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Does full employment mean no unemployment? The answer is no. When the economy operates at full employment, unemployment remains. The unemployment rate is not zero.
Why not zero percent?
Only the cyclical unemployment rate is zero percent during full employment. This shows that job seekers have filled available job vacancies.
The economy operates at its natural rate of unemployment, leaving structural unemployment and frictional unemployment. Both are never zero percent.
In the United States, economists say the natural unemployment rate is between 4 and 5 percent. If it decreases further, it will only produce inflationary pressure, which is undesirable because it diminishes the purchasing power of money.
Let me talk about what full employment is all about. Then, I also discuss structural, cyclical, and frictional unemployment. As I mentioned earlier, at the natural rate of unemployment, only cyclical unemployment is zero percent. In contrast, structural and frictional unemployment still exists.
Full employment definition
Full employment occurs when the economy uses all available resources, including labor. The economy’s output (reflected in real GDP) is at its potential output (potential GDP).
In a graph, it occurs when the short-run equilibrium (the intersection of the short-run aggregate supply curve and the aggregate demand curve) is right on the long-run aggregate supply curve.
In these conditions, everyone who is willing to work at a decent wage level gets a job. Those who are actively looking for work find suitable jobs. Unemployment is at its natural rate, which is equal to structural plus frictional unemployment.
Structural unemployment explained
Structural unemployment occurs due to fundamental problems in the economy. Economic changes make some skills obsolete and irrelevant, leaving previously employed people out of work. When they do not adapt and acquire new skills demanded by the market, they are unemployed forever.
For example, when industrialization was underway, the contribution of the agricultural sector to labor absorption decreased. In contrast, the manufacturing and service sectors grew. Farmworkers can lose their jobs.
Some workers do not have the skills necessary to work in the manufacturing or service sector. They are also unable to acquire new skills because problems such as education and retraining programs are unavailable. Finally, they can become structurally unemployed.
Frictional unemployment explained
Frictional unemployment is a temporary phase caused by the natural ebb and flow of the job market. It’s the time it takes for workers and jobs to find a perfect match. This can happen for several reasons:
Job seekers in transition: You might leave your current job for a better opportunity, get laid off, or experience a company closure. In the meantime, you’ll be searching for a new position, going through interviews, and potentially negotiating salary. This period of in-between employment falls under frictional unemployment.
New entrants to the workforce: Recent graduates are prime examples. They need time to find suitable jobs that match their skills and experience. This search process contributes to frictional unemployment.
Imperfect labor market information: Sometimes, information gaps exist between employers and potential employees. You might find a job that seems like a good fit, but after negotiation, the salary doesn’t meet your expectations. This mismatch can lead you to keep searching, contributing to frictional unemployment.
In essence, frictional unemployment is a natural part of a healthy job market. It’s the time it takes for the puzzle pieces (workers and jobs) to find the right fit.
Cyclical unemployment explained
Cyclical unemployment occurs when the economy produces less than its potential output, as during a recession. Businesses cannot fully use their production capacity. If, for example, a company used to use 100 workers to operate a production machine, now it only uses 90 workers.
During a recession, aggregate demand slumps due to the gloomy outlook for household income. Businesses respond by cutting production and reducing labor.
If they are producing at full capacity, it will only increase the pressure on profitability. Supply will exceed demand, pushing down prices.
Conversely, during expansion, the economy is headed for full employment. Aggregate demand increases, encouraging businesses to increase production and recruit workers. Businesses operate at near full production capacity, absorbing all available qualified workers.
Long story short, cyclical unemployment is due to insufficient aggregate demand (also called demand-deficient unemployment). Unemployment is high because businesses are cutting production.
The labor market faces a higher supply of labor than demand. That should lower wages.
But that doesn’t happen because wages are stiff to go down. Thus, businesses cannot maintain profit margins. Finally, they chose to reduce workers.
Full employment does not mean 0 unemployment.
Since the economy uses all available labor, the unemployment rate is at its natural rate. Cyclical unemployment does not exist. Those who are qualified and actively looking for work have already been employed. The labor market leaves fewer qualified people waiting to be recruited. Those without skills (structural unemployment) also remain unemployed. This means:
- The natural rate of unemployment: The unemployment rate sits at its “natural rate,” which reflects the unavoidable churn of people entering or leaving the workforce, changing jobs, or searching for better opportunities.
- Cyclical unemployment disappears: Economic downturns cause cyclical unemployment. At full employment, this type of unemployment is absent because the economy is operating at peak capacity.
- Limited pool of unemployed: With the economy firing on all cylinders, there are fewer qualified people actively seeking work. This is a positive sign, indicating a healthy job market with high employment.
However, a small portion of unemployment remains:
- Structural unemployment persists: Even at full employment, structural unemployment persists. This means those lacking the skills demanded by the current job market remain unemployed.
In essence, full employment signifies a well-functioning economy with low unemployment, but not its complete elimination.
Why full employment is bad
While full employment signifies a strong economy with low unemployment, some argue it can have drawbacks. As the available pool of qualified workers shrinks, companies face a tighter labor market. This increased competition for talent can drive wages upward.
Businesses may be incentivized to raise prices of goods and services to maintain profit margins, leading to inflationary pressures. This becomes especially true if the unemployment rate falls significantly below its natural rate.
However, the potential for inflation shouldn’t completely overshadow the benefits of full employment. A healthy labor market with low unemployment fosters increased consumer spending power, boosting overall economic activity. Additionally, higher wages can improve worker morale and productivity, potentially leading to a virtuous cycle of growth.
Finding the sweet spot between full employment and stable prices is a key challenge for policymakers. Central banks often utilize monetary policy tools like interest rates to manage inflation.
Higher interest rates make borrowing more expensive, which can cool down economic activity and slow down wage growth. However, these measures can also have unintended consequences, such as slowing down investment and potentially hindering economic growth.
Ultimately, achieving and maintaining full employment requires careful balancing. Policymakers need to consider the trade-offs between maximizing employment and maintaining price stability.
While there may be some inflationary pressures associated with full employment, the economic benefits of a thriving labor market and increased consumer spending can be significant. The key lies in managing inflation through appropriate policy tools without stifling economic growth.
