Natural Rate of Unemployment

Transcription

1 This is a very first version of an incomplete paper. Please, do not quote from or cite this paper without the author s permission. Natural Rate of Unemployment Danilo Freitas Ramalho da Silva Center for the History of Political Economy Duke University November, dfr6@duke.edu or danilofrs@uol.com.br 1

2 1. Introduction This paper attempts to construct a narrative of the developments in macroeconomics in the postwar period through the debates about the so-called natural rate of unemployment. By doing so we can unravel different understandings macroeconomists had on how the overall economy works and thus the kinds of policy prescriptions they proposed, mainly related to unemployment. It will be shown that the term natural rate of unemployment is a product of the discussion established in the developed western countries, mainly in the U.S., in the decades following the Second World War, on the proper economic policies to deal with unemployment and inflation. More than this, the paper intends to track down the origins of the term and show that it synthesizes a concept that was already disseminated in the economic literature at that time - the ineffectiveness of the economic policy to peg the rate of unemployment - and had its momentum in the late 1960 s. The American political and economic environment of the 1960 s and 1970 s will be given a fundamental role in the explanation of this origin and of the further stabilization into the economic literature. As a stabilized concept, it will be argued that the natural rate of unemployment is a pivotal concept to differentiate three major theoretical macroeconomic frameworks: new classical, Keynesian and post-keynesian. Baring this in mind, it will become clear the economic policy prescriptions implied in each framework, regarding, mainly, unemployment. In his presidential lecture to the American Economic Association, in Washington, D.C., on December 19, 1967, while discussing the role of the monetary policy and, specifically, its limitations, Milton Friedman (1968) used the term natural 2

3 rate of unemployment in order to express the idea that the level of unemployment in a society could not be pegged by monetary policy, once it was a result of real economic forces only. In his own words, follows the definition of the natural rate of unemployment and the description of the real forces related to it: The natural rate of unemployment, in other words, is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility and so on [Friedman, 1968:8]. So, we can say that for Friedman the natural rate of unemployment is the outcome of imperfections, frictions and rigidities either in the labor or in the commodity market that prevent a Walrasian general equilibrium market-clearing position in the economy. As a consequence of such understanding, unemployment is nothing else but a non-market-clearing position in the labor market. It is already important to notice that Friedman was not a Walrasian (Hoover, 2003; De Vroey, 2004:76), so one could interpret his placement of the natural rate of unemployment into a Walrasian system of general equilibrium equations as a rhetorical instrument applied to the American Economic Association audience 1. Milton Friedman was not the only one working on the idea of a natural rate of unemployment, in the period. The same concept, without the natural rate of unemployment label was being developed, simultaneously and independently, by Edmund Phelps (1967, 1968). The basic idea of both authors, as mentioned before for Friedman (1968), was that economic policy could not be used to peg the rate of 1 The question why Friedman (1968) places the natural rate of unemployment in a Walrasian general equilibrium framework, despite his Marshallian approach to economics, will not be addressed in this study. Further discussion can be found in De Vroey (2001). 3

4 unemployment of the economy, at least in the long-run. Surely this was not a new idea in economics 2 and one can go further and say that it was not a dominant one in the U.S. academy and politics, at the time, too. In the 1960 s, unemployment was mainly diagnosed as an aggregate demand problem, not as an outcome of imperfections in the labor or commodity markets 3. More than this, policy-makers with straight connections to the academia were relying on demand-oriented prescriptions in order to conduct the economic policy (Sloan, 1985: 90). The theoretical framework that backed up this demand-oriented policies at that time was the Phillips curve - due to Phillips (1958) -, which established a trade-off between the rate of unemployment and the rate of change in money wage rates, as an addition to the IS-LM model of the neoclassical synthesis. Later, Samuelson and Solow (1960) modified this trade-off to be between the rate of unemployment and the rate of inflation, and this version became standard in the economics literature afterward. This framework paved the way for fine-tuning policies that aimed at exploiting this trade-off, as if the scatter diagram relating unemployment and inflation was a menu of combinations available for policymakers to choose. However, the inflation of the late 1960 s and the stagflation of the 1970 s that took place in the U.S. profoundly wounded this theoretical framework and its demandoriented policies, making room for competing macroeconomic theories and creating a favorable momentum for the adoption of the natural rate of unemployment hypothesis in alternative theoretical models. 2 See, for example, Simons (1936: 15). 3 According to the Economic Report of March 6, 1961, Some have attributed the growth of unemployment in recent years to changing characteristics of the labor force rather than to deficiencies in total demand Measures to improve the mobility of labor to jobs and jobs to labor are and should be high on the agenda for economic policy. But they are no substitute for fiscal, monetary and credit policies for economic recovery (Economic Report, 1961/1988: 30; emphasis added). 4

5 For instance, Hoover (1988: 27) cites the work of Lucas and Rapping (1969a) as the first paper that deserved to be called new classical, remarking the fact that it put Friedman s (1968) concept of the natural rate of employment in the center of the analysis. On the other hand, Tobin (1997) argues that the natural rate of unemployment could not be considered a feature of models with Keynesian inspiration; these models, instead, adopted the different idea of a non-accelerating inflation rate of unemployment (NAIRU) to deal with the inflation/unemployment question. Galbraith (1997) criticizes the use of both natural rate of unemployment and NAIRU concepts as a guide for economic policy, arguing that they neglect the positive impacts of demand stimuli on labor productivity and economic growth. As we can see, the natural rate of unemployment is a fundamental concept for post-war macroeconomics and to understand its meaning and its implications for economic policy, as much as the skepticism raised by its critics, one should investigate its origins, its stabilization into the macroeconomic framework and the shape it has assumed in the models nowadays. The second section of this paper is devoted to the search for the origin of the concept; the third deals with its penetration and spread in macroeconomics; the fourth section analyzes how it is currently understood and modeled; the last section concludes the paper. 2. Origins of the Natural Rate of Unemployment 2.1. Friedman Milton Friedman (1968) can be considered responsible for the baptism of the natural rate of unemployment, as claimed by himself, ten years later, in his Nobel Prize lecture: 5

6 The natural rate of unemployment, a term I introduced to parallel Knut Wicksell s natural rate of interest, is not a numerical constant but depends on real as opposed to monetary factors - the effectiveness of the labor market, the extent of competition or monopoly, the barriers or encouragements to working in various occupations, and so on [Friedman, 1977: 458]. But long before its baptism, the idea of a natural rate of unemployment was already present in Friedman s work, and we can surely track it down in his papers, books and speeches prior to the famous lecture of December, In April, 1966, for instance, Friedman (1966b: 60) talked about a natural level of unemployment, when discussing wage-price guideposts with Robert Solow in a conference held at the University of Chicago. The idea seemed incipient, but, definitely, was the same as the natural rate one, regarding its independence from monetary forces: In my opinion, there is what might be termed a natural level of unemployment in any society you can think of [ ] for any given labor market structure, there is some natural level of unemployment at which real wages would have a tendency to behave in accordance with productivity [ ]If you try, through monetary measures, to keep unemployment below this natural level, you are committed to a path of perpetual inflation at an ever-increasing rate [Friedman, 1966b: 60-61]. Just before this conference, in October 17, 1966, on Neewsweek, Friedman (1966c/1975: 60-61) had made a prediction about an inflationary recession that would take place in the U.S. in the following year: This prediction was an explicit confrontation to the New Economics policy of the Council of Economic Advisers and to the theoretical framework of the Phillips curve. Our record economic expansion will probably end sometime in the next year. If it does, prices will continue to rise while unemployment mounts. There will be an inflationary recession. Many will regard this prediction as a contradiction in terms, since it is widely believed that rising prices always go with expansion and falling prices with recession. Usually they do, but not always [Friedman, 1975:60-61]. 6

7 Another confrontation, this time implicit, to the Phillips curve theoretical framework and to the economic policy of the CEA had been made in Friedman s (1963/1968b) lecture in India, in 1963, on the causes and consequences of inflation. It is shown, again, the author s point of view that inflation is a monetary phenomenon and, thus, monetary policy would lead only to inflation: I did not say that full employment led to inflation. I said that a full employment policy led to inflation. That is quite a different thing. A full employment policy is likely to mean that you do not have full employment, because a full employment policy tends to be an open invitation to everybody to try to push up wage rates here, there, and elsewhere. The rises in wage rates lead to unemployment. In trying to counter the unemployment, the Government is likely to increase the money supply and this tends to produce inflation [Friedman, 1968b: 39]. Despite these previous references, Friedman (1968a) actually introduces the term natural rate of unemployment only in December, 1967, in his discussion about the ineffectiveness of the monetary policy in pegging the rate of unemployment for long periods, as said before. In the famous lecture, the author makes the analogy with the natural rate of interest, as proposed by Wicksell, saying that in the same way that monetary expansion could not lower interest rates, it could not lower unemployment rates as well. We can say that Friedman (1968a: 8) considers the natural rate of interest and the normal real wage as being, respectively, the long run price of capital and labor. So, in the same way as the natural rate of interest in the capital market, the normal real wage should be compatible with a position of no excess demand (or supply) in the labor and commodity markets, reaching, this way, a Walrasian market-clearing equilibrium position. If the monetary authority tried to peg the rate of unemployment below the natural rate by increasing the rate o monetary growth, it would be only temporarily successful, until the price level (and its anticipations) adjusted to the new monetary 7

8 growth, the real wage returned to the market-clearing value and the unemployment to its natural rate. The only way to keep the rate of unemployment below its natural value would be through continuous rise in the inflation rate. The interesting thing is that Friedman (1968a: 8) calls attention for the similarity between his idea on the natural rate of unemployment and the Phillips curve, meaning that the wages changes reflect pressures in the labor market. But Friedman (1968a) criticizes Phillips (1958) for mistakenly relating these pressures to changes in the nominal wages instead of real wages 4. This is, according to the author, the same mistake made by Wicksell, when analyzing the rate of interest: that of not distinguishing between real and nominal phenomena. And this is the strong argument that Friedman (1968a) uses to justify the ineffectiveness of the monetary policy to peg the rate of unemployment: monetary policy deals with nominal forces while the rate of unemployment is a real phenomena and should be determined, then, by real forces such as legal minimum wage rates, labor unions and imperfect information in the labor market. Following this argument and going against the ideas behind the Phillips curve, Friedman (1968a) sates that there is always a temporary trade-off between inflation and unemployment due to unexpected inflation what would, ultimately, imply continuous rise in the rate of inflation for the monetary policy to be effective - but there is no permanent trade-off at all, even under high inflation rates Phelps 4 Forder (2010) argues that although Phillips (1958) did not treat the real/nominal question properly, his followers were aware of the problem and immediately corrected it by adding the change in the price index as an explanatory variable to the change in money wages. 8

9 Together with Milton Friedman, Edmund Phelps is responsible for placing the idea of the natural rate of unemployment into the economics literature in the late 1960 s, although they have worked independently on it. Phelps (1967) proposes a macrodynamic model from which he derives an optimal time path for the aggregate employment. The model contains a Phillips curve representing the trade-off between inflation and unemployment, but it does not imply that the fiscal authority can choose a desired level of unemployment by controlling aggregate demand. On the contrary, the trade-off represented by the Phillips curve would be just a static relationship, in one particular point in time, and in a dynamic model the actual rate of unemployment would be homing in toward an equilibrium unemployment rate, determined by intertemporal utility maximization of individuals, choosing between consumption and leisure, in the labor market. So, as also proposed by Friedman (1968a), aggregate demand stimuli would just generate a higher inflation rate, without permanent effects to the rate of unemployment: The quantity u* measures the equilibrium unemployment ratio, for it is the unemployment rate at which the actual rate of inflation equals the expected rate of inflation so that the expected inflation rate remains unchanged [ ] The dynamical approach recognizes that any optimal timepath of the unemployment ratio must approach the steady-state equilibrium level, u*; perpetual maintenance of the unemployment ratio below that level (perpetual over-employment) would spell eventual hyper-inflation [ ] The policy trade-off is not a timeless one between permanently high unemployment and permanently high inflation, but a dynamic one: a more inflationary policy permits a transitory increase of the employment level in the present at the expense of a (permanently) higher inflation and higher interest rates in the future steady-state [Phelps, 1967: 255-6]. Two features of Phelps s (1967) model must be taken into account if one intends to track down the origins of his idea on the equilibrium unemployment ratio/natural rate of unemployment. The first is the dynamic aspect of his analysis and the second is the equilibrium approach embedded in it. The two ideas combined would imply the 9

10 ineffectiveness of economic policy to peg the rate of unemployment in the long run and, consequently, the existence of a natural/equilibrium rate of unemployment. As much as in Friedman (1968a), Phelps (1967) admits that a trade-off between inflation and unemployment might exist in the short-run, but not in the long-run; and also admits that the unemployment rate has a tendency to home in to a level that is determined by the real forces governing the labor and commodity markets. Roots of the dynamic aspect of his analysis can be found in his early work on fiscal policy and economic growth, in Phelps (1965: 103) actually cites the work of Ramsey (1928) on socially optimum growth when discussing the ethics behind taxation over generations. Phelps (1965) can be considered part of the literature on optimal economic growth that took place in the 1960 s and applied the mathematical tools used by Ramsey (1928) in trying to combine utility-maximizing agents and aggregate-level control (Duarte, 2009). This specific literature can be considered one of the unfoldings of the broader move in economics, from its interwar pluralism to a postwar neoclassicism (Morgan and Ruttherford 1998) through the mathematization of economics (Duarte 2009, Weintraub 2002). Nevertheless, it should be noted that the Ramsey-Cass-Koopmans model that emerged in the postwar period was different from Ramsey s [1928] original contribution (Duarte, 2009: 177). Anyway, it is the same Ramsey s (1928) apparatus that Phelps (1967: 264) uses to build his social utility function as the integral over time of the possibly discounted instantaneous rate of utility and to reach the conclusion that unemployment below the equilibrium rate, today, would just generate a higher inflation, in the future, while the rate of unemployment would go back the equilibrium/natural rate. 10

11 On the equilibrium approach to the unemployment problem, Phelps (1995: 16) gives credit to Abba Lerner (1949) and William Felner (1959) for introducing the idea of the neutrality of inflation to the equilibrium path of unemployment: Abba Lerner s (1949) work deals basically with the inflationary process; more specifically with its definition, the harms it may cause, its origins and possible remedies. According to the author, inflation is just excess of demand over supply and it is harmful because it disturbs the price system and, consequently, the efficient allocation of resources. But if inflation could be anticipated by the agents, no disturbances would arise at all and, this way, one could say that money would be neutral to the employment determination (Lerner, 1949: 194). William Fellner (1959) tried to formalize the concepts of demand and cost inflations and to investigate the role played by collective bargaining in the inflationary process. The author relates the existence of cost inflation to the monopoly power of either firms or unions which, eventually, have some degree of control over prices and wages; on the other hand, a pure demand driven inflation would take place in a competitive environment, without changes in the level of resource utilization (Fellner, 1959: 227). From this point of view, one can tell, then, that in a competitive environment aggregate demand is not able to influence the level of output and employment. It is interesting, however, to notice that, one year after the publication of his paper (Phelps 1967) on the equilibrium unemployment, Phelps (1968) introduces a slightly, but important, different concept of what should be understood as the natural rate of unemployment. In this 1968 paper, the author intends to study wage and price dynamics in an out of equilibrium framework where there is not Walrasian market- 11

12 clearing in the labor market at all, due to imperfect information by the agents, which implies that firms and workers incur in search costs. This friction prevents a homing in path for the rate of unemployment, although there is, indeed, an equilibrium rate of unemployment from which demand-driven deviations would cause rising inflation (or deflation). Recollecting about the differences and similarities between his ideas on the natural rate of unemployment and those of Friedman (1968), Phelps (1995: 15) says that: Modeling the natural rate idea led to two propositions. One of these was a conclusion from the model sketched in my 1968 paper (Phelps, 1968, part 2). Management of monetary demand cannot engineer an arbitrary unemployment rate other than the natural level without sooner or later generating a continuing disequilibrium manifested by rising inflation or mounting deflation - then collapse. [ ] The other proposition was implied by my 1967 paper (Phelps, 1967) and rather a similar thesis was forcefully argued by Milton Friedman in his 1968 paper (Friedman, 1968). Monetary policy can make a permanent difference only to nominal variables: a policy to generate a finite increase or decrease in the inflation rate will generate only a transient dip of the actual unemployment rate relative to the path it would otherwise have taken. In particular, the actual unemployment rate, though occasionally hit by such shocks, is constantly homing in on the natural rate. This last part equilibration makes this the stronger proposition of the two, as we could believe the former without having much faith in the homing in [Phelps, 1995:15]. In fact, Phelps s (1995) statement quoted above is not totally accurate when dealing with Friedman s (1968a) idea of the homing in to the natural rate of unemployment. Friedman (1968a: 10) indicates that the monetary policy can, indeed, maintain a rate of unemployment different from the natural one by raising inflation: As in the interest case, the market rate can be kept below the natural rate only by inflation. And as in the interest case, too, only by accelerating inflation. So, we can say that Phelps (1967) and Friedman (1968) imply the homing in to the natural rate of 12

13 unemployment unless there is unexpected inflation. Phelps (1968) is more concerned about the specificities of the labor market in an out of equilibrium framework Phillips curve and the menu of choice In order to better understand the development of the natural rate of unemployment hypothesis it is important to know what its advocates were trying to condemn or supplant. We can promptly say that the target was the Phillips curve framework, which was dominant at the time, in the American academy 6. This framework was embedded in the broader context of the debate over the post-war inflations from the 1940 s and 1950 s in the U. S., and the dispute between cost-push and demand-pull approaches (Wulwick, 1987: 838). Phillips (1958) original work was an attempt to explain the rate of change of money wage rates by the level of unemployment as well as by the rate o change of unemployment in the UK, between 1861 and The author specifies three different sources for the rate of change in the money wages: excess demand (supply) for labor, the rate of change of the demand for labor and the rate of change of retail prices. He analyzes the effect of the first two into the rate of change of money wage rate, controlling for the third and, thus, isolating demand-pull effects from the cost-push one. 5 The great economist Milton Friedman and I had to share the credit for injecting the notion of the natural rate into macroeconomics and showing how the economy can be blown off it s the natural path it has been following. Our additive efforts killed off the Phillips Curve and triggered the reformulation of monetary economics embodied in the subsequent New Keynesian literature, which I anticipated toward the end of my 1968 paper and which was developed at Columbia by Taylor, Calvo and myself in the second half of the 1970s *Phelps, 2005: According to Pearce and Hoover (1995: 205), the Phillips curve was rapidly incorporated into Samuelson s Economics in its fifth edition appendix (1961), as a menu for the society to choose in the inflation/unemployment trade-off. The first time it appeared in the main text was in its eight edition (1970), being kept in the appendix in the sixth (1964) and seventh (1967) editions. A quick search on JSTOR shows 85 results for Phillips curve, from 1958 to A more detailed search is needed. 13

14 According to the author, the results support the hypothesis that demand-pull effects (level of unemployment and rate of change of unemployment) determine the rate of change in money wages, except, in or immediately after those years in which there is a sufficiently rapid rise in import prices to offset the tendency for increasing productivity to reduce the cost of living (Phillips, 1958: 299). To conclude, Phillips (1958: 299) suggests that different levels of aggregate demand could peg different combinations of unemployment rates and rates of change of money wage rate. Following the work of Phillips (1958), Lipsey s (1960) paper is an attempt to develop the findings and conclusions of the former by (i) testing his hypothesis on the role of the unemployment rate and its rate of change in the determination of the rate of change in money wages, (ii) constructing a theoretical model for the behavior of this variables in a single commodity market and then expand it to the whole economy and (iii) analyzing specifically the post-1918 period, in the U. K.. The results of the tests show that there is, indeed, a significant relation between the rate of change of money wage rates and the level and rate of change of unemployment, as proposed by Phillips (1958). On the other hand, the model outlined by the author indicates the existence of problems with the relation between the rate of change of money wages and the level of unemployment if the last is maintained unchanged for a long time 7. Finally, the author makes an important warning, regarding the lack of theoretical explanation and independency tests to understand the high correlation between the money wage movement ( ) and the price level one ( ) (Lipsey, 1960: 301). This warning is because the price level movement ( ) increased its importance as an explanatory variable to changes in money wages ( ) in the years and 7 Desai (1975: 2) calls attention for the under-identification problem found in the estimation of Lipsey s (1960) model. 14

15 compared to the period before World War I (Lipsey, 1960: 26). At the same time, the rate of unemployment (U) lost importance in the determination of changes in the money wages, in the same period. All these findings led the author to conclude that the data and the model are compatible with versions of the cost-push inflation hypothesis, although Phillips (1958) used it as evidence in favor of the demand-pull inflation hypothesis. Bearing this in mind, Lipsey (1960: 32) sums-up his research by saying that: In my opinion it would be a serious mistake to try to judge between cost-push and demand-pull hypotheses solely, or even mainly, on the basis of the present paper although the material presented here is relevant evidence. The conclusions of this analysis would seem to be much more important for economic theory than for immediate policy issues [Lipsey, 1960: 32] One can say that the American version of the Phillips curve, that was developed by Samuelson and Solow (1960), was not very cautious about this last point made by Lipsey (1960). The authors related, in the first place, the rate of unemployment to the rate of change in the money wages and, after that, modified the original curve to relate the unemployment rate to the rate of inflation. This procedure is perfectly understandable since the authors were interested in analyzing anti-inflationary policies, within the debate between, basically, cost-push and demand-pull inflations, but, at the same time, is not a theoretically rigorous one. Samuelson and Solow (1960) found an inverse relation between the rate of unemployment and the rate of change in money wages, in the U.S., that was very similar to the relation found by Phillips (1958). The next step was the modification of the curve, plotting the unemployment rate against the rate of annual inflation, and emphatically presenting this relation as a menu of choices 15

16 between unemployment rate and price stability that policymakers could freely choose 8. As noted by Leeson (1997: 145): Midway through the monetarist decade, Robert Solow offered a reflection : I remember that Paul Samuelson asked me when we were looking at these diagrams for the first time, Does that look like a reversible relation to you? What he meant was Do you really think the economy can move back and forth along a curve like that? And I answered Yeah, I m inclined to believe it, and Paul said Me too. And thereby hangs a tale (Solow, 1979: 38) [Lesson, 1997: 145] The Political Economy Background The circumstances surrounding the advocacy of the Phillips curve trade-off as an instrument of economic policy are examined by Leeson (1997) through the debates in the American Economic Association meeting, in 1959, and in the work of Samuelson and Solow (1960). The broader background is the American election of 1960, involving the dispute between John F. Kennedy and Richard M. Nixon and the debate on unemployment and inflation. According to Leeson (1997: 129), Samuelson and Solow (1960) made explicit use of the Phillips curve as a weapon in the battle over economic policies, in the 1960 s U.S. election. Additionally they used it to demonstrate that an inflation rate of 4% to 5% would be necessary to keep the employment and output at high levels in the following years. This battle was against the Republican s antiinflationary policy and, also, against the left Keynesianism of Galbraith and the structuralists, who advocated explicit price controls. According to the author, the right Keynesians, that included Samuelson and Solow, co-opted the Phillips curve and transformed it into a menu of economic policy, as mentioned before. It was their 8 According to Laidler (1997: 93-4), Samuelson and Solow (1960) did not give any information about the sources of their data nor how about the estimations were made. More than this, Samuelson and Solow (1960: 193) refer to their menu of choice as simply our best guesses. 16

17 solution to deal with inflationary problems caused by high rates of employment without making use of price controls. Recollecting about the first years of the Kennedy administration, Solow and Tobin (1988) explain the predominant view of the Council of Economic Advisers, at that time, and the content of their Economic Reports 9, which used the Phillips curve as an instrument to deal with the inflation and the unemployment questions: The intellectual framework that led the Council in this direction is clear in retrospect and was quite clear then. We believed we were trying to shift favorably the level of the Phillips curve, by talking it down in the first instance and by informal intervention if necessary. Phillips curves appeared on the backs of our envelopes...since then there has been much debate about the meaning and validity of a trade-off between unemployment and inflation. The use made of this notion in the 1962 Economic Report has sometime been characterized as naïve. We do not think it was; but we may have banked too heavily on the stability of the Phillips curve indicated by postwar data through The Council s estimate in 1961 was that 4 percent unemployment was a reasonably safe interim target. We meant to state our belief that expansion of aggregate demand could return the economy to an unemployment rate of 4 percent last achieved in 1957 without much danger of wage-induced inflation. Since then, much research effort has gone into estimation of the natural rate of unemployment, a closely related but much more theory-laden concept. Some of that research suggests that 4 percent was too low a target unemployment rate in 1961, and some suggests that it was close to being right. We observe that the unemployment rate did indeed get down to 4 percent at the very end of 1965 without signs of labormarket strain and with negligible acceleration of inflation. It took the clear wartime excess demand of to set off a wage-price-wage spiral [Solow and Tobin, 1988: 15]. It is interesting to notice that Solow and Tobin (1988: 15) talk about the natural rate of unemployment to refer to the rate of unemployment that would be compatible with a negligible acceleration of inflation. As said before, this term was not used in the 9 The American Economy in 1961: Problems and Policies, Statement of the Council of Economic Advisers (Walter W. Heller, Chairman; Kermit Gordon; James Tobin) before the Joint Economic Committee, Monday, March 6, Economic Report of the President, January, 1962 The Annual Report of the Council of Economic Advisers,

18 early 1960 s but, apparently, it was so well diffused in the late 1980 s that the authors chose it instead of any other term. A natural candidate to be in the place of natural rate of unemployment would be the NAIRU (non-accelerating inflation rate of unemployment), which fits just right in the Phillips curve framework, as advocated by Tobin (1997: 12) himself: The NAIRU is the rate of unemployment that generates no change in the average wage change. At the NAIRU the excess-demand and excesssupply markets components of wage changes average to zero. Does this model imply that the long-run Phillips curve is vertical at the NAIRU, just as it is vertical at the natural rate in the Friedman-Phelps model? The answer is not always [Tobin, 1997:12]. In the spring of 1972, James Tobin had the opportunity to deliver lectures in Princeton University in which he recollected about his days in the Council of Economic Advisers, in the early 1960 s 10. These recollections had the aid of Walter Heller (former chairman of the Council) and one can see how inspired in the Phillips curve trade-off was the policy advocated 11 : The inflationary consequences of low employment were an even more serious blow to the reputation of the New Economics The facts of life pictured in the Phillips curve came as a shock. Had we economists failed to come clean? Perhaps, although the steepness of the Phillips curve below 4% unemployment was an unpleasant surprise to us as well. The 1962 Economic Report, in the course of explaining the 4% unemployment target, contains an extended discussion of the Phillips problem Maybe it would be healthy for the country to have an explicit public debate about which point on the Phillips trade-off we should aim for [Tobin, 1974: 37-9; emphasis added]. 10 The original lectures were edited and revised by Tobin and published in Forder (2010: 338-9) claims that the Council did not deployed the Phillips curve, at the time, in the Economic Reports, despite its expansionary policy and the concern about unemployment and inflation. Indeed, the words Phillips curve are not present in the 1961 and 1962 Economic Reports, nor even a diagram similar to Phillips s (1958) one. But one can definitely say, based on their own recollections, that the members of the Council were aware of an inflation/unemployment trade-off, which became known in the U.S. as Phillips curve, much because of the work of Samuelson and Solow (1960). 18

19 In the end of 1965, Gardner Ackley, who was the chairman of the Council of Economic Advisers at that time, also mentioned the Phillips curve when talking about the contribution of economists to policy formation: Four years ago, the Council set an interim target of 4 per cent unemployment. This reflected a rough judgment that 4 per cent is about where the Phillips curve really begins to bend (Ackley, 1966: 175). Cochrane (1975: 203) mentions the 1964 Economic Report when talking about the guideposts of the Johnson s years, saying that they were an attempt to avoid the Phillips-curve inflation-unemployment tradeoff. The author cites a passage of the chapter 4 of this report in which the idea of the Phillips curve trade-off is also clear: we would be forced once more into the dreary calculus of the appropriate trade-off between acceptable additional unemployment and acceptable inflation (Economic Report 1964, ch. 4: XX apud Cochrane, 1975: 203). The fact is that inflation in the U.S. was increasing throughout the 1960 s and by the end of the decade, many economists were aware that inflation was becoming a major problem, very much because of the governmental budget deficits caused by the Vietnam war, the rapid monetary expansion that began in the 1965 and the increase in federal spending for domestic programs (Leeson, 2000: 7). Apparently, the smooth waters of the first half of the 1960 s were becoming more dangerous to the American economy from 1966 on, as stated by Tobin (1974: 34): Through 1965, the management of the domestic economy under the New Economics was a great success, and was generally perceived as such Then things began to fall apart. The Vietnam War and the refusal to accept the tax increase proposed by the Council of Economic Advisers were considered by the American policy-makers at the time as the great villain of the New Economics fine tuning, responsible for the 19

20 acceleration of inflation in the period, as we can see, again, from the recollections of two former members of the Council, James Tobin and Robert Solow: Evidently the Pentagon did not tell the Council, Budget Bureau, and Treasury how rapidly it was letting contracts in 1965 and spending money in Evidently the Council nevertheless advised President Johnson to recommend a tax increase in the January 1966 budget and economic messages, and the advice was rejected [Tobin, 1974: 35]. The point at which policy went wrong was with the financing of the Vietnam War about I regard the economic profession as blameless for that; records will show that Okun and Ackley, who were Johnson s economic advisors, warned him of the inflationary consequences of his policies [Solow, 1984: 135]. Inflation and Unemployment in the U. S. (%) Unemployment Inflation Source: U. S. Bureau of Labor Statistics This was the context in which Friedman and Phelps were developing their ideas on what became known as the natural rate of unemployment. The never ending debate over the right economic policy to deal with inflation and unemployment, which had been backed up by the Phillips curve apparatus in the 1960 s, in the U.S., would gain a new concept, surely based on old ideas, that would enter the economic literature and make room for new theories. 20

21 3. Stabilizing the Natural Rate If we take into account the stagflation that took place in the U.S. in the 1970 s, one can think of Friedman s lecture, in the end of 1967, and the Phelps s models, by the same time, as anticipations of the facts or, also powerfully, as an accurate prediction of the deleterious effects of demand expansion policies. Friedman formulated his model of the augmented Phillips curve with Natural-Rate expectations in the beginning of the 1960 s, although the written version of it only appeared in April, 1966 (Friedman, 1966a, 1966b; Leeson, 2000, ch. 4: 1); Phelps s papers were published in 1967 and Surely, the confirmation of their predictions, in the 1970 s, gave the idea of a long run vertical Phillips curve and of the existence of a natural rate of unemployment a major status in the macroeconomic theoretical framework. Lesson (2000, ch. 4: 5) attributes the success of Friedman s natural rate of unemployment and of his Natural Rate Expectations Augmented Phillips curve model to the fact that it presented an alternative theory to confront the Keynesian Phillips curve, something that many other authors were not able to do. I would add that not only it presented an alternative theory but it presented a theory that was perfectly compatible with the Walrasian general equilibrium framework, which was a strong component of the core of the science - the neoclassical/keynesian synthesis. What the neoclassical/keynesian synthesis tried to do, by merging the Walrasian general equilibrium model with the Keynesian macroeconomics, could be done in a smoother way replacing the Keynesian macroeconomics of involuntary unemployment by the system of Walrasian equations that implied a natural rate of unemployment and no involuntary unemployment at all. 21

22 Natural Rate of Unemployment in economic journals, from 1968 to 2009: Journals Freq. AEReview 112 JPKE 76 Brookings Papers 75 EJ 70 Journal of Money Credit and Bank 61 Economica 44 Oxford Economic Papers 44 The Review of Economics and Stats 42 Southern EJ 41 JPE 37 Scandinavian Journal of Economics 36 CJE 35 QJE 33 Journal of Economic Perspectives 33 Journal of Economic Issues 31 Canadian Journal of Economics 30 Others 356 Total Natural Rate of Unemployment in journals NRU

23 It is interesting to notice that although Friedman invoked the Walrasian general equilibrium to define the natural rate of unemployment in his 1968 article, his method of analysis was Marsahallian and not Walrasian at all. De Vroey (2004: 76) claims that despite his normative anti-keynesianism approach, Friedman did not reject the method Keynes used to build his theory of unemployment, nor did he deny the IS-LM model to expose his theoretical perspective or the Phillips curve apparatus to make his expectations-augmented argument. Hoover (2003) and Solow (1984: 35) also note this confluence of approaches between Friedman (and the monetarists) and the Keynesians. Despite this methodological controversy, one can say that Friedman (1968) and Phleps (1967, 1968) paved the way for the emergence of a theoretical framework that, indeed, employed the Walrasian general equilibrium approach to analyze the labor market and the economic system as a whole, making the natural rate of unemployment one of its cornerstones: the new classical macroeconomics The New Classical Macroeconomics According to Hoover (1988: 27), Lucas and Rapping s (1969a) analysis of the American aggregate labor market is the first paper that can be considered new classical because it treats the equilibrium unemployment implicit in Friedman s (1968a) natural rate hypothesis in a framework that unifies the short-run and long-run analysis. Lucas and Rapping (1969a) intends to reconcile the apparently contradiction of a short-run elastic supply of labor with a long-run inelastic one by building a model that describes completely the transition from short-run equilibrium to long-run equilibrium in the labor market. More than this, the authors attempt to understand the correlation between unemployment and inflation, namely, the Phillips curve, in a purely supply- 23

24 demand framework, in spite of other explanations such as collective bargaining. Lucas (1984) explains how this idea appeared and how it was developed with the help of Rapping: The labor part of macroeconomic models, in those days, was pretty disgraceful Rapping and I knew some labor economics, and it s hard to get up in front of a class and talk nonsense deliberately. So we were trying to cook up simple supply and demand models which would fit what you see happening over business cycles. We got interested enough in that so that we thought we d pursue it as a research topic.in the tradition of Friedmand and Lewis it is hard to think about labor markets without supply and demand. You have to tell how wages and employment arise from certain from shifts in supply and demand curves We were really developing a supply and demand model for employment and wages. Unemployment gets tacked on a side story. We introduced a Phillips curve to make contact with macroeconomic stuff. We wanted to make sure that the labor supply piece didn t assume away business fluctuations [Lucas, 1984: 35-36]. To achieve these goals, the model the authors proposed assumes that the labor market is always in short-run equilibrium, as a result of individual utility maximization (which determines the supply of labor) and firms marginal productivity condition for labor (which determines the demand for labor). The transition to the long-run equilibrium is made through an adaptive scheme by which the agents form their expectations about future prices based on previous prices. So, in the long-run, when future prices are, eventually, equal to actual prices, short-run equilibrium is equal to long-run equilibrium. It is no surprise that Lucas and Rapping s (1969a) conclusion is the same as Friedman s (1968) and Phleps s (1967) one, that the trade-off between inflation and unemployment is just a short-run phenomenon and that, eventually, the rate of unemployment reaches a long-run equilibrium position, free from the money illusion caused by frustrated expectations on prices. It appears that a policy designed to sustain an inflation can temporarily reduce unemployment, but unless the higher rate of increase in prices can be permanently maintained a subsequent attempt to return to the 24

25 original rate of inflation will result in an offset to the initial employment gains [Lucas and Rapping, 1969a: 739]. In an immediate following paper, Lucas and Rapping (1969b) test their adaptive expectations Phillips curve for the period between 1904 and 1965, in the U. S.. Lucas was clearly frustrated with the results of the tests and especially with the adaptive expectations used in it, that implied the persistence of previous expectations into present expectations, as we can see in his answer letter 12 to Rapping on 8 July, : I guess I am now convinced that our original results (with lagged prices and unemployment) don t mean anything except possibly as part of a general argument to the effect that estimating Phillips curve is more complex than is generally recognized. The newest results indicate that trying to account for effects on unemployment other than expectations simply by postulating serial correlation doesn t mean much either. This would seem to me to add urgency to the search for a model which incorporates sources of persistence in unemployment other than the persistence of expectations. Despite Lucas s frustration with the results I never liked the paper. It doesn t have any results in it (Lucas, 1984: 37) -, the authors are even more emphatic about the inexistence of the long-run trade-off between inflation and unemployment and about the ineffectiveness of the Phillips curve as an instrument of economic policy: First, it is clear that the existence of a short-run Phillips curve is consistent (in practice as well as in principle) with the absence of a long-run inflation-unemployment trade-off. Second, the expectations view as we have developed it appears to have promise in the sense that the additional explanatory variables it suggests are frequently (though by no means uniformly) significant. Third, and most important, statistical Phillips curves are highly unstable over time, and this instability is far too serious to be dismissed by a vacuous reference to structural change in either 1929 or Until the variables which are shifting these curves can be identified, and verified as important by testing over the entire period, we see no 12 Lucas Papers, Box 1, file folder Rapping had written to Lucas before saying that he thought it was possible, as you suggested, to rationalize the presence of a lagged unemployment in our Phillips curve in terms of the search process (Lucas Papers, Box 1, file folder 1968 ). 25

26 alternative to the conclusion that empirical Phillips curves (ours included) are a weak foundation on which to base policy decision [Lucas and Rapping, 1969b: 349]. Nevertheless, Lucas was not really happy with the adaptive expectations used in his papers with Rapping, because it led to systematic errors in worker`s expectations on future wages. This kind of behavior generated a never ending disequilibrium path in the labor market opposing to the idea of a natural rate of unemployment (Hoover, 1988: 28). Lucas (1972a, b) introduced, then, Muth`s (1961) idea of rational expectations into its model of the labor market in order to solve this problem and avoid systematic errors by the workers. Not only systematic errors would be avoided but also the shortrun/long-run dichotomy would lose its significance due to the merge of their logical meanings. In Lucas s (1972b) econometric testing of the natural rate of unemployment hypothesis, the author shows how under the assumption of an adaptive expectation schema, price forecasts could be biased and both short-run and long-run Phillips-like trade-offs between inflation and real output (p. 95) would be necessarily allowed. On the other hand, the assumption of rational expectations, meaning that actual and future price expectations are the same, would imply the existence of the natural rate of unemployment. Following the same line, Lucas (1972a) argues that if one knows the true probability distribution of next period s price (p. 110), the long-run prices are short-run prices simultaneously and an incidental nominal shock, as a monetary expansion, for example, has just a transitory effect. In this way, one could advocate the ineffectiveness of the monetary policy to generate deviations from the natural rate of unemployment, as Friedman (1968) did, without appealing to the concept of a mysterious, never reachable 26