What is the natural rate of unemployment;

What is the natural rate of unemployment?

Ellen R. Rissman

The unemployment rate is the composite

of three distinct types of unemployment: fric-

tional, cyclical, and structural. This fact poses

a potentially serious problem for government

policymakers because high unemployment rates

are not necessarily indicative of a slack econ-

omy. Structural change as well as cyclical fac-

tors affect the unemployment rate. If

policymakers are not able to distinguish higher

unemployment rates due to a change in the

structure of employment from higher unem-

ployment rates due to a weak economy, then

they run the risk of implementing expansionary

policies at the wrong time, thereby creating or

adding to inflationary pressures. Hence, to

adequately gauge the state of the economy, it

is necessary to know what portion of the cur-

rent unemployment rate is due to purely cy-

clical phenomena as opposed to structural and

frictional.

The natural rate of unemployment is de-

fined simply as the rate of unemployment that

is compatible with a steady inflation rate. The

natural rate can therefore be thought of as the

rate of unemployment that would occur in the

absence of cyclical fluctuations. In other words

the natural rate is essentially the sum of struc-

tural and frictional unemployment. Because

structural and institutional factors change over

time, the natural rate of unemployment will

also vary. However, the need to understand

the determinants of the natural rate and its re-

lation to the actual rate of unemployment is

quite real as the cost of error may be acceler-

ating inflation or deflation.

The purpose of this article is to answer the

question: What is the natural rate of unem-

ployment? The answer relies heavily on the pi-

oneering work of Lilien (1982) and is in two

parts. First, a working definition of the natural

rate of unemployment is developed. Second,

with this definition, estimates of the natural

rate of unemployment are calculated.

The analysis indicates that the natural

rate of unemployment has been quite variable

over the last 27 years, reaching a high of 7.01

percent in the third quarter of 1981 and at-

taining a low of 3.48 percent in the first quarter

of 1966. But to understand the performance

of the economy, it is the difference between the

natural rate and actual rate of unemployment

that is significant. This difference has varied

widely over time. From 1958 through 1966 the

natural rate was well below the actual; the re-

verse held from 1967 to 1973. From 1974

through 1976 the actual rate again exceeded

the natural rate although in more recent years

the reverse appears once more to be the case.

Because the difference between the nat-

ural and actual rates of unemployment is

thought to be indicative of the degree of

tightness in the labor market, this measure

should be positively correlated with the in-

flation rate. Indeed, the correlation coefficient

between the difference and the inflation rate

as measured by the Consumer Price Index is

0.46. This compares with an almost zero cor-

relation of inflation with the actual unemploy-

ment rate.

Categories of unemployment

In general it is useful to distinguish con-

ceptually among three distinct types of unem-

ployment in analyzing the historical pattern of

the unemployment rate.' First, there is fric-

tional unemployment. Frictional unemploy-

ment arises as a result of the normal labor

turnover that occurs in a healthy dynamic

economy. At any given time employed workers

change jobs, lose jobs, or leave the labor force.

Similarly, unemployed workers may find em-

ployment or may decide to stop seeking em-

ployment, while still others may enter or

reenter the labor force. Even in the best of

times there is some unemployment that arises

from this dynamic friction in the economy.

The type of unemployment that is per-

haps perceived and felt most acutely is cyclical

unemployment. As its name suggests, it is the

type of unemployment that is associated with

business cycles. Decreases in aggregate de-

mand such as occur during recessions cause a

general overall decline in labor demand. The

real wage rate is relatively unresponsive to

Ellen R. Rissman is an economist at the Federal Reserve

Bank of Chicago.

federal Reserve Bank of Chicago



these changing conditions, that is, real wages

do not decline as labor demand declines.

As a

result, unemployment occurs. If real wages

were free to adjust to these changed conditions

in the labor market, then recessions would not

produce any noticeable increase in the unem-

ployment rate. Cyclical unemployment is

temporary and when demand conditions return

to their previous level, the excess labor supply

disappears. Even permanent declines in ag-

gregate demand result in only temporary un-

employment because sooner or later wages in

a competitive economy must adjust so as to

equate labor supply and labor demand, though

now at a lower equilibrium wage rate.

The third type of unemployment is prob-

ably the least understood and also the most

traumatic to endure. Unlike cyclical

unemployment, structural unemployment is the

result of shifts in the

relative

demand for differ-

ent types of labor. Whether these relative shifts

in labor demand are caused by changes in rel-

ative factor prices (e.g., an oil price shock),

technological innovations, changes in tastes

and preferences, or perhaps changes in institu-

tional or other characteristics of the economy,

is not important. The essential point is that as

labor demand for one type of labor falls relative

to another, a temporary mismatch occurs be-

tween the skills that employers desire and those

that the work force actually possesses. This

produces only temporary unemployment be-

cause in time those who are structurally unem-

ployed will either retrain to find employment

in the now higher labor demand industries, re-

locate to find jobs requiring the types of skills

they already have, or perhaps leave the labor

force altogether, in which case they are not

counted as unemployed. How long this process

takes depends upon the costs of education, the

costs associated with relocating or finding em-

ployment further from one's original location,

and the costs of job search, and, of course, ad-

ditional opportunity and psychological costs.

In terms of these three components, the

natural rate of unemployment is simply the rate

that would occur in the absence of cyclical

fluctuations. It is the sum of frictional and

structural unemployment.

Historical perspective

Figure 1 presents the civilian unemploy-

ment rate quarterly from 1948 through 1985

with the periods between business cycle peaks

and troughs shaded for reference. There ap-

pear to be three distinct phases. The decade

of the 1950s is characterized by three re-

cessions, with unemployment peaking at each

economic downturn. Between these periods,

the unemployment rate hovered somewhere

between four and five percent. Even when the

unemployment rate reached its highest value

of 7.37 percent, it was substantially below the

two-digit unemployment rates of recent years.

The decade of the 1960s was one of eco-

nomic growth with no major recessions re-

corded after 1961. And as a result, the

unemployment rate drifted downwards from a

high at the depth of the recession of 7.00 per-

cent to a low in 1969 of 3.40 percent.

Unsurprisingly, structural unemployment

was not an issue at this time. Indeed, the pat-

tern of unemployment is very well explained

by two components: cyclical and frictional.

The business cycles of the 1950s and early

1960s attest to the significance of the cyclical

element, while the relatively economically calm

remainder of the 1960s underscores the impor-

tance of frictional unemployment.

Economists and policymakers of the time

alike recommended a seemingly reasonable

unemployment rate target for policy of around

three percent. This three percent level was

called, with perhaps unconscious irony, the full

employment rate of unemployment. While the

nomenclature is unfortunate, the term was

meant to indicate the level of unemployment

that would occur in the absence of cyclical

factors. From the perspective of the 1950s

and

1960s, then, the full employment level of un-

Figure 1

Civilian unemployment rate

A111111111111111111111111111111111'111

949 '53

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Economic Perspectives

age

percent

0.77

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0.66

0.55

0.44

0.33

0.22

0.11

0.00

011

employment was essentially the frictional level

of unemployment.

The 1970s and 1980s to date exhibit a

much different unemployment rate pattern.

Over this time the unemployment rate rose

from a low of 4.17 percent in the first quarter

of 1970 to a high of 10.60 percent in the fourth

quarter of 1982. As in previous years, the un-

employment rate responded to cyclical factors,

peaking in the trough of each of the four major

recessions. But, the unemployment rate ap-

pears to be trending upwards during the period

so that the average unemployment rate from

1970 through 1985 was 6.94 percent as com-

pared to 4.51 percent and 4.78 percent respec-

tively for the 1950s and 1960s. In addition, the

unemployment rate appears to be much more

volatile in these later years: The calculated

standard deviation is 1.50, compared to stan-

dard deviations of 1.28 and 1.08 in the two

earlier decades.

Demographic change

This abrupt change in the pattern exhib-

ited by the unemployment rate suggests that

there were factors involved other than merely

frictional and cyclical unemployment. One

possible explanation is that the underlying la-

bor force demographics changed, thereby ad-

versely affecting the unemployment rate.

Specifically, the labor force composition

changed over the 1970s relative to what it was

in the 1960s in such a way that the labor force

now contains a significantly higher proportion

of individuals subject to higher unemployment

rates, such as nonwhites, females, and youths.

A simple way of testing the effects of the

changing demographic composition of the la-

bor force on the unemployment rate is to com-

pare the actual civilian unemployment rate

(UR) with a fixed-weight unemployment rate

(WUR). Specifically, the unemployment rate

is calculated as:

URt =

Eyi

URi



i = 1, . .,1



[1]

:=1

where

UR,

is the unemployment rate at time

indexes the I demographic groups, y

, is the

fraction of the total labor force in group

time

and the sum of the y

's equals one.

The fixed-weight unemployment rate at

time

is calculated as:

Federal Reserve Bank of Chicago

WUR, =



yip UR



i = 1, . .

.,/



[2]

where

is some pre-assigned base period.

Thus, the fixed-weight unemployment rate

computes what the civilian unemployment rate

would have been if the demographic composi-

tion of the labor force had remained as it was

in base period

Figure 2 plots the differences between the

actual quarterly unemployment rate and vari-

ous fixed-weight measures where the base pe-

riod

is selected to be the first quarter of

1960.

Positive values indicate that the demo-

graphic changes that have occurred relative to

the first quarter of 1960 unfavorably affect the

unemployment rate while negative values indi-

cate that the unemployment rate would have

been higher if the demographic composition of

the labor force had been the same as in the base

period. The calculations were done for race,

sex and age categories.

As is obvious from Figure 2, the increase

in the proportion of females, nonwhites, and

young people in the labor force resulted in a

small increase in the unemployment rate. The

most important effect occurred as a result of

changes in the age distribution. At its peak in

1975, the changing age distribution contributed

around three quarters of a percentage point to

the overall unemployment rate. However, this

effect has been decreasing as the labor force has

aged.

In contrast, the changing racial composi-

tion of the labor force tended to increase the

Figure 2

Effect of changing demographics on

the unemployment rate

unemployment rate at an accelerating rate over

the 1970s and early 1980s, reaching its maxi-

mum effect in 1983. But race never contributes

more than one quarter of a percentage point to

the aggregate unemployment rate.

Finally, the increased labor force partic-

ipation of women relative to 1960 has for the

most part adversely affected the unemployment

rate, contributing approximately an additional

two tenths of a percentage point in 1978.

However, since 1979 the relation between the

sex composition of the labor force and the un-

employment rate has become less marked due

to a decline in the unemployment rate of fe-

males relative to males.

This change is not necessarily attributable

to lower levels of sex discrimination. An alter-

native explanation may be that women are

clustered in jobs that are relatively more pro-

tected from market forces. For example, blue

collar jobs are more frequently filled by men

than women. Those blue collar jobs that are

located in declining industries would contribute

to a higher unemployment rate for males than

for females, all other things equal.

Thus, it seems that the changing demo-

graphic composition of the labor force has re-

sulted in an increase in the civilian

unemployment rate since 1960, but the magni-

tude of the effect is quite modest—adding less

than one percentage point to the total unem-

ployment rate. Even after controlling for

changes in the demographic composition of the

labor force, the unemployment rate of the

1970s and early 1980s is still significantly

higher and more volatile than in the previous

two decades.

Changing industrial composition

Just as the demographic distribution (and

possibly the geographic distribution) of the la-

bor force provides clues to analyzing the more

recent behavior of the unemployment rate, the

distribution of employment across industries

also plays a role. It is the changes in the dis-

tribution of employment across industries that

is most closely related to the concept of struc-

tural unemployment. As noted previously,

structural unemployment arises due to relative

shifts in the demand for different types of labor

causing a period of economic adjustment dur-

ing which time some displaced labor will be

temporarily unemployed. Changes in the rela-

tive demands for labor will be accompanied by

changes in the distribution of employment

across industries.

Perhaps the most prominent movement in

the employment profile in recent history is the

change of the private economy from one based

upon manufacturing and other traditional in-

dustries to one based upon services and

service-related industries.' Figure 3 presents

this trend for selected industries, and prompts

important observations. First, the decline in

manufacturing and concurrent rise in the share

of employment in services are not recent phe-

nomena. The graph shows that these adjust-

ments have been occurring almost continuously

throughout the post-World War II period.

Secondly, even within manufacturing

there are notable differences between the be-

havior of employment shares in durable and

nondurable goods. The decline in nondurable

goods has proceeded much more smoothly than

the decline in employment share in durable

manufacturing.

This steady decline in the relative impor-

tance of nondurable manufacturing is not nec-

essarily an indication of structural change in

the sense that it documents the ebb and flow

of the fortunes of the industry in question.

The

historical pattern is also consistent with a steady

stream of technological innovation which enables pro-

duction to remain unchanged while employment levels

decline.

While the steady decline in employ-

ment share is almost certain to contribute to

the flow of unemployment, it may well be that

the unemployment generated is much less in

volume and of shorter duration than that which

would occur in industries experiencing a more

sporadic, volatile decline such as durable man-

ufacturing. The reason is that rational workers

are more likely to be able to predict and

therefore cushion or even avoid the blow of

unemployment altogether by preparing for the

event sufficiently in advance.

The third observation concerning the

patterns seen in Figure 3 pertains to the effect

of business cycles on the distribution of em-

ployment across industries. Recessions clearly

and consistently are associated with declines in

employment share in durable goods manufac-

turing. It is well known that business cycles

have a differential impact across industries, af-

fecting some more adversely than others.

Just

why this occurs depends upon the nature of the

demand for the good as well as the costs of in-



Economic

Perspectives

Figure 3

Share of total employment in

selected industries

percent

30 — P T

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111111111111111111111111111111111111.■11

1947

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ventorying. If the good is viewed as a luxury

item or requires a relatively large expenditure,

then purchases are more likely to be postponed

during periods of low aggregate demand, when

discretionary income falls. For example, hous-

ing starts and new construction are particularly

susceptible to changes in the economic outlook.

In addition, those industries with high inven-

tory costs are less able to smooth production

and are therefore more susceptible to the

vagaries of the market.

The post-World War II era has seen

considerable change in the distribution of em-

ployment across industries. Such shifts in em-

ployment are likely to generate unemployment

temporarily as displaced workers search for

employment. Large movements in employ-

ment across industrial sectors are likely to be

associated with temporary increases in the un-

employment rate because these movements

signify a change in the underlying structure of

the economy. However, change in and of itself

does not cause unemployment. The unem-

ployment arises because of friction or inertia in

the economy which make it difficult for indi-

viduals to adapt instantaneously. Given these

frictions, the larger is the flow of workers into

and out of the various industries, the more

likely it is that a larger volume of unemploy-

ment will be generated.

One way of measuring these flows is to

define a variable ol where:



(



sit-1 [git

—

gt.1

[3]

:=1

sa is the share of total employment in industry

at time t,

g„ is the growth rate of employment

in the ith industry between period

and period

— 1, and I is the number of industries. Thus,

is the weighted sum of squared deviations of

industry growth from average aggregate

growth where the weights are given by the

employment share of the ith industry.

This measure captures those employment

flows that are associated with changes in the

distribution of employment across industries

and not those changes in employment that oc-

cur as a result of economic growth. Further-

more, those industries experiencing a large

deviation in employment growth relative to the

average growth rate of employment are given

more weight in the calculation due to the

squaring of the term in parentheses. Such a

weighting scheme is appropriate if, for exam-

ple, large deviations in employment growth

from the average are associated with dispro-

portionately large increases in unemployment.

For further details on the interpretation of 491

see Box,

Measuring employment flows.

Figure 4 displays the measure of employ-

ment adjustment

from the first quarter of

1947 through 1985.

There appear to be many

periods of rapid employment adjustment across

industries during the post-war period. Fre-

quently, these adjustments are coincidental

with business cycles as noted in the preceding

discussion of industry employment shares. The

period from 1947 to 1960 is marked by three

episodes of employment adjustment corre-

sponding roughly with the recessions in 1950,

1954, and 1958. The more stable 1960s exhibit

very little change in the distribution of em-

ployment across industries. The 1970s and

early 1980s in contrast indicate a pronounced

change in employment shares occurred in late

1970 and again in 1975 and 1978. The 1980s

are surprisingly stable in comparison to the ex-

perience of the 1970s, providing preliminary

evidence that structural change was perhaps

not a major contributing factor to the histor-

ically high unemployment observed in the 1982

recession.

The effect of employment adjustment

across industries on the civilian age-weighted

unemployment rate is analyzed over the period

from 1954 through the third quarter of 1985.

The results of the analysis are found in Table

1, which presents the estimates and associated

Federal Reserve Bank of Chicago



.00090 P T

.00000



,......„„„„

.00075

.00060

.00045

.00030

.00015

Figure 4

Measure of employment adjustment

across industries

1947

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standard errors of the parameters of interest as

well as some additional descriptive statistics.

Other variables included in the analysis

are measures of unanticipated changes in real

Gross National Production (GNP) and unan-

ticipated money growth (M). Unanticipated

real GNP is calculated as the residuals from the

estimated ARIMA process generating real

GNP where the estimates are obtained by the

maximum likelihood method. Unanticipated

money growth is computed as discussed in

Barro (1978).

Columns (1) through (3) of Table 1 pre-

sent estimates of ordinary least squares re-

gressions on various sets of variables including

two lagged dependent variables.

All three models reported in Table 1 in-

dicate that unanticipated movements in real

Gross National Product are negatively associ-

ated with the age-weighted unemployment

rate. Thus, realizations of real GNP above

trend tend to decrease the unemployment rate

while realizations below trend tend to increase

the unemployment rate.

Intuition suggests that unanticipated

money growth should also be negatively asso-

ciated with the unemployment rate if unantic-

ipated positive changes in monetary growth

signal expansionary monetary policy. As seen

in columns (2) and (3) of Table 1, the coeffi-

cient on unanticipated money growth is nega-

tive only for current realizations and positive

for lagged values. However, the magnitude of

the effect is imprecisely determined as seen by

the large associated standard errors.

Finally, the inclusion of current and

lagged values of the measure of employment

Table 1

The effect of employment adjustment

on the unemployment rate

(1)

(2)

(3)

GNP

-0.018

-0.019

-0.016

(0.002)

GNP

-0.011

-0.012

-0.008

(0.003)

GNP

t_2

-0.005

-0.004

(0.002)

(0.003)

(0.002)

-3.215

-2.551

(3.556)

(3.312)

Mt-1

2.444

1.054

(3.700)

(3.417)

Mt-2

3.313

2.721

(3.946)

(3.619)

790.443

(212.599)

393.051

(234.715)

/VI

t-2

-387.709

(234.671)

106.700

(215.610)

t-4

-603.343

(199.532)

1.387

1.385

1.308

(0.074)

(0.076)

(0.086)

-0.406

-0.402

-0.319

(0.076)

(0.079)

(0.086)

0.093

0.078

0.030

(0.087)

(0.091)

(0.083)

0.976

0.977

0.982

5.74

5.43

3.80

adjustment has a clear and significant effect on

the unemployment rate. Increases in the

amount of interindustry employment adjust-

ment have an initial adverse affect upon the

unemployment rate, as expected. Thus, the

larger are the changes in the distribution of

employment across industries, the higher is the

unemployment rate. The long term effects of

such shifts in employment are not immediately

obvious, however, due to the inclusion of the

two lagged dependent variables in the re-

gression model. The difficulty arises because

current changes in o

-2

affect not only the cur-

rent unemployment rate but also future unem-

I ,

1 1 I

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Economic Perspectives

Measuring employment flows

To further motivate the use of

711 ,

defined in equation [3], let

e„

be employ-

ment in industry

at time

and let

E e“

be the total level of employment

i=i

in the economy at time

The change in

the number of people employed in indus-

try

between periods

and

t — 1 is simply

e, —

However, employment changes

can occur for two reasons: economic

growth and shifts in the underlying indus-

trial composition of employment. For

purposes of measuring structural change

and relating structural change to the un-

employment rate, adjustments in employ-

ment due to shifts in the employment

distribution across industries alone are of

interest. Thus, the expression

e, — s

simply the difference between employment

in industry

at time

and the amount of

employment in industry

that would have

occurred at time

if the

industry had

grown at the same rate as the aggregate

economy, i.e. the employment share of in-

dustry

had remained unchanged. Obvi-

ously, if no change in employment share

had occurred, then the expression

—

equals zero. Similarly, if

e, — s

is posi-

tive (negative), then the

industry's em-

ployment share is rising (falling).

The change in employment attribut-

able solely to changes in employment

share and not economic growth can be re-

written in terms of growth rates as

e„._

(A, —A) . Since the unemployment rate

is assumed to respond to the magnitude

and not the direction of employment

changes, the total volume of employment

flows attributable to shifts in the distrib-

ution of employment is simply calculated

Ee,_, I

—

A I which is proportional to

i=1



g„ —

1 .

Finally, by squaring the

r=1

amount within the absolute value signs,

the original expression for

results.

As discussed briefly in the text, by

squaring g

—A

I those industries expe-

riencing relatively large deviations of

employment growth from the aggregate

are given more weight in the calculation.

Since structural shifts of large magni-

tudes are thought to have a dispropor-

tionately large impact upon the

unemployment rate, such a weighting

scheme is appropriate.

ployment rates. Simulations show that the

maximum effect of an increase in the volume

of interindustry employment changes is felt af-

ter a one-quarter lag, damping thereafter.

It should be noted that while the coeffi-

cient estimates on current and lagged values of

are quite large in magnitude, the actual

values of

are relatively small, with an aver-

age value over the entire time period of

1.3x10

-4

. If, for example, a one standard de-

viation increase in

occurred at time 0, the

unemployment rate would rise by only 0.20

percent in the first quarter, 0.36 percent in the

second quarter, and 0.16 percent after one

year.

While the evidence reported in Table 1

suggests that the volume of interindustry

movement of employees is positively related to

the unemployment rate, the interpretation that

the associated movements in the unemploy-

ment rate are due to structural change is not

that easily justified. Thus, drawing inferences

about structural unemployment or the natural

rate of unemployment from the results found in

Table 1 is inappropriate. The difficulty arises

because of the simultaneous effect of cyclical

and structural factors on employment flows.

As illustrated in Figure 3, the ebb and flow of

employment shares is dependent upon the stage

of the business cycle. In durable manufactur-

ing recessions are invariably associated with

declining employment shares and therefore a

greater amount of employment adjustment.

The problem therefore is to develop a measure

that distinguishes employment flows attribut-

able only to structural factors from employ-

ment flows attributable to purely cyclical

factors.

federal Reserve Bank of Chicago

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0.03

0.02

0.01

0.00

Structural change

There are a variety of ways to extract the

purely cyclical effect on the distribution of em-

ployment across industries from the purely

structural. These techniques all rely upon an

assumption that cyclical changes in employ-

ment are temporary while structural changes

are more or less permanent by definition.

In attempting to eliminate the effect of

cyclical factors on the distribution of employ-

ment across industries, calculations can proceed

along one of two lines. A measure of the vari-

ability of employment shares (or possibly em-

ployment growth) across industries can be

calculated first and then decomposed into a

permanent (structural) component and a tem-

porary (cyclical) one. Alternatively, the em-

ployment share or level in each industry is

decomposed into its permanent and cyclical el-

ements and then, using only the permanent

portion, a single measure of permanent change

in employment distribution is devised. The

first approach, while computationally easier,

may obscure much of the underlying dynamics

which by hypothesis are what give rise to

structural unemployment. For this reason the

second approach is preferred.'

As noted above, certain industries experi-

ence relatively smooth changes in employment

shares over time while others experience much

more volatile changes. While both of these

types of changes can be permanent, intuition

suggests that abrupt permanent changes in

employment share add more to the volume of

unemployment than do smoothly occurring

changes. Thus, the permanent portion of

changes in employment shares that is not

explainable by past experience is the appropri-

ate measure of structural change.

Calculating the difference between the

actual employment share in industry

at time

and that which would be expected based upon

past behavior is relatively straightforward.

However, separating this measure into its per-

manent and temporary components is a more

complicated endeavor. See Box,

Measuring

structural change.

Assuming that deviations of employment

shares from trend in industry

at time

can be

accurately decomposed into permanent

changes (AO and temporary changes (Aj) ,

then the measure of permanent structural

change for the aggregate economy at time

(AO is simply defined as:

[



[4]

(Azt)

1/2

Similarly, the measure of temporary change in

employment shares (AD , is defined as:

[

1/2

(Azt )



[5]

Because the expression in parentheses is

squared, effectively those industries experienc-

ing relatively large permanent changes in em-

ployment shares are weighted more heavily in

the calculation.

The behavior of

and AT from the first

quarter of 1952 through the third quarter of

1981 is examined in Figure 5.

' As can be seen,

permanent changes in the distribution of em-

ployment across industries correspond closely

to business cycles, exhibiting quite noticeable

peaks in 1958, 1961, 1970, and 1975, and pos-

sibly in 1980. In contrast, temporary changes

in the employment distribution do not appear

to be significantly correlated with the business

cycle.

A comparison of the measurement of em-

ployment adjustments, ti

-2

, with the constructed

measure of permanent structural change, AP,

yields some interesting insight. The crude

measure of employment adjustment records its

largest value in 1975, leading to the premature

conclusion that structural change was most

Figure 5

Permanent and temporary changes

in the distribution of employment

across industries

1=1



Economic Perspectives

Measuring structural change

Let be the /x1 vector of employ-

ment shares at time

Thus



is simply

defined as (s

„ s

„...,

)

for

= 0,. .



where (') indicates the transpose and is

the employment share of industry

at time

1. The vector of employment shares is as-

sumed to be related to its past and future

values. Specifically, assume that



—Z

j— t+j j— —j

j=1

The left hand side of equation [ii] can be

interpreted as the deviation in current

employment shares from its expected value

based upon past experience. This devi-

ation is seen to be the sum of two compo-

nents: a temporary component, s

, and a

permanent component,

(1 —

[i]



—Z fi

s,_

j=1

where

is some time varying parameter,

the /31s are geometrically declining

weights,

Efl

1 and

t is an additive in-

J=1

dependent and identically distributed

random error term. Thus, the current

vector of employment shares is assumed

to be a two-sided moving average of its

past and future values. Subtracting

6,,

from both sides of equation [i],

the following results:

B .s • =

j =1

j=1



j=1

Equation [ii] can be estimated by

ordinary least squares assuming, a fixed

and specific values for the /31s. The per-

manent component for the th industry is

simply defined as:



it±i

—

]

j=i



j=1

where 'A' indicates the estimated value of

the parameter, while the temporary com-

ponent is calculated as the regression resi-

dual:

sit

—

sit„

—

t[Z

—3

i •

j=1



j=1

[iv]

pronounced at that time. The more refined

measure of permanent structural change, on

the other hand, clearly indicates that structural

change was far less important a factor in the

1975 recession than it was in the 1970 recession.

Interestingly enough, even the recession that

occurred in 1958 appears to have been associ-

ated with a more pronounced permanent

change in the structure of employment than

was the 1975 recession.

Structural change and the

unemployment rate

The calculation of permanent and

transitory changes in the distribution of em-

ployment across industries is a refinement of the

measure of interindustry employment flows

employed previously. It is constructed so as to

give meaning to the concept of structural

change. If structural change is rapid and ac-

companied by large employment shifts, then

I ederal Reserve Bank of Chicago



unemployment is thought to be the by-product

as workers struggle to adapt to the changing

situation.

Analysis of the relation between the com-

puted permanent and transitory variation of

the employment distribution and the unem-

ployment rate may proceed along lines similar

to that presented in Table 1. However, it is

implicitly assumed there that once demo-

graphic changes have been controlled for, all

other unemployment results from cyclical,

structural, or frictional factors where frictional

unemployment is assumed to be some constant

amount. In essence, this assumption denies the

existence of other factors, particularly institu-

tional arrangements, that have an effect upon

the unemployment rate.

Changing institutional conditions are not

cyclical by nature. Nor should they be thought

of as contributing to structural unemployment

because structural unemployment as defined

here is the result of the changing relative de-

mand for different types of labor. These

changing institutional characteristics are most

properly associated with frictional unemploy-

ment. As discussed elsewhere, frictional unem-

ployment arises due to the functioning of a

dynamic labor market where workers are con-

tinuously making decisions as to the proper al-

location of their labor. These decisions are

based upon the parameters of the underlying

institutional framework. Thus, when this

framework changes, it will also have an effect

upon the decisions of the workers to seek work

or quit work, and therefore it will have an ef-

fect upon the frictional rate of unemployment.

Much research has been devoted to ana-

lyzing the effect of unemployment insurance on

job search. Critics argue that the existence of

such unemployment insurance schemes lowers

the costs of job search and therefore encourages

unemployed workers to remain unemployed for

a longer duration than they would have in the

absence of such benefits. Thus, more lenient

benefits tend to increase the unemployment

rate. While this may in fact occur initially, it

is also quite possible that by encouraging peo-

ple to search longer for employment, better job

matches between employees and employers will

result, thereby having a negative long-run ef-

fect on the unemployment rate.

The regression models presented in Table

2 analyze the effect of permanent and

transitory changes in the distribution of em-

ployment on the age-weighted unemployment

rate. As presented previously, other explana-

tory variables include deviations in real Gross

National Product from trend and unantic-

ipated money growth. In light of the preceding

comments on institutional arrangements, an

additional variable is included (SI) which is

social insurance expenditures as a percentage

of Gross National Product.

This variable is

assumed to proxy for the costs associated with

unemployment.

Table 2 presents ordinary least square es-

timates from regressions on the civilian age-

weighted unemployment rate over the period

from 1954 through the third quarter of 1981.

Parameter estimates and their associated

standard errors in parentheses' are reported

along with some descriptive statistics. As in the

regressions reported in Table 1, the models of

Table 2 include two lagged dependent vari-

ables. Therefore, the OLS estimates are

asymptotically equivalent to maximum likeli-

hood estimates only if the errors are not

heteroskedastic. The adjusted Box-Pierce sta-

tistic (Q) is reported testing for autocorrelation

of the estimated residuals for a lag length of six

quarters. Judging from the small magnitude

of this statistic, the residuals appear to be

"white noise".

The results indicate that structural

change adversely affects the unemployment

rate while transitory changes in the distribution

of employment across industries have no dis-

cernible effect. As in Table 1, the inclusion of

lagged dependent variables in the regression

model complicates the interpretation of the co-

efficients. This occurs because current struc-

tural change not only affects the current

unemployment rate but also influences the fu-

ture time path of the unemployment rate di-

rectly through a one-quarter lag and indirectly

through the two lagged dependent variables.

Figure 6 reports the results of a simulation

based upon the parameter estimates found in

column (1) of Table 2. The effect of a one

standard deviation temporary increase in AP at

time 1 on the time path of the unemployment

rate is analyzed. By temporary, it is meant that

the disturbance occurs at time 1 after which

AP returns to its previous level. As seen in the

graph, although current structural change ad-

versely affects the unemployment rate both

currently and into the future, the effects damp

quite quickly. A one standard deviation rise in



Economic Perspectives

change

0.48

0.40

quarters

Table 2

Structural change and the

unemployment rate

(1)

(2)

GNP

-0.009

(0.003)

t_1

-0.008 -0.008

(0.003)

GNP

-0.002

(0.003)

-7.740

-7.413

(3.330)

(3.444)

Mt-1

3.083

3.293

(3.492)

(3.564)

Mt-2

-0.563

-0.358

(3.780)

(3.848)

94.448

96.450

(14.734)

(16.439)

tti

-86.213

-88.514

(14.683)

(16.545)

0.537

(35.092)

9.103

(36.516)

3.332

3.158

(1.038)

(1.114)

1.185

1.177

(0.078)

(0.082)

-0.247

-0.239

(0.078)

(0.081)

0.018

-0.072

(0.101)

(0.224)

0.978

3.30

3.49

lying structure of employment. This is surpris-

ing because it is widely held that structural

change is responsible for creating a large pool

of chronically unemployed workers. However,

the numbers indicate that most of the effect

occurs within two quarters of the disturbance

and long-term effects are minimal. This evi-

dence is at least partially corroborated by sta-

tistics on the distribution of unemployment by

duration.

Table 3 reports for the period 1960 to

1985 the percentage of unemployed workers in

a given year who have been unemployed for

various specified lengths of time. As can be

seen, the vast majority of the unemployed be-

come reemployed (or perhaps leave the labor

force) within six months of losing or leaving a

job. Even in the worst year from unemploy-

ment duration standards, less than a quarter

of the unemployed were unemployed for longer

than twenty-six weeks. In fact, much of the

change in the distribution of unemployment by

duration that has occurred over this time ap-

pears to be related to cyclical factors associated

with a general weakness in the labor market.

Thus, the perception that structural

change leads to a more or less permanent pool

of chronically unemployed workers is not en-

tirely justified. However, this evidence should

not be taken as confirmation that structural

factors have an impact of only limited duration

on the overall performance of the labor market.

It may well be the case that structural change

results in an increased frequency of unemploy-

ment rather than an increased duration so that

AP at time 1 causes the unemployment rate to

rise by approximately one half of a percentage

point that quarter. The following quarter

when

returns to its previous level, the un-

employment rate is still larger than it would

have been by approximately one tenth of a

percentage point. Within four quarters of the

structural change the effect on the unemploy-

ment rate is small, being only one hundredth

of a percentage point and continuing to decline

thereafter. Thus, the long-term effects, i.e.

greater than one year, of structural change on

the unemployment rate are negligible.

The evidence provided in Table 2 and

Figure 6 suggests that the unemployment rate

adjusts quite rapidly to changes in the under-

Federal

Reserve

Bank

of Chicago

Figure 6

Effect of a one standard deviation

increase in structural change on

the unemployment rate

Table 3

Distribution of unemployed

by duration of unemployment,

1960-1985

Year

Less

than

5 weeks

5-14

weeks

15-26

weeks

and

over

1960

1961

1962

1963 43 30

1964

13 13

1965

1966

27 10 8

1967

1968

9 6

1969

58 29

9 5

1970

1971

1972

12 12

1973

1974

51 31

1975

1976

38 30

1977 42 30

13 15

1978

1979

1980

32 14

1981

14 14

1982

16 17

1983

27 15 24

1984

13 19

1985

12 15

SOURCE:

Economic Report of the President, February 1986,

Table B-33,

a worker who has been displaced by structural

events may become unemployed more often in

the future than those workers who have not

been so affected.1

It also appears from Table 3 that social

insurance expenditures are significantly posi-

tively associated with the unemployment rate.

Thus, the evidence supports the hypothesis that

increases in the amount and availability of so-

cial insurance that tend to reduce the opportu-

nity cost of unemployment cause an increase in

the unemployment rate.

Measuring the natural rate

of unemployment

If the natural rate of unemployment is,

as stated earlier, the sum of frictional and

structural unemployment, it is now relatively

straightforward to calculate the natural rate

from the regression results presented previously.

The natural rate is simply calculated as the rate

of unemployment that would result if all cy-

clical variables, namely GNP and M, were set

identically equal to zero over the entire time

period. To implement these computations, it

is necessary to specify initial values for the nat-

ural rate. However, the effect of these initial

values on the calculations decreases rapidly.

As a result, within two years the natural rate

is virtually independent of the assumed initial

values.

Figure 7 presents the actual age-weighted

unemployment rate and the estimate of the

natural rate of unemployment based upon the

parameter estimates found in column (1) of

Table 2. Initial values of the natural rate were

taken to be equal to the actual values of the

unemployment rate for the first and second

quarters of 1954. The figure shows the esti-

mates over the period from 1958 through the

third quarter of 1981 so as to minimize the in-

fluence of this assumption about initial values

on the natural rate.

As seen from the graph, the natural rate

of unemployment has at times been below the

actual unemployment rate and at other times

has been above it. Until late 1966 the natural

rate was consistently below the actual by as

much as two percentage points. From late

1966 through 1973 the reverse occurred al-

though the natural rate never exceeded the ac-

tual by more than one percentage point. The

rise in the natural rate over this time is due

predominantly to the relatively large amount

of structural change that occurred and to a

lesser extent the increase in social insurance

expenditures as a percentage of GNP. From

1974 through 1977 the actual rate again ex-

ceeded the natural rate while for the brief pe-

riod from 1978 to 1981 the opposite was true.

Not only has the relation between the ac-

tual and natural rates of unemployment

changed over time, but the estimate of the

natural rate has varied widely from a high of

7.01 percent in the third quarter of 1981 to a

low of 3.48 percent in the first quarter of 1966.

This variability of the natural rate makes ap-

propriate policy-making difficult.

As suggested in the introduction, the dif-

ference between the natural rate of unemploy-

ment and the actual rate of unemployment is

directly related to movements in the inflation

rate. If the natural rate exceeds the actual

rate, then labor market conditions are tight



Econo

171

Perspectives

1,81t

'77

Figure 7

The natural and fixed-weight

unemployment rates

percent

Figure 8

Inflation and the natural rate

of employment

and inflation occurs. Conversely, if the actual

rate exceeds the natural rate, then labor mar-

ket conditions are slack and lower inflation or

even possibly deflation results. Thus, the in-

flation rate should be positively correlated with

the calculated difference. This indeed seems to

be the case. The estimated correlation coeffi-

cient between the inflation rate and the differ-

ence between the natural and actual rates of

unemployment is computed to be 0.46, indi-

cating that the two do vary directly. In addi-

tion, there is no apparent linear relation

between the inflation rate and the actual un-

employment rate as the calculated correlation

coefficient is a mere -0.01. Although these cal-

culations are somewhat crude, they indicate

that inflation does not depend upon the actual

level of unemployment but rather the actual

rate relative to the natural rate.

Figure 8 displays both the difference be-

tween the natural and actual rates and the an-

nual inflation rate based upon quarterly data.

The inflation rate from 1958 through 1966

fluctuates around two percent per year with no

noticeable upward trend. During this time the

actual unemployment rate was above the nat-

ural unemployment rate, implying that labor

market conditions were somewhat slack. From

1967 to 1973 labor market conditions appear

to be tighter as the natural rate rose above the

actual. Inflation appears to be trending up-

wards during the same time period. Finally,

the two drops in the difference between the

natural and actual rates of unemployment oc-

curring in 1975 and again in 1980 appear to

coincide with rapid declines in the inflation

rate.

While the two series are clearly positively

related, a great deal of the variation in the in-

flation rate is unexplainable by changes in this

measure of labor market tightness. If the esti-

mates of the natural rate of unemployment are

indeed correct, then a more adequate under-

standing of inflation requires incorporating

other elements of the economy, such as mone-

tary policy, into the analysis.

Conclusions

The historically high unemployment rates

of recent decades are attributable in large part

to a combination of two factors: rapid and

pronounced structural change and low aggre-

gate demand. Although demographic changes

in the composition of the labor force have

tended to adversely affect the unemployment

rate, the actual impact has been quite modest.

The unemployment of the 1970s is at-

tributable in large part to shifts in the distri-

bution of employment across industries brought

on by some sort of structural change. Unfor-

tunately, the measure of structural change de-

veloped can be computed only with a four-year

lag, thereby making policy decisions based

upon such dated calculations inadvisable.

Nevertheless, the need for policymakers to have

some knowledge of the current magnitude of

structural change is quite real.

The evidence on interindustry employ-

ment flows suggests that structural change has

Federal Reserve Bank of Chicago



not been as large a determinant of unemploy-

ment in the 1980s as it was in the 1970s. Thus,

the double-digit unemployment of recent years

is more closely associated with cyclical rather

than structural or frictional factors.

Extrapolation of data used in the compu-

tation of Figure 7 suggests that the current

natural rate of unemployment is approximately

6 percent. Given the actual unemployment

rate of 7.07 for the first quarter of 1986, it ap-

pears that policymakers need not be unduly

concerned with inflation at this time.

The

discussion here is based to a large extent on

Ronald G. Ehrenberg's and Robert S. Smith's book

entitled

Modern Labor Economics: Theory and Public

Policy,

2nd edition, published by Scott, Foresman

and Company, 1985.

Real wages may not readily respond to decreases

in aggregate demand because of long-term labor

contracts which specify nominal wages, minimum

wage legislation, and risk aversion on the part of

workers who prefer fixed real wages and more var-

iable employment.

The unemployment rates have been constructed

as in equation [1] so as to guarantee that the sum

of the y

's equals one.

The age categories investigated were

16-to-19-year-olds, 20-to-24-year-olds, and those

25-years-of-age or older.

Other traditional industries include construction,

mining, transportation and public utilities.

Service-related industries refer to wholesale and

retail trades, finance, insurance, and real estate.

This phenomenon was originally documented by

Wesley C. Mitchell in

Business Cycles and Their

Causes,

(Berkeley, CA: University of California

Press, 1941).

The industry categories examined include gov-

ernment, construction, mining, durable manufac-

turing, nondurable manufacturing, transportation

and public utilities, services, wholesale trades, retail

trades, and finance, insurance, and real estate.

The dependent variable in the analysis is the

fixed-weight unemployment rate adjusting for the

effects of the changing age composition of the labor

force. Similar calculations were also performed on

the unadjusted unemployment rate but provide lit-

tle additional insight.

In the absence of serially correlated errors, ordi-

nary least squares is equivalent to maximum likeli-

hood estimation for large sample sizes. The

adjusted Box-Pierce statistic (Q) is reported testing

for serial correlation of the residuals through a lag

length of six quarters. In all three regressions the

hypothesis that the estimated residual is not serially

correlated can be accepted at the five percent sig-

nificance level.

1°

The measurement of permanent change in the

distribution of employment across industries dis-

cussed below is found in George R. Neumann and

Robert

Topel, "Employment Risk, Sectoral

Shifts, and the Geographical Distribution of Un-

employment," forthcoming

Quarterly Journal of Eco-

nomics.

Calculations are based upon the same ten indus-

tries as those used in computing r

. The measures

have been compiled assuming J = 16, creating a

four-year lag in the estimate. As a result, values

and AT can be estimated only through the

third quarter of 1981. The

are assumed to be

geometrically declining weights that sum to unity

over 16 quarters. Therefore, /i

CqJ

where

(1 —

q)l[q(1 —

q")]. The results reported here

are based upon the assumption that

q =

0.9.

However, in practice the actual weighting scheme

used makes little difference in the final results. [See

box for a discussion of the estimation.]

Social insurance expenditures is available annu-

ally from the Social Security Administration's

Social

Security Bulletin: Annual Statistical Supplement.

Quarterly data were calculated by linear interpo-

lation.

Some limited evidence to this effect is found in

Robert E. Hall's article, "Why Is the Unemploy-

ment Rate So High at Full Employment?" in

Brookings Papers on Economic Activity,

vol. 3: 1970, pp.

369-396.



Economic Perspectives

Bibliography

Barro, Robert J., "Unanticipated Money, Output,

and the Price Level in the United States,"

Journal of Political Economy,

August 1978,

86(4), pp. 549-80.

Hall, Robert R., "Why Is The Unemployment

Rate So High at Full Employment?,"

Brookings Papers on Economic Activity,

1970(3),

pp. 369-410.

Lilien, David. "Sectoral Shifts and Sectoral Unem-

ployment,"

Journal of Political Economy,

Au-

gust 1982, 90(4), pp. 777-93.

Mitchell, Wesley C.,

Business Cycles and Their

Causes,

(Berkeley, CA: University of

California Press, 1941).

Neumann, George R. and Robert H. Topel, "Em-

ployment Risk, Sectoral Shifts, and the Ge-

ographical Distribution of Unemployment,"

forthcoming

Quarterly Journal of Economics.

Federal Reserve Bank of Chicago

