A Changing Natural Rate of Unemployment: Policy Issues (CRS Report for Congress)
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| Release Date |
July 10, 2006 |
| Report Number |
RL32274 |
| Report Type |
Report |
| Authors |
Marc Labonte, Government and Finance Division |
| Source Agency |
Congressional Research Service |
Summary:
A concept that is fundamental to understanding the economy is that there is an equilibrium,
market-clearing rate of unemployment determined by labor market characteristics, policy, and
conditions. This rate of unemployment is referred to as the "natural rate" or "full employment rate"
of unemployment or the NAIRU (non-accelerating inflation rate of unemployment). Although
expansionary fiscal or monetary policy might be able to temporarily push unemployment below the
natural rate in exchange for higher inflation, eventually actual unemployment would rise back to the
natural rate without inflation falling. This concept is consistent with the view that monetary policy
has no long-run effect on real variables such as economic growth or unemployment, and affects only
prices in the long run. If unemployment did not return to a natural rate, it would imply that monetary
policy could permanently affect unemployment.
There are periods of U.S. history when a constant natural rate concept cannot explain the
behavior of unemployment and inflation. For example, in the 1970s, inflation rose although
unemployment was above estimates of the natural rate, and in the 1990s, inflation fell although
unemployment was below estimates of the natural rate. A more sophisticated theory is needed to
explain these periods. Since the natural rate is determined by the characteristics of the labor market,
it is possible that changes in the labor market lead to changes in the natural rate over time. For
example, an aging workforce, unexpectedly rapid productivity growth, policy changes, and a growing
temporary workforce are some of the factors that could have led to a decline in the natural rate in the
1990s. In this view, at any given moment, there is some natural rate of unemployment, below
(above) which inflation will rise (fall), but that rate may be different from the natural rate in the past
or future because of labor market changes. It is estimated that the natural rate rose during the 1970s
and 1980s, and fell back to earlier levels in the 1990s.
Although there is no theoretical drawback to the concept of a changing natural rate, economists
have been unsuccessful in empirically predicting when changes would take place. This leaves the
theory open to the criticism that, rather than offering a meaningful explanation of the empirical
record, it does little more than offer post hoc rationalization for contradictory results. Any natural
rate estimate must be accompanied by a wide range of uncertainty -- some research suggests a natural
rate of 5.9%, with a 95% confidence interval of 3.9% to 7.6%. Yet alternative theories to the natural
rate have done a little better at explaining or predicting economic outcomes. The unpredictability
of a changing natural rate suggests that excessive weight should not be placed on the gap between
actual unemployment and natural rate estimates in fiscal and monetary policy decisions. The natural
rate is probably most useful to policymakers as one of many economic indicators that can predict
changes in inflation or the business cycle. Although changes in the natural rate have not been
successfully predicted, it would be difficult to make systematic policy decisions without some notion
of full employment.
