Why the unemployment rate does not tell the whole story about the state of the economy

Imagine a state, State X, with a population of 2,000 people.  Assume 1,000 of those people are children, stay-at-home moms, and retired people.  The other 1,000 are either working full time or are out of work and actively looking for a job.  Thus, the “labor force” is 1,000 people and what the Bureau of Labor Statistics (BLS) calls the “labor participation rate” is 50%.

Now assume that there are only 900 total jobs in State X.  That will mean that the remaining 100 people in the labor force are unemployed and looking for a job.  The unemployment rate is 100 ÷ (divided by)1,000 = 0.10, or 10%.  None of the unemployed are not going to find a job unless some net new jobs are created.  If in the current month 50 new jobs are created and 50 of the 100 unemployed take those jobs, the number working increases to 950 and the number of unemployed decreases to 50.  The unemployment rate also decreases to 5%, calculated as 50÷1000=.05.

Pretty straightforward so far, right?

OK, let’s assume that instead of 50 new jobs created in the current month, assume no new jobs are created.  Now instead of 50 people getting jobs this month, 50 people become discouraged and give up looking for jobs.  According to how the BLS measures the labor participation rate, it has declined to 47.5%, calculated 950 ÷2,000=0.475 or 47.5%.  What is the new unemployment rate?  It has also declined to 5.26%, calculated 50÷950=.0526 or 5.26%.

Suppose Barry Okadokee is governor of State X and he is running for re-election.  His re-election slogan is “I lowered unemployment in our state from 10% to 5.26% in one month!”  It’s true that State X’s unemployment rate declined by exactly that figure, but the total number of jobs remained the same.  The total number of people out of work remained the same.  But since 50 of those people have given up looking for work they are no longer counted as unemployed. Thus, without any improvement in State X’s economy the unemployment rate has declined and given a false picture of the health of the economy in State X.

It turns out that we must look not only to whether the unemployment rate fell, we must also ask what made it fall.  Was it the creation of new jobs, or was it a decline in the labor participation rate?  If the latter, the new lower unemployment rate is not good news after all.

Keep this in mind as you read about Iowa’s unemployment rate being lower than the national unemployment rate, but Iowa is suffering a double dip recession.

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