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Unemployment - Natural Rate

Author: Geoff Riley  Last updated: Sunday 23 September, 2012


The natural rate of unemployment (NRU) is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level

It is where the aggregate supply of labour is in balance with the aggregate demand for labour.

At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and there is no involuntary unemployment

There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions.

Consider the next diagram. At the real wage rate W1, E1 workers are employed. But at this prevailing wage rate, the total labour force exceeds than the employed labour force.

The natural rate of unemployment = AB and consists of frictional and structural unemployment.

The government might try to reduce the natural rate by bringing down the horizontal distance between the supply of labour and the labour force curve.

Any supply-side policy that can increase the number of people willing of working age that are willing and able to find employment in the labour market will shift the labour supply curve to the right, thus narrowing the gap. This is shown in the second diagram.

Policies to reduce the natural rate of unemployment focus on removing “labour market imperfections”. E.g. a government wanting to achieve a lower equilibrium rate of unemployment might:

  • Reform the system of welfare benefits to reduce the risk of the “poverty trap” – where some people find themselves in a poverty trap, whereby it’s not worth getting a job
  • Reform trade unions to reduce their collective bargaining power and also reducing some of the barriers to labour mobility put up by professional bodies and associations which have the effect of limiting the supply of labour into an occupation
  • Reducing income tax to improve the incentives to look for and accept paid work
  • Adopting a more relaxed approach to labour migration to help fill job vacancies
  • Relax employment laws to reduce the costs for businesses wanting to employ extra workers

Economists who believe that the natural rate of unemployment can be reduced argue that government policies should seek to make labour markets more competitive and flexible.
The structural problem of youth unemployment

Youth unemployment rates are higher than for the rest of the working population. Nearly 4 people out of 10 who are unemployed are aged between 16 and 24.

NEETs: NEET stands for Not in Employment, Education or Training

Reasons for higher youth unemployment

  1. Human capital: A number of students leave school or college with few qualifications and therefore lack the human capital needed to find secure employment
  2. Experience: Younger workers have less experience in the labour market and employers may decide to employ someone with a track record in work that is perceived to be more productive. In recruitment freeze, younger workers often miss out because of the experience factor.
  3. Training costs: Some employers may not want to cover the extra costs of training younger workers – preferring instead to take a free-ride on employees who have received training in their previous job
  4. Apprenticeships: There has been a decline in the number of apprenticeships available for people leaving school aged 16. High quality vocational education makes younger workers more employable.
  5. Benefit reforms: Some economists believe that youth unemployment is partly the result of the benefits system and that claiming benefit should be made harder for those who have not taken paid work after leaving school or college. For example, unemployment benefits could rise according to how many years a person has been working and paying national insurance.


An OECD report into youth unemployment published recently made this telling observation
‘A lack of qualifications makes it hard to get a firm foothold in the labour market. In 2005, one year after leaving education, only 45% of young people who left school without an upper secondary qualification – A levels or five good GCSEs or the vocational equivalent – were employed compared with 67% of their higher-qualified counterparts. In the same year, 20% of young people without an upper secondary qualification were neither in employment nor in education or training, more than twice the share among their more educated counterparts.’

  • Youth unemployment is a major structural problem in the UK labour market
  • Some economists are calling for a rise in government spending on schools and colleges, whilst others want the government to lower employer national insurance contributions for businesses that take on and train younger workers
  • In the long run, such measures will pay dividends because of the economic and social costs if we suffer another generation of younger people with limited employment opportunities

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