policy Implications of the Labour Market Approach to

Unemployment

• European Central Bank

• Bundesbank (pp 380-382)

• OECD Jobs Study 1994

• Professor Stephen Nickell (September 2001)

“The problem of unemployment in Europe is overwhelmingly structural

in nature. It is caused mainly by inflexibility in

euro area labour and goods markets.”

European Central Bank, Monthly

Bulletin, January 1999

BUNDESBANK VIEW OF THE CAUSES OF UNEMPLOYMENT

Mismatch between demand and supply

Poverty and employment traps

Labour legislation

CONCLUSIONS FROM THE BUNDESBANK

“Most unemployment is structural, not cyclical”

“Monetary policy cannot be expected to make an active and direct contribution to a (lasting) reduction in unemployment”

“In light of deficits. No scope for expansionary fiscal policy”

Trend in UK unemployment has been downward and the

unemployment rate is at lowest level for 35 years. Nickell gives

two main reasons:

• Shift in balance of power between trade unions and employers

• Real value of unemployment benefits have declined and access to other benefits made more dependent on work-seeking behaviour

Source: Royal Economic Society Newsletter October 2001

But are we leaving out a major part of the unemployment story?

Aggregate demand doesn’t figure in the above theories.

Keynes argued that ignoring AD was a huge mistake --- that could result in massively counterproductive policies.

“I believe myself to be writing a book on Economic Theory

which will largely revolutionise - not I suppose at once but in

the course of the next ten years - the way the world thinks

about our problems”

Keynes - letter to George Bernard Shaw

The General Theory

I have called this book the General, Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of such a total is to contrast the character of my arguments and conclusions with those of the classical1 theory of the subject, upon which I was brought up and which dominated the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.

KEYNESIAN APPROACH

Focus: demand side of the labour market

Investment highly volatile

Multiplier effect

Self-adjustment is slow and weak

State intervention needed

AGGREGATE DEMAND AND KEYNESIAN AGGREGATE

SUPPLY CURVE

KAS

AD’’

AD’

AD

P

P’’

National OutputQ*Q0

OECD JOBS POLICY

Set appropriate macroeconomic policy

Enhance the creation and diffusion of technological know-how

Nurture an entrepreneurial climate

Increase labour cost flexibility

Increase working-time flexibility

Reform security-of -employment provisions

Reform unemployment benefit systems

Improve labour skills and competence

Expand and enhance active labour policies.

“There can exist no expedient by which labour as a whole can reduce its real wage to a given

figure by making revised money bargains with the

entrepreneurs.”

Keynes’ “Fundamental” objection to classical model

“…a somewhat comprehensive socialisation of investment will

prove the only means of securing an approximation to

full employment…”

General Theory p.378

“Unemployment will not decline unless business men have the

incentive of plentiful credit, high hopes and a slightly rising level of prices - a slight inflation of prices

but not of costs.”

Keynes “How to organise a wave of prosperity” article in Evening Standard, 1928