3.2.2
Model essay [25]

Causes of Unemployment and the Determinants of Policy Choice

3.2.2 Macro issues 3.2.3 Macro policies

Question

As much as one-third of the United States workforce could be out of a job by 2030 thanks to automation, according to new research from McKinsey. Meanwhile in Samoa, a small developing country, the tourism industry is badly hit with poor outlook globally.

(a) Explain the various causes of unemployment across different countries. [10]

(b) Discuss the extent to which the nature of an economy affects a government’s choice of macroeconomic policies in addressing unemployment. [15]

Answer

Part (a) [10]

Unemployment describes a situation in which people in the labour force who are willing and able to work cannot find employment. Its causes differ across countries; this part explains demand-deficient and structural unemployment, the two illustrated by the preamble.

Demand-deficient unemployment. Demand-deficient unemployment arises when the economy operates below full employment because aggregate demand is insufficient. A fall in AD raises firms’ unplanned inventories, prompting them to cut output and employ fewer factors, including labour. In Samoa, a poor global outlook lowers foreign confidence and so export demand (X) — tourism — causing tourism firms to shed workers.

General price level (GPL)Real national output (RNO)AD₀AD₁LRAS₀LRAS₀Y₁Yf
Demand-deficient unemployment. A fall in export demand shifts AD left from AD₀ to AD₁; real national output falls from the full-employment level Yf to Y₁, opening an output gap and demand-deficient unemployment of Yf − Y₁.

Structural unemployment. Structural unemployment arises from a skills mismatch between the skills workers have and those the labour market demands, often following technological change or a shift in economic structure. In the US, automation renders certain skill sets obsolete — for instance, autonomous vehicles displacing drivers — and because automation lowers unit costs, firms switch from labour to capital. Displaced low-skilled workers, whose skills no longer match available vacancies, become structurally unemployed.

Part (b) [15]

A government’s choice of policy to address unemployment is shaped both by the nature of the economy — its openness and size — and by the root cause of the unemployment. The stand of this essay is that the root cause is the more important determinant, because it is logically prior to the choice among demand-side instruments.

Nature of the economy. The openness and size of an economy bear on policy choice. A small, open economy like Singapore, with a small domestic market, gains little from domestic demand-side policy and may prefer exchange-rate depreciation: cheaper exports and dearer imports raise net exports and AD, moving output towards full employment and reducing demand-deficient unemployment. A large, less open economy like China, with large domestic consumption, gains more from expansionary fiscal policy: lower taxes and higher government spending raise C, I and hence AD substantially.

In-body evaluation. Where a country lacks a pronounced character — both large and open, like Indonesia — the nature of the economy is less decisive, since both depreciation and fiscal policy would be comparably effective.

Root cause of the unemployment. The chosen policy must address the specific cause. For structural unemployment, demand-side policy is futile — no rise in AD cures a skills mismatch — and supply-side policy, through retraining and reskilling, is required to raise labour quality and reduce the mismatch. For demand-deficient unemployment, whose root cause is a shortfall of AD relative to full-employment output, demand-side policy is appropriate.

In-body evaluation. Even once the root cause is identified, constraints may override the ideal policy: a government facing a budget constraint may be unable to fund supply-side retraining even where structural unemployment calls for it.

Judgement. The root cause is the more important determinant. The nature of the economy matters only after the root cause has been identified as demand-deficient, because that identification is what makes any demand-side policy — and hence the choice between depreciation and fiscal policy — relevant at all. If the unemployment is in fact structural, no feature of the economy can make a demand-side policy work; the root cause must be diagnosed first. Because the root cause is logically prior, it is the weightier factor in the government’s choice.