Natural rate of unemployment

 Natural rate of unemployment:

The average rate of unemployment around which
the economy fluctuates.
 In a recession, the actual unemployment rate rises
above the natural rate.
 In a boom, the actual unemployment rate falls below
the natural rate.

CHAPTER 6 Unemployment slide 1

 Actual and natural rates of
unemployment in the U.S., 1960-2006
12
Percent of labor force

Unemployment rate
10

4 Natural rate of
unemployment
2

0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 6 Unemployment slide 2
 A first model of the natural rate

Notation:
L = # of workers in labor force
E = # of employed workers
U = # of unemployed
U/L = unemployment rate

CHAPTER 6 Unemployment slide 3

 Assumptions:

1. L is exogenously fixed.
2. During any given month,
s = fraction of employed workers
that become separated from their jobs
s is called the rate of job separations
f = fraction of unemployed workers
that find jobs
f is called the rate of job finding
s and f are exogenous

CHAPTER 6 Unemployment slide 4

 The transitions between
employment and unemployment
s E

Employed Unemployed

f U

CHAPTER 6 Unemployment slide 5

 The steady state condition

 Definition: the labor market is in

steady state, or long-run equilibrium,
if the unemployment rate is constant.
 The steady-state condition is:
s E = f U
# of employed
people who # of unemployed
lose or leave people who find
their jobs jobs

CHAPTER 6 Unemployment slide 6

 Finding the “equilibrium” U rate

f U = sE
= s  (L – U )
= sL – sU
Solve for U/L:
(f + s)  U = s  L
so,
U s

L s f
CHAPTER 6 Unemployment slide 7
 Example:

 Each month,
 1% of employed workers lose their jobs
(s = 0.01)
 19% of unemployed workers find jobs
(f = 0.19)
 Find the natural rate of unemployment:
U s 0.01
   0.05, or 5%
L s f 0.01  0.19

CHAPTER 6 Unemployment slide 8

 Policy implication

 A policy will reduce the natural rate of

unemployment only if it lowers s or increases f.

See Supplements 6-1, Social Costs of

Unemployment, 6-2, Job Finding and Job
Separation, and 6-3, A More General Theory of
the Natural Rate of Unemployment

CHAPTER 6 Unemployment slide 9

 Why is there unemployment?

 If job finding were instantaneous (f = 1),

then all spells of unemployment would be brief,
and the natural rate would be near zero.
 There are two reasons why f < 1:
1. job search
2. wage rigidity

CHAPTER 6 Unemployment slide 10

 Job search & frictional unemployment

 frictional unemployment: caused by the time

it takes workers to search for a job
 occurs even when wages are flexible and there
are enough jobs to go around
 occurs because
 workers have different abilities, preferences
 jobs have different skill requirements
 geographic mobility of workers not instantaneous
 flow of information about vacancies and job
candidates is imperfect
CHAPTER 6 Unemployment slide 11
 Sectoral shifts
 def: Changes in the composition of demand
among industries or regions.
 example: Technological change
more jobs repairing computers,
fewer jobs repairing typewriters
 example: A new international trade agreement
labor demand increases in export sectors,
decreases in import-competing sectors
 Result: frictional unemployment

CHAPTER 6 Unemployment slide 12

 CASE STUDY:
Structural change over the long run
Agriculture
Manufacturing
1960 Other industry
2000
Services
57.9% 73.5%

4.2%
1.6%

9.9% 17.2%
28.0% 7.7%
CHAPTER 6 Unemployment slide 13
 More examples of sectoral shifts
 Late 1800s: decline of agriculture,
increase in manufacturing
 Late 1900s: relative decline of manufacturing,
increase in service sector
 1970s: energy crisis caused a shift in demand
away from gas guzzlers toward smaller cars.

In our dynamic economy,

smaller sectoral shifts occur frequently,
contributing to frictional unemployment.
CHAPTER 6 Unemployment slide 14
 Public policy and job search

Govt programs affecting unemployment

 Govt employment agencies:
disseminate info about job openings to better
match workers & jobs.
 Public job training programs:
help workers displaced from declining industries
get skills needed for jobs in growing industries.

CHAPTER 6 Unemployment slide 15

 Unemployment insurance (UI)
 UI pays part of a worker’s former wages for a
limited time after losing his/her job.
 UI increases search unemployment,
because it reduces
 the opportunity cost of being unemployed
 the urgency of finding work
f
 Studies: The longer a worker is eligible for UI,
the longer the duration of the average spell of
unemployment.
CHAPTER 6 Unemployment slide 16
 Benefits of UI

 By allowing workers more time to search,

UI may lead to better matches between
jobs and workers,
which would lead to greater productivity and
higher incomes.

CHAPTER 6 Unemployment slide 17

 Why is there unemployment?

U s
The natural rate of unemployment: 
L s f
 Two reasons why f < 1:
DONE 1. job search
Next  2. wage rigidity

CHAPTER 6 Unemployment slide 18

 Unemployment from real wage
rigidity
Real Supply
If real wage is wage
stuck above Unemployment
its eq’m level,
then there Rigid
aren’t enough
jobs to go real
around. wage
Demand

Labor
Amount of
Amount of labor
labor hired
willing to work
CHAPTER 6 Unemployment slide 19
 Unemployment from real wage
rigidity
Then,
Then, firms
firms must
must ration
ration the
the
If real wage is
scarce
scarce jobs
jobs among
among workers.
workers.
stuck above
its eq’m level, Structural
Structural unemployment:
unemployment:
then there
The
The unemployment
unemployment resulting
resulting
aren’t enough
from
from real
real wage
wage rigidity
rigidity and
and
jobs to go
job
job rationing.
rationing.
around.

In
In economics, rigidities are real prices
economics, rigidities are real prices and wages that
and wages that failfail to
to
adjust
adjust to
to the
the level
level indicated
indicated byby equilibrium
equilibrium or
or ifif something
something holds
holds
one
one price
price or wage fixed
or wage fixed to to aa relative
relative value
value of
of another..
another..
CHAPTER 6 Unemployment slide 20