The natural or (equilibrium) level of unemployment is determined by calculating the level of unemployment when the labour market is in equilibrium.
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 his or her 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 shown by the below diagram and is Q2- Q1
Diagram of Natural Rate of Unemployment
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.
Monetarist View of Natural Rate of Unemployment
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.
Monetarist explanation of the 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 increase 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.)