Unemployment and Economic Growth

I just found this at an old blog of mine and decided to re-post it, with a few editorial changes. Perhaps I’ll get around to updating it, but the results given here should be robust because the data set consists of 117 observations (1891-2007).

An increase an the rate of unemployment usually signifies slower economic growth, but it need not signify negative economic growth. Alternatively, slower economic growth need not lead to a higher rate of unemployment. Why is that?

The key to economic growth is greater output per worker. (A note to leftists: Greater output may be due to capital investments.) A sufficiently large increase in productivity can offset a decline in the proportion of workers employed (i.e., a rise in the unemployment rate), with the result that real GDP can rise even as the unemployment rate rises.

Here is the historical relationship between the change in real, per-capita GDP and the change in the unemployment rate:

Sources: Rates of real, per-capita GDP derived from What Was the U.S. GDP Then? (http://www.measuringworth.org/usgdp/). Unemployment rates taken from Statistical Abstracts of the United States: Colonial Times to 1970, Series D85-D86 (http://www2.census.gov/prod2/statcomp/documents/CT1970p1-05.pdf) and Bureau of Labor Statistics, Employment Status of the Civilian Noninstitutional Population, 1942 to date (ftp://ftp.bls.gov/pub/special.requests/lf/aat1.txt).

There is, as one would expect, a negative relationship between economic growth (as measured by year-over-year changes in real, per-capita GDP) and unemployment (as measured by year-over-year percentage-point changes in the unemployment rate). But, note that the unemployment rate must rise by 1 percentage point (i.e. reach +1 on the horizontal axis) before real, per-capita GDP begins to decline (i.e., drop below 0 on the vertical axis).

Or, to look at it the other way around, declining real growth need not lead to a rising unemployment rate. Only when the real growth rate drops below 2 percent does the unemployment rate begin to rise (i.e., the change is 0 or positive). Why is that? At a growth rate below 2 percent, businesses cannot absorb all new entrants to the labor market, given their (generally) low productivity relative to experienced workers.