Natural rate of unemployment
Encyclopedia
The natural rate of unemployment (sometimes called the structural unemployment rate) is a concept of economic
activity developed in particular by Milton Friedman
and Edmund Phelps
in the 1960s, both recipients of the Nobel prize in economics. In both cases, the development of the concept is cited as a main motivation behind the prize.
It represents the hypothetical unemployment rate consistent with aggregate production
being at the "long-run" level. This level is consistent with aggregate production
in the absence of various temporary frictions such as incomplete price adjustment in labor and goods markets. The natural rate of unemployment therefore corresponds to the unemployment rate prevailing under a classical
view of determination of activity. It is mainly undetermined by the economy's supply side, and hence production possibilities and economic institutions. If these institutional features involve permanent mismatches in the labor market or real wage rigidities, the natural rate of unemployment may feature involuntary unemployment.
Occurrence of disturbances (e.g., cyclical shifts in investment sentiments) will cause actual unemployment to continuously deviate from the natural rate, and be partly determined by aggregate demand factors as under a Keynesian view of output determination. The policy implication is that the natural rate of unemployment cannot permanently be reduced by demand management policies (including monetary policy
), but that such policies can play a role in stabilizing variations in actual unemployment.
Reductions in the natural rate of unemployment must, according to the concept, be achieved through structural policies directed towards an economy's supply side.
relationship between inflation
and unemployment began to break down. Until then, it was widely believed that a stable negative relation between inflation and unemployment existed. This belief had the policy implication that unemployment could be permanently reduced by expansive demand policy and thus higher inflation.
Friedman and Phelps opposed this idea on theoretical grounds, as they noted that if unemployment was to be permanently lower, some real variable in the economy, like the real wage, would have changed permanently. That this should be the case because inflation was higher appeared to rely on systematic irrationality in the labor market. As Friedman remarked, wage inflation would eventually catch up and leave the real wage, and unemployment, unchanged. Hence, lower unemployment could only be attained as long as wage inflation and inflation expectations lagged behind actual inflation. This was seen to be only a temporary outcome. Eventually, unemployment would return to the rate determined by real factors independent of the inflation rate. According to Friedman and Phelps, the Phillips curve was therefore vertical in the long run, and expansive demand policies would only be a cause of inflation, not a cause of permanently lower unemployment.
Milton Friedman emphasized expectations errors as the main cause of deviation in unemployment from the natural rate, whereas Edmund Phelps focused more in detail on the labor market structures and frictions that would cause aggregate demand changes to feed into inflation, and for sluggish expectations, into the determination of the unemployment rate. Also, his theories gave insights into the causes of a too high natural rate of unemployment (i.e., why unemployment could be structural
or classical).
. The latter terminology incorporates the idea that it is not possible to achieve a reduction in unemployment below the NAIRU at the cost of a higher, but stable rate of inflation. However, the implication, inherent in the "natural rate" terminology that this rate is determined by the structure of labor markets is dropped.
.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
activity developed in particular by Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
and Edmund Phelps
Edmund Phelps
Edmund Strother Phelps, Jr. is an American economist and the winner of the 2006 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Early in his career he became renowned for his research at Yale's Cowles Foundation in the first half of the 1960s on the sources of economic growth...
in the 1960s, both recipients of the Nobel prize in economics. In both cases, the development of the concept is cited as a main motivation behind the prize.
It represents the hypothetical unemployment rate consistent with aggregate production
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
being at the "long-run" level. This level is consistent with aggregate production
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
in the absence of various temporary frictions such as incomplete price adjustment in labor and goods markets. The natural rate of unemployment therefore corresponds to the unemployment rate prevailing under a classical
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
view of determination of activity. It is mainly undetermined by the economy's supply side, and hence production possibilities and economic institutions. If these institutional features involve permanent mismatches in the labor market or real wage rigidities, the natural rate of unemployment may feature involuntary unemployment.
Occurrence of disturbances (e.g., cyclical shifts in investment sentiments) will cause actual unemployment to continuously deviate from the natural rate, and be partly determined by aggregate demand factors as under a Keynesian view of output determination. The policy implication is that the natural rate of unemployment cannot permanently be reduced by demand management policies (including monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
), but that such policies can play a role in stabilizing variations in actual unemployment.
Reductions in the natural rate of unemployment must, according to the concept, be achieved through structural policies directed towards an economy's supply side.
The natural rate of unemployment and the Phillips curve
The development of the theory of the natural rate of unemployment came in the 1960s where economists observed that the Phillips-curvePhillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
relationship between inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
and unemployment began to break down. Until then, it was widely believed that a stable negative relation between inflation and unemployment existed. This belief had the policy implication that unemployment could be permanently reduced by expansive demand policy and thus higher inflation.
Friedman and Phelps opposed this idea on theoretical grounds, as they noted that if unemployment was to be permanently lower, some real variable in the economy, like the real wage, would have changed permanently. That this should be the case because inflation was higher appeared to rely on systematic irrationality in the labor market. As Friedman remarked, wage inflation would eventually catch up and leave the real wage, and unemployment, unchanged. Hence, lower unemployment could only be attained as long as wage inflation and inflation expectations lagged behind actual inflation. This was seen to be only a temporary outcome. Eventually, unemployment would return to the rate determined by real factors independent of the inflation rate. According to Friedman and Phelps, the Phillips curve was therefore vertical in the long run, and expansive demand policies would only be a cause of inflation, not a cause of permanently lower unemployment.
Milton Friedman emphasized expectations errors as the main cause of deviation in unemployment from the natural rate, whereas Edmund Phelps focused more in detail on the labor market structures and frictions that would cause aggregate demand changes to feed into inflation, and for sluggish expectations, into the determination of the unemployment rate. Also, his theories gave insights into the causes of a too high natural rate of unemployment (i.e., why unemployment could be structural
Structural unemployment
Structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment...
or classical).
The natural rate of unemployment and the NAIRU
The term "natural rate of unemployment" has largely been displaced by reference to the "non-accelerating inflation rate of unemployment", or NAIRUNAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...
. The latter terminology incorporates the idea that it is not possible to achieve a reduction in unemployment below the NAIRU at the cost of a higher, but stable rate of inflation. However, the implication, inherent in the "natural rate" terminology that this rate is determined by the structure of labor markets is dropped.
Hysteresis
Experience has suggested that the NAIRU is not stable, even in the absence of structural changes in labor markets. Rather, increases in unemployment tend to induce persistent increases in estimates of the NAIRU. This phenomenon has been referred to as hysteresisHysteresis (economics)
In economics, hysteresis refers to the possibility that periods of high unemployment tend to increase the rate of unemployment below which inflation begins to accelerate, commonly referred to as the natural rate of unemployment or non-accelerating inflation rate of unemployment )...
.
See also
- Phillips curvePhillips curveIn economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
- Diamond coconut modelDiamond coconut modelThe Diamond coconut model is an economic model constructed by the American economist and 2010 Nobel laureate Peter Diamond which analyzes how a search economy in which traders cannot find partners instantaneously operates. The model was first presented in a 1982 paper published in the Journal of...
- NAIRUNAIRUIn monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...
- Reserve army of labourReserve army of labourReserve army of labour is a concept in Karl Marx's critique of political economy. It refers basically to the unemployed in capitalist society. It is synonymous with "industrial reserve army" or "relative surplus population", except that the unemployed can be defined as those actually looking for...
- Frictional unemploymentFrictional unemploymentFrictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual....