The Natural Rate of Unemployment

A crowded yet functioning city street demonstrates chaos theory.
Takahiro Yamamoto

Economists often talk about the "natural rate of unemployment" when describing the health of an economy, and specifically, economists compare the actual unemployment rate to the natural rate of unemployment to determine how policies, practices, and other variables are affecting these rates.

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Actual Unemployment Versus the Natural Rate

If the actual rate is higher than the natural rate, the economy is in a slump (more technically known as a recession), and if the actual rate is lower than the natural rate then inflation is expected to be right around the corner (because the economy is thought to be overheating).

So what is this natural rate of unemployment and why is not just an unemployment rate of zero? The natural rate of unemployment is the rate of unemployment that corresponds to potential GDP or, equivalently, long-run aggregate supply. Put another way, the natural rate of unemployment is the unemployment rate that exists when the economy is in neither a boom nor a recession—an aggregate of the frictional and structural unemployment factors in any given economy.

For this reason, the natural rate of unemployment corresponds to a cyclical unemployment rate of zero. Note, however, that this doesn't mean that the natural rate of unemployment is zero since frictional and structural unemployment can be present.

It is important, then, to understand that the natural rate of unemployment is merely a tool used to determine what factors are affecting the unemployment rate that is making it perform better or worse than what is expected given the current economic climate of a country.

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Frictional and Structural Unemployment

Frictional and structural unemployment are generally viewed as a result of the logistical features of an economy as both exist in even the best or worst of economies and can account for a large part of the unemployment rate that happens despite current economic policies.

Frictional unemployment is mainly determined by how time-consuming it is to match with a new employer and is defined by the number of people in an economy currently moving from one job to another.

Similarly, structural unemployment is largely determined by workers' skills and various labor market practices or a reorganizing of the industrial economy. Sometimes, innovations and changes in technology affect the unemployment rate rather than supply and demand changes; these changes are called structural unemployment.

The natural rate of unemployment is considered natural because it's what unemployment would be if the economy were in a neutral, not too good and not too bad, state without external influences like global trade or dips in the value of currencies. By definition, the natural rate of unemployment is that which corresponds to full employment, which of course implies that "full employment" doesn't actually mean that everyone who wants a job is employed.

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Supply Policies Affect Natural Unemployment Rates

Natural unemployment rates cannot be shifted by monetary or management policies, but changes in the supply side of a market can affect the natural unemployment. This is because monetary policies and management policies often alter investment sentiments in the market, which make the actual rate deviate from the natural rate.

Before 1960, economists believed that inflation rates had a direct correlation with unemployment rates, but the theory of natural unemployment developed to point to expectations errors as the main cause of deviations between the actual and natural rates. Milton Friedman posited that only when actual and expected inflation are the same could one accurately anticipate the inflation rate, meaning you would have to understand these structural and frictional factors.

Basically, Friedman and his colleague Edmund Phelps furthered our understanding of how to interpret economic factors as they relate to the actual and natural rate of employment, leading to our current understanding of how supply policy is truly the best way to effect a change in the natural rate of unemployment.