Cyclical unemployment accompanies a business cycle. It decreases as the economic activity expands and increase as the economy contracts. It is the opposite of structural unemployment, which will persist regardless of the conditions of the ongoing business cycle.
What is a business cycle?
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 is when economic activity declines, while expansion occurs when it increases. Trough represents the lowest point and the highest point of the cycle.
When the economy is operating below its full capacity (potential output), the economy is contracting. It means some production factors are underutilized, which leads to a downward pressure on the general price (might cause a deflation). In this phase, employment shrinks and unemployment tends to increase.
Conversely, when the economy is above its potential level, economic activity is expanding. There is upward pressure on general prices. The unemployment rate is low, but when unemployment falls further, this results in higher inflationary pressure.
Cyclical unemployment in the detailed explanation
Fluctuations in economic activity affect labor demand. When the economy expands, the demand for labor is high. However, demand will fall when the economy experiences a contraction.
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 taking effect, the economy starts to recover and expand. Consumers spend more on goods and services.
Faces with high-demand prospects, business increases its 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 move from one phase to other phases. Governments also could intervene to reduce this type of unemployment.
Solution for cyclical unemployment
Cyclical unemployment declines when governments to stimulate economic growth. Expansionary policies will lead businesses to increase production and hire more workers.
Expansionary policies can be fiscal or monetary. Monetary policy transmission typically faster than fiscal policy because it involves a shorter policy lag.
Assumes governments (central bank) opts to implement expansionary monetary policy. Several tools are available for this policy, including cutting policy rates, lowering reserve requirements, and conducting open market operations by buying government securities.
Say, the central bank decides to cut policy rates. Lower policy rate increases the money supply and liquidity in the economy. Lending rates decline, and banks willing to make more loans.
At another side, cheaper borrowing cost encourages households and businesses to apply for a new loan. They use the money to purchase, for instance, durable goods and capital goods. This increase stimulates the business sector to increase production and create more jobs.