Lesson preview · Jobs and prices, in depth
Unemployment and inflation in depth
~9 min · Free to read
Imagine a country whose labour force (everyone working or looking for work) is 10 million people. In a normal year, 5 in every 100 of them are unemployed. Some are between jobs. Others have skills that no longer fit the jobs on offer.
Then a recession hits: a period when the whole economy shrinks. Unemployment climbs to 8 in every 100. That is 300,000 more people out of work.
Key Term
The natural rate and cyclical unemployment
The 5% unemployed in a normal year is the natural rate of unemployment: the unemployment an economy has even when there is no recession. It has two main parts:
- Frictional: people between jobs, or just starting out, while they search.
- Structural: people whose skills or location no longer match the jobs on offer.
Some courses also count seasonal unemployment (work that comes and goes with the time of year). This lesson leaves it aside.
The extra 3 percentage points are cyclical unemployment: jobs lost because a recession cut spending. An economy is at full employment when cyclical unemployment is zero. Total unemployment never is.
How much output does a recession cost? Economists compare what an economy makes with its potential output: what it would make at full employment. The difference between the two, as a percentage of potential, is the output gap. In a recession it is negative: output falls short of potential. In a boom, output can rise above potential for a while, and that pushes up prices.
In 1962, the US economist Arthur Okun found a rough rule. Each point of unemployment above the natural rate came with output about 3% below potential. This is Okun’s law. Modern textbooks usually put it nearer 2%. Estimates differ, so the model below uses 2.5%.
Every point of cyclical unemployment means goods and services that never get made. In this model, 3 points mean output 7.5% below potential.
Trap · Common Misconception
"Okun's law is a law"
It is a pattern in past data, not a law of nature, and the figure differs between countries. A 2013 study published by the International Monetary Fund (IMF) found that when output falls, unemployment rises little in Japan and a lot in Spain. So each point of unemployment in Japan goes with a much bigger fall in output than in Spain. The authors’ likely reasons: Japanese firms often keep staff through bad times, and many Spanish jobs are on temporary contracts that are easy to end. Use Okun’s law for rough estimates, not exact forecasts.
Worked Example
In Country X, unemployment is 7% and the natural rate is 5%. Potential output is 2,000 billion dollars a year. Use Okun’s law with a figure of 2.5. (a) How far below potential is output? (b) How much output is lost in a year? (c) If you knew only actual output, how would you find potential output?
Trap · Warning
Long recessions leave scars
People who stay unemployed for a long time can lose skills. Young people miss the training they would have got on the job. Some cyclical unemployment can then turn structural, so the natural rate itself can rise. Economists call this hysteresis.
In 1973–74, the price of a barrel of oil quadrupled. Oil fuels lorries, heats factories and goes into plastics, so firms’ costs jumped, and many raised their prices. This is cost-push inflation, one of three causes of inflation (a rise in prices across the whole economy):
| Demand-pull | Cost-push | Expectations-driven | |
|---|---|---|---|
| What drives it | Spending grows faster than the economy can produce | The cost of making things rises | People expect prices to keep rising, often after an earlier burst of inflation |
| Example | A boom: shops sell out, firms can’t find staff | Oil prices quadruple, 1973–74 | Workers expect 6% inflation and ask for 6% pay rises; firms raise prices to pay them |
| What else happens | Output and jobs are high | Output and jobs can fall as prices rise | Inflation can keep going after the first cause fades |
Trap · Warning
Too low, or far too high
A deflation spiral. Deflation means prices across the economy are falling. When people expect them to keep falling, some may wait to buy. If many do, firms sell less and cut jobs. People then spend even less, and prices fall further. The evidence on how often this happens is mixed: the clearest case is the Great Depression of the 1930s.
Hyperinflation. At the other extreme, prices rise so fast that money becomes almost worthless. It usually starts with a huge budget deficit: a government spending far more than it collects in taxes. The government pays the difference by printing money. By one IMF estimate, Zimbabwe’s yearly inflation rate reached about 500 billion per cent at one point in 2008.
Key Term
Why aim for 2%, not zero?
Many central banks (the banks that look after a currency, such as the euro or the yen) aim for inflation of about 2% a year. Three reasons:
- Room to cut interest rates. In a recession, central banks cut interest rates to boost spending, but rates can’t go far below zero. Lenders add expected inflation to the interest they charge, so 2% inflation keeps normal rates higher. That leaves more room to cut.
- Pay. Firms rarely cut wages. With a little inflation, a frozen wage buys slightly less each year. So a firm can lower real pay (what a wage can buy) without cutting wages or laying people off.
- Measurement. Price indexes (which track the cost of a typical basket of shopping) tend to overstate inflation a little. They partly miss people switching to cheaper goods, and products getting better. So a measured 0% could hide falling prices.
Whatever the target, steady inflation matters too: when people can predict it, they can plan their saving and borrowing.
Check yourself · no marks
An oil shock pushes inflation up to 8%. A year later, oil prices stop rising. Why might inflation stay high for a while?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 6
Country X’s unemployment rate is 7.5%. Of this, 2 points are frictional, 3 points are structural and 2.5 points are cyclical. What is its natural rate of unemployment?
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