Types of Unemployment and the Natural Rate (Cambridge International A-Level Economics)

Key terms

• Working-age population - all people of employable age (typically 16–64)

• Labour force (LF) - those in the working-age population who are either employed OR actively seeking work

  • Excludes students, retirees, homemakers, and others not seeking work (the "economically inactive")

• Employed - people currently working for pay (full-time, part-time, or self-employed)

• Unemployed - people in the labour force who are not working but actively seeking work

• Participation rate - labour force as a % of working-age population

• Unemployment rate - unemployed as a % of labour force

$\mathrm{Unemployment} \mathrm{rate}=\frac{\mathrm{unemployed}}{\mathrm{labour} \mathrm{force}}x100$

Full employment

• Full employment is the level of employment at which everyone willing and able to work at the going wage rate is employed

• Full employment does NOT mean zero unemployment

  • Some unemployment always remains due to frictional, structural and voluntary factors

Full employment can be seen on a LRAS diagram

• At full employment, the only unemployment is the natural rate of unemployment (NRU)

  • This corresponds to real output Y_FE on the vertical section of LRAS

Equilibrium and disequilibrium unemployment

Equilibrium unemployment

The equilibrium labour market

Diagram analysis

• D_L (downward sloping) - firms hire more workers at lower wages

• S_L (upward sloping) - more workers willing to work at higher wages

• LF (vertical) - everyone who could potentially work (labour force)

• Equilibrium at W, Q*_L - labour market clears

• Horizontal gap between S_L and LF at W* = natural rate of unemployment

  • This is voluntary as workers are in the labour force but not willing to work at W*

Hysteresis

• Hysteresis is the tendency of unemployment to persist at higher levels after a temporary shock has passed

  • Long-term unemployed lose skills (human capital erodes)
  • Employers view them as less employable (signalling effect)
  • Discouraged workers stop searching

• Consequence - a cyclical shock can permanently raise the natural rate of unemployment unless addressed through active labour market policy

  • Example - European unemployment rose sharply after the 1980s oil shocks and remained elevated for over a decade, even after recovery

Voluntary and involuntary unemployment

Spec point — 9.3.3

Involuntary/disequilibrium unemployment

Involuntary unemployment

Diagram analysis

• The real wage is stuck at W₁ above equilibrium W (e.g. due to minimum wage, union action, or sticky nominal wages)

• At W₁, firms demand only Q_L1 workers, but Q_L2 workers are willing to work

• Gap between Q_L1 and Q_L2 = involuntary unemployment

  • Workers are ready and able to work at W₁ but cannot find jobs

The natural rate of unemployment (NRU)

• The NRU is the rate of unemployment when the labour market is in equilibrium

  • This corresponds to full employment output Y_FE
  • It comprises frictional + structural + voluntary unemployment

• The NRU cannot be reduced permanently by expansionary demand-side policy

  • Doing so only creates inflation (see expectations-augmented Phillips curve)

Determinants of the NRU

Policy implications

• Demand-side policies (fiscal, monetary) cannot reduce unemployment below the NRU in the long run - they only cause inflation

• Reducing the NRU requires supply-side policies:

  • Education and retraining to reduce structural mismatch
  • Job-search support and improved labour exchanges
  • Benefit reform to reduce disincentives
  • Increasing labour mobility

Exam Hint Always distinguish equilibrium and disequilibrium unemployment clearly in your opening paragraph — equilibrium unemployment is voluntary (workers choosing not to work at W*) and forms the NRU; disequilibrium unemployment is involuntary (workers wanting work but unable to find it at a sticky wage).

Draw both labour market diagrams where the question demands a comparison - a single diagram cannot show both cases.

For questions on why expansionary demand-side policy cannot permanently reduce unemployment, link directly to the expectations-augmented Phillips curve - AD stimulus reduces unemployment below the NRU in the short run but raises inflation. Once workers adjust wage expectations upward, unemployment returns to the NRU at a higher inflation rate.

Hysteresis is a high-value AO3 evaluation point - it explains why recessions can have permanent effects and why active labour market policies (training, job-search support) are justified even after the immediate shock has passed.