What’s it: The natural rate of unemployment (NARU) is the unemployment rate when the economy is operating at full employment. Sometimes, it is equated with the non-accelerating inflation rate of unemployment (NAIRU), which is the lowest level of unemployment without causing inflation. In other words, if NAIRU goes down, it will only result in rising inflation.
The natural rate of unemployment arises from all sources except fluctuations in aggregate demand. Changes in aggregate demand cause the economy to operate around its potential output, affecting the unemployment rate.
At one time, the economy operates below its potential output, resulting in more unemployment. Other times, the economy operates above its potential output.
And when the natural unemployment rate is reached, the economy uses its productive capacity to its maximum. Thus, the economy is at its potential output. And real GDP equals potential GDP.
Economists estimate potential GDP through models and then determine the natural unemployment rate. If real GDP equals potential GDP, unemployment is at its natural rate. Meanwhile, if real GDP exceeds potential GDP, the unemployment rate is below its natural rate, bringing inflationary pressures higher. Conversely, if real GDP is less than potential, unemployment is above its natural rate, and some resources are unemployed, including labor.
What is the difference between the actual and the natural unemployment rate?
There are several differences between the natural unemployment rate and the actual unemployment rate. First, the actual unemployment rate includes structural unemployment, frictional unemployment, seasonal unemployment, and cyclical unemployment. What are the differences between the four? We will discuss this below. Meanwhile, the natural rate of unemployment excludes cyclical unemployment.
Second, the increase or decrease in the actual unemployment rate is influenced by economic fluctuations (business cycle) and changes in the economy’s productive capacity. In contrast, the natural rate of unemployment is affected only by changes in productive capacity, not by the business cycle.
Third, the actual unemployment rate is the number we read from the news or reports from the Central Statistics Agency. It is calculated manually, for example, through a survey. Meanwhile, the natural unemployment rate is a hypothetical figure calculated using the model.
Why is the unemployment rate never zero?
When harnessing its full capacity, the economy is at full employment. However, full employment does not mean unemployment equals zero. Instead, unemployment is at its natural rate.
Unemployment will not equal zero, for example, due to structural or frictional problems. Moreover, economists define unemployment as those of working age and actively looking for work. Thus, individuals may not have found the right job when the central statistical agency calculates the unemployment rate. Or, they are not recruited because they do not have the competencies demanded by employers even though they are still actively looking for work.
When unemployment is at its natural rate, a further increase in aggregate output – so that real GDP exceeds potential GDP – only results in higher inflationary pressures. And this situation jeopardizes the economy’s stability.
High inflation causes the purchasing power of money to fall. And it can spiral out of control through the wage-price spiral. For this reason, policymakers often intervene in the economy by tightening economic policies.
For example, the central bank raises interest rates to moderate inflationary pressures. This policy weakens aggregate demand, pushes aggregate output down, and lowers the price level. But, it also causes the unemployment rate to rise.
What is the natural rate of unemployment?
What is the natural unemployment rate? That’s hard to answer exactly. So economists usually calculate it through models. And because of this, it is a hypothetical figure.
During the 1980s, the natural unemployment rate in the United States was estimated at around 6%. However, it has decreased in the last decade. And in 2022, it’s around 4.5%. The decline was caused by factors such as changes in technology, demographics, and minimum wages.
What is the difference between full employment and the natural rate of unemployment?
Full employment and the natural unemployment rate describe the same situation. When full employment is achieved, unemployment is at its natural rate.
Full employment is achieved when the economy is operating at full capacity. Thus, the economy produces output at the potential output level, i.e., the maximum output achieved by the economy using available resources.
Long story short, when the economy is at full employment, then:
- The unemployment rate is at its natural rate
- Aggregate output equals potential output (real GDP equals potential GDP)
- The economy operates at full capacity
- Available economic resources, including labor, are fully utilized
- The economy is at a point along the production possibilities curve
Why is there a natural rate of unemployment?
As mentioned, the unemployment rate is never zero due to structural and frictional problems. And when unemployment is at its natural rate, only cyclical unemployment is absent. However, other unemployment (frictional, structural, and seasonal) will continue.
So, to answer why there is a natural unemployment rate? Let’s discuss each type of unemployment and explore the causes.
Type of unemployment
Economists divide unemployment into four based on the cause. They are:
- Frictional unemployment
- Structural unemployment
- Seasonal unemployment
- Cycle unemployment
Frictional unemployment occurs because individuals need time before effectively working in a new place. That may be because the information in the labor market is imperfect. Thus, individuals find it difficult to find the right job.
Or, when individuals have found the right job vacancy, they should apply in advance and wait to be called for an interview. And as long as they follow the process, they are still recorded as unemployed.
Then, when applicants are in the interview and negotiation process, the salary and benefits provided by the employer may be below their expectations. So, ultimately, they did not take the opportunity and looked for vacancies elsewhere.
Long story short, frictional problems occur because there is a time lag for individuals to switch from one job to another or from unemployed to return to work. And the internet is one solution to reduce this problem, for example, by making it easier to find job vacancies.
Structural unemployment arises because the unemployed do not have the skills required by employers. For example, industrialization has impacted increasing unemployment in the agricultural sector. As a result, farm laborers cannot switch jobs to the manufacturing sector because they do not have the necessary skills. Without refining skills, they end up being unemployed forever.
Structural problems can also occur due to barriers to geographic mobility. For example, an industrial area was destroyed when many manufacturers went bankrupt. As a result, the unemployed have to look for work elsewhere. Of course, moving to another area to find a new job takes time. Some unemployed also do not want to move to another area for reasons such as family and social ties or the cost of renting a property.
Retraining is a solution to reduce structural unemployment. In addition, infrastructure improvements also reduce barriers to geographic mobility. Providing housing allowances is another way.
Seasonal unemployment occurs due to fluctuations in recruitment following a seasonal pattern. For example, many people are unemployed during one season and work in another. While seasonal patterns last one year with the same period, cyclical has a different period length between each stage and can last more than one year or even shorter.
A good example is those who work in the tourism sector. Job creation increases in peak season and decreases in the normal season. For example, ski resorts see peak demand and experience the busiest time during winter.
Cyclical unemployment arises due to fluctuations in the economy around full employment. In other words, it is closely related to the current business cycle.
For example, during a recession, cyclical unemployment increases. The economy operates under full employment. Thus, aggregate output is less than potential output, and some resources are idle, including labor.
In contrast, during expansion, cyclical unemployment declines. This is because businesses see strong demand, prompting them to hire more workers to increase production. As a result, the unemployment rate decreased.