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
ADJUSTMENT TO A FALL IN THE DEMAND FOR LABOUR Fall in Demand Supply exceeds demand Unemployment FLEXIBLE LABOUR MARKET (A) INFLEXIBLE LABOUR MARKET (B) Fall in pay Pay rigidities Rise in demand for workers No decline in pay Unemployment persists Full employment
CLASSICAL LABOUR MARKET Real wage (w/p) S D1 D S1 E R T W W1 W2 S D1 S1 D L L2 Quantity of labour L1
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, January1999
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 P’’ AD’’ P AD’ AD 0 Q* National Output Q
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