The term natural rate of unemployment was introduced by Milton Friedman in 1968, in his article “The Role of Monetary Policy”, following his presidential address delivered at the annual meeting of the American Economic Association, in 1967. It is based in Knut Wicksell’ concept of “natural” rate, which defines how there will be no permanent changes in the considered variable below or above its natural level.

The natural rate of unemployment defines the level at which unemployment will remain, no matter how great the effects of monetary policy. The only way to permanently keep unemployment under its natural rate is to resort to higher and higher inflation rates, which in turn would be highly hazardous for the economy. This can be easily understood using an expectations-augmented Phillips curve.

Even though the natural rate of unemployment is usually merged in the economic literature with the term NAIRU, there are a few differences between both terms. These differences are summarized in the following grid:

The expectations-augmented Phillips curve introduces adaptive expectations into the Phillips curve. These adaptive expectations, which date from Irving Fisher’s book “The Purchasing Power of Money”, 1911, were introduced into the Phillips curve by monetarists, specially Milton Friedman. Therefore, we could say that the expectations-augmented Phillips curve was first used to explain the monetarists’ view of the Phillips curve.

Adaptive expectations models led to an important shift in the perception of a government’s ability to act. Under Keynes’ money illusion, changes in nominal variables (prices, wages, etc…) were accepted by agents as real despite overall purchasing power remaining stable.

However, monetarism embraced the adaptive expectations theory to mean that people would stumble once or twice on the same stone, but not a third. In this way, if the government decided on an expansionist monetary policy, inflation would rise and unemployment would fall, based on the Phillips curve. However, a second or third time around, agents would be quick to associate higher inflation with rising salaries in a vicious circle, and adjust their behaviour accordingly based on past experiences. They would anticipate that inflation would drain their purchasing power accordingly, and monetary policy would have little effect. If we see this graphically:

Initially, unemployment and inflation are at point A. The government decides to embark on an expansionist monetary policy, which floods the markets with inexpensive credit, incentivising consumption. Expectations shift to point B along the Phillips curve: unemployment is reduced through economic stimulus with a trade off in the form of inflation. However, after a short period, agents will begin to associate expansionist policies with inflation, which means a drain on their resources, and they will push for higher wages. This will stop the consumption stimulus and also deincentivise hiring. Eventually, agents will shift their expectations curves to point C. A second time around, D will be achieved, leading more or less rapidly to point E. This is why, in the long term, inflation has little effect on unemployment and vice versa. Expansionist monetary policy will lead directly to inflation, with no permanent effect on unemployment.

In summary, monetarists sustained that the Phillips curve will hold up in the short term, but not in the long term. In the long term, the Phillips curve is completely vertical and determines the natural rate of unemployment, as Friedman puts it in his article “The role of Monetary Policy”, 1968.

Adaptive expectation models are ways of predicting an agent’s behaviour based on their past experiences and past expectations for that same event. They are first used by Irving Fisher in his book “The Purchasing Power of Money”, 1911, and further developed in the 1940s and 1950s, especially by Phillip Cagan in his article “The Monetary Dynamics of Hyper-Inflation”, 1956 and, most famously, by Milton Friedman in 1957, in his book “A Theory of the Consumption Function”.

Models are usually based around the following formula: 

E_t x_t+1 is our expectation (E) in year  for a variable x in the year t+1. It is based on our expectation from the year before (t-1) for variable x in our current year, and a weighted proportion of our past expectations. Remember that our expectations from last year were, in turn, based on those of the year before, so all our expectations from the first time we ever dared assume anything are contained within the equation.

λ will depend on how much we were off last year versus this year: if our predictions are proving to be volatile, we will be more likely to adjust them. It will also depend on how much groundbreaking new information we have received, rendering previous expectations useless. Basically, it depends on how much we feel we might have been off last year when we predicted things for next year.

The easiest way to know how adaptive expectations work, is to understand the expectations-augmented Phillips curve. Using also this same curve, it is also easy to understand how rational expectations work.

From the University of Chicago, and opposing Keynesianism, a number of contributions and doctrinal attitudes of authors can be identified, which turn back to neoclassical economics, are in favour of laissez faire and monetarism. Created around the 1940s, its main precursor is Milton Friedman, along with Frank H. Knight and Friedrich A. von Hayek, the latter acting as a liaison with the Austrian School.

The common view of the Chicago School focuses on the idea that governmental interventions should be at its minimum required, being deregulation the most desirable path. Another characteristic theory of the Chicago School is that the reduction or eradication of all types of regulation on business activities is beneficial for the economy as a whole. They support monetary policies when required by the economic environment, as they assume these to be more reliable and effective than fiscal policies.

The Chicago School based their assumptions on the concept of rational expectations. Milton Friedman defended that the price levels in a certain economy are always determined by the amount of money moving in circulation. According to the Chicago School, by acting and allocating resources in a rational way, people drive economic growth, while at the same time controlling price levels.

Milton Friedman, 1912-2006, was an American economist, Professor at the University of Chicago and main figure of the Chicago School. He was awarded the Nobel Prize of Economic Sciences in the year 1976 for his achievements in the fields of consumption analysis, monetary history and theory, and for his studies about the complexity and difficulty of economic stabilizer policies.

He was a great admirer of von Hayek and became one of the main challengers of Keynesian government policies, especially fiscal policy. He was a strong defender of free market and of monetary policy, having written numerous studies on this last topic.

In “A monetary History of the United States, 1867-1960”, 1963, Friedman together with Anna J. Schwartz, analyse the role of money in the business cycle, and argued about the effects of both monetary expansion and contraction. As Friedman said “inflation is always and everywhere a monetary phenomenon”.

Friedman, in his “The Role of Monetary Policy”, 1968, theorized about the existence of a natural rate of unemployment and stated that policies trying to decrease it would be unbeneficial for the economy and bring inflation with it. He foresighted the instability of the Phillips curve and predicted what was later known as stagflation.

Friedman became an economic adviser at the Ronald Reagan administration, and advocated for minimal government intervention.