|from the blog of Dean Baker, a pen-l alumnus:
October 09, 2006
Edmund Phelps and the Natural Rate of Unemployment
The awarding of the non-Nobel prize (this prize was created by the
Bank of Sweden in 1968, not Alfred Nobel) to Columbia University
Professor Edmund Phelps, in part for his work on the theory of the
natural rate of unemployment, provided the media with a good
opportunity to talk about the current status of the natural rate
theory. Unfortunately, they seem to have largely missed the
The great innovation that Phelps, along with Milton Friedman, brought
to the theory of the natural rate of unemployment is that workers
would develop expectations of inflation, so that they could not be
systematically fooled about the true value of the real wage. This
fooling process was important for at least some strains of Keynesian
economics at the time, because they held that inflation could be used
to reduce unemployment by fooling workers. According to this Keynesian
view, because workers fail to recognize inflation, they can
effectively be tricked into working for a lower real wage. This allows
us to get a lower rate of unemployment.
Phelps' contribution was to make the reasonable point, that if workers
are motivated by the real wage, then they will be smart enough to
figure out the impact of inflation on the value of the real wage.
Therefore, they could not be systematically fooled by inflation. The
effort to fool workers would require ever higher rates of inflation,
and would eventually lead to hyperinflation, if central banks tried to
keep the rate of unemployment below the natural rate.
This story can run into several potential problems. First, it is not
clear that workers' decision to work or not work is very sensitive to
small changes in the real wage (we're typically talking about changes
of around 1 percent or less). Keynes argued that workers were largely
concerned about relative wages (within certain bounds). The advantage
of moderate inflation in his view is that it allows for adjustments in
real wages without workers having to accept nominal pay cuts, which
would clearly lower their wages relative to other workers. If workers
don't have a rigid view of the real wage that they require, then
Phelps view about inflation necessarily accelerating once the
unemployment rate falls below a certain level, does not follow.
The second major flaw in the Phelps' view is that if workers'
productivity is itself a function of their recent employment (e.g.
unemployed workers pulled into the workforce by a strong economy
quickly develop new skills and become more productive workers), then
there would be no "natural" rate of unemployment. The lowest rate of
unemployment consistent with a stable inflation rate would itself be a
function of the actual unemployment rate.
[this is true for several reasons.]
The natural rate view took a real beating in the nineties. The
overwhelming consensus within the economics profession was that the
natural rate of unemployment was in the range of 5.8-6.4 percent. This
meant that if the unemployment rate fell below this range, the
inflation rate would increase. It turned out that the unemployment
rate fell below this range in the summer of 1995 and stayed below this
range until the recession hit in 2001. There was no increase in the
inflation rate through most of this period, and only a modest increase
in 2000, which was driven as much by rising energy prices as a tight
Proponents of the natural rate view, or more correctly the
"non-accelerating inflation rate of unemployment" (NAIRU) view, have
worked to rescue the theory with ideas about "time-varying" NAIRUs,
but if it is really possible for an economic theory to be disproved by
evidence, the nineties business cycle did the trick on the natural
rate theory. The mainstream within the economics profession has done
its best to sweep the recent history under the rug, and still claims
that there is a consensus within the economics profession on
But, they should not be allowed to get away with re-writing history.
If policy had been directed by the mainstream of the profession
(rather than an eclectic follower of Ayn Rand named Alan Greenspan),
we never would have seen the late nineties boom. They would have
raised interest rates in late 1995 and the unemployment rate never
would have been allowed to get below the NAIRU, and the economy never
would have been given the opportunity to disprove Mr. Phelps theory.