The Natural Rate of Unemployment

The natural rate is defined as the equilibrium rate of unemployment i.e. the rate of
unemployment where:-

real wages have found their free market level

the aggregate supply of labour is in balance with the aggregate demand for labour.

At the natural rate, all those wanting to work at the real wage rate have found
employment and therefore there is no involuntary unemployment.

Some voluntary unemployment may remain as some people remain out of a job
searching for work offering higher real wages or better conditions or jobs that need their
outdated skills (structural unemployed).

The natural rate concept is supported by economists who believe in the power of markets
to clear at an equilibrium price and who view the labour market much as any other
market in the economy.

Some other economists disagree with the concept of a natural rate of unemployment.
They argue that the ‘natural rate’ can be reduced through supply side policies e.g:-

Reform the system of welfare benefits so as to reduce the risk of the “poverty trap”

Reforming trade unions to reduce their collective bargaining power and also reducing
some of the barriers to labour mobility put up by professional bodies and associations
which have the effect of limiting the supply of labour into an occupation

Reducing income tax to improve the incentives to look for and accept paid work

Adopting a more relaxed approach to labour migration

By making the labour market more competitive and flexible.

At the real wage rate W1, E1 workers are employed. But at this prevailing wage rate, the
total labour force exceeds than the employed labour force. The natural rate of
unemployment = ab and consists of frictional and structural unemployment. The
government might attempt to reduce the natural rate by reducing the horizontal distance
between the supply of labour and the labour force curve.

The supply of labour can be increased through supply-side policies that aim to increase
the number of people willing of working age that are willing and able to find employment.
Such policies would shift the labour supply curve to the right, thus narrowing the gap and
reducing unemployment. This is shown in the second diagram.