Unemployment Is an Economic Indicator - Essay Example

Wanqian Feng ECO 418 4 Unemployment Unemployment is among the economic indicators. It is applicable to evaluate and measure the financial status and give an outlook on the economy. Governments in most countries across the world frequently review the rates of unemployment and share the same on a monthly basis. This is indicative of the significance that unemployment has to the rest of the economy. Unemployment affects the economy in two ways. Firstly, an increase or decrease in the rate of unemployment has a direct effect on the rate of inflation in the economy. Secondly, news of a rise or fall of unemployment significantly affects the stock market; that is, it affects the pricing of stocks and bonds. This report will, therefore, identify, summarize, and give an evaluation of the two relationships. Firstly, it will explain unemployment. Secondly, it will explain the relationships that exist between unemployment and inflation, and that between unemployment and stock prices. Finally, it will give a summary conclusion. An unemployed individual does not currently have a job, has sort for a job in the prior 4 weeks and ready for work as defined by the U.S. Department of Labor (1). This is usually denoted as a percentage. Unemployment is a very significant measure or indicator of the economy and serves to indicate how healthy or ailing an economy is. The unemployment rate, which by definition is the ratio of people who are unemployed to the total number of people in the labor market, is the most common measure used to define and size up employment. There are instances when unemployment is voluntary (Gay 30). This scenario occurs when persons opt not to seek employment due to a number of reasons such as low wages in the market. Unemployment generally significantly affects parameters such as inflation and stock prices. What then is the relationship that exists between unemployment and inflation? Market players, such as the Federal government and corporate world usually relate low unemployment rates are attributed to high inflation levels. Low unemployment is consequently related to an increase in the growth of the economy. These market participants also view the reverse as true, which means that an increase in unemployment and a slow economic growth are indicative of a decrease in unemployment. Theoretically, the relationship between unemployment and inflation is explained by the Phillips curve. According to this theory, unemployment and inflation work in opposite direction. Chang asserts that in a period of low unemployment as compared to a period of high unemployment, there are fewer unemployed laborers in the labor market (Chang 10). Businesses will actively compete for them by offering competitive packages, mostly higher wages. This resultantly piles an upward pressure on wages. Industrialists tend to pass this cost to consumers in the form of increased prices of goods and services. Industrialists do this in order to cover the additional cost of production that results from the higher wages offered. This results in increased inflation, and this has been proved empirically. In the September employment report of 2014, the Bureau of Labor Statistics reported a 5.9 percent decline in unemployment. Consequently, there was increased expectation that the Federal Reserve would raise interest rates to curtail any inflationary pressures. Raising interest rates would reduce public borrowing from financial institutions thus reducing the cash amount of cash in the hands of the public. However, lower unemployment rate will not always lead to higher inflation whenever it occurs. This is because employers sometimes reward higher productivity levels with higher wages and do not necessarily pass that cost to consumers. In this case, the high productivity, directly counters the higher wages paid out and consequently the cost of production is me, adequately. What is the relationship between unemployment and stock prices? Why is it that the stock and bond prices sometimes fall when there is a release of good news concerning the economy? An understanding of how stock prices are determined is imperative. The knowledge serves to outline the various factors that determine stock prices and the effect of unemployment on such factors. The factors include industry performance, economic factors, and investor sentiment. Economic factors include changes in economic policy, interest rates, the value of the dollar and economic outlook. Inflation and deflation also determine stock prices. So far, the relationship between inflation and unemployment is outlined in this article. The effect of unemployment on inflation also results in an effect of inflation on the stock price. Inflation results in higher consumer prices leading to interest rates being increased and consequently stock prices are reduced. In any economy, low unemployment rates are generally indicative of a robust economy. This is because the economy operates at levels of near full employment suggesting that most resources are being utilized, and companies are positive about the outlook, thus hires more labor. The stock market is expected to resonate positively on this aspect. However, participants in the stock market normally view low unemployment as a probable cause of inflation that may result in an increase in interest rates by the Federal Reserve (Gay 23). It is so because with more people being employed production costs are magnified, and this is passed to consumers. Increased interest rates work against stock prices leading to a fall in the prices of stocks. High interest rates cause a commensurate escalation in the cost of borrowing funds for business growth, thereby denying companies projected earnings. The high cost of borrowing has a negative effect on the businesses’ financial base. As a result, businesses would not be able to expand their production operations due to the lack of adequate funds. Maintaining the prevailing production levels will also be hard since the pool of funds is reduced. Consequently, low productivity levels reduce the earnings. Reduced earnings result in a reduced return on capital for shareholders investments causing lower stock prices (Cogley 15). During economic expansions, bond and stock prices normally rise when the announcement of rising unemployment is made. Because of the bond response, bad labor market news causes expected future interest rates to go down. As such, the stock prices also rise in response to this. However, it should not be the case because the equity risk premium also changes during this expansion (Boyd, Hu, and Jagannathan 650). In conclusion, unemployment can be singled out as one of the most important economic indicators that generally are used to measure the health of an economy. Unemployment is one of the problems that shed a dark light on economic wellbeing of a country. The unemployed are individuals who are actively seeking employment in the labor market, but fail to secure a job. To attain consistency in economic progress, unemployment is one of the key issues that must be addressed by governments. Unemployment has causal-effect relationships with two other important parameters being inflation and stock prices. In relation to inflation, low unemployment results to high inflation. This is because employers will pay higher wages to attract the few unemployed workers and consequently pass this cost to the consumer in the form of higher prices of goods and services. In the stock market, good economic news, such as low employment, will suppress the prices of bonds and stocks. This is because of increased interest rates resulting from increased inflation, which tend to work against stock and bond prices. Works Cited Boyd, John H., Jian, Hu and Ravi, Jagannathan. "The stock markets reaction to unemployment news: Why bad news is usually good for stocks." The Journal of Finance 60.2 (2005): 649-672. Chang, Roberto. "Is low unemployment inflationary?" Economic review QI (1997): 4-13. Cogley, Timothy. “Why do Stock Prices Sometimes Fall in Response to Good Economic News?” Federal Reserve Bank of San Fransisco, Economic Letter No. 96-36; December 13, 1996. Gay, Robert. Effect of Macroeconomic Variables on Stock Market Returns for Four Emerging Economies: A Vector Regression Model for Brazil, Russia, India, and China. New York: ProQuest. 2008. Print. U.S. Department of Labor. Labor Force Statistics from the Current Population Survey. June 12, 2014. Web. 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