Why Do Economists Refer To The Economy As Fully Employed

1a Why Do Economists Refer To The Economy As Fully Employed Even W

Economists refer to the economy as "fully employed" when the unemployment rate is at its natural rate, which includes frictional and structural unemployment but excludes cyclical unemployment. The natural rate of unemployment, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), represents the level at which inflation remains stable and does not accelerate. Despite measured unemployment figures as high as 5% to 5.5%, the economy can still be considered fully employed because this rate reflects the normal turnover in the labor market—people voluntarily transitioning between jobs and structural changes—not an economy operating below its capacity.

The measured unemployment rate includes frictional unemployment—the time period when workers are searching for new jobs—and structural unemployment—mismatches between workers' skills and job requirements. Cyclical unemployment, caused by economic downturns, is not included in the natural rate; thus, when the actual unemployment is near the natural rate, the economy is considered at full employment, even if some unemployment persists.

In January 2015, the US unemployment rate was approximately 5.7%. This figure indicates that the economy was very close to, or perhaps slightly above, the natural rate of unemployment, suggesting that it was nearly at full employment. Therefore, despite some measured unemployment, the US economy was likely operating near its potential output.

When the unemployment rate dips below the NAIRU, inflation tends to accelerate because labor market conditions tighten, giving workers less bargaining power and leading employers to raise wages. Increased wages increase production costs, which firms often pass onto consumers as higher prices, thus raising inflation. Currently, with the unemployment rate near 5.7%, inflation pressures remain moderate, but if unemployment falls below the NAIRU, inflation could accelerate.

The current US economy, in 2015, was in the late recovery or expansion phase of the business cycle. The unemployment rate was decreasing and economic growth was continuing, yet inflation remained subdued, indicating that the economy was close to or at full employment but not overheating.

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Economists often characterize the state of full employment as the condition when the unemployment rate equals the natural rate of unemployment, which typically hovers around 4.5% to 5.5% in developed economies like the United States. This natural rate comprises frictional unemployment, which results from the normal search process for jobs; structural unemployment, reflecting mismatches between workers’ skills and job requirements; and other factors like seasonal unemployment. Importantly, full employment does not imply a zero unemployment rate, but rather a rate consistent with stable inflation. When unemployment exceeds this rate, cyclical unemployment—caused by downturns—is prevalent, signaling an economy operating below its capacity.

During periods like January 2015, when the US unemployment rate hovered around 5.7%, economists argued that the economy was close to or at full employment because this rate was near the estimated natural rate, indicating minimal cyclical unemployment. The measured unemployment figure does include frictional and structural components, which are always present in a dynamic economy. Therefore, a measured unemployment rate slightly above or below the natural rate does not necessarily imply a deviation from full employment. Instead, it reflects ongoing labor market fluidity.

The concept of NAIRU helps refine this perspective. NAIRU represents the unemployment rate at which inflation is stable; if unemployment falls below NAIRU, labor market tightness accelerates inflation. Conversely, if unemployment exceeds NAIRU, inflation tends to slow. Today’s low unemployment rate of around 5.7% suggests the US economy was approaching or at NAIRU, but not exceeding it significantly enough to cause inflationary pressures to accelerate substantially.

In conclusion, even with measured unemployment around 5%, the US economy can be considered fully employed because this rate approximates the natural or NAIRU level. The economy's capacity to operate at this level without triggering accelerating inflation justifies the use of the "full employment" terminology. This perspective aligns with the current business cycle phase in early 2015, characterized by ongoing recovery, decreasing unemployment, and stable inflationary pressures.

Furthermore, if the actual unemployment rate declines below the NAIRU, inflationary pressures would likely intensify. This is because tighter labor markets mean higher wages and increased production costs, leading to upward pressure on prices. In the context of the current US economic conditions in 2015, the economy faces an expansionary phase, with unemployment decreasing but not yet at levels that would disrupt price stability. The potential for inflation to accelerate remains contingent on whether unemployment drops below the NAIRU, which, based on recent data, it has not.

The AS/AD diagram illustrating this scenario would show the aggregate demand (AD) curve shifting outward, increasing real GDP above potential (full-employment) output, causing upward pressure on prices. In this diagram, the short-run aggregate supply (SRAS) curve remains relatively fixed, while the AD shifts rightward during economic expansion. This results in higher output and prices, aligning with the scenario of near-full employment and impending inflationary pressures.

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