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Natural Rate of Unemployment Natural rate of unemployment was the most famous theory of Milton Friedman. It should be noted that it was developed with the goal of achieving zero unemployment, yet failed to do so. In the following essay I am going to speak about concept called natural rate as well as mention the Phillips curve as well as natural hypothesis together with my personal findings and opinion. Zero unemployment does not mean 100 percent employment.
For various reasons, the unemployment rate cannot be reduced to zero, if only because people are always being fired, laid off or moving between jobs. But even granting that unemployment can never be completely eliminated, it still might be possible to ensure that anyone searching for a job can find one reasonably quickly. Economists call this happy state of affairs "full employment. " Keynes thought that the zero unemployment could be achieved by expanding the money supply. Keynes himself knew of the possibility to overdo it and wrote about the central bank could expand the money supply right up to the point where full employment was reached; after that, any monetary expansion would result in inflation. The question everyone was interested in was how much to expand the money supply. Another famous British economist A.
W. Phillips in the late 1950 s had discovered a relationship between wages and unemployment in British historical statistics. When unemployment was high, wages had fallen; when unemployment was low, wages had risen. A look at American statistics revealed the same tradeoff.
Since wage changes are indicators of inflation, this discovery actually showed that a tradeoff existed between inflation and unemployment. Accepting more of one meant less of the other. When graphed, this tradeoff produced a nice, neat curve, which became known as the "Phillips Curve. " The Phillips amazing discovery helped policy-makers determine how much to expand the money supply. Previously, no one really knew what constituted "full employment. " Now they could make a judgment call. The curve showed them how far they could expand the economy without letting the cost of inflation outweigh the cost of unemployment.
This seemed to be 3 or 4 percent inflation in return for 4 percent unemployment. Please refer to the diagram below for illustration of the Phillips curve (taken from: web From the Phillips curve a conclusion can be made that over the next few decades, many public figures would call for the unemployment rate to be reduced to 4 percent; the 1978 Humphrey-Hawkins Act went so far as to put it into law. But economic events and advances in theory would overtake them. Yet only ten years after the invention of the Phillips curve, Milton Friedman challenged the whole concept of the Phillips Curve, and his efforts would secure him lasting fame and the 1976 Nobel Prize. His argument went something like this: Imagine an economy where the cost of everything doubles.
You have to pay twice as much for your groceries, but you don't mind, because your paycheck is also twice as large. Economists call this the neutrality of money. If inflation worked this way, then it would be harmless. Of course, inflation does have other negative consequences, but they are minor compared to the terrible costs of widespread unemployment. Hence the Keynesian policy of accepting high inflation in exchange for low unemployment.
Milton, Quantity Theory, 1968. The main argument Friedman presented was why is it that when the Fed expands the money supply by, say, 6 percent, all prices and wages everywhere do not go up by 6 percent as well? Why wouldn't the neutrality of money make this expansion meaningless? Friedman argued that it was because the public didn't know that they should raise their prices by 5 percent. That's because they were unaware of the expansion, or what it meant, or how large it was if they did.
When the extra money was pumped into the economy, therefore, it was unwittingly translated into more economic activity, not higher prices. From the economic point of view if businessmen knew that a 6 percent increase was coming, it would be in their best interest just to raise their prices 6 percent. That way, they would make the same increased profits without having to work for them. Or, seen another way, if businessmen knew that inflation was going to be 6 percent every year, they would simply build those expectations into their normal price increases. But if everyone did this, then the Fed's monetary increases would become meaningless -- instead of resulting in more jobs, they would just create higher inflation. In other words, the neutrality of money would take over.
To maintain the job creation effect, the Fed would have to surprise businessmen with a 10 percent increase the next year. But businessmen would eventually come to expect that as well -- requiring a 15 percent increase the next year, and so on, all the way to hyperinflation. The father of monetarism, Milton Friedman argued that as businessmen became wiser to the Fed's actions, the Fed would no longer have a tool to fight unemployment. And without this tool, unemployment would eventually start climbing as well, along with inflation. Milton Friedman also commented on the impossibility of the monetary policy use to achieve full employment. Unfortunately, inflation starts accelerating before full employment is reached.
The best a nation can do is to settle for the lowest level of unemployment that will not begin accelerating inflation. Friedman called this point the "natural rate of unemployment, ." No one still knows for certain what the natural rate is, because it depends partly on what markets expect inflation will be. But in the Great Britain today, economists estimate it to be slightly less than 6 percent (Maxam, 2002). The natural rate of unemployment is also called "NAIRU, " which stands for Non-Accelerating Inflation Rate of Unemployment.
This is said to have been developed after the Friedman's proof that zero unemployment is unrealistic. The Friedman's inventions regarding the natural rate of unemployment does not mean that Keynesianism is still not a useful tool for smoothing out the business cycle. Six percent is merely an average; in reality, unemployment can deviate substantially from 6 percent. Keynesian policies are therefore useful for stabilizing unemployment at this figure. It should also be noted that the natural rate of unemployment is not without controversy. Although most top-level economists -- on both the left and the right -- accept its validity, there are many economists who believe the NAIRU doesn't even exist.
A few important dissidents include John Kenneth Galbraith and Robert Eisner, both past Presidents of the American Economics Association. A much more widespread controversy, though, is where to peg the natural rate. Nearly all economists agree that it is not a fixed figure, but that it can float. Galbraith, tongue firmly in cheek, writes: "That 5. 5 to 6 percent consensus is easily explained: it's where the actual unemployment rate is. And that is usually been true: the estimated NAIRU tracks actual unemployment.
When unemployment goes up, conservative economists raise their NAIRU. When it falls, they predict inflation, and if inflation doesn't happen they cut their estimated NAIRU. There is a long and not-very-reputable literature of such estimates -- you can look it up. In fact, this little corner of the professional record is embarrassing. " () Apparently one would not doubt that the concept of unemployment also bears political connotations well: conservatives like a high NAIRU, liberals, a low one. Furthermore, when the unemployment rate is high, wages tend to fall, in accordance with the laws of supply and demand on the labor market. Exploiting labor, as they say, is profitable business.
The current Fed chairman, Alan Greenspan, is a died-in-the-wool conservative and a self-described "inflation hawk, " meaning that he is committed to a high NAIRU. Conversely, liberals prefer a low NAIRU because it raises workers' wages. In order to make this conclusion work, several assumptions must be made. The most prominent is that information is generally known.
If the government conducts an acceleration ist monetary policy in complete secrecy, agents might not know it was systematic and supply more labor. However, as the New Classicals argued, secrecy is never really complete and the workers will soon enough wise up to the fact that the acceleration is systematic. In other words, by perceiving the inflation patterns, etc. , they will gradually realize that the government is conducting a systematic acceleration policy, in which case they will incorporate this information and change their expectations accordingly -- and thus foil the government's policy again. The other necessary assumption is no systematic error. Why should not agents be stupid and irrational and just assume that this year's freakish drought implies a drought next year?
The New Classicals admit, indeed, that people can be quite stupid: any particular agent can easily make strange extrapolations and systematic errors. However, they argue that it cannot be that all people make the same systematic error. As we are working with "aggregates", each worker may be make systematic errors and have idiosyncratic errors, but by an intuitive appeal to the law of large numbers, these idiosyncratic errors are washed out in the aggregate. In other words, one agent's peculiar stupidity cancels out another agent's stupidity so that, on average, the "representative agent", the "aggregate", is in fact quite smart - by which we mean, that, on average, workers does not make systematic errors. In conclusion it should be said that when Milton Friedman discovered the natural rate of unemployment, the prestige of the Chicago School of Economics rose and it turned into a leading advocate of unfettered capitalism. But in the end he did not accomplish what he had set out to do: replace Keynesianism.
The proposed theory was not complicated: during the time when unemployment fell below some level (called the natural rate of unemployment), inflation would start to rise. This theory, called the Phillips Curve, has filled economic textbooks for more than 25 years. Unemployment, however, has fallen since the 1990 s with no sign as yet of an increase in inflation. When unemployment first started to fall, with no pickup in inflation some economists talked of a shift in the natural rate of unemployment. As this trend has continued, some are questioning whether the world needs another theory regarding the unemployment.
Traditionally, the inverse correlation between unemployment and inflation seemed to be a useful tool for economists. For example, when the unemployment rate fell to 5. 3 percent in 1989, economists predicted that inflation would increase. Inflation, which had averaged 2. 4 percent between 1984 - 87, did jump to 4. 1 percent in 1990. Tighter monetary policy, oil price shocks and the Gulf War raised unemployment to 7. 6 percent in June 1992 and, in accordance with the theory, inflation fell. The Phillips Curve theory was not sufficiently precise to enable economists to accurately forecast the response in either unemployment or inflation. Part of the imprecision involved uncertainty about the level of the natural rate of unemployment.
Commenting on the historical unemployment rates, I would like to note that when during the 1990 - 92 recession proceeded, unemployment started to fall - to 6. 1 percent in 1994 and to 4. 2 percent by 1999 and so did inflation. While economists held different opinions as to the level of the natural rate of unemployment, virtually no one believed it was 4. 2 percent. No one knew what was happening to the great trade offs. Some economists felt special circumstances, i. e. , a decline in health care costs, the widespread use of computers; etc. had temporarily suspended the unemployment / inflation tradeoff.
Others felt that the natural rate had in fact declined due to productivity growth and a better matching of jobs and vacancies. Even today various economists believe that the relationship between unemployment and inflation is far more complex than first believed. Evidence suggests that the tradeoff has not worked well outside the United States and even in the United States the relationship was neither very strong nor predictable. It is clear that the economics profession needs to develop a more sophisticated theory to explain inflation. "A lasting favorable effect on employment might be produced if the State undertook - and succeeded in its undertaking - not merely to make the real demand for labour higher than it would otherwise have been, but to make it progressively higher. The expenditure on public works, the rate of bounty paid to private enterprises, the rates of duties in the protective tariff, or whatever it may be, would have to be raised again and again.
If these devices succeeded in expanding progressively the real demand for labor, the time lag that intervenes between the stimulus to and the enforcement of claims to higher wages would enable them to make employment permanently larger than it would otherwise have been. " (Arthur Cecil Pigou, Theory of Unemployment, 1933: p. 250 - 1). Yet in my personal opinion, both Milton and Keynes theories, together with the findings of Phillips should be deployed to work in tandem to the benefit of a given country, while attempting to kill two birds with one stone: tame the inflation and reduce the unemployment, to the rate close to NAIRU. The developing countries indeed present a wonderful research field for the fact that their governments constantly are striving to influence their economies with the tools originally developed by Milton and Keynes. Bibliography: Milton Friedman, Quantity Theory, 1968 Phillips, The Phillips curve, 1958. Samuelson, Economics, Prentice Hall, reprinted edition, 2001.
Maxam, Economics of today, Prentice Hall, 2002. web (prepaid archive on economic thought) Don Patinkin, "Some Observations on the Inflationary Process", in Flanders and Rating, editors, Developments in an Inflationary World, 1981: p. 31 Arthur Cecil Pigou, Theory of Unemployment, 1933: p. 250 - 1
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Research essay sample on Natural Rate Of Unemployment
