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Natural Rate of Unemployment : Definition and Formula

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  1. 0:05 Introduction to Unemployment
  2. 2:00 Classical Theory of Unemployment
  3. 5:35 Reducing the Natural Rate of…
  4. 7:09 Lesson Summary
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Taught by

Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Explore the natural level of employment through the eyes of the Classical School and Keynesian economics, including fiscal policies that may reduce it.

Introduction

We're talking about the natural rate of unemployment. There are some important terms and definitions regarding the labor market that you need to know in economics.

Just imagine we find ourselves in the little town of Ceelo - quite a breathtaking place, if you ask me. Within the town of Ceelo, we find that Cindy just graduated from college, and she's actively looking for work. Cindy is frictionally unemployed, meaning that her decision is part of the normal turnover that happens in a healthy job market.

The natural level of employment occurs when the labor market is in equilibrium
Labor Market Equilibrium Point Graph

Now Cindy's dad, Matt, has lost his job because he no longer has the skills necessary to perform his job at the factory since they replaced all the machinery with high-tech gear and also moved a lot of the factory overseas. In addition, Matt's Uncle Fred works seasonally as a Santa Claus for Christmas parties on Wall Street and loves to eat salmon from the buffet, but he's not working since the holidays have long since passed. Matt and Fred are what we call structurally unemployed.

Matt's Uncle Fred has a brother named Frohm, and Frohm has lost his job as a high school gym teacher because of an economic slowdown. Things were going well, but when the economy slowed down, the school had to lay him off, so he's now unemployed. This is an example of cyclical unemployment. Frohm is cyclically unemployed.

Now, what we want to do is take the concept of supply and demand and apply it to the labor market.

When the labor market is in equilibrium, employment is at what economists consider the natural level of employment. That means employment is at a level at which the quantity of labor demanded equals the quantity supplied.

Classical Theory of Unemployment

So, let's talk about the classical theory of unemployment for a minute. In theory, the labor markets should be very quickly moving and efficient, which should lead supply and demand into equilibrium most of the time, and everyone should have a job that wants one. Right? This is the view of the classical theory of unemployment. Classical economists believe that unemployment must be due to some interference in the labor markets, such as regulations, which they believe should be removed.

In reality, Cindy, Matt, Fred, and Frohm are unemployed for one reason or another. Even if the economy is operating at an equilibrium level, there will still be some unemployment. Specifically, there will be frictional and structural unemployment, but no cyclical unemployment. That means that when the economy is at the natural rate of unemployment, Cindy, Fred, and Matt may be unemployed, but Frohm will still have his job. Therefore, most economists believe that over the long term, an unemployment rate of zero is unobtainable.

The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment. Economists also describe an economy at this natural rate as the full employment level of output. Now, because it's a theoretical concept, it's not possible to measure the natural rate, so economists have to estimate it.

Structural and frictional unemployment still occurs at the natural rate of unemployment
Natural Rate Unemployment Graph

Now, most of us, when we hear this, would think the natural rate is zero because we assume that the goal of government leaders is to remove unemployment so that everyone has a job who wants one. However, economists suggest that the natural rate of unemployment is between four and six percent. In our example, Cindy, her dad Matt, and his Uncle Fred are unemployed for reasons not caused by a recession.

The ups and downs of the economy - the expansions and contractions in real GDP - that we continue to experience over time will bring the employment level above or below the natural rate. For example, when the economy experiences a recession, additional unemployment is generated, which we call cyclical unemployment, or unemployment that's directly caused by an economic slowdown (hey, remember Frohm?). However, as firms and employees adjust their expectations to the ups and the downs, the economy generally moves back towards a natural level where there is no cyclical unemployment but only frictional and structural.

When the economy is growing rapidly, the actual unemployment rate is usually below the natural rate of unemployment. On the other hand, when it is growing very slowly, actual unemployment tends to be above the natural rate.

As it turns out, inflation is closely tied to this concept. The Federal Reserve tends to define the natural rate of unemployment as the rate of unemployment at which there is no tendency for inflation to accelerate or decelerate - in other words, where inflation is fairly stable and doesn't change from year to year. We can infer from this definition that when actual unemployment is below the natural rate, the likely result would be higher inflation.

Reducing the Natural Rate of Unemployment

Let's talk more about structural unemployment (which, in the previous example, would be Matt and Fred in the town of Ceelo). Structural unemployment can be caused by a mismatch between available jobs and workers' skills, as well as by a mismatch of location or challenges with the flow of information about jobs. Seasonal unemployment is also considered structural (remember, this is Fred, the Santa Claus who loves salmon).

Actual unemployment typically falls below the natural rate if there is rapid economic growth
Natural Rate Unemployment Rate Graph

According to economists at the Federal Reserve Bank of New York, the dominant type of unemployment that was prevalent during the 1991 and 2001 recessions was structural. They determined this by measuring the number of layoffs, then watching to see if those jobs were recovered after the recession. While some of them were recovered (cyclical unemployment of course), many were not.

In response to these causes of structural unemployment, there are certain fiscal policies that could lead to a reduction in the natural rate of unemployment - for example, providing additional job training programs to workers who are less skilled. When you help workers get better job training for the kind of jobs that are available, they improve their skills and gain knowledge that will help them qualify for these new jobs, and that's going to reduce unemployment.

So, that's an example of a fiscal policy that would help reduce the natural rate of unemployment.

Lesson Summary

So, let's summarize what we've talked about.

When the labor market is in equilibrium, employment is at what economists consider the natural level of employment. That means employment is at a level at which the quantity of labor demanded equals the quantity supplied.

Although the Classical School of economics believes that everyone can have a job who wants one, most economists believe that over the long term, an unemployment rate of zero is unobtainable.

The rate of unemployment consistent with the natural level is called the natural rate of unemployment. Economists describe an economy at this natural rate as the full employment level of output. The Federal Reserve tends to define it as the rate of unemployment at which there is no tendency for inflation to accelerate or decelerate. When actual unemployment is below the natural rate, however, the likely result is going to be higher inflation. Economists suggest that the natural rate of unemployment is between four and six percent. There are certain fiscal policies that could lead to a reduction in this natural rate of unemployment, such as providing additional job training programs to workers who are less skilled.

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