5.2 Natural Rate of Unemployment
5 min read•august 15, 2024
Unemployment isn't just about people without jobs. It's a complex economic concept with different types and causes. The is key to understanding how the job market works in the long run.
This rate includes (people between jobs) and (skill mismatches). It's the lowest sustainable unemployment level and plays a crucial role in economic stability and growth.
Natural Rate of Unemployment
Definition and Relationship to Full Employment
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Top images from around the web for Definition and Relationship to Full Employment
CBO’s Unnatural Estimates of the Natural Rate of Unemployment | CEPR Blog | CEPR View original
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Information Transfer Economics: Latest unemployment numbers and structural unemployment View original
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Who Counts in Unemployment? | Macroeconomics with Prof. Dolar View original
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- The natural rate of unemployment is the unemployment rate that exists when the economy is at , meaning all available resources are being used efficiently
- Full employment does not mean zero unemployment, as there will always be some level of frictional and structural unemployment in the economy
- Frictional unemployment occurs when workers are temporarily unemployed due to the normal turnover in the labor market (job searching, transitioning between jobs)
- Structural unemployment occurs when there is a mismatch between the skills and qualifications of unemployed workers and the requirements of available jobs
- The natural rate of unemployment is the sum of frictional and structural unemployment and is considered the lowest sustainable level of unemployment in the long run
- When the actual unemployment rate is equal to the natural rate, the economy is said to be at full employment and operating at its
- Deviations from the natural rate of unemployment can lead to changes in inflation and economic growth (, )
Factors Influencing Natural Unemployment
Frictional Unemployment
- Frictional unemployment is short-term and is considered a natural part of the
- Factors that contribute to frictional unemployment include:
- Voluntary job changes as workers seek better opportunities or career advancement
- , such as new graduates entering the workforce or workers retiring
- Time required for job search and matching, as workers and employers take time to find suitable matches
- Examples of frictional unemployment:
- A recent college graduate searching for their first job in their field of study
- A worker who quits their current job to look for a higher-paying position elsewhere
Structural Unemployment
- Structural unemployment is longer-term and can result from changes in technology, shifts in industrial composition, or changes in the geographic location of jobs
- Factors that contribute to structural unemployment include:
- , such as automation replacing certain jobs (manufacturing, data entry)
- , leading to jobs being outsourced to other countries with lower labor costs
- Changes in consumer preferences, causing a decline in demand for certain products or services (VCRs, travel agencies)
- Examples of structural unemployment:
- A factory worker whose job is replaced by an automated assembly line
- A coal miner who loses their job due to a shift towards renewable energy sources
Institutional Factors
- The natural rate of unemployment is affected by various institutional factors, which can influence the incentives for workers to search for jobs and for firms to hire
- These factors include:
- , which can increase labor costs and reduce the number of low-skilled jobs available
- , which can extend the duration of unemployment by reducing the urgency to find a new job
- , such as employment protection legislation, which can make it more difficult for firms to hire and fire workers
- Examples of institutional factors:
- A state raising its minimum wage, leading to some small businesses reducing their workforce
- A worker receiving unemployment benefits and taking longer to find a new job than they would have without the benefits
Natural Unemployment and Potential Output
Relationship between Natural Unemployment and Potential Output
- Potential output is the maximum sustainable level of output that an economy can produce when all its resources, including labor, are fully employed
- The natural rate of unemployment corresponds to the level of employment at which the economy is producing at its potential output
- When the actual unemployment rate is below the natural rate, there is upward pressure on wages and prices, as firms compete for scarce labor, leading to an increase in inflation
- When the actual unemployment rate is above the natural rate, there is downward pressure on wages and prices, as there is an excess supply of labor, leading to a decrease in inflation
Impact of Changes in Natural Unemployment on Potential Output
- Changes in the natural rate of unemployment can affect potential output
- A higher natural rate of unemployment implies a lower level of potential output, as more resources (labor) are underutilized
- A lower natural rate of unemployment implies a higher level of potential output, as more resources (labor) are being used efficiently
- Examples of factors that can change the natural rate of unemployment and affect potential output:
- Improvements in education and training, which can reduce structural unemployment and increase potential output
- Demographic shifts, such as an aging population, which can increase the natural rate of unemployment and reduce potential output
Deviations from Natural Unemployment
Inflationary Gap
- When the actual unemployment rate is below the natural rate, there is an inflationary gap, as exceeds potential output
- This situation leads to , as firms compete for scarce labor, putting upward pressure on wages and prices
- Policymakers may respond to an inflationary gap by implementing contractionary monetary or fiscal policies to reduce aggregate demand and bring the economy back to full employment
- Examples of contractionary policies:
- The central bank raising interest rates to discourage borrowing and spending
- The government reducing spending or increasing taxes to decrease aggregate demand
Recessionary Gap
- When the actual unemployment rate is above the natural rate, there is a recessionary gap, as aggregate demand falls short of potential output
- This situation leads to a decline in economic growth and an increase in , as firms reduce production and lay off workers
- Policymakers may respond to a recessionary gap by implementing expansionary monetary or fiscal policies to stimulate aggregate demand and bring the economy back to full employment
- Examples of expansionary policies:
- The central bank lowering interest rates to encourage borrowing and spending
- The government increasing spending or reducing taxes to boost aggregate demand
Long-run Adjustments
- In the long run, deviations from the natural rate of unemployment are expected to be temporary, as wages and prices adjust to bring the economy back to full employment and the natural rate of unemployment
- This adjustment process occurs through the of the economy, as changes in wages and prices create incentives for firms and workers to adjust their behavior
- Examples of :
- During an inflationary gap, rising wages and prices may reduce the competitiveness of firms, leading to a decrease in aggregate demand and a return to the natural rate of unemployment
- During a recessionary gap, falling wages and prices may make it more attractive for firms to hire workers, leading to an increase in aggregate demand and a return to the natural rate of unemployment
Key Terms to Review (28)
Aggregate Demand: Aggregate demand represents the total demand for all goods and services in an economy at a given overall price level and in a given time period. It is a critical component in understanding how various factors, including consumption, investment, and government spending, interact to influence economic activity and overall demand in the economy.
Contractionary fiscal policy: Contractionary fiscal policy is a government strategy aimed at reducing public spending and increasing taxes to decrease overall demand in the economy. This approach is often used during periods of economic growth or inflation to stabilize the economy by slowing down spending, thereby helping to maintain price stability and control inflationary pressures.
Contractionary monetary policy: Contractionary monetary policy is a form of economic policy that aims to reduce the money supply and increase interest rates to curb inflation and stabilize the economy. By making borrowing more expensive, this policy helps control excessive spending and investment, which is crucial in times of economic overheating. It is often implemented through tools such as open market operations, changes in reserve requirements, and adjustments to the discount rate.
Cyclical unemployment: Cyclical unemployment refers to the type of unemployment that occurs due to fluctuations in the economic cycle, specifically during periods of economic downturn or recession. When the economy slows down, demand for goods and services declines, leading to reduced production and consequently, layoffs and higher unemployment rates. This form of unemployment is directly linked to changes in the business cycle and is an important aspect of understanding broader economic dynamics.
Demand-pull inflation: Demand-pull inflation occurs when the overall demand for goods and services in an economy exceeds the supply, leading to an increase in prices. This type of inflation often arises in a growing economy where consumers, businesses, and government spending rise significantly, creating upward pressure on prices. It connects closely with the causes of inflation, the relationship depicted in the Phillips Curve, the phases of the business cycle, and its impact on the natural rate of unemployment.
Edmund Phelps: Edmund Phelps is an influential economist known for his work on the natural rate of unemployment and the concept of expectations in economic models. His research helped establish the idea that there is a level of unemployment consistent with stable inflation, which significantly impacted macroeconomic policy and theory. Phelps' contributions have broadened our understanding of how labor markets function and the interplay between inflation and unemployment.
Expansionary fiscal policy: Expansionary fiscal policy is a government strategy used to stimulate economic growth by increasing public spending or reducing taxes. This approach aims to boost aggregate demand, encourage investment, and create jobs, particularly during periods of economic downturn or high unemployment.
Expansionary monetary policy: Expansionary monetary policy is a macroeconomic strategy used by central banks to stimulate economic growth by increasing the money supply and lowering interest rates. This approach aims to boost consumer spending and investment, ultimately leading to higher levels of employment and economic activity. The effectiveness of this policy is influenced by various factors, including the tools employed by the central bank, the responsiveness of the economy, and potential limitations that may arise in certain economic conditions.
Frictional unemployment: Frictional unemployment refers to the short-term unemployment that occurs when individuals are temporarily without a job while transitioning from one position to another or entering the workforce for the first time. This type of unemployment is a natural part of a dynamic economy, reflecting the time it takes for workers to find jobs that match their skills and preferences.
Full Employment: Full employment refers to the condition in which all available labor resources are being used in the most efficient way possible, typically implying that there is no cyclical unemployment and that any remaining unemployment is due to frictional or structural factors. This concept connects deeply with the balance between economic output, labor market efficiency, and stabilization measures that aim to maintain a healthy economy.
Globalization: Globalization is the process by which businesses, cultures, and economies become interconnected and interdependent on a global scale. This phenomenon has led to increased trade, investment, and communication across national borders, influencing how countries interact and share resources. The impact of globalization extends to labor markets, production processes, and the distribution of goods and services worldwide.
Inflationary Gap: An inflationary gap occurs when the actual output of an economy exceeds its potential output, leading to upward pressure on prices. This situation often arises during periods of economic expansion, where demand outstrips supply, causing inflation to rise. An inflationary gap indicates that resources are being utilized beyond their sustainable limits, resulting in increased production costs and potentially unsustainable economic growth.
Job search process: The job search process refers to the steps and strategies individuals use to find employment, including identifying job opportunities, preparing application materials, networking, and interviewing. This process is influenced by various factors such as the labor market conditions and the individual's skills, qualifications, and personal circumstances. Understanding the job search process is crucial for navigating the complexities of employment and its relationship to the natural rate of unemployment.
Labor Market Entry and Exit: Labor market entry and exit refers to the process of individuals entering or leaving the workforce, impacting employment levels, unemployment rates, and overall economic activity. This dynamic is crucial for understanding fluctuations in the labor market, as it relates to factors such as job creation, job destruction, and the natural rate of unemployment, which represents the level of unemployment that exists when the economy is at full capacity.
Labor Market Regulations: Labor market regulations refer to the laws and policies governing the hiring, firing, wages, working conditions, and rights of workers within an economy. These regulations aim to protect workers' rights, ensure fair treatment, and maintain a balanced labor market. They can influence the natural rate of unemployment by affecting how easily firms can hire and fire employees, as well as how wage levels are determined in relation to labor supply and demand.
Long-run adjustments: Long-run adjustments refer to the economic changes that occur when markets have had enough time to reach equilibrium after a disturbance or shock. These adjustments involve shifts in prices, wages, and employment levels as the economy moves toward its natural state, ultimately affecting factors like the natural rate of unemployment and overall economic output.
Milton Friedman: Milton Friedman was an influential American economist known for his strong belief in the importance of free markets and limited government intervention in the economy. His ideas significantly shaped macroeconomic thought, particularly around consumption, inflation, and monetary policy, advocating for the role of money supply in influencing economic activity.
Minimum wage laws: Minimum wage laws are regulations set by the government that establish the lowest amount of compensation that employers must pay their employees for work performed. These laws aim to protect workers from exploitation and ensure a basic standard of living, while also influencing labor market dynamics and employment levels.
Nairu - non-accelerating inflation rate of unemployment: The nairu, or non-accelerating inflation rate of unemployment, is the level of unemployment at which inflation does not accelerate. It reflects the balance in the labor market where the economy can operate without triggering inflationary pressures. This concept connects closely to the natural rate of unemployment, highlighting how structural factors in the economy determine both unemployment levels and price stability.
Natural Rate of Unemployment: The natural rate of unemployment is the level of unemployment that exists when the economy is at full employment, accounting for frictional and structural unemployment but not cyclical unemployment. It reflects the economy's normal turnover and adjustments in the labor market, ensuring that individuals who are temporarily out of work or transitioning between jobs are factored in. Understanding this rate helps policymakers gauge the health of the labor market and make informed decisions regarding monetary and fiscal policies.
Phillips Curve: The Phillips Curve illustrates the inverse relationship between the rate of inflation and the rate of unemployment in an economy, suggesting that as inflation rises, unemployment tends to decrease, and vice versa. This concept connects key economic indicators and helps understand trade-offs policymakers face when addressing inflation and unemployment.
Potential Output: Potential output refers to the highest level of economic activity that an economy can sustain over the long term without increasing inflation. It represents the maximum productive capacity of an economy when all resources are used efficiently. This concept is crucial as it helps identify the output gap, which is the difference between potential output and actual output, and is tied to understanding economic cycles and labor markets.
Recessionary gap: A recessionary gap occurs when an economy's actual output is lower than its potential output, leading to increased unemployment and underutilized resources. This situation indicates that the economy is not operating at full capacity, and it typically arises during economic downturns or recessions. The presence of a recessionary gap highlights the need for policy interventions to stimulate demand and restore full employment.
Self-correcting mechanism: A self-correcting mechanism is an economic concept referring to the inherent ability of an economy to return to its long-term growth path following a disturbance or shock. This process often occurs through adjustments in wages and prices that help eliminate imbalances in the labor market, enabling the economy to move towards its natural rate of unemployment over time.
Structural unemployment: Structural unemployment occurs when there is a mismatch between the skills of the labor force and the skills needed for available jobs, often due to technological advancements or changes in consumer preferences. This type of unemployment highlights the long-term issues within the economy, as it suggests that workers may need retraining or education to find new jobs. It connects with broader discussions about the economy's performance, labor market dynamics, and how different factors can create persistent joblessness.
Technological Change: Technological change refers to the process through which new technologies are developed and adopted, leading to shifts in production methods, efficiencies, and overall economic growth. This change plays a vital role in enhancing productivity, creating new industries, and changing the dynamics of labor markets, which can significantly affect employment levels and types of jobs available.
Unemployment insurance: Unemployment insurance is a government-provided financial support system that offers temporary assistance to individuals who have lost their jobs through no fault of their own. This program aims to stabilize the economy by providing a safety net for unemployed workers, helping them meet their basic needs while they search for new employment opportunities. It is also closely linked to the measurement of unemployment and can influence the natural rate of unemployment by affecting workers' decisions to accept new jobs or remain in the labor market.
Wages and prices adjustments: Wages and prices adjustments refer to the changes in the levels of wages and prices in response to shifts in economic conditions, such as demand and supply factors. These adjustments play a crucial role in maintaining equilibrium in the labor market and overall economy, impacting the natural rate of unemployment as they influence hiring decisions and consumer behavior. When wages and prices adjust appropriately, they help to smooth out fluctuations and restore balance within the economy.