The Natural Rate and The Phillips Curve
The development of the theory of the natural rate of unemployment came in the 1960s where economists observed that the Phillips-curve relationship between inflation and unemployment began to break down. Until then, it was widely believed that a stable negative relation between inflation and unemployment existed. This belief had the policy implication that unemployment could be permanently reduced by expansive demand policy and thus higher inflation.
Friedman and Phelps opposed this idea on theoretical grounds, as they noted that if unemployment was to be permanently lower, some real variable in the economy, like the real wage, would have changed permanently. That this should be the case because inflation was higher appeared to rely on systematic irrationality in the labor market. As Friedman remarked, wage inflation would eventually catch up and leave the real wage, and unemployment, unchanged. Hence, lower unemployment could only be attained as long as wage inflation and inflation expectations lagged behind actual inflation. This was seen to be only a temporary outcome. Eventually, unemployment would return to the rate determined by real factors independent of the inflation rate. According to Friedman and Phelps, the Phillips curve was therefore vertical in the long run, and expansive demand policies would only be a cause of inflation, not a cause of permanently lower unemployment.
Milton Friedman emphasized expectations errors as the main cause of deviation in unemployment from the natural rate,. For Friedman, the notion that there was a unique Natrual rate was equivalent to his assertion that there is only one level of unemployment at which inflation can be fully anticipated (when actual and expected inflation are the same). Edmund Phelps focused more in detail on the labor market structures and frictions that would cause aggregate demand changes to feed into inflation, and for sluggish expectations, into the determination of the unemployment rate. Also, his theories gave insights into the causes of a too high natural rate of unemployment (i.e., why unemployment could be structural or classical).
Read more about this topic: Natural Rate Of Unemployment
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