Natural Rate of Unemployment

Milton Friedman was first who thought up the concept of the “Natural Rate of Unemployment” (NRU), when he realised that 100% of the population could not be full employed. This is mainly due to the fact that people are constantly moving between jobs laid off, or being fired. At the same time Friedman was aware of the importance of dealing with unemployment in relation to the economy so that no detrimental effects would be seen. In order to illustrate what is meant by NRU, paper will refer to the types of unemployment, the Phillips curve and NAIRU, to then demonstrate effective policy measures. (Layard et al. 1991, ch. 2)

Unemployment is distinguishable into four categories: Cyclical, Frictional, Structural and Seasonal. Cyclical unemployment occurs when there is insufficient demand in the economy for all workers who wish to work at current wage rates to obtain a job. Frictional unemployment refers to the movement of labour from one work place to another. Structural unemployment occurs when the supply of labour exceeds demand, this is often caused by a change in pattern to demand and production procedures leaving workers unemployed in labour markets where demand has shrunk. (BizEd, 2005)  Seasonal unemployment is fairly self-explanatory. “Father Christmas tends to only be in demand for a short period of the year, and the rest of the year would certainly be classified as seasonally unemployed.” (BizEd, 2005)

To further segregate Unemployment it can be thought of in terms of involuntary and voluntary. Excluding cyclical unemployment all other forms can be considered as voluntary unemployment. The reasoning behind this is that although the job they want may not be available there are still other jobs available, which could be taken. People who are frictionally unemployed have the option to spend less time searching for their ideal job in order to take another job which they maybe less suited to or pays less. In the same way those who find themselves structurally unemployed could find another place of employment if they were willing to take a reduced salary. (Layard et al. 1991, ch. 2)

In contrast cyclical unemployment is considered to be involuntary. Cyclical unemployment follows the path of the business cycle and so when the economy is experiencing a boom cyclical unemployment is low however in recession demand for labour falls and so many become unemployed and then find it hard to find employment as there are to few jobs available in the economy. (Dornbusch 2004)

The natural rate of unemployment is the rate of unemployment where the labour market is in a position of equilibrium. This means that the labour supply is equal to labour demand at a given real wage rate. All those people willing and able to take paid employment at the going wage rate do so. The NRU is therefore made up of all those who cannot work and those who simply choose not to. (Burda & Wyplosz 2005, ch. 2)

Some people do not have to option of working this maybe due to illness, disability or injury. Those individuals who are less well off or poorly educated often choose not to work due to low job satisfaction and poor motivation and opt to claim government benefits instead of working. In the extreme some individuals may be tempted to work in the untaxed black market. (Dornbusch 2004)

The diagram below shows the labour supply (those willing and able to take work at a going wage rate) and the labour force – the number of active participants in the labour market. The labour force expands as the real wage rises because there is a greater incentive to search for paid work and sacrifice leisure. Employment on the x-axis measures the total labour hours supplied by workers in the economy in a given time period. As the real wage increases, the total number of hours supplied by the labour force will expand. (Layard et al. 1991, ch. 2)

The natural rate of unemployment is not zero – at the equilibrium wage W1 in the diagram above, there is unemployment measured by AB. This is made up of frictional plus structural unemployment. At a wage rate W2 (above the equilibrium “market-clearing wage”) employment contracts along the labour demand curve and total unemployment rises. (Carlin & Soskice 2004, ch. 2)

Dis-еquilibrium unеmploymеnt risеs to thе lеvеl shown by thе distancе CD. This is bеcausе labour dеmand has fallеn and thе labour forcе has еxpandеd. Thеrе is an еxcеss supply of labour – somе pеoplе who arе willing and ablе to find еmploymеnt cannot gеt paid work.

The Natural rate occurs when the economy is in a position of long run equilibrium, i.e. when the long run aggregate demand equals long run aggregate supply. (Burda & Wyplosz 2005, ch. 2) This means that when the economy is below the natural rate aggregate demand is above long run aggregate supply therefore workers should be able to bid up wages so that the short run aggregate supply curve shifts upwards causing the long run equilibrium to re-establish itself. Correspondingly if the economy is above the natural rate, workers will be forced to accept pay cuts. Therefore when the labour market is in equilibrium so is the economy. (Levacic & Rebmann 1982)

Often associated with the NRU is “the rate of unemployment, which can be sustained without a change in inflation”, this is commonly referred to as “The non accelerating inflation rate of unemployment”, NAIRU. (Miller & Upton 1986, sec.5) At NAIRU the demand for labour is equal to the number of people prepared to supply their labour for the prevailing wage rate. Any unemployment is equilibrium unemployment and arises from labour market imperfections.

NAIRU is the rate of unemployment at which there is neither upward pressure on inflation nor downward pressure on inflation. Where as NRU is derived from a competitive market, NAIRU is usually developed from a model that rеcognizеs impеrfеct compеtition in thе labour markеt (Layard еt al. 1991). Thе sustainablе lеvеl of unеmploymеnt is sееn hеrе as a bargaining еquilibrium bеtwееn firms and workеrs rathеr than a markеt clеaring outcomе.

A.W.Phillips, first dеvеlopеd this rеlationship bеtwееn inflation and unеmploymеnt in 1958 and showеd that thеrе was a strong corrеlation bеtwееn unеmploymеnt and wagе changеs. Hе found that thеrе was a tradе-off bеtwееn unеmploymеnt and inflation, so that any attеmpt by govеrnmеnts to rеducе unеmploymеnt was likеly to lеad to incrеasеd inflation. (Carlin & Soskice 2004, ch. 2)

Oncе again it was Friеdman who dеvеlopеd this thеory suggеsting that oncе еxpеctations arе takеn into account thе unеmploymеnt/inflation tradе off is only a short-tеrm possibility.  According to Friеdmans еxpеctation thеory thе currеnt ratе of inflation dеtеrminеs firms’ and workеrs’ еxpеctations of its futurе lеvеl, i.е. thе еxpеctеd ratе of inflation on thе Philips Curvе which is еqual to zеro. Mеaning that thеrе is no prеssurе upon pricеs or wagеs to changе. (Levacic & Rebmann 1982)

If thе Govеrnmеnt attеmpts to rеducе thе natural ratе of unеmploymеnt by incrеasing thе supply of monеy in thе еconomy, it would lеad to a growing prеssurе upon wagеs and pricеs. Firms thеrеforе will attеmpt to incrеasе thеir output by еmploying morе workеrs, however in order to do this they must offer a wage increase. The extra costs of production will be passed on to the consumers in the form of a similar price rise for goods and services, this initial price rise that made it profitable to bid for extra labour. As long as the money wage increase is less than the price increase firms will be happy to employ the extra workers who have been fooled into believing that they are receiving higher real wages by unexpectedly high inflation. Therefore in the short run workers will suffer what is known as a money illusion. Unemployment has now fallen and inflation increase. (Carlin & Soskice 2004, ch. 2)

In the long-run the workers realise that real wages have remained the same and thus withdraw from employment. Worker will now take the new and higher expected rate of inflation into account in their wage bargains firms will therefore cut back on the labour they employed. Therefore unemployment rises back to its natural rate where the expected rate of inflation. The economy then moves to point on the new Philips Curve labelled. If the Government continued with reflationary policies it will lead to accelerating inflation as the process is repeated. Attempts to push unemployment below the natural rate will result in accelerating inflation, demonstrating why the NRU is sometimes referred to as NAIRU. (Carlin & Soskice 2004)

In order for the government to control the NRU, supply side policies will be used in an attempt to attract those voluntarily unemployed through increased incentives. Such policies are intended to increase the economy’s productive capacity through increasing the supply of factor inputs and their productivity. However throughout economists there is controversy between them as to what policy is best suited to control and reduce natural employment.

New Classical economists have often focused upon trade unions as contributing to an increase in natural unemployment in particular by restricting the supply of labour through the threat of industrial action. Linked to this the establishment of the minimum wage has discouraged firms to employ labour in certain occupations. (Alogoskoufis & Smith 1991)

New classical economists favour government legislation in order to reduce the bargaining power of trade unions. Such legislation would mean employers are able to offer a lower wage rate therefore employing more workers. Similar policies would include the reduction in both personal income tax and social security benefits in order to lower the poverty gap along with the abolition of wage councils. These methods will ultimately shift the actual supply curve for labour nearer to the potential supply curve, in so doing lowering the natural rate of unemployment. (Bean 1992)

The current Labour government has introduced several state welfare benefit schemes aimed at encouraging people to work by making it more profitable to do so. The “New Deal Programme” introduced in 1997 aimed to provide all young people with either training or a job all those who refused were refused benefit. Many commentators see education and training as an important determinant. Improved training should lead to increased productivity and efficiency in the long run and will make individuals more employable by potential employers. (Rowthorn 1999)

In 1999 the Families tax credit was introduced which allowed poorly paid working parents tax relief and a possible extra sum of cash.,Such schemes were successful through the Lawson boom over the late 1980’s. At this time a scheme was introduced to return the long time unemployed back into the workplace this was done through retraining and reclassification so that they were able to claim invalidity benefits. (Rowthorn 1999)

The fundamental aspect of schemes such as these are to make it more profitable to work than to stay at home thus increasing the incentive to go out and get a job. The natural rate of unemployment ‘callous’ because it implies that there is something natural about unemployment. Modern economics prefers to use the phrase the non-accelerating inflation rate of unemployment (NAIRU) i.e. the level of unemployment that is associated with a constant rate of inflation. (Adams & Coe 1990)  At NAIRU the demand for labour is equal to the number of people prepared to supply their labour for the prevailing wage rate. Any unemployment is equilibrium unemployment and arises from labour market imperfections.

Bibliography:

Carlin, Wendy and Soskice, David. 2004, New Keynesian Macroeconomics: Imperfections, Information & Institutions. Oxford University Press Ch. 1-4.

Layard, R., Nickell S., and Jackman R. 1991, Unemployment: Macroeconomic Performance and the Labor Market .New York: Oxford University Press. Ch. 1-3, 8

Burda, Michael, Wyplosz, Charles. 2005, Macroeconomics – a European text, 4th Edition, Oxford University Press. Ch. 2

Dornbusch R., Fischer S., Startz R. 2004, Macroeconomics, 9th Ed., McGraw-Hill. Ch. 2-4

Rowthorn, R. 1999, “Unemployment, Wage Bargaining and Capital-Labour Substitution”, Cambridge Journal of Economics, July.

Levacic R. and Rebmann, A. 1982, Macroeconomics: an introduction to Keynesian-Neoclassical controversies, Second Ed. Ch. 1-3

Miller, Merton H. and Upton, Charles W. 1986,  Macroeconomics: A Neoclassical Introduction. Sec. 5

BizEd. Institute for Fiscal Studies (IFS). Virtual Economy – Unemployment Theory. [Online]: http://www.bized.ac.uk/virtual/economy/policy/outcomes/unemployment/

Adams, C., Coe, D.  1990, “A systems approach to estimating the natural rate of unemployment and potential output for the United States”, IMF Staff Papers, Vol 37, pp. 232–93.

Alogoskoufis, G.  Smith, R. 1991, “The Phillips Curve, the persistence of inflation and the Lucas Critique: evidence from exchange-rate regimes”, American Economic Review, Vol 81, pp. 1,254–75.

Bean, C. 1992, “Identifying the causes of British unemployment”, Centre for Economic Performance Discussion Paper, No 276.