The Natural Rate Concept

In the 1960s, economists Milton Friedman and Edmund Phelps independently developed theconcept of a "natural rate" of unemployment or "full employment" rate of unemployment or NAIRU(non-accelerating inflation rate of unemployment.) (1) They posited that there was an equilibrium, market-clearing rateof unemployment determined by labor market characteristics, policy, and conditions. Although expansionary fiscal or monetary policy may be able to temporarily pushunemployment below the natural rate in exchange for higher inflation, eventually actualunemployment would rise back to the natural rate without inflation falling. This concept isconsistent with the view that monetary policy has no long-run effect on real variables such aseconomic growth or unemployment, and affects only prices in the long run. A Changing Natural Rate? The natural rate is determined by labor market conditions;economists reason that since labor market conditions change over time, so could the naturalrate. (4) If this were thecase, the unemployment rate would always return to the natural rate, as the original theory suggests,but at any given point in time, unemployment would be reverting to a unique natural rate. Actual Unemployment and CBO's Estimate of the Natural Rate,1950-2002
Source: Congressional Budget Office

	Potential Causes of a Falling Natural Rate in the 1990s

From the mainstream perspective, the 1970s and 1980s were a period of a rising natural rate,and the 1990s were a period of a falling natural rate. Labor Market Policy Changes Some policymakers point to changes in labor market policy in the1990s as a potential cause of the decline in the NAIRU. (17) 

		Back to the Future? Onepossible reason why is that the natural rate was rising during this time. Part of the "rational expectations" movement in the economics professionin the 1970s, this conclusion is reached by assuming that individuals are always rational and wellinformed, so that changes in the money supply instantly lead to changes in the inflation rate. The qualifiers include (1) because of business cycle fluctuations, actual unemployment willrarely if ever equal the natural rate; (2) the natural rate can change unpredictably over time; and (3)the relationship between the natural rate and inflation will not hold when other factors that alsoinfluence inflation are present. Thisis problematic for policymakers: it implies that at any given point, they cannot distinguish whethera movement in unemployment is caused by the business cycle (and should be counteracted withstabilization policy) or by a change in the natural rate (and should not be counteracted with policy). (33) Forexample, in the first quarter of 1994, they estimate a NAIRU of 5.9% using the consumer price index(CPI), with a 95% confidence interval of 3.9% to 7.6%. Despite its shortcomings, the natural rate of unemployment is arguably a concept so deeplyingrained in economic policymaking that it would be difficult to imagine how to formulatepolicymaking without it. (37) Rather than target the (unknown) natural rate of unemployment,policymakers can target sustainable economic growth, using an estimate of the natural rate as onevariable to help determine sustainability. Evenif the natural rate is relegated to one of many indicators of a fully employed economy, without theconcept of the economy moving above or below full employment, it does not seem clear howdecisions to change macroeconomic stabilization policy could be made.
A concept that is fundamental to understanding the economy is that there is an equilibrium,market-clearing rate of unemployment determined by labor market characteristics, policy, andconditions. This rate of unemployment is referred to as the "natural rate" or "full employment rate"of unemployment or the NAIRU (non-accelerating inflation rate of unemployment). Althoughexpansionary fiscal or monetary policy might be able to temporarily push unemployment below thenatural rate in exchange for higher inflation, eventually actual unemployment would rise back to thenatural rate without inflation falling. This concept is consistent with the view that monetary policyhas no long-run effect on real variables such as economic growth or unemployment, and affects onlyprices in the long run. If unemployment did not return to a natural rate, it would imply that monetarypolicy could permanently affect unemployment.
There are periods of U.S. history when a constant natural rate concept cannot explain thebehavior of unemployment and inflation. For example, in the 1970s, inflation rose althoughunemployment was above estimates of the natural rate, and in the 1990s, inflation fell althoughunemployment was below estimates of the natural rate. A more sophisticated theory is needed toexplain these periods. Since the natural rate is determined by the characteristics of the labor market,it is possible that changes in the labor market lead to changes in the natural rate over time. Forexample, an aging workforce, unexpectedly rapid productivity growth, policy changes, and a growingtemporary workforce are some of the factors that could have led to a decline in the natural rate in the1990s. In this view, at any given moment, there is some natural rate of unemployment, below(above) which inflation will rise (fall), but that rate may be different from the natural rate in the pastor future because of labor market changes. It is estimated that the natural rate rose during the 1970sand 1980s, and fell back to earlier levels in the 1990s.
Although there is no theoretical drawback to the concept of a changing natural rate,economists have been unsuccessful in empirically predicting when changes would take place. Thisleaves the theory open to the criticism that, rather than offering a meaningful explanation of theempirical record, it does little more than offer post hoc rationalization for contradictory results. Anynatural rate estimate must be accompanied by a wide range of uncertainty -- some research suggestsa natural rate of 5.9%, with a 95% confidence interval of 3.9% to 7.6%. Yet alternative theories tothe natural rate have done a little better at explaining or predicting economic outcomes. Theunpredictability of a changing natural rate suggests that excessive weight should not be placed onthe gap between actual unemployment and natural rate estimates in fiscal and monetary policydecisions. The natural rate is probably most useful to policymakers as one of many economicindicators that can predict changes in inflation or the business cycle. Although changes in the naturalrate have not been successfully predicted, it would be difficult to make systematic policy decisionswithout some notion of full employment.