Chapter (7)

Unemployment and its Natural Rate

(Chapter 28 in the book)
 Introduction
• A country that saves and invests a higher fraction of its income, for instance,
enjoys more rapid growth in its GDP than a similar country that saves and
invests less.

• An even more obvious determinant of a country’s standard of living is the

amount of unemployment it typically experiences.

• When a country keeps its workers as fully employed as possible, it achieves a

higher level of GDP than it would if it has many workers standing idle.
 How is Unemployment Measured?
To identify or measure unemployment, we will consider first the labor force.
What does the labor force consist of?

• The employed people: these are people with jobs. Employed people are
people who perform any paid work as well as those with jobs but absent from
work because of illness or vacation.

• People without jobs but looking for work and those are called the unemployed
people.

• Those together constitute the components of the labor force.

 How is Unemployment Measured?
• Labor Force = number of employed + Number of Unemployed where as
people without jobs who are not looking for work are outside the labor force.

• The Unemployment Rate = No. of Unemployed x 100

Total No. of Labor Force
• And it has nothing to do with those who are not working and not looking for
jobs.
 How is Unemployment Measured?
• The labor force participation rate measures the percentage of the total adult
population of the country that is in the labor force

Labor-Force Participation Rate = Labor Force x 100

Adult Population
 How is Unemployment Measured?
Example: Consider the figures of the USA economy is 1998:
• No. of employed people = 131.5 million
• No. of Unemployed people = 6.2 million
• US Adult population = 205.2 million

Calculate the Labor Force and the Unemployment Rate, and

the Labor force participation rate.
 How is Unemployment Measured?
Answer:
• Total Labor Force in the USA = 131.5 + 6.2 = 137.7 million
• Unemployment Rate = 6.2 / 137.7 x 100 = 4.5%
• Labor – Force Participation Rate = 137.7 / 205.2 x 100 = 67.1%
• Hence in 1998, 2/3 of the US adult population were participating in the labor
market, and 4.5% is the unemployment rate.
 Kinds or Types of Unemployment
Unemployment is classified into 3 kinds:
• Frictional Unemployment
• Structural Unemployment
• Cyclical Unemployment
 Frictional Unemployment
arises because of the continuous movement of people between different
regions and jobs or through different stage of the life cycle,

So Frictional unemployment arises of workers who:

o Newly enter the labor force (such as new graduated)
o Or those who Re-enter labor force at a late stage of their life. (such
as women after having children)
o Or those who move between different jobs or cities.
 Frictional Unemployment
So even if an economy were at full-employment at its Potential GDP, there
would always be people searching for jobs:
o when they graduate from school or moving to a new city and looking for
new jobs.
o Women, as well, will always get out and re-enter the labor force at different
periods of their lives.

• However frictional unemployment is inevitable because the economy is

always changing as well as voluntary type of unemployment.
 Structural Unemployment
• arises of workers who are in regions and industries that experience persistent
changes.

o For example, a sharp depression in the auto or steel industry creates

structural unemployment which shows that whenever there is a mismatch
between SS and DD for labor, then structural unemployment arises.

• With a depression in one industry, DD is less than SS, hence excess supply
of labor and the result is what we call Structural Unemployment.
 Cyclical Unemployment
• exists when the overall economy suffers downtown or a recession.

• With a recession, the demand decreases, hence consumption and GDP

decrease.

• As GDP decreases, Unemployment arises, which is called Cyclical

Unemployment.
 Natural Rate of Unemployment (NRU)
• One of the key concepts in modern macroeconomics is the NRU.

• It is the level of unemployment that occurs even if the nation’s labor market is
said to be in equilibrium (fully employment).

• This NRU means that even if at equilibrium in labor market, a certain rate of
unemployment exists which is the natural rate of unemployment.

• The NRU represents the lowest sustainable level of unemployment which

occurs at the level of full-employment or Potential GDP of the economy.
 Natural Rate of Unemployment (NRU)
Two important points should be known about this rate:
1- NRU is not ZERO but rather a number above it:
o So even if the economy is at its Potential GDP in a state of long-run
equilibrium, there will still exist a certain rate of unemployment called the
NRU which is higher than zero.

o This is due to the fact that there is a constant change in the DD and SS
for goods and services and consequently a change in the demand and
supply of labor which will cause some rate of unemployment to exist and
this represents the NRU.
 Natural Rate of Unemployment (NRU)
2- The NRU is related to inflation:
o There is always a tradeoff (opposite relationship) between Unemployment
and Inflation in an economy,
o so that if to decrease unemployment to zero, inflation rises highly and a
serious problem arises in the economy.
 Natural Rate of Unemployment (NRU)
• That is why economists don’t try to get NRU = 0.

• For example, if to decrease unemployment, economy increases GDP which

automatically leads to reducing unemployment; this usually comes at the
expense of increasing inflation in an economy.
 Natural Rate of Unemployment (NRU)
• So the only reason why economists do not allow the economy to attain such
low unemployment rate is the fear if increasing inflation.

• That is why NRU is defined as the lowest unemployment rate that a nation
can enjoy without risking or causing inflation.
 Natural Rate of Unemployment (NRU)
• Thus the economy keeps in decreasing unemployment till that rate when the
price starts to increase and this achieved rate is the NRU, and it is found that
this NRU occurs at the nation’s potential GDP.
 Public Policy to Reduce Unemployment
• Facilitate Job Search

• Unemployment Insurance programs

• Minimum Wage Laws

 Facilitate Job Search
• The more the government can facilitate job search, the more it will be
able to reduce frictional unemployment,

• So if policy can reduce the time it takes the unemployed workers to find
new jobs, it can reduce the economy’s rate of unemployment.
 Facilitate Job Search
• Government programs try to facilitate job search in various ways:

o One ways is through government-run employment agencies, which give

out information about the available job vacancies in the market.

o Another way is through public training that aims at improving labor

qualifications to match requirements of the modern labor market.
 Facilitate Job Search
• Advocates of these programs believe that it will make the economy work more
efficient by keeping the labor force more fully employed.

• The critics of these programs say that government should not get involved
with the process of job search.

• In fact the government has much more important roles to perform rather that
looking for jobs for the unemployed people.
 Unemployment Insurance programs
• One government program that increases the amount of frictional
unemployment without intending to do so, is unemployment insurance
programs.

• Under this program, the unemployed who quit their jobs, were fired for
cause, or just entered the labor force are not eligible.

• Benefits are paid only to the unemployed who were laid off because
their previous employers no longer needed their skills.

• Under such programs, a typical worker will receive 50% of his former
wage for a period of 26 weeks.
 Unemployment Insurance programs
• While such programs was intended to reduce the hardship of unemployment,
it tended to increase the number of unemployed people inside the economy.

• Critics against these programs are mainly against the increase in

unemployment rate that these programs tend to increase.

• Not only that, but it makes unemployment less hard on workers in not too
much hurry to seek employment.
 Minimum Wage Laws
Minimum Wage Laws : are government actions increasing the labor
wages above the equilibrium or market wage rates.

• When government sets minimum wage rates, the direct effect is an

increase in the number of unemployed people in the economy, hence
increasing unemployment rather than decreasing it.

• This is due to the fact that as government sets minimum wages, the
quantity supplied of labor > quantity demanded of labor resulting in
excess labor, hence unemployment occurs.