Policies for unemployment and intervention in the labour market

Overview

How expansionary fiscal policy reduces cyclical unemployment, cut in interest rates reduce unemployment and demand-side policy the wrong instrument for structural unemployment.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain how expansionary fiscal policy reduces cyclical unemployment, using AD–AS analysis.

   Model answer

   Increasing government spending adds directly to aggregate demand, while cutting income tax raises households' disposable income and therefore consumption. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the AD curve shifts to the right. At the new equilibrium real output is higher, and since labour is a derived demand, firms producing more need more workers, so employment rises and cyclical unemployment falls. The price level is also higher at the new equilibrium, and how much of the adjustment falls on prices rather than output depends on the amount of spare capacity.

2. 2

   How does a cut in interest rates reduce unemployment, and what is the main limitation of this route?

   Model answer

   A lower policy rate reduces the cost of borrowing for households and firms and lowers the return on saving. Households increase spending on durables and housing, and firms find that more investment projects cover their cost of finance, so consumption and investment rise. A lower rate may also depreciate the currency, raising net exports. Aggregate demand shifts right, output rises and firms hire. The main limitation is that the transmission depends on households and firms choosing to borrow, and in a deep downturn pessimism about the future can leave them unwilling to do so at any rate, so the policy pushes on a channel that does not respond.

3. 3

   Why is demand-side policy the wrong instrument for structural unemployment?

   Model answer

   Structural unemployment exists because the unemployed cannot fill the vacancies that already exist, owing to a mismatch of skills or location. Raising aggregate demand creates more vacancies, but the mismatch is unchanged, so the same people remain unemployed while employers bid harder for the workers who do have the required skills. The result is upward pressure on wages and prices with little fall in unemployment, so the AD shift produces inflation instead of jobs. The diagnostic that reveals this in advance is high unemployment coexisting with high vacancies.

4. 4

   How does education and training policy reduce unemployment, and what is the diagrammatic effect?

   Model answer

   Training gives unemployed workers the skills that existing vacancies require, which directly addresses occupational immobility and allows the mismatch causing structural unemployment to be reduced. As workers become employable in expanding sectors, the effective supply of suitable labour rises and firms can expand output further before hitting a skills constraint. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the aggregate supply curve shifts to the right, so at the new equilibrium real output is higher and the price level is lower. This is a rare case in which employment rises without any inflationary cost.

5. 5

   Why is the effect of training policy on unemployment slow and uncertain?

   Model answer

   Acquiring a substantial skill takes years, so the effect on employment arrives long after the spending. There is uncertainty about which skills will be needed by the time the training is complete, and a programme aimed at an occupation that has itself been automated in the interval produces no benefit. Take-up is also a problem, since those most in need of retraining are often those least confident about returning to education. The gains are real but they are long-term, which makes the policy unsuitable as a response to a recession.

6. 6

   How can improving the flow of information about vacancies reduce unemployment, and which type does it address?

   Model answer

   It addresses frictional unemployment, which exists because matching workers to vacancies takes time in the presence of imperfect information. Job-matching services, online vacancy databases and support with applications shorten the search period, so each unemployed person spends less time between jobs and the number unemployed at any moment falls even though the same number of people move between jobs each year. The measure is inexpensive relative to its effect but its scope is limited, since it cannot help a worker who lacks the skills the vacancies require.

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