The Natural Rate of Unemployment
The Phillips curve had become a central piece of Keynesian macroeconomics; however, it took no time before it was attacked, with far-reaching consequences. Two economists, the veteran critic of Keynesian policy, Milton Friedman, and a younger economist, Edmund Phelps, were at the heart of the offensive.
Although Phelps’s two papers (1967, 1968) provided the most subtle and theoretically innovative argumentation, Friedman’s Presidential Address to the American Economic Association in 1967 (Friedman 1968) got most of the fame for the new development. Both were honoured with the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, Friedman in 1976, Phelps 30 years later. For lack of space, the discussion is limited to Friedman’s paper.Friedman’s Presidential Address had a critical purpose. It attacked two central policy tenets of Keynesianism. The first was the view that governments should press central banks to keep the interest rate as low as possible, a prescription that Keynes made in chapter 24 of the General Theory. In Friedman’s eyes such a policy cannot be sustained in the long term. His second target, the only one that we shall discuss, is the view that a trade-off exists between inflation and unemployment, that is, the idea that a government can durably decrease unemployment in a sustainable way by monetary activation. Such a trade-off requires a stable Phillips curve. Friedman readily admits that money supply has real effects in the short term. His claim is that no justification for a money creation policy ensues because these real effects only occur when the changes in money supply are unanticipated. To make his point, Friedman assumes a difference in perception between firms and workers. While firms’ expectations are correct, those of workers are mistaken. Friedman shows that in such a context an increase in money supply is non-neutral.
A displacement along the Phillips curve takes place. But this is only a short-run effect. In the next period of exchange, workers realise their earlier mistake, and integrate the rise in prices into their expectations. This triggers a displacement of the whole Phillips curve to the right. In order to maintain the rise in employment, the money supply needs to be increased at an accelerated rate, so that workers are fooled again. If this process continues, inflation is transformed into hyperinflation, a threat to the functioning of the monetary system, which compels the monetary authorities to abandon their expansionary policy. While the short-run Phillips curve is downwards sloping, in the long term it is vertical at a level of unemployment that Friedman dubbed the natural rate of unemployment, a terminology that became widely accepted. Friedman’s conclusion is that it is useless to try to reduce unemployment below its natural level. His recurrent plea for monetary rules is thereby reinforced. Managing the money supply is not a task that should be left to the discretion of the central bank authorities, and even less to that of Ministers of Finance. On the contrary, they should function under strict monetary rules.Friedman’s argument was shrewd because he based his attack on Keynesian theory on one of its pillars, the Phillips relation. Keynesians could have retorted that his case against monetary policy rested on a situation in which there was no rationale for engaging in it to begin with. However, such a view was only brought out much later, after the main debate had moved to other topics. Moreover, while Friedman’s argumentation was a mere sketch (and, for that matter, a rather sloppy one), the course of events, it has been widely claimed, verified its prediction. The emergence of the stagflation phenomenon (the joint existence of a high rate of inflation and a high rate of unemployment) came to be invoked as a quasi-real-world confirmation of the correctness of Friedman’s claim.
Friedman’s criticism of the Phillips curve was hardly a frontal attack on Keynesian macroeconomics. Unlike Lucas at a later date, Friedman had few qualms about Keynes’s method; time and again, he praised Keynes for having adopted the Marshallian method. Likewise, Friedman had no problems with the IS-LM model per se, his target being rather the policy conclusion that Keynesian authors drew from it. The difference between Keynesians and monetarists, Friedman claimed, was mainly empirical. His plea was that the classical sub-system of the IS-LM model, assuming wage flexibility, was the “good” model and not the Keynesian sub-system, assuming wage rigidity.
At this juncture, it ought to be remarked that at the time the “Keynesian” adjective designated two distinct objects: a conceptual apparatus, the IS-LM model, on the one hand and a vision of the functioning of the economy on the other (the view that, for all its virtues, the market economy can exhibit market failures, which state intervention, in particular demand stimulation, can remedy). So, one may speak of “Keynesianism in the methodological sense” and of “Keynesianism in the policy-viewpoint sense”. While Keynesian macroeconomics would be Keynesian on both scores, Friedman’s theory turned out to be a hybrid combination of methodological Keynesianism and an antiKeynesian policy standpoint.