Natural Rate Theory

Overview of The Natural Rate Theory

Early Keynesians believed in setting nominal wages and prices respectively and not taking into account inflationary expectations. New Classical revisionists believe in setting real wages and prices with fully incorporating inflationary expectations. This new classical behavior results in a long-run neutrality which will limit the affect on unemployment and output. What happens when price and wage setters only care about relative wages and prices? If unemployment is below the natural rate, accelerating inflation will occur. In contrast, if unemployment is above the natural rate, accelerating deflation will occur.

The dynamics of inflation

If unemployment is below the natural rate this will cause…

• Demand for goods and for labor to increase
• Firms will decide to charge higher prices than others
• This will cause actual inflation to exceed expected. This gap will cause a further reaction
• Expectations are adjusted upwards and inflation rises higher still. Inflation is ever increasing

The acceptance of the natural rate theory

The question Akerlof asks is if the wages and prices set are a realistic view of employers and consumers preferences? In other words do employers and consumers think the wages and prices should or should not be set? Most macroeconomists believe that the natural rate theory is a description of reality. The fundamental assumption of the natural rate theory is that the economy only cares about the real outcome. The natural rate theory is also not sensitive to changes from the perfect competitive model.

Phillips Curve

The Phillips Curve pre 1970s. The curve was derived from about 100 years of data and from this data showed a fit between the rate of change of nominal wages and inverse of the unemployment rate. Before the 1970s a steady decline in unemployment in the U.S. resulted in a steady increase in inflation.

The Phillips Curve post 1970s. In the 1970s wage inflation and unemployment rate rose. Natural Rate Theory helped explain this occurance, the rise in inflation was due to oil shocks and increase inflationary expectations. This shifted the Phillips Curve outwards and from this economists created the modified/accelerationist Phillips Curve. After the 70s the Phillips curve shows a negative relationship between the unemployment rate and the change in the inflation rate. A low unemployment rate leads to an increase in the inflation rate and an increase in price.

Inconsistencies in the Natural Rate Theory

Nominal considerations AFFECT wage setting

1. Nominal wage rigidity. Money wages are downwardly rigid because many wages and prices are set in nominal terms for some time and are not readjusted when there is a change in policy. There is no way to account for nominal rigidity with the present model for natural rate because of the assumption that people in the economy only care about real prices and wages.

2. Different perspective of money wage rigidity. Thomas Bewley researched firms and discovered that employers are reluctant to cut wages because of the negative effect on morale. Workers would shirk and in some cases most likely quit. Once again this worker and employer behavior fails to conform to the natural rate theory assumptions. Workers are not only thinking about their wages relative to price level and to wages received by others but dislike cuts to their wages below the nominal levels.

3. The Great Depression. The new Phillips Curve (accelerationist) would say that during the time of the Great Depression from 1930 to 1940 inflation should have been below the inflationary expectations. “The data revealed no evidence whatsoever in any country of constantly declining inflation, even under conditions of massive unemployment”. “Sticky-money” wage model explains the occurrences during the Great Depression. Employers are still reluctant to cut wages in fear that they will lose workers.

4. Wage bargains are not made with only real considerations in mind.

• In 1997, Shafir, Diamond, and Tversky conducted a survey wherein participants were asked to comment on the case of two women who begin their first jobs at the same starting salary. Respondents were asked who will be better off: Barbara, who receives a five percent raise in the face of four percent inflation; or Ann who receives a two percent raise in the face of zero inflation. 79 percent of respondents indicated Barbara would be in a worse state than Ann economically. However, 64 percent indicated that Barbara would be happier. This contradicts the assumption of natural rate theory that workers are only concerned with real outcomes.

• In support of this argument, Robert Shiller found that 49 percent of the general public fully or weakly agreed with the statement: “if my pay went up I would feel more satisfaction in my job, more sense of fulfillment, even if prices went up as much.” In contrast, 90 percent of economists weakly or strongly disagreed.

• This discrepancy highlights the lack of concordance between economists and the public with regard to real outcomes. Economists believe people should be only concerned with their real wages; however, these examples demonstrate that this is not the case and weakens the appeal of natural rate theory.

5. The absence of wage indexation in union contracts.

• Natural rate theorists contend that throughout the bargaining process, agents first agree upon a real wage in current prices and then add inflationary expectations. From this theory, it would follow that "firms and workers with risk aversion will both have their welfare improved by contracts with wages indexed to inflation" (Akerlof 34).

• On the contrary, studies have shown that the majority of contracts are incompletely indexed. Christofides and Peng (2004) examined a sample of 12,000 Canadian union contracts from 1976 to 2000, which had a mean length of 25 months. Only 19 percent of these contracts were indexed. In addition, only 58 percent of these contracts fully covered price increases.

• This points to another anomaly of wage indexation. In many contracts, wages are only adjusted if inflation passes a certain trigger level. This provision does not seem to follow from the fact that agents are solely concerned with real variables.

6. Not all Phillips Curve estimates produce coefficients of unity on lagged inflation.

• William Brainard and George Perry made estimates of Phillips Curves wherein the lag coefficients did not some to unity, as natural rate theory would predict.

• Economists have uncovered systematic differences between times when the coefficients sum to unity and times when the sum of lag coefficients is considerably less than one. William Dickens, George Perry, and George Akerlof (2000) estimated Phillips Curves in the US during high and low inflationary periods. They discovered that in high inflationary periods, the sum of coefficients on lagged inflation in wage and price equations approaches one. In contrast, in low inflationary periods, the sum on wage equations is close to zero and the sum on price equations in greater than zero but considerably less than one.

• Estimates of Phillips Curves with direct measures of expectations generate similar results wherein the sum of lagged inflation in wage equations averages .3 and sum in price equations averages .6.

• "These findings question the universality of Phillips Curves with coefficients of one on proxies for expected inflation."

Resolution with Economic Theory

• The aforementioned findings shed doubt upon the ability of natural rate theory to describe economic reality. Yet all of these anomalies can be explained if one considers the implications of norms on the behavior of economic agents.

• Employees are concerned with both nominal and real aspects of their wages. "In each and every case, they have a notion of what their nominal, and not just their real wage, should be" (Akerlof 37). This can be captured by utility maximization theory insofar as agents lose utility when there is a gap between what they perceive their nominal wages should be and what they actually are. The incorporation of these concerns into workers' utility functions succeeds in explaining each of the six anomalies.

• Regarding nominal wage rigidity, "a belief that workers should not take wage cuts is sufficient to explain downward nominal wage rigidity...and the asymmetric agglomeration of wages cuts precisely at zero" (Akerlof 37). Brewley discovered that firms have a tendency not to reduce wages during recessions, because they fear workers will become alienated if their money wages are lowered. This seems to account for the tendency of wages and prices not to decline during the Great Depression.

• Let's return to the case of Barbara and Ann. Incorporating a nominal component into each agent's utility function serves to theoretically account for the finding that respondents felt Barbara would be happier than Ann, while simultaneously worse off economically. When these agents' utility functions include nominal considerations, it follows that Barbara might, indeed, be happier than Ann if she receives a higher wage increase, despite the fact that Ann's real income has increased more than Barbara's. This way of conceptualizing agents' utility functions also accounts for Schiller's finding: "If people think that they should receive a nominal raise and they do receive it...they will be happier if their wages go up and prices go up as much" (Akerlof 38).

• Incomplete wage indexation can be explained in a similar manner. Failure to index until inflation hits a certain trigger points to workers' concern for nominal considerations. Workers will begin to feel they should receive wage increases when inflation reaches a certain point, which could roughly be construed as when inflation hits the trigger.

• This also serves to theoretically account for the instance in which workers tend to ignore inflationary expectations when inflation is low and to consider them when inflation is high.

Consequences of Nominal Considerations

• "It is well-known that downward nominal wage rigidity will induce a long-run tradeoff between inflation and unemployment, contrary to natural rate theory" (Akerlof 38). This permits for the simultaneous instance of higher long-run inflation and lower long-run unemployment.

• In cases where there is a low coefficient on inflationary expectations in Phillips Curves, a long run trade-off between inflation and unemployment emerges.

High Inflation

• In high inflationary environments, agents' psychological reactions to wage increases that are exactly proportional to increases in inflation are likely to be very different from agents' reactions in low inflationary environments.

• Contrary to Shiller's questionnaires, in high inflationary environments, agents may feel worse off if they receive wage increases that exactly match inflation.

Prices

• Long-run trade-offs between inflation and unemployment can also occur as a result of customers' views of what nominal prices should be.

• Iawi (1981), Rotemberg (1982), and Caplin and Leahy (1991) devised models positing real costs to nominal price changes. There are "menu" costs to inform the public of nominal price changes. Additionally, insofar as consumers feel firms should not raise prices, higher nominal inflation will act to increase consumers' elasticities of product demand, lowering firm mark-ups, and reducing equilibrium unemployment.

• Evidence suggests firms are not fond of instituting price changes in consumer markets. Kackmeister compared price changes at the conclusion of the 19th century to price changes at the conclusion of the 20th century. He discovered that, in the 19th century, when consumer-firm relations were more personal, price spells lasted an average of 80 months. He attributed the greater frequency of price changes today to the decline in long-term customer relationships.

• Nakamura and Steinsson posited a reason for consumers' feeling that firms should not change prices. Consumer purchases are habit-forming and consumers' tendency to frequent a particular store puts them in a situation where they may be exploited. Firms make an implicit contract with consumers wherein they will not change their prices without justification. This implicit contract is easier to make in nominal terms.

Summary

• In conclusion, there is a sizable body of evidence, contradicting the assumptions and predicted outcomes of natural rate theory.

• Evidence suggests that agents are more sensitive to nominal than to real concerns, which can be explained by the introduction of norm theory.

• Despite the fact the agents do consider inflationary expectations, there will be long-run trade-offs between inflation and unemployment.

• The inclusion of norms in utility functions nullifies the notion of a natural rate of unemployment where inflation neither steadily increases nor decreases.

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