Macroeconomics guide, Unit 2, step 2 of 23Previous step Next step

Step 2: Unemployment

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Macro 2.3 · Cambridge 4.5, 9.3 · IB 3.3

In 30 seconds

You are unemployed only if you are without work, actively seeking work and available to start. Miss any one of these and you are outside the labour force.
$ \text{Unemployment rate} = \dfrac{\text{unemployed}}{\text{labour force}} \times 100 $, where the labour force is the employed plus the unemployed, not the whole working-age population.
There are three types: frictional (between jobs), structural (skills or location mismatch) and cyclical (too little demand). The natural rate is frictional plus structural.
Main exam trap: when discouraged workers stop looking, the unemployment rate falls even though nobody has found a job.

Video lesson coming soonA short animated lesson for this step will appear here.

Who counts as unemployed?

Think about five people in your street: a retired grandmother, a cousin at university full-time, a neighbour who stopped applying for jobs after hundreds of rejections, a friend working 12 hours a week in a café who wants full-time work, and a young woman applying for jobs every day who could start on Monday.

Only the last person is officially unemployed. Under the International Labour Organization (ILO) definition, a person must meet all three conditions: without work, actively seeking work, and available to start.

The retired grandmother is not seeking work.
The full-time student is not available.
The neighbour who gave up is not actively seeking. He is a discouraged worker.
The café worker has a job, so she counts as employed, even though she wants more hours.

The first three are not in the labour force at all.

Key termLabour force: everyone who is either employed or unemployed, meaning working, or actively seeking work and available to start.

Key termWorking-age population: everyone above the minimum working age (typically 16); it includes people in the labour force and people outside it, such as students, carers, retired people and discouraged workers.

Measuring unemployment: three rates

Three different rates come from the same data, and examiners like to check that you can tell them apart.

\[ \text{Unemployment rate} = \frac{\text{unemployed}}{\text{labour force}} \times 100 \]

\[ \text{Participation rate} = \frac{\text{labour force}}{\text{working-age population}} \times 100 \qquad \text{Employment rate} = \frac{\text{employed}}{\text{working-age population}} \times 100 \]

The participation rate shows how many adults are economically active. The employment rate shows what share of adults actually have a job. Notice the different bottom lines: the unemployment rate divides by the labour force, while the other two divide by the working-age population.

Worked example

A country has a working-age population of 50 million. 36 million are employed and 4 million are unemployed. Calculate the three rates. Then 1 million unemployed people give up searching. Recalculate.

Step 1$ \text{Labour force} = 36 + 4 = 40\text{m} $

Step 2$ \text{Unemployment rate} = \dfrac{4}{40} \times 100 = 10\%; \quad \text{Participation} = \dfrac{40}{50} \times 100 = 80\%; \quad \text{Employment rate} = \dfrac{36}{50} \times 100 = 72\% $

Step 3$ \text{After: unemployed} = 3\text{m}, \ \text{labour force} = 39\text{m}, \ \dfrac{3}{39} \times 100 = 7.7\%; \quad \dfrac{39}{50} \times 100 = 78\%; \quad \dfrac{36}{50} \times 100 = 72\% $

The unemployment rate fell from 10% to 7.7% without a single job being created. The employment rate stayed at 72%, which correctly shows that nothing improved.

Exam tipWhen a question says people “give up looking for work”, the unemployment rate falls. When discouraged workers “start searching again”, it rises. That is why a recovery often begins with the unemployment rate going up, as people re-enter the labour force.

Why the official rate can mislead

The official rate may understate true joblessness because of:

Discouraged workers, who want a job but have stopped searching, so they are not counted. After the 2008 crisis, US participation fell by roughly 3 percentage points, hiding a lot of unemployment.
Underemployment: part-timers who want full-time hours, or a qualified engineer driving a taxi, count as fully employed. The US publishes a broader measure, U-6, which includes these groups and usually runs several points above the headline rate.
The informal economy: in developing countries, people in unrecorded cash or subsistence work count as employed, even when that work is insecure and badly paid.

It may overstate joblessness when people claim benefits while secretly working, or when someone has quit voluntarily to look for a better job.

Three types of unemployment

Unemployment is not one problem but three, each with a different cause and a different cure. Mixing them up is the most common error in essays.

Key termFrictional unemployment: short-term unemployment while people search for a suitable job, such as a graduate looking for a first position or a worker who has moved city.

Frictional unemployment is healthy within limits: it shows people are looking for good matches.

Key termStructural unemployment: long-term unemployment caused by a mismatch between workers’ skills or location and the jobs that are available.

When British coal mines closed in the 1980s, miners in South Wales and Yorkshire could not simply move into the new finance jobs in London. Their skills belonged to an industry that had gone, and housing costs made moving impossible. Structural unemployment comes from technological change, globalisation and shifts in what people buy, not from a lack of spending.

Key termCyclical unemployment: unemployment caused by too little aggregate demand, which rises in recessions and falls in booms (also called demand-deficient unemployment).

In a recession, firms sell less, produce less and lay workers off. Those workers were productive before and would be again if spending recovered. This is the type that government spending, tax and interest-rate policy aim to fight.

Type	Cause	Example	Best policy
Frictional	Time spent searching	Graduate applying for three months	Better job-matching services and information
Structural	Skills or location mismatch	Steelworker whose mill closed, only software jobs nearby	Supply-side: retraining, education, help to relocate
Cyclical	Too little aggregate demand	Mass lay-offs in a recession	Demand-side: tax cuts, more spending, lower interest rates

Exam tipTo classify a scenario, ask: is there a shortage of jobs overall (cyclical), are there jobs the person cannot do or reach (structural), or is the person simply between jobs (frictional)? A retrained miner who takes six weeks to find a software job is frictionally unemployed; the same miner, untrained and unable to move, is structurally unemployed.

The natural rate of unemployment

Even in a healthy economy, some people are always between jobs and some industries are always shrinking. So economists define full employment not as zero unemployment but as zero cyclical unemployment.

Key termNatural rate of unemployment: the sum of frictional and structural unemployment, which is the rate that remains when the economy is at its potential output and cyclical unemployment is zero.

A closely related idea is NAIRU, the Non-Accelerating Inflation Rate of Unemployment: the lowest unemployment rate consistent with stable inflation.

\[ \text{Actual unemployment} = \text{natural rate} + \text{cyclical unemployment} \]

Milton Friedman and Edmund Phelps argued that boosting demand can remove cyclical unemployment, but pushing below the natural rate brings inflation rather than jobs. The catch is that the natural rate cannot be observed; it must be estimated, and estimates change.

Worked example

Actual unemployment is 7%, the natural rate is estimated at 4.5%, and the labour force is 30 million. Each worker would produce £40,000 of output a year. How many people are cyclically unemployed, and how much output is lost each year?

Step 1$ \text{Cyclical rate} = 7\% – 4.5\% = 2.5 \text{ percentage points} $

Step 2$ 0.025 \times 30{,}000{,}000 = 750{,}000 \text{ workers} $

Step 3$ 750{,}000 \times £40{,}000 = £30{,}000{,}000{,}000 = £30\text{bn} $

About £30 billion of output is lost every year and is gone for good. Extra demand could in principle remove these 2.5 points, but not the remaining 4.5%, which is frictional and structural.

What sets the natural rate? Labour market flexibility (strict job protection can make firms slow to hire), how generous and long-lasting unemployment benefits are, the pace of technological change, the quality of skills training, and hysteresis.

Key termHysteresis: the process by which a long spell of cyclical unemployment becomes permanent structural unemployment, because skills fade, work habits weaken and employers avoid the long-term unemployed.

Costs of unemployment and policies to reduce it

The economic costs are lost output (gone for good), higher benefit spending with lower tax revenue, and fading skills. The social costs are often larger: job loss is linked to depression, illness, family breakdown and poorer outcomes for children.

Because each type has a different cause, each needs a different remedy:

Cyclical: raise aggregate demand through fiscal policy (tax cuts, more government spending) or monetary policy (lower interest rates).
Structural: supply-side policy such as retraining, vocational education, relocation help and housing reform. Denmark’s “flexicurity” model combines easy hiring and firing with generous benefits and intensive retraining.
Frictional: better information and job-matching. The goal is faster, better matches, not zero frictional unemployment.

After 2008, US unemployment took until 2016 to return to its pre-crisis level. In 2020 it leapt from 3.5% to 14.8% in one month, yet with much larger support it was back to 3.6% by June 2022, which suggests a strong response can prevent hysteresis.

Common mistakeRecommending demand-side stimulus for structural unemployment. Extra spending does not give a former steelworker software skills; it mostly pushes up wages and prices. Always match the policy to the type.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Classify each person as employed, unemployed or not in the labour force: (a) a full-time student not looking for work; (b) a part-time worker who wants full-time hours; (c) someone who has stopped searching after many rejections; (d) someone without work who applied for jobs this week and can start immediately. Show worked answer

(a) Not in the labour force: not seeking work and not available.
(b) Employed: underemployed, but still counted as employed.
(c) Not in the labour force: a discouraged worker is not actively seeking.
(d) Unemployed: meets all three ILO conditions.

EasyQ2. 18 million people are employed and 2 million are unemployed. Calculate the unemployment rate. Show worked answer

Labour force $ = 18 + 2 = 20\text{m} $
$ \text{Unemployment rate} = \dfrac{2}{20} \times 100 = 10\% $

MediumQ3. The working-age population is 30 million, with 21 million employed and 3 million unemployed. Calculate the unemployment rate, participation rate and employment rate. Show worked answer

Labour force $ = 21 + 3 = 24\text{m} $
Unemployment rate $ = \dfrac{3}{24} \times 100 = 12.5\% $
Participation rate $ = \dfrac{24}{30} \times 100 = 80\% $
Employment rate $ = \dfrac{21}{30} \times 100 = 70\% $

MediumQ4. Name the type of unemployment: (a) a nurse who moves city and spends a month finding a new hospital job; (b) checkout staff replaced by self-service machines, with only IT jobs available locally; (c) car workers laid off because sales collapse in a recession. Show worked answer

(a) Frictional: short-term search between jobs.
(b) Structural: their skills no longer match the jobs available, caused by technological change.
(c) Cyclical: caused by a fall in aggregate demand, so it should reverse when demand recovers.

MediumQ5. Working-age population 40 million; employed 27 million; unemployed 3 million. A recovery encourages 2 million discouraged workers to start job-hunting, but none finds work yet. Calculate the unemployment, participation and employment rates before and after. Show worked answer

Before: labour force $ = 30\text{m} $. Unemployment $ = \dfrac{3}{30} \times 100 = 10\% $; participation $ = \dfrac{30}{40} \times 100 = 75\% $; employment rate $ = \dfrac{27}{40} \times 100 = 67.5\% $.
After: unemployed $ = 5\text{m} $, labour force $ = 32\text{m} $. Unemployment $ = \dfrac{5}{32} \times 100 = 15.6\% $; participation $ = \dfrac{32}{40} \times 100 = 80\% $; employment rate still $ 67.5\% $.
The unemployment rate rises even though nobody lost a job and the economy is recovering.

ExamQ6. Actual unemployment is 7.5% and the natural rate is estimated at 4.5%. The labour force is 20 million and each worker would produce $60,000 of output a year. (a) Calculate the cyclical unemployment rate. (b) Calculate the number of cyclically unemployed workers. (c) Estimate the annual output lost. (d) Explain why demand-side policy could not reduce unemployment to zero. [6 marks] Show worked answer

(a) $ 7.5\% – 4.5\% = 3 $ percentage points. [1 mark]
(b) $ 0.03 \times 20{,}000{,}000 = 600{,}000 $ workers. [2 marks]
(c) $ 600{,}000 \times \$60{,}000 = \$36\text{bn} $ per year, permanently lost. [2 marks]
(d) The remaining 4.5% is frictional and structural unemployment, caused by search time and mismatch rather than too little spending. Extra demand would bid up wages and prices rather than create matched jobs, so it would cause inflation. [1 mark]

Check yourself

1. Many unemployed workers become discouraged and stop searching. The measured unemployment rate will:

They leave the labour force, so the number unemployed falls proportionally more than the labour force does.

2. “Full employment” means:

Frictional and structural unemployment remain at full employment; together they make up the natural rate.

3. Hysteresis in the labour market refers to:

Long spells without work erode skills and employability, so a temporary shock can permanently raise the natural rate.

Your score: 0 out of 3

The short version

Unemployed means without work, actively seeking and available. Fail any condition and you are outside the labour force.
Unemployment rate = unemployed ÷ labour force × 100. The employment rate (employed ÷ working-age population) is not distorted by discouraged workers.
Frictional = between jobs; structural = mismatch; cyclical = too little demand. Each needs its own policy.
Natural rate = frictional + structural. Full employment means zero cyclical unemployment, not zero unemployment.
Hysteresis means recessions left too long can do permanent damage.

This guide covers the core of Chapter 20 of Economics Made Simple. For the full chapter, including the US 2008 and 2020 case study and 15 exam-style questions with a complete answer key, get the book.