Revision: Natural Rate of Unemployment

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

It is worth stating at this point that some economists simply do not believe in the validity of a simple natural rate of unemployment when the labour market is in balance and where a rate of unemployment “settles” at a level consistent with stable wage and price inflation. The natural rate concept is supported by economists who believe in the power of markets to clear at an equilibrium price and who view the labour market much as any other market in the economy.

Policies to reduce the natural rate of unemployment normally focus on improving the efficiency of the labour market be removing what are called “labour market imperfections”. For example a government wanting to achieve a lower equilibrium rate of unemployment might do the following:

- Reform the system of welfare benefits so as to reduce the risk of the “poverty trap”
- Reforming 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

In general terms, 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. We now move on to discuss the nature of flexible labour markets as part of strategies to boost employment and thereby reduce unemployment.