Guide to Natural Rate of Unemployment
The natural or (equilibrium) level of unemployment is determined by calculating the level of unemployment when the labour market is in equilibrium.
Diagram Showing Natural Rate of Unemployment
The labour force includes everyone of working age who is either working or looking for work. The AS of labour is every one who is able and willing to supply their labour. Not everyone in the labour force will actually be able to supply their labour, and this leads to the natural rate of unemployment.
The natural rate includes frictional and structural unemployment. Frictional unemployment occurs when workers are in between jobs, for example it will take time for graduates to find a suitable job. Structural unemployment occurs due to occupational and geographical immobility’s. For example some workers may not have the necessary skills to apply for a job, therefore they cannot supply their labour even though jobs are available.
The natural rate of unemployment is therefore caused by supply side factors. Thus even when the macro economy is at full output or a “full employment” there can still be unemployment, this unemployment is the natural rate.
Therefore the natural rate is not determined by a deficiency of AD.
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.
Graph of Monetarist View of NAIRU
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.)
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