Why Too Low Unemployment Can Actually Hurt the Economy
Why Too Low Unemployment Can Actually Hurt the Economy
The idea of a high unemployment rate may seem daunting, especially for a developed country such as the United States. Thanks to the Coronavirus, the U.S. unemployment rate now sits around 11.1% in June, down 3.6% since its all-time high of 14.7% in April, but still far from the 3.5% seen earlier this year.
A record 6.8 million initial claims were filed in March
The question now looms: How do we fix it?
In an ideal world, everyone would be educated and employed. Instead, the reality is not so forgiving. If the unemployment rate were too low, productivity would decrease, inflation would rise, and the American economy would be at risk.
Questioning Productivity
Once the labor market reaches a certain number of employed workers, where each job does not add or create enough productivity to cover rising costs, every job added after that is essentially inefficient. This is called output gap, or often called “slack,” which in an ideal world would be zero-meaning the economy is at full capacity and there is no output gap. Take, for example, the graph below.
In economics, “slack” is calculated by subtracting U-3, total unemployment, from U-6, total unemployment in addition to hidden unemployment (such as illness or disability, or those no longer looking for work) and part-time workers seeking full-time employment.
When the output gap falls, it suggests that the economy’s resources are being underutilized and that the economy is not at full capacity. This is due to an indicated general lack of demand within the economy, which can lead manufacturers and companies to operate below their maximum efficiency.
When there is a positive trend in the output gap, it suggests that the economy is overusing its resources, and as a result is becoming less efficient, due to the high demand for goods in the economy. This can be beneficial but as a result, employees must work beyond their maximum efficiency level to meet demands, which can lead to inflation and an increase in the price of goods.
The level at which unemployment and positive output gap equal each other is still highly debated, but economists suggest that as the United States unemployment rate nears 5% and below, the U.S. economy is at or very close to full capacity and is becoming less efficient.
Wage Inflation
As more workers are hired, more wages are paid, and as a result, more companies and small businesses may struggle to meet certain demands. Small businesses, in particular, may not have the margins to cope with rising wages.
“In addition to profitability, small-caps generate less revenue per employee and conduct a larger share of their business in the U.S.” - Ben Snider, Strategist, Goldman Sachs
Wage inflation comes as a result of fewer unemployed workers, but as the demand for labor increases, employers are forced to increase wages and hold on to existing staff. In some cases, as the unemployment rate decreases and wages rise, smaller businesses are forced to look into the less talented work pool and decrease productivity as a result.
Phillips Curve
Another example of the relationship between the unemployment rate and inflation can be seen in the Phillips Curve. A.W. Phillips, a New Zealand economist, was one of the first economists to present compelling evidence for the inverse relationship between unemployment and wage inflation.
As the unemployment rate increases, the wage inflation rate decreases. As the unemployment rate decreases, the wage inflation rate increases.
When the unemployment rate is low, and the demand for labor is high, employers must raise wages in order to attract scarce labor, thus increasing wage inflation. When the unemployment rate is high, and the demand for labor is low, workers are reluctant to accept wages lower than what is already prevalent, thus decreasing wage inflation.
Although the Phillips Curve does not apply to all situations, it is still fundamental when it comes to understanding and forecasting inflation.
The Reality of It All
Even though the Federal Reserve might adjust monetary policy in order to maintain the perfect balance between employment and unemployment rates and maintain full capacity in the labor market, there’s not much it can do.
The Fed estimates natural unemployment rate to be 3.5%-4.5%
It is constantly choosing between the economic advantages and social advantages of a constantly changing economy. At the end of the day, Americans will take the opportunity to search for jobs-something they can’t be denied.