Many of us might think that 0% is the lowest possible unemployment rate. Unfortunately, this is not the case in economics. Even if businesses are struggling to find workforce, unemployment can never drop to 0%. The natural rate of unemployment explains the lowest possible unemployment rate that can exist in a well-functioning economy. Want to know more about it? Read on!
What is the natural rate of unemployment?
The natural rate of unemployment is the lowest possible unemployment rate that can occur in an economy. Natural is the lowest unemployment rate because ‘full employment’ is not possible in the economy. This is due to three main factors:
- Recent graduates searching for work.
- People changing their careers.
- People lacking the skills to work in the current market.
The natural rate of unemployment is the lowest unemployment rate that occurs when demand and supply for labour are at the equilibrium rate.
Components of the natural rate of unemployment
The natural unemployment rate includes both frictional and structural unemployment but excludes cyclical unemployment.
Frictional unemployment
Frictional unemployment describes a period when people are unemployed while searching for a better job opportunity. The frictional unemployment rate is not harmful. It can be beneficial to a workforce and society as people take their time and effort to choose a job that matches their skills and where they can be the most productive.
Structural unemployment
It is possible to have structural unemployment even when the labour supply matches job availability. This type of unemployment is caused by either an excess of labour with a particular skill set or a lack of the skills needed for the current employment opportunities. Another possible cause may be that there are too many job seekers compared to the number of jobs available on the market at the current wage rate.
Cyclical rate of unemployment
The natural rate of unemployment doesn’t include cyclical unemployment. However, it is important to know how it works. The business cycle causes cyclical unemployment. A recession, for example, can cause cyclical unemployment to increase significantly. Conversely, if the economy grows, this type of unemployment is likely to decrease. It is important to note that cyclical unemployment is the difference between actual and natural unemployment rates.
The actual unemployment rate combines the natural rate and the cyclical unemployment rate.
Diagram of the natural rate of unemployment
Figure 1 below is a diagram of the natural rate of unemployment. Q2 represents the labour force that would like to work at the current wage. Q1 represents the labour that is willing to work and have the skills needed in the current labour market. The gap between Q2 to Q1 represents natural unemployment.
Figure 2. Natural rate of unemployment, StudySmarter Originals
Characteristics of the natural rate of unemployment
Let’s quickly summarise the key characteristics that define the natural rate of unemployment.
- The natural rate of unemployment is the lowest unemployment rate that occurs when demand and supply for labour are at the equilibrium rate.
- The natural rate of unemployment consists of the frictional and the structural unemployment rates.
- The natural rate of unemployment can never be at 0% due to factors such as new university graduates searching for a job.
- The natural unemployment rate represents labour movement into and out of employment for voluntary and non-voluntary reasons.
- Any unemployment that isn’t considered natural is called cyclical unemployment.
Causes of the natural rate of unemployment
There are a few causes that influence the natural rate of unemployment. Let’s study the main causes.
Changes in labour force characteristics
Experienced and skilled labour forces usually have lower unemployment rates compared to unskilled and inexperienced labour.
During the 1970s, the percentage of new workforce that included women under 25 who were willing to work rose significantly. However, this workforce was relatively inexperienced and did not have the skills to undertake many of the jobs available. Therefore, the natural rate of unemployment at the time increased. Currently, the labour force is more experienced compared to the 1970s. Therefore, the natural unemployment rate is relatively lower.
Changes in labour market institutions
Trade unions are one example of institutions that may affect the natural unemployment rate. Unions allow employees to participate in negotiations regarding the increase of salaries above the equilibrium rate, and this causes the natural unemployment rate to rise.
In Europe, the natural rate of unemployment is relatively high due to the union power. However, in the US, the natural rate of unemployment decreased due to the decline in union power during the 1970s and 1990s.
Online job websites that enable job seekers to research and apply for jobs also reduce frictional unemployment. Employment agencies that match jobs according to workers’ skills also contribute to reducing the frictional unemployment rate.
Furthermore, technological change impacts the natural unemployment rate. Due to technological enhancements, the demand for skilled labour force has increased significantly. Based on economic theory, this should result in wages for skilled workers rising and unskilled workers dropping.
However, if there is a set legal minimum wage, salaries can’t drop lower than what is legal leading to increased structural unemployment. This results in an overall higher natural unemployment rate.
Changes in government policies
Government policies can increase or decrease the natural unemployment rate. For example, increasing the minimum wage can cause the structural unemployment rate to rise as it will be expensive for companies to hire a lot of workers. Furthermore, if the benefits for the unemployed are high this can increase the rate of frictional unemployment as less workforce will be motivated to work. So, even when government policies are focused on helping the workforce, they can have some undesirable effects.
On the other hand, some government policies cause the natural unemployment rate to drop. One of those policies is employment training, which is aimed to provide workers with skills needed in the job market. Additionally, the government can provide employment subsidies to businesses, which are financial compensations that companies should use to hire more workforce.
Overall, supply-side factors affect the natural rate of unemployment more than the demand-side factors.
Policies to reduce the natural rate of unemployment
A government puts supply-side policies in place to reduce the natural rate of unemployment. These policies include:
- Improving education and employment training to improve the skills of the labour force. This helps them acquire the knowledge required for jobs currently available in the market.
- Making relocation easier for both labour and companies. The government can achieve this by making the housing market more flexible, such as giving short-term renting possibilities. The government can also encourage and make it easier for firms to expand in cities with high job demand.
- Making hiring and firing workers easier.
- Increasing the flexibility of the labour force. For example, reducing minimum wage and trade union power.
- Reducing welfare benefits to encourage workers to seek employment at the current wage rate.
How to calculate the natural rate of unemployment
We calculate the natural rate of unemployment in a region or country using the government's statistics. It is a two-step calculation method.
Step 1
We need to calculate the natural unemployment. To do that we need to add frictional and structural unemployment.
Frictional unemployment + Structural unemployment = Natural employment
Step 2
To find out the natural rate of unemployment, we need to divide the natural unemployment (Step 1) by the total number of the employed labour force, which is also called total employment.
Lastly, to get a percentage answer, we need to multiply this calculation by 100.
(Natural employment/ Total employment) x 100 = Natural rate of unemployment
Imagine a region where the frictionally unemployed people are 1000, the structurally unemployed 750, and the total employment is 60,000.
What is the natural rate of unemployment?
First, we add frictional and structural unemployment to find natural unemployment: 1000+750 = 1750
To determine the natural unemployment rate, we divide the natural unemployment by the total employment number. To get the percentage, we multiply this calculation by 100. (1750/60,000) x 100 = 2.9%
In this case, the natural rate of unemployment is 2.9%.
Example of the natural rate of unemployment
Let’s see how the natural rate of unemployment changes and varies in the real world.
If the government increases the minimum wage significantly, this can impact the natural rate of unemployment. Due to the high labour costs, businesses are likely to lay off workers and look for technology that can replace them. Increased minimum wage will increase the costs of production, which means that businesses have to increase the prices of goods. This will likely decrease their demand. As demand for products decreases, businesses will not require to employ as much labour force, which will lead to a higher natural unemployment rate.
Natural Rate of Unemployment - Key takeaways
- The natural rate of unemployment is the unemployment rate that occurs when the market is at equilibrium. That is when demand equals supply in the labour market.
- The natural rate of unemployment only includes frictional and structural unemployment.
- The natural rate of unemployment is the lowest possible unemployment rate that can occur in the economy.
- The actual unemployment rate is the natural rate of unemployment and the cyclical rate of unemployment.
- The main causes of the natural rate of unemployment are changes in labour force characteristics, changes in labour market institutions, and changes in government policies.
- The key supply-side policies put in place to reduce the natural rate of unemployment are:
- Improving education and employment training.
- Making relocation easier for both labour and companies.
- Making it easier to hire and fire workers.
- Reducing minimum wage and trade union power.
- Reducing welfare benefits.
- The cyclical rate of unemployment is the difference between the actual and natural rates of unemployment.
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