Background Paper on Full Employment

This paper considers the meaning of full employment and attempts to gauge the appropriate level of "sustainable" full employment. The second section of the paper reviews the various theories of employment that have been applied to gain an understanding of the concept of full employment. The starting point is the classical theory of a perfectly functioning labour market where wages adjust to equilibrate supply and demand and all unemployment is voluntary. Next is introduced the Keynesian concept of voluntary unemploymenL where workers are willing to supply more labour at the current fixed money wage rate and where money wages are assumed to be fixed. The concept of unemployment called the Non-accelerating Inflation Rate of Unemployment (NAIRU), which is derived from the extended Phillips curve model of wage determination is also examined in the second section. According to this model, there is a certain unemployment rate (or range of rates) that is consistent with a steady rate of inflation. Given the necessity to avoid an accelerating rate of inflation, this is the unemployment rate that is sustainable in the longer run. Any trade-off between inflation and unemployment is necessarily short-run in nature with the duration of the trade-off dependent on the speed with which expectations adapt. To the extent that expectations are rational and accurate, the trade-off can be expected to disappear. The rational expectations view of unemployment can be carried even further and some proponents would argue that all unemployment stems from errors in expectations about, most importantly, the real wage. The search theory view of unemployment developed by Phelps and others is summarized critically. This theory posits that unemployment is voluntary and results from job search. This section of the paper also discusses the traditional decomposition of unemployment into frictional, seasonal, structural, and cyclical components. The second section of the paper ends by drawing together the main threads of the discussion of theories of employment to shed some light on the question of what might constitute a viable goal for full employment. The data on labour force trends is examined in the third section of the paper. Trends in unemployment by age and sex are considered. The nature of the questions on the labour force survey and their significance for the interpretation of unemployment are discussed. The fourth section of the paper reviews the evolution of goals for full employment as the various theories of unemployment came to be applied to the actual unemployment situation. The increase in the unemployment rate goal from the Economic Council's medium term goal of 3 per cent proposed in 1964 to theMacdonald Commission's 6 1/2 to 8 per cent range for the NAIRU is chronicled. Estimates of the NAIRU derived from the companion paper reviewing the literature on inflation and unemployment are used to shed additional light on the meaning of full employment in the current context. The methodologies used to calculate the estimates of NAIRU are fully discussed. Conclusions concerning factors such as the demographic composition of the labour force and changes in Unemployment Insurance that are expected to have an impact are highlighted. The fifth section of the paper considers the prospect for full employment. Current short- and medium- term and long-term forecasts for the rate of unemployment are reviewed. Special attention is paid to those presented in the May 1985 budget because of their official status. The sixth section presents the conclusions on sustainable levels of unemployment.