Real wage (aka classical) unemployment occurs when demand and supply aren’t equal. Therefore it is a disequilibria issue. This can occur if the wages demanded by the labour force are higher than the amount that industry is willing to pay. Hence classical unemployment can occur through government intervention (by establishing minimum prices; in the UK the national minimum wage is an example of a policy which can lead to classical unemployment), trade unions bargaining for higher wages or reserve wages (a limit set by employees as to how much they wish to earn to accept a job offer). If workers refuse employment because they aren’t offered their reserve wage then they are considered to be voluntarily unemployed. 

 

Cyclical unemployment occurs because labour is a derived demand, if there is a deficiency in aggregate demand then the derived demand for the production of goods and services will fall, leading firms to make redundancies. Labour is a lagging economic indicator because during cyclical unemployment firms won’t immediately reduce their work force in spite of a fall in demand. This is because they don’t know how long the downturn will last and it is costly to fire a workforce, to simply rehire one and have to train the up a few weeks later (if that is the case), therefore managers hold on to their trained and experienced workers until they are sure that demand is going to be suppressed for a great period of time. During this period they are likely to build up stocks of unsold goods until they eventually make redundancies. Some firms may even decide to keep on their workforce during a period of time of suppressed demand if they can afford to do so and the workforce is suitable trained and experienced to make themselves vital for the firm. During the upturn firms may have large stores of unsold stock and hence may sell this before they hire more workers to increase production, they do this to ensure that the upturn is permanent (and not just a positive quarter) and to make room in warehouses for more goods.

Seasonal unemployment could also come under this heading; it occurs when workers are only required during certain periods of the year/business cycle, for example retail workers may be required during the busy trading period of Christmas, or some farmers may only be needed during harvest to help collect the produce.

 

Frictional unemployment always occurs and happens when workers leave a job, and are technically unemployed, whilst they search for another job. They may decide to leave for personal reasons, or because they want to find a better job with higher pay/perks, or it may be because they have been laid off, also new workers entering the labour force are considered frictionally unemployed whilst they come to terms with the labour market. Imperfect information can increase frictional unemployment if unemployed members of the labour force are unaware of the existence of jobs. 

 

Structural unemployment can occur due to capital-labour substitution (workers are replaced by machines, hence they are no longer needed) or due to a long run (permanent) decline in demand in the sector in which they work. This can be a problem of occupational and geographical immobility; workers may not be in the place where the jobs are, or may not have the skills and training to do the required work. 

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Okun's Law shows the negative relationship between unemployment and GDP. It is named after the American economist Arthur Okun who studied it. We would expect the relationship between unemployment and GDP to be negative - employed workers produce goods which contribute to GDP, whereas unemployed workers do not. Hence we would expect a rise in unemployment to result in a negative change in GDP.

 

An empirical study has proven that unemployment is largely inversely related to the rise in GDP growth (economic growth) as shown in the graph to the left. The data provided is for the US between 1990 and 2011 and is shown as a scatterplot.  

 

Studies have shown that Percentage Change in Real GDP = 3% - 2*(Change in the Unemployment Rate). (For the US). 

If the unemployment rate remains constant (it doesn't increase - note, this doesn't mean there are no changes in the number of unemployed, just that the overall rate which takes into account the number of unemployed and the number of employed remains the same) then GDP grows at about 3% according to Okun. The reason this growth occurs is due to the increase in the labour force (which increases at the same rate as demand for workers), capital accumulation due to investment and through technological advancements. 

It is considered a rule of thumb, for every 1% rise in a countries unemployment rate, real GDP (taking into account inflation) will be operating at 2% below potential GDP. 

 

Hysteresis is the theory that a period of high unemployment (usually caused by demand deficiency) can lead to an increase in the value of NAIRU. That is high unemployment now, can cause high unemployment in the future. The reason for this is that unemployment has long term effects (as well as the short term effect of not having an income other than unemployment benefits) in that workers forget their skills and as they aren’t practising them they may deteriorate or at least not improve at the rate they would have done had they been in employment. Furthermore some people may become so disillusioned with the labour market that they leave it completely and remain unemployed perpetually. 

 

Additionally hysteresis can also occur because after a negative shock, there are fewer workers, who may decide to collectively bargain (in the form of a union) for higher wages. Because firms have few workers to choose from (skills wise, and considering that some people would have exited the job market), they may (at least in the short term) have to give in to the unions' demands. These higher wages will then keep out new workers in the future as the firm has less money to spend on new workers. In the long run however, firms may decide to move production abroad, or make production more capital intensive as a result of higher wages. These higher wages may alternatively be passed on to consumers in the form of higher prices, leading to inflation.

 

Another way hysteresis can occur is through the reduction in a business network resulting from unemployment. During periods of unemployment, workers loose touch of old colleagues and associates who form a valuable network which may help them get a job, or who without which may not be able to 'stay in the loop'.

 

High unemployment means workers are likely to have less disposable income (as they are depleting savings, becoming dependent on other relatives' income, or are on benefits) and may reduce their consumption. This results in less aggregate demand and may worsen the situation of cyclical unemployment (lower AD may cause higher, cyclical, unemployment). A result of lower aggregate demand may be that firms decide to lower their prices in order to sell more goods, this potentially could lead to deflation.

Hysteresis is a theory developed by the Keynesians to explain why laissez-faire economic policy may be damaging in the long run. Neoclassicalists would argue that during an economic downturn, when an external shock causes demand to fall, wages should be allowed to fall which would increase the international competitiveness of the economy so that exports can grow to increase demand and provide a boost to the economy fueling further growth until the economy is out of the slump and growing again. Even if we ignore the Keynesian argument that lower wages will further reduce consumption (because people have less money to spend and save instead - the paradox of thrift - for fear that they may lose their job in the future) and possibly investment (because there is lower demand which means reduced future profitability and "animal spirits" may be weak) we still have to consider the short-term effects that the economic downturn causes. Hysteresis is the argument that these short-term effects manifest themselves into long term problems which inhibit growth and make it difficult to return to pre-recession growth trends as the neoclassicalists presume.

 

These hysteresis channels are: skills atrophy, signalling effects, cognitive dissonance, capital depreciation and beachhead effects/trade penetration.

 

Skills Atrophy - unemployed workers will begin to forget their skills or at the very least lose productive efficiency as they forget particular ways of producing goods and services. This may mean that education is needed before output can expand, in some cases some skills may permanently be lost (perhaps not completely relevant to this discussion, but consider in Britain how many workers remain with textile skills, this is despite the UK being a world-lead in textiles only 30/40 years ago).

 

Signalling Effects - normally firms would hire workers who have had a steady employment history, as this is a useful signalling effect to show that they are reliable and skilled workers. During a recession workers may be put out of work, - made redundant - not due to their own failings but due to insufficient demand. Some workers may be employed by many firms during the course of a recession, with short periods of employment as firms only have limited amounts of work. To a firm hiring after the recession this could be a negative signalling effect, implying that the worker isn't reliable. Therefore it becomes difficult for a firm to hire additional workers, they may need to expend greater effort into hiring decisions to consider whether a worker was unemployed due to his own deficiency, or due to the economic situation. This may explain why long term unemployment remains low, but shouldn't be too great an obstacle if the economy is expanding quickly.

 

Cognitive Dissonance - simply stated this is when unemployed workers become so disillusioned with the labour force - and the fact that they are unable to find work - that they exit the labour market completely. This could manifest itself in a number of ways, it could be that some workers decide to emigrate and find work elsewhere: it is likely these workers would be lost forever, or at the very least would be difficult to get back. Some workers may decide to have a family, and thus exit the workforce for X period of time. Older workers may decide to take an early retirement, permanently exiting the labour market. Some may simply give up looking for a job, and thus are no longer statistically considered as unemployed but as not in the workforce. Fortunately these workers are easier to return to the labour market, as they may start looking for jobs when the economy speeds up and thus won't significantly, or irreversibly, shift the LRAS curve left.

 

Capital Depreciation - over time capital goods (factories, machinery and equipment) depreciate: that is their condition is deteriorated through wear and tear. For example, factories may begin to crumble, IT equipment becomes outdated and tools begin to rust. This happens because during an economic downturn there is little incentive for firms to invest in replacing and fixing capital - demand is low so they don't need to produce as much output. As a result, the long run aggregate supply curve has shifted left and even when output begins to pick up again, unemployment will persist because it will take time for firms to purchase new equipment and fix other capital to allow for a larger workforce.

 

Trade Effects - sometimes called trade penetration or a beachhead effect, this is when a downturn means that domestic producers lose ground to foreign competition. This could occur because domestic producers focus on the domestic market, perhaps they increase foreign prices to maintain profitability, fail to reduce prices significantly domestically and lose out to competition or fail to invest in R+D so they don't develop the latest consumer products. Perhaps significant numbers of firms go bankrupt, such that foreign competition gets a stronghold. Whatever the cause, foreign competition erodes at domestic exporters and attacks domestic producers through cheaper imports. The result is that the foreign firm is selling more output and so may gain from economies of scale allowing it to produce even cheaper than competition and thus expand further. The effect of this is that domestic firms lose output share and thus lose economies of scale, hence making it more expensive to produce so eroding the price competitiveness of the firm. If domestic firms fail then it may be the case that unemployment rises, although presumably foreign firms would need to have some production/offices in the domestic economy which would mitigate job losses. In short, an economic downturn means domestic firms temporarily lose export and import market share to foreign competition, which means they lose economies of scale and are thus permanently at a disadvantage.

 

However, during an economic downturn we would expect the domestic exchange rate to depreciate which would make imports more expensive and exports cheaper. This could ameliorate the situation and prevent foreign competition from expanding output shares and gaining from economies of scale.

 

In short, these channels mean that unemployment could be persistently high even for a period after the external shock. It can be seen as a leftward shift of the long run aggregate supply curve meaning that the economy has permanently lost a chunk of output and that more resources will need to be expended to try and return the economy to its previous position and then expand further to increase living standards. This gives Keynesian's an argument for government spending during economic downturns to restore aggregate output and prevent the hysteresis channels from taking effect.