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.
Is full employment means zero unemployment
At full employment, every worker available for work has a job. It this case, all people in the labor force are having an appointment now. The unemployment rate cannot go down without upward pressure on inflation.
Please note, full employment does not mean zero unemployment. The unemployment rate cannot be zero due to structural and frictional factors. 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.
Frictional unemployment
It takes time to get a new job. They need to find the right position, apply 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 of them cannot work in factories because they do not have 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, 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.
To prevent a declined purchasing power of money due to high inflation, governments would adopt contractionary economic policies. Several options they can choose, including by increasing policy rates, reserve requirements, tax rates, or decreasing government spending.
How to achieve full employment
Economic policy can direct the economy to achieve full employment. But, it depends on the current short-term equilibrium of the economy.
In the short term, the economy moves around its potential level (full employment), which forms a business cycle. It can be lower or higher.
When the economy is above full employment (high inflation conditions), it requires contractionary policies. Governments could choose several options, including tax increases, rising interest rates, decreasing government spending, or selling government bonds. All these alternatives will reduce aggregate demand, thereby moderating the rate of inflation and economic growth.
Conversely, when under full employment, the economy is experiencing a recession or even depression. Recipes for stimulating economic activity is to carry out expansionary economic policies. This policy has the same instruments as contractionary policies, but in the opposite direction: lower interest rates, tax cuts, increased government spending such as public infrastructure, and so on.
Please note, both policies are useful when short-term fluctuations are sourced from aggregate demand movements. And, when the cause is from the supply side, it requires structural policy.
