The Natural Rate of Unemployment

Posted on: 16th May 2023


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The Natural Rate of Unemployment

Policymakers and economists use the natural rate of unemployment – also called u-star – to examine the state of the labor market. However, these policymakers and economists cannot directly observe the natural unemployment rate. They have to estimate it. These estimates are useful in answering the central microeconomics question – why does unemployment exist? According to D’Urbino (2017), “there are bigger wastes than the loss to the idleness of hours, days, and years by people who would rather be working.” Joblessness can topple governments, sink budgets, and ruin lives. Even so, the fight against unemployment is not extensive. Authorities and responsible institutions such as America’s central bank target the natural unemployment rate to resolve the problem.

At the natural rate of unemployment, inflation is stable. Therefore, when authorities and policymakers target this rate, they aim to control inflation or prevent unemployment from fluctuating too much. Unfortunately, it is impossible to eradicate unemployment. For one, its natural rate is an article of faith in many respects. Economists always seek it but never find it. They do not understand where it comes from and how it changes human lives (D’Urbino, 2017). Second, there are many reasons why policymakers cannot fully eradicate unemployment. First, moving from one job to another is time-consuming. This job shift causes “frictional unemployment,” which affects the natural rate. In some cases, shifting from one job to another leads to structural unemployment because those intending to change jobs have outdated skills.

The concern for economists around the world is not unemployment per se. It is the tradeoff between unemployment and inflation. They are following in the footsteps of John Maynard Keynes – the great British economist. In his book “The General Theory,” published in 1936, Keynes noted that it was difficult for many people to find jobs at the going wage in the aftermath of the Great Depression (D’Urbino, 2017). This difficulty did not affect the unskilled employees alone. It also impacted individuals with the right qualifications, experiences, and skills. With his treatment of involuntary unemployment, Keynes took the first step towards the natural-rate hypothesis. Classical economists believed the involuntary unemployment was due to high wages caused by trade unions (Barnichon & Matthes, 2017). But Keynes was sure this unemployment was due to lackluster spending. Keynes believed that workers would still have less to spend even if wages fell, worsening the demand deficiency. His preferred solution was for the governments to ensure full employment by managing aggregate demand.

When managing aggregate demand, policymakers are doing more than just selecting an unemployment rate. They are also simultaneously affecting the rate of price increment. This assertion had become central to Keynesianism by the late 1960s. Surprisingly, Keynes was not the founder of this component of his theory. He barely considered inflation in his analysis of unemployment.

Irving Fisher was the first to study the relationship between unemployment and inflation. He did so in 1926. His work resulted in the Phillips Curve, named for the London School of Economics’ William Phillips (see Figure 1). He is particularly noted for his 1958 study that tracked the association between joblessness and wage increases in the United Kingdom from 1861 to 1957. The results revealed a pretty stable relationship between the two: wages rose faster when unemployment was low, and vice versa. This discovery was remarkable because the numerous workers’ rights changes had occurred throughout the period. For example, most workers in Britain could not vote in 1861 (D’Urbino, 2017). By 1957, however, the government had nationalized the economy.

Figure 1: Effects of supply and demand shocks on Phillips Curve

Robert Solow and Paul Samuelson investigated the relationship between inflation and labor in the United States. With the Phillips Curve shifting around, the two economic luminaries concluded that no special relationship between the two components (inflation and unemployment) (Barnichon & Matthes, 2017). However, Samuelson and Solow noted that “wage rates tend to rise when the labor market is tight” in any era. They further concluded that the tighter the market, the faster the rate. The relationship between inflation and unemployment was like a menu to these two economists. It encouraged the concept that Keynesian policy makers’ job was picking a point on the Phillips Curve and illustrating how well that point matched their likes. In this regard, the tolerable rate of inflation determined the extent to which unemployment could fall because if the wages rose, prices would go up, too. Although the idea that inflation and unemployment were like a menu was prominent in the 1960s, it is not clear if policymakers thought of the relationship that way.

Nobel laureates Milton Friedman and Edmund Phelps were the two main detractors of the “menu” idea. Friedman canonically criticized ancient economic thinking when talking to the American Economics Association in 1967, after Mr. Phelps started issuing groundbreaking labor market models (D’Urbino, 2017). In his speech, Friedman contended that a natural unemployment rate would ultimately triumph over the rest even if policymakers had various options (like a menu). Friedman argued that if a central bank printed more money to lower unemployment, the large money supply would encourage spending. As people demand more products and services, prices for these products and services will increase, leading to inflation that catches the workers (buyers) by surprise. Since their wage increases happened when there was no inflation, these payments are worth nothing now that there is inflation. During this period of inflation, labor would be artificially cheap, and firms would hire more people, causing the unemployment rate to fall below the natural rate (and the central bank would have attained its objective).

The next time workers negotiate their pay, they demand a raise in their pay equivalent to the prevailing rate of inflation to restore their living standard, forcing the natural rate of unemployment to re-establish itself because neither the employer nor the employee has lost their bargaining power. This back and forth process will continue until employees demand to be paid higher salaries than the anticipated inflation to maintain their standard of living when this inflation finally arrives. If employees get a high salary in advance, they will not experience surprise inflation, and no instance of suddenly inexpensive labor would exist. Since there will be no hiring, joblessness will not reduce. This reality implies that central banks can only keep unemployment below the natural rate by outdoing themselves. Thus, Friedman concluded that it was wrong for Keynesians to fix a low unemployment rate to a determined high inflation rate. It was the condition for maintaining joblessness even a bit under the natural rate. This condition allowed inflation to increase every year.

Yet, no society can tolerate a rate of inflation that is infinitely increasing or dwindling. A temporary trade-off between employment and unemployment exists, and none of this trade-off is permanent. Central banks in developed countries understand and still utilize this principle. Thus, the Phillips Curve refers to Friedman’s temporary trade-off, and unemployment always end up being similar to the natural rate. This idea is still influential today because it emerged at the right time. Two years before 1968, unemployment was below four percent and inflation under three percent. When Friedman delivered his address, prices were increasing. Inflation reached 4.2 percent by the end of 1968 and hit 5.4 percent the following year, and unemployment did not change much (Barnichon & Matthes, 2017). However, Friedman’s idea was shaky because inflation did not fall as long as high unemployment. Oil-price shocks and bad supply-side policies pushed the rate up. Theorists also began attacking Friedman’s concept, claiming that its basis was the belief that inflation was “adaptive.”

Nonetheless, economists now understand the natural unemployment rate as a hypothetical rate of unemployment. Its main distinguishing characteristic is stable aggregate production and inflation (Barnichon & Matthes, 2017). Economists use this concept to determine the degree of labor market slack and assess the proper monetary policies. One challenge regarding the natural unemployment rate is estimating its value. As a result, various approaches are now available. For example, some scholars use statistical methods to infer the natural unemployment rate from the Phillips Curve directly. Others use the Phillips Curve in the context of more elaborate macroeconomic models. All the available approaches for approximating the rate have one thing in common: they hope to separate the fundamental slow-moving unemployment fluctuation components constant with unwavering growth and inflation. In all approaches, scholars use some components of the Phillips Curve to make an approximation given this tool’s ability to capture the relationship between aggregate supply and the economy. Phillips Curve links business pricing decisions with the production level. Its typical nature describes the fluctuation of inflation every time unemployment moves away from its natural level. It generally associates higher unemployment with lower inflation and vice versa.

Figure 2: Headline unemployment and natural rate estimate

Changes in what the public expects to be the future inflation rate can also affect Phillips Curve. These expectations may influence prices for various future transactions needing a benchmark value. Cost-push shocks are another typical factor affecting its performance. When people expect that inflation or cost-push shocks will increase in the future, the Phillips Curve moves upwards to suggest this high inflation rate. This understanding is the basis of the new approach for measuring the natural rate of unemployment used by (Barnichon & Matthes, 2017). They believe that if cost-push factors and inflation expectations are constant, inflation fluctuations should correspond to changes in this gap. The change will also convey critical information about the underlying natural rate of unemployment’s value over time. (Barnichon & Matthes, 2017) estimate the natural unemployment rate to forecast what is expected to be the unemployment rate over the long term considering the current state of the economy. This estimate can and often does vary over time, as shown in figure 2. The most interesting aspect of the natural unemployment rate estimated by (Barnichon & Matthes, 2017) is remarkably stable over time, ranging between 4.5 and 5.5 percent over the past century. This approximation is the elusive natural unemployment rate. 

Hannah Preston

Hannah Preston

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