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Intermediate Macroeconomics Unit 5: Unemployment

This unit explains why some unemployment exists even in a healthy economy, what sets the natural rate, and how policies and institutions change it.

Covers: The natural rate and steady-state flows, Job search and frictional unemployment, Unemployment insurance, Wage rigidity: minimum wages and unions, Efficiency wages, Duration of unemployment and international differences

Study guide

The natural rate of unemployment is the average rate around which the economy fluctuates. A simple model explains it with flows. Let L be the labor force, E the employed and U the unemployed. Each period a fraction s of the employed separate from their jobs, and a fraction f of the unemployed find jobs. In steady state the number unemployed is constant, so inflows equal outflows: sE = fU. Substituting E = L − U and solving gives U/L = s ÷ (s + f). Any policy that lowers the separation rate or raises the job-finding rate lowers the natural rate. When unemployment is above its steady state, outflows exceed inflows and it falls back.

Job finding is not instant, because workers and jobs differ in skills, location and preferences, and information is imperfect. The resulting frictional unemployment is unavoidable in a changing economy. Sectoral shifts, such as a decline in oil drilling and growth in health care, raise frictional unemployment as workers move between industries and regions. Policies can affect it: job-matching services and retraining help raise f. Unemployment insurance has two effects. It helps workers cope with job loss and may produce better matches, but it lowers the cost of staying unemployed, which reduces search effort and f, and, without full experience rating, it lets firms lay off workers without bearing the cost.

A second type of unemployment comes from wage rigidity, the failure of real wages to fall to the level where labor supply equals demand. With the real wage stuck above equilibrium, firms hire fewer workers than want to work, and the excess are unemployed while they wait for jobs. This is structural unemployment from job rationing. Three sources of rigidity are important. Minimum wage laws bind mostly for young and low-skilled workers. Unions raise wages for insiders, while the cost falls on outsiders who cannot get union jobs. And firms may choose to pay efficiency wages.

Efficiency wage theories argue that paying more than the market wage raises productivity. Higher pay can improve nutrition in poor countries, lower turnover and hiring costs, attract a better pool of applicants (adverse selection) and discourage shirking when effort is hard to monitor (moral hazard). Henry Ford's $5 day in 1914 is the classic example. In the shirking model, unemployment acts as a discipline device: firms pay enough that losing a job is costly, and the resulting unemployment makes the threat of firing credible.

Unemployment data show patterns that theories must explain. Most spells are short, but long spells make up a large share of unemployment at any moment, because long-term unemployed people stay in the pool. Benefits matter: job-finding rates jump just before benefits expire. Differences across countries are large; many European economies have had higher unemployment than the United States since the 1980s, which economists often trace to generous benefits and rigid labor rules interacting with shocks that reduced demand for low-skill labor. Hysteresis, the idea that long recessions raise the natural rate by eroding skills and attachment to work, links short-run downturns to long-run unemployment.

Key ideas

• The steady-state unemployment rate is s ÷ (s + f).
• Frictional unemployment comes from job search and sectoral shifts.
• Unemployment insurance tends to lower the job-finding rate and raise frictional unemployment.
• Real-wage rigidity above equilibrium causes structural (wait) unemployment.
• Minimum wages, unions and efficiency wages are the main sources of wage rigidity.
• Most unemployment spells are short, but long spells account for much unemployment at a point in time.
• Hysteresis means deep recessions can raise the natural rate.

Formulas and rules

Common mistakes

• Dividing s by f instead of by s + f in the steady-state formula.
• Applying the separation rate to the whole labor force instead of to the employed.
• Treating efficiency wages as legally required rather than chosen by firms for productivity.
• Counting only lost jobs, not new job seekers, as the unemployment created by a minimum wage.
• Assuming the natural rate is zero or the lowest rate ever observed.

Before the test, make sure you can

• Derive and calculate the steady-state unemployment rate from s and f.
• Compute next-period unemployment from flows and explain convergence to steady state.
• Distinguish frictional, structural and cyclical unemployment with examples.
• Explain how unemployment insurance and experience rating affect s and f.
• Calculate unemployment caused by a binding minimum wage from supply and demand.
• Explain the four efficiency wage channels and the shirking model.
• Calculate spell durations and explain why long spells dominate measured unemployment.

Words to know

Natural rate of unemployment

The average unemployment rate around which the economy fluctuates; the steady-state rate s/(s + f).

Steady state

A situation where the unemployment rate is constant because flows in equal flows out.

Separation rate (s)

The fraction of employed workers who lose or leave their jobs each period.

Job-finding rate (f)

The fraction of unemployed workers who find jobs each period.

Frictional unemployment

Unemployment caused by the time it takes to match workers and jobs.

Sectoral shift

A change in the composition of demand across industries or regions that requires workers to move.

Unemployment insurance

A program paying benefits to workers who lose their jobs, for a limited period.

Experience rating

Charging firms higher payroll taxes when their past layoffs were higher.

Wage rigidity

The failure of real wages to adjust to the level that balances labor supply and demand.

Structural unemployment

Unemployment from wage rigidity and job rationing; workers wait for jobs.

Insiders and outsiders

Employed union members who set wages versus the unemployed who bear the cost.

Efficiency wages

Above-market wages paid by firms to raise worker productivity.

Shirking model

An efficiency wage theory where high wages and unemployment discourage workers from slacking.

Adverse selection

In labor markets, the idea that lower wages attract a worse pool of applicants.

Cyclical unemployment

The deviation of unemployment from its natural rate caused by economic fluctuations.

Hysteresis

The long-lasting effect of history, such as a deep recession, on the natural rate.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.