Types of Unemployment and the Natural Rate (Cambridge (CIE) A Level Economics): Revision Note

Key terms

• Working-age population — all people of employable age (typically 16–64)

• Labour force (LF) — those in the working-age population who are either employed OR actively seeking work

  • Excludes students, retirees, homemakers, and others not seeking work (the "economically inactive")

• Employed — people currently working for pay (full-time, part-time, or self-employed)

• Unemployed — people in the labour force who are not working but actively seeking work

• Participation rate — labour force as a % of working-age population

• Unemployment rate — unemployed as a % of labour force

Full employment

• Full employment is the level of employment at which everyone willing and able to work at the going wage rate is employed

• Full employment does NOT mean zero unemployment

  • Some unemployment always remains due to frictional, structural and voluntary factors

• At full employment, the only unemployment is the natural rate of unemployment (NRU)

  • This corresponds to real output Y_FE on the vertical section of LRAS

Equilibrium and disequilibrium unemployment

Equilibrium unemployment

Diagram analysis

• D_L (downward sloping) — firms hire more workers at lower wages

• S_L (upward sloping) — more workers willing to work at higher wages

• LF (vertical) — everyone who could potentially work (labour force)

• Equilibrium at W*, Q_L* — labour market clears

• Horizontal gap between S_L and LF at W* = natural rate of unemployment

  • This is voluntary as workers are in the labour force but not willing to work at W*

Hysteresis

• Hysteresis is the tendency of unemployment to persist at higher levels after a temporary shock has passed

  • Long-term unemployed lose skills (human capital erodes)

  • Employers view them as less employable (signalling effect)

  • Discouraged workers stop searching

• Consequence — a cyclical shock can permanently raise the natural rate of unemployment unless addressed through active labour market policy

  • Example — European unemployment rose sharply after the 1980s oil shocks and remained elevated for over a decade, even after recovery

Voluntary and involuntary unemployment

Involuntary/disequilibrium unemployment

Diagram analysis

• The real wage is stuck at W₁ above equilibrium W* (e.g. due to minimum wage, union action, or sticky nominal wages)

• At W₁, firms demand only Q_L1 workers, but Q_L2 workers are willing to work

• Gap between Q_L1 and Q_L2 = involuntary unemployment

  • Workers are ready and able to work at W₁ but cannot find jobs

The natural rate of unemployment (NRU)

• The NRU is the rate of unemployment when the labour market is in equilibrium

  • This corresponds to full employment output Y_FE

  • It comprises frictional + structural + voluntary unemployment

• The NRU cannot be reduced permanently by expansionary demand-side policy

  • Doing so only creates inflation (see expectations-augmented Phillips curve)

Determinants of the NRU

Policy implications

• Demand-side policies (fiscal, monetary) cannot reduce unemployment below the NRU in the long run - they only cause inflation

• Reducing the NRU requires supply-side policies:

  • Education and retraining to reduce structural mismatch

  • Job-search support and improved labour exchanges

  • Benefit reform to reduce disincentives

  • Increasing labour mobility