What exactly is “Full Employment”? There’s no perfect answer. This is a controversial subject amongst economists; even Janet Yellen isn’t totally sure about the answer.
Simply put, Full Employment refers to the situation where everyone who is willing to work at the prevailing wage rate, is able to find a job. In chart 1 below, the labour market is at Full Employment at equilibrium E3 where at the prevailing wage (wo), everyone in the labour force who is willing to work at this wage (L0), is able to find employment.
Chart 1: The labour market is at Full Employment at E3
It follows that at Full Employment, the economy’s output is at full capacity as well. This makes sense because when everyone who’s willing to work is employed, output would be maximized too.
Full Employment doesn’t mean 0% Unemployment
Does this mean then, that at the Full Employment level, unemployment is 0%? No. In reality, there is never a situation where everyone who’s looking for a job is able to find one. Even at the Full Employment level, there is always some amount of what of we call 1) Frictional Unemployment, and 2) Structural Unemployment.
Frictional Unemployment is the unemployment caused to due to the fact that it takes time for job seekers to find the kind of positions they desire. So when you’re in-between jobs - sending out resumes, interviewing and turning down jobs that you’re not interested in (until you find one that you do accept), you are counted amongst the frictionally unemployed.
Frictional unemployment is not an undesirable phenomenon. If a job seeker jumps at the first job that comes her way, she may make a sub-optimal decision and end up feeling professionally dissatisfied. It’s better for her to take the time to find a suitable profile so that she can experience longevity and optimal productivity in this new position. Frequent displacement and dissatisfaction is not desirable for the individual worker or the workforce as a whole.
Structural Unemployment occurs when there is a gap/ mismatch/ incompatibility between the skills required for the available jobs and the skill set of the unemployed. Read my previous post What is Structural Unemployment? for a quick yet deep understanding of this concept with relevant, real-world examples.
While some Structural unemployment is unavoidable, unlike Frictional unemployment, it’s not a desirable phenomenon because what it essentially represents is the reality that while there are jobs out there, the unemployed lack the skills needed to do these jobs.
While Frictional unemployment goes away with time (for current job seekers anyway, even though a new set of unemployed workers who are in-between jobs takes their place), Structural unemployment can become chronic and long-lasting because the structurally unemployed are unable to find employment unless they retrain themselves in new disciplines.
At the Full Employment level, there is no Cyclical Unemployment...
The type of unemployment that is not present at the Full Employment level is Cyclical or Demand-deficient Unemployment, which is caused by a lack of Aggregate Demand in the economy (happens when the economy is slowing down, in a recession or recovering from one).
It’s important to note here that both frictional and structural unemployment are types of “supply-side” unemployment. They occur due to factors on the supply side (or labour force side), and not the demand side of the economy. Frictional unemployment occurs because workers need time to find the right job, and not because of a lack of demand for their skills. Similarly, structural unemployment occurs due to inflexibilities in the labour market i.e. unemployed workers not possessing the specific skills needed to fill the available positions, and not due to a general lack of demand for labour.
....Which means that stimulating Aggregate Demand will not increase Output/lower Unemployment, but rather lead to Inflation
Since the unemployment that persists at the Full Employment level is not caused by a deficiency in demand, it cannot be reduced by stimulating Aggregate Demand (AD). All an increase in AD will do is cause inflation.
Let’s understand this using Chart 2 below. Y0 is the Full Employment level of output, which is why the Aggregate Supply (AS) curve is vertical at this level. The economy is initially at equilibrium at E1 (price=P1 and output=Y0).
If the government now decides to increase spending or reduce taxes in order to stimulate AD (from AD1 to AD2), the equilibrium will move to E2. Output will not rise (since at Y0 output is already at capacity), but prices/inflation will (from P1 to P2).
Chart 2: An Increase in AD once the Full Employment level has been reached, leads to excessive Inflation
Infact, this is how most economists tend to identity the Full Employment level - it is that level of employment where the work force is as fully employed as possible and output is as high as possible, yet inflation hasn’t started rising excessively.
Let’s explain further. Let’s assume the economy has reached full employment (Y0) once it is at equilibrium at E1. This means that that everyone willing and able to work is employed. Unemployment is as low as possible and output (Y0) is as high as possible. Trying to push unemployment below this point would be counter-productive. For example, if the Central Bank believes that we still haven’t reached full employment, it may cut interest rates or continue to keep them low which will tend to stimulate AD. To keep up with this demand, employers will want to hire more workers. However, since unemployment is as low as it can get, in order to hire more workers, employers will have to lure them away from other employers by offering higher wages. This will cause wages to rise. With wages rising, employers will have to raise prices of their final products/services in order to protect their margins. This will lead to a general rise in the price level i.e. inflation, above and beyond what is consistent with the existing trend.
What I’ve described in detail above is the mechanism through which a delay in recognizing Full Employment can lead to unnecessary inflation. Since Central Banks are wary of Inflation, they do not like to be late in calling Full Employment.
Why Full Employment is Hard to Estimate
(Note: I added this section in Nov 2017. It is especially relevant given all the discussion in 2017 around whether the US economy was at full employment or not.)
With this background, one can begin to appreciate why the Full Employment level is so hard to estimate.
First of all, no one knows what the exact level unemployment (frictional and structural) should be at the full employment level. Let’s take the example of the US. Economists tend to believe that when unemployment falls below 5%, the US economy is at Full Employment. This estimate is based on historical data. It’s not clear however, if historical patterns are the way to go as far as estimating Full Employment is concerned. For one, the level of structural unemployment keeps changing over time depending on changes in technology and barriers to trade. So does the level of frictional employment. Mobility between jobs, geographies and industries does not remain constant. How then can one use historical data to represent the present?
Second, the Full Employment level derives its significance for economists from the fact that an attempt to tighten the job market beyond this level, leads to excessive inflation. There is no reason to believe that in the case of the US, this level is 5%. Infact, the US Unemployment rate for October 2017 was 4.1%, even though economists have been saying that the economy is close to full employment since late 2015, when the unemployment rate hit 5% and the Fed first raised rates after 9 years. Even today, at 4.1% unemployment, wage growth remains sluggish, which technically means that this condition for full employment (wages rising threatening to cause excessive inflation) is still not fulfilled.
No one can say for sure even today, if the US economy is at Full Employment and if not, when it will get there.
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