How Does the Unemployment Rate Work?

Learn What the Unemployment Rate is and Why it Matters at Read on Now!

The unemployment rate is one economic indicator used to gauge the health of a country's economy. Calculated based on monthly household surveys by governments and statistical agencies, it measures how many people who are willing and able to work do not have jobs and are actively looking for employment.

The Bureau of Labor Statistics (BLS) in the United States defines the unemployed as individuals without jobs who are able, available and actively seeking work. This definition is used when calculating all three types of unemployment rates: U-1 through U-6.

U-1, also known as the "official" unemployment rate (called this because it's what official organizations like the International Labor Organization report), is the percentage of unemployed people who are actively seeking employment within the past four weeks. It does not include discouraged workers, those working part-time involuntarily or marginally attached workers (those who have given up looking for jobs). Those numbers can be found in U-2 through U-6.

What Does Unemployment Mean for the Economy?

Economists and investors look at the unemployment rate to get a better idea of how well the economy is doing. When the unemployment rate is high, it generally means workers are experiencing more difficulty finding jobs and earning money for their needs. In turn, they have less disposable income to spend on goods and services that drive economic growth. This can also lead to higher inflation rates and lower GDP (gross domestic product) growth, since low unemployment usually means a tight labor market that encourages employers to offer higher salaries for new hires and entice people to leave their positions and work elsewhere.

When the jobless rate is on the rise, it can indicate an economic slowdown or impending recession. Conversely, when the unemployment rate is falling, it can mean that the economy has been growing and employers are feeling confident enough to add jobs.

What Does Unemployment Mean for Stock Markets?

Unexpected movements in a country's unemployment rate can have a huge impact on its stock market. In fact, evidence shows there may be a significant correlation between changes in the unemployment rate and changes in the stock market.

One study by two professors at California Polytechnic State University found that when unemployment rose on a month-to-month basis, the S&P 500 lost an average of 0.37%; however, on a day-to-day basis, this figure rose to 1.48%. This means that a large-scale expansion of unemployment leads to a significant reduction in stock market performance.

When unemployment is low, it usually means that the economy has been growing and consumers feel secure in their employment. One way investors can determine if a country's unemployment rate will have a significant impact on its stock market is by looking at how much of an effect it had during previous recessions.

In the United States since 1945, every time the country's unemployment rate has gone above 6.5%, the S&P 500 declined and did not recover until it reached that point again. This means that if we estimate that a 1% change in the unemployment rate leads to a 0.13% change in the S&P 500, then if it rises to 7%, we can expect a 13% drop in the market when it eventually does recover.

This information can be used to forecast when a recession will begin. When the unemployment rate reaches 6.5%, investors are forced to consider whether or not the economy is strong enough for them to invest their money. If they believe it is, then they continue investing money into the stock market. However, if they believe a recession will occur soon, they may stop investing money and opt to keep it in a safer place. This withdrawal en masse from the market can cause stocks to drop suddenly as investors look for other opportunities that offer more safety.

The Unemployment Rate and the Consumer

People who work in the financial industry, such as portfolio managers and traders, look for indicators of how well the economy is doing by examining economic data like unemployment rates. Market reaction to the unemployment rate occurs not only due to its impact on the economy, but also because it can predict consumer confidence and spending.

When unemployment is high, workers may fear being laid off or have difficulty getting new jobs, so they are less likely to spend their disposable income. Due to this decrease in consumer spending , the economy will be hit by a negative shock that can cause GDP to fall and inflation rates to rise.

One way that investors look at the health of an economy is through consumer confidence indexes. These measure how willing consumers are to spend on big-ticket items like clothing, cars and appliances. When the unemployment rate is high, consumer confidence tends to decrease, so investors may sell their stocks in anticipation of an economic slowdown.

However, if the uptick in unemployment rates is expected to be temporary or improvements are already happening, then some investors may not see any reason to reduce their investments.

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