Natural rate of unemployment is a course material to both UG and PG students of Economics.

1. JIJIKUMARI T

2. Natural rate of Unemployment
• Definition: The natural rate of unemployment
is a combination of frictional, structural and
surplus unemployment. Even a healthy
economy will have this level of unemployment
because workers are always coming and going,
looking for better jobs. This jobless status,
until they find that new job, is the natural rate
of unemployment.

3. • The Federal Reserve estimates that this rate is
between 4.5 percent and 5.0 percent.
• Both fiscal and monetary policymakers use that
rate as the goal for a full employment. They use 2
percent as the target inflation rate. They also
consider the ideal GDP growth rate to between 2
percent and 3 percent. They must try to balance
these three goals when setting interest rates, tax
rates or spending levels.

4. Three Components of the Natural Rate
of Unemployment
• Frictional Unemployment
• Structural Unemployment
• Surplus Unemployment – This occurs whenever
the government intervenes with minimum
wage laws or wage/price controls. It can also
happen with unions. When wages are reset to a
higher level, unemployment often results. Why?
To keep within the same payroll budget, the
company must let go of some workers to pay the
remaining workers the mandated higher salary.

5. Did the Recession Raise the Natural
Rate of Unemployment
• The financial crisis of 2008 wiped out a
staggering 8.3 million jobs.
• The unemployment rate rose from 4.7 percent
to 10.1 percent at its peak in 2009. This huge
loss meant that many of the unemployed
stayed that way for six months or more. Long-
term unemployment made it even more
difficult for them to get back to work. Their
skills and experience became outdated.

6. • The natural rate of unemployment typically
rises after a recession. Frictional
unemployment increases, since workers can
finally quit their jobs, confident they can find a
better one now that the recession is over. In
addition, structural unemployment is higher,
since workers have been unemployed for so
long their skills no longer match the needs of
businesses.

7. • Between 2009 and 2012, the natural rate of
unemployment rose from 4.9 percent to 5.5
percent. That was higher than during the
recession itself.
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8. Adaptive expectations-Augmented Phillips
curve
• The augmented Phillips curve introduces adaptive
expectations into the Phillips curve. These
adaptive expectations, which date from Irving
Fisher’s book “The Purchasing Power of Money”,
1911, were introduced into the Phillips curve
by monetarists, specially Milton Friedman.
Therefore, we could say that the expectations-
augmented Phillips curve was first used to explain
the monetarists’ view of the Phillips curve.

9. • Adaptive expectations models led to an
important shift in the perception of a
government’s ability to act.
Under Keynes’ money illusion, changes in
nominal variables (prices, wages, etc…) were
accepted by agents as real despite overall
purchasing power remaining stable.

10. • However, monetarism embraced the adaptive
expectations theory to mean that people
would stumble once or twice on the same
stone, but not a third. In this way, if the
government decided on an
expansionist monetary policy, inflation would
rise and unemployment would fall, based on
the Phillips curve.

11. • However, a second or third time around,
agents would be quick to associate higher
inflation with rising salaries in a vicious circle,
and adjust their behaviour accordingly based
on past experiences. They would anticipate
that inflation would drain their purchasing
power accordingly, and monetary policy would
have little effect. If we see this graphically:

13. • Initially, unemployment and inflation are at
point A. The government decides to embark
on an expansionist monetary policy, which
floods the markets with inexpensive credit,
incentivising consumption. Expectations shift
to point B along the Phillips curve:
unemployment is reduced through economic
stimulus with a trade off in the form of
inflation.

14. • However, after a short period, agents will
begin to associate expansionist policies with
inflation, which means a drain on their
resources, and they will push for higher
wages.

15. • This will stop the consumption stimulus and
also deincentivise hiring. Eventually, agents
will shift their expectations curves to point C.
A second time around, D will be achieved,
leading more or less rapidly to point E. This is
why, in the long term, inflation has little effect
on unemployment and vice versa.
Expansionist monetary policy will lead directly
to inflation, with no permanent effect on
unemployment.

16. • In summary, monetarists sustained that the
Phillips curve will hold up in the short term,
but not in the long term. In the long term, the
Phillips curve is completely vertical and
determines the natural rate of unemployment,
as Friedman puts it in his article “The role of
Monetary Policy”, 1968.
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