Natural Rate of Unemployment - Term Paper Example

Natural Rate of Unemployment s 23 March Natural Rate of Unemployment 0 Introduction The topic of unemployment has always been one that elicits various reactions and opinions among different entities involved such as the governments, policymakers and market analysts among others. Currently, the rate of unemployment in the world is probably at an all-time high which can largely be attributed to the global recession effects that hit the world in the recent past. However, there is an unemployment limit believed to be the normal and perhaps sustainable where if it is achieved, the economy is said to be sustainable. The limit, believed to be about 6 percent unemployment rate, is seen to correlate with the acceptable rate of inflation in a country. This means that for a country to comfortably handle its rate of inflation and the corresponding effects, its policymakers have to respond by formulating policies that ensure that unemployment rate does not substantially diverge from the optimum rate of 6 percent. This rate is referred to as the natural rate of unemployment or the non-accelerating rate of unemployment (NAIRU) (Cross 1995). The aim of this paper, therefore, is to make a hypothetical evaluation of the theory of natural rate of employment while also determining the policy implications that accompany the same. The paper will analyse some of the literary works on the topic to make a discussion that will consequently determine the viability of this concept of the natural rate of unemployment. 2.0 Background information The natural rate of unemployment is widely defined as the rate of unemployment that does not induce any significant change in the inflation rate i.e. does not lead to an increase or decrease in a countrys inflation. It has been found that workers and firms working in an economy that is at the natural rate and constant inflation have their decisions based on the natural rate of unemployment. Before the concept of the natural rate of unemployment came, it was believed that there existed a relationship (balance) between the inflation rate and that of unemployment. This was demonstrated through the popular Phillips Curve, which was the tool used by policymakers in determining the point at which the economy was to be maintained. That was popularly used in the 1960s and the early 1970s. However, this trade-off (between the rate of unemployment and inflation) was put into questions following a period characterised by high inflation that ran through the 1970s and the early 1980s. Milton Friedman challenged the Phillips Curve asserting that it was not as stable as earlier perceived. Rather, it was dependent on the inflation expectations of both the firms and the workers. For example, Friedman questioned the reasons why an increase in the money supply by the federal government in the market by certain percentage do not guarantee a similar rise in the prices of goods or even that of the wages. Friedman argued that it was the unawareness by the public (both workers and the firms) about the actions taken by the federal government that leads to lack of this correlation. He, therefore, observed that if the public knew or anticipated that the government was to increase a money supply to the markets, it would be natural for them to increase their goods prices as well. This would mean that the purpose to which the expansion (addition of money to the market by the government) was initially meant for would become meaningless. It would be expected that the governments monetary increment into the market would spur the countrys economic activity through ways such as creating new jobs but, on the contrary, this would result in creation of higher inflation. A higher inflation would certainly result in increased unemployment with firms and other employers seeking to cut on costs in order to tackle inflation. Consequently, this would result in a rise in both the inflation and unemployment in a state described by Paul Samuelson as stagflation. As a solution to this, Friedman suggested that a country should strive to achieve the lowest rate of unemployment which does not induce an accelerating inflation. This rate has over the years been found to lie between 5 and 7 percent of unemployment and is referred to as the natural rate of unemployment (Friedman 1968). 3.0 Components of Natural rate of employment It is common knowledge that unemployment in any economy is an inevitable concept since there will always be cases of people quitting their jobs, workers being fired and industries reducing or increasing them at some point of the economy. This in all measures contribute to the unemployment levels through two main ways described as either frictional unemployment or structural unemployment. Frictional unemployment is represented by unemployment caused by workers who temporarily out of the labour force perhaps in search of opportunities in another trade or industry. On the other hand, structural unemployment occurs when workers, especially the young population, do not have the necessary skills to meet the training or education demands of the employers. The natural rate of unemployment theory states that the average level of both frictional and structural unemployment is quite unaffected by the monetary policies (Dobrescu et al. 2011). 4.0 Key sources of the natural rate of unemployment As earlier mentioned, the natural rate of unemployment is dependent on two of the major types of unemployment such as frictional and structural unemployment. In this section, the discussion will have a close look at the underlying sources of this natural rate of unemployment especially in regard to the contribution of structural unemployment. This will entail the labour market imperfections that contribute to a creation of the natural rate of unemployment. They include location mismatch, skills mismatch, imperfect information flows, and institutional barriers among others (Weiner 1986). 4.1 Location mismatch This can be explained as the mismatch caused by a worker’s location being different from the available job’s location. This kind of mismatch exists where job seekers qualify for jobs being offered in a location different from their current living position. It can largely be attributed to factors such as various regions of a country growing at different rates. 4.2 Skills mismatch This is a common phenomenon among the young population especially those seeking jobs where their skills fail to match those being demanded in the available job. This type of employment typically affects new entrants into the labour force, workers whose skills have been outgrown by their respective industry’s skills requirements and re-entrants into the labour force (Phelps 1995). 4.3 Institutional barriers This generally involves the existence of social practices and laws that act as an impediment to efficient operations of labour markets. For example, some of these inhibitions include the minimum wage laws, racial and sexual discrimination and union membership restrictions. As such, these barriers may have adverse effects on the employment prospects for the lowly skilled and paid workers. 4.4 Imperfect information flows There are occasions when job opportunities and openings go unrecognised due to unawareness on the side of the job seekers. On the other hand, job seekers might apply inefficient methods in seeking the available jobs which could be impacting on their ability to secure these positions. 5.0 Policy implications- reasons why policies may not be the ultimate answer to solving the problem of achieving natural rate of employment As seen in the earlier discussion, natural rate of employment is a complex concept that requires a lot of calculations to achieve. It is only through the use of various tactics that an economy can eventually achieve the natural rate of unemployment. In explaining this, the discussion will consider using a hypothetical example where a correlation between inflation and unemployment. For example, assuming a country’s economy achieves the natural rate of unemployment at 6 percent, and an inflation rate of 3 percent, the economy of the respective country would experience no pressure at all for change. On the other hand, an intervention by policy makers towards reducing the rate of unemployment from the existing stable condition at 6 percent will consequently destabilise the economy. For example, the policymakers would attempt to reduce unemployment through pursuing a more expansionary monetary policy for the country or by running a larger budget deficit. Through these methods, the country would invoke more aggregate spending resulting in an increased need for hiring more workers. In this case, there would be an increase in demand for labour which would mean firms would have to bid up their wages in order to attract them. Consequently, the higher wages would result in a hike in product prices. The trend thus would mean that the rate of unemployment would decline but, on the other hand, lead to a hike in the inflation rate. Due to the unstable condition of the economy in this position, the economy would shift and the rise in expectations by the workers for higher wages, it would result in firms cutting on hiring thus unemployment would rise again. At this point, both the rate of unemployment would be high, similar to that of inflation (Weiner 1986). Looking at this example, it is easy to tell that policies may not have much effect on the natural rate of unemployment in an economy. However, various aspects of policy (public policy) can be employed to tackle this issue. For example, the government can aid in disseminating the right information especially regarding available jobs opportunities in a way that would make easier the process of matching the workers’ skills with those demanded by these jobs. Additionally, workers would benefit from public job training programs established by the government in enabling them acquire skills necessary for jobs available in growing industries. In summary, a policy viable enough to sustainably lower the rate of natural employment would need to lower the population of workers who have been separated from their jobs while also making it easier for those unemployed to finding relevant jobs (Cross 1995). Bibliography Corry, Bernard (1995) Politics and the natural rate hypothesis: a historical perspective in Rod Cross, The Natural Rate of Unemployment. Reflections on 25 years of the hypothesis. Cambridge, Cambridge University Press. Cross, R. (1995). The natural rate of unemployment: reflections on 25 years of the hypothesis. Cambridge, Cambridge Univ. Press. Dobrescu, M., Paicu, C., & Iacob, S. (2011). The Natural Rate of Unemployment and its Implications for Economic Policy. Theoretical and Applied Economics, vol. 18, no. 2, pp. 181-194. Farmer Roger. Animal spirits, financial crises and Persistent Unemployment, NBER Working  Paper, No. 17137, available at: http://www.nber.org/papers/w17137 accessed 23 March 2015 Friedman, M., 1968, The Role of Monetary Policy American Economic Review, vol. 58, no. 1, pp. 1-17 Phelps, E. (1995). The origins and further development of the natural rate of unemployment in Rod Cross, The Natural Rate of Unemployment. Reflections on 25 years of the hypothesis. Cambridge: Cambridge University Press. Weiner, S. E. (1986). The natural rate of unemployment: concepts and issues. Economic Review, pp. 11-24. Read More