Question

Use the model of natural rate of unemployment and the steady state condition for unemployment for this question. Suppose that the rate of job separation in an economy is 0.03 and the rate of job finding is 0.12, while the current unemployment rate is 0.10. How do you think unemployment rate will change in the upcoming periods (increase, decrease, no change or ambiguous) and why do you expect to see this pattern?

Answer 1

The labor market is said to be in the steady state or at long run equilibrium when the unemployment rate is constant. The steady state rate of unemployment is the natural rate of unemployment. When the economy is in a recession, the current level of unemployment rises above the natural rate and when the economy is experiencing expansion, the current level of unemployment falls below the natural rate.

The steady state condition is:

sE = fU (where, s = job separation rate and f = job finding rate)

Or, fU = s(L - U)

Or, fU = sL - sU

Or, U(s + f) = sL

Or, U/L = s/(s + f)

Or, U/L = 0.03/(0.03+0.12) = 0.03/0.15 = 0.20

The natural rate of unemployment is 0.20, which is greater than the current unemployment rate, 0.10. It means the economy is currently experiencing an expansion. In the long run however, expansion will increase inflation, which will result in stock market crash, decrease in Consumers confidence and therefore economic growth will decline. Therefore, in the upcoming periods, the economy will enter a contractionary phase and output will decrease. As a result, unemployment rate will increase and eventually will reach the natural rate. But if the recession continues, unemployment rate will further increase until the economy starts to expand again.