The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Unemployment and Inflation

             It's the economy, stupid.
                                    .....James Carville, political strategist for Bill Clinton

             Rapid growth in aggregate supply (AS) enables economic growth, but what about aggregate demand (AD)?  If shifts in AD fail to match those in AS, other problems can occur.  Mismatches between AS and AD cause unemployment and inflation.

Unemployment          

            Think first about unemployment.¹  Of course unemployment will never be zero.  Even in the best of times some workers will find themselves temporarily between jobs (frictional unemployment). Suppose an electrician quits his job today and begins looking for a new employer.  Even if several firms make quick offers, it may take the worker several weeks to choose a new firm, relocate, and resume working.  During that interim period of time the electrician would be counted as unemployed.

             In other cases, plenty of jobs are available, but there may be a mismatch between jobs and workers either in terms of geographical location or skills (structural unemployment).  Openings for medical technologists in Oregon are of little help to an unemployed textile worker in South Carolina. 

             As a rough approximation, about one in twenty workers (or five percent) is likely to be a victim of these inevitable frictional and structural issues at any point in time.  Thus, the unemployment rate will be at about five percent even in a fully employed U.S. economy. Economists often term this five percent as the natural rate of unemployment.

             However, during an economic downturn or recession the rate of unemployment soars above that five percent level.   During such downturns there are simply more people looking for work than there are jobs available.

            What causes a recession or economic downturn?  Cuts in AD are the most common cause.  Look at the graph below.  If AD falls to AD₂ the equilibrium level of real GDP or income falls as well.  With less demand, there is less need for production and less need to employ workers.

            Imagine you run a successful bakery that sells 1,000 doughnuts per day that employs 50 workers.  The doughnuts cost you $2 a dozen and you resell to the public for $2.25.  If consumers decide to stop eating your doughnuts, what will you do?  With excess doughnuts piling up on your shelves you probably will cut the price of your products to stimulate sales.  Suppose that by cutting prices to $1.95 per dozen you can get sales back to 1,000 dozen per day. Your sales are back to normal, but your profits are not.  Baking doughnuts at $2 a dozen and selling at $1.95 is hardly a path to fiscal fitness. What now?

            Cut production.  You can no longer sell 1,000 dozen per day at a price that covers your $2 costs, but you might be able to sell 900 or 800 or 700 at such a price.  However, less production means less need for workers.  What will you do with the workers who are no longer needed?  You will unload them.  Call it a layoff, call it retrenchment, call it downsizing, the effects are all the same: unemployed bakery workers.

            If demand for other products remains strong, the unemployed workers might relocate in other sectors quickly.  But, if the demand for goods and services is down across the economy, the workers are stuck; the unemployment will persist.  In other words, if the demand for doughnuts drops, output and employment in bakeries will also drop.  If aggregate demand across the economy drops, output and employment across the economy will also drop.  Too little demand means too much unemployment.

            Will unemployment persist forever unless demand picks back up?  Probably not.  Falling wage rates eventually should restore full employment.  Return to the bakery example.  If workers were willing to accept a wage cut, the lay-offs could be avoided.  Remember that you unloaded workers because your costs were too high to make a profit at the $1.95 price needed to continue selling 1,000 dozen doughnuts.  If wages dropped far enough, your costs could easily fall far enough to make that $1.95 price a profitable one.

            However, in the real world, workers aggressively resist wage cuts.  For example, suppose you offered your bakery employees the following options: (1) keep wage rates constant but lay off ten percent of the workers (presumably those with the least seniority) or (2) maintain everyone’s job but cut wages across the board by ten percent.  Note that both options will save ten percent of your labor costs.  Which option will your employees prefer?  Probably the first option.  Option number two does avoid layoffs, but requires that more senior employees -- who are in no danger of being laid off -- be willing to accept wage cuts to save the jobs of others.  The workers who stand to lose their jobs will certainly prefer option number two, but the other ninety percent are better off with option number one. 

Inflation         

            If AD lags behind AS, we get unemployment.  What happens if AD exceeds AS?  We get inflation.²  Think again of the bakery.  Suppose that customers clamor for more doughnuts than you are baking.  What will you do?  You have two choices.  You can try to meet the new demand by expanding output and hiring more workers or you can choke off the new demand by raising prices.  If the economy is in the midst of a recession and new workers are easy to find, expansion is a logical choice.  But suppose the economy is already sitting at or near full employment.  If everyone willing to work is already employed, you are stuck.  You cannot expand; you can only raise prices.

            What is true for an individual firm largely is true for the economy as a whole.  If increases in AD outpace what a fully employed economy can produce, the extra demand will drive up prices or cause inflation. Too little demand causes unemployment, too much causes inflation.

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Notes:

1.         The U.S. Bureau of Labor Statistics counts as unemployed: "All persons who had no employment during the reference week, were available for work, except for temporary illness, and had made specific efforts to find employment some time during the 4 week-period ending with the reference week."  In other words, the unemployed are persons who have actively looked for a job within the past four weeks but are not working currently.

2.         Inflation is defined as rising prices.  If prices rise by four percent on average during a year, we have a four percent rate of inflation.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.     Explain why unemployment will exist even in strong economies with ample job opportunities.

2.     Define the concept of the natural rate of unemployment.

3.     Explain how recessions can create unemployment, how flexible wages might combat this unemployment, and why wages are not always flexible.

4.     Describe the cause of inflation.

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