Defining The Natural Rate Of Unemployment And Analyzing Its Determinants

Defining the Natural Rate of Unemployment and Analyzing its Determinants

I. Defining Unemployment Terms

A. Underemployment refers to resources employed only partially, or somewhat less than their productive capacity. Unemployment refers to unused resources.

B. The unemployment rate is calculated by:

(Number of people Unemployed/ Number in Labor Force) * 100%

As an example, if a country of 100 Million people, all labor force participants, has Five Million out of work, the calculation is 5,000,000/100,000,000*100%=5%

The Labor Force is the number employed plus the number of people actively searching for employment.

C. The terms underemployment and unemployment can apply to all four Factors of Production: Land, Labor, Capital and Entrepreneurial skills. Within Labor, there are four types of unemployment. The first three are considered “natural” byproducts in an economy where upward mobility is allowed, and expected to be part of the labor force even in boom. The presence of these types of unemployment also reflects labor markets responding to dynamic industries that change the composition of their output based on signals from the product markets. 1. Structural unemployment – the unemployment created by the varying strength of industries in a dynamic economy. Structural unemployment is the result of a mismatch between skills possessed in the Labor Force and skills demanded by employers. There generally is some degree of mismatch between the structure of the Labor Force (in terms of skills, occupation choice/ specialization, industry, or geographical location) and the composition of Labor firms demand. Labor adjusts to dynamic requirements of the productive economy, but it takes time to retrain or move and during this time, that portion of the Labor Force is Structurally Unemployed. Example: Over time, an auto industry worker in Detroit may find he needs to broaden his skill set and/or move geographically, and during the transition period he is structurally unemployed.

2. Frictional unemployment – job changes and time graduates take to land a job that will come closer to maximizing their output and income. Sometimes termed “search employment”, usually close to 2% of the Labor Force are Frictionally Unemployed.

3. Seasonal unemployment – that portion of the labor force whose work depends on weather (construction, ski resorts) predictably experience seasonal unemployment in the off–season.

These three types comprise the Natural Rate is roughly 5%, but can vary over time from four to above six percent. Full Employment of the Labor Force does not mean 0% unemployment, but unemployment roughly equal to 5%. An Unemployment Rate below the Natural Rate reflects an economy below its average frictional and structural unemployment levels. Anything above the Natural Rate indicates presence of the fourth type of unemployment: Cyclical.

4. Cyclical unemployment – job loss due to economic fluctuations. In a boom, cyclical unemployment may be zero, but in a recession the number of cyclically unemployed will grow. How serious the problem (resource underutilization = inefficiency) becomes depends on the severity of the contraction in the economy. Cyclical unemployment is not considered a permanent fact in the economy, and is the type that Fiscal and Monetary policy seeks to eliminate

II. Changes in the Natural Rate Setting aside Cyclical unemployment, and focusing just on the important components of the Natural Rate (Frictional and Structural Unemployment): What is it that will increase or decrease the natural rate, that rate at which we can call an economy fully employed?

A. Structural Unemployment: 1. Can Fall if workers are developing modern skills more rapidly so the labor force adjusts more quickly to the changing demands of employers. 2. Can Fall to the extent governments support schools, skills training, and targeted retraining programs. 3. Can Rise if there is a dramatic change in the composition of goods produced such as in the 70’s and 80’s when jobs in Auto & Oil industries were supplanted by jobs in computer & biotech sectors. The reverse is also true, that Structural Employment falls if goods composition becomes more static. 4. Can Rise with the migration of a consumer base (especially for service sector employees) or globalization when imports replace domestic production

B. Frictional Unemployment: 1. Can Rise in expansions (booms) because there is a lot of voluntary labor mobility as workers seek higher paying jobs. 2. Both Frictional and Structural Unemployment can Fall if employers and searching workers have improved information about each other. The more prospective workers know about the skills required by hiring firms, which industries are growing and their geographical locations, the lower the natural rate. The Natural Rate will also reduce if Employers have better information enabling them to match job duties with a candidate’s core competencies. We can expect, over time, that improved communication methods and particularly online job sites, databases, and resume-delivery tools will improve information in the labor market, reducing the Natural Rate.