The unemployment rate is one of the key variables that policy makers are interested in. There are different causes of unemployment and it is very difficult for governments to determine which causes are most important and how to deal with them. The two main types of causes of unemployment can be split as demand-sided and supply-sided. The unemployment has both economic and noneconomic costs (McConnell and Brue, 2005). The economic costs of unemployment are; (i) decrease in income and output which is measured in terms of the GNP gap and, (ii) burden of unemployment is not distributed equally among employees especially during recession periods (Petroff, 2002). On the other hand, loss of self-confidence, social and political conflicts can be counted as some of the noneconomic costs of unemployment (McConnell and Brue, 2005). Thus, it is important to analyse causes and outcomes of unemployment especially during recession period.
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Unemployment during Recession
Since Industrial Revolution, the entire world economy has gained a momentum. This momentum has led to economic expansion an increase in quality of life. However, this momentum hasn’t shown continuity. Countries have experienced many ups and downs in their economic activities since they industrialized. These up and down movements in economic activities or in production level are known as business or economic cycle (Parkin, 2012; Abel et al., 2008). There are two main periods of the business cycle (Parkin, 2012); expansion and recession. An expansion is a period which represents an increase in the economic activities and production level of an economy/country (Burda and Wyplosz, 2001). Contrary, recession is an extended time period when the economic activities and gross domestic product (GDP) of a nation are slowing or falling down (Abel et al, 2008; Harris, 2002). These activities are including level of employment, investments, household income, business profits and inflation rate. In a business or economic cycle, recession occurs between peak and trough points. It is also known as a business cycle contraction. This is represented in the Figure 1.
-Causes of Recession: Negative Demand and Supply Shocks
According to Abel et al. (2008), two main causes of economic recession are negative aggregate demand shock (ADS) and negative aggregate supply shock (ASS). A negative ADS is a sudden event that decreases the aggregate demand in an economy (Burda and Wyplosz, 2001). There are several reasons for this type of negative shock. It generally occurs because of tight fiscal and monetary policies (Abel et al., 2008). Government sets high taxes and reduces government expenditures to decrease the inflationary pressures. On the other hand, these policies can causes a fall in the aggregate demand and as a result economic recession takes place. The recession that United Kingdom (UK) experienced during 1980-81 was caused by tight fiscal and monetary policies (Pettinger, 2012). There were high tax rates, low government expenditure, and high interest rates for reducing spending, consumption and investment. The UK government was applied these tight policies for reducing the inflationary pressures which was formed in the late of 1980’s. Inflation had fallen but the cost of these policies was the economic recession. Classical economists suggest that the negative ADS do not cause continued fluctuations in output level (Burda and Wyplosz, 2001). However, they view that a negative ASS is a major reason behind the critical changes in output and employment level (Burda and Wyplosz, 2001). A negative supply shock or a negative production shock is an unexpected event that decreases the aggregate supply in an economy/country (Abel et al., 2008). A negative ASS causes an inward shift in the long run aggregate supply (LRAS) curve of an economy (Abel et al., 2008).
In figure 2, there is an inward shift in the LRAS curve because of a negative supply shock. It is reducing full-employment output from Q1 to Q2 and increase the price level from P1 to P2. This change in the price level represents that a negative supply shock causes prices to rise during the recession. Some of the real world examples of negative supply shocks are; changes in weather, such as an unexpected cold weather; changes in the structure of industries, such as merging of two or more dominant companies (Abel et al., 2008). Sometimes, the dominant suppliers join together for increasing their market power. By this way, they can restrict supply and set higher prices for making more profit. The real world reflection of this happened in 1970’s by the Organization of Petroleum Exporting Countries (OPEC) where members were imposed an oil embargo and then increased oil prices. When the oil prices rise, firms began to produce less since the cost of production was increase independently from aggregate demand. During oil price shock, labour demand, employment and real wage rate had fallen (Carlstrom and Fuerst, 2006).
A negative supply shock reduces the quantity of labour demanded at any given real wage rate and causes an inward shift in the labour demand curve (Abel et al., 2008). In figure 3, the negative supply shock causes a fall in the labour market equilibrium from point A to B. At the new equilibrium both real wage and employment level falls. This graph also reflects the effects of oil price shock on the labour market.
-Supply Side Factors
During recession both businesses and individuals tend to retrench their economic belts and this causes negative effects on the level of production and consequently demands for labour decrease. Thus, during recession unemployment turns out to be one of the major problems on both government and society. Some of the unemployment during recession base on supply-side factors like personal transferable skills, job-seeker research channel, occupational mobility (job skills), and geographical mobility (Adams et al., 2000). For example; in UK, economic structure is turning to service based from manufacturing based economy (Parkin, 2012). The main reason of this structural change is globalisation and international trade agreements. According to Parkin (2012), UK has completely lost its cost advantages in manufacturing goods since the cost of production is much cheaper in Eastern Europe countries. Structural changes lead primary and secondary sector workers lose their jobs and many of them cannot find new jobs since they don’t have necessary skills for working in service sectors such as financial service institutions and information technology.
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However, even when economy is operating at full capacity, there is some unemployment that causes by the supply side factors. This is generally known as the natural rate of unemployment or equilibrium unemployment (Blink and Dorton, 2007). The natural rate of unemployment exists when the labour market is in equilibrium (Abel et al., 2008). In figure 4, the total labour force (TLF) in an economy and aggregate supply of labour (ASL), which stands for the number of people who are willing to work at every given wage rate, are presented. The difference between points “a” and “b” is natural rate of unemployment. The natural rate of unemployment is the combination of frictional and structural unemployment (Abel et al., 2008). Frictional unemployment occurs when employees leave their jobs for finding more suitable job opportunities in order to satisfy their career and income expectations (Parkin, 2012). While employees are searching for new jobs, there is always some frictional unemployment in the economy. The poor job information may lead this searching process to take longer than what the employees expected and consequently employees may lose their motivations for finding new jobs. Unemployment benefits are also a factor that affect the incentive to not to work.
Also, structural unemployment occurs when the structure or production methods of an industry are changed in order to keep pace with changes in consumers’ tastes and new production techniques (Sloman, 2004). Structural unemployment is generally known as the long-term unemployment since workers must retrain or they may have to relocate for staying at their current jobs or finding new jobs (Parkin, 2012). On the other hand, the financial and mental costs of retraining and relocation lead structural unemployment that contains geographical and occupational immobility. Housing prices are one of the most important financial problems that cause geographical immobility. For example; in London, the active capital city life creates more job opportunities than in the North of England, but housing prices and rents are much more expensive than in the North of England. So, some workers may prefer to take unemployment benefits and staying at their neighbourhoods rather than paying high rents or buying expensive houses in London. This causes geographical immobility.
An increase in unemployment rate also increases the burden of the government. High unemployment means an increase in the total amount of unemployment benefits that governments have to pay. As a result of an increase in unemployment rate, government’s revenues fall. So, it causes budget deficits. In order to decrease the rate of unemployment, government may use both supply-side and demand-side policies. The main aim of the supply-side polices is to make labour force more responsive and flexible against the changes in job opportunities (Sloman, 2004). However, if there is lack of aggregate demand, supply-side policies can be ineffective. Thus, for achieving more effective results government can support supply-side policies by using demand-side policies as well as fiscal and monetary policies.
In recent years, recession become one of the major problems that the entire world economies encountered. It is inevitable for governments to take certain measures to determine the causes of economic downturn. It can be caused by demand side or supply side shocks. During the recession, unemployment becomes one of the serious problems because of low levels of consumption, demand and investment (Pettinger, 2011). However, unemployment exists even when economy is operating at full capacity. Unemployment never becomes zero because of supply-side factors, like; personal transferable skills, job-seeker research channel, occupational mobility (job skills), and geographical mobility (Adams et al., 2000). Structural and frictional unemployment are unemployment types that cause by supply side factors. There are massive research efforts to find out causes of unemployment and how to deal with it. The long lasting effects of unemployment make it an important problem for all economies and governments that encourage governments to try to find solutions for it since it has economic, social and political consequences.