The natural unemployment rate is the lowest level sustainable without creating inflation. In a healthy economy, workers are always coming and going, looking for better jobs. Until they find that new job, this jobless status is the natural rate of unemployment.
The natural rate of unemployment has been declining since the 1980s. One reason is that the percentage of older workers (age 55 and over) has increased, from 12.1% in 2000 to 23.6% in 2020. Older workers who lose their jobs are more likely to retire and leave the labor force instead of adding to unemployment levels.
The Cleveland Federal Reserve noted that "job polarization" has shifted the labor force into either low-skill or high-skill occupations. The middle-skill occupations have been replaced by technology, while high-skill workers are less likely to be laid off, which lowers the natural unemployment rate.
Even in a healthy economy, there is some level of unemployment for three main reasons:
- Frictional unemployment: There are always some workers who are in between jobs. Examples are new graduates looking for their first job, or workers who move to a new town without lining up another position. Some people may quit abruptly, knowing they'll get a better job shortly. Others might decide to leave the workforce for personal reasons such as retirement, pregnancy, or sickness. When they return and start looking again, the Bureau of Economic Analysis (BEA) counts them as unemployed.
- Structural unemployment: As the economy evolves, there is an unavoidable mismatch between workers' job skills and employers' needs. It happens when workers are displaced by technology, like when automation takes over manufacturing jobs. It also occurs when factories move to cheaper locations. For example, the U.S. auto industry lost 350,000 jobs after the North American Free Trade Agreement (NAFTA) was signed. Structural unemployment remains until workers receive new training.
- Surplus unemployment: This occurs whenever the government intervenes with minimum wage laws or wage/price controls. It can also happen with unions because employers must pay the mandated wage while staying within their payroll budget. The only way to do this is to let some workers go. It's the consequence of an unfunded mandate.
There are also six other serious types of unemployment: cyclical, long-term, real, seasonal, classical, and underemployment.
When setting interest rates, the Federal Reserve seeks to balance unemployment with growth and inflation. It uses 2% as the target inflation rate. Economists agree that the ideal gross domestic product growth rate is around 2%.
The Fed does not have a specific target for unemployment. It found that employers can find innovative ways to attract workers without raising wages.
The only way an economy could have a 0% unemployment rate is if it is severely overheated. Even then, wages would probably rise before unemployment fell to absolute zero.
The U.S. has never experienced zero unemployment. The lowest unemployment rate recorded was 2.5% in May and June of 1953. It occurred because the economy overheated during the Korean War. When this bubble burst, it kicked off the recession of 1953.
The natural rate of unemployment typically rises after a recession. Frictional unemployment increases once the downturn is over. Workers become confident they can quit their jobs and find a better one. Structural unemployment can also increase as the numbers of long-term unemployed rise. Their skills and experience became outdated.
The financial crisis of 2008 wiped out 8.7 million jobs and increased the unemployment rate to 10.2% in 2009. Many experts wondered if the severity of the recession would contribute to a higher natural rate of unemployment.
The Cleveland Federal Reserve found that the recession shifted the natural rate a bit higher, but less so than expected given its severity. Long-term trends that drive down the rate of natural unemployment outweighed the short-term impact of the recession.
- The natural rate of unemployment is the lowest level that a healthy economy can sustain without creating inflation.
- Natural unemployment contains three components: structural unemployment, surplus unemployment, and frictional unemployment.
- Zero unemployment is unattainable because employers would raise wages first.
- The 2008 financial crisis did not offset the long-term trends that are lowering the U.S. natural rate of unemployment.
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Natural unemployment, or the natural rate of unemployment, is the minimum unemployment rate resulting from real or voluntary economic forces. Natural unemployment reflects the number of people that are unemployed due to the structure of the labor force, such as those replaced by technology or those who lack certain skills to gain employment.
- Natural unemployment is the minimum unemployment rate resulting from real or voluntary economic forces.
- It represents the number of people unemployed due to the structure of the labor force, including those replaced by technology or those who lack the skills necessary to get hired.
- Natural unemployment persists due to the flexibility of the labor market, which allows for workers to flow to and from companies.
We often hear the term “full employment,” which can be achieved when the U.S. economy is performing well. However, full employment is a misnomer, because there are always workers looking for employment, including new college graduates or those displaced by technological advances. In other words, there is always some movement of labor throughout the economy. The movement of labor in and out of employment, whether it’s voluntary or not, represents natural unemployment.
Any unemployment not considered to be natural is often referred to as cyclical, institutional, or policy-based unemployment. Exogenous factors can cause an increase in the natural rate of unemployment; for example, an economic crash or steep recession might increase the natural unemployment rate if workers lose the skills necessary to find full-time work or if certain businesses close and are unable to reopen due to excessive loss of revenue. Economists call this effect “hysteresis.”
Important contributors to the theory of natural unemployment include Milton Friedman, Edmund Phelps, and Friedrich Hayek, all Nobel winners. The works of Friedman and Phelps were instrumental in developing the non-accelerating inflation rate of unemployment (NAIRU).
It was traditionally believed by economists that if unemployment existed, it was due to a lack of demand for labor or workers. Therefore, the economy would need to be stimulated through fiscal or monetary measures to bolster business activity and ultimately the demand for labor. However, this method of thinking fell out of favor as it was realized that, even during robust economic growth periods, there were still workers out of work due to the natural flow of workers to and from companies.
The natural movement of labor is one of the reasons why true full employment can’t be achieved, as it would mean that workers were inflexible or unmoving through the U.S. economy. In other words, 100% full employment is unattainable in an economy over the long run. True full employment is undesirable because a 0% long-run unemployment rate requires a completely inflexible labor market, where workers are unable to quit their current job or leave to find a better one.
According to the general equilibrium model of economics, natural unemployment is equal to the level of unemployment of a labor market at perfect equilibrium. This is the difference between workers who want a job at the current wage rate and those who are willing and able to perform such work. Under this definition of natural unemployment, it is possible for institutional factors—such as the minimum wage or high degrees of unionization—to increase the natural rate over the long run.
Ideas about the relationship between unemployment and inflation are continuing to evolve.
Ever since John Maynard Keynes wrote “The General Theory” in 1936, many economists have believed there is a special and direct relationship between the level of unemployment in an economy and the level of inflation. This direct relationship was once formally codified in the so-called Phillips curve, which represented the view that unemployment moved in the opposite direction of inflation. If the economy was to be fully employed, there must be inflation, and conversely, if there was low inflation, unemployment must increase or persist.
The Phillips curve fell out of favor after the great stagflation of the 1970s, which the Phillips curve suggested was impossible. During stagflation, unemployment and inflation both rise. In the 1970s stagflation was in part due to the oil embargo, which sent oil and gasoline prices higher while the economy sank into recession.
Today economists are much more skeptical of the implied correlation between strong economic activity and inflation, or between deflation and unemployment. Many consider a 4% to 5% unemployment rate to be full employment and not particularly concerning.
The natural rate of unemployment represents the lowest unemployment rate whereby inflation is stable or the unemployment rate that exists with non-accelerating inflation. However, even today many economists disagree as to the particular level of unemployment that should be considered the natural rate of unemployment.