Goldilocks and the Three Economies, part 1

When is an economy just right?

In the last post we looked at unemployment. In past posts, I’ve said that the current unemployment rate was lower than the natural rate, which is 4.5-5.5 percent. Where did I get that number? How can we use the natural rate to tell us something about the economy?

This economy is too hot!

For most of the post-lockdown period (2021-2022) the economy was too hot. Inflation was too high, growth exceeded expectations in 10 of the last 14 quarters, and unemployment was too low.

Wait, what?

How can unemployment be too low?

Don’t we want everyone who wants a job to have a job?

Here’s an exercise to help you think about the problem. Suppose you start out a 1000 feet from a finish line and you can make steps as large or as small as you like to get you to the line. You plan to get there by making each step one half the distance you need to go.

The first step is half the distance (500 feet). (We said the steps could be large.) That leaves you with 500 feet to go. Then the next step is half that distance, or a quarter of a mile. Then you cover one eighth the distance, then one sixteenth, and so on. After ten steps you are just over one foot from the line. You can keep going in inches, but theoretically, you’ll never get there.

In economics we can think about that ideal, everyone who wants a job has a job, as having a similar theoretical bar. The bar is made up of frictional and structural unemployment.

The types of unemployment

Frictional unemployment occurs when the job is there. Time and knowledge get in the way of finding it. Job seekers need time for a job hunt to result in a job. They also need to know about the right openings. [1]

Frictional unemployment is typically short-lived and voluntary. These job seekers fall into three categories: new job seekers, those who are returning to the labor market, and those who have quit their jobs to look for work. In the next post I’ll show how two of the people in our (fictional) list are frictionally unemployed.

Structural unemployment occurs because the finish line—the labor market—changes.

Structural unemployment is long-term and usually involuntary. The job is gone and isn’t coming back. This occurs for three reasons: 1) technological changes in the structure of the economy, so that new goods and services displace older ones, 2) a lack of relevant skills, and 3) offshoring. [2]

There is one more type of unemployment—cyclical. [3] During expansions and contractions of the business cyclical unemployment can deviate from the natural rate. When the cyclical rate is negative, then the economy can get too hot.

Pandemic and post-pandemic

When cyclical unemployment is negative, as experienced just after World War II, during the late 1990s, and the pandemic period (2020-2023), the economy experiences inflationary pressures. Since 2021 we saw:

·      Illness shut down factories and ports.

·      Limited public transportation affected some workers.

·      Women had to “stop out” of the labor market to take care of children and other family members who needed care. [4]

·      Some of the workforce left their jobs for other opportunities.

At one point, there were two job openings for every job seeker. New employees were often untrained leading to temporarily lower productivity. Hostile workplaces led to some employees to seek new opportunities. Funding during the Trump and Biden administration, as well as the temporary halt to student loan payments, allowed workers to finish their education.

When employees are hard to find, wages go up to attract them back into the market or away from other employers. During the late 1990s, retirees returned to their jobs as the opportunity cost of staying out of the labor market rose. [5] Unemployment was below the natural rate from April 1998 until June 2001.

We also saw this in the post-pandemic period, as workers with low labor force attachment came back into the market. Mompreneurs discovered online gig work to overcome forced stop outs. Higher wages entice potential employees since they overcome two barriers to labor force participation: commute times and hours offered. [6]

Historically, the frictional rate is about 2 percent, and the structural rate is about 2.5–3.5 percent, so the natural rate is about 4.5-.5.5 percent. [7]

natural rate = frictional rate + structural rate

So, when the unemployment rate is less than the natural rate, the economy experiences inflationary pressures. When the unemployment rate is greater than the natural rate, the economy experiences recessionary pressures.

We saw this during the Great Recession. In the next post, we’ll finish our Goldilocks tale and take a deeper dive into frictional and structural unemployment.

As always, thank you for reading,

Nikki

[1] There are also other pitfalls to avoid. My favorite pitfalls in academia were the ones that led to automatic rejection: addressing the wrong institution, misspelling names, or applying for the wrong job. A highly qualified candidate without an H1-B Visa sponsor is still a problem at smaller colleges and universities.

[2] Outsourcing is letting another company do part of your work for you. In the US, many businesses outsource payroll. Offshoring is moving operations to another country.

[3] The literature sometimes refers to a fourth type—institutional. We don’t need to discuss it for this short course.

[4] “Stop out” means withdrawing from employment (or college) temporarily to pursue other activities. For mothers in the labor force, school and day care closings caused the withdrawal.

[5] As wages rise, the cost of the next best choice, leisure, also rises.

[6] From my dissertation.

[7] Barnichon, R. And C. Matthes, The Natural Rate of Unemployment Over the Past 100 Years. FRBSF Economic Letter, August 14, 2017.

[8] Practically speaking, when the unemployment rate suddenly rises above six percent, we worry.