Busting the ‘natural rate of unemployment’ myth

Lars Syll

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 me 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 the ‘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 policy-makers who make decisions based on NRH models systematically implement austerity measures and kill off economic expansion. The costly and unnecessary unemployment that this self-inflict-ed and flawed illusion eventuates, is something that New Classical and ‘New Keynesian’ advocates should always be kept accountable for.

“If 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 any-thing, the long-run Phillips is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically bias-ed over decades, I conclude that the [NRH] is false …”
-Roger Farmer

Source:
Real World Econ Rev blogs, 27 Nov 2024
https://rwer.wordpress.com/2024/11/27/busting-the-natural-rate-of-unemploy-ment-myth-2/

Note: The following is a reference on the difference between the NAIRU (non-accelerating inflation rate of unemployment) and NR (natural rate of unemployment):
https://www.economicshelp.org/blog/glossary/the-difference-between-the-nairu-and-the-natural-rate-nr-of-unemployment