The natural rate of unemployment is a concept of economic activity developed in particular by Milton Friedman and Edmund Phelps in the 1960s, both recipients of the Nobel prize in economics. In both cases, the development of the concept is cited as a main motivation behind the prize. It represents the hypothetical unemployment rate consistent with aggregate production being at the "long-run" level. This level is consistent with aggregate production in the absence of various temporary frictions such as incomplete price adjustment in labor and goods markets. The natural rate of unemployment therefore corresponds to the unemployment rate prevailing under a classical view of determination of activity. It is mainly determined by the economy's supply side, and hence production possibilities and economic institutions. If these institutional features involve permanent mismatches in the labor market or real wage rigidities, the natural rate of unemployment may feature involuntary unemployment. The natural rate of unemployment is a combination of frictional and structural unemployment that persists in an efficient, expanding economy when labor and resource markets are in equilibrium.
Occurrence of disturbances (e.g., cyclical shifts in investment sentiments) will cause actual unemployment to continuously deviate from the natural rate, and be partly determined by aggregate demand factors as under a Keynesian view of output determination. The policy implication is that the natural rate of unemployment cannot permanently be reduced by demand management policies (including monetary policy), but that such policies can play a role in stabilizing variations in actual unemployment. Reductions in the natural rate of unemployment must, according to the concept, be achieved through structural policies directed towards an economy's supply side. According to multiple surveys, two-thirds to three-quarters of economists generally agree with the statement, "There is a natural rate of unemployment to which the economy tends in the long run."
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Development
A classic statement regarding the natural rate appeared in Milton Friedman's 1968 Presidential Address to the American Economic Association:
However, this remained a vision - Friedman never wrote down a model with all of these properties. When he illustrated the idea of the Natural Rate he simply used the standard text-book labor market demand and supply model that was essentially the same as Don Patinkin's model of full employment. In this there is a competitive labor market with both labor supply and demand depend on the real wage and the natural rate is simply the competitive equilibrium where demand equals supply. Implicit in his vision is the notion that the natural rate is Unique: there is only one level of output and employment that is consistent with equilibrium.
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Phillips curve
The development of the theory of the natural rate of unemployment came in the 1960s where economists observed that the Phillips-curve relationship between inflation and unemployment began to break down. Until then, it was widely believed that a stable negative relation between inflation and unemployment existed. This belief had the policy implication that unemployment could be permanently reduced by expansive demand policy and thus higher inflation.
Friedman and Phelps opposed this idea on theoretical grounds, as they noted that if unemployment were to be permanently lower, some real variable in the economy, like the real wage, would have changed permanently. That this should be the case because inflation was higher appeared to rely on systematic irrationality in the labor market. As Friedman remarked, wage inflation would eventually catch up and leave the real wage, and unemployment, unchanged. Hence, lower unemployment could only be attained as long as wage inflation and inflation expectations lagged behind actual inflation. This was seen to be only a temporary outcome. Eventually, unemployment would return to the rate determined by real factors independent of the inflation rate. According to Friedman and Phelps, the Phillips curve was therefore vertical in the long run, and expansive demand policies would only be a cause of inflation, not a cause of permanently lower unemployment.
Milton Friedman emphasized expectations errors as the main cause of deviation in unemployment from the natural rate. For Friedman, the notion that there was a unique Natural rate was equivalent to his assertion that there is only one level of unemployment at which inflation can be fully anticipated (when actual and expected inflation are the same). Edmund Phelps focused more in detail on the labor market structures and frictions that would cause aggregate demand changes to feed into inflation, and for sluggish expectations, into the determination of the unemployment rate. Also, his theories gave insights into the causes of a too high natural rate of unemployment (i.e., why unemployment could be structural or classical).
Criticisms
The natural rate hypothesis makes the fundamental assumption that there exists a unique equilibrium level of unemployment. Importantly, Milton Friedman himself never wrote down an explicit model of the natural rate (in his Nobel Lecture, he just uses the simple labor supply and demand model). Others have argued that there might be multiple equilibria: for example due to search externalities as in the Diamond coconut model or that there might exist a "natural range" of unemployment levels rather than a unique equilibrium.
According to Roger Farmer of UCLA, the assumption that, after a shock, the unemployment rate returns to its so called "natural rate' does not hold in the data.
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