What Can Policymakers Do To Decrease Cyclical Unemployment?

Cyclical unemployment is a type of unemployment caused by periodic declines in economic activity. To combat this type of unemployment, governments and policymakers can work to increase output, which creates demand for jobs, thereby lowering unemployment.

Learn more about cyclical unemployment and what steps governments can take to reduce it.

How Cyclical Unemployment Works

There are four main sources of unemployment: cyclical, seasonal, frictional, and structural. Cyclical unemployment is the result of a general decline in macroeconomic activity that occurs during a business-cycle contraction.

During a downturn, or recession, aggregate demand declines: household, business, government, and foreign sectors buy fewer goods and services. Unemployment increases because less output is produced, so fewer workers and other resources are needed. Businesses face declining revenues and find themselves forced to cut costs. As a consequence, they lay off workers, and unemployment rises.

Two Methods for Reducing Cyclical Unemployment

There are two main approaches to reducing unemployment: demand-side policies and supply-side policies. When there is a rise in cyclical unemployment caused by a recession, it is considered demand-deficient unemployment and it is addressed by demand-side policies.

One of the primary policy goals of macroeconomics is to reduce or eliminate cyclical unemployment. To prevent cyclical unemployment, policymakers should focus on expanding output, which is most effectively achieved by stimulating demand. The goal of expansionary monetary and fiscal policies is to boost aggregate demand by cutting interest rates and taxes. Additionally, policymakers may also depreciate the exchange rate in order to boost export demand or introduce specific legislation and initiatives that target particular areas of the economy.

Using Fiscal Policy To Reduce Unemployment

The goal of expansionary fiscal policy is to manage output and employment through increasing government spending and decreasing taxation. Lower levels of taxation lead to higher levels of disposable income and an increase in consumption. An increase in consumption results in higher aggregate demand and higher gross domestic product (GDP).

Firms will respond to an increase in demand and higher GDP by increasing production, which requires more workers. Therefore, there will be less cyclical unemployment. Additionally, when there is strong economic growth and higher aggregate demand, there are fewer job losses, because companies remain in business.

The economist John Maynard Keynes was a proponent of expansionary fiscal policy during recessionary periods. According to Keynes, there are idle resources—capital and labor—during a recession. Therefore, it is the job of the government to create additional demand and intervene in order to reduce unemployment.

Using Expansionary Monetary Policy to Reduce Unemployment

The goal of expansionary monetary policy is to increase aggregate demand and economic growth through cutting interest rates. Lower interest rates mean that the cost of borrowing is lower. When it’s easier to borrow money, people spend more money and invest more. This increases aggregate demand and GDP and decreases cyclical unemployment. In addition, when interest rates are lower, exchange rates are also lower, and an economy’s exports are more competitive.

Sometimes policymakers may also introduce specific initiatives that target particular areas of the economy in order to reduce unemployment and increase output. Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, giving businesses cash incentives for hiring workers, and paying businesses to train workers to fill specific positions.

The Bottom Line

Although it's a natural occurrence in economic contractions, cyclical unemployment can worsen the effects, dampening demand and even extending the contraction. To combat cyclical unemployment, governments often stimulate demand through expansionary fiscal or monetary policies. That results in increased output and can be enough to improve liquidity in the money supply, encourage investment, and get unemployment back to pre-recesson levels.