Cyclical Unemployment: Causes and Effects

Cyclical unemployment is the main cause of high unemployment rates. It's caused by a downturn in the business cycle. It's part of the natural rise and fall of economic growth that occurs over time. Cyclical unemployment is temporary and depends on the length of economic contractions caused by a recession. A typical recession lasts around 18 months. When the business cycle re-enters the expansionary phase (rising toward the peak of the wave), the unemployed tend to be rehired.

Causes

When consumer demand for goods and services drops, it leads to a reduction in production. This reduction lowers the need for workers, which causes layoffs. Consumers then have less to spend, further causing a loss of revenue; in turn, this causes companies to lay off more workers in attempts to maintain their profit margins.

By the time cyclical unemployment starts, economies are generally already in a recession. Businesses generally wait until they're sure the downturn is severe enough to warrant layoffs before initiating them.

Sometimes, a stock market crash is the cause of cyclical unemployment. Examples include the crash of 1929, the tech crash of 2000, and the financial crash of 2008. A bad market crash can cause a recession by instilling panic and loss of confidence in an economy.

When this happens, businesses suffer a loss of net worth as stock prices plummet. When the market dives, so do the opportunities to raise capital for growth and expansion. Investors lose confidence in the financial markets; they begin selling their holdings to mitigate losses, and stock prices begin to fall. Consumers then tend to delay purchases, waiting to see if investor confidence returns or if prices continue falling.

This phase is the contractionary period of the business cycle. If investor confidence returns, then economic growth resumes—the expansionary period—and cyclical unemployment is avoided. If confidence continues to erode, lowered demand forces businesses to continue laying off more workers.

Effects of Cyclical Unemployment

Unfortunately, cyclical unemployment can become a self-fueling downward spiral. The newly unemployed have less disposable income, lowering demand, and business revenue, thus leading to even more layoffs.

Without intervention, this spiral continues until supply has dropped to meet the lowered demand. Unfortunately, this may not happen until unemployment reaches 25%. This height of unemployment is what happened during the Great Depression, which lasted a decade. While monetary policies were implemented at the time, it was not enough. It is generally accepted that what truly ended the Depression was the demand for military equipment and supplies as the United States entered World War II.

Unemployment Examples

One 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 two million construction workers lost their jobs.

Structural unemployment is a mismatch of skills and knowledge needed in a workforce. An example of this might be a city where a tire plant that employs a large workforce is shutdown. These workers might be skilled in the processes and activities of the plant, but be unable to find other work because they might not meet the workforce needs of current employers.

Someone can start out being cyclically unemployed, then end up structurally unemployed. During the Great Recession, many factories switched to sophisticated computer equipment to run machinery. Some employers laid off workers and then realized fewer workers were needed. The workers that had not been updating their knowledge and skills became structurally unemployed. Their skills no longer matched the needs of local employers.

To remain relevant, workers needed to get updated computer and technical skills so they could manage the robots that run the machinery on which they used to work.

Finding the Cyclical Unemployment Rate

The cyclical unemployment rate is the difference between the natural unemployment rate (unemployment due to workers coming and going or searching for other work) and the current rate (the total amount of unemployed). It's difficult to look at data and determine why each person is unemployed. Economists have come up with three methods to estimate how much of the measured unemployment is cyclical.

The first and most common method utilizes the business cycle. To use this method, find the unemployment rate at the peak of the business cycle. Next, find the unemployment rate at the trough. Then subtract the two—the difference is the cyclical unemployment rate.

Second, you subtract the structural, frictional, and seasonal unemployment rates from the aggregate unemployment rate to get the cyclical unemployment rate.

The third method is to compare the unemployment rate for recent college graduates with the unemployment rate overall. If the recent graduate rate is similar to the overall rate, then most of the nation's unemployment is cyclical. This reasoning is that recent college graduates have new skills and can move to wherever the jobs are. They have a very small chance of structural unemployment. Using this method, researchers found that most of the unemployment in 2011 was cyclical.

Solutions

Because cyclical unemployment can spiral out of control, the federal government must usually step in to stop it. The first and easiest response is with expansionary monetary policy. The Federal Reserve (the Fed) can start lowering interest rates or use other innovative methods to influence the economy.

Lowering rates makes loans and credit card payments cheaper, which, in turn, encourages spending and is designed to boost market confidence. Knowing that the Fed is taking action may restore the confidence needed to boost aggregate demand.

If that's not enough, then the government must use expansionary fiscal policy. Expansionary policies take longer because Congress must vote for additional federal spending. This spending raises the budget deficit and re-ignites the bi-partisan debate on whether tax cuts or spending are more effective job creators.

A third option is for the government to extend unemployment benefits. According to some research, tax cuts are less effective in creating the demand needed to stop cyclical unemployment.

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