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What is the current natural rate of unemployment? How has it changed, and why is it important?

The natural rate of unemployment is arguably one of the most controversial economic topics. With no real, accurate consensus as to what the actual natural rate is, all theories and policies that surround it are bound by the notion of uncertainty. How is it determined? How is it known that this amount of labor brings the economy to its productive potential from a labor standpoint? With so many economists sharing various degrees of theories as to what the natural rate is, there is no general consensus, but yet its such a heavily relied upon benchmark for the state of our economy. Its so important due to the effects it has on all other economic factors such as inflation and output. Through theory, concept, and graphical explanations we will try to delve into the underlying consensus as to how the NAIRU has changed during this time of economic confusion and why it is such a critical factor in our economy. Over the past few years amidst the turmoil of the Great Recession, the unemployment rate has become a more substantially relied upon indicator to the health of the economy. Although the unemployment rate has traditionally only been a measure of the health of the Labor Market, as of late its had a much larger value applied to its concept. The unemployment rate is defined as the percentage of the Labor Force that is unemployed. A person is considered unemployed if they are actively looking for a job over a four week period but still have no job. While this doesnt seem like an accurate measure of the health of the economy because it only measures the labor force, not the entire civilian population, the labor force is the productive form of human capital which contributes to the overall productivity of the economy as a whole. While this doesnt have many long run implications since the economic model states the economy will

reconfigure back to the natural rate of unemployment, it does measure the short run health of the economy. As a result of this past recession it has also shown us how this short run economic indicator can have a long-term permanent effect on the overall natural rate of unemployment in an economy. The natural rate of unemployment is defined as the rate at which the economy is at full employment. When the economy is at the natural rate of unemployment it is producing at its fullest potential, meaning firms are producing at their profit maximizing potential in terms of labor employed. This includes the frictional and structural unemployment with regards to skill mismatches, geographical mismatches, and time in between jobs. The Federal Reserve states its dual mandate as maintaining price stability and promoting maximum employment. This isnt just so everyone in America can have their little country house with the white picket fence, two kids, and a dog, this is because its a true measure and keystone to the health of the overall economy. In the case of the 1960s and 70s economists exploited the short run tradeoff of the Phillips Curve by lowering unemployment to historic levels and in turn sacrificed higher long run inflation. Eventually inflation expectations caught up with this flawed policy, and the economy was pushed back to the natural rate of unemployment while inflation was permanently raised due in part to the demand of real wages and oil price shocks. This caused for a serious of induced recessions due to Paul Volckers raised interest rates to choke off the upward accelerating inflation. Then during the 1990s, the technology wave pushed aggregate supply to the right in the form of a positive permanent supply shock, unemployment was kept at the natural rate or NAIRU (Non-Accelerating-Rate-of-Inflation) which held inflation at bay and led to a large increase in overall economic productivity and the largest economic expansion in U.S. history (120 months). The natural rate is so important because of the way it affects all other variables of

the economy. Even though many foreign economies and governments only have the single mandate of pursuing an inflation target they have much higher unemployment rates. Although this is due somewhat to stricter work policies in the European Union and stronger labor unions, it also shows the productive capacity of the economy. The U.S., even though it may be severely in debt at this point in time, is far and away the worlds leader in gross domestic product.

Our ability to undoubtedly produce more domestic revenue than any other country in the world by nearly $9 trillion says something. We are not saying that unemployment is the reason that we can produce so much more than the rest of the world, but it has a major influence. You may also interpret it in terms of the American Dream. Ever since the late 1800s the notion of coming to the United States in pursue of the American dream where job opportunities are endless and the roads are painted with gold has held strong. Weve been a keystone for education and a stronghold for jobs, but over the last few years in this economic turmoil weve become a black

hole of labor reduction. Over the course of the last Great Recession from 2007-2008 the U.S. economy shrank 4.5%. Jobs were cut, corporations shut down, banks fell out, and confidence was about as low as the Federal Funds Rate, at the zero -lower bound. 8.3 million Jobs were lost as unemployment rose from a productive 4.7% to a peak of 10.1% in 2009. The issue of unemployment in the past hasnt been as terrible and sluggish as it is today. The typical turn around periods have been much more reactive after past recessions when the economy has started to expand aggregate demand and as jobs are filled throughout the upswing. The reason unemployment has been so painfully slow to recover is the time that people stay unemployed. This recession lasted longer than it should have given the low levels of consumer and business confidence. The psychological combustion of both employees and employers led to a 50% increase in the amount of time workers stay out of work. When 14.5 million people are unemployed for an average duration of 34 weeks that has a lasting effect on the economy and a permanent effect on the natural rate of unemployment. It was a permanent supply shock in terms of the employment of labor. The depth of economic uncertainty not only surrounding the labor market but the housing market has led to this increase in unemployment duration and job mismatches. With unemployed workers not being able to sell their houses or relocate to find jobs more suitable to their skill set it increases the time off from work.
The degree of mismatch between job seekers and potential employers has increased. The construction, finance, and real estate sectors have shrunk after the bursting of the housing bubble and the subsequent financial crisis. The skills of workers who used to be employed in those sectors may not be easily transferable to growing sectors such as education and health care.Similarly, the housing bust has left millions of homeowners underwater on their mortgages, which locks them into their homes and may make it more difficult for them to move to higher growth areas. These sectoral and geographic mismatches between workers and job openings may be making it harder for employers to fill vacancies. (Weidner and Williams, 2011)

Not to mention that with increased long-term unemployment with workers out of work for a more extended period of time, the skills the acquired begin to deteriorate.

With workers out of work for longer periods of time its a slower recovery process. Not to mention that the partisanship of our government and its inept ability to not make decisions that act to help enact policies that immediately provide economic expansion has not helped this cause. Given uncertainty politically and across the world, its been hard for many firms to be able to offer many jobs without losing money. With businesses just beginning to recover from the recession theyre very uncertain about the future of the economy and are reluctant to spend money and invest in more labor. Uncertainty is eminent in nearly every realm of this economy, but largely on unemployment. No one actually knows the natural rate of unemployment, especially during this period of increased uncertainty. Economists have widely varying views on whether the natural rate is as low as 5.5% or as high as 7%.

Increased uncertainty makes it increasingly harder for policy makers to come up with a solution. If they induce a policy while they believe unemployment is low when its actually a lot higher than they forecasted they could have reverberations around the economy unintentionally affecting inflation and other factors they did not intend to. How can the Fed alleviate our labor problems when estimates vary so widely? With the largest economic downturn since the 1930s Great Depression with economic activity receding so substantially there were pronounced permanent effects on the economy. Some had to do with new financial policies and regulations, but given such severe reductions and financial credit system catastrophes there was a permanent effect in the productive potential of the economy. Though most may not have a lasting effect, this recession which depleted the labor market has had a long term effect on the Natural rate of Unemployment.

Citations

1) Tasci, Murat, and Saeed Zaman. "Unemployment after the Recession: A New Natural Rate?"Cleveland Fed. Federal Reserve Bank of Cleveland, 80 Sept. 2010. Web. 07 Dec. 2011. <http://www.clevelandfed.org/research/commentary/2010/2010-11.cfm>. 2) Weidner, Justin, and John C. Williams. "What Is the New Normal Unemployment Rate."Economic Research. Federal Reserve Bank of San Francisco, 12 Nov. 2011. Web. 3 Dec. 2011. <http://www.frbsf.org/publications/economics/letter/2011/el2011-05.html>.