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May 2012
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The unemployment puzzle

The official unemployment rate has been dropping:

 

Yet, employment to population ratio shows nothing has really improved:

 

So what to believe?  Is US labor market thawing?  Or are we still in a slump?

 

The official unemployment rate is calculated as the number of unemployed divided by labor force.  Let’s use an example to illustrate.   An economy has a total labor force of 100; if 10 is unemployed, then the unemployment rate is 10/100=10%.

To understand the issue, we need to appreciate how the labor force is calculated.  If 3 out of 10 people who are previously unemployed drop out of labor force, because they are discouraged by not being able to find a job for quite some time, labor force now changes from 100 to 97.  And the new unemployment rate is (10-3)/(100-3)=7/97=7.2%. This represents a 2.8% improvement, although the labor market condition has not improved at all.

Is this what’s happening now in the US?  If so, it will show up in labor participation rate, which is defined as the ratio between total labor force and adult population.  And let’s assume the adult population is 150.  When there are discouraged workers giving up and exiting the labor market,  labor participation rate drops from 100/150=67% to 97/150=65%.

Not surprisingly, that is what we see in the real data:


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