Below is an extract from a RBNZ paper from March this year on Estimating the NAIRU and the Natural Rate of Unemployment. Especially useful for A2 students.
The headline unemployment rate in New Zealand has been trending down over time. This fall in the unemployment rate has not been accompanied by a rise in inflation, suggesting that the underlying natural rate and the NAIRU may have also declined through time. In this section, we document some of the changes in the New Zealand economy that have influenced the unemployment rate over history.
As a first step, we disaggregate the unemployment rate into three sub-components as follows:
a. Cyclical unemployment results from changes in aggregate demand conditions over the course of a business cycle. As firms experience weaker demand, existing workers may be laid off and fewer new workers will be hired.
b. Frictional unemployment refers to the regular short-term churn in the labour market, both within, and in and out of, the labour force. It is determined by the efficiency of the matching process given the diversity of job-seekers and vacancies.
c. Structural unemployment represents a more fundamental mismatch between those hiring and job seekers given their skills and geographic location. This could arise from long-lasting changes in the structure of the economy such as socio-demographic trends, technological change, or a rapid change in the mix of industries.
The lines between these categorisations can be indistinct. For example, some argue that a prolonged period of cyclical unemployment could also lead to hysteresis effects that could spill over to structural unemployment. For example, an extended period of unemployment may lead to an erosion of human capital making workers less attractive to employers and hence reducing their bargaining power. In principle, frictional unemployment and structural unemployment should be captured by the trend in the NAIRU or the natural rate, as both forms of unemployment may continue to exist even if the labour market is in equilibrium. This is because those that are structurally unemployed may not be easily drawn back into employment despite an increase in labour demand and an upward adjustment in wages. In addition, the level of frictional unemployment is largely determined by the efficiency with which potential workers and employers can find jobs. In contrast, cyclical unemployment captures when the labour market may be operating below capacity as a result of a shortfall in demand.
Monetary policy has little influence over the level of frictional and structural employment. These are largely determined by the evolution of technology and the obsolescence of skills, and by structural policies to facilitate the acquisition of new skills and improve the match between employers and job-seekers. For example, policies that affect the cost of hiring (e.g. employment protection laws), the incentives for job finding (e.g. unemployment insurance), or the bargaining power of workers (unionisation and labour contract laws).
In Figure 3, we decompose the pool of unemployed workers on the basis of unemployment durations. In particular, we categorise those who have been unemployed for less than 4 weeks as contributing to frictional unemployment, 4 to 52 weeks as cyclical unemployment, and greater than 52 weeks as structural unemployment.