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The Natural Rate of Unemployment and Monetarist View of Inflationary Spirals
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Del curso dictado por University of California, Irvine
Strategic Business Management - Macroeconomics
18 calificaciones
De la lección
Inflation and the Warring Schools of Macroeconomics
Conoce a los instructores
Dr. Peter NavarroProfessor
Paul Merage School of Business
In our last module,
we introduced the Phillips curve which depicts
the possible inverse relationship between the rates of inflation and unemployment.
However, we also learned that this Phillips curve relationship and trade-off between
inflation and unemployment may break down during certain periods of time,
thereby calling into question the ability Keynesian,
fiscal and monetary policies always succeed in stimulating growth.
Our goal in this module is to solve
the mystery as to why the Phillips curve relationship,
might indeed break down at times.
And to find clues to solve this mystery,
we're going to begin with an analysis of
the modified Phillips curve theory of the monetarist school of economics.
This monetarist school of macroeconomics,
which grew out of the work of Nobel Prize winning
economist Edmund Phelps and Milton Friedman during the last century would emerge
to offer a strong challenge to the Keynesian orthodoxy at
a critical time when the world was grappling with a severe inflationary spiral.
And to be very clear here,
despite the name of the monetarist school,
its advocates do not support the use of the kinds
discretionary monetary policies advocated by Keynesians.
Instead, the monetarist prefer
a much more hands-off and free market approach to the economy that
focuses most simply on the growth of the money supply itself.
The modified Phillips curve theory of
the monetarist school asserts the existence of a so-called natural rate of unemployment.
In this key definition,
the natural rate of unemployment is the lowest rate of
unemployment an economy can sustain without increasing inflation.
Let me repeat that because this is indeed a key definition.
The natural rate of unemployment,
also called the non-accelerating inflation rate of unemployment or NARU,
represents the lowest sustainable rate of unemployment
an economy can sustain without causing inflation.
So, what do you think this monetarist assertion,
that a natural rate of unemployment exists,
implies about the slope and shape of
the long run Phillips curve relationship between output and the unemployment rate.
Think about this and try to draw the long run Phillips curve.
When you're ready, let's move on.
So, if the monetarists
are right and you cannot drive unemployment below its natural rate,
the long run Phillips curve must be vertical.
Just why is this important?
Simply because this idea helps us better understand how
well-intentioned Keynesian stimulus policies can
sometimes inadvertently trigger an inflationary spiral.
Here's the argument in its full monetarist exposition.
From a monetarist perspective,
any nation can use expansionary fiscal and monetary policy to stimulate
more growth and temporarily drive unemployment below the natural rate.
However, such a Keynesian joy ride along the short run Phillips curve
must inevitably come at the price of rising inflation.
Even more to the point,
if a nation repeatedly uses
Keynesian policies to try and keep unemployment below the natural rate,
only result over the longer run would be a deadly upward spiral of wages and prices,
precisely like the ones we have periodically witnessed since
Keynes walked onto the world stage in the 1930s.
So, how exactly might such an inflationary spiral happen?
Perhaps the best historical example is offered up by
the experience of the United States during the 1960s and 1970s.
In order to understand this example,
we first have to understand this very key point about the natural rate of unemployment,
with the natural rate of unemployment is not a constant immutable rate, it never changes.
Rather, the natural rate must be constantly
shifting as the structure of the underlying economy changes.
We repeat this key point,
it is essential to the monetarist argument.
The natural rate of unemployment is not a constant immutable rate.
It may change over time as the structure of the underlying economy changes.
For example, if an economy benefits from
a tremendous positive productivity shock to its aggregate supply curve,
that may increase the economy's potential GDP output,
thereby lower the natural rate of unemployment.
Contrast, if an economy suffers from
a negative supply side shock like a permanent rising energy prices,
that may increase the natural rate of unemployment,
making it more difficult for the economy to grow at
its historical norms without causing inflation.
To see how an upward shift in
a natural rate of unemployment can contribute to an inflationary spiral,
consider the prosperous decade of the 1960's in the United States.
During this period, the natural rate of unemployment was somewhere
in the four percent to five percent range.
So, if the economy simply stayed in this range of unemployment,
there would be no inflationary pressures to worry about.
In the 1970's however,
the natural rate of unemployment climbed into the five percent to six percent range.
Reason? Negative supply side shocks in
the form of energy price hikes due to turmoil in the oil markets,
and food price hikes due to worldwide droughts,
raise the real cost of production in the U.S. economy.
These supply side shocks in turn,
lower the economy's full unemployment output potential to below what it had been,
and thereby, raised the natural rate of unemployment.
And here's the key point,
if policymakers fail to recognize it.
When natural rate of unemployment has risen,
and they try to drive the unemployment rate down to its old level,
the result will not be more growth,
but simply an inflationary spiral.
This was precisely the mistake of American policy makers in the 1970's.
This figure illustrates, from a monetarist perspective of the Phillips curve,
how inflation can indeed begin to spiral out of control.
Macroeconomic policy makers attempt to
expand the economy below its natural rate of unemployment.
In the figure, we started point a_1,
where the core rate of inflation is three percent,
natural rate of unemployment is six percent,
is indicated by the vertical curve.
Note however, that from a political perspective,
this six percent rate of unemployment is seen as
unacceptably too high by the congress and Keynesian president who,
in an earlier decade,
may have become accustomed to a four percent unemployment rate without inflation.
So, what do you think these policymakers and politicians are going to do?
A minute now to jot down some thoughts before moving on.
Well, if government policymakers
and politicians mistakenly believe the natural rate of unemployment is four percent,
and with their voters growing restive over an apparent recession,
they're going to engage in expansionary fiscal policy
to reduce the unemployment rate to four percent.
This is where the idea of adaptive expectations comes back in.
In particular, cause people are assuming inflation will remain at three percent,
they do not immediately demand higher wages
even as inflation rises above the core rate to six percent.
This lag in wage demands allows
the economy to move up the short run Phillips curve to point b_1,
and the unemployment rate does indeed fall to four percent.
Note however, once people finally figure out the inflation has risen,
and successfully we demand higher wages to offset this rise in inflation,
the short run is over.
At this time, the rise in nominal wages brought about by
successful wage demands shifts the short run Phillips curve,
PC_1 out to PC_2.
And, we are back to where we started,
at an unemployment rate of six percent.
But of course, now we have a higher inflation rate.
Now, frustrated again by the apparent recession,
the politicians once again try to drive the unemployment rate back down to four percent,
well below the natural rate.
This works again in the short run,
as the economy moves back to point b_2,
but the Keynesians, you are right again, doesn't last.
With inflation now at nine percent,
people's adaptive expectations eventually change,
and get another shift,
and the short run Phillips curve to PC_3.
So, we are back to in natural unemployment rate, six percent,
with even more inflation,
caught in a vicious deflationary spiral.
And that's the monetarist argument for not
engaging in discretionary fiscal monetary policies.
Note however, that this is also a Keynesian argument for using
discretionary fiscal and monetary policies to stimulate
an economy so long as policymakers don't try to push growth too far,
push the real unemployment rate below the natural rate.
So, you can see how this Keynesian versus monetarist debate goes.
The important thing to understand from a business and
investing point of view is this, it's critical.
Always be able to distinguish between demand pull and across push inflation,
as well as between stimulus policies,
that are likely to actually stimulate growth,
and those which may primarily cause inflationary pressures to rise.
As for how governments may seek to stop inflationary spirals,
that's the topic of our next module.
So when you're ready, let's move on.
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