Natural Rate of Unemployment

Milton Friedman postulated that inflation in this time period was based on inflationary expectations formed in the previous time period. It was like predicting the weather. One could look outside and assume that the next hour's weather would be much like the last hours. Let's look at the formula. Inflation was related to the deviation of the actual unemployment, U, from the natural rate, U*. Thus, I = I' - .5(U - U*), where I is inflation this time period and I' is inflation from the previous time period.

If the actual unemployment is greater than the natural rate, the inflation is falling. If the actual unemployment is less than the natural rate, then inflation is falling. This is the Phillips Curve.

In this blog post, I want to opine what can happen to U*, or the natural rate. The natural rate equals frictional plus structural unemployment. Any changes to frictional or structure will change U*. If jobs are being destroyed by changes in employer demand faster than jobs are being created, then the natural rate will increase. If it takes workers a longer time to find a job, then U* will increase. U* is what I call a fluid dynamic since there are flows into and out of it.

Robert Hall and Greg Mankiw have written this dynamic as: s/(s+f) which measures the ratio of job separations, s, to job separations and job findings, f. Both s and f are fractions. It's f that has the greatest effect on the unemployment rate. Say f equals .2. This means that it takes a job seeker 5 months to find a job. If f increases to .5, then it takes that worker 2 months to find a job. Assuming s is constant, a larger f, or less time to find a job, will lower the unemployment rate. To see how the duration of unemployment is increasing, visit the Bureau of Labor Statistics and view Table 12. The link is here. In February, 09, the percent of displaced workers was 22.4% who were out of a job more than 27 weeks. In February, 10, that figure was 40.9. This is alarming since unemployment benefits have expired.

There are changes constantly taking place in the labor market that influence the ability to find a job. Some of these changes come from being able to search for a job on your computer instead of incurring shoe leather costs. Changes in consumer demand will change the demand for workers as this demand is derived. Technology will allow more women to go to work and at the same time make manufacturing skills obsolete. New laws might prohibit teachers from retiring early and lengthen their attachment to the labor force, s. Thus, U* is a flow variable. Measurment of both frictional and structural unemployment then yields insight into both the inflation rate and the natural rate of unemployment.

This blog helps me to understand concepts and allows me to think out loud. If you like this discussion, please comment.