Interest Rate Determination

Economists typically say that an economy is at full employment output when the unemployment rate is at the natural rate. The natural rate is defined as the rate that does not cause inflationary pressures in the economy. It is a rate that allows for common transitions that characterize labor markets. For example, some people are currently unemployed because they have recently finished school and are looking for their first job. Some are unemployed because they have quit one job and are in search of another. Some people have decided to move to another city, and are unemployed during the transition. Finally, some people may have lost a job in a company that has closed or downsized and may spend a few weeks or months in search of their next job.

These types of transitions are always occurring in the labor market and are known as frictional (or transitional) unemployment. When employment surveys are conducted each month, they will always identify a group of people unemployed for these reasons. They count as unemployed, since they are all actively seeking work. However, they all will need some time to find a job. As one group of unemployed workers find employment, others will enter the unemployment ranks. Thus there is a constant turnover of people in this group and thus a natural unemployment rate.This type of unemployment is also called frictional, or transitional, unemployment. It is distinguished from a second type called structural unemployment. Structural unemployment occurs when there is a change in the structure of production in an economy. For example, if the textile and apparel industry closes down and moves abroad, the workers with skills specific to the industry and the capital equipment designed for use in the industry will not be employable in other sectors. These workers and capital may remain unemployed for a longer period of time, or may never find alternative employment.

There is no simple way to measure the natural rate of unemployment. It will likely vary with economic conditions and the fluidity of the labor market. Nonetheless, economists estimate the natural rate of unemployment to be around 5 percent in the United States today.

When economists talk about the inflationary effect of money supply increases, they typically refer to the natural rate of unemployment. A money supply increase will likely be inflationary when the unemployment rate is below the natural rate. In contrast, inflationary effects of money supply increases are reduced if the economy has unemployment above the natural rate. Here's how the story would work.