Unemployment
Key terms
Define each term.
Multiple choice
Circle the correct answer.
Which policy is most likely to reduce structural unemployment?
A shipyard closes and its welders remain out of work for three years despite vacancies existing in software and healthcare. This is best described as:
Which consequence of higher unemployment affects the government budget from both directions at once?
An economy has a negative output gap and rising unemployment following a fall in consumer confidence. Which policy addresses the binding constraint most directly?
Real wages are held above the market-clearing level by union bargaining. The unemployment that results is best described as:
Worked problems
Show your working.
Percentage points against percentages. A country's unemployment rate rises from 5% to 6% over a year. A newspaper reports this as 'a 1% rise in unemployment'. Calculate the change correctly in both forms and explain why the newspaper's phrasing is misleading.
Measuring the cost of a recession, and why the estimate is unreliable. An economy has potential output of $500 billion and actual output of $480 billion. Calculate the output gap as a percentage. Then explain why the true cost may be larger than this figure suggests, and why the figure itself is uncertain.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How a demand shock becomes unemployment
- A They cut output in response, so real GDP falls and a negative output gap opens.
- B Cyclical unemployment rises.
- C Aggregate demand falls again, deepening the contraction unless policy intervenes.
- D Consumption and investment fall, so aggregate demand shifts left.
- E Unemployed households have lower incomes, so consumption falls further, and the multiplier works in reverse.
- F Firms find inventories building up as sales fall short of production.
- G Labour is a derived demand, so producing less requires fewer workers and firms reduce hours, stop recruiting, then make redundancies.
- H Consumer and business confidence falls, so households postpone purchases and firms delay investment.
Diagrams
Draw a production possibility curve and mark a point inside it. Label that point as an economy with cyclical unemployment. Show the movement that would occur if demand recovered, and separately show what would be needed to reduce structural unemployment once the economy is back on the curve.
Draw an AD/AS diagram showing an economy in equilibrium below full employment. Mark the full employment level of output, the current equilibrium, and the negative output gap between them. Then show the effect of expansionary policy closing the gap.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Explain the difference between structural, cyclical and seasonal unemployment and discuss whether a general rise in income in a country would have the same effect on each of these types. (13 marks)
Answers
Unemployment: People of working age who are without work, are available for work and are actively seeking work.
Employment: The use of labour in producing goods and services: people of working age who are in paid work, full time or part time, or self-employed.
Full employment: A situation where everyone of working age who wants a job at the current wage can find one, so the only unemployment is short-term frictional or seasonal unemployment.
C. Structural unemployment exists because workers' skills do not match the jobs available. Retraining addresses that mismatch directly. The other three raise total demand, which helps cyclical unemployment but does not give a redundant worker the skills a vacancy needs.
C. Jobs exist, so this is not a shortage of demand. The problem is that the skills of the welders do not match the vacancies available, which is the definition of structural unemployment. The three-year duration also rules out frictional, which is short term by nature.
B. Spending rises because more people claim benefits, and revenue falls because fewer people pay income tax and unemployed households spend less, so indirect tax receipts drop too. The other three are real costs but they fall on the economy or the individual rather than directly on the budget.
B. The unemployment here is cyclical, caused by insufficient demand rather than by any mismatch. Retraining workers for vacancies that do not exist changes nothing. The other three are supply-side measures aimed at structural, real-wage and frictional unemployment respectively, all of which are real problems but not this one.
B. At a wage above the market-clearing level more people want to work than firms wish to employ, so the labour market does not clear: that is disequilibrium unemployment. The people left without jobs would accept work at the going wage, so it is involuntary.
Step 1. Calculate the change in percentage points. 6% - 5% = 1 percentage point. This is the difference between the two rates.
Step 2. Calculate the percentage change. Percentage change = ((6 - 5) / 5) x 100 = 20%. Unemployment has risen by a fifth.
Step 3. Identify what the newspaper got wrong. 'A 1% rise' suggests the increase was small. In fact one in five more people are unemployed than a year ago. The rate rose by 1 percentage point, not by 1%.
Step 4. Show why it matters in the other direction too. Suppose unemployment falls from 10% to 9%. That is also 1 percentage point, but only a 10% fall, because the base is larger. The same percentage point change means a different proportional change depending on where you start, which is why data-response answers must say which measure they are using.
This distinction appears constantly in data-response questions across inflation, growth and unemployment alike. Write 'percentage points' when you mean percentage points. Examiners penalise the confusion because it changes the size of the claim being made.
Step 1. Apply the output gap relationship. Output gap = ((480 - 500) / 500) x 100 = (-20 / 500) x 100 = -4%.
Step 2. State what this means. The economy is producing 4% less than it is capable of. That $20 billion of output is not delayed, it is lost permanently, since the labour and capital idle this year cannot be used retrospectively.
Step 3. Explain why the true cost may be larger: hysteresis. If the downturn persists, long-term unemployment erodes skills and reduces labour force participation. Potential output itself falls, so the loss is not only the $20 billion this year but a permanently lower path for output in every year afterwards.
Step 4. Explain why the figure is uncertain. Actual output is measured, but potential output is estimated and cannot be observed. If potential has already been damaged by hysteresis, the estimate of $500 billion is too high and the measured gap overstates the spare capacity available. A policymaker who acts on an overstated gap will stimulate an economy with less room than they think, producing inflation rather than output.
Step 5. Draw the policy conclusion. The two errors point in opposite directions and both are serious. Underestimating the gap means tolerating avoidable unemployment and inviting hysteresis; overestimating it means stimulating into a capacity constraint and generating inflation. This uncertainty, rather than disagreement about the theory, is what most macroeconomic policy argument is actually about.
Step 4 is the sophisticated point and is worth deploying in any essay about the reliability of policy. Potential output is an estimate, not a measurement, and treating it as a known quantity is a mistake examiners reward candidates for avoiding.
H, D, F, A, G, B, E, C
- Consumer and business confidence falls, so households postpone purchases and firms delay investment.
- Consumption and investment fall, so aggregate demand shifts left.
- Firms find inventories building up as sales fall short of production.
- They cut output in response, so real GDP falls and a negative output gap opens.
- Labour is a derived demand, so producing less requires fewer workers and firms reduce hours, stop recruiting, then make redundancies.
- Cyclical unemployment rises.
- Unemployed households have lower incomes, so consumption falls further, and the multiplier works in reverse.
- Aggregate demand falls again, deepening the contraction unless policy intervenes.
The last two steps are what makes recessions self-reinforcing and are the analytical basis for the case for intervention. AO2 is 40% of the written papers, and the reverse multiplier is a step most candidates omit.
This separates the two problems visually. Cyclical unemployment is a point inside the curve, so recovery is a movement towards it using capacity that already exists. Structural unemployment persists even on the curve, because the mismatch is between the skills people have and the jobs available, so curing it requires retraining rather than more demand.
Label the gap explicitly rather than leaving it implied. The distance between the current equilibrium and full employment output is the cyclical unemployment, and showing it as a measurable horizontal distance is what turns a description into analysis. Note also that closing the gap raises the price level only slightly while AS is flat, which is the argument for acting early.
Explain the three types: Define each precisely and distinguish by cause rather than by description. Cyclical is caused by deficient aggregate demand and varies with the business cycle. Structural is caused by a mismatch of skills or location following a change in the pattern of production, and persists regardless of the cycle. Seasonal is caused by predictable variation in demand or production across the year. Use a brief example of each; the marks here are for the distinction, so do not over-write this section.
Analysis: the effect on cyclical unemployment: A general rise in income raises consumption and therefore aggregate demand. Firms increase output, and because labour is a derived demand they employ more workers. Cyclical unemployment falls, and the multiplier amplifies the effect. This is the type on which rising income works directly and strongly, and it should be argued with a chain, not asserted.
Analysis: the effect on structural and seasonal: Structural unemployment responds weakly at best. Higher demand does not give a redundant welder the skills for a software vacancy, and if the declining industry itself does not recover, the mismatch is untouched. Concede the partial effect: a stronger economy creates more vacancies overall and may draw some structurally unemployed workers into unrelated low-skilled work, and it makes employers likelier to train. Seasonal unemployment barely responds at all, since its cause is the calendar rather than the level of demand, though higher income may lengthen the tourist season or extend the construction year at the margin.
Evaluation: Weigh the differences rather than restating them. The effects are clearly not the same, and the reason is that rising income addresses a demand deficiency while two of the three types have non-demand causes. Qualify with time: over a long period sustained high demand may erode structural unemployment through employer-funded training and induced migration. Qualify with degree: hysteresis means cyclical unemployment left too long becomes structural, so the type is not fixed and the answer depends on how long the downturn lasted. Note that the size of the effect on cyclical unemployment also depends on the output gap, since near capacity extra income produces inflation rather than jobs.
Judgement: Conclude that the effects differ sharply and rank them: large on cyclical, weak and indirect on structural, minimal on seasonal. Then add the condition that makes the answer sophisticated, that the boundary between cyclical and structural is not fixed, so a rise in income arriving early prevents structural unemployment from forming while the same rise arriving after years of slump finds the damage already done. Timing changes the answer, and saying so is what reaches the top band.