Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Reducing the ‘Natural’ Rate of Unemployment

Unemployment varies from month to month and from year to year. Sometimes the economy is booming and firms are hiring a lot of people, and at other times they stop hiring or even let people go. This situation is normal and referred to as the business cycle. Unfortunately, policy makers can do little about short-term changes in unemployment caused by the business cycle.

What policy makers can influence, however, is the long-run average level of unemployment. Economists call this the natural rate of unemployment. Policies designed to reduce the natural rate of unemployment are called supply-side policies. This is because short-term fluctuations in unemployment tend to be due to the ‘demand side’ of the economy, while the average long-term level of unemployment is determined by the ‘supply-side’. (More on this in Part III.)


Determining the natural rate of unemployment

Here’s how economists work out the natural rate of unemployment. The labour force (L) is made up of those people who are employed (E) and those who aren’t employed but would like to be (the unemployed, U):

Now, every month some of the employed people sadly lose their jobs and become unemployed. If s is the proportion of employed people who lose their job in any given month, then sE represents the number of people who lose their job: s is called the rate of job separation.

On the flipside, some of the unemployed will find work and become employed. If f is the proportion of employed people who find jobs in any given month, then fU represents the number of people who find a job: f is called the rate of job finding.

Clearly, if the number of people who find a job (fU) is greater than the number of people who lose their job (sE), unemployment falls and vice versa. Figure 6-6 shows the cyclical nature of employment numbers.

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Figure 6-6: Flows in and out of employment.


The interesting thing is, if in a certain month the flows from one state (employment or unemployment) to another are larger than the flows in the opposite direction, this impacts the flows in the following month. Eventually the flows in and out of employment (or unemployment) become equal.

For example, imagine starting in a situation with 1,000 unemployed and 1,000 employed. The rate of job finding is 0.2 and the rate of job separation is 0.1:

In the first month, 200 unemployed people find a job, while 100 employed people lose their jobs. As a result, 900 people are now unemployed and 1,100 employed.

In the second month, 180 unemployed people find a job, while 110

employed people lose their jobs. This leaves 830 unemployed and 1,170 employed.


In the third month, 166 unemployed people find a job, while 117 employed people lose their jobs. This leaves 781 unemployed and 1,219 employed.


This process continues. Notice that the number of unemployed people who find a job is falling every month and the number of employed people who lose their job is increasing every month. This is because the total stock of unemployed people is falling and the total stock of employed people is rising. Eventually, the number of people finding work is exactly equal to the number who lose their job:

Using this expression along with the fact that L = E + U allows you to solve for the natural rate of unemployment (U/L): that is, the proportion of the labour force who are unemployed (for the full derivation, see the nearby sidebar ‘Derivation of the natural rate of unemployment’):

From this equation, you discover that anything that increases the rate of job separation (s) increases the natural rate, while anything that increases the rate of job finding (f) decreases the natural rate.