Question

Using wage- and price-setting relations, explain how the natural rate of unemployment is
determined and how it is different from the cyclical unemployment?

Answer 1

Let’s assume that nominal wages depend on the actual price level, P, rather than on the expected price level . Wage setting and price setting determine the equilibrium rate of unemployment . This relation between the real wage and the rate of unemployment is the wage-setting relation . The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting .

The natural rate of unemployment is the unemployment rate that exists even when economy is producing the full employment output . NRU is the unemployment rate during full-employment real output .

NRU = Frictional + Structural Unemployment ( Frictional unemployment is unemployment due to job search , structural is due to mismatch of skills )

Even when an economy is on the boundary of PPC or prodcuing fully efficient amount , this unemployment will be there . When on PPC , unemployment rate = NRU . So NRU is never equal to zero because its components are never zero . The cyclical unemployment affects the current unemployment rate which does not affect NRU . The cyclical unemployment depends on business cycle fluctuations .