When the economy is at full employment What is the natural unemployment rate equal to zero?

Does full employment mean no unemployment? The answer is no. When the economy operates at full employment, unemployment remains. The unemployment rate is not zero.

Why not zero percent?

Only the cyclical unemployment rate is zero percent during full employment. It shows you job seekers have occupied available job vacancies.

The economy operates at its natural rate of unemployment, leaving structural unemployment and frictional unemployment. Both are never zero percent. 

In the United States, economists say the natural unemployment rate is between 4 and 5 percent. If it decreases further, it will only produce inflationary pressure, which is undesirable because it diminishes the purchasing power of money.

Let me talk about what full employment is all about. Then, I also discuss structural, cyclical, and frictional unemployment. As I mentioned earlier, at the natural rate of unemployment, only cyclical unemployment is zero percent. In contrast, structural and frictional unemployment still exists.

Full employment definition

Full employment occurs when the economy uses all available resources, including labor. The economy’s output (reflected in real GDP) is at its potential output (potential GDP). 

In a graph, it occurs when the short-run equilibrium (the intersection of the short-run aggregate supply curve and the aggregate demand curve) is right on the long-run aggregate supply curve.

In these conditions, everyone who is willing to work at a decent wage level gets a job. Those who are actively looking for work find suitable jobs. Unemployment is at its natural rate, which is equal to the structural plus frictional unemployment.

Structural unemployment definition

Structural unemployment occurs due to fundamental problems in the economy. Structural changes in the economy make some skills obsolete and irrelevant, leaving previously employed people out of work. When they do not adapt and acquire new skills demanded by the market, they are unemployed forever.

For example, when industrialization was underway, the contribution of the agricultural sector to labor absorption decreased. In contrast, the manufacturing and service sectors grew. Farmworkers can lose their jobs.

Some workers do not have the skills necessary to work in the manufacturing or service sector. They are also unable to acquire new skills because problems such as education and retraining programs are unavailable. Finally, they can become structurally unemployed.

Frictional unemployment definition

Frictional unemployment arises because of the time lag to find and fill suitable job vacancies. For example, you might leave your current job for reasons such as seeking a higher position, being fired, or the company going bankrupt.

Of course, you will need time to work in a new place. You must look for related job vacancies and follow the recruitment process before you can become effective. As long as you are waiting to start a new job, you fall into the category of frictional unemployment.

Such a situation also occurs for recent graduates. They need time to find a job and be employed.

In general, labor market imperfections give rise to frictional unemployment. For example, it occurs because of incomplete information between employers and workers regarding job vacancies, salaries, and required qualifications. 

You may find the right job, but the salary offered does not match your expectations after negotiating. Finally, you don’t pick it up and look elsewhere.

Cyclical unemployment definition

Cyclical unemployment occurs when the economy produces less than its potential output, as occurs during a recession. Businesses cannot make full use of their production capacity. If, for example, a company uses 100 workers to operate a production machine, now they only use 90 workers.

During a recession, aggregate demand slumps due to the gloomy outlook for household income. In response to these conditions, businesses cut production and reduce labor.

If they are producing at full capacity, it will only increase the pressure on profitability. Supply will exceed demand, pushing down prices.

Conversely, during expansion, the economy is headed for full employment. Aggregate demand increases. That encourages businesses to increase production and recruit workers. Businesses operate at near full production capacity, absorbing all available qualified workers.

Long story short, cyclical unemployment is due to insufficient aggregate demand (also called demand-deficient unemployment). Unemployment is high because businesses are cutting production.

The labor market faces a higher supply of labor than demand. That should lower wages.

But that doesn’t happen because wages are stiff to go down. Thus, businesses cannot maintain profit margins. Finally, they chose to reduce workers.

Since the economy uses all available labor, the unemployment rate is at its natural rate. Cyclical unemployment does not exist. Those who are qualified and actively looking for work have already employed.

The labor market leaves fewer qualified people waiting to be recruited. Those without skills (structural unemployment) also remain unemployed.

Additional: why full employment is bad

Some people may say, full employment is bad. Why?

During full employment, the supply of qualified labor becomes scarce. The market only provides those who are less qualified.

This situation ultimately increases competition between companies to find suitable employees. That ultimately pushed wages up. 

The increase in wages pushes the price of goods and services to increase. The company is likely to pass the increase in costs to the selling price to maintain profitability margins.

As the prices rise, the economy faces rising inflationary pressures. Suppose the unemployment rate falls above its natural rate. In that case, the pressure for rising wages becomes even more significant – so will inflation.

That’s why some people think full-time jobs are bad. A further decline in the unemployment rate below its natural rate will only produce inflationary pressures, an undesirable consequence.

When inflationary pressures start to increase, the government will usually step in. For example, the central bank will raise the policy rate. It makes borrowing costs for consumption and investment more expensive. That ultimately lowers aggregate demand, prompting businesses to reduce their output.