The natural rate of unemployment is the rate of unemployment where the labour market is in a position of equilibrium. This means that the labour supply is equal to labour demand at a given real wage rate. All those people willing and able to take paid employment at the going wage rate do so. The NRU is therefore made up of all those who cannot work and those who simply choose not to.
Some people do not have to option of working this maybe due to illness, disability or injury. Those individuals who are less well off or poorly educated often choose not to work due to low job satisfaction and poor motivation and opt to claim government benefits instead of working. In the extreme some individuals may be tempted to work in the untaxed black market.
The diagram below shows the labour supply (those willing and able to take work at a going wage rate) and the labour force - the number of active participants in the labour market. The labour force expands as the real wage rises because there is a greater incentive to search for paid work and sacrifice leisure.
Employment on the x-axis measures the total labour hours supplied by workers in the economy in a given time period. As the real wage increases, the total number of hours supplied by the labour force will expand.
The natural rate of unemployment is not zero - at the equilibrium wage W1 in the diagram above, there is unemployment measured by AB. This is made up of frictional plus structural unemployment.
At a wage rate W2 (above the equilibrium "market-clearing wage") employment contracts along the labour demand curve and total unemployment rises.
Dis-equilibrium unemployment rises to the level shown by the distance CD. This is because labour demand has fallen and the labour force has expanded. There is an excess supply of labour - some people who are willing and able to find employment cannot get paid work.
The Natural rate occurs when the economy is in a position of long run equilibrium, i.e. when the long run aggregate demand equals long run aggregate supply. This means that when the economy is below the natural rate aggregate demand is above long run aggregate supply therefore workers should be able to bid up wages so that the short run aggregate supply curve shifts upwards causing the long run equilibrium to re-establish itself. Correspondingly if the economy is above the natural rate, workers will be forced to accept pay cuts. Therefore when the labour market is in equilibrium so is the economy.
Often associated with the NRU is ‘the rate of unemployment, which can be sustained without a change in inflation’, this is commonly referred to as ‘ The non accelerating inflation rate of unemployment’, NAIRU. At NAIRU the demand for labour is equal to the number of people prepared to supply their labour for the prevailing wage rate. Any unemployment is equilibrium unemployment and arises from labour market imperfections.
NAIRU is the rate of unemployment at which there is neither upward pressure on inflation nor downward pressure on inflation. Where as NRU is derived from a competitive market, NAIRU is usually developed from a model that recognizes imperfect competition in the labour market (Layard 1986). The sustainable level of unemployment is seen here as a bargaining equilibrium between firms and workers rather than a market clearing outcome.
A.W.Phillips, first developed this relationship between inflation and unemployment in 1958 and showed that there was a strong correlation between unemployment and wage changes. He found that there was a trade-off between unemployment and inflation, so that any attempt by governments to reduce unemployment was likely to lead to increased inflation
Once again it was Friedman who developed this theory suggesting that once expectations are taken into account the unemployment/inflation trade off is only a short-term possibility.
At point Ua the economy is at the NRU and zero inflation is being experienced. (NRU being; 0 to Ua).
According to Friedmans expectation theory the current rate of inflation determines firms’ and workers’ expectations of its future level, i.e. the expected rate of inflation on the Philips Curve is ‘b’ which is equal to zero. Meaning that there is no pressure upon prices or wages to change.
If the Government attempts to reduce the natural rate of unemployment by increasing the supply of money in the economy, it would lead to a growing pressure upon wages and prices. Firms therefore will attempt to increase their output by employing more workers, however in order to do this they must offer a wage increase. The extra costs of production will be passed on to the consumers in the form of a similar price rise for goods and services, this initial price rise that made it profitable to bid for extra labour.
As long as the money wage increase is less than the price increase firms will be happy to employ the extra workers who have been fooled into believing that they are receiving higher real wages by unexpectedly high inflation
Therefore in the short run workers will suffer what is known as a money illusion. Unemployment has now fallen from Ua to Ub and inflation increase from b to d.
In the long-run the workers realise that real wages have remained the same and
thus withdraw from employment. Worker will now take the new and higher expected rate of inflation into account in their wage bargains firms will therefore cut back on the labour they employed. Therefore unemployment rises back to its natural rate Ua where the expected rate of inflation ‘b’. The economy then moves to point C on the new Philips Curve labelled. If the Government continued with reflationary policies it will lead to accelerating inflation as the process is repeated.
Attempts to push unemployment below the natural rate will result in accelerating inflation, demonstrating why the NRU is sometimes referred to as NAIRU.
In order for the government to control the NRU, supply side policies will be used in an attempt to attract those voluntarily unemployed through increased incentives. Such policies are intended to increase the economy’s productive capacity through increasing the supply of factor inputs and their productivity. However throughout economists there is controversy between them as to what policy is best suited to control and reduce natural employment.
New Classical economists have often focused upon trade unions as contributing to an increase in natural unemployment in particular by restricting the supply of labour through the threat of industrial action. Linked to this the establishment of the minimum wage has discouraged firms to employ labour in certain occupations.
New classical economists favour government legislation in order to reduce the bargaining power of trade unions. Such legislation would mean employers are able to offer a lower wage rate therefore employing more workers. Similar policies would include the reduction in both personal income tax and social security benefits in order to lower the poverty gap along with the abolition of wage councils. These methods will ultimately shift the actual supply curve for labour nearer to the potential supply curve, in so doing lowering the natural rate of unemployment.
The current Labour government has introduced several state welfare benefit schemes aimed at encouraging people to work by making it more profitable to do so.
The ‘New Deal Programme’ introduced in 1997 aimed to provide all young people with either training or a job all those who refused were refused benefit. Many commentators see education and training as an important determinant. Improved training should lead to increased productivity and efficiency in the long run and will make individuals more employable by potential employers.
In 1999 the Families tax credit was introduced which allowed poorly paid working parents tax relief and a possible extra sum of cash.
Such schemes were successful through the Lawson boom over the late 1980’s. At this time a scheme was introduced to return the long time unemployed back into the workplace this was done through retraining and reclassification so that they were able to claim invalidity benefits.
The fundamental aspect of schemes such as these are to make it more profitable to work than to stay at home thus increasing the incentive to go out and get a job.
The natural rate of unemployment ‘callous’ because it implies that there is something natural about unemployment. Modern economics prefers to use the phrase the non-accelerating inflation rate of unemployment (NAIRU) ie the level of unemployment that is associated with a constant rate of inflation. At NAIRU the demand for labour is equal to the number of people prepared to supply their labour for the prevailing wage rate. Any unemployment is equilibrium unemployment and arises from labour market imperfections.
