Busting the natural rate of unemployment myth

1 Apr, 2023 at 17:15 | Posted in Economics | 2 Comments

Almost sixty years ago Milton Friedman wrote an (in)famous article arguing that (1) the natural rate of unemployment was independent of monetary policy and that (2) trying to keep the unemployment rate below the natural rate would only give rise to higher and higher inflation.

The hypothesis has always been controversial, and much theoretical and empirical work has questioned the real-world relevance of the idea that unemployment really is independent of monetary policy and that there is no long-run trade-off between inflation and unemployment.

My own view on the subject is that the natural rate hypothesis does not hold water simply because the relations it describes have never actually existed.

The only thing that amazes yours truly is that although this is pretty common knowledge,  so-called ‘New Keynesian’ macroeconomists still today use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why? Because without it ‘New Keynesians’ have to give up their (again and again empirically falsified) neoclassical view of the long-run neutrality of money and the simplistic idea of inflation as an excess-demand phenomenon.

The natural rate hypothesis approach (NRH) is not only of theoretical interest. Far from it.

The real damage done is that policymakers that take decisions based on NRH models systematically implement austerity measures and kill off economic expansion. The unnecessary and costly unemployment that this self-inflicted and flawed illusion eventuates, is something New Classical and ‘New Keynesian’ advocates should always be kept accountable for.

 74-7495-LTNQ100ZIf the [NRH] and rational expectations are both true simultaneously, a plot of decade averages of inflation against unemployment should reveal a vertical line at the natural rate of unemployment … This prediction fails dramatically.

There is no tendency for the points to lie around a vertical line and, if anything, the long-run Phillips is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically biased over decades, I conclude that the  [NRH] is false …

Roger Farmer

2 Comments

  1. As Professor William Vickrey at Columbia University once wrote in his famous paper Fifteen Deadly Fallacies of Financial Fundamentalism
    : A disquisition on Demand Side Economics
    in 1996 about NIARU:

    “The underlying assumption that there is an exogenous NIARU that entails an inevitable limitation of macroeconomic opportunity can be seriously questioned on both historical and analytical grounds.

    Historically, the United States had an unemployment rate of 1.8% for 1926 as a whole with the price level falling, if anything.
    West Germany enjoyed about 0.6% unemployment for several years around 1960, and most developed countries have had periods of unemployment below 2% without serious inflation.

    Thus, a NIARU, if it exists at all, must be considered highly variable over time and place. It is not clear that estimates of the NIARU have not been tainted by failure to take into account the possible impact of inflation on employment as well as the impact of unemployment on inflation.

    A Marxist interpretation of the insistence on a NIARU can be like a stalking horse to exploit the fear of inflation to justify maintaining a “reserve army of the unemployed”, allegedly to prevent wages from initiating a “wage-price spiral”.

    One never hears of a “rent-price spiral” or an “interest-price spiral”, although these costs must also be considered in pricing. In fact, when the FRB raises interest rates in an attempt to stave off inflation, the increase in interest costs for merchants may well trigger a small price increase…

    Analytically, it would be more rational to expect that there might be a maximum non-inflationary accelerating rate of unemployment reduction (NIARRU), so that if an attempt was made to move faster through a greater recovery of excess savings into purchasing power through government deficits , prices would begin to rise faster than had been widely expected.

    This would occur as a result of supply not keeping pace with increased demand, creating shortages and some of the increased demand being lost to faster rising prices. ”
    http://www.columbia.edu/dlc/wp/econ/vickrey.html

    Comment by Jan Milch— 9 Apr, 2023 #

  2. Isn’ the theory of NRU just an ideological method to motivate moving of the target of macroeconomic regulation away from full employment. Full employment policy makes it hard or even impossible to create income from capital that isn’t used in production of new use-value. And to force capital to compete by raising productivity will, at least under a policy of full employment, make kapitalism redundant by and by. The Swedish regulators seems to have reached a macroeconomic strongpoint against further development in that direction. http://www.fredtorssander.se/fredpress/2020/02/29/a-non-monetary-graphical-description-of-the-productivity-growth-in-sweden-1870-2017/

    Comment by fredtorssander— 2 Apr, 2023 #


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