A Model of the Natural Rate of Unemployment

Summary

Since the publication of Edmund Phelps' volume, the “new” macroeconomics has treated the labor market as a dynamic process of rational search by unemployed workers for available vacancies. Wages are viewed as at least potentially flexible, though free contracting between workers and firms may lead to fixed wages in the short run. Imperfect information is a crucial element of the theory, for it implies both a need for contracting and a need for rational search rather than simple market clearing in each period.

A positive rate of frictional unemployment may exist in equilibrium, denoted as the “natural” rate. This unemployment is due to the frictions in the search process and imperfections in information rather than to any deficiency in aggregate demand. Milton Friedman defined the natural rate as

the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on. [p.8]

This paper reexamines the micro foundations of the natural rate in a model of labor market equilibrium in which turnover flows and imperfect information are explicitly considered. Workers may quit their current jobs to enter the unemployment pool in order to search among available vacancies for a more preferred position. Firms economize on turnover by an appropriate wage policy.