Eleanor Finch
The natural rate of unemployment is a key concept in the study of economic activity. It is the unemployment rate that would exist in a healthy and growing economy at full employment. This rate is a combination of frictional and structural unemployment, with frictional unemployment occurring when workers are in-between jobs and structural unemployment caused by a mismatch between the skills a worker has and those demanded by employers. The natural rate of unemployment is mainly determined by the economy's supply side, including production possibilities and economic institutions. However, demand-side factors such as government rules, social institutions, and the presence of unions can also affect the natural rate of unemployment by influencing the willingness of firms to hire. While the natural rate of unemployment is a hypothetical concept, it is generally accepted by economists, with surveys showing that two-thirds to three-quarters agree with the statement 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 unemployment rate that would exist in a growing and healthy economy. |
| Synonyms | Natural unemployment rate of unemployment, natural rate of employment |
| Types | Frictional, structural, cyclical |
| Causes | Workers moving from job to job, workers replaced by technology, workers lacking necessary skills, institutional factors (e.g. minimum wage, unionization), government policies, wage rigidity, changes in productivity |
| Effects | Not considered natural if it leads to cyclical, institutional, or policy-based unemployment; may cause uncontrollable inflation |
| Economic Indicators | Full employment, potential real GDP |
| Related Theories | Phillips Curve, Non-Accelerating Inflation Rate of Unemployment (NAIRU), General Equilibrium Model of Economics |
| Critics | Milton Friedman, Edmund Phelps |
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What You'll Learn
Frictional unemployment
However, frictional unemployment can have negative consequences for both employers and the economy as a whole. High frictional unemployment may make it difficult for employers to retain talent, as workers may compare different offers and wait for strong opportunities. Additionally, if the job search process takes too long or results in frequent mismatches, the economy may suffer as some work remains undone. Governments may seek to reduce unnecessary frictional unemployment through various policies, such as optimizing recruitment services and training systems, establishing graduate employment tracking databases, and evaluating the labour market to help new entrants find suitable jobs.
The length of time it takes to transition from one job to another can be influenced by economic conditions. A prosperous economy may shorten the transition period, while a constricting economy may lengthen it. However, regardless of economic conditions, some people will choose to change jobs, establishing a minimum yet ineradicable level of frictional unemployment. This can be further influenced by factors such as unemployment benefits, which can provide workers with the financial means to be more selective in finding their next job, and companies abstaining from hiring due to a perceived lack of qualified candidates.
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Structural unemployment
Another factor contributing to structural unemployment is competition, particularly from globalization. Developing countries generally provide cheaper labour, leading many companies from developed countries to relocate their manufacturing facilities to take advantage of this. As a result, workers in the developed countries who were previously involved in manufacturing become unemployed. While geographic immobility is not a direct cause of structural unemployment, it can worsen its effects. For instance, if individuals in a high unemployment region are unwilling to relocate to areas with more job opportunities, the high unemployment rate will persist.
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Involuntary unemployment
In an economy with involuntary unemployment, there is a surplus of labour at the current real wage. This occurs when there is some force that prevents the real wage rate from decreasing to the rate that would equilibrate supply and demand, such as a minimum wage above the market-clearing wage. Involuntary unemployment can be caused by a deficiency of aggregate demand, labour market inflexibilities, implicit wage bargaining, or efficiency wage theory. For example, if a government makes it difficult for businesses to start up or expand by imposing bureaucratic red tape, businesses will be less inclined to hire.
In the Keynesian model, involuntary unemployment is associated with insufficient aggregate demand and is closely related to demand-deficient unemployment. If aggregate demand falls, this leads to involuntary unemployment because wages are 'sticky downwards'. Cutting real wages will not solve this problem, as it will lead to a further fall in aggregate demand. Instead, the solution is to increase aggregate demand.
Several economic theories have been proposed to explain involuntary unemployment, including implicit contract theory, disequilibrium theory, staggered wage setting, and efficiency wages. While the concept of involuntary unemployment is widely accepted, it is not universal among economists. Some economists do not accept it as a real or coherent aspect of economic theory.
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Cyclical unemployment
During recessions, consumers may delay purchases, leading to a decline in consumer demand for goods and services. This reduction in demand has a ripple effect on businesses, causing a decrease in production levels. To compensate for lower production, companies may reduce their workforce, resulting in cyclical unemployment. The number of unemployed individuals in the market may surpass the number of available job vacancies during these periods.
Conversely, during economic expansions or peaks in business cycles, cyclical unemployment tends to be low. Sales and income increase, leading to higher demand for labour. Companies may rehire previously laid-off workers or expand their workforce to meet the increased demand for their products and services.
The duration of cyclical unemployment depends on the length of the recession or economic downturn. Recessions can last for about 18 months, while depressions may take a decade or more to recover. Governments often intervene during periods of high cyclical unemployment by implementing expansionary monetary policies to stimulate the economy and reduce unemployment.
It is important to note that multiple types of unemployment can coexist simultaneously. While cyclical unemployment is influenced by economic cycles, other forms of unemployment, such as structural unemployment, may persist even during periods of economic growth. Structural unemployment arises from long-term underlying issues, such as technological changes or skill mismatches, that leave workers unable to compete for available jobs.
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Surplus unemployment
The natural rate of unemployment is the lowest level of unemployment that a healthy and expanding economy can sustain without creating inflation. It is the unemployment rate that would exist in an ideal economy, where labour markets are in equilibrium. It is a combination of frictional, structural, and surplus unemployment.
While the natural rate of unemployment is a theoretical concept, it has been influential in economic thinking. The concept was developed by Nobel Prize recipients Milton Friedman and Edmund Phelps in the 1960s. They argued that there is a unique natural rate of unemployment at which inflation can be fully anticipated, and that attempts to lower unemployment below this rate would only result in temporary outcomes.
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Frequently asked questions
The natural rate of unemployment is the unemployment rate that would exist in a growing and healthy economy. It is the minimum unemployment rate resulting from real or voluntary economic forces.
The natural rate of unemployment is a combination of frictional and structural 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. Structural unemployment refers to unemployment caused by a mismatch between the skills a worker has and the skills employers demand.
Unemployment that is cyclical, institutional, or policy-based is not considered natural unemployment. Cyclical unemployment occurs due to economic shifts such as recessions. Institutional factors such as minimum wage laws and high degrees of unionization can increase the natural rate of unemployment over time.
The natural rate of unemployment exists when an economy is at "full employment". Full employment does not mean zero unemployment, as workers naturally flow to and from jobs and companies. Instead, full employment means that the actual unemployment rate is equal to the natural rate.
When an economy is at the natural rate of unemployment, it is said to have reached its potential real GDP. When the economy is below full employment, the unemployment rate is greater than the natural unemployment rate and real GDP is less than potential. Conversely, when the economy is above full employment, the unemployment rate is less than the natural rate and real GDP is greater than potential.
