Full Employment, Potential Output and the Unemployment Rate
Frictional, Structural & Cyclical Unemployment
“Full” employment means that there are enough jobs available to employ everyone who wants to work at current wage levels. However, even when this condition exists, there will still be some individuals who wish to work but are not working, and there will be a corresponding number of unfilled job vacancies. Thus, full employment does not mean that there is “0” unemployment. Even at full employment there will be “frictional” unemployment and some “structural” unemployment.
Frictional unemployment refers to unemployment that is due to “frictions” in the process of matching unemployed workers to vacant jobs. Employers wish to interview several candidates before deciding to whom to offer their job. Individuals are interviewing with several prospective employers and may turn down an offer or stall an employer while trying to negotiate a better offer. Thus, even when there is enough work for all, there will always be some individuals in a mobile economy “between” jobs, caught up in the frictions and delays of the interview/job search process. This definition implies that the frictionally unemployed individual, if qualified, should find work fairly quickly… within a month or two.
Structural unemployment refers to a situation where the individual’s unemployment is of longer duration because his/her skills do not match the qualifications that employers are looking for to fill vacant jobs. At full employment, there will be a “normal” level of frictional and structural unemployment. This “normal” level of frictional & structural unemployment may shift over time as the demographic makeup of the labor force changes or as labor market institutions change. For example, younger workers switch jobs more frequently than mature workers and are subject to possible frictional unemployment each time they switch. Thus, in decades where there is a high % of younger workers in the labor force, the normal level of frictional unemployment will be higher than otherwise.
Of course, it is possible for an economy to operate at either an above full employment state or in a below full employment state. If an economy is operating with unemployment greater than normal levels of frictional + structural unemployment, then there are not enough jobs available for all who want to work. In this case, the economy is said to be suffering from “cyclical unemployment.” Cyclical unemployment refers to the excess of job seekers over job vacancies. Ucyclical = (job seekers – job vacancies). When the economy is fully employed, cyclical unemployment = 0. In this course, when we say an economy is experiencing unemployment, we mean that it is experiencing cyclical unemployment. In the latter half of this course, we will analyze federal government and central bank policies to prevent or ameliorate episodes of pronounced cyclical unemployment.
An economy may also operate for a time with unemployment levels below normal levels of frictional + structural unemployment. That is, if business is booming and all (or nearly all) qualified workers have already found employment, employers may take chances on workers that they would normally consider unqualified and they will make job offers more quickly with fewer interviews for each job vacancy. This has the effect of squeezing structural and frictional unemployment below their normal levels. This is not a desirable situation for an economy. When labor markets are this tight, we assume that workers are able to bargain for faster rates of wage growth, well in excess of labor productivity growth rates. As employers increase prices to cover the resulting increases in unit labor costs, inflation accelerates.
Full Employment and NAIRU
The US government publishes data on unemployment every month based on household surveys. In that data, the “unemployment rate,” is defined to be the number of unemployed workers divided by the number of people in the “labor force”. The labor force consists of everyone who is employed + everyone who is actively looking for work.
u = unemployment rate = U/LF
U = # of unemployed workers
E = # of employed workers
LF = labor force = U+E
To be counted as unemployed in the official survey, a potential worker must be actively looking for work and be completely without work in the week of the employment survey. Workers who would like a job, but aren’t looking because they believe jobs aren’t available are counted as “out of the labor force’, rather than as unemployed. Also, workers who would like full time employment, but can only find part-time work are not counted as partially unemployed. They are simply counted as employed. Thus, the official data on unemployment understate somewhat the pool of labor available for work.
Even allowing for this understatement, however, the important question for economic forecasters and policy makers is: What measured rate of unemployment in the official data corresponds to a state of “full employment?” Put differently, how much measured unemployment corresponds to a “normal” level of frictional & structural unemployment? This question is crucial for policy makers at the central bank in debates over appropriate monetary policies, and it logically should play a role in congressional discussions over government tax & spending packages.
Unfortunately, it is not a question with a clear unambiguous answer. We do not have any good data on nationwide job vacancies. Thus, we can’t compare the number of estimated job seekers from our unemployment surveys with a nationwide estimate of job vacancies to see if there are more job seekers than job vacancies and, therefore cyclical unemployment. Moreover, the real world boundaries between the different types of unemployment are unclear. For example, as we have already noted, when demand for labor is very high, employers will take chances on people for jobs whom they would normally have considered unqualified. This blurs the boundary between cyclical and structural unemployment.
Given these difficulties measuring the different types of unemployment directly, economists have relied on the idea that when frictional and structural employment are reduced below their normal levels by unusually strong demand for labor, wage growth will accelerate while labor productivity falls. This combination of events pushes up unit labor costs at an increasing rate and causes inflation to accelerate as producers mark up prices to cover those rising labor costs. Thus, “full employment” has come to mean the lowest unemployment rate that can be sustained without causing an acceleration of the inflation rate. This unemployment rate is variously referred to as the “natural rate” of unemployment, or as NAIRU (the Non-Accelerating Inflation Rate of Unemployment). Your textbook prefers the term “natural rate” of unemployment, while I prefer the acronym “NAIRU”…but both the text book and I are referring to the level of unemployment at which cyclical unemployment is eliminated and at which normal levels of frictional and structural employment exist.
Unfortunately, in the last 40 years as the economy has experienced several periods of expansion and falling unemployment rates, the unemployment rate at which inflation has begun to accelerate has varied from one expansion to another in ways which were not forecast in advance. For example in the late 1970’s, inflation pressures started to increase noticeably with measured unemployment rates as high as 6% -6.5%! However, in the very late 1990’s unemployment fell as low as 4% and remained at that level for much of year 2000 without any noticeable increase in unit labor costs or inflation rates. Thus, it appeared that NAIRU = 4% at that time. More recently, (say Dec 2014), as we have recovered from the great recession of 2008, the unemployment rate has dropped to 5.6%, but rates of growth of labor compensation have started to increase and upward price pressures (even excluding declining energy prices) have started to increase. Thus, 4.5% – 5.5% measured unemployment might now represent “full employment.” This is still true even at the recent state of great recession with existing unemployment rate of 5.6% (as of Dec 2014). For more information and current data on employment-unemployment, please visit www.bls.gov.
Potential Output, NAIRU, and the AS/AD Model
The amount of output (RGDP) which the economy can produce at a point in time (given its current technology, labor force and capital stock), when it is operating with u=NAIRU is called its Potential Output (Potential RGDP). As noted in an earlier set of notes in this lesson, we visually represent potential output on an AS/AD diagram with a vertical line drawn at the RGDP level assumed to be consistent with u=NAIRU.
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In next week’s lesson we will discuss the concept of inflation, various measures of inflation, and the critically important distinction between “real” and “nominal” rates of return on investment.
Answer at least five questions and post in the assignment drop box for WK2A by clicking on the assignments option from the left hand side menu. This set of questions are individual assignments without sharing with others.
1) Agree or disagree with each of the following statements and explain your answer.
a) The economy cannot be considered fully employed until measured unemployment is less than 1% of the labor force.
b) It is possible for an economy to operate for a time with an unemployment rate less that the “natural” unemployment rate. (Also known as NAIRU, the non-accelerating inflation rate of unemployment).
a) What is the difference between structural, frictional and cyclical unemployment? How are these three types of unemployment related to the concept of full employment?
b) Why is it difficult to know which measured rate of unemployment corresponds to “full employment,” and why is there currently uncertainty about the level of NAIRU?
c) What is the current unemployment rate? (hint: the update on the unemployment rate is usually released the first Friday of each month). Do you think this unemployment rate is generally considered to be above, below or equal to NAIRU? Hint: to collect teh u-rate dat, visit www.bls.gov and click unemployment rate link.
3a) Suppose nominal GDP rose from 16,245 billion in 2012 to 16,800 billion in 2013. If the GDP deflator rose from 105 to 106.59 during this time, what was the percent growth in real GDP (not Nominal GDP, please read my lecture notes)?
3b) Given the data in part (a), what was the rate of inflation for goods and services produced in the U.S. economy? Hint: Please read my lecture notes how to use the GDPD data (Inflation index for estimating price level) to calculate inflation rate.
4a) What are the major categories of “investment” expenditure in the GDP accounts?
4b) What are “transfer” expenditures of governments? Why aren’t they included as part of “government spending” in calculating GDP?
4c) Why aren’t “intermediate” goods purchases by businesses added to GDP spending totals?
4d) Agree or disagree: GDP = wages + rents + net interest + dividends + net taxes.
4e) Agree or disagree: Annual mortgage payments by households are counted as part of consumer spending when adding up C+I +G + (X-IM) to determine RGDP.
5) Draw an Aggregate Supply/Aggregate Demand diagram that shows an economy operating at an output level higher than full employment RGDP. Label the axes and all lines on your diagram clearly.
6) Draw an Aggregate Demand -Aggregate Supply diagram that would represent an economy suffering from both a rise in its aggregate price level and a rise in its unemployment rate. (You will have to shift either the AS schedule, the AD schedule, or both schedules to illustrate this.)
7) Why do economists expect inflation to accelerate when u< NAIRU?
8) Agree or disagree with the following statement and explain your answer. “In 1950, RGDP per person in the U.S. was about $10,000. By 2000, RGDP per person in the U.S. was about $30,000. This implies that the living standard of the typical U.S. resident tripled in 50 years!”