New classical economists predictably disagree with Keynesian interpretations of recent history. Natural rate theory, a strand of new classical economics, rejects the idea that macroeconomic policy ultimately affects any "real" variable. Thus, these theorists perceive no permanent connection between unemployment and inflation. They reason that money is a veil in the long run and that nominal things, such as the absolute price level, are determined by the money supply but will be unrelated to any aspect of real behavior, such as unemployment or relative prices. Natural rate theory concludes that any negatively-sloped Phillips curve is transitory, and that Aggregate Supply will shift persistently only because of changing inflationary expectations.

 

The Natural Rate of Unemployment

 

            Is zero unemployment a worthy goal? "Yes, of course" seems an easy answer. But keeping the unemployment rate at zero would require people dissatisfied with their jobs to stick with them until they found new ones---or they would be unemployed. Moreover, firms would be pressured to immediately hire anyone who applied for work. And if you were not in the labor force and then decided to look for work, you would be forced to take the first job offered---otherwise you would be unemployed. Zero unemployment is not as attractive a goal as it sounds.

 

            Natural rate analysis concludes that nearly all unemployment is voluntary, the sole exceptions being unskilled people who are unemployed because minimum-wage laws prevent employers from hiring these workers at the low wages commensurate with their productivity. Natural rate theorists view all other unemployment as the result of friction---it takes people time to find what they regard as suitable employment, and while they are looking for work, they are unemployed by choice. Individuals can presumably get jobs almost instantly if they are willing to take the wage they are worth to the first employer willing to hire them. Frictional unemployment can be viewed as a cost of investment in labor market information and mobility. Table 1 presents estimates of the natural rate of frictional unemployment for several developed economies.

 

Table 1  Unemployment (Frictional) Rates Required to Keep Inflation Stable (%)
	1971--1975	1981--1983
United States	6.0	6.5
Japan	1.0	2.0
West Germany	1.5	8.0
France	3.5	8.0
Britain	4.0	9.0
Italy	7.0	6,5
Canada	7.0	7.5
Holland	4.0	10.5
The rate of unemployment required to keep inflation in check moved up sharply throughout much of the industrialized world after 1970. Whether this reflected higher inflationary expectations or structural changes that boosted frictional unemployment is debatable.   Sources: OECD, Layard and Nickell, 1984, from The Economist, 14 May 1988, p. 69. Reprinted by permission.

 

            According to natural rate theory, expansionary macroeconomic policy reduces frictional unemployment only because workers are fooled by unanticipated inflation into thinking that the higher wages offered by firms represent real increases in the purchasing power of their earnings. Anyone who is unemployed can get a seemingly "suitable" high-paying job quickly during expansionary periods, when the pool of frictionally unemployed workers is small. In the natural rate view, these artificial declines in frictional unemployment reflect cyclical overemployment that is a consequence of inadequate investment in labor market information. But why do employers offer higher wages when expansionary policies are followed? Expansionary policies cause business firms to forecast booming sales that will enable them to raise the prices of their products. After workers recognize that their wages do not buy as much as expected because prices are also rising, many will become dissatisfied and quit to look for more lucrative work.

 

            The eventual result is that frictional unemployment will rise back to its "natural rate" when workers cease being fooled. The natural rate of unemployment is the rate that exists before expansionary policy is initiated; it is achieved when all transactors have accurate expectations about inflation. If expansionary policies are continued, workers will learn to expect inflation and will demand wages that rise continuously to compensate for inflation. This means that Aggregate Supply will shrink continuously. 

Wage Adjustments to Inflation

 

            A starting point for the natural rate explanation for Phillips curves is to assume a macroeconomic equilibrium with no inflation, as at points a in both panels in Figure 6. The price index is 100 (point ain Panel A), and the unemployment rate is consistent with potential real output (point a in Panel B). Inflation is initially zero, and the natural rate of unemployment, Un, is between 5 and 7 percent. The shaded parts of Figure 6 represent output and unemployment below and above the natural rate respectively.

 

Figure 6  Equilibrium Output and the Rate of Inflation (Natural Rate Approach)

"Natural rate" theory suggests that attempts to maintain unemployment below its normal, frictional rate require continuous expansions of Aggregate Demand, raising the possibility of accelerating inflation.

            Now assume that overly expansionary monetary policy drives Aggregate Demand up to AD1. Real output will rise to Q1 (point b), but the adjustment process entails 6 percent inflation, and the price level rises from 100 to 106. We suggested earlier that this equilibrium cannot be sustained for long. Workers will find their real wages falling, triggering attempts to catch up. As they do so, the Aggregate Supply curve shrinks to AS1 and the economy moves toward point c in Panel A. If policymakers try to maintain output at Q1 and unemployment at U1 by shifting Aggregate Demand to AD2, another inflationary round equal to roughly 6 percent is unleashed as the economy moves to equilibrium at point d in Panel A. The equilibrium path for the economy is denoted by the arrow: Policymakers must continually create 6 percent inflation to maintain unemployment at U1.

 

            Our model to this point naïvely supposes that workers always expect inflation to be zero, only seeking wage adjustments after the price level has risen. Policymakers are confronted with additional problems if workers begin to anticipate inflation.

 

The Long-Run Phillips Curve

 

Natural rate theory suggests that Phillips curves do not present policymakers with stable frontiers along which inflation can be "traded off " against unemployment.

Natural rate theory that each Phillips curve is associated with a particular rate of expected inflation. If workers foresee higher rates of inflation, the Phillips curve worsens by shifting outward.

            Panel A of Figure 7 illustrates how this occurs. Suppose that the economy is at point a initially; there is frictional unemployment equal to Un, with zero inflation and zero inflation expected; E(p)  indicates the inflation rate that workers expect. What happens if policymakers view unemployment of Un as unacceptably high and follow expansionary policies? Growth of Aggregate Demand yields increased sales, so firms offer higher wages to attract new workers to accommodate the higher demands for their products. Workers who are frictionally unemployed will have little difficulty finding what they perceive as good, high-paying jobs. Thus, expansionary policies push the economy along the Phillips curve from point a toward point b.

Figure 7  Natural Rate Theory and the Shifting Phillips Curve Natural rate theory suggests that unemployment will be less than the natural rate (Un) only if workers expect less inflation than occurs and that it will be more than the natural rate if workers expect more inflation than results from macroeconomic policy. In the long run, workers will adjust perfectly to any changes in price levels so that normal, frictional unemployment will be maintained, which is totally independent of the price level or inflation. Notice that the Phillips curve improved substantially from 1982 into the 1990s, perhaps as a consequence of a substantial decline in expected inflation.

Source: Economic Report of the President, 1994.

 

            The fly in this ointment is that higher demands for goods are seen as opportunities to raise prices. As workers learn to expect 5 percent price hikes, the Phillips curve shifts rightward and the economy moves to point c at the old natural rate of unemployment Un. This occurs because workers will demand wage increases of 10 percent---5 percent to cover past inflation plus 5 percent for expected inflation. But firms forecast only 5 percent growth in nominal demands for their outputs and will refuse to meet workers' demands for 10 percent wage hikes. Frictional unemployment rises as workers hit the pavement looking for better jobs.

 

            If policymakers again view unemployment (Un) as unacceptably high, they might follow even more expansionary policies. If so, the economy initially will move from point c to d, but then ultimately to e as workers again cease being fooled. All that policymakers will have achieved is 10 percent inflation with no long-term reduction in unemployment. If policymakers were undaunted by their failures, they might even proceed to f.

            If they had learned their lesson, however, they would find moving directly and quickly back from e to aalmost impossible. The buildup of inflationary momentum may force policymakers to engineer a recession to point g to dampen inflationary expectations. An extended recession may be required before the economy will return to point a. Similar adjustments may explain why a severe recession occurred in 1981--1983 when deflationary monetary policies brought inflation under control. Panel B of Figure 7 shows data for 1960--1990, suggesting that natural rate theory explains the experience of recent decades reasonably well.

            Pure natural rate theorists view rising expectations of inflation as the only explanation for any worsening of any short-term relationship between inflation and unemployment. There is a family of short-run Phillips curves; each depends on different expectations of inflation by labor. Unemployment will gravitate back to its natural rate in the long run. Thus, no long-run trade-off exists between inflation and unemployment. In Figure 7, the long-run Phillips "curve" is the vertical path ace. According to natural rate theory, if policymakers try to hold unemployment below the natural rate, the short-run Phillips curve trade-off worsens. Accelerating bouts of inflation (up the vertical arrow in Panel A) are inevitable until policymakers accept the futility of trying to hold unemployment below its natural rate.