- Introduction: Why?Unemployment is a crucial indicator of any economy. At the end of the day, economies are made of demand and supply. If unemployment is high that means that for some reason demand side is not interested in employing people to create goods or provide services. And if unemployment is high it will also mean that consumers don’t have an income and therefore their level of consumption will be lower.As a consequence, strong economies tend to show decreasing levels of unemployment, and weak economies tend to the opposite. And it’s also important to understand the economic cycle of the economy.
- Unemployment in the short run: Confirmation indicator
The most obvious information that unemployment provides is a description of the actual state of the economy. Which should be analyzed from two perspectives.First, we want to know the actual level of unemployment. If unemployment is high we know that the economy might be going through trouble. If unemployment is low, we know that the economy has been experiencing an expansion. To determine if the level is “high” or “low” we have to compare it to rates seen in the past.Secondly, we want to check the rate of change (like with most indicators). This is in what direction is the indicator moving and if it’s accelerating or not. We basically want to know if unemployment is increasing or decreasing. And if it’s doing that faster each month or slower.So we can have 4 different situations:
-Low and decreasing unemployment. This means that things are working very well.
-Low but increasing unemployment: This means that things might have started to go south.
-High and increasing unemployment: This means that the current situation is terrible, we have a very weak economy.
-High but decreasing: This means that things have been very difficult recently, but the storm might be over.
- Unemployment in the long run: The cycleOn the long term, things are different. To understand this way of thinking we first have to understand the economic cycle. The economic cycle is the idea that the economy goes through for main phases:
-Expansion: The economy grows very fast, unemployment decreases, inflation increases, consumption goes up, etc. Good stuff in general, except that bubbles might be generated during this process.
-Peak: Now unemployment is very low, salaries are going up by a lot increasing the costs for companies, at some point the economy starts slowing down.
-Recessión: Employment increases, inflation is low, growth is low or even negative, consumption goes down, salaries go down, etc. Bad stuff is general, here is where any bubble will explode. When things start going south is when bubbles tend to be clear and therefore they explode.
-Trough: Unemployment is high but it’s not increasing anymore, we start growing again, consumption doesn’t go down anymore, etc. The economy stops going down and we should prepare for a new expansion phase.What is the problem? It’s not easy (some even suggest is impossible) to predict when we are going to change from one phase to another. However I do think its possible to at least know in which phase we are, and therefore we know what kind of things we can expect. In order to do these, unemployment and labor market indicators happen to be a very useful tool.
As you can see the relationship between unemployment and recessions is very clear.
During the expansion phase, unemployment decreases. Then its rate of change starts to decrease and it troughs. This leads to a new recession and an increase in unemployment. After the recession unemployment peaks. And it starts going down starting new recessions.
As we’ve seen the relationship is obvious, the problem is that is very difficult to know how long will each phase be But we can definitely understand where we are and therefore what we can expect.
In the next posts, we will go through the most important indicators to follow. And how to analyze their information in order to understand the current state of the economy and where we are in the economic cycle.
Nuño Pérez del Barrio