Everything about The Natural Rate Of Unemployment totally explained
The
natural rate of unemployment is a concept of
economic activity developed in particular by
Milton Friedman and
Edmund Phelps in the 1960s. It represents the hypothetical
unemployment rate consistent with
aggregate production being at the "long-run" level. This is the level the economy reaches in the absence of various temporary frictions such as incomplete price adjustment in
labor and goods markets. The natural rate of unemployment therefore corresponds to the unemployment rate prevailing under a
classical view of determination of activity. It is mainly determined by the economy's supply side, and hence production possibilities and economic institutions. If these institutional features involve permanent mismatches in the labor market or real wage rigidities, the natural rate of unemployment may feature involuntary unemployment.
Occurrence of disturbances (for example, cyclical shifts in investment sentiments) will cause actual unemployment to continuously deviate from the natural rate, and be partly determined by aggregate demand factors as under a
Keynesian view of output determination. The policy implication is that the natural rate of unemployment can't permanently be reduced by demand management policies (including
monetary policy), but that such policies can play a role in stabilizing variations in actual unemployment.
Reductions in the natural rate of unemployment must, according to the concept, be achieved through structural policies directed towards an economy's supply side.
The natural rate of unemployment 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. Why 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, whereas 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 what could cause the natural rate of unemployment to be too high (for example, why unemployment could be
structural or
classical).
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