Employment/Unemployment

Unemployment can be divided into equilibrium and disequilibrium types according to whether the labour market is in balance.

Equilibrium unemployment is the unemployment that exists when the aggregate demand for labour equals the aggregate supply of labour at the going real wage — the labour market 'clears' in aggregate. Even so, some people are unemployed: this is frictional unemployment (people between jobs, searching), structural unemployment (skills or location mismatch), and seasonal unemployment. Together these make up the natural rate of unemployment (NRU) — the rate of unemployment consistent with the labour market being in equilibrium, and the rate associated with stable inflation. Importantly, the NRU is determined by supply-side factors — job-search efficiency, benefit levels, skills mismatches and labour mobility — not by the level of aggregate demand.

Disequilibrium unemployment is unemployment above the natural rate, where the labour market is not in balance. The main type is demand-deficient (cyclical) unemployment, caused by a fall in aggregate demand in a recession, so there are too few jobs overall and many workers are involuntarily unemployed (willing to work at the going wage but unable to find jobs). Another type is real-wage (classical) unemployment, where real wages are held above the equilibrium (e.g. by powerful trade unions or a high minimum wage), so the quantity of labour supplied exceeds the quantity demanded.

The distinction matters greatly for policy. Disequilibrium cyclical unemployment can be reduced by demand-side policy (boosting AD). But the natural rate (equilibrium unemployment) cannot be reduced by raising AD — attempting to push unemployment below the NRU only causes accelerating inflation, and unemployment returns to the NRU. Reducing the natural rate requires supply-side policies that tackle its frictional and structural causes. There is also the risk of hysteresis, where prolonged cyclical unemployment becomes entrenched, raising the natural rate itself.

Reducing unemployment requires matching the policy to the type and cause of unemployment, because demand-side and supply-side policies tackle different causes.

Demand-side policies for cyclical unemployment. When unemployment is demand-deficient (cyclical) — caused by a fall in AD in a recession — expansionary fiscal and monetary policy (higher government spending, lower taxes, lower interest rates) raises AD, increasing output and employment. Strengths: it works relatively quickly and directly addresses deficient demand, which is vital in a slump and when spare capacity exists. Limitations: near full capacity it causes inflation rather than jobs; it enlarges the budget deficit; it suffers time lags and possible crowding out; and it does nothing for the natural rate — it cannot cut unemployment below the NRU without accelerating inflation.

Supply-side policies for structural and frictional unemployment. Much unemployment is equilibrium unemployment at the natural rate — frictional and structural. Reducing it requires supply-side policy: retraining and education (occupational mobility), relocation/housing support and transport (geographical mobility), better job information/matching, and benefit reform so that work pays. These tackle the root causes, lowering the natural rate and reducing structural unemployment, and they help reverse hysteresis. Limitations: they are slow (training takes years), costly, and uncertain (training may not match job needs); some (benefit cuts) raise equity concerns.

Matching policy to cause. Using the wrong policy fails: boosting AD will not re-employ workers who lack the right skills (structural), and retraining will not help if there is simply no demand for output (cyclical). Effective policy therefore depends on diagnosing the cause first.

Judgement. No single policy is universally best — it depends on the type of unemployment and the time horizon. For a recession-driven (cyclical) rise in unemployment, demand-side policy is most effective in the short run. For the long-run, structural unemployment that makes up much of the natural rate, supply-side policy is most effective, because only it lowers the natural rate sustainably. The most defensible conclusion is that a government should combine demand-side stabilisation (for cyclical unemployment) with supply-side reform (for structural/frictional unemployment and the natural rate), with the emphasis depending on whether the problem is deficient demand or a structural mismatch. This matching of policy to cause, rather than relying on one tool, is the key to effectively reducing unemployment.

The fact that unemployment remains high even though AD has recovered, with most of the unemployed jobless for over a year, suggests hysteresis — the cyclical unemployment of the recession has become entrenched and structural.

During the long recession, many workers became long-term unemployed. Over a year or more of unemployment, they have likely lost skills, work habits and motivation, and employers may be reluctant to hire the long-term unemployed. So even though demand (and hence the number of jobs) has recovered, these workers are no longer well matched to the available vacancies — their unemployment has shifted from cyclical to structural, and the natural rate of unemployment has risen.

Because the problem is now structural (supply-side), simply boosting AD further will not solve it — there are jobs, but the unemployed cannot fill them. The suitable policy is supply-side: government-funded retraining and education to rebuild and update the long-term unemployed's skills (improving occupational mobility), together with work-experience schemes and job-search/relocation support to re-attach them to the labour market.

This would lower the natural rate by tackling the structural mismatch caused by hysteresis, reducing long-term unemployment — though it works slowly and is costly.

Whether a government can reduce unemployment without inflation depends on the type of unemployment and which policy is used.

Where there is a conflict (demand-side policy). If unemployment is cyclical and the economy has spare capacity, expansionary demand-side policy can raise AD, cutting unemployment with little inflation — output rises rather than prices. However, once the economy approaches the natural rate of unemployment, further increases in AD push unemployment below the NRU only temporarily, at the cost of accelerating inflation (the Phillips-curve trade-off): demand for labour exceeds the sustainable supply, so wages and prices rise. So using AD to cut unemployment below the NRU does cause inflation, and unemployment returns to the natural rate. In this sense there is a short-run trade-off between unemployment and inflation.

Where there is no conflict (supply-side policy). Supply-side policies can reduce unemployment without causing inflation, because they lower the natural rate itself by tackling structural and frictional unemployment — retraining and education (skills), improved job information and mobility, and benefit reform. By raising the economy's productive capacity (shifting LRAS right) and improving the labour market, they allow lower unemployment and stable (or lower) inflation simultaneously. This avoids the demand-side trade-off.

Judgement. A government can reduce unemployment without causing inflation, but only in certain ways. Demand-side policy can do so while spare capacity exists (cyclical unemployment), but not once unemployment is at the natural rate — pushing below the NRU causes inflation. Supply-side policy can reduce unemployment without inflation by lowering the natural rate, though it works slowly. The most defensible conclusion is that there is a short-run trade-off when using demand-side policy near full employment, but the trade-off can be overcome in the long run through supply-side measures that lower the natural rate — so reducing unemployment without inflation is possible, but mainly through supply-side reform rather than demand expansion alone.