The causes of unemployment and of economic inactivity

Overview

How a fall in aggregate demand causes unemployment, demand for labour described as a derived demand and rise in the exchange rate cause unemployment in traded sectors.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain how a fall in aggregate demand causes unemployment, naming the axes of the diagram you use.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, a fall in consumption, investment, government spending or net exports shifts the AD curve to the left. At the new equilibrium real output is lower and the price level is lower than it would have been. Labour is a derived demand, wanted for the output it produces, so firms producing less need fewer workers: they cut overtime, stop replacing leavers and then make redundancies. The resulting unemployment is cyclical, is involuntary, and is spread across sectors.

2. 2

   Why is the demand for labour described as a derived demand, and what follows from this for unemployment?

   Model answer

   Firms do not want workers for their own sake; they want the output workers produce and the revenue that output generates. Demand for labour is therefore derived from demand for the product. It follows that unemployment usually originates in the product market rather than the labour market, so a collapse in demand for a good causes unemployment among those producing it even if nothing about those workers has changed. It also follows that measures to reduce unemployment must ultimately work either by raising demand for output or by making workers employable in sectors where demand exists.

3. 3

   How can a rise in the exchange rate cause unemployment in traded sectors?

   Model answer

   An appreciation raises the foreign currency price of exports and lowers the domestic price of imports. Exporters lose sales abroad because their goods are dearer to foreign buyers, while domestic producers lose sales at home to cheaper imports. Both effects reduce output in industries exposed to trade, and since labour demand is derived from output, employment in those industries falls. The effect is concentrated in manufacturing and other traded sectors, so it can raise unemployment in particular regions even while the national economy grows.

4. 4

   How does globalisation contribute to structural unemployment in an advanced economy?

   Model answer

   Trade allows production to relocate to wherever costs are lowest, so labour-intensive activities in which lower-wage economies have a comparative advantage contract in advanced economies. The workers displaced possess skills specific to the industries that have gone, and the expanding sectors, typically in services and higher-technology manufacturing, require different skills and are often in different regions. The result is a mismatch that persists after the adjustment, alongside an aggregate gain from trade that accrues to consumers and to workers in the expanding sectors.

5. 5

   How does automation cause unemployment, and why is the effect uneven across the workforce?

   Model answer

   Automation substitutes capital for labour in tasks that can be codified, so workers whose jobs consist mainly of such tasks are displaced and the value of their specific skills falls. It simultaneously raises the productivity of workers whose tasks complement the technology, raising their wages. The effect is uneven because tasks differ in how easily they can be automated: routine work in the middle of the skill distribution is most exposed, while work requiring judgement, dexterity in unpredictable settings or personal interaction is less so. The consequence is displacement concentrated among a particular group rather than a general fall in employment.

6. 6

   How does a lack of geographical mobility cause unemployment to persist in particular regions?

   Model answer

   When an industry contracts in one region while vacancies open in another, unemployment can only clear if workers move. High house prices and rents in the areas with vacancies make moving unaffordable for someone on a modest wage, particularly if they own a house in a depressed region worth far less than one in a prosperous area. Family ties, schooling and the cost of moving reinforce the barrier. Labour therefore stays where the jobs have gone, so unemployment remains high in one region and vacancies unfilled in another.

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