The Natural Rate of Unemployment




  • The Natural Rate of Unemployment is the rate of Unemployment when the labour market is in equilibrium.
  • It is the difference between those who would like a job at the current wage rate and those who are willing and able to take a job. (Q2-Q1)
  • The Natural Rate of Unemployment will therefore include:
    • frictional unemployment
    • structural unemployment
    • E.g. a worker who is not able to get a job because he doesn’t have the right skills
  • The natural rate of unemployment is unemployment caused by supply side factors rather than demand side factors
  • Monetarists argue that the Natural Rate of Unemployment occurs when the Long Run Phillips Curve crosses the x axis
  • The Natural Rate of Unemployment is sometimes known as the
    Non accelerating inflation rate of Unemployment NAIRU
    This is because when unemployment is 4% there is no tendency for inflation
    to increase
  • In this example the Natural rate of unemployment is 4%. If the govt increased AD there may be a temporary fall in unemployment but in the Long Run it would return to the natural rate of 4%
  • Sometimes the natural rate is known as the full employment level of unemployment
  • This is because even if the economy is operating at full capacity and there is no demand deficient unemployment then there will still be some unemployment caused by supply side factors.

What Determines the Natural Rate of Unemployment?

M. Freidman argued the Natural rate of unemployment would be determined by institutional factors such as:

  • Availability of job information. A factor in determining frictional unemployment
  • Skills and Education. The quality of education and retraining schemes will influence the level of occupational mobilities.
  • Degree of labour mobility
  • Flexibility of the labour market E.g. powerful trades unions may be able to restrict the supply of labour to certain labour markets
  • Hysteresis. A rise in unemployment caused by a recession may cause the natural rate of unemployment to increase. This is because when workers are unemployed for a time period they become deskilled and demotivated and are less able to get new jobs.


Explaining Changing Natural Rates of Unemployment

It has been argued that the UK has seen a fall in the natural rate of unemployment since the 1980s (even when growth was 5% in 1988 Unemployment was 1.6 million) This has been explained by:

  1. Increased labour market flexibilities e.g. unions less powerful
  2. Privatisation has helped increased competitiveness of industry leading to more flexible labour markets
  3. Better education and Training
  4. The New Deal has made it more difficult to remain on benefits

Natural Rate of Unemployment in EU

The rest of the EU has seen a rise in the natural rate of unemployment in the 1990s this could have caused by:

  1. Rigidity in EU labour markets e.g. min wages, max working week
  2. Restrictions on closing factories and mandatory severance pay for workers made unemployed, this makes firms more reluctant to set up in these countries
  3. High degrees of unionisation resulting in wage rigidity
  4. Generous benefits which lessen the pain of unemployment
  5. Hysteresis effects. The cyclical recessions of the 1970s and 1980s had long lasting effects resulting in more unemployment. However this does not appear to have effected the UK
  6. Growing competition from Asian countries

However the rising unemployment may not just be due to the Natural rate increasing but also due to lower economic growth. Therefore part of the unemployment is cyclical.

NAIRU and Non-Accelerating Rate of Unemployment


A very similar concept to the natural rate of unemployment is the NAIRU – non-accelerating rate of unemployment.

This is the rate of unemployment consistent with a stable rate of inflation. If you try to reduce unemployment by increasing aggregate demand, then you will get a higher rate of inflation.

The natural rate of unemployment can also be illustrated using the Monetarist view of the Phillips Curve. Monetarists argue that the LRAS is inelastic. Thus increased AD only causes a temporary increase in output and a temporary fall in unemployment.

  • If there is an increase in AD, firms pay higher wages to workers in order to increase in output, this increase in nominal wages encourage workers to supply more labour and therefore unemployment falls.
  • However the increase in AD also causes inflation to increase and therefore real wages do not actually increased but remain the same. Later workers realise that the increase in wages was only nominal and not a real increase.
  • Therefore they no longer work overtime. Therefore the supply of labour falls and unemployment returns to its original or Natural rate of unemployment. It is only possible to reduce unemployment by causing an increase in the rate of inflation. Therefore the natural rate is also known as the NAIRU (non accelerating rate of unemployment.

This model assumes workers do not correctly predict the rate of inflation but have adaptive expectations.

(Some economists argue workers will correctly predict higher AD causes higher inflation and therefore there will not be even a short term fall in unemployment , this is know as rational expectations.)