The natural rate of unemployment

The natural rate of unemployment (NRU) refers to the amount of unemployment that exists in an economy when the labour market is in equilibrium.

Hence, the NRU is a microeconomic model that attempts to explain the macroeconomic problem of being unable to achieve full employment.

The labour market

The labour market is comprised of the demand for labour - which is derived from the demand for goods and services - and the supply of labour.

The demand for labour reflects the marginal productivity of labour.

The supply of labour has two elements to it.

The labour force

Firstly, there is the labour force as a whole, which represents the maximum that could be employed from those willing and able to work if there are no rigidities and labour is flexible and mobile.

Graphically, this curve slopes upwards, and is relatively steep (inelastic) because its takes time for the labour force as a whole to respond to changes in the wage rate.

For example, if there is a 10% increase in real wages in a given year, the amount entering the labour force is unlikely to increase by 10%, due to time lags between the increase in wages and a change in the labour force. This is because of factors including the imperfect flow of information, the time to train, and the need to obtain work visas if the labour force contains foreign workers.

The effective labour supply

The 'second' element of the supply of labour refers to those who can accept jobs at the going market wage rate - called the 'effective supply of labour'. This is less than the maximum because of imperfections arising from frictions and structural rigidities. For example, an individual in the labour force who is willing and able to work might simply be out of work because of the failure of a business, or because they need to acquire new skills to gain a particular job. They may also be in the process of searching for work, or have imperfect information about job availability.

Supporters of natural rate theory [1] also suggest that trade union power and the minimum wage prevent labour markets from clearing quickly, which adds to the NRU.

The 'gap' at any one time between the labour force and the effective supply of labour is the natural level of unemployment, and the natural rate is expressed as a percentage of the labour force. For example, for country X, the labour force might be 80m, and the effective labour supply is 75m, making an NRU of 6.25%.

We can see this graphically:

natural rate of unemployment

Here we can see that the market wage rate for the whole labour market is at W, where the demand for labour equals the effective supply. At this rate, the amount of labour employed is Es. However, there are still some unemployed, shown at the gap between E5 and Lf, which is the natural level of unemployment, which is made up largely of rigidities and imperfections.

Replacement ratio

A high replacement ratio can also add to the NRU.

Replacement ratio = disposable income when out of work
disposable income from being in work

The higher the replacement ratio, the greater the disincentive effect to accept employment. For example, a ratio of 1.0 would mean that there is nothing to be gained from work.

Can the NRU be reduced?

While the NRU model can explain the tendency of an economy to fall short of reaching full employment, it also give some clues as to how the 'gap' between the labour force and the effective supply of labour can be closed - namely, by reducing the rigidities and imperfections in the labour market.

Possible policies include:

The following policies may help reduce the NRU.

  1. Reducing the power of trade unions to control the supply of labour and other 'restrictive practices' including insisting that employers use a given number of employees for a particular job (such as an airline pilots union insisting on a certain number of pilots on every long-haul flight).
  2. Improving education and skills to make workers more 'employable'.
  3. Providing useful information to job seekers about job vacancies.
  4. Reducing the replacement ratio by reducing welfare benefits, or reducing marginal tax rates (to 'make work pay').

All of these are part of the collection of policies called supply-side policy.

Criticisms

There are several criticisms of NRU theory, the main ones being:

  1. Unlike traditional measures of unemployment, such as those claiming to be unemployed and seeking benefits, the 'natural rate' is not directly observable.
  2. This means it is not particularly useful for policy purposes, because if it cannot be observed then it cannot be targeted. This is unlike the similar concept of NAIRU - the non-accelerating-inflation rate of unemployment. While NAIRU is not directly observable the use of statistical models can provide an unemployment rate which is useful for policy purposes. 

[1] Natural rate theory was developed by American economists, Milton Friedman and Edmund Phelps in the late 1960s and is associated with the monetarist and New Classical schools of economic thought.