equilibrium and disequilibrium unemployment (including hysteresis)

Employment and Unemployment

Learning Objectives

• Define and measure the different types of unemployment.
• Distinguish between equilibrium (natural) and disequilibrium (cyclical) unemployment.
• Identify the six determinants of the natural rate of unemployment (NAIRU) and explain how each influences the *marginal‑decision* of firms and workers.
• Explain hysteresis, its mechanisms and implications for policy.
• Analyse the strengths and limitations of the main policy tools used to reduce unemployment, noting which are macro‑economic and which are micro‑economic.

Key Definitions

• Labour Force: All persons aged 16 + who are either employed or actively seeking work.
• Unemployment Rate (u): \[ u=\frac{\text{Number of unemployed}}{\text{Labour force}}\times100\% \]
• Equilibrium (Natural) Unemployment (u_n): The unemployment rate when the labour market clears at the *natural real wage*. It consists of frictional + structural unemployment.
• Disequilibrium (Cyclical) Unemployment (u_c): The deviation of the actual unemployment rate from the natural rate: \[ u_c = u - u_n \]
• NAIRU (Non‑Accelerating Inflation Rate of Unemployment): The unemployment rate at which inflation is stable; essentially the natural rate but linked to the Phillips curve.
• Hysteresis: The process by which prolonged periods of high unemployment raise the natural rate permanently.

Types of Unemployment (AS 5.5)

• Frictional: Time needed for workers to find jobs that match their skills and preferences. Example: A recent graduate searching for a graduate‑training position.
• Structural: Mismatch between workers’ skills (or locations) and the requirements of available jobs. Technological change is a *subset* of structural unemployment. Example: Coal‑miners displaced by the shift to renewable energy.
• Cyclical (Demand‑deficient): Result of insufficient aggregate demand; the labour‑demand curve shifts left. Example: Rising unemployment during the 2008‑09 global financial crisis.
• Seasonal: Regular fluctuations linked to the calendar (e.g., tourism, agriculture). Example: Spain’s unemployment peaks in winter when tourist‑related jobs disappear.

Consequences of Unemployment (macro‑economic & social)

• Reduced output and slower GDP growth.
• Higher government spending on benefits and lower tax revenues → fiscal pressure.
• Increased poverty and income inequality.
• Loss of skills (human‑capital depreciation) and lower future productivity.
• Social costs: higher crime rates, mental‑health problems, and reduced social cohesion.

Labour‑Market Framework

The labour market is represented by the interaction of:

• Labour demand (L_D): Derived from the marginal product of labour; downward‑sloping in the real wage (W).
• Labour supply (L_S): Reflects workers’ willingness to work at different real wages; upward‑sloping.

Equilibrium occurs where L_D = L_S = L*.

Equilibrium (Natural) Unemployment

Even at equilibrium a non‑zero unemployment rate persists because:

• Frictional unemployment arises from the *search* and *matching* margin‑decision of workers and firms.
• Structural unemployment reflects the *marginal productivity* versus *marginal cost* of employing workers with particular skills.

In the long run the economy tends to return to this rate unless hysteresis is operating.

Disequilibrium (Cyclical) Unemployment

Occurs when the actual unemployment rate deviates from u_n. Main causes:

1. Demand‑side shocks: A fall in aggregate demand shifts the labour‑demand curve left.
2. Supply‑side shocks: Increases in the real‑wage floor (e.g., a minimum wage above equilibrium) shift the labour‑supply curve left.
3. Policy‑induced rigidities: Wage contracts, strong unions, or generous unemployment benefits that keep wages above the market‑clearing level.

Mathematical Representation

Let L_D = f(W) denote labour demand and L_S = g(W) denote labour supply.

Equilibrium:

\[ L_D = L_S = L^{*} \]

Natural‑rate unemployment:

\[ u_n = \frac{L_{\text{force}} - L^{*}}{L_{\text{force}}}\times100\% \]

Cyclical unemployment:

\[ u_c = u - u_n \]

NAIRU and the Phillips Curve

Short‑run expectations‑augmented Phillips curve (adaptive expectations):

\[ \pi_t = \pi_{t-1} - \beta\,(u_t - u^{*}) + \varepsilon_t\qquad (\beta>0) \]

where \(\pi_t\) = inflation, \(u_t\) = actual unemployment, \(u^{*}\) = NAIRU, and \(\varepsilon_t\) = shock.

Long‑run Phillips curve: Vertical at the NAIRU because expectations fully adjust; any attempt to keep unemployment below NAIRU only leads to accelerating inflation.

Determinants of the Natural Rate (A 9.3)

Determinant	Margin‑decision link	Illustrative example
Demographic structure	Changes the marginal cost of hiring (e.g., higher youth share → higher turnover, more search time).	Japan’s ageing population raises frictional unemployment among older workers.
Institutions & regulations	Employment protection or high minimum wages raise the marginal cost of firing/hiring, shifting the labour‑supply curve left.	France’s strict firing rules → higher structural unemployment.
Skill mix & education	Mismatched marginal productivity of workers versus the marginal product required by firms.	Rapid growth of ICT jobs in the UK outpacing the supply of qualified graduates.
Labour‑market flexibility (geographic & occupational mobility)	Higher mobility reduces the marginal search cost, lowering frictional unemployment.	Germany’s “dual” training system improves occupational mobility.
Real wage level	If the real wage exceeds marginal productivity, firms hire fewer workers, raising structural unemployment.	High minimum wage in Australia relative to low‑skill productivity.
Aggregate‑supply conditions	Supply‑side shocks (e.g., oil price spikes) reduce marginal productivity, shifting the natural rate upward.	1970s oil crises increased structural unemployment in many OECD countries.

Patterns & Trends (including Labour Mobility)

• Geographic mobility: Workers moving from declining regions to growth areas. Low mobility can keep regional unemployment high.
• Occupational mobility: Re‑skilling or up‑skilling to move into expanding sectors. High mobility reduces structural unemployment.
• Historical trend: In most advanced economies the natural rate fell from ~8 % in the 1970s to 4–5 % in the 2000s, then rose again after the 2008‑09 crisis, partly due to hysteresis effects.
• Data illustration (OECD, 2023): Spain’s long‑term unemployment (≥12 months) averaged 14 % in 2022, well above the EU average of 7 % – evidence of persistent structural problems and limited mobility.

Measurement Difficulties (A 9.3)

• Hidden unemployment: Discouraged workers who stop looking are not counted as unemployed.
• Under‑employment: Part‑time workers who would like more hours, or over‑qualified workers in low‑skill jobs.
• Definition & coverage: Variations in the age range, treatment of marginally attached workers, and informal‑sector employment.
• Statistical revisions: Seasonal adjustments and survey errors affect comparability over time.

Mini‑case: In the United States the official “U‑3” unemployment rate (the headline figure) was 3.6 % in early 2024, but the broader “U‑6” measure – which adds discouraged workers and part‑time workers seeking full‑time work – was 6.8 %. The gap shows how definition choices can double the reported rate.

Hysteresis

Prolonged high unemployment can raise the natural rate permanently. Two principal mechanisms:

• Skill loss: Long‑term unemployed lose firm‑specific and general skills, reducing their marginal productivity.
• Discouragement effect: Persistent unemployment lowers labour‑force participation, effectively raising u_n.

Blanchard‑Wolfensohn simple hysteresis model:

\[ u_{t+1}= \lambda u_t + (1-\lambda)u_n\qquad(0<\lambda<1) \]

A high \(\lambda\) means past unemployment heavily influences the next period’s natural rate, creating persistence.

Policy Tools and Their Impact on Unemployment Types

Policy Tool	Primary Target (type of unemployment)	Macro‑/Micro‑economic classification	Effect on NAIRU	Risks / Limitations
Expansionary fiscal policy (e.g., increased government spending)	Cyclical (demand‑deficient) unemployment	Macro‑economic	Temporarily lowers uc; little long‑run impact on un unless sustained.	Inflationary pressure if output exceeds potential; possible crowding‑out of private investment.
Expansionary monetary policy (lower interest rates, QE)	Cyclical unemployment	Macro‑economic	Same as fiscal – short‑run reduction in uc.	Risk of asset‑price bubbles; limited effectiveness when the interest rate is near zero.
Active labour‑market programmes (training, job‑matching, wage subsidies)	Frictional & structural unemployment	Micro‑economic	Can lower un by improving matching efficiency and skill levels.	Costly; effectiveness depends on design, coverage and relevance of training.
Minimum‑wage legislation	Structural (if set above equilibrium)	Micro‑economic	May raise un by creating a wage floor above the marginal product of low‑skill labour.	Potential job loss in low‑skill sectors; may increase informality.
Unemployment‑benefit reforms (duration, eligibility, conditionality)	Frictional & cyclical unemployment	Micro‑economic	Stricter benefits can reduce uc but may increase labour‑force turnover.	Social welfare concerns; risk of higher poverty and reduced consumption.
Supply‑side reforms (deregulation, flexible contracts, reduced hiring‑costs)	Structural unemployment	Micro‑economic	Increase labour‑market flexibility → lower un.	May reduce job security and increase income inequality.

Evaluating Hysteresis Evidence

Empirical approach: regress the estimated natural rate on lagged unemployment.

\[ u^{*}_t = \alpha + \rho\,u_{t-1} + \eta_t \]

A statistically significant \(\rho>0\) supports hysteresis. Empirical results vary across countries, reflecting differences in labour‑market institutions, welfare generosity and the duration of recessions.

Summary Checklist

• Define all four AS‑level unemployment types and give a real‑world example.
• Explain why the natural rate is never zero (frictional + structural) and link it to the marginal‑decision of firms and workers.
• List the six A‑level determinants of the natural rate, describe the margin‑decision mechanism for each, and provide an illustrative example.
• Identify patterns/trends (geographic & occupational mobility, historic changes) and recognise measurement problems (hidden unemployment, U‑6 case).
• State the expectations‑augmented Phillips‑curve relationship, write both short‑run and long‑run equations.
• Describe hysteresis mechanisms and the Blanchard‑Wolfensohn model.
• Match each policy tool to the type of unemployment it tackles, indicate whether it is macro‑ or micro‑economic, and assess its impact on the NAIRU.
• Recall the main macro‑economic and social consequences of unemployment.

Suggested Further Reading

• Blanchard, O. & Wolfers, J. (2000) “The Role of Hysteresis in Unemployment Dynamics”.
• Barro, R. (1999) Macroeconomic Theory. Chapter on labour markets.
• OECD (2023) Employment Outlook – data tables on natural rates and long‑term unemployment.
• Cambridge International AS & A Level Economics (9708) – Unit 3: Labour Market.