Romblon State University

College of Business and Accountancy

Graduate Education and Professional Studies

Position Paper on Seminar on Current Economic Problems

THE LONG RUN: THE NATURAL RATE OF UNEMPLOYMENT

The natural rate of unemployment is not “natural” in the sense that water freezes at 32
degrees Fahrenheit or boils at 212 degrees Fahrenheit. It is not a physical and
unchanging law of nature. Instead, it is only the “natural” rate because it is the
unemployment rate that would result from the combination of economic, social, and
political factors that exist at a time—assuming the economy was neither booming nor in
recession. These forces include the usual pattern of companies expanding and
contracting their workforces in a dynamic economy, social and economic forces that
affect the labor market, or public policies that affect either the eagerness of people to
work or the willingness of businesses to hire. Let’s discuss these factors in more detail.

FRICTIONAL UNEMPLOYMENT

In a market economy, some companies are always going broke for a variety of
reasons: old technology; poor management; good management that happened to make
bad decisions; shifts in tastes of consumers so that less of the firm’s product is desired;
a large customer who went broke; or tough domestic or foreign competitors.
Conversely, other companies will be doing very well for just the opposite reasons and
looking to hire more employees. In a perfect world, all of those who lost jobs would
immediately find new ones. But in the real world, even if the number of job seekers is
equal to the number of job vacancies, it takes time to find out about new jobs, to
interview and figure out if the new job is a good match, or perhaps to sell a house and
buy another in proximity to a new job. The unemployment that occurs in the meantime,
as workers move between jobs, is called frictional unemployment. Frictional
unemployment is not inherently a bad thing. It takes time on part of both the employer
and the individual to match those looking for employment with the correct job openings.
For individuals and companies to be successful and productive, you want people to find
the job for which they are best suited, not just the first job offered.

In the mid-2000s, before the recession of 2008–2009, it was true that about 7% of U.S.
workers saw their jobs disappear in any three-month period. But in periods of economic
growth, these destroyed jobs are counterbalanced for the economy as a whole by a
larger number of jobs created. In 2005, for example, there were typically about 7.5
million unemployed people at any given time in the U.S. economy. Even though about
two-thirds of those unemployed people found a job in 14 weeks or fewer, the
unemployment rate did not change much during the year, because those who found
new jobs were largely offset by others who lost jobs.

Of course, it would be preferable if people who were losing jobs could immediately and
easily move into the new jobs being created, but in the real world, that is not possible.
Someone who is laid off by a textile mill in South Carolina cannot turn around and
immediately start working for a textile mill in California. Instead, the adjustment process
happens in ripples. Some people find new jobs near their old ones, while others find that
they must move to new locations. Some people can do a very similar job with a different
company, while others must start new career paths. Some people may be near
retirement and decide to look only for part-time work, while others want an employer
that offers a long-term career path. The frictional unemployment that results from people
moving between jobs in a dynamic economy may account for one to two percentage
points of total unemployment.

The level of frictional unemployment will depend on how easy it is for workers to learn
about alternative jobs, which may reflect the ease of communications about job
prospects in the economy. The extent of frictional unemployment will also depend to
some extent on how willing people are to move to new areas to find jobs—which in turn
may depend on history and culture.

Frictional unemployment and the natural rate of unemployment also seem to depend on
the age distribution of the population. Figure 2 from Patterns of Unemployment (b)
showed that unemployment rates are typically lower for people between 25–54 years of
age than they are for those who are either younger or older. “Prime-age workers,” as
those in the 25–54 age bracket are sometimes called, are typically at a place in their
lives when they want to have a job and income arriving at all times. But some proportion
of those who are under 30 may still be trying out jobs and life options and some
proportion of those over 55 are eyeing retirement. In both cases, the relatively young or
old tend to worry less about unemployment than those in-between, and their periods of
frictional unemployment may be longer as a result. Thus, a society with a relatively high
proportion of relatively young or old workers will tend to have a higher unemployment
rate than a society with a higher proportion of its workers in middle age.

STRUCTURAL UNEMPLOYMENT

Another factor that influences the natural rate of unemployment is the amount
of structural unemployment. The structurally unemployed are individuals who have no
jobs because they lack skills valued by the labor market, either because demand has
shifted away from the skills they do have, or because they never learned any skills. An
example of the former would be the unemployment among aerospace engineers after
the U.S. space program downsized in the 1970s. An example of the latter would be high
school dropouts.
Some people worry that technology causes structural unemployment. In the past, new
technologies have put lower skilled employees out of work, but at the same time they
create demand for higher skilled workers to use the new technologies. Education seems
to be the key in minimizing the amount of structural unemployment. Individuals who
have degrees can be retrained if they become structurally unemployed. For people with
no skills and little education, that option is more limited.

NATURAL UNEMPLOYMENT AND POTENTIAL REAL GDP

The natural unemployment rate is related to two other important concepts: full
employment and potential real GDP. The economy is considered to be at full
employment when the actual unemployment rate is equal to the natural unemployment.
When the economy is at full employment, real GDP is equal to potential real GDP. By
contrast, when the economy is below full employment, the unemployment rate is greater
than the natural unemployment rate and real GDP is less than potential. Finally, when
the economy above full employment, then the unemployment rate is less than the
natural unemployment rate and real GDP is greater than potential. Operating above
potential is only possible for a short while, since it is analogous to all workers working
overtime.

PRODUCTIVITY SHIFTS AND THE NATURAL RATE OF UNEMPLOYMENT

Unexpected shifts in productivity can have a powerful effect on the natural rate of
unemployment. Over time, the level of wages in an economy will be determined by the
productivity of workers. After all, if a business paid workers more than could be justified
by their productivity, the business will ultimately lose money and go bankrupt.
Conversely, if a business tries to pay workers less than their productivity then, in a
competitive labor market, other businesses will find it worthwhile to hire away those
workers and pay them more.

However, adjustments of wages to productivity levels will not happen quickly or

smoothly. Wages are typically reviewed only once or twice a year. In many modern
jobs, it is difficult to measure productivity at the individual level. For example, how
precisely would one measure the quantity produced by an accountant who is one of
many people working in the tax department of a large corporation? Because productivity
is difficult to observe, wage increases are often determined based on recent experience
with productivity; if productivity has been rising at, say, 2% per year, then wages rise at
that level as well. However, when productivity changes unexpectedly, it can affect the
natural rate of unemployment for a time.

The U.S. economy in the 1970s and 1990s provides two vivid examples of this process.
In the 1970s, productivity growth slowed down unexpectedly (as discussed in Economic
Growth). For example, output per hour of U.S. workers in the business sector increased
at an annual rate of 3.3% per year from 1960 to 1973, but only 0.8% from 1973 to
1982. Figure 1 (a) illustrates the situation where the demand for labor—that is, the
quantity of labor that business is willing to hire at any given wage—has been shifting out
a little each year because of rising productivity, from D0 to D1 to D2. As a result,
equilibrium wages have been rising each year from W0 to W1 to W2. But when
productivity unexpectedly slows down, the pattern of wage increases does not adjust
right away. Wages keep rising each year from W2 to W3 to W4. But the demand for
labor is no longer shifting up. A gap opens where the quantity of labor supplied at wage
level W4 is greater than the quantity demanded. The natural rate of unemployment
rises; indeed, in the aftermath of this unexpectedly low productivity in the 1970s, the
national unemployment rate did not fall below 7% from May, 1980 until 1986. Over time,
the rise in wages will adjust to match the slower gains in productivity, and the
unemployment rate will ease back down. But this process may take years.

Fi
gure 1. Unexpected Productivity Changes and Unemployment. (a) Productivity is rising,
increasing the demand for labor. Employers and workers become used to the pattern of
wage increases. Then productivity suddenly stops increasing. However, the
expectations of employers and workers for wage increases do not shift immediately, so
wages keep rising as before. But the demand for labor has not increased, so at wage
W4, unemployment exists where the quantity supplied of labor exceeds the quantity
demanded. (b) The rate of productivity increase has been zero for a time, so employers
and workers have come to accept the equilibrium wage level (W). Then productivity
increases unexpectedly, shifting demand for labor from D0 to D1. At the wage (W), this
means that the quantity demanded of labor exceeds the quantity supplied, and with job
offers plentiful, the unemployment rate will be low.

The late 1990s provide an opposite example: instead of the surprise decline in
productivity in the 1970s, productivity unexpectedly rose in the mid-1990s. The annual
growth rate of real output per hour of labor increased from 1.7% from 1980–1995, to an
annual rate of 2.6% from 1995–2001. Let’s simplify the situation a bit, so that the
economic lesson of the story is easier to see graphically, and say that productivity had
not been increasing at all in earlier years, so the intersection of the labor market was at
point E in Figure 1 (b), where the demand curve for labor (D0) intersects the supply
curve for labor. As a result, real wages were not increasing. Now, productivity jumps
upward, which shifts the demand for labor out to the right, from D0 to D1. At least for a
time, however, wages are still being set according to the earlier expectations of no
productivity growth, so wages do not rise. The result is that at the prevailing wage level
(W), the quantity of labor demanded (Qd) will for a time exceed the quantity of labor
supplied (Qs), and unemployment will be very low—actually below the natural level of
unemployment for a time. This pattern of unexpectedly high productivity helps to explain
why the unemployment rate stayed below 4.5%—quite a low level by historical
standards—from 1998 until after the U.S. economy had entered a recession in 2001.

Average levels of unemployment will tend to be somewhat higher on average when

productivity is unexpectedly low, and conversely, will tend to be somewhat lower on
average when productivity is unexpectedly high. But over time, wages do eventually
adjust to reflect productivity levels.

PUBLIC POLICY AND THE NATURAL RATE OF UNEMPLOYMENT

Public policy can also have a powerful effect on the natural rate of unemployment. On
the supply side of the labor market, public policies to assist the unemployed can affect
how eager people are to find work. For example, if a worker who loses a job is
guaranteed a generous package of unemployment insurance, welfare benefits, food
stamps, and government medical benefits, then the opportunity cost of being
unemployed is lower and that worker will be less eager to seek a new job.

What seems to matter most is not just the amount of these benefits, but how long they
last. A society that provides generous help for the unemployed that cuts off after, say,
six months, may provide less of an incentive for unemployment than a society that
provides less generous help that lasts for several years. Conversely, government
assistance for job search or retraining can in some cases encourage people back to
work sooner. See the Clear it Up to learn how the U.S. handles unemployment
insurance.

How does U.S. unemployment insurance work?

Unemployment insurance is a joint federal–state program, established by federal law in

1935. The federal government sets minimum standards for the program, but most of the
administration is done by state governments.

The funding for the program is a federal tax collected from employers. The federal
government requires that the tax be collected on the first $7,000 in wages paid to each
worker; however, states can choose to collect the tax on a higher amount if they wish,
and 41 states have set a higher limit. States can choose the length of time that benefits
will be paid, although most states limit unemployment benefits to 26 weeks—with
extensions possible in times of especially high unemployment. The fund is then used to
pay benefits to those who become unemployed. Average unemployment benefits are
equal to about one-third of the wage earned by the person in his or her previous job, but
the level of unemployment benefits varies considerably across states.

Bottom 10 States That Pay the Lowest Top 10 States That Pay the Highest
Benefit per Week Benefit per Week

Delaware $330 Massachusetts $674

Georgia $330 Minnesota $629

South Carolina $326 New Jersey $624

Missouri $320 Washington $624

Florida $275 Connecticut $590

Tennessee $275 Pennsylvania $573

Alabama $265 Rhode Island $566

Louisiana $247 Ohio $564

Arizona $240 Hawaii $560

Mississippi $235 Oregon $538

Table 5. Maximum Weekly Unemployment Benefits by State in 2014.

(Source: http://jobsearch.about.com/od/unemployment/fl/unemployment-benefits-by-
state-2014.htm)

One other interesting thing to note about the classifications of unemployment—an

individual does not have to collect unemployment benefits to be classified as
unemployed. While there are statistics kept and studied relating to how many people
are collecting unemployment insurance, this is not the source of unemployment rate
information.

View this article for an explanation of exactly who is eligible for unemployment benefits.

On the demand side of the labor market, government rules social institutions, and the
presence of unions can affect the willingness of firms to hire. For example, if a
government makes it hard for businesses to start up or to expand, by wrapping new
businesses in bureaucratic red tape, then businesses will become more discouraged
about hiring. Government regulations can make it harder to start a business by requiring
that a new business obtain many permits and pay many fees, or by restricting the types
and quality of products that can be sold. Other government regulations, like zoning
laws, may limit where business can be done, or whether businesses are allowed to be
open during evenings or on Sunday.

Whatever defenses may be offered for such laws in terms of social value—like the value
some Christians place on not working on Sunday—these kinds of restrictions impose a
barrier between some willing workers and other willing employers, and thus contribute
to a higher natural rate of unemployment. Similarly, if government makes it difficult to
fire or lay off workers, businesses may react by trying not to hire more workers than
strictly necessary—since laying these workers off would be costly and difficult. High
minimum wages may discourage businesses from hiring low-skill workers. Government
rules may encourage and support powerful unions, which can then push up wages for
union workers, but at a cost of discouraging businesses from hiring those workers.

THE NATURAL RATE OF UNEMPLOYMENT IN RECENT YEARS

The underlying economic, social, and political factors that determine the natural rate of
unemployment can change over time, which means that the natural rate of
unemployment can change over time, too.

Estimates by economists of the natural rate of unemployment in the U.S. economy in

the early 2000s run at about 4.5 to 5.5%. This is a lower estimate than earlier. Three of
the common reasons proposed by economists for this change are outlined below.

1. The Internet has provided a remarkable new tool through which job seekers can
find out about jobs at different companies and can make contact with relative
ease. An Internet search is far easier than trying to find a list of local employers
and then hunting up phone numbers for all of their human resources
departments, requesting a list of jobs and application forms, and so on. Social
networking sites such as LinkedIn have changed how people find work as well.
2. The growth of the temporary worker industry has probably helped to reduce the
natural rate of unemployment. In the early 1980s, only about 0.5% of all workers
held jobs through temp agencies; by the early 2000s, the figure had risen above
2%. Temp agencies can provide jobs for workers while they are looking for
permanent work. They can also serve as a clearinghouse, helping workers find
out about jobs with certain employers and getting a tryout with the employer. For
many workers, a temp job is a stepping-stone to a permanent job that they might
not have heard about or gotten any other way, so the growth of temp jobs will
also tend to reduce frictional unemployment.
3. The aging of the “baby boom generation”—the especially large generation of
Americans born between 1946 and 1963—meant that the proportion of young
workers in the economy was relatively high in the 1970s, as the boomers entered
the labor market, but is relatively low today. As noted earlier, middle-aged
workers are far more likely to keep steady jobs than younger workers, a factor
that tends to reduce the natural rate of unemployment.
The combined result of these factors is that the natural rate of unemployment was on
average lower in the 1990s and the early 2000s than in the 1980s. The Great
Recession of 2008–2009 pushed monthly unemployment rates above 10% in late 2009.
But even at that time, the Congressional Budget Office was forecasting that by 2015,
unemployment rates would fall back to about 5%—lower than it currently is, though not
by much. As of early 2015, policymakers still think that unemployment has not yet
reached its natural rate.

THE NATURAL RATE OF UNEMPLOYMENT IN EUROPE

By the standards of other high-income economies, the natural rate of unemployment in

the U.S. economy appears relatively low. Through good economic years and bad, many
European economies have had unemployment rates hovering near 10%, or even
higher, since the 1970s. European rates of unemployment have been higher not
because recessions in Europe have been deeper, but rather because the conditions
underlying supply and demand for labor have been different in Europe, in a way that
has created a much higher natural rate of unemployment.

Many European countries have a combination of generous welfare and unemployment

benefits, together with nests of rules that impose additional costs on businesses when
they hire. In addition, many countries have laws that require firms to give workers
months of notice before laying them off and to provide substantial severance or
retraining packages after laying them off. The legally required notice before laying off a
worker can be more than three months in Spain, Germany, Denmark, and Belgium, and
the legally required severance package can be as high as a year’s salary or more in
Austria, Spain, Portugal, Italy, and Greece. Such laws will surely discourage laying off
or firing current workers. But when companies know that it will be difficult to fire or lay
off workers, they also become hesitant about hiring in the first place.

The typically higher levels of unemployment in many European countries in recent

years, which have prevailed even when economies are growing at a solid pace, are
attributable to the fact that the sorts of laws and regulations that lead to a high natural
rate of unemployment are much more prevalent in Europe than in the United States.

A PREVIEW OF POLICIES TO FIGHT UNEMPLOYMENT

The Government Budgets and Fiscal Policy and Macroeconomic Policy Around the
World chapters provide a detailed discussion of how to fight unemployment, when these
policies can be discussed in the context of the full array of macroeconomic goals and
frameworks for analysis. But even at this preliminary stage, it is useful to preview the
main issues concerning policies to fight unemployment.

The remedy for unemployment will depend on the diagnosis. Cyclical unemployment is
a short-term problem, caused because the economy is in a recession. Thus, the
preferred solution will be to avoid or minimize recessions. As Government Budgets and
Fiscal Policy discusses, this policy can be enacted by stimulating the overall buying
power in the economy, so that firms perceive that sales and profits are possible, which
makes them eager to hire.

Dealing with the natural rate of unemployment is trickier. There is not much to be done
about the fact that in a market-oriented economy, firms will hire and fire workers. Nor is
there much to be done about how the evolving age structure of the economy, or
unexpected shifts in productivity, will affect the natural rate of unemployment for a time.
However, as the example of high ongoing unemployment rates for many European
countries illustrates, government policy clearly can affect the natural rate of
unemployment that will persist even when GDP is growing.

When a government enacts policies that will affect workers or employers, it must
examine how these policies will affect the information and incentives employees and
employers have to seek each other out. For example, the government may have a role
to play in helping some of the unemployed with job searches. The design of government
programs that offer assistance to unemployed workers and protections to employed
workers may need to be rethought so that they will not unduly discourage the supply of
labor. Similarly, rules that make it difficult for businesses to begin or to expand may
need to be redesigned so that they will not unduly discourage the demand for labor. The
message is not that all laws affecting labor markets should be repealed, but only that
when such laws are enacted, a society that cares about unemployment will need to
consider the tradeoffs involved.

The Mysterious Case of the Missing Candidates

After reading the chapter you might think the current unemployment conundrum may be
due to structural unemployment. Indeed, there is a mismatch between the skills
employers are seeking and the skills the unemployed possess. But Peter Cappelli has a
slightly different view on this—it is called the purple squirrel. The what?

In human resource parlance, a purple squirrel is a job candidate who is a perfect fit for
all of the many different responsibilities of a position. A purple squirrel candidate could
step into a multi-faceted position with no training and permit the firm to higher fewer
people because the worker is so versatile. During the Great Recession, Human
Resources (HR) positions were reduced. This means today’s hiring managers are
drafting job descriptions and requirements without much, if any HR feedback. “It turns
out it’s typically the case that employers’ requirements are crazy, they’re not paying
enough, or their applicant screening is so rigid that nobody gets through,” Cappelli
stated in a 2012 Knowledge@Wharton interview about the findings in his book, Why
Good People Can’t Find Jobs: Chasing After the Purple Squirrel. In short, managers are
searching for “purple squirrels” when what they really need are just versatile workers.
There really is not a shortage of “normal squirrels”—candidates who are versatile
workers. The managers just cannot find them because their requirements, screening
processes, and compensation will filter out all but the “purple” ones.