CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

CBO

PAPER

APRIL 2002

The Effect of

Changes in

Labor Markets

on the Natural

Rate of 

Unemployment

© Royalty-free/Corbis

THE EFFECT OF CHANGES 

IN LABOR MARKETS ON THE 

NATURAL RATE OF UNEMPLOYMENT

April 2002

The Congress of the United States

Congressional Budget Office
NOTES

All years referred to in the text and figures are calendar years, unless otherwise

indicated.

The figures in this report use shaded vertical bars to indicate periods of recession.

The bars extend from the peak to the trough of each recession.
PREFACE

The Congressional Budget Office (CBO) is required to project the unemployment

rate over a 10-year period. Such projections are closely linked to the concept of the

natural rate of unemployment, the level of unemployment that would occur if aggregate demand for goods and services was in balance with aggregate supply.

This paper summarizes and assesses recent research on the ways in which

changes in the composition of the labor force and in the operation of labor markets

may have affected the natural rate of unemployment. In particular, the experience

of the late 1990s—when supply seemed to keep up with rapidly growing demand

even though labor markets were tight, and the unemployment rate fell well below

previous estimates of the natural rate—led many observers to speculate that the

natural rate may have fallen substantially over the past two decades. This paper

finds that several factors, most notably shifting demographics and the expansion of

the temporary-help industry, have combined to reduce the natural rate significantly

since the mid-1980s. Some other factors, such as higher levels of skill and Internet

job searching, may also have played a role in reducing the natural rate, but those

factors have not been incorporated into CBO's projections for the next 10 years

because they cannot now be quantified.

David Brauer of CBO’s Macroeconomic Analysis Division prepared this paper

under the supervision of Robert Dennis and John Peterson. The manuscript benefited from suggestions by Arlene Holen, Deborah Lucas, Kim Kowalewski, Bob

Arnold, Christopher Williams, Frank Russek, Kathy Ruffing, Ralph Smith, Bruce

Vavrichek, and Paul Cullinan, all of CBO, as well as by Robert J. Gordon of Northwestern University and June O’Neill of Baruch College at the City University of

New York. John McMurray provided research assistance.

Christine Bogusz edited the paper, and Christian Spoor proofread it. Linda

Lewis Harris prepared the report for publication, and Annette Kalicki produced the

electronic versions for CBO’s Web site (www.cbo.gov).
 
CONTENTS

SUMMARY AND INTRODUCTION 1

EXPLANATION OF TERMS 2

CHANGES IN THE LABOR FORCE 5

Age and Sex 6

Percentage Incarcerated in Prisons 10

Policies Affecting Welfare and Disability 10

Educational Attainment, Skills, and Training 13

CHANGES IN THE OPERATION OF LABOR MARKETS 14

Use of Temporary Labor 15

Internet Job Searches 16

Synchronization Among Regions 17

Job Stability 19

Technological Change 20

Institutional Changes 22

Use of Performance-Based Pay 23

Security Concerns 24
vi THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

FIGURES

1. The Unemployment Rate and Core Inflation 2

2. The Natural and Actual Rates of Unemployment 4

3. The Unemployment Rate by Age Group 8

4. People Ages 16 to 24 in the Labor Force as a Share

of the Total Labor Force 9

5. People Ages 18 to 64 Receiving Federal Disability

Benefits as a Share of the Population 12

6. Employment in the Temporary-Help Industry

as a Share of Total Employment 16

7. Union Membership as a Share of Wage and Salary Employment 23

8. The Federal Minimum Wage as a Percentage of 

Average Hourly Earnings 24

BOXES

1. The Natural Rate, the NAIRU, and CBO’s Estimating Procedures 6
SUMMARY AND INTRODUCTION

To project the unemployment rate over a 10-year horizon, the Congressional Budget

Office (CBO) must abstract from the booms and busts of the business cycle and

estimate the rate of unemployment that is likely to prevail, on average. Such an

estimate is closely linked to the concept of the “natural” rate of unemployment.

That term has been used in various ways by economists, but the natural rate is

essentially an estimate of the level of unemployment that would result if aggregate

demand for goods and services was in balance with aggregate supply. The concept

of a natural rate of unemployment is connected to a number of questions that deal

with policy and forecasting, as well as 10-year projections. For example, if the

unemployment rate is reduced by policy actions, will real wage growth or price

growth increase as a result? If so, at what critical point will the acceleration be

triggered, and how big will the response be?

In debates over those questions and others, analysts have referred to that

critically important rate of unemployment in various ways. Some analysts use

terms such as the natural rate, the equilibrium rate of unemployment, and the nonaccelerating inflation rate of unemployment (NAIRU) interchangeably; others make

careful distinctions between those terms. Analysts also disagree about whether

there is a relatively stable critical rate and, if so, whether it can be estimated reliably. Because of those fundamental disagreements, analysts’ estimates of that rate

vary widely.

The debate about the natural rate has intensified in recent years. Some observers have claimed that increased globalization could boost domestic unemployment for certain groups of workers, raising the natural rate. But unemployment has

dropped sharply. Moreover, prices have generally not shot up as unemployment has

declined. When the unemployment rate fell below 5 percent in 1997, many economists expected inflation to reaccelerate; instead, inflation continued to fall through

the middle of 1999 (see Figure 1). An unanticipated pickup in the growth of productivity at that time helped keep inflation from rising; other factors, such as falling

prices for commodities and imports, may also have played an important role. However, changes in labor markets, such as the rise in the use of the Internet for job

searches, may have contributed, too.

This paper summarizes the recent research on how changes in labor markets

over the past two decades may have affected the unemployment rate. Those

changes involve ongoing shifts in the composition and characteristics of the labor

force as well as in the structure and operation of labor markets. Theory and qualitative evidence suggest that the natural rate of unemployment has declined over the

past two decades and that some of the factors causing that decline may continue to

grow in importance over the next decade. One factor—the aging of the adult

population—has been widely discussed and quantified, and it has been incorporated

directly in CBO’s projections for many years. Other factors have only recently been
2 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

FIGURE 1. THE UNEMPLOYMENT RATE AND CORE INFLATION

SOURCE: Department of Labor, Bureau of Labor Statistics.

a. The year-over-year percentage change in the consumer price index for all urban consumers, excluding the food and

energy sectors, applying the current methodology to historical price data since 1978 (CPI-U-RS).

examined. The expanded role of the temporary-help industry has probably reduced

the natural rate, but the effects of Internet job searching and higher levels of skill

are difficult—if not impossible—to quantify. Nonetheless, CBO estimates that, on

balance, changes in labor markets have reduced the natural rate of unemployment

from 6.0 percent to 5.2 percent since the mid-1980s. Although the unemployment

rate rose sharply immediately after the September 11 terrorist attacks, the natural

rate is unlikely to be affected to any significant and lasting degree.

EXPLANATION OF TERMS

The unemployment rate is the number of unemployed people as a percentage of the

civilian labor force, which consists of all employed and unemployed people ages 16

and higher. The Bureau of Labor Statistics classifies people as employed if they

performed any work for pay or profit during the reference week (the week including

the 12th day of the month) or held a job but were temporarily absent because of

illness, vacation, inclement weather, a labor dispute, or personal reasons. To be
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 3

counted as unemployed, people must not have been employed during the reference

week, must have been available to work during that week, and must have either

made some specific effort to find work during the previous four weeks or been laid

off from their job and expecting to be recalled. People without jobs who fail to

meet those conditions are classified as not in the labor force.

The overall concept of the natural rate of unemployment comprises a number

of other concepts. Frictional unemployment stems from the normal turnover of

jobs and workers (the turnover that is independent of the effects of business cycles)

and from the fact that it takes time for unemployed workers to find and accept a

suitable job offer. A related concept, structural unemployment, refers to the unemployment caused by mismatches between available workers’ skills and those

necessary to fill vacant positions. Structural unemployment includes geographic

mismatches, so its level is influenced by regional disparities in labor market conditions and by the degree of worker mobility.

Frictional and structural unemployment together determine the equilibrium

rate of unemployment. That rate is theoretically the lowest unemployment rate that

would prevail if labor markets functioned smoothly, with flexible wage rates allowing the supply of and the demand for labor to balance. In practice, however, several

factors tend to keep wages from falling when supply exceeds demand, thereby

slowing the economy’s adjustment to equilibrium. Those factors include minimum

wages set by law, the presence of unions, social conventions, and wage-setting

practices by employers that are aimed at boosting workers’ morale and effort, minimizing turnover costs, or otherwise stimulating greater output. The unemployment

arising from those so-called institutional factors, together with the equilibrium rate

of unemployment, is termed the natural rate of unemployment. The natural rate

represents all sources of unemployment except the unemployment associated with

fluctuations in aggregate demand. Cyclical unemployment represents the difference between the estimated natural rate and the actual unemployment rate. Near the

end of an economic boom, the actual rate will tend to be lower than the natural rate;

in a recession, it will tend to be higher. The bulk of the variation in the actual

unemployment rate is attributable to cyclical unemployment (see Figure 2). Finally,

the NAIRU is generally considered to be equivalent to the natural rate in the long

run (see Box 1 on pages 6 and 7).

In broad terms, the natural rate of unemployment is determined by any factor

—demographic, economic, or institutional—other than the business cycle that influences the number of people searching for work, the number of vacant positions, and

the rate at which vacancies are filled. Several factors affect the flow into frictional

or structural unemployment and thus the natural rate. The age distribution of the

population is particularly important because it affects the number of new entrants

into the labor force. The simultaneous creation and destruction of jobs also contributes to frictional unemployment because workers displaced from existing jobs will
4 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

FIGURE 2. THE NATURAL AND ACTUAL RATES OF UNEMPLOYMENT

SOURCES: Congressional Budget Office; Department of Labor, Bureau of Labor Statistics.

often be unemployed until they can find new ones, even as newly created vacancies

remain unfilled for a time. That creation and destruction can occur through establishments’ opening, closing, expanding, contracting, or restructuring (even if the total

number of positions at an establishment is unchanged, newly created jobs may

require a set of skills different from those that they replace). The same effect results

from vacancies that are created when workers quit voluntarily or are dismissed

because of their performance.

In addition to those factors, the natural rate of unemployment depends on the

rate at which job seekers are matched with, and are willing to accept, vacant positions. The greater the mismatch, in terms of either skills or geography, between

vacant positions and unemployed workers, the longer the matching process will take

and, consequently, the higher the natural rate will be. In contrast, technological or

institutional changes that improve the efficiency of job searches will shorten the

search process and thus reduce the natural rate.
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 5

1. That effect is not necessarily undesirable from a social welfare perspective if the extra search time ultimately results in a better, more durable match (which could itself at least partially offset the direct effect

on the unemployment rate of greater search time). The unemployment insurance (UI) system can also

influence the measured unemployment rate through its effect on workers’ decisions about whether to

search for work or drop out of the labor force. Higher benefits will encourage some jobless workers who

might otherwise have dropped out of the labor force to instead search for work at least enough to retain

eligibility for UI benefits. In the early 1980s, the ratio of UI recipients to unemployed job losers (those

people theoretically eligible for UI benefits provided other criteria are satisfied) fell sharply; that ratio has

since drifted upward for reasons not fully understood by economists. Unemployment insurance, a

federal/state system, has not undergone fundamental changes at the federal level over the past two decades; it is not discussed further in this paper.

Any factors affecting the likelihood that a job seeker will choose to accept a

particular offer will also influence the natural rate. When a job offer is made, a

worker must choose between accepting its terms or rejecting the offer and remaining

unemployed while continuing to search in the hope of eventually obtaining a better

offer. For example, higher unemployment insurance benefits will tend to motivate

workers to continue to search longer before accepting a job offer, thus increasing the

natural rate.1

CHANGES IN THE LABOR FORCE

The characteristics of the workforce exert considerable influence on the natural rate

of unemployment. Younger and less-skilled workers change jobs more frequently

than their older and more-skilled counterparts do and are consequently more likely

to become unemployed. The less-skilled may also take longer to find a new job

when unemployed. Since the late 1970s, however, the population’s age mix has

shifted from younger workers to older workers; that increase in the average age of

the adult population has reduced the natural rate by about 0.4 percentage points.

Expansion of the nation’s incarcerated population has lowered it by a further 0.1 to

0.2 percentage points by removing some of the least-skilled people from the labor

force. Changes in policies that govern payments for disability may also have reduced the natural rate by inducing unskilled workers to leave the labor force. Recent changes in the administration of welfare programs appear to have increased

labor force participation and reduced unemployment among single mothers, but

quantitative effects are difficult to assess. In addition, more-educated workers, with

their higher skill levels, are less likely to become unemployed. Expansion of

employer-provided training might in principle have reduced the natural rate, but

economists lack the data necessary to assess that effect fully.
6 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

BOX 1. 

THE NATURAL RATE, THE NAIRU, AND CBO’S ESTIMATING PROCEDURES

The natural rate of unemployment is associated with the NAIRU, or nonaccelerating inflation rate of unemployment. The NAIRU model is built on the theory that there is an overall

national unemployment rate at which hourly compensation growth tends to neither increase

nor decrease. In some versions of the model, changes in compensation growth directly

affect price inflation. In other versions, an unemployment rate below the NAIRU primarily

indicates a high level of aggregate demand, which generates upward pressure on inflation

even without a direct link between compensation and prices.1

 Some analysts reject the

premise of the NAIRU model—namely, that one can infer short-run inflationary pressures

from the unemployment rate—and instead emphasize the importance of monetary policy in

determining inflation. CBO does not adhere strictly to the NAIRU model in forecasting

near-term inflation but uses it as one indicator among many. In its projections of inflation

over 10 years, CBO does not use the NAIRU at all.

Analysts who stress the link between compensation and prices argue that it is possible

to estimate a critical rate of unemployment (the NAIRU) and use that estimate to predict

changes in the growth of real hourly compensation. If the actual rate of unemployment

falls below the estimated NAIRU for a significant period of time, the rate of growth of

compensation will tend to increase, rising faster than the sum of price inflation and the

trend rate of productivity growth. The reason is that the relative scarcity of labor will force

employers to bid up the rate of wage growth to attract and retain workers with the desired

skills. Conversely, if the unemployment rate rises above the NAIRU, employers will be

less willing to bid up wages, and workers will be more willing to accept lower wage offers.

It is unclear exactly how far and for how long the actual unemployment rate must deviate

from the NAIRU in order to obtain those effects. 

CBO uses standard procedures to estimate the NAIRU and then uses those estimates

as a guide for evaluating near-term pressures on compensation growth and inflation and for ________________________

1. Economic Report of the President (February 1997), pp. 45-50; and Flint Brayton, John M. Roberts, and John

C. Williams, What’s Happened to the Phillips Curve? Finance and Economics Discussion Series, Paper No.

1999-49 (Washington, D.C.: Board of Governors of the Federal Reserve System, September 1999).

Age and Sex

Shifts in the age distribution of the population played a significant role in lowering

the natural rate over the past two decades. Younger workers traditionally experience spells of unemployment while looking for their first job or while shuttling

between participation in the labor force and other activities, such as attending school

or receiving support from their parents. Younger workers are also more likely than

older workers to change jobs, generating additional periods of unemployment (see

Figure 3).

Since the late 1970s, the share of younger workers as a percentage of the total

labor force has declined significantly (see Figure 4). Several studies have found
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 7

2. Lawrence F. Katz and Alan B. Krueger, “The High-Pressure Labor Market of the 1990s,” Brookings

Papers on Economic Activity, vol. 1 (1999); Robert J. Shimer, “Why Is the U.S. Unemployment Rate So

Much Lower?” in Ben Bernanke and Julio Rotemberg, eds., NBER Macroeconomics Annual, vol. 13

(Cambridge, Mass.: MIT Press, 1998), pp. 11-61; and Robert Horn and Philip Heap, “The Age-Adjusted

Unemployment Rate: An Alternative Measure,” Challenge, vol. 42, no. 1 (January-February 1999), pp.

110-115.

BOX 1.

CONTINUED

projecting the unemployment rate over a 10-year horizon.2

 The historical estimate of the

NAIRU derives from an econometric estimate of a Phillips curve, which is an equation that

relates the change in inflation to the unemployment rate and other variables, including

changes in productivity trends, oil price shocks, and wage and price controls in effect in the

early 1970s. Specifically, CBO estimates a NAIRU for married men—a group with very

high and stable labor force attachment during the normal working years and with a low

average unemployment rate. It then estimates a NAIRU for specific age/sex groups on the

basis of the observed relationship between each group’s unemployment rate and that of

married men. The overall NAIRU is derived from the group-specific rates, so demographic

shifts are directly factored into CBO’s estimates.

The NAIRU is only one of several indicators that CBO uses to forecast inflation in the

short run. CBO also considers information about productivity, sectoral price pressures,

unusual developments in labor markets, and (occasionally) inflation-measurement issues.3

For example, an apparent shift to higher productivity growth in the late 1990s, changes in

medical costs, and unusually low energy prices and declining import prices in 1998 and

1999 help to explain the very low inflation seen in those years. The analysis of labor market developments in this paper is just one of the ways in which CBO seeks to evaluate the

usefulness of, and improve the value of, its estimate of the NAIRU. 

CBO assumes the natural rate is synonymous with the NAIRU over a 10-year horizon,

therefore projecting that the actual unemployment rate will average out to the NAIRU

during the projection period. That practice also assumes that the influence of transitory

factors on inflation is neutral, on average, throughout the 10-year span.

________________________

2. For a more detailed description of the procedure used to estimate the NAIRU and the way the NAIRU is

used in estimating potential output, see Congressional Budget Office, CBO’s Method for Estimating Potential Output: An Update (August 2001).

3. For further discussion, see Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years

2001-2010 (January 2000), pp. 29-33.

that shifts in the population’s age mix toward older workers accounted for a decline

in unemployment of 0.3 to 0.5 percentage points between the mid-1980s and the late

1990s. (Those shifts have already been incorporated in CBO’s estimate of the natural rate of unemployment.)2

 Calculations based on the Census Bureau’s most
8 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

3. Bureau of the Census, Population Projections of the United States by Age, Sex, Race, Hispanic Origin,

and Nativity: 1999 to 2100 (February 2000). Those projections do not reflect results of the 2000 census.

Updated projections by age and sex, which incorporate data from the 2000 census, are expected to be

available later this year. The updated projections are unlikely to significantly alter the conclusions in this

report.

FIGURE 3. THE UNEMPLOYMENT RATE BY AGE GROUP

SOURCE: Department of Labor, Bureau of Labor Statistics.

recent population projections by age imply that the natural rate should decline by

roughly another 0.1 percentage point over the next decade.3

Changes in the composition of the labor force by sex played an important part

in explaining the increase in the natural rate of unemployment during the 1960s and

1970s, but they have had little effect on the rate since then. Between 1959 and

1979, women’s share of the labor force climbed from 33 percent to 42 percent.

During that span, the average unemployment rate among women was 6.4 percent,

compared with 4.9 percent for men. The higher unemployment rate among women

reflected their entry into, and frequent movement in and out of, the labor force.

Reentry often entailed a period of unemployment while women looked for work,

which caused the natural rate to rise.
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 9

4. June O’Neill and Solomon Polachek, “Why the Gender Gap in Wages Narrowed in the 1980s,” Journal

of Labor Economics, vol. 11, no. 1, part 1 (January 1993), pp. 205-228.

FIGURE 4. PEOPLE AGES 16 TO 24 IN THE LABOR FORCE AS A SHARE 

OF THE TOTAL LABOR FORCE

SOURCE: Department of Labor, Bureau of Labor Statistics.

Women’s share of the labor force has continued to grow since the early 1980s,

albeit at a slower pace than during the previous two decades, but unemployment

rates for men and women have been about equal, on average. Women’s relative

status in the labor market has steadily improved over time, and the wage gap between men and women has substantially narrowed, for three reasons.4

 First, demand

in traditionally female occupations, such as teaching and nursing, has risen relative

to that in traditionally male occupations, such as mechanics and machine operation.

Second, women have increasingly entered more highly skilled occupations. And

third, women’s average educational attainment has increased relative to that of men.

Although women are still more likely than men to temporarily leave the labor force

in midcareer, those interruptions are less frequent and typically shorter than in the
10 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

5. Katharine G. Abraham and Robert Shimer, Changes in Unemployment Duration and Labor Force

Attachment, Working Paper No. 8513 (Cambridge, Mass.: National Bureau of Economic Research,

October 2001).

6. Statistics are from the Bureau of Justice Statistics. Inmates of jails and prisons are excluded from the

population for purposes of calculating the unemployment rate and other statistics about the labor force.

7. Katz and Krueger, “The High-Pressure Labor Market of the 1990s.”

past. As a result, women today experience fewer short spells of unemployment than

they did in earlier decades.5

Percentage Incarcerated in Prisons

Over the past two decades, the percentage of the population incarcerated in jails and

prisons has nearly quadrupled (from about half a million in 1980 to 1.9 million in

2000), and the removal of those people from the labor force has helped to reduce the

natural rate of unemployment.6

 Young males, presumably with skills and job qualifications that are well below average, account for most of the increase in the prison

population. Under reasonable assumptions about what their labor force attachment

and unemployment rates would have been had they remained out of prison, the

overall unemployment rate for men would have been about 0.3 percentage points

higher.7 Because men account for slightly more than half of the labor force, that

figure suggests that greater incarceration rates have reduced the unemployment rate

by between 0.1 and 0.2 percentage points. CBO does not project changes in the

prison population, so it assumes that there will be no further effect on the natural

rate during the 10-year projection period.

Policies Affecting Welfare and Disability 

In 1996, the Congress adopted far-reaching changes in welfare policy through its

passage of the Personal Responsibility and Work Opportunity Reconciliation Act.

The law was broadly intended to replace the traditional welfare entitlement with

work requirements and other changes designed to encourage welfare recipients to

seek employment. A number of states had already begun to implement welfare

reforms toward that same end several years before 1996. 

When the reforms were implemented, some observers feared that they would

lead to a sharp increase in unemployment. They believed that a large number of

women with limited skills and, in many cases, difficulties with child care and transportation arrangements would be forced to enter the paid labor force but would have

difficulty finding and retaining a job. In addition, the new work requirements cre-
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 11

8. June E. O’Neill and M. Anne Hill, Gaining Ground: Women, Welfare Reform, and Work (Dallas, Texas:

National Center for Policy Analysis, February 2002).

9. The 1993 reforms substantially increased the value of the tax credit, especially for families with two or

more children. Several studies found that those reforms significantly boosted the labor force participation and employment of single mothers. See Nada Eissa and Jeffrey B. Liebman, “Labor Supply Response to the Earned Income Tax Credit,” Quarterly Journal of Economics, vol. 111, no. 2 (May 1996),

pp. 605-657; and Dan T. Rosenbaum and Bruce D. Meyer, “Welfare, the Earned Income Tax Credit, and

the Labor Supply of Single Mothers,” Quarterly Journal of Economics, vol. 116, no. 3 (August 2001),

pp. 1063-1114. 

10. David H. Autor and Mark G. Duggan, The Rise in Disability Recipiency and the Decline in Unemployment,” Working Paper No. 8336 (Cambridge, Mass.: National Bureau of Economic Research, June

2001). Earlier work documented a link between the availability of disability income and the decline in

labor force participation of older men from 1948 to 1976. See Donald O. Parsons, “The Decline in Male

Labor Force Participation,” Journal of Political Economy, vol. 88, no. 1 (February 1980), pp. 117-134.

ated an incentive for people without a job to claim that they were searching for

work, which would tend to raise the measured unemployment rate. 

Nonetheless, the first few years of welfare reform coincided with declines not

only in the overall unemployment rate but also specifically among female heads of

households—the group most directly affected by that reform. One explanation is

that the welfare changes gave recipients a strong incentive to intensify their job

search and to accept an offer rather than remain unemployed or out of the labor

force.8

 The decline in unemployment among single mothers also stems from the

exceptionally tight labor markets of the late 1990s. The 1993 expansion of the

earned income tax credit is another factor that probably increased the labor force

participation and employment of single mothers.9

 Disentangling those effects is

difficult, which is why economists have not yet reached any firm conclusion about

the lasting impact of welfare reform on the rate of unemployment. It may be possible to estimate the effects more accurately several years from now, when unemployment data reflecting a recession and a recovery should be available.

Disability policy can also influence the unemployment rate because, for some

people, income from disability benefits provides an attractive alternative to either

unemployment or low-wage employment. Following the adoption of the Disability

Benefits Reform Act of 1984, which loosened federal restrictions on eligibility for

disability benefits, the number of people receiving federal disability payments rose

substantially. In 2000, 4.8 percent of the population ages 18 to 64 received

disability-related income from Social Security, Supplemental Security Income (SSI),

or both; that figure was just 2.9 percent of the population in 1984 (see Figure 5).

Among men, the rise in the number receiving disability income was concentrated

among the less skilled, a group that has experienced an adverse shift in demand over

the past two decades and whose increased use of disability benefits cannot be explained by worsening health status.10 
12 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

11. John Bound, "Health and Earnings of Rejected Disability Applicants," American Economic Review, vol.

79, no. 3 (June 1989), pp. 482-503.

FIGURE 5. PEOPLE AGES 18 TO 64 RECEIVING FEDERAL DISABILITY BENEFITS

AS A SHARE OF THE POPULATION

SOURCE: Social Security Administration.

NOTE: Data points are year-end values. The value for 2000 is preliminary.

Greater availability of disability income could be expected to reduce the labor

force participation rate for workers (generally the less skilled) who would have

above-average unemployment rates if they were part of the labor force. As a result

of inducing those workers to leave the labor force, the natural rate of unemployment

would be expected to decline, although the magnitude of such an effect is unclear.

Studies of workers whose applications for disability insurance were rejected and of

beneficiaries whose benefits were terminated suggest that applicants for and recipients of SSI and disability-related Social Security would have low labor force participation rates even without those programs. That conclusion implies that an increase

in the number of claims for disability insurance might not have a large effect on the

measured unemployment rate.11
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 13

12. Ann P. Bartel and Nachum Sicherman, “Technological Change and the Skill Acquisition of Young

Workers,” Journal of Labor Economics, vol. 16, no. 4 (October 1998), pp. 718-755.

Educational Attainment, Skills, and Training

Over the past two decades, the educational attainment of the labor force has increased, on average, suggesting that the skill level of the population is also rising.

Because more-educated workers tend to have lower unemployment rates than lesseducated workers do, such an increase in skills may have contributed to a reduction

in the natural rate of unemployment. In 2000, the unemployment rate for workers

ages 25 and older with less than a high school diploma averaged 6.4 percent, compared with rates of 3.5 percent for workers with a high school diploma but no college education, 2.7 percent for workers who had attended college but did not complete a bachelor’s degree, and a relatively minuscule 1.7 percent for workers with at

least a bachelor’s degree. 

Increased proficiency in the skills valued by employers—whether that increase

stems from education, employer-provided training, or other sources—could reduce

the natural rate of unemployment. The link between higher skill levels and lower

unemployment is clearest when skills are firm-specific. Because firm-specific

training is of little or no value outside a firm, employers will typically subsidize it

by paying workers their regular wages while accepting diminished output during the

training period. Once employers have made that investment, they will seek to protect it through practices and policies aimed at minimizing turnover. At the same

time, workers with such firm-specific skills will be less likely to leave for another

job in which those skills will not be rewarded. That implicit contract is one of the

most important explanations for long-tenure jobs; consequently, more firm-specific

training might be associated with reduced turnover of employees and thus a lower

natural rate of unemployment. 

Analysts have only limited information on changes over time in the incidence

of employer-provided training. Much training, especially of the firm-specific type,

occurs informally through observation and interaction with more-experienced workers and is therefore virtually impossible to quantify. The information that is available, however, points to at least a modest increase in training. In a 1991 supplement

to the Current Population Survey, 42 percent of workers indicated that they had

received some form of training since being hired for their current job, up from 36

percent in a similar survey conducted in 1983. Most of that increase was in formal

company-provided training (from 12 percent in 1983 to 17 percent in 1991), and the

additional recipients were largely older and better-educated workers. Separately, the

incidence of formal company-provided training appears to be associated with the

rate of technological change within establishments, so more-rapid technological

change in general may have induced more companies to provide training.12 Like-
14 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

wise, the fraction of occupations in which training is necessary has grown. But the

absence of historically consistent data on the provision of training makes drawing

broader conclusions difficult.

Education and general training could also reduce the natural rate of unemployment, although the link is more complex than in the case of firm-specific training.

On the one hand, higher educational attainment connoting higher skill and learning

capacity makes workers able to qualify for or adapt to a wider range of jobs. Educated workers may also be more skilled in the job search process. Moreover, employers are more likely to invest in firm-specific training when their workers have

already demonstrated general skills.

On the other hand, two factors could limit the impact of increased educational

attainment on the natural rate. First, the increase in education may not be associated

with a proportional increase in skill. Some economists maintain that the value of a

college degree may have risen because it is increasingly used by prospective employers to screen candidates, regardless of the actual skills a prospective employee

obtained while in college. Such screening would diminish the impact of rising

educational attainment on the natural rate of unemployment. Second, the effect of

any genuine increase in skill on the natural rate might be limited if skill enhancement raised a typical worker’s reservation wage—the lowest wage rate needed to

persuade a person to accept an offer of employment rather than continue to search—

in tandem with the boost to that worker’s productive capacity. Skill enhancement

would increase the average worker’s opportunity cost of continuing to search but

also his or her expected reward from holding out for a better job offer. 

CHANGES IN THE OPERATION OF LABOR MARKETS 

Changes in the structure and operation of labor markets and in demand for workers

with different skills can also affect the natural rate of unemployment. Those

changes could involve the process by which unemployed workers search for jobs,

the degree to which unemployed workers possess the skills desired by employers

with vacancies, or the way in which the economy adjusts to shifts in demand for

workers. One such change—the expanded use of temporary labor—has probably

reduced the natural rate by between 0.2 and 0.4 percentage points over the past two

decades. Growth in the use of the Internet to search for jobs may have affected the

natural rate to a similar—or even greater—extent, but it is difficult to know for sure.

In addition, greater synchronization of labor market conditions among geographic

regions may have reduced the natural rate. Moreover, decreased job stability and an

associated rise in the rate of simultaneous job creation and destruction may have

boosted the natural rate, although the evidence remains inconclusive. A more rapid

rate of technological change may also have worked to push up the natural rate, but

the magnitude of that effect is impossible to quantify. Institutional changes, such as
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 15

13. Maria W. Otoo, Temporary Employment and the Natural Rate of Unemployment, Finance and Economics Discussion Series, Paper No. 1999-66 (Washington, D.C.: Board of Governors of the Federal Reserve

System, December 1999); and Katz and Krueger, “The High-Pressure Labor Market of the 1990s.”

weakened unions, a declining relative minimum wage, and forms of compensation

that are generally more flexible may have helped to lower the natural rate by making

it easier for companies to adjust to changing demand. However, estimates of the

size of those effects are few and tend to vary widely.

Use of Temporary Labor

The rapid growth of the temporary-help industry has in all likelihood significantly

lowered rates of frictional and structural unemployment and thus the natural rate. In

1982, slightly more than 400,000 people (about 0.5 percent of total payroll employment) worked in the temporary-help industry. Employment in that industry reached

its peak level of 3.5 million (2.7 percent of total employment) in mid-2000, but it

declined by more than 600,000 people through the end of 2001 as the economy

slipped into recession (see Figure 6). Until that recent drop, the impact of the

temporary-help industry’s expansion appears to have been substantial. Two studies

that examined variation between states or metropolitan areas in the use of temporary

workers concluded that the industry’s expansion between the mid-1980s and late

1990s could account for a decline in the natural rate of 0.2 to 0.4 percentage

points.13

From the perspective of employers, one important function of temporary-help

agencies is to manage short-term fluctuations in demand. In economic booms,

employers can often fill vacancies more quickly by using temporary-help agencies

than by hiring directly. Even if the marginal cost of an additional hour worked was

the same for temporary employees as it would be for workers hired directly as permanent staff members, employers would still save on recruiting and other one-time

hiring costs as well as firing costs once demand returned to normal. Furthermore,

especially in recent years, some employers have begun to take on workers from

temporary-help agencies with the idea that the workers who performed well would

be hired permanently. Although some workers prefer temporary employment, many

more use temporary-help agencies to try various types of work or to take advantage

of the agencies’ screening function with the hope of landing a permanent job instead

of remaining unemployed while searching.
16 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

14. For example, Monster.com—a leading Internet firm in the field of employment listings—reported having

over 1 million job postings and approximately 2.7 million subscribers to its free newsletter in January

2002. The company arose from a merger between two firms that began Internet operations in the early to

mid-1990s.

FIGURE 6. EMPLOYMENT IN THE TEMPORARY-HELP INDUSTRY

AS A SHARE OF TOTAL EMPLOYMENT

SOURCE: Department of Labor, Bureau of Labor Statistics.

NOTE: The data in this figure reflect employment in help supply services (Standard Industry Classification 7363), which

primarily consists of temporary-help agencies. It includes all workers on an agency’s payroll, regardless of the

industry to which they are currently assigned.

Internet Job Searches

People’s use of the Internet to search for a job has grown rapidly over the past several years.14 The Internet may have reduced frictional unemployment directly by

improving the efficiency of job searches and therefore shortening the search period,

but it is difficult to assess the magnitude of any such reduction. Furthermore, the

Internet may have lowered the natural rate by making it easier for currently employed workers to search for a new job, increasing the probability that workers will

change employers without experiencing a spell of unemployment between jobs.

Finally, because Internet searching provides job seekers with more-complete infor-
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 17

15. David H. Autor, “Wiring the Labor Market,” Journal of Economic Perspectives, vol. 15, no. 1 (Winter

2001), pp. 25-40.

16. Peter Kuhn and Mikal Skuterud, “Job Search Methods: Internet vs. Traditional,” Monthly Labor Review,

vol. 123, no. 10 (October 2000), pp. 3-11.

17. Peter Kuhn and Mikal Skuterud, “Does Internet Job Search Reduce Unemployed Workers’ Jobless

Duration?” (paper presented at the Society of Labor Economists conference, Austin, Texas, April 2001).

18. CBO’s current estimate for the natural rate of unemployment is 5.2 percent; the Administration’s is 4.9

percent.

mation about employers they are considering, it may improve the quality of matches

and thus reduce the probability of a subsequent quit or performance-based dismissal.

Increased job searching through the Internet could have far-reaching implications for labor markets.15 One recent study found that 15 percent of workers who

were unemployed in December 1998 looked for work via the Internet.16 In general,

Internet job searches by the unemployed appeared to supplement, rather than replace, more traditional forms of searching, such as reading classified ads or networking. In addition, 7 percent of employed workers in 1998 used the Internet to

investigate other job opportunities. In a follow-up to that study, the same authors

tracked the subsequent labor force status of many of the people who had been unemployed in December 1998. They found that those who used the Internet to search

for a job experienced considerably shorter spells of unemployment between jobs: a

median duration of one to two months, compared with three to four months for

people who did not use the Internet.17

Taken together, those results translate to a decline of roughly 0.3 to 0.4 percentage points from a baseline natural rate of unemployment of 5 percent (which is

close to the current estimated rate) relative to the early 1990s, before Internet

searching became widely practicable.18 Moreover, that estimated reduction may be

too small, for two reasons: Internet job searching has probably continued to increase in importance since the data for those studies was collected, and that estimate

does not take into account spells of unemployment that may have been averted as a

result of Internet searching while people were still employed. However, those results came from a period of exceptionally tight labor markets, when demand for

workers greatly exceeded supply. It is unclear whether Internet job searching would

be equally productive relative to other search methods under less favorable labor

market conditions. 

Synchronization Among Regions

Macroeconomic conditions were considerably more synchronized among regions

during the economic expansion of the 1990s than during the previous two expan-
18 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

19. Even in December 2001, nine months after the economy entered recession, the variation among regions

remained quite narrow, with a seasonally adjusted low of 4.2 percent in the West North Central region

and a high of 6.4 percent in the Pacific region. State unemployment rates ranged from 3.1 percent, in

North Dakota, to 7.8 percent, in Oregon.

sions (especially that of the 1980s), and that synchronization may have contributed

to a reduction in the natural rate. In 1979, when the economy was at a stage of the

business cycle comparable to where it stood in 2000, unemployment rates by Census

division ranged from 4.0 percent (West North Central) to 7.0 percent (Middle Atlantic). Similarly, in 1989, they ranged from 3.8 percent (New England) to 6.8 percent

(West South Central). But in 2000, the range was 2.8 percent (New England) to just

4.8 percent (Pacific), and the highest unemployment rate in any state in the continental United States was 5.7 percent (in Mississippi).19

In general, any regional variation in employment conditions implies that while

some areas are outperforming the national average, others are performing more

poorly. Starting from a situation in which the supply of and demand for workers are

balanced in all regions, if demand falls in one region, unemployment there will rise.

If demand rises in another region at the same time, the unemployment rate in that

region will fall. However, that decline may not be proportional to the increase

elsewhere because the skills demanded by employers do not match those of available workers or because relative wages do not adjust by enough to restore equilibrium. As a result, for a given set of aggregate demand conditions, as the degree of

synchronization increases, the national unemployment rate decreases.

Several factors may have contributed to the increased synchronization seen

over the past decade. First, a number of states and regions have reduced their dependence on a single industry or cluster of industries, making those areas more like

the rest of the nation and less vulnerable to industry-specific shocks. For example,

the Texas economy is considerably less dependent on oil and gas today than it was a

generation ago; similarly, the economy of western Pennsylvania no longer relies so

heavily on the steel industry. Second, changes in the operation of financial markets—in particular, the removal of restrictions on interstate banking—may also have

bolstered synchronization by permitting capital to flow more easily across state

lines. Third, Internet job searching probably contributes to synchronization by

facilitating the movement of information about job opportunities across broader

geographic areas. If employment conditions slacken in one area, the most mobile

workers there—typically young, well-educated, childless people—can seek employment in another area where conditions are more favorable. That easier movement of

information and people tends to equalize labor market conditions. 

All of those factors should imply a lessening in the degree of geographic mismatch between people seeking jobs and available positions, which would reduce

structural unemployment. However, if the greater degree of synchronization seen

during the latest expansion reflects the absence of region-specific shocks rather than
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 19

20. This measure is based on a series of special supplements to the Census Bureau’s Current Population

Survey that focus on employee tenure.

21. See the October 1999 special issue of the Journal of Labor Economics; and David Neumark, Changes in

Job Stability and Job Security: A Collective Effort to Untangle, Reconcile, and Interpret the Evidence,

Working Paper No. 7472 (Cambridge, Mass.: National Bureau of Economic Research, January 2000). 

improved efficiency or more diverse regional economies, the effect on unemployment might not be permanent. 

Job Stability

Some observers have suggested that over the past several decades, employment has

become increasingly unstable, with fewer long-tenure jobs than in the past. If so,

such increased instability would imply greater turnover of workers and a higher

natural rate of unemployment. 

The evidence on instability is mixed, however, with different data sets and

measures yielding different results. Data from one simple measure of instability—median tenure—suggest little change in tenure overall but some shifts within

particular demographic categories.20 Between 1987 and 1998—years that seem to

reflect similar points in the business cycle—overall median tenure rose marginally,

from 3.4 years to 3.6 years, although that increase could be explained at least in part

by the aging of the workforce. Job tenure declined significantly among men ages 35

and over, but it rose among women. 

Evidence from some studies points to reduced job stability during the economic expansion of the 1990s, compared with previous expansions, after data are

adjusted for changes in the age mix of the labor force. But it is not entirely clear

what portion of that reduction results from voluntary quits and what portion stems

from involuntary layoffs or dismissals. For example, most defined-benefit pension

plans reward workers with long tenure, effectively penalizing those who frequently

change employers. But employers’ ongoing shift from defined-benefit plans to

defined-contribution pensions has reduced the cost to workers of changing jobs and

has therefore quite likely encouraged greater voluntary turnover. Although voluntary job changes often do not entail a spell of unemployment, they do create vacancies that must be filled. To the extent that any decline in job stability comes from

involuntary displacement, it is unclear whether that reduction is part of an ongoing

trend or whether it simply reflects the short-term effect of a wave of corporate restructuring that took place during the early to mid-1990s.21

Changes in the mix of industries and occupations may also have contributed to

changes in job stability. In principle, one possible source of increased instability is

the declining share of jobs in manufacturing, a sector in which average tenure in the
20 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

22. Simon Burgess, Julia Lane, and David Stevens, “Job Flows, Worker Flows, and Churning,” Journal of

Labor Economics, vol. 18, no. 3 (July 2000), pp. 473-502.

23. Sometime soon, the Bureau of Labor Statistics plans to release data from a new monthly Job Openings

and Labor Turnover Survey (JOLTS), which will focus on turnover and on the availability of unfilled

jobs. That survey will cover 16,000 establishments, and its design will be comparable to that of the

bureau’s monthly establishment survey (including government). JOLTS will contain information on total

hires and separations as well as the number of job openings. Unfortunately, no historical data will be

available.

past was significantly higher than in the economy as a whole. Between 1987 and

1998, the share of jobs in that sector fell by about 4 percentage points, whereas the

share of jobs in services—a sector with below-average tenure—increased by 6

percentage points. The implications of that shift may not be as important as the

numbers seem to imply, however, because the difference in average tenure between

sectors has diminished over the past several decades. At the same time, shifts in the

occupational mix appear to have had little effect on job stability. The share of jobs

held by skilled and semiskilled blue-collar workers—a group with high tenure—fell

by about 2.5 percentage points over that period. But that of managers and professionals—another group with high tenure—rose by 5 percentage points over the same

span.

A phenomenon closely related to job stability is “churning,” the flow of workers into and out of jobs with no lasting effect on total employment at any establishment. Churning can arise from workers’ quitting and subsequently being replaced

or from simultaneous hiring and firing within an establishment. A greater degree of

churning theoretically means higher frictional and structural unemployment while

vacancies remain unfilled and workers who have quit or been terminated search for

their next job. One recent study that examined churning using a unique data set

covering Maryland establishments between 1985 and 1994 found it to be considerably higher in nonmanufacturing sectors than in the manufacturing sector but “high

and pervasive” across all sectors of the state’s economy.22 The authors did not find

any clear trend in the degree of churning. Their findings may be of limited usefulness in establishing a link between churning and a higher rate of unemployment,

however, because the data do not include information on whether workers affected

by churning actually experienced spells of unemployment and because the data may

not be representative of the national economy.23

Technological Change

Some observers have suggested that the rapid rate of technological advance over the

past several decades may have, at least for a time, increased the natural rate of unemployment by creating mismatches between the skills of available workers and

those desired by employers. A large volume of literature focuses on the effect of

technological change on relative wages and the wage distribution. That research
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 21

24. Lawrence F. Katz and Kevin M. Murphy, “Changes in Relative Wages, 1963-1987: Supply and Demand

Factors,” Quarterly Journal of Economics, vol. 107, no. 1 (February 1992), pp. 35-78; and Frank Levy

and Richard J. Murnane, “U.S. Earnings Levels and Earnings Inequality: A Review of Recent Trends and

Proposed Explanations,” Journal of Economic Literature, vol. 30, no. 3 (September 1992), pp. 1333-

1381.

25. John Bound and George Johnson, “Changes in the Structure of Wages in the 1980s: An Evaluation of

Alternative Explanations,” American Economic Review, vol. 82, no. 3 (June 1992), pp. 371-392.

26. David Autor, Lawrence F. Katz, and Alan B. Krueger, “Computing Inequality: Have Computers

Changed the Labor Market?” Quarterly Journal of Economics, vol. 113, no. 4 (November 1998), pp.

1169-1213; and Steven G. Allen, “Technology and the Wage Structure,” Journal of Labor Economics,

vol. 19, no. 2 (April 2001), pp. 440-483.

27. Stephan Danninger and Jacob Mincer, “Technology, Unemployment, and Inflation,” in Solomon W.

Polachek, ed., Worker Well-Being, vol. 19, Research in Labor Economics (Amsterdam: Elsevier Science, 2000), pp. 1-28.

was motivated by the observed widening of the wage distribution in general and by

the growing wage premium for people with college degrees in particular. Clearly,

growth in the demand for skilled workers (relative to that for unskilled workers) has

exceeded growth in the relative supply of those workers since at least the late

1970s.24 Early studies identified technological change that favors skilled workers as

a likely contributor to growing wage inequality, mainly by showing that other factors (such as trade, immigration, weaker unions, and the minimum wage) could not

fully explain it.25 More recently, studies have found direct links between changes in

the wage distribution and specific aspects of technological change.26

Technological change could increase the natural rate of unemployment if it

raised demand for workers at higher skill levels and lowered demand for unskilled

workers. Higher unemployment might result to the extent that labor market institutions such as unions, the minimum wage, and established relative pay scales within

establishments prevented the relative wages of the unskilled from falling in tandem

with the decline in demand. But it is unclear whether that has actually occurred. In

fact, technological change may reduce the natural rate in the long run by encouraging more workers to obtain training.27 Moreover, the nature of technological change

itself may have begun to shift, which could also tend to reduce the natural rate.

Some forms of new technology have made very unskilled workers—a group with

limited job opportunities—more able to work as retail clerks or in fast-food restaurants. It is too soon to gauge the magnitude of that shift, but it could at least offset,

it not reverse, any past tendency for technological change to boost unemployment.
22 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

28. Older measures of union membership rates indicate that membership peaked in the 1950s and began to

drop sharply in the mid-1970s.

29. Peter Tulip, Do Minimum Wages Raise the NAIRU? Finance and Economics Discussion Series, Paper

No. 2000-38 (Washington, D.C.: Board of Governors of the Federal Reserve System, August 2000).

30. David Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage

(Princeton, N.J.: Princeton University Press, 1995).

31. Based on unpublished tabulations provided to CBO by the Bureau of Labor Statistics.

Institutional Changes

As noted above, institutions such as unions, internal pay scales, the minimum wage,

and various practices and social conventions that restrict wage flexibility may hold

wages for some occupations in some locations above their equilibrium level. Those

institutions could increase unemployment in two ways—by reducing the number of

workers demanded and by inducing greater labor force participation (which means

more spells of unemployment). 

At least some of those forces appear to have diminished in importance in

recent decades, however, which may have helped to reduce the natural rate of unemployment. Union membership as a share of total wage and salary employment fell

from 20 percent in 1983 (the first year in which measures consistent with those used

today became available) to 13.5 percent by 2001 (see Figure 7).28 In addition, over

the past two decades, the federal minimum wage has declined relative to wages

economywide (see Figure 8), largely because it remained constant in nominal terms

between 1981 and 1990. During the 1970s, as inflation accelerated, the federal

minimum wage was adjusted frequently; between 1975 and 1981, the ratio of the

minimum wage to average hourly earnings of production and nonsupervisory workers averaged 46 percent. That ratio fell as low as 34 percent before the minimum

wage was again raised in 1990. Since then (with three subsequent increases in the

minimum wage), the ratio has ranged from 36 percent to 41 percent. 

One study estimates that a 10 percent increase in the minimum wage (relative

to an economywide average) raises the natural rate of unemployment by about half

a percentage point.29 That finding implies that reductions in the relative minimum

wage may have lowered the natural rate by more than a percentage point between

the late 1970s and the late 1980s. Other research, however, suggests that the impact

of the minimum wage on employment is slight, in part because only a small fraction

of the labor force is affected by changes to the minimum wage.30 In late 2001, about

1 percent of private-sector workers earned the minimum wage ($5.15 per hour), and

another 6 percent earned between $5.15 and $6.65 per hour.31 Nonetheless, future

legislation raising the minimum wage could boost the natural rate during CBO’s 10-

year projection period. In contrast, the absence of such legislation could reduce the
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 23

32. That statement does not imply that those rigidities have disappeared entirely. Rigidities arising from

“efficiency wage” considerations, notions of fairness, or the preservation of customary wage differentials

between occupations within an establishment are likely to still exist in many instances.

FIGURE 7. UNION MEMBERSHIP AS A SHARE OF WAGE 

AND SALARY EMPLOYMENT

SOURCE: Department of Labor, Bureau of Labor Statistics.

natural rate, because fewer and fewer workers would become affected by the minimum wage as wages rose throughout the economy.

Use of Performance-Based Pay

Along with those institutional changes, shifts toward more variable forms of pay,

such as bonuses and stock options, may have contributed to a decline in the natural

rate by weakening rigidities that had prevented labor markets from adjusting toward

equilibrium.32 If wages could adjust fairly readily to changes in demand for labor,

that adjustment could at least forestall, and possibly preclude, the generation of

structural unemployment in response to such shifts in demand. One study found

that the use of performance-based pay has grown in importance in recent years and

suggested that such growth could have reduced the natural rate (and the NAIRU) by
24 THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE April 2002

33. David Lebow and others, Recent Trends in Compensation Practices, Finance and Economics Discussion

Series, Paper No. 1999-32 (Washington, D.C.: Board of Governors of the Federal Reserve System, July

1999).

FIGURE 8. THE FEDERAL MINIMUM WAGE AS A PERCENTAGE 

OF AVERAGE HOURLY EARNINGS

SOURCE: Department of Labor, Employment Standards Division and Bureau of Labor Statistics.

making labor markets more efficient and flexible.33 However, that study does not

provide an estimate of the quantitative significance of the shift toward performancebased pay. 

Security Concerns

The heightened emphasis on security after the September 11 terrorist attacks may

increase the natural rate by generating new frictions in the labor market. If people

were less comfortable relocating away from their family and friends, mobility between regions could fall as a result.

Another way in which security concerns could affect the natural rate of unemployment is through employers’ perceived need to conduct extensive background

checks on prospective employees before hiring them. Results from one study imply
THE EFFECT OF CHANGES IN LABOR MARKETS ON THE NATURAL RATE 25

34. Kuhn and Skuterud, “Does Internet Job Search Reduce Unemployed Workers’ Jobless Duration?” That

paper found that Internet job searching cut median search time from between three and four months to

between one and two months. Under the assumption that 20 percent of unemployed workers used the

Internet to search for a job, the estimated average completed spell is roughly 12 weeks.

that a completed spell of unemployment typically lasts about 12 weeks.34 If new

background-check requirements added half a week, on average, to the process of

filling vacant positions, the unemployment rate would rise by 4 percent (an increase

of 0.2 percentage points if the natural rate was 5 percent). But the impact of new

security requirements is likely to be considerably smaller, for two reasons. First,

many job openings already require extensive background checks, and others are not

likely to require such checks even in a period of heightened security. Second, procedures for conducting background checks are likely to be streamlined over time,

and even additional checks need not add significant time to the hiring process if they

can be conducted concurrently with other parts of that process. 


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