How Might Unemployment Be Above The Natural Rate?

The equilibrium wage rate between all the workers prepared to accept jobs and firms to hire them all at that price is expressed as the natural rate of unemployment and broadly corresponds to the non acceleration rate of unemployment (NAIRU). It occurs as a result of shocks to the economy such as a decline in aggregate demand, the sum of all demands in the economy. Figure 3 highlights how a shift in aggregate demand to the left from AD0 to AD1 creates a sharp drop in the economy. This demand deficient unemployment has voluntary and involuntary aspects. The voluntary aspect has already been described in the previous section. The other is involuntary, cyclical or Keynesian.

Prior to the drop in demand the economy was resting at point A, wage level W* and employment level N* in figure 4. There is a shift in the demand for labour by the firms from P0 to P1 as a result of less profitability in the economy. If the employees as a result of trade unions encourage wage stability (or sticky wages) then the price level would remain at W*. This has the effect of creating voluntary employment between N1 and N* as the real wage has been forced up as the price level has lowered and the wages have remained the same. If employees do not perceive a price level fall but supply to their expected real wage not money wage, then NS0 remains the supply curve as they haven’t perceived the fall in the price level. They will then accept a lower monetary wage as the real wage has increased as a result of the price level falling faster than their wages. This is still voluntary, as a further fall in money wages would reduce real wages back to the equilibrium level. In the long run the stickiness of wages should erode following contract negotiations over time, which should shift the labour supply curve from NS0 to NS1, resulting in full employment at N* but a lower wage rate of W2.

Voluntary unemployment occurs when a decline in the output of the economy from Y* to Y1 (shown by figure 3) prevents firms from selling as many goods as before. As a consequence there will be a shift in the labour demand curve from ND0 to ND1 in figure 4 and the firms will not hire beyond N1 as any extra employment would reduce their profits. As a result the labour demand curve B C N1 is kinked at C on figure 4. If the money wage stays at W* then D will not be anywhere near the unconstrained supply or demand curves, creating involuntary employment as a result. Consequentially, because workers cant price themselves in being employed at lower wages there will not be a reduction in the level of unemployment in the economy.

Returning to figure 1, with NC (the constrained labour demand) being the total level of employment and W* being the wage rate there would be cyclical unemployment between NC and N* and structural and frictional unemployment between N* and N1. At wage rate W1 cyclical unemployment would be between NC and N2, classical unemployment between N2 and N3 and frictional and cyclical unemployment between N3 and N4. Such demand deficient unemployment can add to hysteresis and result in increased structural unemployment and a shift of the labour force and labour supply curves to the left as a result of discouraged people not being able to find positions and loosing their skills.

Written By Jonathan McHugh in June 2005