Natural rate of unemploymenty

Natural rate of unemployment is a course material to both UG and PG students of Economics.

1. JIJIKUMARI T

2. Natural rate of Unemployment Definition:  The natural rate of unemployment is a combination of frictional, structural and surplus unemployment. Even a  healthy economy  will have this level of unemployment because workers are always coming and going, looking for better jobs. This jobless status, until they find that new job, is the natural rate of unemployment. 

3. The  Federal Reserve  estimates that this  rate is between 4.5 percent and 5.0 percent . Both  fiscal  and  monetary policymakers  use that rate as the goal for a full employment. They use 2 percent as the  target inflation rate . They also consider the  ideal GDP growth rate  to between 2 percent and 3 percent. They must try to balance these three goals when setting interest rates, tax rates or spending levels.

4. Three Components of the Natural Rate of Unemployment Frictional Unemployment   Structural Unemployment Surplus Unemployment  – This occurs whenever the government intervenes with  minimum wage  laws or wage/price controls. It can also happen with unions. When wages are reset to a higher level, unemployment often results. Why? To keep within the same payroll budget, the company must let go of some workers to pay the remaining workers the mandated higher salary.

5. Did the Recession Raise the Natural Rate of Unemployment The  financial crisis of 2008  wiped out a staggering 8.3 million jobs. The unemployment rate rose from 4.7 percent to 10.1 percent at its peak in 2009. This huge loss meant that many of the unemployed stayed that way for six months or more. Long-term unemployment made it even more difficult for them to get back to work. Their skills and experience became outdated. 

6. The natural rate of unemployment typically rises after a recession. Frictional unemployment increases, since workers can finally quit their jobs, confident they can find a better one now that the recession is over. In addition, structural unemployment is higher, since workers have been  unemployed for so long  their skills no longer match the needs of businesses. 

7. Between 2009 and 2012, the natural rate of unemployment rose from 4.9 percent to 5.5 percent. That was higher than during the recession itself . -----------------------------------------------

8. Adaptive expectations-Augmented Phillips curve The augmented Phillips curve introduces  adaptive expectations  into the  Phillips curve . These adaptive expectations, which date from  Irving Fisher ’s book “The Purchasing Power of Money”, 1911, were introduced into the Phillips curve by  monetarists , specially  Milton Friedman . Therefore, we could say that the expectations-augmented Phillips curve was first used to explain the monetarists’ view of the Phillips curve.

9. Adaptive expectations models led to an important shift in the perception of a government’s ability to act. Under  Keynes ’  money illusion , changes in nominal variables (prices, wages, etc…) were accepted by agents as real despite overall purchasing power remaining stable.

10. However, monetarism embraced the adaptive expectations theory to mean that people would stumble once or twice on the same stone, but not a third. In this way, if the government decided on an expansionist  monetary policy ,  inflation  would rise and  unemployment  would fall, based on the Phillips curve.

11. However, a second or third time around, agents would be quick to associate higher inflation with rising salaries in a vicious circle, and adjust their behaviour accordingly based on past experiences. They would anticipate that inflation would drain their purchasing power accordingly, and monetary policy would have little effect. If we see this graphically:

12. Initially, unemployment and inflation are at point A. The government decides to embark on an expansionist monetary policy, which floods the markets with inexpensive credit, incentivising consumption. Expectations shift to point B along the Phillips curve: unemployment is reduced through economic stimulus with a trade off in the form of inflation .

13. However, after a short period, agents will begin to associate expansionist policies with inflation, which means a drain on their resources, and they will push for higher wages.

14. This will stop the consumption stimulus and also deincentivise hiring. Eventually, agents will shift their expectations curves to point C. A second time around, D will be achieved, leading more or less rapidly to point E. This is why, in the long term, inflation has little effect on unemployment and vice versa. Expansionist monetary policy will lead directly to inflation, with no permanent effect on unemployment.

15. In summary, monetarists sustained that the Phillips curve will hold up in the short term, but not in the long term. In the long term, the Phillips curve is completely vertical and determines the  natural rate of unemployment , as Friedman puts it in his article “The role of Monetary Policy”, 1968 . ----------------------------------------------