What is the Natural Rate of Unemployment?

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Milton Friedman developed the concept of the natural rate of unemployment. If we divide unemployment up into 3 categories, one of the categories, cyclical unemployment, is due to lack of demand for labor. The other two factors are frictional, which reflects the time it takes to match job seekers with those looking to hire, and structural unemployment which is a mismatch between the skills in the labor force and the skills needed by firms. The combination of frictional unemployment and structural unemployment is used to determine the natural rate of unemployment. Friedman claimed that efforts to reduce unemployment below the natural rate would accelerate the rate of inflation.

Our current rate of unemployment of 9% reflects all three of these factors. If the structural rate has increased over time for one reason or another, then a smaller portion of the unemployment rate is due to the lack of demand for labor. Consequently, it would not make sense to use government policies to lower the unemployment rate by stimulating demand for labor. On the other hand, if there has been little change in structural factors, then the high rate of unemployment is due to a lack of demand for labor and government could use fiscal and monetary policy to stimulate demand without accelerating the rate of inflation.

There have been some studies, that indicate a mismatch between labor force skills and job openings. Most of the information, however, has been anecdotal reports in the media in which some employers report difficulty in finding workers with the right skill set. The San Francisco Fed study, referred to in this article, indicates that there might be short term spike in structural unemployment but that cyclical factors are largely responsible for the 9% unemployment rate. As you might imagine, conservatives prefer to keep government out of the unemployment situation, so they argue that the problem lies in a workforce that does not have the proper skill set. Others point to the Clinton administration in which the unemployment rate was below 4% and there was no spike in the inflation rate. They find it hard to believe that labor force skills would have eroded to the point where structural factors are responsible for the high rate of unemployment. They look to factors that have affected the demand for labor such as offshoring production, low wage growth, high levels of household debt to income etc. as the more important factors.