Unemployment

A permanent reduction of the fraction of unemployed individuals who find jobs each period will result in a permanent increase in the unemployment rate. True or False? Explain your answer.

Let U denote the total number of unemployed workers and E denote the number of workers who are employed. The labour force is equal to the total number of workers whether they are employed or unemployed---i.e.

(1) -- L = E + U

Let f be the fraction of the total number of unemployed workers who find jobs in each period and s be the fraction of employed workers who lose (become separated from) their jobs each period. When the unemployment rate is at an equilibrium level it will be neither increasing nor decreasing, so the number of people losing their jobs will equal the number finding jobs:

(2) -- f U = s E

Rearranging equation (1) we obtain

(3) -- E = L - U

Substitution of equation (3) into equation (2) yields

(4) -- fU = sL - sU

Dividing both sides of this by L to express the equilibrium unemployment rate as U/L yields

(5) -- f (U/L) = s - s (U/L)

When we add [s (U/L)] to both sides of this equation we obtain

(6) -- (f + s) (U/L) = s

so that

(7) -- U/L = s/(f + s)

A permanent reduction in f will reduce the denominator of equation (7) and increase the unemployment rate (U/L).

The payment of efficiency wages by some firms in the economy will result in an increase in the country's unemployment rate. True or False? Explain your answer.

The payment of efficiency wages by a firm will enable it to select the best (i.e., most productive) workers from the labour force in return for paying them higher wages than they could obtain elsewhere. Workers who end up not being employed by efficiency wage firms will bid wages down elsewhere until they too are employed. There will be no effect on the aggregate unemployment rate. That is, everyone who wants a job at their reservation wage (the minimum wage at which they will work) or higher will have one.

Unionization of workers causes unemployment. True or False? Explain your answer.

It will cause unemployment in the unionized industries in the sense that people willing to work in those industries at the wages firms are forced by the union to pay will not be able to obtain jobs in the unionized sector. But those individuals will still be able to find jobs in the non-unionized sector as long as the wages in that sector do not fall below their reservation wage (in which case they will choose not to work). Wages in the non-unionized sector will be bid down until everyone who wants a job at the market wage has one. Unionization will not affect the unemployment rate in the economy as a whole unless the entire economy is unionized. In this latter case, workers squeezed out of the unionized sector by the union-engineered increase in the wage rate will have no where else to go.

The contract theory of unemployment is more consistent with the observed facts than either the auction theory or the search theory. True or False? Explain your answer.

Yes. The contract theory can explain two facts that the other theories cannot:

• Workers quit their jobs less frequently in recessions than in booms. The search and auction theories imply that quit rates should be higher in recessions because workers will take more leisure in the expectation that current wages are lower than future wages (auction theory) or quit to begin a search for a new job in recessions when wages fall below their perceived reservation wages (search theory).

• When the economy is in recession firms lay off workers and refuse to employ workers who are willing to work for less than the wages those firms are currently paying.

A negative Phillips curve relationship between the unemployment rate and the inflation rate cannot occur in the long run. True or False? Explain your answer.

True. In the short-run the government, by increasing money growth unexpectedly, can cause wage setters to under-price labour causing more labour to be employed than would be employed under conditions where information was perfect. The monetary expansion will tend to cause the inflation rate to increase and the under-pricing of labour will cause the unemployment rate to decline. A negative relationship between the unemployment rate and the inflation rate will be observed. In the long run, however, wage setters will learn that the government is pursuing a policy of faster money growth and will adjust wages at an appropriate rate through time to take that into account. At each point in time, therefore, the wage rate will be such as to produce the desired level of employment of workers and firms at the known, existing rate of inflation.

Unemployment will return to its natural rate in the long run. The greater rate of inflation will be associated with the original, natural rate of unemployment. The Phillips curve will thus shift up in response to the greater expected rate of inflation.

The natural rate of unemployment is independent of domestic economic policy. True or False? Explain your answer.

False. For one thing, the more generous the government sponsored unemployment insurance scheme, the smaller the incentive unemployed workers will have to find jobs quickly---they will be able to set their reservation wages higher and search longer because the government is subsidizing the search. Government policies can also improve the flow of information about who is looking for work and who has job openings. This could reduce the natural rate of unemployment. Finally, the government will always increase the natural rate of unemployment when it increases the minimum wage rate because everyone incapable of contributing as much to the value of output as the minimum wage will become unemployable.