What is Full Employment?

Interesting post by Alex Tabarrok of Marginal Revolution. Here is what I usually say about it in class:

Full-employment unemployment rate-The lowest rate of unemployment compatible with price stability.

Price stability-An annual inflation rate of 3% or less (The Fed now goes for 2%). Inflation is when prices rise throughout the economy.

So the full-employment unemployment rate tells us how low the unemployment rate can be and still have a low rate of inflation. Economists are not sure what percentage it is. It is probably between 4% and 6%.

The Natural Rate of Unemployment Rate-Another name for the full-employment unemployment rate. It is normal or natural to always have some unemployment since every year we have seasonal, frictional and structural unemployment. The factors that cause seasonal, frictional and structural unemployment occur naturally, every year in our economy. So we really can’t have a 0% unemployment rate.

 

The relationship between unemployment and inflation

The graph below shows short-run the relationship between unemployment and inflation.

First, the labels in the graph need to be explained:

AD-aggregate demand or the demand for all goods in the economy, not just one.

SRAS-short-run aggregate supply or the supply of all goods in the economy, not just one. 

P and CPI-The price of all goods in the economy. CPI stands for Consumer Price Index and it is an average of all the prices in the economy.

Q-The quantity of all goods. That is why it is also labeled GDP.

If government spending increases in the graph below, AD increases and Q or GDP will increase. That will lower the unemployment rate. But if AD increases too much, then prices rise too much.
 
Tabarrok talks about how costs in the economy can change, thereby changing the natural rate of unemployment. If it costs less to search for jobs or applicants, then SRAS will shift out to the right, lowering prices and unemployment. The natural rate falls.

That does not mean that last year monetary policy (which can also increase AD) was too conservative. If the Fed had increased the money supply too much last year, then inflation would have been too high last year