Full Employment and the Natural Rate of Unemployment

It commonly has been the goal of policy makers to use monetary policy to achieve the goal of full employment in the economy. Over the years, several different definitions have been proposed for full employment, but such a definition is complicated by the fact that the economy always has some unemployment, even during economic expansions. This non-zero rate of unemployment is due to:

• Frictional unemployment - caused by the fact that it takes time for employers and workers to find an appropriate match. For example, job seekers tend to spend time to find the best possible job rather than take the first one available, and employers take the time to interview several candidates to find the best fit. Unemployment insurance increases frictional unemployment by decreasing the opportunity cost of unemployment, thereby increasing the lowest wage that the job seeker would be willing to accept and lengthening the job search.
• Structural unemployment - refers to unemployment caused by a mismatch between workers and jobs. This mismatch may be in geographical location or in skills. For example, technological change may have caused a worker's skills to become obsolete, and he or she may experience a period of unemployment before finding the opportunity to develop new skills and to adapt. The resulting surplus of labor (quantity supplied is greater than quantity demanded) is influenced by minimum wage laws, collective bargaining, and efficiency wages, all of which create higher wages that attract more people into the labor force while decreasing the demand for labor.

Since zero unemployment is unachievable in a free labor market, Milton Friedman used the term natural rate of unemployment to describe the baseline rate of unemployment, considering that some unemployment cannot be avoided. The natural rate of unemployment is the sum of the frictional and structural unemployment rates. It does not include cyclical unemployment that results from a downturn in the business cycle.

When the unemployment rate falls below its natural rate, there is upward pressure on wages, and the economy runs the risk of inflation. Rather than a simple trade-off between the rate of inflation and the rate of unemployment, under the natural rate hypothesis once the rate went below the natural rate, inflation would accelerate. The natural rate of unemployment became known as the non-accelerating inflation rate of unemployment (NAIRU).

The natural rate of unemployment changes over time. In the U.S., some mainstream economists have placed the natural rate of unemployment in the 5% to 6% range, though other economists have placed it as low as 4% and as high as 7% over the past several decades. This variability and lack of precision in the natural rate of unemployment represent a source of uncertainty with which policy makers must deal.

Public policy itself has an impact on the natural rate of unemployment. With regard to frictional unemployment and labor surplus we see at least two levers controlled by public policy: 1) unemployment insurance, and 2) minimum wage laws. As discussed above, both of these tend to increase the natural rate of unemployment, and there is a trade-off between the benefits of such labor policies and an increased natural rate of unemployment.