Cyclical Unemployment, Its Causes, and Effects
The Solution When Unemployment Spirals Out of Control
Cyclical unemployment is when workers lose their jobs because of downturns in the business cycle. You can tell when the economy contracts by measuring gross domestic product. If the economy contracts for two quarters or more, it's in a recession.
Cyclical unemployment is usually the main cause of high unemployment. It's known as “cyclical” because it’s tied to the business cycle. When the economy re-enters the expansion phase of the business cycle, the unemployed will get rehired. Cyclical unemployment is temporary. It depends on the length of the contraction. A typical recession lasts around 18 months. A depression can last ten years.
Cyclical unemployment results from a large drop-off of demand. It usually starts with decreased personal consumption. When consumer demand for goods and services drops, business revenues decline. Eventually, companies have to lay off workers to maintain profit margins. Often there isn't enough production to keep the workers busy.
The last thing a business wants to do is lay off workers. It's a traumatic event. A company could lose valuable employees that it's invested a lot in. That's why by the time cyclical unemployment starts, the economy is usually already in a recession. Businesses wait until they're sure the downturn is severe before starting layoffs.
What can kick off the economic downturn that results in cyclical unemployment? Often it's a stock market crash. Examples include the crash of 1929, the tech crash of 2000, and the financial crash of 2008. A bad crash can cause a recession by creating panic and loss of confidence in the economy. Businesses suffer a loss of their net worth as stock prices plummet. Even before demand in the general economy falls, they can lose their ability to raise capital for growth and expansion.
As stock market wealth evaporates, consumers delay purchases. They’re waiting to see if confidence returns. If it does, then economic growth resumes and cyclical unemployment doesn't start. This is what happened in the 1987 Black Monday stock market crash. If confidence continues to erode, lowered demand forces businesses to lay off workers. Economic contraction is only of one of many causes of the different types of unemployment that has affected America over the years.
Unfortunately, cyclical unemployment can become a self-fulfilling downward spiral. That's because the newly unemployed now have less disposable income. This further lowers demand and business revenue, leading to even more layoffs.
Without intervention, this spiral will continue until supply has dropped to meet the lowered demand. Unfortunately, this may not happen until unemployment reaches 25%. This is what happened during the Great Depression, which lasted a decade. In fact, what truly ended the Depression was demand for military equipment as the United States entered World War II. This massive fiscal spending resulted in an increase in the U.S. debt.
An example of cyclical unemployment is the loss of construction jobs during the 2008 financial crisis. As the housing crisis unfolded, home builders stopped constructing new homes. As many as 2 million construction workers lost their jobs. Whenever home building starts up again, they will be able to go back to work.
Someone can start out being cyclically unemployed then wind up as a victim of structural unemployment. During the recession, many factories switched to sophisticated computer equipment to run machinery. Workers now need to get updated computer skills so they can manage the robots that now run the machinery they used to work on themselves. Fewer workers are needed, too. Those who don't go back to school are structurally unemployed. Their skills no longer match the needs of the workforce.
Cyclical Unemployment Rate
The cyclical unemployment rate is the difference between the natural unemployment rate and the current rate. The natural rate includes structural, frictional, seasonal, and classical unemployment. Subtract those from the unemployment rate to get the cyclical unemployment rate.
In real life, it's difficult to look at the data and determine why each person is unemployed. Therefore, economists have come up with two other methods to estimate how much of unemployment is cyclical.
The first and most common method utilizes the business cycle. Find the unemployment rate during the peak phase of the business cycle. Next, find the unemployment rate during the trough phase. Then subtract the two. The difference should be cyclical unemployment.
The second is to compare the unemployment rate for recent college graduates with the unemployment rate overall. If their rate is similar to the overall rate, then most of the nation's unemployment is cyclical. Why? Recent college graduates have new skills and are able to move to wherever the jobs are. They have a very small chance for structural unemployment. Using this method, researchers found that most of the unemployment in 2011 was cyclical.
Because cyclical unemployment can spiral out of control, usually the federal government must step in to stop it. The first and easiest response is with expansionary monetary policy. The Federal Reserve will start lowering interest rates. This is like putting money into the pockets of families and businesses. It makes loans and even credit card payments cheaper. And just knowing that the Fed is taking action may restore the confidence needed to boost demand.
If that's not enough, then the government must use expansionary fiscal policy. This takes longer because usually the president and Congress must vote on spending more. This raises the budget deficit. It also re-ignites the bi-partisan debate on whether tax cuts or spending are more effective job creators.
But a University of Massachusetts Amherst study shows that the most cost-effective unemployment solution is government spending. The study found that spending on public works projects to create construction jobs is the best use of funds. Cyclical unemployment hits construction jobs hard.
The second response is extending unemployment benefits. According to the research, tax cuts are less effective in creating the demand needed to stop cyclical unemployment.
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