Unit 5 - What is the Full Employment Rate of Unemployment?

Full employment, or the natural rate of unemployment, is considered to be consistent with a level of unemployment that predominantly comprises voluntarily unemployed workers. In other words, those members of the labor force who really want a job have one. Leaving the nuances of who is part of the labor force for the main text, the rate of unemployment consistent with full employment is a major issue for economic policymakers. Small differences in the perceived rate of full employment lead to significant variations in the policy response to economic growth.

The definition of full employment is critical, because as unemployment rates reach and fall below this level, inflationary pressures start to build. The further that the unemployment rate falls below the natural rate, the greater the pressure on inflation. This is a result of modern production methods. Even in a capital-favoring production country like the United States, worker wages represent over 70% of all production costs. Rising wages increase costs, which are usually passed on to consumers as price increases, leading to climbing inflation.

To understand the relationship between full employment and wage increases, let us assume that the agreed upon natural unemployment rate is 5%. If the unemployment rate is 8%, then there are workers who desire jobs but cannot obtain one (known as involuntary unemployment). With high unemployment rates, the existing labor surplus implies that employers have little trouble finding people to work at the prevailing wage. But as economic growth accelerates, the labor surplus diminishes as more workers are hired, and the unemployment rate falls. Finally, due to strong economic growth, the unemployment rate falls to a level consistent with full employment.

As the story unfolds, economic growth remains persistently bullish, but now everyone (give or take) who wants a job has one. Yet increases in the demand for labor continue to grow and employers must pay existing workers overtime and entice non-labor force participants into the labor force by offering them higher wages. As wages increase, more people are willing to work (reaching their reservation wage), but production costs rise. If strong economic growth persists, wages pressures continue to build, leading to increasing inflation (also known as cost-push inflation).

OK you say; no big deal. When the unemployment rate reaches full employment, use restrictive economic policies to slow economic growth to a level consistent with labor force growth (and labor productivity). That way the unemployment rate will stay constant at the full employment rate, and wage pressures will remain muted. That's a great idea. However, what is the full employment rate of unemployment?

Certainly, full employment in the United States has changed over the years. During the 1950s and 1960s it remained low, consistent with 3-5% unemployment rates. In the 1970s two main changes swept through the American labor force:

  1. The post-World War II baby boomers began to enter the labor force.
  2. Females increased their participation rate to 50% of the total women of working age.

Since both boomers and the wave of new females entering the labor force tended to be younger and less experienced job turnover, increased. By the late 1970s the natural unemployment rate had risen to the 7% range.

During the 1980s the increasing participation rates of women stabilized and the boomers were followed by the baby bust. The natural unemployment rate fell into the 6% range. The consensus among policymakers today is that the full employment rate of unemployment is roughly 4.5%. Once unemployment rates reach that level, economic growth needs to be slowed (we will see how later in this course), in order to level out the changes in the unemployment rate.

The problem with this analysis is what if economic policymakers are wrong? Many argue that the natural unemployment rate has fallen to about 3%. If during an expansion, economic growth is slowed to maintain a 4.5% rate of unemployment, while 3% is consistent with non-inflationary growth, then there are still plenty of people (well over 1 million) who want to work at prevailing wages but cannot find a job. By putting on the growth brakes too soon, many involuntarily unemployed workers will still be denied meaningful work.

There are several arguments against using 4.5% as the full employment benchmark and that even if full employment is reached (whatever the level) wage increases will remain tame, causing only muted inflationary pressures. Some reasons that have been given include:

  1. Recent evidence showed that even as the unemployment rate fell from 6.7% at the beginning of 1994 to 5.4% by the end of that year, employee wage and benefit costs, along with inflation, remained steady.

  2. The productivity of American businesses has increased dramatically since 1993, rising at roughly a 3.0% rate in 1994. This helps to keep inflation low by offsetting any wage pressures. This is reflected by an increase in unit labor costs (total compensation adjusted for productivity) of only 1% in 1994. In contrast, at this stage in a typical business cycle, unit labor costs are rising at a 5% to 6% rate.

  3. A loss of worker negotiating power (unions, etc.) weakens the ability of employees to negotiate wage raises.

  4. The re-engineering of the workplace has led to large-scale layoffs during periods of economic growth and in companies earning record profits. Insecure workers have little ability to ask for raises.

  5. The global economy makes it easier to shift jobs into overseas production when domestic wage pressure build. Foreign production provides a relief valve to domestic wage pressures.

The above evidence indicates that the natural unemployment rate does lie well below 5% and that businesses are increasingly effective in keeping labor costs low. Higher worker productivity helps maintain the nation's standard of living by keeping inflation under control and boosting the competitiveness of U.S. products overseas. Regardless, policy makers are content with a non-accelerating inflationary growth rate consistent with an unemployment rate of around 4.5%

Low Unemployment Rates Help Reduce Structural Unemployment

Individuals seeking work are often placed in broad categories. People who have been laid off from their jobs due to poor macroeconomic conditions are part of cyclical unemployment that corresponds to fluctuations in economic growth rates. The solution to a rise in the rate of unemployment due to a recession or economic slowdown is simply to increase the growth rate of the economy. As economic activity picks up, firms will increase hiring and the number of unemployed will decrease.

Even as renewed economic vigor allows many unemployed people to return to work, unemployment rates do not fall to zero. Some individuals choose to be unemployed during a brief transition, usually lasting less than five weeks. Perhaps they are taking some time off in-between jobs or moving to another part of the country. Students and spouses leave school and home to find their first jobs. In contrast to those who are voluntarily unemployed are those who remain unemployed regardless if the economy is booming or sinking.. The long term unemployed are considered to be structurally unemployed. Members of this group may lack the education and skills to find work or they may simply be in the wrong place. Many younger African-Americans find themselves in the city when the majority of available jobs are located in the suburbs. The same holds true for Native-Americans who may find few jobs on their home reservations.

The prolonged U.S. economic boom that began in 1992 has helped to reduce unemployment rates to levels not seen in 30 years. Finally, by the late 1990s, the growing economy and record rate of job growth reached many of those previously considered to be permanent fixtures on welfare. For many residents of poorer rural America, and a significant number of blacks and other minorities who have had little opportunity for sustained employment in the past, jobs have become available. As a  group, the unemployment rates among blacks and Hispanics, though still high compared with that for whites, have fallen to record lows. By 1999, joblessness among high school dropouts has fallen to about half the rate in 1992. And wages for the lowest paid are rising faster than inflation for the first time in decades.

The key point made here is that when full employment is reached, the remaining unemployed are considered to be structurally unemployed. There individuals lack the skills and education that are in demand.  For years the blame for structural unemployment was primarily placed on the lack of opportunity or the individuals themselves. Favorite solutions included government intervention to create jobs, provide training and to give the structurally unemployed incentives to work. It now appears that many of the structurally unemployed have wanted to work all along when given the opportunity and they really should have been considered cyclically unemployed.


Copyright   1999, Jay Kaplan
All rights reserved
Last updated January 15, 1999