Determinants of AFDC Caseload Growth. 1. The Dynamic Effects of an Unemployment Rate Increase

07/01/1997

We consider below the dynamics of the effects of a one-percentage point increase in the unemployment rate (i.e., an increase from 5 percent to 6 percent--a 20 percent increase in the unemployment rate) on the caseload under the two hypothetical scenarios for the unemployment rate series. Under both scenarios, the unemployment rate is constant at 5.0 percent for at least 14 quarters before it increases by one percentage point, to 6.0 percent. Under the "temporary increase" scenario, the rate stays at 6.0 percent for one quarter then returns to 5.0 percent and remains there for at least the next 14 quarters. Under the "permanent increase" scenario, the rate stays at 6.0 percent for at least the next 14 quarters. Assume also that all other factors are constant during the relevant period.

Under both scenarios, the estimated initial effect of the one percentage point increase in the unemployment rate on the caseload is 0.7 percent for the Basic program and 3.7 percent for the UP caseload. Even if the unemployment rate increase is temporary, according to the estimates its effect on the caseload will be felt for the next three and one-half years (Exhibit 5.7). Both caseloads start to decline immediately.(16) The decline is faster for the UP caseload than for the Basic caseload, but the UP caseload increased by much more in the first place. By the end of the second year after the temporary increase, both caseloads are above their original levels by about half the initial increase.

If the unemployment rate increase is permanent, the effects of the increase accumulate (Exhibit 5.8). One year after the change the Basic caseload is 2.8 percent higher than originally and the UP caseload is 14.5 percent higher. The increase continues, but at a decreasing rate. By the end of the second year the Basic caseload is 4.3 percent above its original level and the UP caseload is 20.4 percent higher. The caseloads continue to gradually increase, to 5.7 percent and 25.9 percent higher than their original levels after 3.5 years (14 quarters ).

Real recessions are different than either of these stylized scenarios. The increase in the unemployment rate is usually substantially greater than in this example. For instance, from 1989 to 1992 the unemployment rate increased by about two percentage points, and from 1979 to 1983 it increased by about four percentage points. Hence, the magnitude of a recession's effect may be two to four times as large as indicated here. Second, increases in the unemployment rate of substantial magnitude are seldom if ever as temporary as in the first scenario and do not increase and remain indefinitely constant at a higher level as in the second. Instead, they increase and decrease gradually over long periods. In both recessions in the sample period, they stayed close to their peak levels for about two years. This is well short of the 3.5 years in the permanent change scenario. At the same time, however, in each case the rate stayed above 6.0 percent for at least three years. In fact, for the seven years from 1980 to 1986 the average monthly unemployment rate was at or above 7.0 percent every year.

In summary, according to the estimates a recession can result in very large cumulative increases in both programs' caseloads, and higher caseloads are likely to remain above pre-recession levels for three or more years after the economy recovers.