Category Archives: Unemployment

Economic Theory v Economic Reality

Most theories in economics rest on the premise that people, companies, and markets behave according to the abstract, two-dimensional illustrations of an introductory economics textbook, even though the assumptions behind those diagrams virtually never hold true in the real world.

Below is a table that I found in James Kwak’s book “Economism”. It takes theories found in most introductory economics textbooks and suggests what actually might happen to these theories in the real world.

 

Does a higher minimum wage mean higher unemployment?

In most economics textbooks the labour market is shown with a simple graph of the supply of labour and the demand for labour and where they intersect the wage that employees receive for their service and the amount employed. The theory is based on the following:

Demand for Labour
In this context the demand for labour is determined by the marginal revenue product where workers are paid the value of their marginal revenue product to the firm. The demand for labour is downward sloping as when there is a fall in the wage rate the firm will expand employment as the labour input has become relatively cheaper for a given level of productivity, compared to other inputs. A rise in the wage rate will causes a contraction of labour demand.

Supply of Labour
Economic theory would suggest that the real wage (adjusted for inflation) is a key determinant of the number of hours. Therefore the supply curve for labour slopes upward because people want to work more hours if you pay them more, at least in theory. An increase in the real wage on offer in a job should lead to someone supplying more hours of work over a given period of time, although there is the possibility that further increases in the going wage rate might have little effect on an individual’s labour supply.

The Minimum Wage

The minimum wage distorts the market equilibrium as there is now a wage floor – a level which the wage cannot fall below. If the minimum wage is below the equilibrium wage then there is no impact as the market will ensure that is reaches equilibrium. However a minimum wage above the equilibrium means that companies will hire fewer workers and therefore result in more unemployment. On the graph below a minimum wage of W1 means that the level of employment has fallen but those prepared to work but are involuntary unemployed has increased. However the people still employed are better off as they are paid more for the same work; their gain is exactly balanced by their employers’ loss. The jobs that someone would have been willing to do at less than the wage of We and for which some company would have been willing to pay more than We. Those jobs are now gone, as well as the goods and services they would have produced.

Real Impact of the Minimum Wage.

In reality the theory of the minimum wage explained above is not as simple as it is made out to be. From records in the USA there is no obvious relationship between the minimum wage and unemployment: adjusted for inflation, the federal minimum wage was highest from 1967 through 1969, when the unemployment rate was below 4%. One study in 1994 by David Card and Alan Krueger evaluated an increase in New Jersey’s minimum wage by comparing fast-food restaurants on both sides of the New Jersey – Pennsylvania border. They concluded, “contrary to the central prediction of the textbook model … we find no evidence that the rise in New Jersey’s minimum wage reduced employment at fast-food restaurants in the state.”

The idea that a higher minimum wage might not increase unemployment goes against the the theory in textbooks as if labour becomes more expensive firms will take on less employees. But there are several reason why this might not be the case:

  • The standard model states that firms will replace labour with machines if wages increase, but what happens if labour saving technologies are not available at a reasonable cost.
  • Some employers may not be able to maintain their business with fewer workers especially in service based industries. Therefore, some companies can’t lay off employees if the minimum wage is increased.
  • Small firms are traditionally labour intensive and can’t afford large capital investment. Therefore the minimum wage doesn’t have the impact of laying off workers.
  • If employers have significant market power that the theory of the supply and demand for labour doesn’t exist, then they can reduce the wage level by hiring fewer workers (only those willing to work for low pay), just as a monopolist can boost prices by cutting production (think of an oil cartel, for example). A minimum wage forces them to pay more, which eliminates the incentive to minimize their workforce.
  • Even though a higher minimum wage will raise labour costs many companies can recoup cost increases in the form of higher prices; because most of their customers are not poor, the net effect is to transfer money from higher-income to lower-income families. In addition, companies that pay more often benefit from higher employee productivity, offsetting the growth in labor costs.
  • Higher wages boost productivity as they motivate people to work harder, they attract higher-skilled workers, and they reduce employee turnover, lowering hiring and training costs, among other things. If fewer people quit their jobs, that also reduces the number of people who are out of work at any one time because they’re looking for something better. A higher minimum wage motivates more people to enter the labor force, raising both employment and output.
  • Higher pay increases workers’ buying power. Because poor people spend a relatively large proportion of their income, a higher minimum wage can boost overall economic activity and stimulate economic growth, creating more jobs.

All the above add a range of variables that are not considered in the simple supply and demand model for labour. It maybe useful as a starting point in discussing the minimum wage but has its limitations in the more complex real world

Source: Economism by James Kwak

Where is global inflation?

The Economist had an article in its Finance and Economics section on the fact that after record low interest rates and extended quantitative easing global inflation seems stubbornly low – see graph. In order to explain this you need to consider the model that central banks use to explain inflation. There are three elements to this model:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low. See graph below showing New Zealand’s Phillips Curve

Recession Recovery or He-cession She-covery?

Radio NZLast Sunday there was a very good interview with Canadian economist Armine Yalnizyan on Radio New Zealand’s ‘Sunday’ Programme (with Wallace Chapman). She mentions that the neoliberal policies of the last 30 years have seen income inequality grow and the collapse of consumer spending (C) the main driver of any domestic economy. There has been an increase in the proportion of income accruing to assets which worsens inequality in many countries. China would be an economy that has relied a lot on its export sector (X) for growth but is now trying to drive domestic demand (C) to generate growth. Remember that Aggregate Demand = C+I+G+(X-M). She makes the point that corporates favour the return for shareholders rather than for example
the wages of employees.

“We have this very unusual situation here where corporations are gaining in strength for a host of reasons, similar to the type of corporate power 100 years ago, in key sectors of the economy with less ability to either tax a proportion of the profits they make or regulate their activities.”

Boosting the minimum wage is stimulatory

She also mentions an increase in the minimum wage being stimulatory with lower income groups spending a much higher proportion of their income and thereby increasing consumption. And the vast majority of this spending happens in the domestic economy – C↑. Some have talked of wage inflation by increasing the minimum wage but with the fall in trade union membership and bargaining power this has been significantly reduced. In fact we have seen wage compression.

He-cession and She-covery

However later on in the interview I was interested to her explanation of He-cession and She-covery during the interview.

Recession = “he-cession” – more men tend to become unemployed as areas that are initially impacted by the downturn are manufacturing, mining, construction etc which are likely to be male dominated.

Recovery = “she-covery”: men who lose $30 an hour jobs wince at accepting $15 an hour offers, but women grab them to make sure the bills get paid.

Have Central Bankers’ got it wrong?

Below is very good video from the FT – here are the main points:

  • Central Banks – by lowering interest rates they could make savings less attractive and spending more attractive
  • After GFC low interest rate and asset purchases increased lending and avoided a global depression.
  • Now the world economy is not behaving as the central bankers’ said it would
  • Their theory was that with lose credit (lower interest rates) the economy would grow and inflation would rise.
  • Inflation is stagnant (unlike the 1960’s – see graph below) and this is worrying as a little inflation is required to lubricate the economy. It allows prices to fall in real terms.
  • The missing inflation may mean that the bankers’ theories are wrong.
  • Cheap money may have encouraged high asset prices and debt levels but it may undermine the economy without doing much for growth.

Inflation Unemployment.png

A2 Revision – New Classical to Extreme Keynesian

The main competing views of macroeconomics (Keynesian vs Monetarist) is part of Unit 5 in the A2 syllabus and is a popular topic in the essay and multiple-choice papers. Begg covers this area very well in his textbook. In looking at different schools of thought it is important to remember the following:

Aggregate Demand – the demand for domestic output. The sum of consumer spending, investment spending, government purchases, and net exports
Demand Management – Using monetary and fiscal policy to try to stabilise aggregate demand near potential output.
Potential Output – The output firms wish to supply at full employment after all markets clear
Full Employment – The level of employment when all markets, particularly the labour market, are in equilibrium. All unemployment is then voluntary.
Supply-side policies – Policies to raise potential output. These include investment and work incentives, union reform and retraining grants to raise effective labour supply at any real wage; and some deregulation to stimulate effort and enterprise. Lower inflation is also a kind of supply-side policy if high inflation has real economic costs.
Hysteresis – The view that temporary shocks have permanent effects on long-run equilibrium.

There are 4 most prominent schools of macroeconomics thought today.

New Classical – assumes market clearing is almost instant and there is a close to continuous level of full employment. Also they believe in rational expectations which implies predetermined variables reflect the best guess at the time about their required equilibrium value. With the economy constantly near potential output demand management is pointless. Policy should pursue price stability and supply-side policies to raise potential output.

Gradualist Monetarists – believe that restoring potential output will not happen over night but only after a few years. A big rise in interest rates could induce a deep albeit temporary recession and should be avoided. Demand management is not appropriate if the economy is already recovering by the time a recession is diagnosed. The government should not fine-tune aggregate demand but concentrate on long-run policies to keep inflation down and promote supply-side policies to raise potential output.

Moderate Keynesians – believe full employment can take many years but will happen eventually. Although demand management cannot raise output without limit, active stabilisation policy is worth undertaking to prevent booms and slumps that could last several years and therefore are diagnosed relatively easily. In the long run, supply-side policies are still important, but eliminating big slumps is important if hysteresis has permanent effects on long-run equilibrium. New Keynesians provide microeconomics foundations for Keynesian macroeconomics. Menu costs may explain nominal rigidities in the labour market.

Extreme Keynesians – believe that departures from full employment can be long-lasting. Keynesian unemployment does not make real wage fall, and may not even reduce nominal wages and prices. The first responsibility of government is not supply-side policies to raise potential output that is not attained anyway, but restoration of the economy to potential output by expansionary fiscal and monetary policy, especially the former.

IMF’s global growth forecast

Below the FT’s Chris Giles talks to Maury Obstfeld, chief economist of IMF, on how the global economy is growing at its fastest rate in almost seven years. One chart (below) shows a falling unemployment rate with stagnant wage growth – Obstfeld talks of lower labour productivity as the reason for this. Well worth a look and very useful for the prospects of global growth – including developed and developing countries.

Unemp v Wages

Don’t abandon the Phillips Curve

I have done numerous blog posts on the Phillips Curve some of which have discussed the missing trade-off between inflation and unemployment. Recent data from the US suggest that reducing rates of unemployment have not activated higher levels of inflation. US Fed Chair Janet Yellen has suggest that the level of unemployment is below the natural rate of unemployment (the lowest rate of unemployment where prices don’t accelerate) and that prices should soon rise. However inflation in the US is only 1.5% (target 2%) so does the Phillips Curve still apply? The Economist looked at another instance where this theory has failed.

2019 – after the financial crisis unemployment exceeded 10% and the excess supply of labour should have had significant downward pressure on prices. However prices were at 1.3% just below what they are today. Some economist explained this situation by an increase in the natural rate of unemployment (NRU) – 6.5% was a figure quoted by some economists. But today with unemployment now at 4.3% and inflation at 1.5% this theory does not seem to stack up. The Fed estimates that the NRU is between 4.7% and 5.8%.

Reasons not to abandon the Phillips Curve

1. The effects of unemployment on inflation can be distorted by one off events such as:
* the rapid decline in oil prices in late 2014
* the price of mobile data – firms have been offering limitless data which has also been   given a higher weighing in the inflation calculation. Mobile phone deals have shaved 0.2% off the inflation rate

2. It is possible with such low unemployment that inflation will eventually increase. This happened in the late 1960’s with unemployment under 4%, inflation rose from 1.4% in November 1965 to 3.2% a year later. By 1969 inflation was at 5%.

3. Self-fulfilling inflationary expectations could explain the low inflation rate. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Source: The Economist – 17th June 2017

The theory of the Phillips Curve and the NAIRU

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

NAIRUSuppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).

Underemployment v Unemployment

Underemployment is a measure of employment and labor utilization in the economy that looks at how well the labor force is being utilized in terms of skills, experience and availability to work. Labour that falls under the underemployment classification includes those workers who are highly skilled but working in low paying jobs, workers who are highly skilled but working in low skill jobs and part-time workers who would prefer to be full time. This is different from unemployment in that the individual is working but is not working at his full capability.

The unemployment rate, which receives the majority of the national spotlight, can be misleading as the main indicator of the job market’s health because it does not account for the full potential of the labor force. The U.S. unemployment rate was 4.3% as of May 2017, but at the same time, the U.S. underemployment rate was 8.4% – see graph below. The unemployment rate is defined by the Bureau of Labor Statistics (BLS) as including “all jobless persons who are available to take a job and have actively sought work in the past four weeks.” As illustrated by the engineering major who works as a delivery man, a measure of underemployment is needed to express the opportunity cost of advanced skills not being used.

Under v Unempl.pngFurthermore, the unemployment rate is calculated based solely off the labour force, which does not include persons who are not seeking a job. There are many instances in which a person is able to work but has become too discouraged to actively seek a job. Below is a very good video clip from PBS where the underemployment rate in Illinois was 10.3% last year.

Source: Investopedia

 

Tight labour market in Japan but wages stagnant.

As is mentioned in simple economic theory, when you have a good or service that becomes more scarce there is an increase in the value of that good or service. The labour market in Japan is becoming very tight in that the supply of labour is starting to decrease with the demand increasing – see graph. This should ultimately lead to higher wage demands by workers as they are becoming more and more scarce relative to the demand. Recent figures out of Japan show this situation:

Japan labour market* Working age population – 15-64 years in Japan – fallen by 3.8m since December 2012 = decrease in supply of labour = upward pressure on wages
* People actually working has increased by 2.2m = increase in demand for labour = upward pressure on wages
* Unemployment in Japan = 2.8% the lowest rate since 1994 = upward pressure on wages

Why has there been no increase in Japanese wages?

Japanese labour unions have not been very aggressive in wage bargaining and there was a wage increase of only 0.2% in 2016 but already in negative territory this year – see chart. Wages have remained stagnant as strong demand has resulted in an increase in supply of labour rather than the price of labour – wages.

Japan - wage growth
Supply of labour increase:
* Japan now has 1 million foreign workers as compared to 680,000 in 2012
* Numbers of elderly men and women in the workforce has increased by over 2 million
* There is a rising share of part-time work

Job security at the expenses of wage increases.
It seems that market forces don’t really affect those employed in large firms. The pay in these firms has been largely unresponsive to the pressure of supply and demand as employees of life-time employment do not worry about being made redundant but don’t expect significant pay rises during the good times. However in times of inflation they do request higher pay to offset the increased cost of living.

So if general workers pay does increase there is the possibility of the general level of prices will also go up which would in turn increases the wage demands of those in large firms. However as stated by The Economist

“Japan’s workers are hugely in demand but strangely undemanding.”