What Is the Natural Rate of Unemployment?
The natural rate of unemployment is a theoretical unemployment rate that exists when an economy is operating at its long-run potential output, with stable inflation. It represents the lowest sustainable level of unemployment that an economy can achieve without causing inflation to accelerate. This concept is a core element within the field of macroeconomics. The natural rate of unemployment reflects the combined effects of frictional unemployment and structural unemployment that are inherent in a dynamic economy.
History and Origin
The concept of the natural rate of unemployment gained prominence in the late 1960s, primarily through the work of economists Milton Friedman and Edmund Phelps. Before their contributions, the prevailing view, often associated with the Phillips Curve, suggested a stable, long-run trade-off between inflation and unemployment. This implied that policymakers could permanently reduce unemployment by accepting a higher, but stable, rate of inflation.
However, Friedman, in his 1968 Presidential Address to the American Economic Association, argued against this notion. He posited that there is no long-run trade-off between inflation and unemployment, and that attempts to push unemployment below its natural rate through inflationary monetary policy would only lead to accelerating inflation without a permanent reduction in unemployment.33, 34, 35 Phelps independently developed similar ideas, focusing on labor market structures and frictions.32 Their combined insights profoundly influenced economic thought and policy, leading to the understanding that the natural rate of unemployment is determined by real factors in the economy, rather than by monetary policy.30, 31
Key Takeaways
- The natural rate of unemployment is the lowest sustainable unemployment rate without accelerating inflation.
- It accounts for frictional and structural unemployment, which are always present in a dynamic economy.
- The concept was developed by Milton Friedman and Edmund Phelps, challenging the notion of a long-run trade-off between inflation and unemployment.
- It is a theoretical benchmark for policymakers seeking to achieve maximum employment and price stability.
- The natural rate of unemployment is not a fixed number and can change over time due to various economic and demographic factors.
Formula and Calculation
The natural rate of unemployment is a theoretical concept and does not have a precise, universally agreed-upon formula for direct calculation. Instead, economists typically estimate it using various models and empirical data. These estimations often involve analyzing the historical relationship between unemployment and inflation rates, often through the lens of the Phillips Curve, which illustrates the inverse relationship between the two.28, 29
One common approach involves statistical techniques to identify the unemployment rate at which inflation tends to stabilize or where inflationary pressures neither accelerate nor decelerate. This often involves looking at long-run trends and adjusting for cyclical fluctuations in the business cycle.
Interpreting the Natural Rate of Unemployment
Interpreting the natural rate of unemployment involves understanding that it represents an economy's equilibrium unemployment level, where labor and resource markets are considered to be in balance. When the actual unemployment rate falls below the natural rate, it suggests that the economy is operating above its sustainable capacity, which can lead to upward pressure on wages and, consequently, accelerating inflation.27 Conversely, if the actual unemployment rate is consistently above the natural rate, it indicates that the economy has spare capacity and there may be downward pressure on inflation or even disinflation.26
Central banks, such as the Federal Reserve, often use estimates of the natural rate as a benchmark in formulating monetary policy.24, 25 The goal is typically to achieve a level of employment close to the natural rate while maintaining price stability.22, 23 It's crucial to remember that the natural rate of unemployment is a dynamic concept, influenced by factors like labor market policies, technological advancements, and demographic shifts.
Hypothetical Example
Consider the hypothetical nation of Economia. For many years, Economia's natural rate of unemployment was estimated to be around 5%. This meant that when unemployment was at 5%, inflation remained stable.
In a particular year, Economia's government implements aggressive fiscal stimulus measures, leading to a surge in aggregate demand. The actual unemployment rate quickly falls to 3%. Initially, this lower unemployment seems beneficial, as more people are employed. However, because unemployment is now below the natural rate, labor markets become very tight. Businesses struggle to find enough workers and begin offering higher wages to attract and retain talent. These increased labor costs are then passed on to consumers in the form of higher prices, leading to a sustained increase in the inflation rate. The central bank of Economia might then respond by raising interest rates to cool the economy and bring inflation back to its target, which would likely cause unemployment to rise back towards its natural rate.
Practical Applications
The natural rate of unemployment has several practical applications for economists, policymakers, and financial analysts. Central banks widely use it as a crucial input for setting monetary policy. For instance, the Federal Open Market Committee (FOMC) of the Federal Reserve considers its longer-run projections for the unemployment rate as an estimate of the economy's normal rate of unemployment, which guides decisions on the federal funds rate.19, 20, 21
Furthermore, the natural rate helps in understanding the underlying health of the labor market. A significant deviation of the actual unemployment rate from the natural rate can signal inflationary or disinflationary pressures. Economic forecasts also incorporate estimations of the natural rate to project future inflation and economic growth.18 For example, the Congressional Budget Office (CBO) in the U.S. uses the natural rate of unemployment (which it sometimes refers to as the noncyclical rate of unemployment) to gauge slack in labor markets, which is important for inflation projections.17
Limitations and Criticisms
Despite its importance, the natural rate of unemployment concept faces several limitations and criticisms. One significant challenge is its imprecise measurement; as Milton Friedman himself acknowledged, the exact value of the natural rate cannot be known with certainty. Estimates can vary widely depending on the statistical methods and data used, leading to a broad range of possible figures.15, 16
Critics also point out that the natural rate is not static and can shift over time due to factors such as changes in labor market institutions, demographics, and technology.14 This makes it challenging for policymakers to rely on a single, fixed estimate. Some economists argue that the relationship between unemployment and inflation, particularly at low unemployment rates, may be more complex or less direct than the natural rate hypothesis suggests. This critique often stems from periods where low unemployment did not immediately lead to accelerating inflation, or where structural changes in the economy altered the traditional Phillips Curve relationship.13
Natural Rate of Unemployment vs. Non-Accelerating Inflation Rate of Unemployment (NAIRU)
While the terms "natural rate of unemployment" and "Non-Accelerating Inflation Rate of Unemployment (NAIRU)" are often used interchangeably, there's a subtle distinction in their origins and implications. The natural rate of unemployment was introduced by Milton Friedman and Edmund Phelps, emphasizing the idea of an equilibrium unemployment rate determined by real economic factors, independent of monetary policy in the long run.11, 12
NAIRU, on the other hand, was introduced later by Franco Modigliani and Lucas Papademos as an improvement or refinement of the natural rate concept.10 NAIRU is specifically defined as the theoretical unemployment rate below which inflation is expected to accelerate.8, 9 While both concepts point to a threshold unemployment rate beyond which inflationary pressures intensify, NAIRU is often seen as a more operational term used in macroeconomic modeling and by central banks to guide policy decisions aimed at maintaining price stability.6, 7 The distinction is primarily in emphasis: the natural rate focuses on the underlying structural components of unemployment, while NAIRU is more directly tied to the inflation dynamic.
FAQs
What causes the natural rate of unemployment to change?
The natural rate of unemployment can change due to various factors, including shifts in labor force demographics, changes in government policies (such as unemployment benefits or minimum wage laws), advancements in technology, and structural changes in industries that affect the demand for certain skills.5
Is full employment the same as the natural rate of unemployment?
No, full employment does not mean zero unemployment. Instead, full employment is generally understood to occur when the economy is operating at its natural rate of unemployment. This acknowledges that some level of frictional and structural unemployment is always present, even in a healthy economy.
How does the Federal Reserve use the concept of the natural rate of unemployment?
The Federal Reserve and other central banks use estimates of the natural rate of unemployment as a benchmark to assess the degree of slack or tightness in the labor market. This assessment informs their decisions on interest rate adjustments and other monetary policy tools aimed at achieving both maximum employment and stable inflation.3, 4
Can the natural rate of unemployment be directly observed?
No, the natural rate of unemployment is a theoretical construct and cannot be directly observed or precisely measured.2 Economists rely on various statistical models and historical data to estimate its value, which can lead to different estimates at any given time.1