Natural Rate Hypothesis and Adaptive Expectations

Natural Rate Hypothesis and Adaptive Expectations – Friedman’s View Regarding Phillips Curve

Another explanation of occurrence of a higher rate of inflation simultaneously with a higher rate of unemployment was given by Friedman. According to him, though there is a trade-off between rate of inflation and unemployment in the short run, means there exists a short run downward sloping Phillips curve, but it is not stable and it often shifts both leftward and rightward. He argued that there is no long run stable trade-off between rates of inflation and unemployment.

According to Friedman’s natural rate hypothesis thought there is trade-off between inflation and unemployment in the short run, in the long run economy comes back to be in stable equilibrium at the natural rate of unemployment. According to him, the long run Phillips curve is a vertical straight line. He argues that Keynesian expansionary fiscal and monetary policies are based on the wrong assumption that a stable Phillips curve exists result in increasing rate of inflation.

Natural Rate of Unemployment –

The natural rate of unemployment is the rate at which in the labour market the current number of unemployed is equal to the number of jobs available. These unemployed workers are not employed for the frictional and structural reasons, though the equivalent number of jobs are available to them.

For instance, due to lack of information or lack of mobility the fresh entrants to the labour force may spend a lot of time in searching for the jobs before they are able to find work. This is called frictional unemployment.

Besides, some industries may be registering a decline in their production rendering some workers unemployed, while others may be growing and creating new jobs for workers. But the unemployed workers may have to be provided new training and skills before they employed in the newly created jobs in the growing industries. These are structurally unemployed workers.

It is these frictional and structural unemployments that constitute the natural rate of unemployment.

Since the equivalent number of jobs are available for them, full employment is said to prevail even in the presence of this natural rate of unemployment. It is presently believed that 4 to 5 percent rate of unemployment represents a natural rate of unemployment in the developed countries. However, this natural rate of unemployment is not constant but varies over time due to changes in mobility and availability of information. If mobility of workers increases and quick information about new jobs are available frictional unemployment falls. If facilities for training unemployed workers and equipping them with new skills required for available jobs increases structural unemployment will decline.

Phillips Curve, Adaptive Expectations and Natural Rate Hypothesis –

It is important to note that expectations about the future rate of inflation plays an important role in the shift of the short run Phillips curve.

Friedman put forward a theory of adaptive expectations according to which people forms their expectations on the basis of previous period rate of inflation, and change or adapt their expectations only when the actual inflation turns out to be different from their expected rate.

According to this Friedman’s theory of adaptive expectations, there may be a trade-off between rates of inflation and unemployment in the short run, but there is no such trade-off in the long run.


In fig. 13.6,  SPC1 is the short run Phillips curve and the economy is at point A0, on it corresponding to the natural rate of unemployment equal to 5 percent of labour force. The location of this point A0 on the short run Phillips curve depends on the level of aggregate demand. Further, we assume that the economy has been experiencing a rate of inflation equal to 5 percent. The other assumption we make is that nominal wages have been set on the expectations that 5 percent of inflation will continue in the future.

Now, suppose the government adopts expansionary fiscal and monetary policies to raise aggregate demand. The consequent increase in aggregate demand will cause the rate of inflation to rise, say, to 7 percent. Given the level of money wage rate which was fixed on the basis that the 5 percent rate of inflation would continue to occur, the higher price level than expected would raise the profits of the firms which will induce the firms to increase their output and employ more labour. As a result of the increase in aggregate demand resulting in a higher rate of inflation and more output and employment, the economy will move to point A1 on the short run Phillips curve SPC1 in fig. 13.6, where unemployment has decreased to 3.5 percent while inflation rate has risen to 7 percent. In moving from A0 to A1, on SPC1 the economy accepts a higher rate of inflation as the cost of achieving a lower rate of unemployment. This is in conformity with the concept of Phillips curve explained.

However, the advocates of natural unemployment rate hypothesis interpret it in a slightly different way. They think that lower rate of unemployment achieved is only a temporary phenomenon. They think when the actual rate of inflation exceeds the one that is expected, unemployment rate will fall below the natural rate only in the short run. In the long run, natural rate of unemployment will be restored.