How will Investment Spending and Interest Rates
affect Unemployment in the Next Seven Years?

 

TRACI PUDELSKI and ERIK EKEBERG
College of Business
Western Carolina University
 

Abstract

U.S. employment is expected to be between 5.6 percent and 7.4 percent during the next seven years. This forecast is based on the Keynesian aggregate expenditure model using unemployment rates, investment spending, and interest rates as the explanatory variables. The relation between the unemployment rate and the explanatory variables is weak. The R-square indicated that only 13.32 percent of the variation in the unemployment rate is explained by the other three variables (unemployment, investment spending, and interest rates). This low R-square could be a result of the three variables being lagged seven years. According to the forecast the workforce is going to increase considerably over the next seven years (JEL: E22, E24).

Part 1. Introduction


 

This paper forecasts the monthly unemployment rate for the years between and including 2000 and 2006.The data period used is from January 1980 through December 1999.The data includes the high rise in interest rates at the beginning of the recession in 1981 up until the end of the available data in 1999.The explanatory variables are previous unemployment rates, private domestic investment, and interest rates.The forecast is for seven years and is based on the Keynesian aggregate expenditure model and the relationships between investment spending, interest rates, and unemployment.This model is easy to understand and explains the relationships between the variables accurately.
 
 

Using the sample data to predict unemployment into the future allows the government and prospective employers to plan for the surplus and/or deficit of capable employees.This forecast will assist in deciding on future regulations, projects, expansions, cutbacks, tax rates, etc.A forecast of unemployment rates will also be valuable for current and future employees.Current employees will have some idea of their level of job security and future employees will have some idea of the difficulty in entering the workforce.
 
 

Because the forecast horizon covers seven years, the forecast could have possible inaccuracies.The sample data used, which includes a significant recession, could also be a factor of inconsistencies in the results.Taking into account any possible discrepancies, the rest of the paper is divided into five other sections starting with: Part 2. explains the data being used to predict the unemployment rate; Part 3. presents the economic theory and relationships between the variables in order to predict the unemployment rate; Part 4.displays the empirical results and discusses the validity of those results; Part 5.evaluates the importance of the forecast for the economy; Part 6. and discusses conclusions and possible explanations.

Part 2. Data

All of the variables are taken from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED).The measures for Real Gross Private Domestic Investment, the Civilian Unemployment Rate, and the 30-Year Constant Maturity Rate are FRED variables GPDIC1, UNRATE, and GS30, respectively.
 
 

Real Gross Private Domestic Investment (GPDIC1) is given in billions of chained 1996 dollars at seasonally adjusted annual rates.The primary source of the data for this variable is the U.S. Department of Commerce, Bureau of Economic Analysis.As a result of this variable (GPDIC1) being observed quarterly and the other two variables (UNRATE and GS30) being observed monthly, data manipulation was conducted on GPDIC1 to convert it into monthly observations.In order to make the time frame consistent with the other two variables, each quarterly observation of the GPDIC1 variable was duplicated for the

following two consecutive months of each quarter corresponding to each individual observation (e.g., the observation in 1980.1 of 711.7 was duplicated to 1980.2 and 1980.3).
 
 

The Civilian Unemployment Rate is seasonally adjusted and is given as a percentage of the total population.The primary source of the data for this variable (UNRATE) is the U.S. Department of Labor, Bureau of Labor Statistics.The other variable (GS30) is given as a percentage and is based on averages of business days.The primary source of this variable is the Federal Reserve Board of Governors - H.15 Release.Neither of these variables required any type of data manipulation.
 
 

The forecast is for seven years into the future.Retrieving the information and preparing the data in order to perform a regression and calculate a forecast for the next seven years was relatively easy.However, forecasting this far into the future will obviously include inaccuracies.Using seven years to forecast means that a larger time period of previous data has to be used.Using a larger time frame of sample data increases the probability that certain observations in the sample data will not be typical in the forecasted time period.For example, the following graph (Figure 1) shows that the unemployment rate was forecasted to increase by nearly 1.5% in the first month of 2000.
 

 
Such an increase is almost impossible unless the economy fell into a major recession, as was seen in the 1980s, for example.The variables used to forecast the unemployment rates did not have any type of strong relationship with the forecasted variable.Considering this, along with the fact that the time period of sample data used included inconsistencies that would not normally occur (severe recession in the early 1980s), an accurate forecast is hardly expected.There are large fluctuations in the unemployment rates during the time period of the sample data.This is important because those fluctuations are incorporated into and will affect the forecast.Including the recession in the early 1980s  in the sample data demonstrates large inconsistencies in the economy that are very unlikely in the forecasted time period.

 

Part 3. Economic Theory

There are several assumptions made in the forecast.The first assumption is that consumption, government spending, and net exports will be held constant and not be included in determining GDP.Another assumption is that investment spending and interest rates determine the unemployment rate.The forecast also assumes that the least squares regression method is the most accurate and consistent given this type of sample data.The final assumption is that the sample data period as well as the seven-year forecast horizon is the most appropriate.The forecast starts with the Keynesian aggregate expenditure model to develop a forecast of the unemployment rates between and including the years 2000 and 2006.
Y = GDP = C + I + G + X = C + I + G + (EX IM)

Where Y is real GDP, C is consumption spending, I is investment spending, G is government spending, and X or (EX IM) is net exports.Net export (X) equals exports (EX) minus imports (IM).Simplifying the Keynesian model by applying the assumption that certain factors can be held constant, we can rewrite the model as:

Y = f (I)

The next step is to introduce the aggregate production function, which is written as:

Y = f (L, K)

Where L is labor and K is capital.This equation can be rewritten as:

Y = f (L)

Stated this way, GDP is written as a function of labor, which allows the forecast to conclude that GDP is also a function of the employment rate, and inversely a function of the unemployment rate.The relationship between GDP (Y) and the unemployment rate (u) can be rewritten as:

u = f (Y)

Last is the relationship between investment spending and interest rates (r):

I = f (r)

Using this principle there is a presumed relationship between interest rates, investment spending, and unemployment rates.Combining these principles together, the hybrid model of unemployment can be written as:

u = f (u, I, r)

After lagging the right hand side of the equation seven years (84 months), the forecasting equation is written as:

ut = A0 + A1 (ut-84) + A2 (It-84) + A3 (rt-84)(1)

The constants A0, A1, A2, and A3 in the equation are estimated coefficients, which are calculated in the regression and reported in Table 1 on the following page.The first coefficient is an intercept and the other three are estimated coefficients assigned to the variables of unemployment rates, investment spending, and interest rates.

Part 4.A Seven Year Forecast of the Unemployment Rates

The unemployment function, equation 1, was estimated with 1980.1-1999.12 monthly data.The least squares regression method was used.The regression estimate is:

ut = 1.247361 + 0.009416 (ut-84) + 0.002834 (It-84) + 0.210681 (rt-84)


Table 1

Regression Estimate of Unemployment Forecasting Equation 1: 1980.1-1999.12

Explanatory variable
Estimated coefficient
t-ratio probability level
Intercept
1.247360664
0.791416
Ut-84
0.009415685
0.112586
It-84
0.002833896
2.479976
Rt-84
0.210680676
4.806573
R2 = 0.133821389
F (zero slopes) = 7.827812
Prob F = 6.18793x10-05

The R-square of the estimate is 0.133821 as shown in Table 1, indicating that approximately 13.4 percent of the variation in unemployment is explained by variation of the variables: past unemployment, past real private domestic investment spending, and 30-year T-bill interest rates.This is a weak relationship and actually does not explain the forecasted variable very thoroughly.The F-statistic is 7.827812 (Table 1), with a probability of 0.0000682.This is very good and indicates that the null hypothesis of zero slopes is strongly rejected.Although the T-statistic for ut-84 is outside the range of the absolute value of two, it was left in the forecast equation because it is the lagged dependent variable.Investment spending and interest rates were left in because the absolute value of the T-statistic was slightly above two and nearly five, respectively.Using the intercept and coefficients of the variables, the equation can be applied to forecast the unemployment rate for a random month:

u2001.1 = 1.247361 + 0.009416(6.8) + 0.002834(1057.3) + 0.210681(6.29) = 5.631078


Table 2

Forecasts of U.S. Unemployment Rate 2000.1-2006.12

(Given as a percentage)

Quarter

Forecast

2000.1
5.59674
2000.2
5.542186
2000.3
5.484361
2000.4
5.497857
2000.5
5.512605
2000.6
5.488489
2000.7
5.441406
2000.8
5.375153
2000.9
5.306794
2000.10
5.441045
2000.11
5.496046
2000.12
5.503532
2001.1
5.631078
2001.2
5.673214
2001.3
5.760759
2001.4
6.009103
2001.5
6.035774
2001.6
6.033667
2001.7
6.024262
2001.8
6.004359
2001.9
6.049767
2001.10
6.235298
2001.11
6.26291
2001.12
6.217725
2002.1
6.248178
2002.2
6.195731
2002.3
6.162022
2002.4
6.050755
2002.5
5.962493
2002.6
5.882434
2002.7
5.888338
2002.8
5.917833
2002.9
5.851581
2002.10
5.907089
2002.11
5.884855
2002.12
5.842719
2003.1
5.89795
2003.2
5.936097
2003.3
6.011942
2003.4
6.225129
2003.5
6.255566
2003.6
6.280129
2003.7
6.411724
2003.8
6.367928
2003.9
6.408899
2003.10
6.369068
2003.11
6.301426
2003.12
6.316174
2004.1
6.495518
2004.2
6.466023
2004.3
6.515645
2004.4
6.739049
2004.5
6.706505
2004.6
6.671631
2004.7
6.62489
2004.8
6.639637
2004.9
6.623724
2004.10
6.663394
2004.11
6.616102
2004.12
6.591762
2005.1
6.855944
2005.2
6.871857
2005.3
6.885439
2005.4
6.823207
2005.5
6.826255
2005.6
6.77874
2005.7
6.882218
2005.8
6.852723
2005.9
6.781092
2005.10
6.862357
2005.11
6.911979
2005.12
6.87195
2006.1
6.932603
2006.2
6.977787
2006.3
7.020147
2006.4
6.990963
2006.5
7.044798
2006.6
7.094196
2006.7
7.228357
2006.8
7.246376
2006.9
7.246376
2006.10
7.381253
2006.11
7.358078
2006.12
7.400215

Due to higher investment spending, this forecast predicts the unemployment rate to steadily increase over the next seven years, as shown in Table 2.As investment spending increases, interest rates will eventually rise.As interest rates increase, the price of consumer goods will rise as a result of inflation.Unemployment rates will start increasing due to lower margins.Those unemployment rates are not favorable for the economy and predict a downturn, or recession, that could possibly produce layoffs.

Part 5. Utilization Declines and the Worker is Unemployed

Many groups and individuals can use unemployment rates for estimates and planning future events and activities.This paper forecasts unemployment to steadily increase over the next seven years, reaching a high of 7.4 percent.This shows a drastic increase from the low unemployment levels that the country now enjoys.With increasing unemployment rates, more people will lose their jobs and income. On the other hand, there will be more employees in the workforce from which businesses can choose.State and federal governments will have to focus more of the budget on unemployment benefits.The higher unemployment rate means more people will be competing for fewer jobs and markets will weaken.

Part 6. Conclusion

Civilian unemployment is projected to rise considerably.The average unemployment rate will be 6.33 percent, but will rise to 7.4 percent in December of 2006 (Table 2).This increase in unemployment rates is devastating to present and future employees in the workforce, but favorable to businesses looking for a cheaper labor market.Unfortunately, higher unemployment rates will mean investment spending and consumer spending will continue to decrease because as unemployment increases people will start planning for emergencies and any unforeseen contingencies in the future.If this forecast does come to pass, businesses will be able to be more particular about whom they hire and what they offer to their employees.On the other hand, this cheaper labor is of no use if consumers are spending less.Another implication of higher unemployment rates is that with investors less willing to loan funds, interest rates will rise and it will cost businesses more to finance operating activities.Businesses can help to reduce these higher unemployment rates by reducing layoffs and cutbacks as much as possible.If consumers are employed they are more likely to spend and/or invest extra savings instead of planning for emergencies.There are also some possible actions the government and/or Federal Reserve can take.The government could increase spending, which would increase economic activity.Another possibility is for the Federal Reserve to lower interest rates, which would induce businesses to invest and as a result help to steady and/or lower unemployment.

Reference

Federal Reserve Bank of St.Louis, Federal Reserve Economic Data (FRED) (12-31-98), http://www.stls.frb.org/fred/, (2-16-00).