Simone Lawson
The natural rate of unemployment is a key concept in the study of economic activity. It is the unemployment rate that persists in a well-functioning, healthy economy considered to be at full employment. This is a hypothetical unemployment rate that exists when the labour market is in perfect equilibrium. The natural rate of unemployment is caused by both voluntary and involuntary factors, including labour market flexibility, wage rigidity, structural factors, and changes in minimum wage laws. It is important to note that the natural rate of unemployment does not imply zero unemployment, as there is always movement of labour and workers transitioning from job to job. Economists generally agree that there is a natural rate of unemployment that the economy tends towards in the long run.
| Characteristics | Values |
|---|---|
| Definition | The natural rate of unemployment is the rate of unemployment when the labour market is in equilibrium. |
| Causes | Frictional unemployment, structural unemployment, wage rigidity, changes in minimum wage laws, institutional factors, economic shocks, lack of demand for labour, wage inflation, and cyclical shifts in investment sentiments. |
| Effects | Higher unemployment rates, reduced GDP, and inflation. |
| Reduction Strategies | Supply-side policies, better education and training, more flexible housing markets, more flexible labour markets, improved job market information, subsidizing training programs, and reducing unemployment benefits. |
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What You'll Learn
Structural unemployment
To reduce structural unemployment, governments can provide support in the form of education or training to help unemployed individuals increase their skills for finding a job in a new industry. Making it easier for workers and firms to relocate can also help, for example, through a more flexible housing market and greater supply of housing in areas of high job demand.
Despite its challenges, addressing structural unemployment is crucial as it can increase the natural rate of unemployment if left unaddressed. The natural rate of unemployment is the minimum unemployment rate resulting from real or voluntary economic forces, such as workers moving from job to job or those lacking the skills to gain employment. It is the unemployment rate that corresponds to a classical view of economic activity, mainly determined by the economy's supply side and production possibilities.
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Frictional unemployment
This type of unemployment is distinct from cyclical unemployment, which refers to the natural ebb and flow of an economy, and structural unemployment, which arises from economic shifts that make it challenging for workers to find work. Frictional unemployment can exist even during periods of full employment, as there will always be some movement in the labour market due to voluntary transitions.
The frictional unemployment rate is calculated by dividing the number of workers actively looking for jobs by the total labour force. While some level of frictional unemployment is expected and beneficial, prolonged or excessive frictional unemployment can have negative consequences. If job-seekers take too long to find new positions, they may experience frustration and a decline in motivation, leading to decreased productivity and a potential production decline in the economy.
To mitigate the negative impacts of frictional unemployment, various measures can be implemented. These include improving information exchange through social networks and online job boards to reduce matching time between job seekers and employers, encouraging employers to offer more flexibility, and addressing institutional factors such as minimum wage levels and unionization that may influence the natural rate of unemployment.
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Cyclical unemployment
Conversely, during economic expansions, demand for products and services increases, requiring more workers to meet the heightened demand. As the economy recovers, financial institutions resume lending, and consumers start buying homes or remodelling, causing real estate prices to climb. This, in turn, creates a demand for construction jobs, thereby reducing cyclical unemployment.
The impact of these economic cycles on the unemployment rate is a significant focus of economic policy. Governments employ various policy tools to stimulate the economy and moderate cyclical unemployment during recessions. One such tool is expansionary monetary policy, where central banks create money to buy government securities, lowering interest rates and increasing the money supply. This, in turn, encourages financial institutions to lend more and makes the money supply more liquid.
While natural unemployment and cyclical unemployment are distinct concepts, they are interconnected. Natural unemployment refers to the minimum unemployment rate resulting from structural factors, such as labour force composition and technological changes. It represents the equilibrium unemployment rate in an expanding economy. Cyclical unemployment, on the other hand, reflects the deviations from this natural rate due to economic fluctuations. Thus, understanding the natural rate of unemployment is crucial for policymakers in addressing cyclical unemployment and achieving full employment without triggering uncontrollable inflation.
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Involuntary unemployment
In a healthy economy, there is always movement of labour, which represents natural unemployment. For instance, new college graduates entering the workforce or workers displaced by technological advances may experience a period of unemployment before finding a new job. This type of unemployment is considered voluntary and is a result of real economic forces.
However, involuntary unemployment refers to situations where individuals are unable to find employment due to factors beyond their control. This can occur when there is a permanent mismatch in the labour market or real wage rigidities. For example, during a recession, workers may become deskilled or demotivated, leading to a rise in the natural rate of unemployment. This concept is known as hysteresis.
Structural unemployment, a form of involuntary unemployment, occurs due to a mismatch between the skills a worker possesses and the skills demanded by employers. For instance, a software engineer skilled in an outdated coding language may struggle to find employment if employers are seeking candidates with expertise in newer programming languages.
Frictional unemployment can also become involuntary when individuals are unable to find suitable employment within a reasonable timeframe due to a lack of job market information or inadequate access to job search resources. Governments can play a role in reducing involuntary frictional unemployment by decreasing information costs and making the job market more accessible.
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Full employment
The concept of "full employment" is often a target when an economy is performing well. However, it is a misnomer as there will always be some unemployment, even in a healthy economy. Full employment does not mean zero unemployment. It is a hypothetical unemployment rate consistent with aggregate production being at the "long-run" level. This level is consistent with aggregate production in the absence of various temporary frictions such as incomplete price adjustment in labour and goods markets.
The natural rate of unemployment is the unemployment rate that persists in a well-functioning, healthy economy that is considered to be at "full employment". It is a hypothetical rate of unemployment and suggests that there is never zero unemployment in an economy. Natural unemployment refers to the unemployment that exists when the labour market is in perfect equilibrium. The theory behind natural unemployment suggests that there is always unemployment, even in a healthy economy, due to the presence of frictional, structural, and cyclical unemployment.
Frictional unemployment occurs when workers are "in-between jobs", i.e., when people in the workforce are looking for jobs but are unable to find one yet. It includes recent graduates and employees facing unexpected layoffs that are actively searching. To reduce frictional unemployment, the government must focus its resources on decreasing information costs so that there is a higher amount of job market information present in the economy.
Structural unemployment refers to unemployment caused by a mismatch between the skills that a worker offers and those that employers demand. An example of structural unemployment is a scenario where a software engineer is skilled at a coding language that is outdated, which results in unemployment.
The natural rate of unemployment is mainly determined by the economy's supply side, and hence production possibilities and economic institutions. If these institutional features involve permanent mismatches in the labour market or real wage rigidities, the natural rate of unemployment may feature involuntary unemployment. The natural rate of unemployment is a combination of frictional and structural unemployment that persists in an efficient, expanding economy when labour and resource markets are in equilibrium.
According to the general equilibrium model of economics, natural unemployment is equal to the level of unemployment in a labour market at perfect equilibrium. This is the difference between workers who want a job at the current wage rate and those willing and able to perform such work.
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Frequently asked questions
The natural rate of unemployment is the unemployment rate that persists in a well-functioning, healthy economy that is considered to be at “full employment”. It is a hypothetical rate of unemployment and suggests that there is never zero unemployment in an economy.
Unexpected increases in productivity can cause the natural rate of unemployment to increase for a time. This is because when productivity increases unexpectedly, the pattern of wage increases does not adjust right away, and a gap opens where the quantity of labour supplied is greater than the quantity demanded. Other factors that can cause the natural rate of unemployment to increase include:
- Generous unemployment benefits
- High minimum wage
- Powerful trade unions
- Recession
The natural rate of unemployment is the unemployment rate that would exist in a growing and healthy economy. The NAIRU, on the other hand, is the rate of unemployment consistent with a stable rate of inflation.
