Part I Paper 2

Lecture 9
Natural Rate of
Unemployment

Chryssi Giannitsarou
Outline
 Definitions and statistics
 The natural rate of unemployment

Lecture 9 Unemployment I slide 1

Definitions and statistics
 Population of an economy = everyone alive!
 Adult, civilian population = everyone not
employed in the military, aged 16+
 Labour force = everyone in the adult,
civilian population, either employed or
actively seeking employment at the time of
measurement and available to start work
within a fortnight

Lecture 9 Unemployment I slide 2

Unemployment

 Labour force = # Employed + # Unemployed

# Unemployed
Unemployment rate = x 100
Labour force

Labour force
Participation rate = x 100
Adult population

 Note: discouraged workers not in labour force

Lecture 9 Unemployment I slide 3

Historical unemployment in the UK

Note: (i) There is always some unemployment in the economy,

(ii) no long run trend, but there is variation.
Lecture 9 Unemployment I slide 4
 0
2
4
6
8
10
12
14

1971 Q1
1972 Q2
1973 Q3

Lecture 9
1974 Q4
1976 Q1
1977 Q2
1978 Q3
1979 Q4
1981 Q1
1982 Q2
1983 Q3
1984 Q4
1986 Q1
1987 Q2
1988 Q3

Unemployment I
1989 Q4
1991 Q1
1992 Q2
1993 Q3
1994 Q4
1996 Q1
1997 Q2
1998 Q3
1999 Q4
2001 Q1
2002 Q2
2003 Q3
2004 Q4
2006 Q1
2007 Q2
2008 Q3
Source: ONS, Unemployment Rate %, SA

2009Q4
2011Q1
2012Q2
2013Q3
2014Q4
2016Q1
Unemployment in the UK, recent data

2017Q2
2018 Q3
2019 Q4
slide 5
Recent unemployment figures, EU

Lecture 9 Unemployment I slide 6

Labour market and the economy
 Wages account for two-thirds of per capita
GDP (labour share = 0.7)
 Average wages in many developed countries
have grown at 2 percent per year for the last
century
 Recessions (mild reductions in GDP) and
especially depressions (strong fall in GDP)
associated with unusually high
unemployment

Lecture 9 Unemployment I slide 7

Unemployment
 Job creation and job destruction
– Occur each month
– Are part of normal changes in the economy
 For most people, periods of unemployment
(unemployment spells) are relatively short
 People who are unemployed for long periods
account for most of the total weeks of lost work
 Many countries have developed social safety
nets

Lecture 9 Unemployment I slide 8

Different kinds of unemployment
 The natural rate of unemployment
– Rate that would prevail if the economy were in
neither a boom nor a bust
 Cyclical unemployment
– The difference between the actual rate and the
natural rate
– Associated with short-run fluctuations in output

Lecture 9 Unemployment I slide 9

 10
12
14

0
2
4
6
8
1971 Q1
1972 Q2
1973 Q3
1974 Q4

Lecture 9
1976 Q1
1977 Q2
1978 Q3
1979 Q4
1981 Q1
1982 Q2
1983 Q3
1984 Q4
1986 Q1
1987 Q2
1988 Q3

Unemployment I
1989 Q4
1991 Q1
1992 Q2
1993 Q3
1994 Q4
1996 Q1
1997 Q2
1998 Q3
1999 Q4
2001 Q1
2002 Q2
2003 Q3
2004 Q4
2006 Q1
2007 Q2
2008 Q3
2009Q4
Natural rate of unemployment

2011Q1
2012Q2
UK data - Source: ONS, Unemployment Rate %, SA

2013Q3
2014Q4
2016Q1
2017Q2
2018 Q3
2019 Q4
slide 10
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

Lecture 9 Unemployment I slide 11

Why is there unemployment?

Milton Friedman (1968):

The natural rate of unemployment is the equilibrium

level of unemployment, embedding the actual
characteristics of the goods and labour markets,
including market imperfections, variability in
demands and supplies, costs of gathering
information on vacancies, costs of mobility, ...

Lecture 9 Unemployment I slide 12

A first model of the natural rate
Pool model:
 Two endogenous variables: employment E
and unemployment U
 Model states how employment and
unemployment evolve over time
 Analogy: water entering and draining a pool
at the same rate
 Dynamic model, features a steady state

Lecture 9 Unemployment I slide 13

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

Lecture 9 Unemployment I slide 14

Assumptions
1. L is exogenously fixed
2. During any given month
s = fraction of employed workers
that become separated from their jobs
f = fraction of unemployed workers
that find jobs

s = rate of job separations

f = rate of job finding
(both exogenous)

Lecture 9 Unemployment I slide 15

Labour market flows
s E

Employed Unemployed

f U

Lecture 9 Unemployment I slide 16

Steady state (equilibrium)
 Definition: the labor market is in
steady state, or long-run equilibrium,
if the unemployment rate is constant
 The steady-state condition is:

# of employed
people who lose # of unemployed
or leave their people who find
jobs jobs

Lecture 9 Unemployment I slide 17

Equilibrium unemployment rate
fU = sE
= s  (L –U )
=sL – sU
Solve for U/L:
(f + s)  U = s  L
so,
U s
Unemployment

L s f
rate

Lecture 9 Unemployment I slide 18

Example
 Each month, 1% of employed workers lose
their jobs (s = 0.01)
 Each month, 19% of unemployed workers
find jobs (f = 0.19)
 Find the natural rate of unemployment:

Lecture 9 Unemployment I slide 19

Drawbacks
 This model gives a way to calculate the
natural rate of unemployment in the long run
BUT it does not explain why and how there
was unemployment in the first place
 Assumes job finding is not instantaneous
BUT it does not explain why

Lecture 9 Unemployment I slide 20

Changing the natural rate
 A policy will reduce the natural rate of
unemployment only if it lowers s or increases f
 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

Lecture 9 Unemployment I slide 21

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

Lecture 9 Unemployment I slide 22

Job search: Sectoral shifts
 DEF: changes in the composition of demand among
industries or regions
 Example: Technological change increases demand
for computer repair persons, decreases demand for
typewriter repair persons
 Example: A new international trade agreement
causes greater demand for workers in the export
sectors and less demand for workers in import-
competing sectors
 It takes time for workers to change sectors,
so sectoral shifts cause frictional unemployment

Lecture 9 Unemployment I slide 23

Sectoral shifts in UK

1980

2001

Lecture 9 Unemployment I slide 24

Sectoral shifts in the UK
 UK jobs, Nov 2019:
 Services: 84%
 Industry: 15%
 Agriculture: 2%

Source: BBC news and ONS

Lecture 9 Unemployment I slide 25

Sectoral shifts in US
Agriculture
Manufacturing
1960 2009
Other industry
Services
57.9% 79.0%

4.2%
1.0%

12.8%
9.9%
28.0% 7.2%

Lecture 9 Unemployment I slide 26

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 a dynamic economy,
smaller sectoral shifts occur frequently,
contributing to frictional unemployment.

Lecture 9 Unemployment I slide 27

Sectoral shifts post pandemic?
 Switch to telecommuting
 Less scope for retail on high-street
 Less entertainment and big events…
 etc

Lecture 9 Unemployment I slide 28

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

Lecture 9 Unemployment I slide 29

Benefits of unemployment insurance
 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

Lecture 9 Unemployment I slide 30

Job search: Public policy
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

Lecture 9 Unemployment I slide 31

Readings
 Jones: Chapter 7.1-7.5 (focuses more on US
labour market)
 Mankiw: Chapters 7 and 10.1

Lecture 9 Unemployment I slide 32