What Is the Relationship Between Economic Growth and the Unemployment Rate?

Using the UK as an example

1. Introduction

There are two critical factors of macroeconomics and two significant determinants of economic progress of an economy, one being economic growth as it reflects the productivity of an economy. The other being the unemployment rate, which is a measure of the number of people who are prepared and can work and are vigorously seeking work but are still unemployed. We would be able to see if one variable would increase or decrease, would the other variable be affected as well, creating a negative or positive relationship through the economic growth or unemployment rate. Therefore, in this essay, the discussion of the relationship between economic growth and unemployment rate will be critically analysed.

2. Economic Growth

Economic growth is defined in an economy by an outward shift in its Production Possibility Curve (PPC).  It is the increase in the goods and services produced by an economy, typically a nation, over a long period (Amadeo, 2019). Economic growth is what every economy tries to achieve for the good of everyone as a whole. However, many economists and the government look up to the Gross Domestic Product (GDP) as an indicator of its country’s economic growth, it can be measured in three ways. Though, all the methods give the same outcome.

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Firstly, GDP can be calculated by adding up the value of all the final goods and services produced in the economy. This calculation determines the value added between businesses, the cost at which the seller sells the product removed from the price it was purchased for from the supplier. Secondly, is by adding up all income earned by factors of production from firms in the economy, such as the wages earned by labour, the interest paid to those who lease their land or structures to firms, etc. (Krugman and Wells, 2013). Lastly, another way is by adding up aggregate spending on domestically produced final goods and services. This calculation is the most commonly used formula for GDP, which depends on the money spent by different groups that take part in the economy. This consist of Consumer spending of goods and services (C), Investment spending on business capital goods (I), Government spending on public goods and services (G), and Exports minus Imports (X-M) (Bondarenko, 2006). The increase of any of these factors would lead to a rise in the economic growth of a country. This can be arranged into the following equation:

GDP= C + I + G + (X – M)

3. Unemployment rate

Another critical factor is the unemployment rate. This is defined as the percentage of unemployed workers in the total labour force. Workers are viewed as unemployed if they currently do not work, even though they are capable and willing to do so. The entire labour force consists of all employed and unemployed people within an economy and delivers insights into the economy’s additional capacity and available assets. Unemployment tends to be cyclical and reduces when the economy expands as companies employ more workers to meet growing demand and usually increases when economic activity slows (FocusEconomics, 2019). There are different types of unemployment:

The first is Cyclical unemployment, which is the change of the actual rate of unemployment from the average rate due to recessions in the business cycle. When business cycles are at their highest, cyclical unemployment is normally low because the total economic output is being maximised. When economic output decreases, as measured by the gross domestic product (GDP), the business cycle is small and cyclical unemployment will increase (Kenton, 2019). The second type of unemployment is Frictional unemployment, “that arises when workers are searching for new jobs or are changing from one job to another” (Corporate Finance Institute, 2019). It is part of natural unemployment and therefore is available even when the economy is considered at full employment. In contrast to different kinds of unemployment, frictional unemployment does not increase throughout an economic recession. In contrast, during a downturn, it tends to decline because workers become more worried about job security since fewer job opportunities are accessible in the market.  The last type of unemployment is Structural unemployment; this is that more people are looking for jobs in a particular labour market than there are jobs accessible at the current wage rate, even when the economy is at the top of a business cycle. Contrasting cyclical unemployment, it is caused by forces other than the business cycle. This happens when a fundamental shift in the economy makes it hard for most people to find jobs. There is a formula widely used to calculate the unemployment rate (in %) which is:

Unemployment Rate = Number of Unemployed Persons

x 100

                                                            Labour force

                                                      (Includes employed and unemployed)

4. The relationship between economic growth and the unemployment rate

The relationship between economic growth and the unemployment rate could be a loose one. It is common for the unemployment rate to exhibit a continuous deterioration after other measures of economic activity become positive and is frequently referred to as a lagging economic indicator. A reason that unemployment might not fall considerably when the economic growth picks up after a recession has finished is that many firms tend to underuse their employees because dismissing employees when the product fails and then hiring them again once the product demand improves has consequences. Consequently, employers are able to produce more output to meet the increasing demand at the beginning of recovery without the need for additional workers by increasing the efficiency of the employees they already have. This briefly boosts labour productivity growth on top of its trend rate.

As soon as the labour at hand is thoroughly utilised, the growth of the output cannot go faster than the rate of productivity growth before the firm starts hiring more workers. The output growth will be driven by the current rates of growth in the labour supply and productivity as the economic expansion advances. Providing that growth in the real gross domestic product (GDP) surpasses an increase in labour productivity, employment will increase. The unemployment rate will fall if the employment growth is quicker than labour force growth.

Figure 1: The Unemployment rate

(Clegg, 2019)

Figure 2: GDP

(Richards, 2019)

Comparing both figures of the economic growth rate and unemployment in the UK, an observation made about the growth rate in 2017 is 1.8% and the unemployment rate of 4.9%. However, in 2018 the growth rate had reduced to 1.4%, and the unemployment rate also decreased to 4.1%. Through this, the two variables have imitated a positive relationship, as the economic growth has reduced by 0.4% where the unemployment rate also saw a reduction of 0.3%. When comparing the two figures together, we are not looking at that one year, which is why we are looking at the data set from 1988 to 2017 of both the economic growth and the unemployment rate.

Figure 1 illustrates the unemployment rate in the United Kingdom (UK) from 1998-2017. During this period the unemployment rate of the United Kingdom has shown substantial fluctuations. From 1988 a slight decline until 1990, where then a constant increase up to 1993. From that point, the unemployment rate has been declining over the period up until 2000. Between the years 2000 and 2007 the rate was relatively stable before rising from 5.3% in 2007 to 8.1 % by 2011. This increase was undoubtedly from the onset of the Great Recession in 2008, which saw the United Kingdom’s GDP contract by 4.2% in 2009. The UK’s unemployment rate decreased after 2011, but only reached its pre-2006 levels in 2015 before decreasing furthermore in the next years, reaching a low for this point of 4.4% in 2017.

Figure 2 illustrates the gross domestic product (GDP) year on year growth from 1988 to 2017. From the year 1991 has reached the point that it has gone into negative after a downturn in the economy. In 2017 the United Kingdom’s economy grew by approximately 1.8% reaching to the point where it will become the slowest it will go since the great recession in 2009, where the economy has shrunk by 4.2%. Before the economic crash of 2008, the British economy expanded at a relatively reasonable rate, particularly in 2000 when gross domestic product grew by 3.5%.

Overall, the indication of the graphs shows that between the economic and unemployment rate there is a negative relationship, where the GDP increases as the unemployment rate decreases. However, there are two times where the GDP rate went negative in the year 1991 and 2009; this was because of the recession in the economy. Whereas, unemployment was not affected as strongly in those years. But there was a period where unemployment has continuously decreased from 1993 to 1995 before slightly increasing to declining again.

The relationship between these two variables is known in economic literature as Okun’s law created by Arthur Okun in 1962. The law claims that both economic growth and the unemployment rate has a negative relationship together since the amount of output produced requires labour force. Therefore, if there were less output produced, then the amount of GDP would be less, which lowers the economic growth and the number of people needed to create goods, which increases the unemployment rate. This helps us to understand the reason there was a higher percentage of the unemployment rate after a recession as the economy would need to increase its production, to keep its unemployment rate low.

One of the critical benefits of Okun’s law is its straightforwardness in stating a 1% decrease in unemployment will happen when the economy grows about 2% faster than predicted (Furhmann, 2019). Though, relying on the law to make precise predictions about unemployment, given economic trends, does not work well. For example, research has been done where it has been known to shift over time and be impacted by more different economic climates, as well as jobless recoveries and the more recent financial crisis.

Nowadays, it is essential to be efficient when producing goods and services so that firms are able to generate more revenue and use a limited amount of resources. The introduction to new technology in the working environment is one way of being efficient as this helps to increase production in a specific period. This also helps to increase the GDP of an economy, but it also reduces the number of jobs for people who were working within that environment, therefore increasing the unemployment rate.

However, many economists have questioned Okun’s law. Such as articles with titles “An Unstable Okun’s Law…” (Meyer and Tasci, 2012) and “The Demise of Okun’s law…” (Gordon, 2010). It has been proposed by observers that the last three U.S. recessions were followed by a “Jobless recovery” where unemployment growth was weaker than what the Okun’s law forecasts. Studies of international data propose that Okun’s law is unstable in a variety of countries.  Many believe that the relationship broke down because of the Great Recession of 2008-2009, where there was a slight correlation across countries amongst the changes in output and unemployment.

5. Conclusion

To conclude, the relationship between the two critical factors of macroeconomics: Economic growth and the Unemployment rate plays an essential role in how the country performs. From the understanding above it is recognised there is a likely chance that there will be a negative relationship between the economic growth and unemployment, where one will increase, and the other will decrease. Also, from the figures above, in 2009 we see a decline in the GDP and an increase in the unemployment rate, which is what Okun’s law is all about but some may question this.

Reference list:

• Amadeo, K. (2019). How Economic Growth Benefits You. [online] The Balance. Available at: https://www.thebalance.com/what-is-economic-growth-3306014 [Accessed 15 Apr. 2019].
• Bondarenko, P. (2006). gross domestic product | Definition & Formula. [online] Encyclopedia Britannica. Available at: https://www.britannica.com/topic/gross-domestic-product [Accessed 1 April 2019].
• Clegg, R. (2019). Unemployment rate (aged 16 and over, seasonally adjusted) – Office for National Statistics. [online] Ons.gov.uk. Available at: https://www.ons.gov.uk/employmentandlabourmarket/peoplenotinwork/unemployment/timeseries/mgsx/lms [Accessed 20 Apr. 2019].
• Corporate Finance Institute. (2019). Frictional Unemployment – Overview, Examples and Causes. [online] Available at: https://corporatefinanceinstitute.com/resources/knowledge/economics/frictional-unemployment/ [Accessed 18 Apr. 2019].
• FocusEconomics [online] Available at: https://www.focus-economics.com/economic-indicator/unemployment-rate [Accessed 18 Apr. 2019].
• Furhmann, R. (2019). Unemployment and Economic Growth: Okun’s Law. [online] Investopedia. Available at: https://www.investopedia.com/articles/economics/12/okuns-law.asp [Accessed 20 Apr. 2019].
• Gordon, R. (2010). The Demise of Okun’s Law and of Procyclical Fluctuations in Conventional and Unconventional Measures of Productivity. [online] Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.361.17&rep=rep1&type=pdf [Accessed 1 April 2019].
• Kenton, W. (2019). Cyclical Unemployment. [online] Investopedia. Available at: https://www.investopedia.com/terms/c/cyclicalunemployment.asp [Accessed 18 Apr. 2019].
• Krugman, P. and Wells, R. (2013). Economics. 3rd ed. p.627.
• Meyer, B. and Tasci, M. (2012). An Unstable Okun’s Law, Not the Best Rule of Thumb. [online] Available at: https://www.clevelandfed.org/en/newsroom-and-events/publications/economic-commentary/economic-commentary-archives/2012-economic-commentaries/ec-201208-an-unstable-okuns-law-not-the-best-rule-of-thumb.aspx [Accessed 1 April 2019].
• Richards, C. (2019). Gross Domestic Product: Year on Year growth: CVM SA % – Office for National Statistics. [online] Ons.gov.uk. Available at: https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/ihyp/qna?fbclid=IwAR1JdCOkbsJc0-LruDMsN5KYXBPmLk-aJJduMMBcA80WxKV8BXSBeeyRSqE [Accessed 20 Apr. 2019].