Natural Rate of Unemployment

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Dictionary of Economics

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Natural Rate of Unemployment

What is the natural rate of unemployment?

It’s defined as the rate of unemployment that would occur in an economy if there were no cyclical unemployment (unemployment correlated with the ups and downs of the business cycle). The natural rate of unemployment is not actually observable, but we can estimate it.

Another way to think about the natural rate of unemployment is that it’s the combined frictional unemployment and structural unemployment.

If we can only estimate the natural rate of unemployment, you may be wondering why we even care about it. Economists think that, under some conditions, governments can reduce unemployment through fiscal and monetary policies. However, these measures only affect cyclical unemployment, not frictional or structural.

If unemployment is close to the estimated natural rate, that suggests that fiscal and monetary policy efforts will have less effect on unemployment.

Want to dive deeper into these topics? We cover Unemployment and Labor Force Participation, Business Fluctuations, Monetary Policy and the Federal Reserve, and Fiscal Policy in depth in our free Macroeconomics course.

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The natural rate of unemployment is defined as the rate of unemployment that would occur in an economy if there were no cyclical unemployment, or unemployment correlated with the ups and downs of the business cycle.

 

In other words, it's the rate of frictional plus structural unemployment. Now, unfortunately, we can't really observe that natural rate of unemployment. We can only estimate it.

 

This figure shows one estimate of the natural rate alongside the actual unemployment rate. As you can see, the natural rate of unemployment changes slowly over time, whereas the actual unemployment rate fluctuates quite a bit around that natural rate.

 

Now, why do we care about the natural rate of unemployment? We care because economists think that under some conditions the government can reduce cyclical unemployment through fiscal and monetary policies -- things like spending more money, cutting taxes, or increasing the money supply. These policies, however, are unlikely to change the natural rate of unemployment, that is, frictional plus structural unemployment. So when the unemployment rate is close to the natural rate, that suggests that the scope for monetary and fiscal policy is diminished.

 

For example, if we return to our graph -- by 2015, seven years after the Great Recession, the actual unemployment rate was very close to that natural rate of unemployment. So by this estimate, the time for fiscal and monetary policy had passed. Clearly, the concept of the natural rate of unemployment is tied to theories about how the government might use fiscal and monetary policy to smooth the business cycle.

 

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