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Cyclical unemployment is an unwelcome companion to the business cycle, rising and falling in a predictable pattern. It decreases as the economic activity expands and businesses thrive, but increases as the economy contracts and companies struggle. This stands in stark contrast to structural unemployment, which persists regardless of the current economic climate. While cyclical unemployment is temporary, it can still cause significant hardship for workers caught in its grip. Let’s delve deeper into the causes and solutions surrounding this economic phenomenon.
What is a business cycle?
A business cycle is an up-and-down phase of economic growth. Its indicator is real GDP growth, which reflects the growth of aggregate output in the economy.
A business cycle occurs because aggregate output deviates around its potential (potential GDP). As the potential output is reached, the economy is at its full capacity.
A typical business cycle comprises four phases: contraction, trough, expansion, and peak. Contraction occurs when economic activity declines, while expansion occurs when it increases. The trough represents the lowest point and the highest point of the cycle.
When the economy operates below its full capacity (potential output), it is contracting. This means some production factors are underutilized, which leads to downward pressure on the general price (which might cause deflation). In this phase, employment shrinks, and unemployment tends to increase.
Conversely, when the economy is above its potential level, economic activity expands, putting upward pressure on general prices. The unemployment rate is low, but when it falls further, this results in higher inflationary pressure.
The boom and bust cycle: causes of cyclical unemployment
Fluctuations in economic activity affect labor demand. When the economy expands, the demand for labor is high. However, demand will fall when the economy contracts.
Cyclical unemployment increases, for instance, when businesses lay off their workers during a recession to cut production costs. During this period, the demand for goods and services drops. Their profitability shrinks and forces them to rationale operations in maintaining efficiency. One option to streamline their costs is through layoffs, especially for job redundancy.
Governments would intervene to stimulate the economy through expansionary policy. When this policy took effect, the economy started to recover and expand, and consumers spent more on goods and services.
Faced with high-demand prospects, businesses increase their production. If the economic expansion continues, they invest in capital goods. Investment requires more workers to operate new equipment. They then hire more workers, and as a result, the unemployment rate is down.
In summary, cyclical unemployment is only temporary. It fluctuates as the cycle moves from one phase to another. Governments could also intervene to reduce this type of unemployment.
Solution for cyclical unemployment
Cyclical unemployment, a by-product of economic fluctuations, can be addressed through targeted government interventions. Here, we explore how expansionary policies can stimulate economic growth and reduce cyclical unemployment:
- Boosting demand through expansionary policies: When the economy contracts and unemployment rises, governments can step in to stimulate demand for goods and services. This is achieved through expansionary policies, either fiscal or monetary.
- Monetary policy in the fast lane: Compared to fiscal policy, expansionary monetary policy often has a faster impact because it involves a shorter time lag between implementation and economic effects.
Monetary policy in action
Assuming the government chooses to implement an expansionary monetary policy, the central bank, acting as its agent, has a toolbox of options at its disposal. These include:
- Cutting interest rates: A crucial tool is reducing the policy rate, the interest rate the central bank charges commercial banks for borrowing. Lowering this rate increases the money supply and liquidity in the economy.
- Lower reserve requirements: The central bank can also ease lending by lowering reserve requirements, the amount of money banks are required to hold in reserve. This frees up more funds for banks to lend to businesses and consumers.
- Open market operations: The central bank can also engage in open market operations by actively buying government securities. This injects money into the economy, making it more affordable for businesses and individuals to borrow.
Let’s take the example of a central bank cutting policy rates. This makes borrowing cheaper for households and businesses. With easier access to credit, consumers are more likely to purchase durable goods like cars or appliances, while businesses are encouraged to invest in capital goods like machinery.
This increased spending across the board stimulates economic activity, leading businesses to ramp up production to meet this growing demand. As production increases, businesses naturally require more workers, leading to a decline in cyclical unemployment.
In essence, expansionary monetary policy creates a domino effect. By making borrowing cheaper and increasing the money supply, the government encourages spending and investment, ultimately leading to increased economic activity and job creation. This targeted approach helps mitigate the negative effects of cyclical unemployment and paves the way for a more stable and prosperous economy.
Fiscal policy: government spending power
Expansionary fiscal policy focuses on government spending and taxation to influence the economy. Here’s how it works:
- Increased government spending: During a recession, the government can increase its spending on infrastructure projects, social programs, or public services. This injects money directly into the economy, stimulating consumer spending and business activity. For example, the government might invest in building new roads and bridges, which creates jobs in the construction sector and increases demand for materials like steel and concrete.
- Tax cuts: Another tool is tax cuts for businesses and individuals. Lower taxes leave more money in people’s pockets, encouraging them to spend more on goods and services. For businesses, tax cuts can improve profitability and free up resources for investment and hiring.
Similar to expansionary monetary policy, increased government spending and tax cuts create a ripple effect. More spending by consumers and businesses leads to increased demand for goods and services. Businesses respond by ramping up production, which necessitates hiring more workers. This ultimately reduces cyclical unemployment.
While monetary policy can act swiftly, fiscal policy can be a more powerful tool for long-term economic growth. However, it often faces delays in implementation due to legislative processes. Ideally, a combination of both expansionary monetary and fiscal policies can deliver the most effective results in combating cyclical unemployment.
