Cyclical unemployment is the difference between the actual unemployment rate and the unemployment rate when the economy is at its natural output level. Swings in the business cycle cause cyclical unemployment.
Detailed Explanation:
Economists estimate that full employment occurs when the employment rate is between 94% and 96%, meaning the unemployment rate falls between 4% and 6%. Some level of unemployment is inevitable—and even considered healthy for the economy. To be classified as unemployed, a person must meet three criteria: (1) they do not have a job, (2) they are willing to work, and (3) they are actively seeking employment, having performed at least one job search activity within the past four weeks.
Economists separate unemployment into three categories: frictional, structural, and cyclical. Frictional unemployment occurs when market inefficiencies delay the job search process; it takes time for people to apply, interview, and begin new jobs. Structural unemployment arises when economic shifts leave some workers behind, such as when jobs are available in locations where workers are unwilling to move or in industries requiring skills they do not possess. Cyclical unemployment results from fluctuations in labor demand caused by changes in the business cycle. The full employment rate represents the natural output level and includes frictional and structural unemployment but excludes cyclical unemployment.
Fluctuations in the business cycle drive cyclical unemployment. It rises during recessions when demand for goods and services declines, inventories build up, and businesses slow production and lay off workers to reduce costs, resulting in a surplus of labor. In contrast, cyclical unemployment decreases during economic expansions when businesses ramp up production and hire more workers to meet their rising demand. At full employment, cyclical unemployment is effectively zero. Unlike frictional and structural unemployment, cyclical unemployment is more volatile and has a greater impact on changes in the overall unemployment rate.
Any event that causes the public or businesses to lose confidence in the economy can lead to a drop in aggregate demand. For instance, the stock market crash in 1929 greatly intensified the Great Depression. Many people had invested their life savings in the market and panicked when it crashed. When they rushed to withdraw their money from banks, they discovered that the banks had also invested heavily in the stock market, leaving their funds unavailable. This led to a sharp decline in aggregate demand. In response, businesses cut back operations and laid off large numbers of workers. Most of the unemployment during the Great Depression was cyclical.
Inflation caused by a supply shock can push the economy into a recession, especially when a central bank responds by raising interest rates to combat inflation. In 1973, inflation was already a concern in the United States, averaging 6.2%. However, it nearly doubled to 11% in 1974, following the Arab Oil Embargo imposed by OPEC’s Arab members in retaliation for US support of Israel during the Arab-Israeli War. The embargo caused a sharp decline in oil supplies and a spike in prices. Since oil was essential for producing and distributing most goods, producer costs rose. Companies passed some of these increased costs onto consumers by raising prices. As wages failed to keep up with the rising cost of goods and services, consumers could afford to buy less. In turn, businesses reduced production, and many workers who were laid off became cyclically unemployed.
A cyclically unemployed worker can become structurally unemployed during a prolonged recession when a laid-off worker is away from his job for so long that when his company reopens, he cannot provide the modified skills now required by the job. For example, assume a recession forces a company to lay off 500 workers. Fifty workers choose to return to school to study computer programming. During the next two years, management decides to improve its efficiency with robots. When growth resumes, management rehires the 50 workers who chose to study computer programming. The remaining 450 workers no longer have the skills demanded by the company. In this example, 450 workers went from being cyclically unemployed to structurally unemployed.
Expansionary fiscal and monetary policies can increase the economy’s aggregate demand or aggregate supply and return many of the cyclically unemployed to work. The Federal Reserve may increase the money supply to lower interest rates, making business borrowing more attractive. Congress may choose to stimulate the economy by increasing spending.
Here's a fun video that explains the different types of unempolyment.
