Question

Define the natural rate of unemployment and list down its determinants. What happens to inflation when unemployment is greater than the natural rate of unemployment? What happens to inflation when unemployment is lower than the natural rate of unemployment?

Answer 1

Natural rate of unemployment is the rate of unemployment at which the economy is operating at its full employment. This implies that when all the resources in the economy are fully employed whatever unemployment exists, is natural to the economy. it does not imply that there is zero unemployment.

It is composed of frictional unemployment and structural unemployment. Unemployment which occurs due to delay in matching job with job seekers is related to frictional unemployment. Unemployment which results because of obsolete skills or market rigidities such as minimum wage is related to structural unemployment

When unemployment is greater than its natural rate, inflation is reduced. When unemployment is less than its natural rate inflation is increased. this is due to the short run tradeoff between unemployment and inflation measured by the Phillips curve.