Lecture 3.

Unemployment, Interest rate, Exchange rate, Stock markets

1. In economic theory, the unemployed are defined as those without a job but who are seeking
work at current wage rates. There are two basic ways in which unemployment can be calculated.
a) Government can undertake a survey of the population to identify the employed and
the unemployed. This is the approach taken in countries such as the USA, Japan, Sweden, etc.
b) The government can count all those who register as unemployed. In some countries a
register of the unemployed is kept by trade unions because unemployment benefit is linked with
union membership.

Unemployment might be expressed in two ways. It can be stated as an absolute figure, as millions
of workers. Or it can be stated as a relative measure, as a percentage of the workforce, the
unemployment rate. Expressing it in millions gives a clear indication of the numbers affected by
unemployment. Expressing it as percentage is better when the number of workers in the economy is
changing.

Economists distinguish between frictional, structural and cyclical unemployment:

Frictional unemployment is the unemployment that results because it takes time for workers to
search for the jobs that best suit skills and testes.
Structural unemployment caused by changes in the structure of demand or consumer goods and in
technology; workers, who are unemployed either because their skills are not demanded by
employers or because they lack sufficient skills to obtain employment.
Cyclical unemployment caused by insufficient aggregate expenditures. In this case when an
economy goes into recession, unemployment rises because there is insufficient demand within the
economy. It is not just labour which becomes unemployed; factories, machines, offices and farms
become unemployed as well.
Seasonal unemployment, which is caused by shifts in the supply and demand for labour (typically
in agriculture, construction, or tourism) during the calendar year.

Natural rate of unemployment is the unemployment rate at which there is no cyclical

unemployment.

To define the unemployment rate suppose L – is labour force, E- number of employed, U – number
of unemployed. Since all capable to work person is either employed or unemployed so:
L = E+U

In this case the level of unemployment is U/L

But do not confuse ‘labour’ versus ‘human’ capital: Human capital refers to intellectual capital,
while labour capital refers to physical capital.

In order to focus on the factors defining the level on unemployment suppose that aggregate labour
force remains unchanged. Let as assume that s- is the portion of employed people sacked each
month from their works, f – portion of unemployed people who finds work. If the level of
unemployment remains unchanged it means sE=f U. We can adjust this equation to find the level of
unemployment. Taking into account that E = L-U and considering it in equation sE=fU we might
get:

fU= s(L-U)
If we divide both part of equation to L we can get: f (U/L) = s (1-U/L) making other adjustment we
could obtain:
U/L = s/(s+f)
This equation shed lights that the level of unemployment depends on the level of people sacked and
found a job.

The labour policy of government has a direct affect on unemployment. Since empirical evidence
makes clears that at times unemployment insurance, compensation for unemployment, wage
rigidity (caused by minimum wage policy, labour unit policy) increases the level of unemployment
causes labour market failure.

Theoretical assumptions suggest that stimulating wages increases productivity of labour. The
argument has always been:
a) Improvement of health conditions (though it is not important for developed countries)
b) Neutralization of the effect of co-called ‘negative selection’
c) Impedes ‘brain drain’
d) Cope with the problem of ‘moral hazard’

‘Free market’ economists believe that labour market failure caused by excess government
intervention.
‘The left’ believes in opposite.

Wait unemployment results when the real wage remains above the level that equilibrates labour
supply and labour demand.

Discouraged workers are people who unemployed for long periods of time and cannot find work
and hence stop seeking and drop out of the labour force. Thus they are not counted as
unemployment. An unemployment rate that does not include discouraged workers understates the
true magnitude of joblessness in the economy.

2. Fluctuations in the unemployment rate are closely related to the deviations of real GDP from
potential GDP. This relation is called OKUN’S LAW named after the economist who first
examined relationship between GDP and unemployment in case of the USA. According to the
Okun’s law if the unemployment rate remains unchanged, real GDP grow by about 3%; due to
population growth, capital accumulation, and the technological progress. If unemployment rises for
1% then real GDP growth typically falls by 2%.

Percent Change in Real GNP = 3% - 2*Change in the unemployment rate

3. In the short run there is the trade off between inflation and unemployment implied by the Philips
curve equation.
(Inflation)

u* u (unemployment)
At any point in time, the government can choose a combination of inflation and unemployment on
the short run Philips curve. The choice depends on expected inflation.

4. The level of stock market as a key economic indicator represents expectations for the future.
Stock exchange is an institution through which company shares, bonds etc. are traded. When the
level of stock market is high, investor expects economic growth to be rapid, profits to be high, and
unemployment to be relatively low. Conversely, when the level of stock market is low, investors
expect the economic future to be relatively gloomy.

Share is a part of the ownership of a company, which can be held by individuals, or other
companies. Ordinary shares normally carry voting rights, though it is possible to have some non-
voting shares. Preference shares gives no right for voting but rank before ordinary shares for
dividends. The amount of dividends depends on the profit of organization.

Bonds are securities which gives possibility for the organization (or government) issued it to attract
free borrowing capital from capita market with the interest rate determined in the market.

5. Different countries use different types of money and currency. The rate at which one
currency can be converted (i.e. bought or sold) into another currency is known as the exchange
rate. Foreign exchange is bought and sold on the foreign exchange market. Foreign exchange
market – the markets organized in major financial centres where currencies are bought and sold.

Purchasing power parity theory suggests that exchange rates in the long run change in line with
different inflation rates between economies.

Depending on the monetary policy a country might have different exchange rate system. An
exchange rate system is any system, which determines the conditions upon which one currency can
be exchanged for another. In theory there might be several exchange rate systems:

 An adjustable peg system is an exchange rate system where, in the short term, currencies are
fixed or pegged against each other and do not change in value, whilst in the long term the
value of a currency can be changed within certain boundaries if economic circumstances
dictate so.

 A fixed exchange rate system is one where a currency has a fixed value against another
currency or commodity. The best-known example of such a system in the past was the Gold
Standards, which operated in the 19th and early 20th centuries.

 In a flexible (also floating or free) exchange rate system the value of a currency is
determined by free market forces. In this case governments, through their central banks are
assumed not to intervene in the foreign exchange market. However, if governments intervene
from time to time to alter the free market price of a currency is known as a managed
floating exchange rate system.

A fall in the price of a currency in terms of other currencies is called depreciation of national
currency.
A rise in the price of a country’s currency in terms of foreign currency is called appreciation of
national currency,
6. When people refer to ‘the exchange rate’ between two countries, they usually mean the nominal
exchange rate. A nation’s export creates a foreign demand for national currency. Conversely a
nation’s import simultaneously creates a domestic demand for foreign exchange.

The real exchange rate tells us the rate at which we can trade the goods of one country for the goods
of another. Let E be the nominal exchange rate, Pd be the price level in our country (measured in
our currency), and Pf be the price level in other country (measured in foreign currency). Then the
real exchange rate RER is:

RER = EN* (Pf/Pd)

The lower the real exchange rate, the less expensive are domestic goods relative to foreign goods,
and thus the greater are our exports.

7. The interest rate is the price at which purchasing power can be shifted from the future into the
present – borrowed today with a promise to pay it back with interest in the future. Interest is not a
single lump sum but an ongoing stream of payments made over time. Depending on taking into
account inflation interest rate is also divided into nominal and real interest rate.
Real interest rate (r) = Nominal interest rate (n) - inflation (i)

So from this equation derives Fisher equation which is: n = r + i