Cyclical unemployment is the difference between the actual unemployment rate and the unemployment rate when the economy is at its natural level of output. Cyclical unemployment is caused by swings in the business cycle.
Economists estimate that the full employment rate is between 94 and 96 percent (meaning the unemployment rate is from 4 to 6 percent). Some unemployment is inevitable – even healthy. An unemployed person must meet three criteria: 1) not have a job, 2) be willing to work, and 3) demonstrate that he or she is actively looking for employment by performing at least one job search task within the last four weeks.
Economists separate unemployment into three categories: frictional, structural, and cyclical. Frictional unemployment occurs when market inefficiencies prevent people from identifying and starting a job as soon as they want one. The process of applying, interviewing, and accepting a job takes time. Structural unemployment results when economic progress may leave some workers behind. Jobs may be available in areas where workers are unwilling to move. Finally, cyclical unemployment is caused by changing labor demands resulting from business cycles. The full employment rate occurs at the natural level of output and includes frictional unemployment and structural unemployment, but excludes cyclical unemployment.
Cyclical unemployment is caused by swings in the business cycle. It increases during recessions. The demand for goods and services contracts. Inventories increase. Managements slow production and lay off workers to cut costs, causing a surplus of workers. Conversely, cyclical unemployment decreases during expansions when businesses need to hire workers to increase production. Cyclical unemployment is zero at full employment and is more volatile than frictional and structural unemployment. Cyclical unemployment has a greater influence over changes in the unemployment rate than the other types of unemployment.
Any event that causes the public and/or business community to lose confidence in the economy can trigger a drop in its aggregate demand. For example, the Great Depression was exacerbated by the stock market crash in 1929. Many had invested their life savings and panicked when the market crashed. They went to withdraw their money from the bank only to learn that banks had also invested in the stock market and the money was not available. Almost all the unemployed during the Great Depression were cyclically unemployed.
Inflation caused by a supply shock can send the economy into a recession, particularly when a central bank chooses to fight inflation by increasing interest rates. In 1973, inflation was a concern in the United States. It averaged 6.2 percent, only to nearly double to 11 percent in 1974. The jump followed October 1973’s Arab Oil Embargo which was imposed by the Arab members of OPEC in retaliation for the US support of Israel during the Arab-Israeli War. Oil supplies dropped, and prices increased. Oil was required in the production and distribution of most products, resulting in an increase in producer costs. Companies passed some of the increase to consumers by raising their prices. Consumers could not purchase as many goods because wage increases did not match the increase in the price of goods and services. Businesses produced less. Most of the employees let go were cyclically unemployed.
A cyclically unemployed worker can become structurally unemployed during a prolonged recession when a laid off worker is away from from his job for so long that when his company reopens he is unable to provide the modified skills now required by the job. For example, assume a recession forces a company to lay off 500 workers. 50 workers choose to return to school to study computer programming. During the next two years management chooses to improve its efficiency with robots. When growth resumes, management rehires the 50 workers who chose to study computer programming. The remaining 450 workers no longer have the skills demanded by the company. In this example, 450 workers went from being cyclically unemployed to structurally unemployed.
Expansionary fiscal and monetary policies can be used to increase the economy’s aggregate demand or aggregate supply and return many of the cyclically unemployed back to work. The Federal Reserve may increase the money supply to lower interest rates, which in turn makes business borrowing more attractive. Congress may choose to stimulate the economy by increasing spending.