The natural rate of unemployment is the percentage of people who are unemployed due to natural movement in the workforce rather than economic instability. If the economy is slow or in trouble, unemployment rises above the natural level. This is an important economic concept that was developed by Nobel Prize-winning economists Milton Friedman and Edmund Phelps in the late 1960s. In fact, they won the Nobel Prize primarily for their work developing the concept of a natural rate of unemployment.
There are three main types of unemployment:
- Frictional: This type of unemployment is caused by normal turnover in a healthy job market. People who are frictionally unemployed might include a new college graduate who hasn't yet found work, or an employee who decides to leave a position before finding a new one elsewhere.
- Structural: Workers who are structurally unemployed have skill sets that have become outdated, or jobs that are being replaced by new technology or cheaper labor in another country.
- Cyclical: This type of unemployment occurs when the economy slows down and workers are laid off.
When unemployment is due to frictional or structural causes, it is considered to be in its natural state. Volatilities in the economy that cause cyclical unemployment, such as the Great Recession, cause unemployment that is not natural.
It's not really possible to have zero unemployment. College graduates cannot always become immediately employed. People sometimes move to another city without first securing a job. Workers need to take time off to update skills. There will always be a certain amount of movement in the job world that causes unemployment.
Because zero isn't possible – or maybe even desirable, say many economists – the ideal rate of unemployment is considered the natural rate. The Federal Reserve puts the natural rate between 4.5 and 5 percent. In 2017, the Congressional Budget Office estimated the rate of unemployment to be 4.7 percent, which is right in the sweet spot of "natural." This means the economy is doing well, and jobs are available.
During the recent Great Recession, overall unemployment hit a high of 10 percent in October of 2009. During this time period, from 2009 to 2012, the natural rate rose from 4.9 to 5.5 percent. As most of us recall, the economy was not doing well, and the high natural rate of unemployment reflects this.
The overall unemployment rate is calculated by dividing the total number of unemployed people (U) by the total number of people in the labor force (LF). The labor force includes working-age adults who want to be employed.
U ÷ LF = Total unemployment
In order to calculate the natural rate, first add the number of frictionally unemployed (FU) to the number or people who are structurally unemployed (SU), then divide this number by the total labor force.
(FU + SU) ÷ LF = Natural rate of unemployment
Unemployment affects inflation. When employment is at its natural rate, inflation is considered to be stable. The Federal Reserve takes this number seriously, and adjusts interest rates accordingly. So, the next time you hear about a cut or increase in the interest rate, know that someone at the Fed is busy calculating the natural rate of unemployment and making predictions based on that number.