Finance & Banking Magazine May/June 2015

Economics: Approaching ‘Full Employment’

May/June 2016 Issue


The unemployment rate in Arkansas has been declining steadily over the past several months — in tandem with the national unemployment rate — and is rapidly approaching pre-recession levels. Now might be a good time to consider how low it will go.

It is tempting to think that we should seek an unemployment rate of zero. After all, unemployment is an undesirable circumstance, and we would like to see everyone who wants a job have a job. But the way that the unemployment rate is measured, there will always be at least some positive level of unemployment. People choose to leave jobs to seek better opportunities, and firms often lay off workers in light of current business conditions. That means that there will always be people between jobs. And because the labor market is one where workers and employers must seek a match between skills and needs, the search process can be time-consuming.

One concept of the lowest possible sustainable level of unemployment goes by the unwieldy name of the Non-Accelerating Inflation Rate of Unemployment, or NAIRU. The NAIRU is based on the idea that as monetary policy stimulates the economy through low interest rates, the unemployment rate can be pushed downward if there exists enough “slack” in labor markets. But if the unemployment rate is pushed too low — when labor markets are tight — the outcome will be an increase in inflation instead of lower unemployment.

There is some controversy about the NAIRU concept. Most economists concede that there is no long-run trade-off between inflation and unemployment, even if there might be a short-run relationship that makes NAIRU operational. Moreover, the only way to determine a value for NAIRU is by using statistical analysis of past episodes of unemployment and inflation, and we can never be certain that fundamental conditions and relationships haven’t changed over time. Another drawback of the NAIRU is that it applies to the entire national economy. It has nothing to say about the possibility that different states or regions of the country might have different “natural” rates of unemployment.

In fact, an alternative concept of the lowest sustainable unemployment rate is known as the Natural Rate Hypothesis. First articulated by Milton Friedman, the natural rate hypothesis is based on the idea that in the long run, there is a balance between the number of unemployed people finding new jobs and the number of people leaving their existing jobs (by choice or otherwise), resulting in an equilibrium level of unemployment. Under the hypothesis, we would expect that the actual unemployment rate would gravitate back toward this natural rate after being pushed away by business cycle fluctuations.

The natural rate of unemployment need not be constant over time or even the same across regions. For example, we would expect the natural rate to be higher when the economy is going through fundamental transformations, as workers take time to acquire new skills in line with changing demands. Demographics matter, too. For example, if the labor force has a relatively high number of younger or otherwise less-experienced workers, the average duration of unemployment might be longer as it takes more time to find matches between employers and employees.

Another consideration in evaluating the natural rate of unemployment is the lingering impact of business cycle fluctuations. The recession of 2008-09 represented a sharp contraction that left many people in the category of the “long-term unemployed.” The longer the spell of unemployment, the more likely it is that workers’ skills depreciate and finding new employment becomes more difficult. Hence, the natural rate may be elevated for some time after such a severe recession. As a matter of fact, one operational measure of the natural rate that is estimated by the Congressional Budget Office shows that the natural rate rose from 5 to 5.5 percent following the last recession, and is expected to decline only gradually back toward 5 percent. This would suggest that we’re already close to the long-run equilibrium.

The natural rate concept also allows for different equilibrium rates in different geographic areas, depending on characteristics of local labor markets and economic conditions. If we look back to pre-recession unemployment rates, there is little reason to expect that Arkansas will differ noticeably from the national average. In 2005, for example, in the middle of the last expansion, the annual unemployment rate for Arkansas was 5.2 percent while the national rate was 5.1 percent. But conditions might differ across regions of the state. During the last expansion, the unemployment rate in northwest Arkansas was persistently lower than the statewide average, while the unemployment rate in the Pine Bluff area tended to be higher. Local labor market conditions might be expected to generate similar outcomes during the current expansion.

The unemployment rate is not the only indicator of the health of an economy, nor is it the best, but it is highly publicized. The rapid decline in unemployment in recent months has been welcome news, but economic theory suggests that we should expect the pace of decline to slow, and that the level of unemployment will stabilize sometime in the near future.

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