Full Employment Rate

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Definition of Full Employment Rate:

The full employment rate is the economy's long-run employment rate where the cyclical unemployment is zero. This is also referred to as the natural rate of employment.

Detailed Explanation:

Economists estimate that the full employment rate is between 94 and 96 percent (meaning the unemployment rate is from 4 to 6 percent). Some unemployment is inevitable – even healthy.  An unemployed person must meet three criteria: 1) not have a job, 2) be willing to work, and 3) demonstrate that he or she is actively looking for employment by performing at least one job search task within the last four weeks. 

Economists separate unemployment into three categories: frictional, structural, and cyclical. Frictional unemployment occurs when market inefficiencies prevent people from identifying and starting a job as soon as they want one. The process of applying, interviewing, and accepting a job takes time. Structural unemployment results when economic progress may leave some workers behind. Jobs may be available in areas where workers are unwilling to move to. Finally, cyclical unemployment is caused by changing labor demands resulting from business cycles. The full employment rate includes frictional unemployment and structural unemployment but excludes cyclical unemployment. To understand why each needs to be defined. 

Frictional Unemployment

Frictional unemployment is normally short-term and transitional. Workers change jobs. People enter and reenter the workforce, such as students seeking a job following graduation, or mothers reentering the workforce. It takes time to match potential employees and employers. The applicant must search for a job, apply, and probably interview for a job. Employers may want to consider many applicants. This is a period of frictional unemployment. 

Unlike structural and cyclical unemployment, frictional unemployment does not harm the economy. In fact, frictional unemployment is healthy because it normally results from people seeking better jobs. Most of the time frictional unemployment is voluntary, so it is just a natural progression of people choosing where they want to work. Frictional unemployment normally increases following a recession because confidence in the economy increases people’s willingness to quit a job in search of a better one. Conversely, people may be hesitant to leave a job during a recession, fearing they will not find one to replace it. 

Frictional unemployment can be reduced by decreasing the time it takes for job seekers to find a job. Job placement companies such as Monster and CareerBuilder have improved the efficiency of identifying potential jobs. 

Structural Unemployment

Structural unemployment is caused by the obsolescence of workers’ skills due to technology or other factors that reduce the demand for their skills. Structural unemployment is not influenced by changes in the business cycle. An increase in the demand for goods or services will not bring the structurally employed back to work, which means those impacted may be out of work for a long time.

Technology has displaced workers for centuries. Agricultural equipment has replaced sharecroppers. Word processing software, answering machines, and other office technologies have replaced many secretaries. Historically, workers have adjusted by acquiring new skills for new jobs. But as jobs become more complex and require more training it becomes harder to get the training and find new jobs. The good news is jobs are often available. The bad news is the disparity between the skills required and what the workers can offer, or between the location of the job and the inability of the worker to move to the area. For example, robotics has reduced the demand for people manning a drill press but has increased the demand for computer programmers to program the robot that has replaced the drill press operator. Unfortunately, the drill press operator may not have the skills to program the robot. 

In another case, assume management chooses to outsource the manufacturing process to another company to lower their cost. The other manufacturer has a demand for drill press operators and may be willing to hire the laid-off worker, but the laid-off drill press operator may be unable to move because his home is underwater. Between 2007 and 2011 real estate values declined, and many homeowners had a mortgage balance that exceeded their home’s value. Homeowners have three unattractive options when confronted with this situation. They can sell their home and pay the difference between the loan balance and sales price at closing. In some cases, homeowners may negotiate a lower balance on their loan to prevent owing more than their home is valued when they sell it. (This is challenging and time-consuming with no guarantee.) Finally, they may choose not to move. Most choose not to sell.

The drill press operator illustrates the primary difference between frictional and structural unemployment. Frictional unemployment normally occurs when someone with transferable skills decides to look for a different job. (Someone would be reluctant to leave their job unless they were qualified.) Structural unemployment happens when someone lacks the skill sets in demand. This makes structural unemployment more difficult to remedy because it usually lasts longer than the other types of unemployment. Structural unemployment is the primary cause of long-term unemployment. Any solution involves either providing an employee the needed skills in the changing economy or the ability to identify and move to an area with jobs matching his skills. 

Management may choose to move manufacturing following a trade agreement, tax policy, or regulations that increase their cost. Each of these actions could potentially increase structural unemployment in a region.

Cyclical Unemployment

Cyclical unemployment is caused by swings in the business cycle. It increases during recessions. The demand for goods and services contracts. Inventories increase. Managements slow production and lay off workers to cut costs, causing a surplus of workers. Conversely, cyclical unemployment decreases during expansions when businesses need to hire workers to increase production. Cyclical unemployment is zero at full employment. Cyclical unemployment is more volatile than frictional and structural unemployment, so cyclical unemployment has a greater influence over changes in the unemployment rate. 

Any event that causes the public and/or business community to lose confidence in the economy can trigger a drop in the aggregate demand. For example, the Great Depression was exacerbated by the stock market crash in 1929. Many had invested their life savings and panicked when the market crashed. They went to withdraw their money from the bank only to learn that banks had also invested in the stock market and the money was not available. 

Inflation caused by a supply shock can send an economy into a recession, particularly when a central bank chooses to fight inflation by increasing interest rates. In 1973, inflation was a concern in the United States. It averaged 6.2 percent, only to nearly double to 11 percent in 1974. The jump followed October 1973’s Arab Oil Embargo which was imposed by the Arab members of OPEC in retaliation for the US support of Israel during the Arab-Israeli War. Oil supplies dropped, and prices increased. The production and distribution of most products required oil to manufacture and transport. Producer costs increased, and companies passed some of the increase to consumers by raising their higher prices. Consumers could not purchase as many goods because wage increases did not match the increase in the price of goods and services. Businesses produced less. 

Curbing inflation became the primary objective of the Federal Reserve, and they succeeded by raising interest rates to record levels. The prime rate, which is the most common rate charged on business loans, eventually exceeded 20 percent in 1980 and dramatically curtailed business investment. 

A prolonged recession can increase structural unemployment when a laid-off worker is away for so long that new job skills are needed which the worker is unable to provide. Assume a recession forces a company to lay off 500 workers. 50 workers choose to return to school to study computer programming. During the next two years management chooses to improve its efficiency with robots. When growth resumes, management rehires the 50 workers who chose to study computer programming. The remaining 450 workers no longer have the skills demanded by the company. In this example, 450 workers went from being cyclically unemployed to structurally unemployed.

Expansionary fiscal and monetary policies can be used to increase the economy’s aggregate demand or aggregate supply and return many of the cyclically unemployed back to work. The Federal Reserve may increase the money supply to lower interest rates, which in turn makes business borrowing more attractive. Congress may choose to stimulate the economy by increasing spending. 

Dig Deeper With These Free Lessons:

Business Cycles
Aggregate Supply and Demand – Macroeconomic Equilibrium
Fiscal Policy – Managing an Economy by Taxing and Spending
Gross Domestic Product – Measuring an Economy's Performance
Production Possibilities Frontier

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