Understanding Unemployment | CFA Level I Economics


This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this short lesson, we’ll learn about the different types of unemployment and the ways to measure unemployment.

Types of Unemployment

In any economy, employers hire to meet increased demand and let go of workers when demand falls. Workers also quit to look for better jobs, and new graduates start job hunting. Let’s look at the various types of unemployment:

  • Frictional unemployment: Unemployment due to the time lag necessary to match job seekers with employers. This is unavoidable, and any economy will always have some frictional unemployment.
  • Cyclical unemployment: Caused by short-run changes in the general level of economic activity. In a recession, the number of available jobs is fewer, so the proportion of unemployed increases.
  • Structural unemployment: Caused by long-run changes in the economy that eliminate some jobs while creating new jobs for which the unemployed workers are not qualified. This is a structural problem because the unemployed workers do not currently have the skills needed to perform the jobs that are available.

Defining Unemployment

Now that we’ve learned about the categories of unemployment, let’s go through some of the formal definitions:

  • An unemployed person is one who is not working but actively searching for work.
  • A long-term unemployed job seeker has been unsuccessfully looking for a job for several months.
  • An underemployed person is someone who is employed part-time but would prefer to work full-time, or is paid far below what their qualifications or skills suggest. However, it can be difficult to identify underemployed persons, as the criteria can be subjective, so comparison of the statistic between nations may not be meaningful.
  • A discouraged worker is one who has given up looking for a job, perhaps because of a weak economy, and has temporarily stopped seeking employment.
  • People who choose not to be employed are said to be voluntarily unemployed, either because wages are not up to their expectation or they choose to retire early.

Measuring Unemployment

The labor force of an economy consists of those who are employed, including the underemployed, and those who are actively searching for a job. The participation ratio is the size of the labor force as a percentage of the working-age population.

Participation ratio = Size of workforce / Working age population

The unemployment rate is the percentage of the labor force that is currently classified as unemployed.

Unemployment Rate = Num of unemployed / Size of workforce

Discouraged workers are statistically outside the labor force, which means they are not counted in the official unemployment rate. As an analyst, you should observe the unemployment rate together with the participation rate. If a drop in unemployment is accompanied by a drop in the participation rate, it may mean that more of the unemployed have given up looking for jobs, rather than an actual pick-up in hiring. So as you can see, the unemployment rate may not be a fair representation of the unemployment situation due to the “hidden unemployed” in the form of discouraged workers.

Other Indicators and Productivity

The unemployment rate is a lagging indicator of the health of the economy. Employers try to minimize hiring and firing as these are costly exercises. The unemployment rate, therefore, lags actual economic output.

To get a better picture of the employment cycle, many analysts prefer to study payroll growth. Although payroll data may be biased, there is a clear indication of economic trouble when payrolls shrink and a clear indication of recovery when they rise.

Number of hours worked, especially overtime, and the use of temporary workers may also be useful indicators of economic activity. Firms tend to increase overtime hours and hire part-time workers to cope with the initial pick-up in demand in the early stage of a recovery. Therefore, these two indicators may be better signals of economic recovery than the unemployment rate.

Productivity measures also offer insight into this cyclical process. Productivity, which is a measure of output against the number of workers, declines early in contractions as firms try to keep workers despite producing less output.

In the early expansion phase, firms try to produce more output with existing workers, so productivity rises.

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