How Unemployment Rates Affect The Economy

by Paul Hudson

After new heights the past few months, the S&P 500 just had the worst week of the year due to a disappointing jobs report. The Dow Jones lost more than 40 points, the Nasdaq dropped 0.7% and the S&P 500 fell 0.4% just on Friday. But how/why does the unemployment rate affect the stock market?

In addition to many different indicators such as GDP, inflation and interest rates, the unemployment rate of a country is a very common measure for determining the health of an economy. I am sure that in your first economics class you learned that unemployment is a key macroeconomic indicator to determine the health of an economy.

However, there is an ongoing debate regarding the extent to which the stock market should be guided by unemployment rates. It is a really simple argument, it should be merely common sense. If there are fewer people with jobs, then they have less disposable income to spend on investments.

Economists call unemployment a lagging indicator of the economy, as the economy usually improves before the unemployment rate starts to rise again. However, unemployment causes a sort of ripple effect across the economy.

With one person losing his job, there is one less person that will pay state and federal income taxes, one less person that will pay additional sales tax revenue as a laid off worker will instantly cut back on their non-necessary spending due to less disposable income and worry about future financial security.

This is an issue, as many countries are facing a big debt crisis that requires higher tax revenues to prevent a default. If the country’s government is not financially stable, then the banks and the whole financial system will experience a decrease in confidence translating to a downturn in the value of the stock market.

In addition, practically every unemployed citizen in the U.S. will become eligible for unemployment insurance and will start slowly sucking money from the economy rather than contributing to it in the form of taxes, thus increasing the State's deficits and tax revenue.

If the rate continues to rise quarter by quarter, the State will probably raise taxes in order to compensate for that loss in tax revenue, thus forcing everyone, both employed and unemployed, to experience a loss of disposable income. Again that loss in disposable income becomes a ripple effect, and less money will be spent in the economy, leading to more people losing their jobs and it starts to become a vicious cycle unless it is broken by changes in policy or other factors.

In addition there is the issue of the real estate market. Studies have shown that 45% of mortgages fall into foreclosure as a direct result of unemployment, thus with a rising rate of unemployment, foreclosure rates will also rise, leading bankruptcy rates to rise and the home values to fall. Hopefully the economy will soon get back on track to its record high.

Juan Martinez | Elite.