If you watch the news or read the paper, you’ve probably seen or read news reports about the unemployment rate. Sometimes the news reports are concerned about the increasing unemployment rate, and other times it’s good news – the unemployment rate is falling. However, while the unemployment rate can be reported quickly, and most people understand why it is an essential barometer for the economy, economists have discovered that it is much more complex than simply the percentage of people out of work.
Unemployment is a Lagging Indicator
Unemployment is a crucial indicator of how an economy is performing. As a trade or investor, you need to take notice of changes in unemployment levels.
Unemployment tends to be looked at as a lagging indicator. Unemployment will usually increase in response to an already deteriorating economy, as employers tend to lay off their workforce when a downturn in their business starts setting in.
Unemployment data will make its presence felt across financial markets. Looking at Non-farm Payrolls, for example, a positive surprise would suggest strengthening the domestic economy. A positive payrolls number will also create a sell-off in bonds, increasing bond yields. Furthermore, better employment conditions offer a strengthening economy; subsequently, equity markets will also push higher.
To understand why the unemployment rate can change monthly, we must define ‘unemployment.’ To be classified as unemployed, an individual must meet three criteria:
- First, they don’t have a job.
- Second, they are looking for jobs.
- Third, they are available for work.
If someone meets all of those criteria, they are unemployed.
Anyone that has a job is considered employed. Simple enough. The total labor force is the sum of unemployed people and employed people. The unemployment rate can then be calculated as the percentage of the unemployed labor force to the total labor force.
Note: the unemployment rate is based on the labor force, not the total population.
If someone doesn’t have a job – they can work, but they just aren’t looking for a job right now – they are not considered unemployed. But, if they change their mind and start looking for a job, now they are counted in the unemployment numbers.
When we see changes in unemployment, we often assume those changes are due to the number of unemployed people or, in the formula for the unemployment rate, the numerator. But remember, in the unemployment calculation, the denominator, the bottom number of a fraction is the total labor market, which can also change each month. So, changes to the unemployment rate can be due to changes in the number of people working, or it can be due to the number of people that say they are looking for work.
Types of Unemployment
Now that we know how unemployment is calculated, what it means, and when it is reported, we can start talking about why the number changes so often. To analyze and understand unemployment trends, economists have defined three types of unemployment:
- Structural unemployment
- Cyclical unemployment,
- Frictional unemployment.
Understanding what causes these three types of unemployment will make the fluctuations in the
The unemployment rate all makes sense.
First, structural unemployment occurs when the labor force cannot provide workers with the skills and abilities employers need. So, for example, the unemployment rate would increase when tech companies cannot fill positions because they can’t find qualified applicants. So if you read an article in your local newspaper about a big tech company opening up an office with 5000 employees in your city, your first thought might be, ‘Great! That’ll bring the unemployment rate down!’
You may be correct, but if those jobs require special skills and there aren’t many people in your town who can fill those jobs, the impact on unemployment won’t be significant. On the other hand, job openings that can’t be filled because of a lack of skilled workers increase unemployment.
Another type of unemployment that can lead to increases or decreases in the overall rate is cyclical unemployment. Cyclical unemployment is the increase or decrease in unemployment due to the natural fluctuations of output as the economy moves through the business cycle.
You’ll recall that any healthy economy goes through a cycle of growth and contraction. During periods of growth, output rises, increasing the demand for labor and thereby decreasing the unemployment rate. Likewise, during periods of contraction, output declines, meaning companies need to lay off employees, which increases the unemployment rate.
Finally, economists have identified frictional unemployment as a type that will impact the overall unemployment rate. Frictional unemployment is unemployment that occurs because workers are changing jobs. This is an essential type of unemployment to understand because it is why no economy will ever have a 0% unemployment rate, nor should policymakers want a 0% unemployment rate. Moreover, workers leaving their jobs to explore other opportunities suggests that the economy is healthy – people have the opportunity to look for better jobs, opening their positions for others to move up.
It’s probably impossible to accurately break down the total unemployment rate into these three categories. However, most economists agree that the total employment rate, or the unemployment rate when all unemployment is frictional, is probably around 3-5%. Beyond that, the complexities of the labor market and unemployment make it very difficult to say how much unemployment is due to cyclical or structural factors.
Bottomline: Unemployment; A Lagging Indicator of the State of an Economy
Economists have identified three types of unemployment. First, structural unemployment is due to the employment positions that can’t be filled due to a shortage of skilled workers. Cyclical unemployment is due to the natural changes in output as part of the business cycle. Finally, frictional unemployment is caused by people voluntarily leaving their jobs to pursue other employment opportunities. Because frictional employment is voluntary and a sign of a healthy economy, the unemployment rate will never be 0%, nor should it be.