Contents
Imagine an economy where everyone who wants a job can find one. This ideal state, known as full employment, represents a healthy economic balance with maximized productivity and minimal unemployment. However, achieving and maintaining full employment is a complex challenge due to various factors. This comprehensive guide explores the nuances of full employment, including its relationship with unemployment rates, inflation, and the role of economic policies.
What is full employment?
Full employment means an economy is fully utilizing its productive resources. At this condition, the economy produces at its potential output, and the unemployment rate is at its natural rate.
Full employment isn’t just about low unemployment. It’s about an economy firing on all cylinders. Imagine all the available workers, factories, and resources being put to good use. This peak performance translates to the economy producing its maximum potential output – the most goods and services it can create with the resources available.
The key indicator of full employment is the unemployment rate reaching its “natural rate.” This natural rate reflects the unavoidable churn of people moving between jobs, entering the workforce, or leaving for various reasons. It’s not zero, but it’s a healthy level that allows the economy to function smoothly.
Full employment doesn’t mean zero unemployment
At full employment, every worker available for work has a job. In this case, all people in the labor force have an appointment now. The unemployment rate cannot go down without upward pressure on inflation.
Please note that full employment does not mean zero unemployment. Due to structural and frictional factors, the unemployment rate cannot be zero. Only cyclical unemployment can reach zero percent.
Sometimes, the unemployment rate of 4 percent is the lowest level the economy can reach. For example, US Federal Reserve economists consider the natural rate of unemployment to be between 5.0 percent and 5.2 percent as the natural rate of unemployment.
Two types of unemployment still exist in full employment
While full employment sounds like a utopia – everyone who wants a job has one – it’s important to understand it’s not about achieving absolute zero unemployment, as we discuss above. There will always be some level of unemployment, even in a healthy economy. These can be categorized into two main types: frictional unemployment and structural unemployment.
Frictional unemployment
Frictional unemployment is a temporary phase that arises due to the natural ebb and flow of the job market. It doesn’t reflect a weakness in the economy, but rather the time it takes for workers and jobs to match up perfectly. They need to find the right position, apply for it, and then follow the selection stages, such as interviews, medical tests, and salary negotiations.
An example is new graduates who have just entered the workforce. In addition, some people also change jobs and apply for a higher-paying job or a higher position. As long as they are not working and are actively looking for jobs, they fall into the frictional unemployment category.
Structural unemployment
Structural unemployment often arises because of changes in economic structure, for example, because of technological changes. Such evolution not only gave rise to entirely new types of skills but also eliminated some jobs with particular qualifications. Because they do not have alternative skills, people whose jobs are eliminated by technology must be unemployed.
During the mechanization of agriculture and industrialization, farmworkers lost their jobs. Some cannot work in factories because they lack sufficient skills. Therefore, they are unemployed. Because their expertise is no longer needed, they are not actively looking for work. As such, they are considered structural unemployment.
Inflation and unemployment trade-off
Unemployment cannot continue to fall without sacrificing inflation. If the unemployment rate falls below its natural rate, the inflation rate surges. William Phillips observed this phenomenon and proposed what we know as the Phillips curve.
Inflationary pressure is soaring as the economy operates above its full employment. The unemployment rate is indeed low. However, when it goes down further, inflation surged, leading to an overheated economy.
The economy experiences a shortage of qualified labor. Hence, to attract workers, businesses will offer high wages. Businesses pass higher production costs on selling prices to maintain profit margins.
Governments would adopt contractionary economic policies to prevent the declining purchasing power of money due to high inflation. They can choose several options, including increasing policy rates, reserve requirements, tax rates, or decreasing government spending.
Policies to steer the economy towards full employment
Economic policy can direct the economy to achieve full employment. However, it depends on the economy’s current short-term equilibrium.
In the short term, the economy fluctuates around its potential level (full employment), which forms a business cycle. Imagine the economy as a seesaw, with full employment representing the balance point. When the economy is above full employment (think the seesaw tilted upwards), it might experience high inflation.
Depending on the situation, policymakers can utilize three main policy approaches:
- Contractionary policies
- Expansionary policies
It’s important to note that these tools are most effective when dealing with fluctuations caused by aggregate demand. If the cause of unemployment lies in structural issues within the workforce (lack of skills, job market imbalances), then structural policies become more relevant. These might involve job training programs, education reforms, or investments that address skill gaps and prepare the workforce for the changing job market.
Contractionary policies: cooling down a hot economy
Imagine the economy overheating, with inflation on the rise and the unemployment rate below its natural rate. To address this, policymakers implement contractionary policies. These measures aim to cool things down by reducing aggregate demand (overall spending in the economy).
Here’s how contractionary policies work:
- Tax increases: Raising taxes puts less money in people’s pockets, leading to a decrease in consumer spending.
- Rising interest rates: Higher interest rates make borrowing more expensive, discouraging businesses from taking out loans to invest and consumers from buying on credit. This reduces overall spending in the economy.
- Decreased government spending: By cutting back on government spending, there’s less money circulating, leading to a decrease in aggregate demand.
The overall goal of contractionary policies is to slow down economic growth and moderate inflation. This brings the economy closer to the ideal state of full employment with stable prices.
Expansionary policies: giving the economy a boost
When the economy is below full employment and struggling with a recession, it’s time for a pick-me-up. Policymakers turn to expansionary policies to stimulate economic activity and get things moving again. These measures aim to increase aggregate demand (overall spending in the economy).
Here’s how expansionary policies work:
- Lower interest rates: By making borrowing cheaper, businesses are encouraged to take out loans to invest in new projects and equipment, while consumers can finance purchases more easily. This leads to increased spending and economic growth.
- Tax cuts: Putting more money in people’s pockets through tax cuts allows them to spend more, boosting consumer demand and stimulating economic activity.
- Increased Government spending: When the government increases spending on infrastructure projects, education, or social programs, it injects money into the economy, creating jobs and stimulating economic growth.
The overall goal of expansionary policies is to encourage businesses to invest and hire, leading to job creation, economic growth, and a decrease in unemployment. This helps move the economy closer to the ideal state of full employment.
