Natural Rate Theory

Terminology

NAIRU: Non-Accelerating Inflation Rate of Unemployment¹

NRT: Natural Rate theory

To understand the NRT we will be using the Phillips Curve

Example

Natural rate of employment is exogenous The first part of the story, short run: How the phillips curve is downward sloping

• Unemployment was at 6%, and inflation was 0%
• To reduce unemployment, we increased money supply
• Reduced to 4%
• But in the long run inflation increases by 2% Our aim is not price stability, its reducing unemployment, so our goal is achieved in the short run.

The second part of the story, long run:

• the real wage goes down $W/G\downarrow$
• so they cut down employment $U\uparrow$
• So, the net result is that

$M^S$	$U$		$\Pi$
	SR	LR
3	4	6	0
5	4	6	2
7	4	6	4
9	4	6	6
11	4	6	8

We note that as Unemployment reduces in the short run, it goes back to the initial value in the long run, but at the cost of increase of inflation, that doesn’t roll back even in the long run.

So, a Phillips curve in the long run is Vertical.

Natural Rate Theory of Unemployment

This theory, developed by Milton Friedman, where he analyzed / looked at the relationships among output, employment and inflation. The NRT states that there exists an equilibrium level of output $Y$ and an accompanying rate of unemployment $U$ by the real-side factors

• Changes in aggregate demand due to changes in money supply causes the temporary movement of the economy away from the natural way. But in the long run, the unemployment goes back to the natural level.
• Thus, in the short run the monetary policy is effective, where as in the long run it is not effective.
• We will be using the Phillips curve to understand this phenomena. The Phillip’s curve shows the negative relationship between unemployment rate $U$ and inflation $\Pi$

Short run

• Suppose the economy has a natural unemployment rate $U$ of $6\%$ and correspondingly inflation of $0$.

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• If the monetary authorities want to bring down the unemployment rate and as a result increase the money supply from $3\%$ to $5\%$.
• Due to this, the economy moves from point $A$ to point $B$. Thereby, reducing the unemployment $U=6\%\to 4\%$ but at a higher inflation rate of $\Pi =0\%\to 2\%$.
• Thus, in the short run, the monetary authorities are able to reduce the unemployment rate from its natural level. So, in the short run, the phillips curve is downward sloping.

Long run

• In the long run, the original equilibrium rate is $U=6\%$ of unemployment and $P_0=0$
• As we discussed in the short run, increasing money supply from $M^S=3\%\to 5\%$ will reduce the unemployment rate from $U=6\%\to 4\%$ (i.e. from $A\to B$) and at an inflation of $\Pi =2\%$. But in the long run, as the labour suppliers^[Households] come to anticipate higher inflation, the unemployment rate returns to the natural rate because the households contribute less employment due to fall in the real wage.
• Thus, in the short run, the economy moved from $A\to B$, but in the long run the economy moved from $B\to C$. At, point $C$, the unemployment rate $U=6\%$ but at a higher rate of inflation $\Pi =2\%$
• Suppose the money supply further increases to $5\%\to 7\%\to 9\%\to 11\%$ resulting in temperory reduction in the unemployment rates from $6\%\to 4\%$ i.e., point $C\to D$, $E\to F$, $G\to H$ but in the longer run, we simply move up in the vertical Phillip’s curve i.e., $A\to C$, $C\to E$, $E\to G$, $G\to I$.
• Thus, in the long run the Phillip’s curve is vertical

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Policy Inference

The policy makers want to reduce the unemployment rates, so it keeps on increasing the money supply, $M^S$. But the economy ends up at a higher inflation $\Pi =8\%$ with same $6\%$ of unemployment.

Policy Implication

The policy makers cannot peg the unemployment rate at some arbitrarily determined target rate. Attempts to lower the unemployment rate by the monetary authorities will work out only in the short run.

Footnotes

1. Unemployment rate is always considered out of 1000 ↩