Natural Rate of Unemployment

BIBLIOGRAPHY

The natural rate of unemployment is a concept that was developed by the economists Milton Friedman and Edmund Phelps in the late 1960s, and it has been extremely influential in shaping the way that the economics profession views the economy. The notion of a natural rate of unemployment represents a return to the classical pre-Keynesian economics that ruled before and during the Great Depression, and many of the arguments are clearly anticipated in David Champernowne’s 1936 discussion of monetary unemployment. The theory was especially influential on policy in the 1970s and 1980s. However, its influence began to wane in the 1990s for a variety of reasons, including the emergence of new ideas and the recognition that the theory has significant operational difficulties when used for policy.

The natural rate is also referred to as the NAIRU (nonaccelerating inflation rate of unemployment). According to the theory, inflation will be steady at the NAIRU, but attempts to lower the unemployment rate further will ignite ever-accelerating inflation. The policy implication is straightforward: do not push unemployment below the natural rate.

The core idea is that the levels of employment and unemployment in an economy are determined by the supply of and demand for labor, which also jointly determine the real value (i.e., purchasing power) of wages. Unemployment arises because of “frictions” and “rigidities” in the economy that prevent the smooth operation of labor markets. How much so-called natural unemployment there is depends on the extent of labor-market frictions and rigidities.

Examples of frictions are imperfect information among workers as to where jobs are, and imperfect information among firms as to which workers want jobs. This gives rise to “search” unemployment, whereby unemployed workers seeking jobs are unable to match up with job vacancies. Examples of rigidities are the minimum wage and trade unions, which are argued to cause unemployment by setting wages too high, thereby reducing labor demand and employment.

According to Friedman and Phelps, the minimum wage and trade unions raise the natural rate of unemployment. This conclusion follows from their description of the labor market in terms of supply and demand. As such, natural rate theory has provided political conservatives with a justification for opposition to the minimum wage and trade unions on the grounds that they prevent the labor market from operating efficiently. From a natural rate perspective, the only way to lower the equilibrium rate of unemployment is to eliminate wage protections, improve matching arrangements between employers with vacancies and unemployed workers, change incentives and attitudes toward work, and change the demographic composition of the workforce. That is fundamentally different from Keynesian economics, which also emphasizes aggregate demand management.

A second important implication concerns policy toward inflation. In the 1960s economic policy was dominated by the idea of the Phillips curve, which claimed that there was a negative relationship between inflation and unemployment. That implied that policymakers could lower unemployment by slightly increasing inflation. The theory of the natural rate of unemployment challenged this claim, and argued that increasing inflation would have no effect on the long-run rate of unemployment. Any increase in the rate of inflation would just be matched by an increase in wage inflation.

Once again, the economic logic follows from the supply-and-demand model of labor markets. Workers supply labor in return for real wages that determine how much they can purchase. Likewise, firms hire workers because of the output they produce, and they pay workers a wage based on the value of that output. The implication is that labor supply and demand are unaffected by inflation. If prices double, then wages will also double, leaving employment and real wages unchanged.

One caveat to this conclusion is so-called unexpected or surprise inflation. Suppose workers see wages rising, but they are unaware that prices are also rising. In this case, they will think the real value (purchasing power) of wages has gone up and workers searching for jobs will accept jobs they would not previously have taken. Employment will therefore rise and unemployment will fall. However, workers will soon learn that prices are also rising so that real wages have not increased. When that happens, they will quit these jobs, and employment will fall back again and unemployment will rise.

This conclusion has had a major impact on monetary policy. In the 1960s and early 1970s, central banks (such as the Federal Reserve) thought that if they kept interest rates low and allowed a little higher inflation, they would lower unemployment. The theory of the natural rate of unemployment contradicted this belief, and instead said there would be no long-run effect. This has ushered in a new era in which policy emphasizes low inflation. The argument is that since inflation cannot reduce unemployment, the Federal Reserve should aim to keep inflation low.

Additionally, the Federal Reserve should aim to keep inflation predictable and stable. Though surprise inflation can temporarily reduce unemployment, such surprises are undesirable. The argument is that workers are being tricked into accepting jobs because they do not realize that prices have also gone up. Workers are therefore making decisions based on incorrect information, and this is a form of economic inefficiency.

The theory of the natural rate is now being challenged. With regard to the relationship between inflation and unemployment, some economists believe that low inflation acts as a form of “grease” that helps adjustment in labor markets, giving rise to a Phillips curve. The economic logic is as follows. Workers will always accept wage increases from their employers, but they will resist wage cuts. This is because workers cannot distinguish whether a wage cut is warranted because business conditions have deteriorated or the firm is just trying to exploit them. Under these conditions, inflation can help reduce unemployment. Prices and money wages will rise at firms where business conditions remain healthy. However, they will remain unchanged at firms where business conditions are weak. Consequently, relative prices and the purchasing power of wages at these weaker firms will fall, thereby shifting demand to them and raising employment at them. The net result is that higher inflation will raise employment and lower unemployment, as predicted by the Phillips curve.

Another reason for the diminished influence of natural rate theory concerns operational policy difficulties. The natural rate is not an observed unemployment rate. Instead, it must be estimated. However, empirical estimates have proven highly variable, and for the U.S. economy they have varied between 4 and 8 percent. This makes it of little use for guiding policy.

When it comes to the minimum wage and unions, these institutions may be needed to correct imbalances of power in labor markets. The supply-and-demand model of labor markets assumes that neither firms nor workers have any labor-market power. When it comes to jobs and the employment relation, power is assumed to be completely absent. However, if this is not the case, the supply-and-demand model is wrong. If the labor market naturally favors firms (since they have greater financial backing and do not have families to feed), then firms will have greater wage-bargaining power. In this case, workers may need minimum-wage laws and trade unions to equalize bargaining power and prevent exploitation.

The equalization of bargaining power can improve the distribution of income and thereby create demand for firms’ output. A mass production economy needs mass consumption. Keynesian economics maintains that free market economies may not automatically generate enough demand to ensure full employment, as exemplified by the experience of the Great Depression in the 1930s. In this case, unions and minimum wages can be seen as economic institutions that create a pattern of income distribution that generates sufficient consumption demand to ensure full employment. This Keynesian view of the economy contrasts with the natural rate’s labor supply-and-demand model that claims the economy automatically reaches full employment via wage adjustment.

If the natural rate of unemployment is so problematic, why did it become so popular in the 1970s and 1980s? Here, politics and history are important. Natural rate theory is a revival of classical laissez-faire economics that opposes institutions such as the minimum wage and trade unions. Classical laissez-faire economics also opposes Phillips curve policies that encourage a little inflation to stimulate higher employment. Political conservatives never accepted these institutions and policies, and natural rate theory gave them new grounds for opposition. When the national political climate became more conservative in the 1970s, this created a favorable environment for the spread of natural rate thinking.

Additionally, the 1970s were a period of great economic disruption owing to OPEC (Organization of Petroleum Exporting Countries) oil shocks. This disruption caused the economy to underperform, and it also created a new type of energy price inflation in which inflation rose but unemployment did not fall. Conservatives opportunistically interpreted this oil shock inflation as evidence confirming natural rate theory and rejecting Phillips curve theory.

The history of the natural rate of unemployment provides two critical lessons. The first is that theories depend on their assumptions. In the case of natural rate theory, its conclusions about unions, minimum wages, and the employment effects of inflation stem from its description of labor markets in terms of demand and supply. If this is an inappropriate description of how labor markets operate in the real world, then the theory of the natural rate of unemployment is wrong. The second lesson is that the spread of economic ideas is influenced by what is happening in society. When society drifts left, economic ideas will likely drift left. And when society drifts right, economic ideas will likely drift right. Like everyone else, economists live in society. That means they too are influenced by what is happening in society.

SEE ALSO Adaptive Expectations; Economics, New Classical; Expectations; Expectations, Rational; Friedman, Milton; Long Run; Market Clearing; Monetarism; Phillips Curve; Sticky Wages; Unemployment; Wages

BIBLIOGRAPHY

Champernowne, David G. 1936. Unemployment, Basic and Monetary: The Classical Analysis and the Keynesian. Review of Economic Studies 3 (3): 201–216.

Friedman, Milton. 1968. The Role of Monetary Policy. American Economic Review 58: 1–17.

Galbraith, John Kenneth. 1997. Test the Limit. Challenge 34: 66.

Palley, Thomas I. 1998 Zero is Not the Optimal Rate of Inflation. Challenge 41: 7–18.

Palley, Thomas I. 1999 The Structural Unemployment Policy Trap: How the NAIRU Can Mislead Policymakers. New Economy 6: 79–83.

Staiger, Douglas, James H. Stock, and Mark W. Watson. 1997. The NAIRU, Unemployment, and Monetary Policy. Journal of Economic Perspectives 11 (1): 33–50.

Tobin, James. 1972. Inflation and Unemployment. American Economic Review 62: 1–18.

Thomas I. Palley