Natural rate of employment is the rate of unemployment at which the economy is said to be in practically full employment situation with regard to utilization of its labour and othere resouirce supply allowing for inevitable, minimum temporary adjustment unemployment without an economy would get into inflationary pressures. Potential Real Gross GDP is the Real GDP that is possible and sustainable to be geberated with full employment of rersouces after allowing for inevitable natural unemployment.
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NATURAL UNEMPLOYMENT: is the combination of frictional and structural unemployment that persists in an efficient, expanding economy when labor and resource markets are in equilibrium. Natural unemployment exists when the economy is at full employment, which for practical purposes is defined as the condition in which the quantity of resources demanded is equal to the quantity of resources supplied. Most important for policy purposes, natural employment exists with stable prices, that is, no inflation.
Frictional and structural unemployment are considered natural bi-products of a healthy, expanding economy. While they can be reduced through improved information, training, and education, total elimination is probably undesirable and likely impossible. The inherent tendency for an economy to have some degree of frictional and structural unemployment gives rise to the notion of natural unemployment.
In principle, full employment exists when all resources (especially labor) are fully engaged in the production of goods and services, that is, full employment puts the economy ON the production possibilities frontier. However, in practice and in terms of macroeconomic policy, full employment is best viewed as the condition that exists after cyclical unemployment has been eliminated by preventing or correcting business-cycle contractions. This leaves frictional and structural unemployment (ignoring the seasonal variety which is largely irrelevant to macroeconomic policy).
When policy makers use the term full employment, they do not mean that absolutely everyone one has a job at any given moment. What they mean is that cyclical unemployment has been eliminated. What remains are frictional and structural unemployment that is a natural part of the economy.
With the labor and other resource markets in equilibrium, there is no pressure for wages or other resource prices to change. If resource prices remain stable, then production cost and output prices remain stable. In fact one of the more important policy aspects is that natural employment can persist with NO inflation.
A few observations about natural unemployment are order:
One, natural unemployment is the combination of frictional and structural unemployment. The economy will always have some degree of frictional and structural unemployment.
Two, frictional and structural unemployment do not result from the lack of available jobs, only from the problems of getting workers and jobs together. In other words, the quantity demanded equals the quantity supplied. Natural unemployment is thus, from a practical viewpoint, considered synonymous with full employment.
Three, because the demand and supply quantities are equal, there is no pressure on factor prices (wages) to change. As such, natural unemployment can be sustained with no changes in inflation. The same cannot be said about cyclical unemployment.
Four, because natural unemployment can be sustained without affecting inflation, it provides an excellent target for macroeconomic stabilization policies. Policies that achieve and maintain ONLY natural unemployment essentially eliminate ALL business-cycle instability.
Because of the policy importance of natural unemployment, a significant amount of controversy exists over the actual level, as measured by the unemployment rate. Some economists and political leaders contend this rate in the range of 6 percent. Others contend it is lower, 5.5 percent, 5 percent, or even less.
The appropriate natural unemployment is not simply a high-brow, academic discourse among pointy-headed economists either. If the economy has reached the natural unemployment level, then the government need take no further action to move it lower. Doing so, in fact, would trigger inflation.
However, the difference between 6 percent and 5 percent unemployment in the U.S. economy is well over a 1 million workers. This corresponds to almost $300 billion worth of goods and services. %26quot;Settling%26quot; for a higher natural unemployment rate that actually includes some cyclical unemployment, at the very least, condemns these workers to temporary hardships and prevents the rest of the economy from enjoying a few hundred billions dollars worth of production.
POTENTIAL REAL GROSS DOMESTIC PRODUCT:
The total real output (real gross domestic product) that the economy can produce if resources are fully employed. In theory this means that the economy is operating ON the production possibilities frontier. Full employment is generally indicated by achieving what is termed the natural unemployment rate. If the economy is at full employment then actual real gross domestic product is equal to potential real gross domestic product and the actual unemployment rate is equal to the natural unemployment rate. The macroeconomy is thus living up to its potential.
Potential real gross domestic product (or potential real GDP) provides a benchmark for identifying phases of the business cycle and as a guide for stabilization policies. A business-cycle contraction, with cyclical unemployment, exists if actual or current real GDP is less than potential real GDP. In contrast, inflation is likely to occur if current real GDP is greater than potential real GDP.
Ideally, current real GDP is equal to potential real GDP. If so, then the economy has full employment with no inflation.
Consider a few hypothetical numbers to illustrate how potential real gross domestic product is calculated. A few valuable tidbits of information are:
The natural unemployment rate is 5%.
The current unemployment rate is 6%.
Current real gross domestic product is $10 trillion.
The first tidbit of information means that potential real gross domestic product is achieved when 95% of the labor force is employed, which is 100% minus the 5% natural unemployment rate. This can be termed the natural employment rate. The second tidbit of information means that the economy currently has only 94% of the labor force employed, 100% minus the actual unemployment rate of 6%. This can be called the actual employment rate. In this example, the actual employment rate is 1% less than the natural employment rate and full employment.
The 94% of the labor force that is working generates $10 trillion worth of real gross domestic product. The question to answer is this: How much real gross domestic product could the economy produce with 95% of the labor force working, with full employment? Here is the simple formula that can be used to answer this question:
potential real GDP
= (natural employment rate/ Actual employment rate) x actual real GDP
= (95% / 94% ) x $10 trillion
= $10.106 trillion
This means that if the economy lives up to its full potential, production-wise, then it can produce $10.106 trillion worth of real gross domestic product. But it is not. It is only producing $10 trillion. Getting the extra 1% of the labor force working would add over $100 billion worth of wants-and-needs satisfying goods and services.
While $100 billion might not seem like much, in light of a $10 trillion total, for a nation of almost 300 million people (about the size of the United States), this averages about $350 for every man, woman, and child in the country. Few people would mind an extra $350 worth of wants-and-needs satisfying goods and services.
Policy makers often look to potential real GDP as a guide for appropriate stabilization policies.
Expansionary policies are designed to counter a business-cycle contraction and are appropriate if actual real GDP is less than potential real GDP. The two most popular types are expansionary fiscal policy, involving an increase in government spending and/or a reduction in taxes, and expansionary monetary policy, involving an increase in the money supply and/or a decrease in interest rates.
Contractionary policies are appropriate when a business-cycle expansion heats up to the point of higher inflation, when actual real GDP is greater than potential real GDP. The two most popular types are contractionary fiscal policy, involving a decrease in government spending and/or an increase in taxes, and contractionary monetary policy, involving a decrease in the money supply and/or an increase in interest rates.
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