MacroeconomicsI_working_version (1)

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Chapter 10
10.2. Natural Rate of Unemployment
The theoretical works by Edmund Phelps and Milton Friedman, based on numerous
econometric studies, suggest distinguishing strictly between the long-run Phillips curve
and the short-run Phillips curve. According to that approach the downward sloping
Phillips curve depicted in Figure 10.1 is valid only in the short run. There is only one
unemployment rate that is consistent with steady inflation in the long run - natural rate of
unemployment. This natural rate theory concludes that the long-run Phillips curve is
vertical.
We must properly define the term of natural rate of unemployment to understand this
natural rate theory. Samuelson and Nordhaus [11] define the natural rate of
unemployment as a rate at which upward and downward forces on price and wage
inflation are in balance. At the natural rate, inflation is stable, with no tendency to
show either accelerating or declining inflation. In an economy concerned with
preventing high inflation rates, the natural rate of unemployment is the lowest level
that can be sustained; it thus represents the highest sustainable level of employment
and corresponds to a nation’s potential output.
Samuelson and Nordhaus [11] explain further the theory in the following way: At any point
in time, the economy has inherited a given inertial or expected rate of inflation. If (a) there
is no excess demand and if (b) there are no supply shocks, then actual inflation will
continue at the inertial rate. What do these conditions signify? Condition (a) means that
unemployment is at that level – the natural rate of unemployment – at which the upward
pressure on wages from vacancies just matches the downward wage pressure from
unemployment. Condition (b) denotes the absence of unusual changes in the costs of
materials like oil and imports, so that the aggregate supply curve is rising at the inertial rate
of inflation. Putting conditions (a) and (b) together leads to a state in which inflation can
continue to rise at its inertial or expected rate.
What would happen if there were either demand or cost shocks? At very low
unemployment inflation will be pushed above its inertial rate as we move along the shortrun
Phillips curve. By contrast, if unemployment rises to levels far in excess of the natural
rate, inflation will decline below its inertial rate as we move down the short-run Phillips
curve.
But the story does not end here. Once actual inflation rises above its inertial or
expected level, people begin to adjust to the new level of inflation and to expect higher
inflation. The inertial rate of inflation then adjusts to the new reality. And the shortrun
Phillips curve shifts.
Thus brief narrative makes a crucial point about inflation: the trade-off between inflation
and unemployment remains stable only as long as the inertial or expected inflation remains
unchanged. But when the inertial inflation rate changes, the short-run Phillips curve will
shift.