What does the natural rate of unemployment equal?

Monetarists believe that in the long run real output tends to an equilibrium level, because employment tends to an equilibrium level. The level of unemployment that exists in equilibrium is referred to as the natural rate of unemployment, which is the amount of structural and frictional unemployment which is left in the economy when supply and demand are in balance. For monetarists, the natural rate of unemployment is the full employment rate and would be consistent with stable wages and prices.

The monetarist view of the labour market differs from the Keynesian view in that it considers unemployment from the supply side of the economy, rather than resulting from deficient demand.

The labour market is considered like any other market where the equilibrium price, i.e. the wage rate, is determined by demand and supply. The amount of labour demand by employers will depended on the level of real wages.

Hence the higher the real wage, the lower the demand for labour
the lower the real wage, the higher the demand for labour
the higher the real wage, the higher the supply of labour
the lower the real wage, the lower the supply of labour

The equilibrium real wage will be established where demand for labour is equal to the supply of labour.

Any unemployment remaining when the labour market is in equilibrium is referred to as the natural rate of unemployment.

Figure 1 Natural rate of unemployment

With reference to figure 1, the labour market is in equilibrium at OM, with a real wage of OW. If the real wage was above the equilibrium, then excess supply of labour would result as the supply of labour is greater than the demand.

The implication from this is that unemployment is caused by real wages being too high, and that the cure for unemployment is for workers to accept lower real wages. Monetarists would say that any unemployment above OM is voluntary, and occurs because workers are not willing to work for a low enough wage. Thus any unemployment at OM is referred to as the natural rate of unemployment, and is the unemployment which remains when the labour market is in equilibrium.

What determines natural rate and how can it be reduced?

The natural rate of unemployment cannot be defined as some percentage of the labour force. It depends on a number of factors which are liable to change over time. For example:

• Technology and information
• Comparative advantage and international trade
• The degree of occupational and geographical mobility
• Information regarding job opportunities
• Restrictive practices imposed by trade unions

According to monetarists it would therefore follow that the natural rate of unemployment could be reduced by removing 'frictions' or obstacles to supply. This could be achieved by various supply-side measures, such as:

• Reducing the power of trade unions to resist reductions in real wages and to impose minimum wage rates (i.e. unions should be made more docile and accepting of the conditions which owners of capital wish to impose on them!).
• A combination of reduced benefits and lower taxes to induce the unemployed to take lower paid jobs.
• Increasing geographical and occupational mobility (e.g. with retraining).
• Establishing an efficient system of information flows.

Reading: AB, chapter 3, section 4.

Types of Unemployment

• Frictional Unemployment: unemployment caused by workers searching for jobs and firms searching for workers.
• Structural Unemployment: long-term chronic unemployment that exists when the economy is not in a recession. The main causes of structural unemployment are: (1) the number of low skilled workers exceeds the number of low skilled jobs (dual labor market idea); (2) some sectors of the economy are contracting while others are expanding and the contracting industries create unemployment.
• Natural Rate of Unemployment: unemployment rate consistent with full employment = frictional rate + structural rate = u*. Currently the natural rate is estimated to be somewhere between 5.5% and 6.5%. However, it is not estimated very precisely. (Note: equilibrium values are denoted with a superscript "*" instead of an overbar since I can't get overbars to print in HTML.)
• Cyclical Unemployment: actual rate of unemployment - natural rate of unemployment = u - u*. The cyclical rate of unemployment is the unemployment created by recessions and booms. During recessions, u - u* > 0; during booms, u - u* < 0.
• Actual Unemployment Rate: natural rate + cyclical rate = u = u* + (u - u*).
• NAIRU: non-accelerating inflation rate of unemployment = rate of inflation consistent with stable prices/inflation = natural rate of unemployment. The NAIRU and the natural rate are the same thing. As we shall see, the natural rate of unemployment (NAIRU) is the rate of unemployment that exists when inflation is neither increasing nor decreasing. When the economy is booming, cyclical unemployment is positive and inflation tends to accelerate; when the economy is in recession, cyclical unemployment is negative and inflation tends to decelerate.

Graphical illustration of u*

The natural rate of unemployment, u*, is the unemployment rate that occurs when the labor market is in equilibrium; i.e. when employment is N*.

Unemployment Statistics

• Labor force (LF): number of employed individuals (E) + number of unemployed individuals seeking work (U).
• Not in the labor force (NLF): those individuals neither employed nor unemployed and not seeking work.
• Adult population: LF + NLF.
• Unemployment rate: u = U/(E + U). Note that the unemployment rate changes whenever U or E changes.

[insert pie chart of unemployment statistics here]

Counter intuitive facts about unemployment

• Most spells of unemployment (i.e., time spend unemployed) are short - about 2 months
• Most people who are unemployed on a given date are experiencing long unemployment spells (i.e., have been unemployed for a long time - about 1 year).

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