4.6: The Natural Rate of Unemployment

The natural rate of unemployment is a hypothetical rate and is often denoted by u*. However, it is not directly observable. Economists use several approaches and different assumptions to explain it. For example, some economists take a statistical approach covering data for over a hundred years.

One such approach was developed by Robert E. Hall. He assumed a fixed labor force, which means the sum of the number of employed and unemployed people remains constant. His model is based on the idea that the natural rate of unemployment is affected by two factors: the rate of job separation and the rate of job finding.

Some employed individuals leave their jobs, either by choice or due to layoffs, in any given period. This is referred to as job separation. The rate of job separation measures the share of employed people who become unemployed.

At the same time, some unemployed individuals secure employment. This process is known as job finding, and the rate of job finding represents the proportion of unemployed people who transition into employment.

Job separation refers to workers leaving jobs, whether voluntarily or involuntarily, while job finding captures the pace at which unemployed individuals are hired. The balance between these flows determines the steady-state level of unemployment.

If the rate of job separation is high, u* is high as many workers are losing jobs and entering unemployment. If the rate of job separation is low, u* is lower, since fewer workers are leaving employment and entering the pool of unemployed individuals.

If the rate of job finding is high, u* is low because unemployed individuals are moving into the pool of employed individuals quickly. If the rate of job finding is low, u* is high, as unemployed individuals remain jobless for longer periods.

Understanding u* is crucial as it is used in making several projections, including the potential output.

The natural rate of unemployment is the minimum level of unemployment that exists in a healthy, growing economy.

It's made up of two components: frictional unemployment and structural unemployment.

Frictional unemployment is temporary unemployment that happens when workers transition from one job to another, enter the labor force for the first time, or re-enter the labor force.

Structural unemployment is a long-lasting form of unemployment caused by fundamental shifts in an economy, such as technological advancements or changes in consumer demand. So, there is a mismatch between workers' skills and available jobs.

In any economy, some employed people lose their jobs by quitting or being laid off in any given period. Such instances are called job separation. At the same time, some unemployed individuals find jobs, which is known as job finding.

The natural rate of unemployment reflects both workers losing their jobs and job seekers finding employment.